SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September, 30, 2003
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OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission file number 0-17706
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QNB Corp.
(Exact Name of Registrant as Specified in Its Charter)
Pennsylvania 23-2318082
- ------------------------------- ------------------------------------
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
15 North Third Street, Quakertown, PA 18951-9005
- -------------------------------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (215)538-5600
----------------------------
Not Applicable
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Former Name, Former Address and Former Fiscal Year, if Changed Since
Last Report.
Indicate by check |X| 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
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes No |X|
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Outstanding at November 12, 2003
Common Stock, par value $.625 3,093,722
QNB CORP. AND SUBSIDIARY
FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2003
INDEX
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (Unaudited) PAGE
Consolidated Statements of Income for Three and
Nine Months Ended September 30, 2003 and 2002.....................1
Consolidated Balance Sheets at September 30, 2003
and December 31, 2002.............................................2
Consolidated Statements of Cash Flows for Nine
Months Ended September 30, 2003 and 2002..........................3
Notes to Consolidated Financial Statements............................4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF
OPERATIONS AND FINANCIAL CONDITION.....................10
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT
MARKET RISK 31
ITEM 4. CONTROLS AND PROCEDURES..............................................31
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS....................................................32
ITEM 2. CHANGES IN SECURITIES................................................32
ITEM 3. DEFAULTS UPON SENIOR SECURITIES......................................32
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITIES HOLDERS...............32
ITEM 5. OTHER INFORMATION....................................................32
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.....................................32
SIGNATURES
CERTIFICATIONS
QNB Corp. and Subsidiary
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except share data)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
Interest Income
Interest and fees on loans $ 3,612 $ 3,755 $ 10,960 $ 11,195
Interest and dividends on investment securities:
Taxable................................................................ 2,095 2,590 6,322 7,888
Tax-exempt ............................................................ 515 508 1,561 1,458
Interest on Federal funds sold.................................................. 36 46 112 125
Interest on interest-bearing balances........................................... 2 1 4 4
Other interest income........................................................... 1 - 1 -
Total interest income........................................................... 6,261 6,900 18,960 20,670
----- ----- ------ ------
Interest Expense
Interest on deposits
Interest-bearing demand accounts ...................................... 136 108 374 265
Money market accounts.................................................. 60 140 225 430
Savings ............................................................... 66 131 273 377
Time .................................................................. 1,127 1,461 3,444 4,563
Time over $100,000 .................................................... 265 388 830 1,288
Interest on short-term borrowings .............................................. 26 63 79 203
Interest on Federal Home Loan Bank advances .................................... 725 735 2,156 2,173
Total interest expense ................................................ 2,405 3,026 7,381 9,299
----- ----- ----- -----
Net interest income ................................................... 3,856 3,874 11,579 11,371
Provision for loan losses ...................................................... - - - -
Net interest income after provision for loan losses ............................ 3,856 3,874 11,579 11,371
----- ----- ------ ------
Non-Interest Income
Fees for services to customers ................................................. 496 433 1,371 1,172
ATM and debit card income ...................................................... 134 132 416 369
Income on cash surrender value of insurance .................................... 74 87 229 245
Mortgage servicing (income) loss ............................................... 84 22 (21) 58
Net (loss) gain on investment securities available-for-sale .................... (73) (418) 229 (577)
Net gain on sale of loans ...................................................... 3 120 853 342
Other operating income ......................................................... 220 149 525 359
Total non-interest income ............................................. 938 525 3,602 1,968
--- --- ----- -----
Non-Interest Expense
Salaries and employee benefits ................................................. 1,858 1,565 5,465 4,738
Net occupancy expense .......................................................... 217 216 642 622
Furniture and equipment expense ................................................ 265 255 804 734
Marketing expense .............................................................. 153 114 368 375
Third party services ........................................................... 184 161 543 440
Telephone, postage and supplies expense ........................................ 138 131 401 399
State taxes .................................................................... 85 81 260 255
Other expense .................................................................. 364 338 1,062 978
--- --- ----- ---
Total non-interest expense ............................................ 3,264 2,861 9,545 8,541
----- ----- ----- -----
Income before income taxes ............................................ 1,530 1,538 5,636 4,798
Provision for income taxes ..................................................... 118 282 1,063 913
--- --- ----- ---
Net Income ..................................................................... $ 1,412 $ 1,256 $ 4,573 $ 3,885
======= ======= ======= =======
Net Income Per Share - Basic ................................................... $ .46 $ .41 $ 1.48 $ 1.26
===== ===== ====== ======
Net Income Per Share - Diluted ................................................. $ .45 $ .40 $ 1.46 $ 1.25
===== ===== ====== ======
Cash Dividends Per Share ....................................................... $ .165 $ .15 $ .495 $45
====== ===== ====== ===
The accompanying notes are an integral part of the consolidated financial
statements.
QNB Corp. and Subsidiary
CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)
September 30, December 31,
2003 2002
Assets
Cash and due from banks ......................................................................... $ 19,430 $ 17,476
Federal funds sold .............................................................................. 7,196 10,001
----- ------
Total cash and cash equivalents ........................................................ 26,626 27,477
Investment securities
Available-for-sale (cost $265,705 and $209,217) ........................................ 270,181 214,741
Held-to-maturity (market value $15,081 and $30,386) .................................... 14,657 29,736
Loans held-for-sale ............................................................................. 889 4,159
Total loans, net of unearned income of $181 and $263 ............................................ 229,681 212,691
Allowance for loan losses .............................................................. (2,935) (2,938)
Net loans ....................................................................................... 226,746 209,753
Cash surrender value of insurance ............................................................... 7,485 7,397
Premises and equipment, net ..................................................................... 5,179 5,497
Accrued interest receivable ..................................................................... 2,477 2,710
Other assets .................................................................................... 2,638 1,960
----- -----
Total assets .................................................................................... $ 556,878 $ 503,430
--------- ---------
Liabilities
Deposits
Demand, non-interest-bearing ........................................................... $ 50,411 $ 47,079
Interest-bearing demand accounts ....................................................... 105,181 70,478
Money market accounts .................................................................. 38,594 39,341
Savings ................................................................................ 51,348 45,338
Time ................................................................................... 154,143 145,849
Time over $100,000 ..................................................................... 46,171 40,828
------ ------
Total deposits .................................................................................. 445,848 388,913
Short-term borrowings ........................................................................... 8,931 14,485
Federal Home Loan Bank advances ................................................................. 55,000 55,000
Accrued interest payable ........................................................................ 1,366 1,555
Other liabilities ............................................................................... 2,317 2,563
----- -----
Total liabilities ............................................................................... 513,462 462,516
------- -------
Commitments and contingencies
Shareholders' Equity
Common stock, par value $.625 per share;
authorized 10,000,000 shares; 3,200,408 shares and 3,188,280 shares issued;
3,093,722 and 3,081,594 shares outstanding ................................................... 2,000 1,993
Surplus 8,861 8,759
Retained earnings ............................................................................... 31,095 28,053
Accumulated other comprehensive gain, net ....................................................... 2,954 3,603
Treasury stock, at cost; 106,686 shares at September 30, 2003 and December 31, 2002 ............. (1,494) (1,494)
------- -------
Total shareholders' equity ...................................................................... 43,416 40,914
------ ------
Total liabilities and shareholders' equity ...................................................... $ 556,878 $ 503,430
========= =========
The accompanying notes are an integral part of the consolidated financial
statements.
QNB Corp. and Subsidiary
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Nine Months Ended September 30, 2003 2002
Operating Activities
Net income ............................................................................. $ 4,573 $ 3,885
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization ..................................................... 632 578
Securities (gains) losses ......................................................... (229) 577
Net gain on sale of loans ......................................................... (853) (342)
Loss on disposal of premises with equipment ....................................... 9 -
Proceeds from sales of residential mortgages ...................................... 39,534 13,477
Originations of residential mortgages held-for-sale ............................... (36,358) (13,711)
Proceeds from sales of student loans .............................................. 402 1,846
Originations of student loans ..................................................... (160) (1,113)
Income on cash surrender value of insurance ....................................... (225) (245)
Life insurance proceeds/premiums net .............................................. 141 (18)
Deferred income tax provision ..................................................... 71 (113)
Change in income taxes payable .................................................... (310) 58
Net decrease (increase) in interest receivable .................................... 233 (29)
Net amortization of premiums and discounts ........................................ 1,136 446
Net decrease in interest payable .................................................. (189) (305)
Increase in other assets .......................................................... (248) (107)
Increase (decrease) in other liabilities .......................................... 82 (1,352)
Net cash provided by operating activities ......................................... 8,237 3,532
----- -----
Investing Activities
Proceeds from maturities and calls of investment securities
available-for-sale ................................................................ 72,235 41,890
held-to-maturity .................................................................. 15,063 12,190
Proceeds from sales of investment securities
available-for-sale ................................................................ 38,303 4,585
Purchase of investment securities
available-for-sale ................................................................ (167,709) (88,151)
held-to-maturity .................................................................. - (5,955)
Net increase in loans .................................................................. (16,616) (8,160)
Net purchases of premises and equipment ................................................ (323) (468)
------ -----
Net cash used by investing activities ............................................. (59,047) (44,069)
-------- --------
Financing Activities
Net increase in non-interest-bearing deposits .......................................... 3,332 7,384
Net increase in interest-bearing deposits .............................................. 53,603 33,424
Net (decrease) increase in short-term borrowings ....................................... (5,554 ) 6,436
Proceeds from Federal Home Loan Bank advances .......................................... - 2,000
Cash dividends paid .................................................................... (1,531) (1,385)
Proceeds from issuance of common stock ................................................. 109 59
Net cash provided by financing activities .............................................. 49,959 47,918
(Decrease) increase in cash and cash equivalents ................................. (851 ) 7,381
Cash and cash equivalents at beginning of year .................................... 27,477 23,881
------ ------
Cash and cash equivalents at end of period......................................... $ 26,626 $ 31,262
======== ========
Supplemental Cash Flow Disclosures
Interest paid .......................................................................... $ 7,570 $ 9,604
Income taxes paid ...................................................................... 1,305 955
Non-Cash Transactions
Change in net unrealized holding gains, net of taxes, on available-for-sale securities . (649 ) 2,410
The accompanying notes are an integral part of the consolidated financial
statements.
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003 AND 2002, AND DECEMBER 31, 2002
(Unaudited)
1. REPORTING AND ACCOUNTING POLICIES
The accompanying consolidated financial statements include the accounts of QNB
Corp. and its wholly owned subsidiary, The Quakertown National Bank, (QNB). All
significant intercompany accounts and transactions are eliminated in the
consolidated statements.
The consolidated balance sheet as of September 30, 2003, as well as the
respective statements of income and cash flows for the three and the nine-month
periods ended September 30, 2003 and 2002, are unaudited. These financial
statements should be read in conjunction with the audited financial statements
and notes thereto included in QNB's 2002 Annual Report incorporated in the Form
10-K.
The financial statements reflect all adjustments, which in the opinion of
management are necessary for a fair presentation of the results of the interim
periods and are of a normal and recurring nature. The results for the periods
presented are not necessarily indicative of the full year. Tabular information
other than share date is presented in thousands of dollars.
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amount of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from such estimates.
STOCK SPLIT
On August 19, 2003 the Board of Directors authorized a two-for-one split of the
Company's common stock, effected by a distribution on October 14, 2003 of one
share for each one share held of record at the close of business on September
30, 2003. All earnings per share and common stock information is presented as if
the stock split occurred prior to the earliest year included in these financial
statements.
STOCK BASED COMPENSATION
At September 30, 2003, QNB has a stock-based employee compensation plan that is
accounted for under the recognition and measurement principles of APB Opinion
No. 25, Accounting for Stock Issued to Employees, and related interpretations.
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 "fair value" approach
under SFAS No. 123, Accounting for Stock-Based Compensation, takes into account
the time value of the option and will generally result in compensation expense
being recorded. Each year since the inception of SFAS No. 123, QNB has
disclosed, in the notes to the financial statements contained in its annual
report to shareholders, what the earnings impact would have been had QNB elected
the "fair value" approach under SFAS No. 123. Such disclosure is now required on
a quarterly basis in accordance with SFAS No. 148, Accounting for Stock-Based
Compensation - Transition and Disclosure - an amendment of FASB Statement No.
123.
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003 AND 2002, AND DECEMBER 31, 2002
(Unaudited)
The following table illustrates the effect of net income and earnings per share
if the company had applied the fair value recognition provisions of FASB
Statement No. 123 to stock-based employee compensation.
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
2003 2002 2003 2002
---- ---- ---- ----
Net income, as reported $1,412 $1,256 $4,573 $3,885
Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax effects 26 22 78 65
Pro forma net income $1,386 $1,234 $4,495 $3,820
Earnings per share
Basic - as reported $0.46 $0.41 $1.48 $1.26
Basic - pro forma $0.45 $0.40 $1.45 $1.24
Diluted - as reported $0.45 $0.40 $1.46 $1.25
Diluted - pro forma $0.44 $0.40 $1.44 $1.23
2. PER SHARE DATA
The following sets forth the computation of basic and diluted earnings per share
(share and per share data have been restated to reflect the two-for-one stock
split paid October 14, 2003 and are not in thousands):
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
2003 2002 2003 2002
---- ---- ---- ----
Numerator for basic and diluted earnings
per share-net income $1,412 $1,256 $4,573 $3,885
Denominator for basic earnings per share-
weighted average shares outstanding 3,093,722 3,079,278 3,090,721 3,077,868
Effect of dilutive securities-employee
stock options 64,610 34,220 50,088 27,179
Denominator for diluted earnings per
share- adjusted weighted average
shares outstanding 3,158,332 3,113,498 3,140,809 3,105,047
Earnings per share-basic $0.46 $.41 $1.48 $1.26
Earnings per share-diluted $0.45 $.40 $1.46 $1.25
There were no stock options that were anti-dilutive for either the three-month
or the nine-month periods ended September 30, 2003 or 2002.
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003 AND 2002, AND DECEMBER 31, 2002
(Unaudited)
3. COMPREHENSIVE INCOME
Comprehensive income is defined as the change in equity of a business entity
during a period from transactions and other events and circumstances, excluding
those resulting from investments by and distributions to owners. For QNB, the
sole component of other comprehensive income is the unrealized holding gains and
losses on available-for-sale investment securities.
The following shows the components and activity of comprehensive income during
the periods ended September 30, 2003 and 2002 (net of the income tax effect):
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
2003 2002 2003 2002
---- ---- ---- ----
Unrealized holding (losses) gains arising during
the period on securities held $(995) $514 $(498) $2,029
Reclassification adjustment for sold securities,
losses (gains) 48 276 (151) 381
-- --- ----- ---
Net change in unrealized (losses) gains during
the period (947) 790 (649) 2,410
Unrealized holding gains, beginning of period 3,901 2,719 3,603 1,099
----- ----- ----- -----
Unrealized holding gains, end of period $2,954 $3,509 $2,954 $3,509
====== ====== ====== ======
Net income $1,412 $1,256 $4,573 $3,885
Other comprehensive income, net of tax:
Unrealized holding (losses) gains arising during (947) 790 (649) 2,410
----- --- ----- -----
the period
Comprehensive Income $465 $2,046 $3,924 $6,295
==== ====== ====== ======
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003 AND 2002, AND DECEMBER 31, 2002
(Unaudited)
4. LOANS
The following table presents Loans by category as of September 30, 2003 and
December 31, 2002:
September 30, December 31,
2003 2002
Commercial and industrial $44,252 $39,546
Agricultural 14 176
Construction 7,907 7,687
Real estate-commercial 89,628 74,125
Real estate-residential 81,904 84,907
Consumer 6,157 6,513
----- -----
Total loans 229,862 212,954
Less unearned income 181 263
--- ---
Total loans net of unearned income $229,681 $212,691
======== ========
5. INTANGIBLE ASSETS
The following table presents Intangible Asset information as of September 30,
2003:
- ------------------------------------ ----------------------- ------------------------- ----------------------
Amortized Intangible Assets Gross Carrying Accumulated Net Carrying
Amount Amortization Amount
- ------------------------------------ ----------------------- ------------------------- ----------------------
Purchased deposit premium $511 $302 $209
- ------------------------------------ ----------------------- ------------------------- ----------------------
Mortgage servicing asset 761 175 586
- ------------------------------------ ----------------------- ------------------------- ----------------------
Total $1,272 $477 $795
- ------------------------------------ ----------------------- ------------------------- ----------------------
The following table presents Intangible Asset information as of December 31,
2002:
- ------------------------------------ ----------------------- ------------------------- ----------------------
Amortized Intangible Assets Gross Carrying Accumulated Net Carrying
Amount Amortization Amount
- ------------------------------------ ----------------------- ------------------------- ----------------------
- ------------------------------------ ----------------------- ------------------------- ----------------------
Purchased deposit premium $511 $264 $247
- ------------------------------------ ----------------------- ------------------------- ----------------------
- ------------------------------------ ----------------------- ------------------------- ----------------------
Mortgage servicing asset 679 250 429
- ------------------------------------ ----------------------- ------------------------- ----------------------
- ------------------------------------ ----------------------- ------------------------- ----------------------
Total $1,190 $514 $676
- ------------------------------------ ----------------------- ------------------------- ----------------------
Included in accumulated amortization for the mortgage servicing asset is a
valuation allowance of $45,000 and $13,000 at September 30, 2003 and December
31, 2002, respectively.
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003 AND 2002, AND DECEMBER 31, 2002
(Unaudited)
5. INTANGIBLE ASSETS (Continued)
Aggregate Amortization Expense
For the Nine Months ended September 30, 2003 $208
Estimated Amortization Expense
For the Year Ended 12/31/03 $252
For the Year Ended 12/31/04 172
For the Year Ended 12/31/05 155
For the Year Ended 12/31/06 134
For the Year Ended 12/31/07 109
6. RECENT ACCOUNTING PRONOUNCEMENTS
Derivative Instruments and Hedging Activities
In April 2003, the FASB issued SFAS No. 149, Amendments of Statement 133 on
Derivative Instruments and Hedging Activities, which establishes accounting and
reporting standards for derivative instruments, including derivatives embedded
in other contracts and hedging activities. The statement amends Statement No.
133 for decisions made by the Board as part of the Derivatives Implementation
Group (DIG) process. The statement also amends Statement No. 133 to incorporate
clarifications of the definition of a derivative. The statement is effective for
contracts entered into or modified and hedging relationships designated after
June 30, 2003. The provisions of this statement did not have a material impact
on QNB's consolidated earnings, financial condition, or equity.
Certain Financial Instruments with Characteristics of both Liabilities and
Equity
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity. This Statement
establishes standards for how an issuer classifies financial instruments with
characteristics of both liabilities and equity. It requires that an issuer
classify these financial instruments as a liability (or, in certain
circumstances, an asset). Previously these financial instruments would have been
classified entirely as equity, or between the liabilities section and equity
section of the statement of financial condition. This Statement also addresses
questions about the classification of certain financial instruments that embody
obligations to issue equity shares. The provisions of this Statement are
effective for interim periods beginning after June 15, 2003. The adoption of
this statement did not have an impact on QNB's consolidated earnings, financial
condition, or equity.
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003 AND 2002, AND DECEMBER 31, 2002
(Unaudited)
6. RECENT ACCOUNTING PRONOUNCEMENTS (Continued)
Guarantor's Accounting and Disclosure Requirements for Guarantees
In November 2002, the FASB issued Interpretation No. (FIN) 45, Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others. This Interpretation elaborates on the
disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has issued. It
also clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. This Interpretation does not prescribe a specific
approach for subsequently measuring the guarantor's recognized liability over
the term of the related guarantee. This Interpretation also incorporates,
without change, the guidance in FASB Interpretation No. 34, Disclosure of
Indirect Guarantees of Indebtedness of Others, which is being superseded. The
initial recognition and initial measurement provisions of this Interpretation
are applicable on a prospective basis to guarantees issued or modified after
December 31, 2002, irrespective of the guarantor's fiscal year-end. There was no
impact on earnings, financial condition or equity upon adoption of FIN 45. The
disclosure requirements in this Interpretation are effective for financial
statements of interim or annual periods ending after December 15, 2002. The
adoption of the disclosure requirements of FIN 45 did not have an impact on the
financial statements or notes to the financial statements.
Consolidation of Variable Interest Entities
In January 2003, the FASB issued Interpretation No. (FIN) 46, Consolidation of
Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation
addresses the consolidation by business enterprises of variable interest
entities as defined in the Interpretation. The Interpretation applies
immediately to variable interests in variable interest entities created or
obtained after January 31, 2003. For public enterprises with a variable interest
in a variable interest entity created before February 1, 2003, the
Interpretation applies to that enterprise no later than the beginning of the
first interim or annual reporting period beginning after December 15, 2003. The
application of this Interpretation is not expected to result in consolidation of
any Variable Interest Entities.
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
QNB Corp. (the "Corporation") is a bank holding company headquartered in
Quakertown, Pennsylvania. The Corporation through its wholly owned subsidiary,
The Quakertown National Bank (the "Bank"), has been serving the residents and
businesses of Upper Bucks, Northern Montgomery and Southern Lehigh Counties in
Pennsylvania since 1877. The Bank is a locally managed community bank that
provides a full range of commercial, retail banking and trust and investment
management services. The consolidated entity is referred to herein as "QNB".
This report includes forward-looking statements within the meaning of the
Private Securities Litigation Reform Act with respect to financial performance
and other financial and business matters. Forward-looking statements are
typically identified by words or phrases such as "believe," "expect,"
"anticipate," "intend," "estimate," "position" and variations of such words and
similar expressions, or future or conditional verbs such as "will," "would,"
"should," "could," "may" or similar expressions. The Corporation cautions that
these forward-looking statements are subject to numerous assumptions, risks and
uncertainties, all of which change over time, and the Corporation assumes no
duty to update forward looking statements. Actual results could differ
materially from those anticipated in these forward-looking statements.
In addition to factors previously disclosed by the Corporation and those
identified elsewhere herein, the following factors, among others, could cause
actual results to differ materially from forward looking statements: increased
credit risk; the introduction, withdrawal, success and timing of business
initiatives and strategies; changes in competitive conditions; the inability to
sustain revenue and earnings growth; changes in economic conditions, interest
rates and financial and capital markets; inflation; changes in investment
performance; customer disintermediation; customer borrowing, repayment,
investment and deposit practices; customer acceptance of QNB products and
services; and the impact, extent and timing of technological changes, capital
management activities, actions of the Federal Reserve Board and legislative and
regulatory actions and reforms.
Critical Accounting Policies and Estimates
Discussion and analysis of the financial condition and results of operations are
based on the consolidated financial statements of QNB, which are prepared in
accordance with accounting principles generally accepted in the United States of
America (GAAP). The preparation of these financial statements requires QNB to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. QNB evaluates estimates on an on-going basis, including those
related to the allowance for loan losses, non-accrual loans, other real estate
owned, other-than-temporary investment impairments, intangible assets, stock
option plan and income taxes. QNB bases its estimates on historical experience
and various other factors and assumptions that are believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
QNB believes the following critical accounting policies affect its more
significant judgments and estimates used in preparation of its consolidated
financial statements: allowance for loan losses, income taxes and other-than-
Critical Accounting Policies and Estimates (Continued)
temporary investment security impairment. Each estimate is discussed below. The
financial impact of each estimate is discussed in the applicable sections of
Management's Discussion and Analysis.
Allowance for Loan Losses
QNB maintains an allowance for loan losses, which is intended to absorb probable
known and inherent losses in the outstanding loan portfolio. The allowance is
reduced by actual credit losses and is increased by the provision for loan
losses and recoveries of previous losses. The provisions for loan losses are
charged to earnings to bring the total allowance for loan losses to a level
considered necessary by management.
The allowance for loan losses is based on management's continuing review and
evaluation of the loan portfolio. The level of the allowance is determined by
assigning specific reserves to individually identified problem credits and
general reserves to all other loans. The portion of the allowance that is
allocated to internally criticized and non-accrual loans is determined by
estimating the inherent loss on each credit after giving consideration to the
value of underlying collateral. The general reserves are based on the
composition and risk characteristics of the loan portfolio, including the nature
of the loan portfolio, credit concentration trends, historic and anticipated
delinquency and loss experience, as well as other qualitative factors such as
current economic trends.
Management emphasizes loan quality and close monitoring of potential problem
credits. Credit risk identification and review processes are utilized in order
to assess and monitor the degree of risk in the loan portfolio. QNB's lending
and loan administration staff are charged with reviewing the loan portfolio and
identifying changes in the economy or in a borrower's circumstances which may
affect the ability to repay debt or the value of pledged collateral. A loan
classification and review system exists that identifies those loans with a
higher than normal risk of uncollectibility. Each commercial loan is assigned a
grade based upon an assessment of the borrower's financial capacity to service
the debt and the presence and value of collateral for the loan. An independent
loan review group tests risk assessments and evaluates the adequacy of the
allowance for loan losses. Management meets monthly to review the credit quality
of the loan portfolio and quarterly to review the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their
examination process, periodically review QNB's allowance for losses on loans.
Such agencies may require QNB to recognize additions to the allowance based on
their judgments about information available to them at the time of their
examination.
Management believes that it uses the best information available to make
determinations about the adequacy of the allowance and that it has established
its existing allowance for loan losses in accordance with GAAP. If circumstances
differ substantially from the assumptions used in making determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be affected. Because future events affecting borrowers and
collateral cannot be predicted with certainty, there can be no assurance that
increases to the allowance will not be necessary should the quality of any loans
deteriorate as a result of the factors discussed above.
Income Taxes. QNB accounts for income taxes under the asset/liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases, as well as operating loss and tax credit carryforwards. Deferred tax
assets and liabilities are measured using enacted tax rates
Critical Accounting Policies and Estimates (Continued):
Income Taxes (Continued)
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date. A valuation allowance is established
against deferred tax assets when in the judgment of management, it is more
likely than not that such deferred tax assets will not become available. Because
the judgment about the level of future taxable income is dependent to a great
extent on matters that may, at least in part go beyond QNB's control, it is at
least reasonably possible that management's judgment about the need for a
valuation allowance for deferred taxes could change in the near term.
Other than Temporary Impairment of Investment Securities
Securities are evaluated periodically to determine whether a decline in their
value is other than temporary. Management utilizes criteria such as the
magnitude and duration of the decline, in addition to the reasons underlying the
decline, to determine whether the loss in value is other than temporary. The
term "other than temporary" is not intended to indicate that the decline is
permanent, but indicates that the prospects for a near-term recovery of value is
not necessarily favorable, or that there is a lack of evidence to support
realizable value equal to or greater than carrying value of the investment. Once
a decline in value is determined to be other than temporary, the value of the
security is reduced and a corresponding charge to earnings is recognized.
RESULTS OF OPERATIONS
QNB reported net income for the third quarter 2003 of $1,412,000 or $.45 per
common share on a diluted basis. This compares to $1,256,000 or $.40 per share
for the same period in 2002. As further discussed below, results for the quarter
include several significant events. Net income for the first nine months of 2003
was $4,573,000 or $1.46 per share diluted, a 17.7 percent increase over the
$3,885,000 or $1.25 per share diluted for the comparable period in 2002. All
earnings per share amounts have been restated to reflect the two-for-one split
paid on October 14, 2003.
Contributing to the increase in net income when comparing the two quarters is
higher non-interest income. Non-interest income for the three months ended
September 30, 2003 was $938,000, a $413,000 increase from the third quarter of
2002. In an effort to reposition the balance sheet during the third quarter of
2003, QNB recorded a loss of $73,000 on the sale of fixed income securities.
This compares to net losses from the sale of fixed income securities and
impairment of equity securities of $418,000 during the third quarter of 2002. In
addition, gains on the sale of loans was $3,000 for the three months ended
September 30, 2003 compared to $120,000 for the same period in 2002. Other
components of non-interest income increased $185,000 or 22.5 percent. A $96,000
reversal of a valuation allowance for mortgage servicing rights, proceeds of
$109,000 from life insurance contracts and higher fee income on deposit accounts
contributed to this increase.
The increase in non-interest income offset a slight decline in net interest
income and an increase in non-interest expense. Net interest income declined by
$18,000 when comparing the two quarters. Included in net interest income for the
third quarter of 2002 was the recognition of $99,000 in interest on non-accrual
loans. The continued low interest rate environment has had a significant impact
on the net interest margin. The net
RESULTS OF OPERATIONS (Continued)
interest margin was 3.31 percent for the third quarter of 2003 compared to 3.69
percent for the same period in 2002. Excluding the impact of the non-accrual
interest the net interest margin for the third quarter of 2002 was 3.61 percent.
The impact from the decline in the net interest margin on net interest income
was partially offset by a 10.5 percent increase in average earning assets with
average loans increasing 12.3 percent. The growth in earning assets was a result
of significant deposit growth during the third quarter of 2003. Average deposits
increased $49,708,000 or 13.2 percent when comparing the third quarter of 2003
to the same period in 2002. Total deposits at September 30, 2003 were
$445,848,000, an increase of $60,309,000 or 15.6 percent from the $385,539,000
reported at September 30, 2002.
Total non-interest expense increased $403,000 or 14.1 percent with salaries and
benefits increasing $293,000 when comparing the two quarters. Higher incentive
compensation expense, payroll tax expense, medical insurance costs, and
retirement plan costs contributed to the increase in salaries and benefits
expense. Higher marketing expense also contributed to the increase in total
non-interest expense.
The effective tax rate was 7.7 percent for the three-month period ended
September 30, 2003 compared to 18.3 percent for the same period in 2002.
Positively impacting the effective tax rate as well as the results for the
quarter was the reversal of a tax valuation allowance of $137,000 recorded in
previous periods. The reversal of the valuation allowance was a result of the
ability to realize tax benefits associated with certain impaired securities, due
to the increase in unrealized gains of certain equity securities held by the
company. The receipt of $109,000 of tax-exempt life insurance proceeds mentioned
above, also had a positive impact on the effective tax rate.
Return on average assets was 1.04 percent and 1.03 percent while the return on
average equity was 14.09 percent and 13.76 percent for the three months ended
September 30, 2003 and 2002, respectively. For the nine-month periods ended
September 30, 2003 and 2002, return on average assets was 1.18 percent and 1.09
percent and the return on average equity was 15.74 percent and 14.72 percent,
respectively.
NET INTEREST INCOME
Net interest income is the primary source of operating income for QNB. Net
interest income is interest income, dividends, and fees on earning assets, less
interest expense incurred for funding sources. Earning assets primarily include
loans, investment securities and Federal funds sold. Sources used to fund these
assets include deposits, borrowed funds and shareholders' equity. Net interest
income is affected by changes in interest rates, the volume and mix of earning
assets and interest-bearing liabilities, and the amount of earning assets funded
by non-interest-bearing deposits.
Net interest income decreased .5 percent to $3,856,000 for the quarter ended
September 30, 2003 as compared to $3,874,000 for the quarter ended September 30,
2002. On a tax-equivalent basis, which allows for the comparison of tax-exempt
loans and investments to taxable loans and investments, net interest income
decreased by .9 percent from $4,231,000 for the three months ended September 30,
2002 to $4,194,000 for the same period ended September 30, 2003. Included in net
interest income for the three months ended September 30, 2002, was the
recognition of $99,000 in interest on non-accrual loans that were paid in full.
There was no such recognition of income in the third quarter of 2003.
NET INTEREST INCOME (Continued)
The growth in deposits and the investment of these deposits into profitable
loans and investment securities could only partially offset the impact of the
declining net interest margin on net interest income. The growth in deposits is
a continuation of the trend that began during 2001. Despite improvement in the
stock market during 2003, its longer term lackluster performance, in conjunction
with a slow growing United States economy, and geopolitical uncertainty have
contributed to the inflow of funds into the banking system. Consumers are
looking for the relative safely of bank deposits despite the low interest rate
environment. An additional significant contributor to the growth in deposits
during the third quarter of 2003 was the growth in municipal deposits. The
majority of the growth in municipal deposits are seasonal and will roll off over
the next nine months. Average deposits increased $49,708,000 or 13.2 percent
when comparing the third quarters of 2003 and 2002 with municipal deposits
contributing $21,388,000 to the increase. These deposits were primarily used to
fund the $25,559,000 or 12.3 percent increase in average loans and $17,778,000
or 7.5% increase in average investment securities during this same time period.
The municipal deposits were primarily invested in securities whose cash flow
will closely match the anticipated run-off of the deposits.
Interest rates during the third quarter of 2003 were extremely volatile. After
closing at 3.10 percent, a 45-year low, on June 13th, the 10-year Treasury rate
began the third quarter at 3.53 percent, its low for the quarter. Rates rose
quickly during the quarter reaching 4.60 percent on September 2nd. A late
quarter rally sent the rate down to 3.94 percent at September 30th. Despite this
volatility during the quarter, the extended period of low rates, which began in
2001 continued, particularly at the short-end of the yield curve. This extended
period of low interest rates has had the impact of lowering the yield on earning
assets and the rate paid on interest-bearing liabilities, as loans, investment
securities and deposits either repriced at lower rates or were originated at
lower interest rates. The yield on earning assets on a tax-equivalent basis was
5.21 percent for the third quarter of 2003 versus 6.33 percent for the third
quarter of 2002, while the rate paid on interest-bearing liabilities was 2.16
percent and 2.99 percent for the same periods. The net interest margin, on a
tax-equivalent basis, declined 38 basis points to 3.31 percent for the
three-month period ended September 30, 2003 compared with 3.69 percent for the
same period in 2002. The net interest margin for the third quarter of 2003
represents a decline of 17 basis points from the 3.48 percent recorded during
the second quarter of 2003.
The yield on loans decreased 1.06 basis points to 6.25 percent when comparing
the third quarter of 2002 to the third quarter of 2003. At the end of June 2003,
the Federal Reserve Bank lowered the Federal Funds rate .25 percent to 1.00
percent. At the same time the prime lending rate declined to 4.00 percent. The
average prime rate when comparing the third quarter of 2002 to the third quarter
of 2003 decreased 75 basis points, from 4.75 percent to 4.00 percent. While QNB
was negatively impacted from the decline in prime rate, the overall yield on the
loan portfolio did not decrease proportionately, since only a percentage of the
loan portfolio re-prices immediately with changes in the prime rate. A greater
contributor to the decline in yield on the loan portfolio was the impact of the
refinancing of residential mortgage, home equity and commercial loans into lower
yielding loans. The yield on the loan portfolio may continue to decline for the
remainder of 2003 and into 2004 as fixed rate loans are refinanced at lower
rates, adjustable rate loans re-price down as they reach their reset date and
new loans are booked at the current lower rates. In anticipation of rising rates
in 2004, QNB, particularly with regard to commercial loans, has attempted to
originate floating rate loans indexed to the prime rate. This should help
increase the yield on the loan portfolio as the prime rate increases.
When comparing the third quarter of 2003 to the third quarter of 2002, the yield
on investment securities decreased to 4.52 percent from 5.69 percent, a decline
of 117 basis points. Despite the increase in rates during the quarter, cash flow
from callable agency and municipal securities, mortgage-backed securities and
NET INTEREST INCOME (Continued)
collateralized mortgage obligations (CMOs) remains high. These funds as well as
new funds from deposit growth were reinvested in lower-yielding securities.
Another result of the increase in the prepayments on mortgage backed securities
and CMOs purchased at a premium was an increase in the amortization of the
premium on these securities. The net amortization on investment securities was
$323,000 during the third quarter of 2003 compared with $198,000 in the third
quarter of 2002. The increase in premium amortization has the impact of reducing
interest income and the yield on the portfolio. QNB has attempted to manage the
prepayment and amortization situation by selling out of certain faster paying
CMOs and mortgage backed securities and purchasing lower coupon, lower premium
mortgage backed securities and CMOs that will not pay as quickly should rates
stay low or decline further. The yield on the investment portfolio should
stabilize over the next couple of quarters as prepayments and amortization on
mortgage backed securities and CMOs slow and new funds are reinvested in the
slightly higher rate environment.
While total interest income on a tax-equivalent basis decreased $658,000 when
comparing the third quarter of 2003 to the third quarter of 2002, total interest
expense decreased $621,000. The rate paid on interest bearing deposits decreased
from 2.66 percent to 1.74 for the quarters ended September 30, 2002 and 2003.
The impact of lower rates on time deposits was the greatest contributor to the
decline in total interest expense and the rate paid on interest bearing
deposits. Total interest expense on time deposits decreased $457,000 when
comparing the two quarters. The average rate paid on time deposits declined from
3.86 percent to 2.78 percent when comparing the two periods. Like fixed-rate
loans, certificates of deposit reprice over time and therefore have less of an
immediate impact on yield in either a rising or falling rate environment.
However, given the extended period of low interest rates, most time deposits
have already re-priced lower and therefore the yield on time deposits will
likely not decline much further. Average time deposits increased $8,638,000 to
$198,591,000 when comparing the third quarter of 2003 to the same period in
2002. A $9,056,000 increase in average time deposits with balances less than
$100,000 offset a $418,000 decrease in average time deposits with balances of
$100,000 or more.
Lower rates paid on money market accounts and savings accounts contributed to
the $80,000 and $65,000 decrease in interest expense for these products. The
average rate paid on money market accounts declined 80 basis points when
comparing the third quarter of 2003 yield of .68 percent to the third quarter of
2002 yield of 1.48 percent. Contributing to the decline in the yield on money
market accounts was the decline in the rate paid on the Treasury Select Money
Market Account. This product is a variable rate account indexed to the monthly
average of the 91-day Treasury bill based on balances in the account. The
decline in the 91-day Treasury rate resulted in significantly lower rates on
this product. In response to lower market rates of interest QNB lowered the
rates paid on savings accounts. The average rate paid on savings accounts
declined 72 basis points to .50 percent when comparing the third quarter of 2003
to the third quarter of 2002. When comparing the third quarter of 2003 to the
third quarter of 2002 average money market accounts decreased $2,255,000 or 6.0
percent, while average savings accounts increased $9,559,000 or 22.4 percent.
Interest expense on interest bearing demand accounts increased from $108,000 to
$136,000, while the yield on these accounts decreased from .68 percent to .60
percent, when comparing the three-month periods ended September 30, 2002 and
2003. The average balance on these accounts increased from $62,675,000 to
$90,669,000 when comparing the same two periods. As discussed previously, the
majority of the growth in interest bearing demand deposits can be attributed to
growth in municipal deposits.
With regard to the yield on non-maturity interest-bearing deposits, which
reprice immediately when their rates are changed, management does not expect the
rate paid to decline significantly as they have reached a level where only a
minimal reduction in rates is possible.
NET INTEREST INCOME (Continued)
Interest expense on short-term borrowing decreased from $63,000 for the third
quarter of 2002 to $26,000 for the third quarter of 2003. This is a result of a
decline in both volume and rate. Average short-term borrowings decreased from
$13,411,000 to $10,975,000 when comparing the two periods while, the rate paid
on short-term borrowings decreased from 1.86 percent for the third quarter of
2002 to .94 percent for the third quarter of 2003. Most of these borrowings are
indexed with the Federal funds rate.
Interest expense on Federal Home Loan Bank borrowings decreased $10,000 for the
quarter to $725,000, as the average rate paid on these borrowings declined from
5.30 percent to 5.23 percent. This decline is a result of the variable rate
nature of $5,000,000 of the borrowings, which are tied to LIBOR. The remaining
$50,000,000 of advances are fixed rate with maturities ranging from 2008 to
2011. QNB may look to prepay some of these higher costing borrowings during the
fourth quarter of 2003. However, the penalties for prepayment can be
significant.
For the nine-month period ended September 30, 2003, net interest income
increased $208,000 or 1.8 percent to $11,579,000. On a tax-equivalent basis net
interest income increased $183,000 or 1.5 percent. The significant growth in
average earning assets offset the decline in the net interest margin. Average
earning assets increased 8.9 percent while the net interest margin declined 25
basis points. The net interest margin on a tax-equivalent basis was 3.48 percent
for the nine-month period ended September 30, 2003 compared with 3.73 percent
for the same period in 2002. Excluding the impact of the recognition of $200,000
of interest on non-accrual loans during 2002, the net interest margin declined
by 19 basis points.
Total interest income decreased $1,710,000 from $20,670,000 to $18,960,000 when
comparing the nine-month periods ended September 30, 2002 to September 30, 2003.
The decline in interest income is a result of the extended period of lower
interest rates. The yield on earning assets decreased from 6.53 percent to 5.52
percent, with the yield on investment securities declining from 6.00 percent to
4.86 percent and the yield on loans declining from 7.35 percent to 6.47 percent
between the nine-month periods. Average loans increased 10.9 percent to
$229,935,000 while average investment securities increased 5.7 percent to
$240,504,000.
Total interest expense decreased $1,918,000 from $9,299,000 to $7,381,000 for
the nine-month periods with interest on money market accounts, savings accounts
and time deposits accounting for $205,000, $104,000 and $1,577,000 of the
decrease. The yield on these accounts declined 72 basis points, 51 basis points
and 121 basis points when comparing the average rate paid for the nine-month
periods ended September 30, 2003 and 2002. Interest expense on interest-bearing
demand accounts increased $109,000 to $374,000 as average balances increased
$22,673,000 to $81,073,000 for the nine-month period ended September 30, 2003.
Interest expense on short-term borrowings declined by $124,000 as the average
rate paid on these accounts declined from 2.00 percent to 1.10 percent and the
average balances declined from $13,594,000 to $9,572,000.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to be charged to operations to bring the allowance for loan
losses to a level that represents management's best estimate of the known and
inherent losses in the loan portfolio. Actual loan losses, net of recoveries,
serve to reduce the allowance.
PROVISION FOR LOAN LOSSES (Continued)
The determination of an appropriate level of the allowance for loan losses is
based upon an analysis of the risk inherent in QNB's loan portfolio. Management
uses various tools to assess the adequacy of the allowance for loan losses. One
tool is a model recommended by the Office of the Comptroller of the Currency.
This model considers a number of relevant factors including: historical loan
loss experience, the assigned risk rating of the credit, current and projected
credit worthiness of the borrower, current value of the underlying collateral,
levels of and trends in delinquencies and non-accrual loans, trends in volume
and terms of loans, concentrations of credit, and national and local economic
trends and conditions. This model is supplemented with another analysis that
also incorporates exceptions to QNB's loan policy and QNB's portfolio exposure
to borrowers with large dollar concentration, defined as exceeding 50% of QNB's
legal lending limit. Other tools include ratio analysis and peer group analysis.
QNB's management determined no provision for loan losses was necessary for
either the three or nine month periods ended September 30, 2003 or 2002 as
charged off loans, non-performing assets and delinquent loans remained at low
levels relative to the allowance for loan losses. QNB had net charge-offs of
$2,000 for the three months ended September 30, 2003 compared to net recoveries
of $12,000 for the third quarter of 2002. For the nine-month period ended
September 30, 2003, QNB had net charge-offs of $3,000. This compares to net
recoveries of $46,000 for the nine-month period ended September 30, 2002.
Non-performing assets (non-accruing loans, loans past due 90 days or more, other
real estate owned and other repossessed assets) remained low amounting to .01
percent of total assets at September 30, 2003. This compares to .15 percent at
September 30, 2002 and .13 percent at December 31, 2002. This improvement was
the result of the collection of the majority of a commercial non-performing loan
during the quarter. Non-accrual loans were $57,000 and $686,000 at September 30,
2003 and 2002. Non-accrual loans at December 31, 2002 were $650,000. QNB did not
have any other real estate owned as of September 30, 2003, December 31, 2002 or
September 30, 2002. There were no repossessed assets as of September 30, 2003 or
2002. Repossessed assets were $11,000 at December 31, 2002.
Overall delinquency, including loans past due 90 days or more, also improved
during the third quarter of 2003 and represented .26 percent of total loans at
September 30, 2003. This compares to .60 percent and .67 percent at December 31,
2002 and September 30, 2002, respectively.
There were no restructured loans as of September 30, 2003, December 31, 2002 or
September 30, 2002 as defined in Statement of Financial Accounting Standards No.
15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings," that
have not already been included in loans past due 90 days or more or non-accrual
loans.
The allowance for loan losses was $2,935,000 and $2,938,000 at September 30,
2003 and December 31, 2002, respectively. The ratio of the allowance to total
loans was 1.27 percent and 1.35 percent at both period end dates. The 8.0
percent growth in total loans between December 31, 2002 and September 30, 2003
was the primary factor in the decline in this ratio. While QNB believes that its
allowance is adequate to cover losses in the loan portfolio, there remain
inherent uncertainties regarding future economic events and their potential
impact on asset quality.
A loan is considered impaired, based on current information and events, if it is
probable that QNB will be unable to collect the scheduled payments of principal
or interest when due according to the contractual terms of the loan agreement.
The measurement of impaired loans is generally based on the present value of
expected
PROVISION FOR LOAN LOSSES (Continued)
future cash flows discounted at the historical effective interest rate, except
that all collateral-dependent loans are measured for impairment based on the
fair value of the collateral.
At September 30, 2003 and 2002, the recorded investment in loans for which
impairment has been recognized in accordance with SFAS No. 114 totaled $34,000
and $605,000, respectively. These represent loans to one borrower and are
collateral-dependent. No valuation allowance was necessary on these loans.
Management in determining the allowance for loan losses makes significant
estimates. Consideration is given to a variety of factors in establishing these
estimates including current economic conditions, diversification of the loan
portfolio, delinquency statistics, results of loan reviews, borrowers' perceived
financial and managerial strengths, the adequacy of underlying collateral if
collateral dependent, or the present value of future cash flows. Since the
allowance for loan losses is dependent, to a great extent, on conditions that
may be beyond QNB's control, it is at least reasonably possible that
management's estimates of the allowance for loan losses and actual results could
differ in the near term. In addition, various regulatory agencies, as an
integral part of their examination process, periodically review QNB's allowance
for losses on loans. Such agencies may require QNB to recognize additions to the
allowance based on their judgments about information available to them at the
time of their examination.
NON-INTEREST INCOME
QNB, through its core banking business, generates various fees and service
charges. Total non-interest income is composed of service charges on deposit
accounts, ATM and debit card income, income on bank owned life insurance,
mortgage servicing fees, gains or losses on the sale of investment securities,
gains on the sale of residential mortgage loans and student loans, and other
miscellaneous fee income. QNB reviews all service charges and fee schedules
related to its products and services on an annual basis. QNB has not materially
changed these fee schedules during 2002 or 2003. During the third quarter of
2002, QNB increased its overdraft fee by 7.1 percent.
Total non-interest income increased $413,000 or 78.7 percent to $938,000 for the
quarter ended September 30, 2003 when compared to September 30 2002. For the
nine-month period total non-interest income increased $1,634,000 or 83.0 percent
to $3,602,000. Excluding gains and losses on the sale of investment securities
and loans during both periods, non-interest income for the three-month period
increased $185,000 or 22.5 percent and for the nine-month period increased
$317,000 or 14.4 percent. Included in the results for both the three and nine
month periods of 2003 were the recognition of $109,000 from life insurance
proceeds.
Fees for services to customers, the largest component of total non-interest
income, are primarily comprised of service charges on deposit accounts. These
fees increased 14.5 percent or $63,000, to $496,000 when comparing the two
quarters and 17.0 percent or $199,000 to $1,371,000 when comparing the
nine-month periods. An increase in the volume of overdrafts as well as the
increase in the fee during the third quarter of 2002 contributed to the $46,000
or 12.9 percent increase in overdraft income when comparing the three month
periods and $191,000 or 20.3 percent increase when comparing the nine month
periods ended September 30, 2003 and 2002. Also contributing to the increase in
fees for services to customers during the quarter was an $11,000 increase in
service charges on business accounts. This increase is a function of the lower
earnings
NON-INTEREST INCOME (Continued)
credit rate, resulting from the decline in interest rates, applied against
balances to offset service charges incurred as well as an increase in the number
of business checking accounts. This rate tends to move in relation to the
Federal Funds rate.
ATM and debit card income is primarily comprised of interchange income on debit
cards and ATM surcharge income for the use of QNB ATM machines by non-QNB
customers. ATM and debit card income was $134,000 for the third quarter of 2003,
an increase of $2,000 or 1.5 percent from the amount recorded during the third
quarter of 2002. For the nine-month periods ATM and debit card income increased
12.7 percent to $416,000. Debit card income increased $6,000 or 6.1 percent for
the three-month period and $44,000 or 17.3 percent when comparing the nine-month
periods ended September 30, 2003 and 2002. The increase in debit card income is
a result of increased acceptance by consumers of the card as a means of paying
for goods and services. Debit card income decreased $15,000 or 13.6 percent when
comparing the second and third quarters of 2003 as a result of the legal
settlement between the card companies and the retailers. This settlement
resulted in a reduction in the amount earned per transaction.
ATM transaction surcharge income decreased $6,000 or 17.0 percent when comparing
the third quarter of 2003 to the third quarter of 2002. For the nine-month
period, ATM transaction surcharge income decreased $14,000 or 14.7 percent. The
decline in ATM transaction surcharge income is a result of a reduction in the
number of transactions by non-QNB customers at QNB machines. Offsetting this
reduction in income was increases in ATM interchange income and card fee income.
ATM interchange income increased $1,000 for the quarter and $11,000 for the
nine-month period while card fee income increased $6,000 for the nine- month
period. In September 2003, Management made the decision to eliminate the $18
annual card fee for debit cards. This will reduce card fee income by
approximately $25,000 over a 12- month period.
Income on cash surrender value of insurance represents the earnings on life
insurance policies in which the Bank is the beneficiary. Income on these
policies was $74,000 for the three months ended September 30, 2003 compared to
$87,000 for the same period in 2002. The insurance carriers reset the rates on
these policies annually. The decline in income during the third quarter is a
result of both adjustments to the accrual rate used during the previous twelve
months and a lower projected rate going forward. For the nine month period
income declined $16,000 to $229,000.
When QNB sells its residential mortgages in the secondary market, it retains
servicing rights. A normal servicing fee is retained on all mortgage loans sold
and serviced. QNB recognizes its obligation to service financial assets that are
retained in a transfer of assets in the form of a servicing asset. The servicing
asset is amortized in proportion to and over the period of net servicing income
or loss. Servicing assets are assessed for impairment based on their fair value.
Mortgage servicing fees for the quarter ended September 30, 2003 were $84,000.
Included in this amount is a $96,000 reversal of a valuation allowance for
impairment of mortgage servicing rights. The fair market value of the
mortgage-servicing asset increased during the third quarter as a result of the
increase in interest rates and the slow down in estimated mortgage prepayment
speeds. For the nine-month period ended September 30, 2003, the net mortgage
servicing income was a loss of $21,000 of which $32,000 was a result of a
valuation allowance. This impairment was a result of the historically high
prepayment speeds on mortgages resulting from the record level of mortgage
refinancing activity created by the low interest rate environment during the
first half of 2003. Excluding the adjustments to the valuation allowance,
mortgage-servicing income would have been a loss of $12,000 for the third
quarter of 2003 compared to $22,000 for the third quarter of 2002. For the
nine-month period ended September 30,
NON-INTEREST INCOME (Continued)
2003 mortgage servicing income would have been $11,000 compared to $58,000 for
the same period in 2002.
Other results from the increase in mortgage refinancing activity are an increase
in amortization expense and an increase in the amount of mortgages serviced.
When a loan is paid off, the servicing asset related to that mortgage must be
expensed. Amortization expense for the three-month periods ended September 30,
2003 and 2002 was $65,000 and $18,000, respectively. For the respective
nine-month periods amortization expense was $139,000 and $57,000. The average
balance of mortgages serviced for others was $86,013,000 for the third quarter
of 2003 compared to $66,724,000 for the third quarter of 2002, an increase of
28.9 percent. The average balance of mortgages serviced was approximately
$80,311,000 for the nine-month period ended September 30, 2003 compared to
$66,649,000 for the first nine months of 2002, an increase of 20.5 percent. The
timing of mortgage payments and delinquencies also impacts the amount of
servicing fees recorded.
QNB recorded a loss of $73,000 on the sale of securities during the third
quarter of 2003. In an effort to reposition the balance sheet, QNB performed two
transactions. The first transaction involved the sale of approximately
$3,500,000 of higher premium fast paying CMO's with the proceeds being
reinvested into 15 year mortgage backed securities and a whole loan CMO. The
results of the transaction were a loss of $27,000, a pick up in current yield of
2.77 percent based on consensus prepayment speeds and a reduction in the Bank's
exposure to premiums and increased amortization expense. The transaction also
resulted in a slight extension of average life and duration. The second
transaction involved the sale of $5,000,000 in higher coupon 10-year mortgage
backed securities and $1,000,000 of a 7 year balloon and the purchase of
$6,000,000 of a 10 year/1 year adjustable rate mortgage security. This
transaction resulted in a loss of $46,000, an increase in book yield of 100
basis points and a reduction in exposure to premiums with minimal extension of
average life and duration.
For the nine-month period net gains on investment securities was $229,000 of
which $204,000 is a result of sales of debt securities and $25,000 relates to
activity in the marketable equity securities portfolio. Included in the net gain
on the equity portfolio was a $126,000 write-down of securities whose decline in
market value below cost was deemed to be other than temporary. These securities
were determined to be impaired. With regard to the sale of debt securities, in
addition to the transactions discussed above, QNB has sold approximately $28
million of mortgage-backed securities and CMO's that were prepaying at very fast
speeds. The proceeds were used to purchase lower coupon mortgage backed
securities and CMO's. The purpose of these transactions was to reduce the amount
of cash flow currently being received and also the amount of premium
amortization being recorded. Management will continue to look at strategies that
will result in an increase in the yield on the portfolio.
QNB recorded a net loss of $418,000 on the sale or other than temporary
impairment of investment securities during the third quarter of 2002. For the
nine-month period ended September 30, 2002 the net loss was $577,000. Included
in these amounts were losses of $351,000 for the quarter and $550,000 for the
nine-month period related to the write-down of marketable equity securities
whose declined in market value below cost were deemed to be other than
temporary. Also during the third quarter of 2002 QNB sold approximately
$3,000,000 of corporate bonds at a net loss of $67,000.
QNB recorded a net gain of $3,000 on the sale of loans during the third quarter
of 2003. This compares to a $120,000 gain for the same period in 2002. For the
nine-month periods ended September 30, 2003 and 2002 net gains on the sale of
loans were $853,000 and $342,000, respectively. The sale of student loans
accounts for $3,000 of the gains during the third quarter of 2002. QNB sold
approximately $140,000 in student loans
NON-INTEREST INCOME (Continued)
during the third quarter of 2002. Gains on the sale of student loans accounted
for $7,000 and $34,000 of the total gains during the nine-month periods ended
September 30, 2003 and 2002, respectively. For the nine-month periods ended
September 30, 2003 and 2002, QNB sold approximately $395,000 and $1,812,000 of
student loans. The decrease in the gain on the sale relates to the lower volume
of loans sold. Effective June 30, 2002 QNB terminated its agreement with the
Student Loan Marketing Association (SLMA). QNB will no longer be originating
student loans for sale but will be working on a referral basis instead. The
remaining balance in the portfolio was sold during the second quarter of 2003.
The net gain on residential mortgage sales is directly related to the volume of
mortgages sold and the timing of the sales relative to the interest rate
environment. As mentioned previously, the decline in interest rates has resulted
in record mortgage refinancing activity and significant gains on the sale of
these loans. Gains are usually recorded as rates fall while rising rates tend to
result in losses. This activity peaked during the second quarter of 2003 as
mortgage rates reached historical lows. The net gains on the sale of residential
mortgage loans were $3,000 and $117,000 for the three-month periods ended
September 30, 2003 and 2002. The rapid rise in interest rates during the third
quarter of 2003 had a negative impact on the sale of mortgage loans as loans
that were originated when rates had reached their lows were sold into a higher
rate environment resulting in losses. QNB does not hedge its mortgage pipeline.
Net gains on the sale of residential mortgages were $846,000 and $308,000 for
the respective nine-month periods. QNB originated $12,812,000 and $3,977,000 in
residential mortgages held for sale during the third quarters of 2003 and 2002
and $36,358,000 and $13,711,000 during the respective nine-month periods.
Proceeds from the sale of residential mortgages were approximately $13,841,000
and 3,247,000 during the third quarters of 2003 and 2002, respectively. For the
nine-month periods proceeds from the sale of residential mortgage loans amounted
to $39,534,000 and $13,477,000, respectively. At September 30, 2003 and 2002,
QNB had approximately $889,000 and $1,255,000 in mortgage loans classified as
held for sale. These loans are accounted for at lower of cost or market.
Other operating income increased $71,000 or 47.7 percent to $220,000 when
comparing the three-month periods ended September 30, 2003 and 2002. Income from
the proceeds of life insurance of $109,000 and a $14,000 increase in merchant
income was partially offset by a $10,000 decline in commissions from consumer
loan insurance premiums and a $26,000 loss on the valuation of mortgage loan
commitments. The results for the third quarter of 2002 also include a $21,000
recovery of a check card transaction that had been charged off in 2001.
For the nine-month period other operating income increased $166,000 or 46.2
percent to $525,000. In addition to the life insurance proceeds other operating
income for 2003 includes a $20,000 gain on residential mortgage loans held for
sale that have been committed but not settled. Dividends from the title
insurance company increased $24,000 while retail brokerage and trust income
increased $14,000 and $7,000, respectively. Merchant income increased $32,000
while consumer loan insurance commissions decreased $30,000 when comparing the
nine-month periods.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee
benefits, net occupancy, furniture and equipment, marketing, third party
services and various other operating expenses. Total non-interest expense of
$3,264,000 for the quarter ended September 30, 2003 represents an increase of
$403,000 or 14.1 percent from levels reported in the third quarter of 2002.
Total non-interest expense for the nine months ended September 30, 2003 was
$9,545,000, an increase of $1,004,000 or 11.8 percent over 2002 levels.
Salaries and benefits, the largest component of non-interest expense, increased
$293,000 or 18.7 percent to $1,858,000 for the quarter ended September 30, 2003
compared to the same quarter in 2002. Salary expense increased $227,000 or 17.8
percent during the period to $1,504,000 while benefits expense increased $66,000
or 22.9 percent to $354,000. For the nine-month period ended September 30, 2003
salaries and benefits expense increased $727,000 or 15.3 percent compared to
2002. Salary expense increased $589,000 or 15.4 percent while benefits expense
increased $138,000 or 15.3 percent.
QNB monitors, through the use of various surveys, the competitive salary
information in its markets and makes adjustments where appropriate. In addition,
in 2002 with the assistance of a consultant, QNB performed a complete analysis
of its compensation program. One result of this analysis was the development and
implementation of a new incentive program. This program has contributed an
additional $145,000 and $361,000 in salary expense when comparing the three and
nine-month periods ended September 30, 2003 and 2002. Excluding the accruals for
the incentive program salary expense increased 6.4 percent for the three-month
period and 6.1 percent for the nine-month period. Merit increases and an
increase in the number of employees also contributed to the increase in salary
expense. The number of full time-equivalent employees increased by four when
comparing the three month periods and five when comparing the nine month
periods.
For the three-month period ended September 30, 2003 payroll tax and retirement
plan expense increased $34,000 and $13,000, respectively. Included in payroll
tax expense was a $30,000 accrual related to the incentive compensation program.
During the same period medical and dental premiums increased by $12,000 or 14.4
percent. For the nine-month period payroll tax and retirement plan expense
increased $45,000 and $31,000, respectively while medical and dental premiums
increased by $46,000 or 16.7 percent. These increases primarily relate either to
the increase in the number of employees, the increase in salary expense or the
increase in the premiums charged by the health insurance carriers.
Net occupancy expense increased $1,000 or .5 percent when comparing the third
quarter of 2003 to the third quarter of 2002. For the nine-month period, net
occupancy expense increased $20,000 or 3.2 to $642,000. Utility expense,
building maintenance and real estate taxes increased $12,000, $7,000 and $6,000,
respectively for the nine-month period while branch rent expense decreased
$5,000 over the same period.
Furniture and equipment expense increased $10,000 or 3.9 percent when comparing
the three-month periods ended September 30, 2003 and 2002 and $70,000 or 9.5
percent when comparing the nine-month periods. Depreciation and amortization
expense increased $2,000 and $54,000 when comparing the three-month and
nine-month periods, respectively. The increase for the nine-month period relates
to the completion of several large projects in the second half of 2002.
Significantly more depreciation expense was recorded in the third and fourth
quarters of 2002 than in the first half because of the timing of completing
projects. Equipment maintenance expense increased $6,000 for both the three and
nine month periods. For the nine-month period expense related to non-depreciable
items increased $15,000.
NON-INTEREST EXPENSE (Continued)
Marketing expense increased $39,000 to $153,000 for the quarter ended September
30, 2003 but decreased $7,000 or 1.9 percent to $368,000 when comparing the
nine-month periods. The increase in marketing expense for the quarter is
primarily a result of the timing of advertising, public relations, sales
promotion and donation expenses. Advertising expense increased $22,000 while
sales promotion expense and donation expense increased $11,000 and $9,000
respectively for the quarter. Outdoor advertising, television advertising and
the redesign of the QNB website contributed to the increase in advertising
expense. An employee function was the primary reason for the increase in
promotion expense. For the nine-month period advertising public relations and
research costs have increased $11,000, $8,000 and $9,000, respectively, while
sales promotion expense and donations expense have decreased $15,000 and
$22,000, respectively. During the fourth quarter of 2002 QNB made several large
long-term charitable pledges that would likely have been made during the first
nine months of 2003.
Third party services are comprised of professional services including legal,
accounting and auditing and consulting services as well as fees paid to outside
vendors for support services of day-to-day operations. These include Trust
services, retail non-deposit services, correspondent banking services,
investment security safekeeping and supply management services, to name a few.
Third party services expense was $184,000 in the third quarter of 2003 compared
to $161,000 for the third quarter of 2002. The outsourcing of the statement
printing and mailing function contributed approximately $17,000 to the increase
in third party services for the three-month period. This function was outsourced
during the second quarter of 2003. A $7,000 increase in legal expense during the
quarter also contributed to the variance. For the nine-month periods ended
September 30, 2003 and 2002 third party service expense was $543,000 and
$440,000, respectively. Outsourcing the statement printing and mail function
contributed $31,000 to the increase when comparing the nine-month periods. Also
contributing to the increase were consulting and training cost related to the
installation of an upgrade to the item processing system. The use of an
executive search firm to fill an open Trust officer position was also a major
contributor to the increase in third party services when comparing the
nine-month periods.
For the three-month period ended September 30, 2003 telephone, postage and
supplies expense increased $7,000 or 5.3 percent to $138,000 with postage and
supplies expense each increasing by $3,000. For the nine-month period these
expenses increased by $2,000 or .5 percent with supply costs decreasing $16,000
while postage expense and telephone expense increased $14,000 and $4,000,
respectively. The higher postage expense is primarily a function of the increase
in the number of customer accounts and the use of additional target marketing
mailings.
The major categories that comprise other expense are regulatory costs, insurance
costs, membership fees, courier expense, ATM and debit card expense and
directors fees. When comparing the three-month periods ended September 30, 2003
and 2002 total other expense increased $26,000 to $364,000. Contributing to this
increase was a $16,000 increase in ATM and debit card expenses, an $8,000
increase in charged-off checking accounts, a $3,000 increase in the Comptroller
of the Currency assessment, a $4,000 increase in insurance costs and a $9,000
increase in costs related to title searches, credit reporting and appraisals.
Partially offsetting these increases was an $11,000 decrease in classified
advertising costs. For the nine-month period total other expense increased
$84,000 or 8.6 percent to $1,062,000. Contributing to this increase was a
$35,000 increase in ATM and debit card expense, a $10,000 increase in the
Comptroller of the Currency assessment, a $10,000 increase in courier costs, a
$14,000 increase in charged-off checking accounts, a $9,000 increase in expense
related to a director deferred compensation plan and an $11,000 increase in
costs related to title searches, credit reporting and appraisals.
INCOME TAXES
Applicable income taxes and effective tax rates were $118,000 or 7.7 percent for
the three-month period ended September 30, 2003, and $282,000 or 18.3 percent
for the same period in 2002. Positively impacting the effective tax rate was the
reversal of a tax valuation recorded in previous periods. The reversal of the
valuation allowance was a result of the ability to realize tax benefits
associated with certain impaired securities, due to the increase in unrealized
gains of certain equity securities held by QNB Corp. The receipt of $109,000 in
tax-exempt life insurance proceeds also had a positive impact on the effective
tax rate. For the nine-month period applicable income taxes and effective rates
were $1,063,000 or 18.9 percent and $913,000 or 19.0 percent, respectively.
QNB utilizes an asset and liability approach for financial accounting and
reporting of income taxes. As of September 30, 2003, QNB's net deferred tax
liability was $724,000. The primary components of deferred taxes are a deferred
tax asset of $725,000 relating to the allowance for loan losses and a deferred
tax liability of $1,522,000 resulting from the SFAS No. 115 adjustment for
available-for-sale investment securities. As of September 30, 2002 QNB's net
deferred tax liability was $1,011,000. A deferred tax asset of $741,000 relating
to the allowance for loan losses was offset by a deferred tax liability of
$1,964,000 resulting from the SFAS No. 115 adjustment for available-for-sale
investment securities.
The realizability of deferred tax assets is dependent upon a variety of factors
including the generation of future taxable income, the existence of taxes paid
and recoverable, the reversal of deferred tax liabilities and tax planning
strategies. A valuation allowance of $95,000 was established during the year
ended December 31, 2002, to offset a portion of the tax benefits associated with
certain impaired securities that management believes may not be realizable.
During the first quarter of 2003 this valuation allowance was increased to
$137,000 because of additional impaired securities. As mentioned above the
entire tax valuation allowance was reversed during the third quarter of 2003.
Based upon these and other factors, management believes it is more likely than
not that QNB will realize the benefits of these remaining deferred tax assets.
BALANCE SHEET ANALYSIS
The Balance Sheet Analysis reviews average balance sheet data for the nine
months ended September 30, 2003 and 2002, as well as the period ending balances
as of September 30, 2003 and December 31, 2002.
Average earning assets for the nine-month period ended September 30, 2003
increased $39,724,000 or 8.9 percent to $484,622,000 from $444,898,000 for the
nine months ended September 30, 2002. Average loans increased $22,552,000 while
average investment securities and Federal funds sold increased $12,984,000 and
$3,438,000, respectively.
The 10.9 percent increase in average loans is a result of the use of a business
development and calling program encompassing lending personnel, branch personnel
and executive management. The focus of this program is to both develop new
lending and deposit relationships as well as strengthen existing relationships.
This program was enhanced during 2002 with the development of a bank-wide sales
initiative that concentrated on sales training, particularly with regard to
identifying lending opportunities. This program has been expanded in 2003 to
include an incentive compensation program that will reward employees not only
for loan growth, but also for asset quality and profitability. The addition of
the Souderton branch location was also key to the growth in loans, especially
commercial loans. The growth in loans was achieved despite the relatively weak
economy during 2002 and the first nine months of 2003.
BALANCE SHEET ANALYSIS (Continued)
Average commercial loans increased $17,591,000, while average consumer loans
increased $6,281,000 when comparing the first nine months of 2003 to the first
nine months of 2002. Average residential mortgage loans held in portfolio
declined by $2,423,000 as most of the mortgages originated were sold because of
the low interest rate environment. The increase in consumer loans is primarily
in the category of home equity loans, which increased $6,591,000 or 16.6
percent. Home equity loans have been popular with consumers; especially those
refinancing existing residential mortgage loans, because they have lower
origination costs than residential mortgage loans.
The increase in average investment securities is a result of the growth in
deposits outpacing the growth in loans. The higher balance in average Federal
funds sold when comparing the nine-month periods is a result of management's
decision to keep additional liquidity in light of the significant growth in
deposits.
The growth in average earning assets was funded by increases in
non-interest-bearing and interest-bearing deposit accounts. Average non-interest
bearing demand accounts increased $6,300,000 or 14.8 percent, while average
interest-bearing deposit accounts increased $36,799,000 or 11.3 percent. The
"Free Checking" promotion, as well as the acquisition of new business accounts
were significant factors in the increase in non-interest bearing deposits. The
significant increase in municipal deposits midway through the third quarter of
2003 also had an impact when comparing the nine-month periods. QNB was able to
increase its deposit relationships with several school districts. These deposits
are seasonal and will likely be withdrawn over the next nine months.
The growth in average interest-bearing deposit accounts is primarily centered in
interest bearing demand deposit accounts which increased $22,673,000 or 38.8
percent. The majority of this growth can be attributed to the successful
development of relationships with several municipal organizations. Average
savings accounts increased $9,216,000 or 22.4 percent. Lackluster performance of
the stock market, a slow growing United States economy, and geopolitical
uncertainty have contributed to the inflow of funds into the banking system.
Consumers are looking for the relative safety of bank deposits despite the low
interest rate environment.
Time deposit accounts continued to increase in 2003 but at a much slower rate
than in previous years. Average total time deposits increased $6,236,000 or 3.3
percent to $195,495,000 when comparing the first nine months of 2003 to the same
period in 2002. Average time deposits with balances less than $100,000 increased
$10,976,000 while those with balances greater than $100,000 decreased
$4,740,000. Another difference in the growth pattern in time deposits was in the
maturity time frame selected by customers. In 2001, the majority of the new time
deposits were opened with maturities under one year, while in 2002 and 2003
customers extended the maturities and opened accounts with maturities between
three and five years. It appears that customers are looking to achieve the
highest yields possible in this low interest rate environment.
Total assets at September 30, 2003 were $556,878,000, compared with $503,430,000
at December 31, 2002, an increase of 10.6 percent. The increase in assets from
December 31, 2002 to September 30, 2003 is primarily centered in investment
securities which increased $40,361,000. These securities were primarily
purchased from the deposit proceeds of the municipalities, with cash flow that
will closely match the anticipated run-off of the deposits over the next nine
months. Total loans held in portfolio increased by $16,990,000 to $229,681,000
at September 30, 2003, while loans held-for-sale decreased by $3,270,000 to
$889,000.
BALANCE SHEET ANALYSIS (Continued)
The growth in assets was primarily funded by a $56,935,000 increase in total
deposits. Total deposits increased from $388,913,000 at December 31, 2002 to
$445,848,000 at September 30, 2003. The increase in deposits was spread across
all product lines except for money market accounts. Non-interest bearing demand
accounts and interest bearing demand accounts increased $3,332,000 and
$34,703,000, respectively when comparing balances at September 30, 2003 and
December 31, 2002. The municipal deposits account for $32,128,000 of the
increase in interest bearing demand accounts. Savings accounts increased
$6,010,000 and total time deposits increased $13,637,000 when comparing the same
time periods. Money market accounts decreased $747,000 during this time frame.
At September 30, 2003 the fair value of investment securities available-for-sale
was $270,181,000 or $4,476,000 above the amortized cost of $265,705,000. This
compares to a fair value of $214,741,000 or $5,524,000 above the amortized cost
of $209,217,000 at December 31, 2002. An unrealized holding gain, net of taxes,
of $2,954,000 and $3,603,000 was recorded as an increase to shareholders' equity
at September 30, 2003 and December 31, 2002, respectively. As a result of both
the low interest rate environment and the deposits of the municipalities the
composition of the portfolio has changed since December 31, 2002. The municipal
deposits were primarily invested in Agency securities with short calls. As a
result the percentage of the portfolio in Agency bonds has increased from
approximately 12 percent to 19 percent of the portfolio. At the same time the
percentage of CMO's has increased from 23 percent to 28 percent while the
percentage of Mortgage backed securities has declined to 24 percent from 29
percent. Municipal bonds, Corporate bonds and Treasury securities have each
declined slightly as a percentage of the total portfolio during the nine month
period.
During the second quarter of 2002, management and the Board of Directors
approved that all future purchases of investment securities will be categorized
as available-for-sale. While there is the potential for increased volatility of
shareholder's equity due to market value changes, management believes it will
provide for more flexibility in managing the portfolio.
Based on the interest rate environment and prepayment assumptions at the
valuation dates, the available-for-sale portfolio had a weighted average life of
approximately 4 years, 1 months at September 30, 2003 and 4 years, 7 months at
December 31, 2002. The weighted average tax-equivalent book yield was 4.58
percent and 5.35 percent at September 30, 2003 and December 31, 2002. The
weighted average life of the portfolio is based on stated contractual maturity,
estimated call dates for bonds that are callable or anticipated cash flow for
mortgage backed securities and CMOs. The average life of the portfolio as of
September 30, 2003 would extend to 5 years, 10 months with an instantaneous 200
basis point increase in rates while the average life would contract to 2 years,
10 months with an instantaneous 100 basis point decline in rates. This is a
function of the optionality found in the callable agency bonds and mortgage
related securities.
Investment securities held-to-maturity are reported at amortized cost. As of
September 30, 2003 and December 31, 2002, QNB had securities classified as
held-to-maturity with an amortized cost of $14,657,000 and $29,736,000 and a
market value of $15,081,000 and $30,386,000, respectively. The held-to-maturity
portfolio had a weighted average life of approximately 2 years, 9 months at
September 30, 2003 and 2 years, 1 month at December 31, 2002. The weighted
average tax-equivalent book yield was 6.36 percent at September 30, 2003 and
6.14 percent at December 31, 2002.
LIQUIDITY
Liquidity represents an institution's ability to generate cash or otherwise
obtain funds at reasonable rates to satisfy commitments to borrowers and demands
of depositors. QNB manages its mix of cash, Federal funds sold, investment
securities and loans in order to match the volatility, seasonality, interest
sensitivity and growth trends of its deposit funds. Liquidity is provided from
asset sources through maturities and repayments of loans and investment
securities, net interest income and fee income. The portfolio of investment
securities available-for-sale and QNB's policy of selling certain residential
mortgage originations and student loans in the secondary market also provide
sources of liquidity. Additional sources of liquidity are provided by The
Quakertown National Bank's membership in the Federal Home Loan Bank and a
$5,000,000 unsecured Federal funds line granted by the Bank's correspondent.
Cash and due from banks, Federal funds sold, available-for-sale securities and
loans held-for-sale were $297,696,000 and $246,377,000 at September 30, 2003 and
December 31, 2002. These sources were adequate to meet deposit withdrawals and
loan growth during the first nine months of 2003 and should be adequate to meet
normal fluctuations in loan demand and or deposit withdrawals. QNB has been able
to fund the growth in earning assets during the first nine months of 2003
through increased deposits. QNB did not use its Federal funds line, overnight
borrowings from the FHLB or the Federal Reserve Bank discount window to fund
loan growth or deposit withdrawals during the first nine months of 2003.
Approximately $91,263,000 and $65,871,000 of available-for-sale securities at
September 30, 2003 and December 31, 2002 were pledged as collateral for
repurchase agreements and deposits of public funds as required by law. In
addition, under terms of its agreement with the Federal Home Loan Bank, QNB
maintains otherwise unencumbered qualifying assets (principally 1-4 family
residential mortgage loans and U.S. Government and Agency notes, bonds, and
mortgage-backed securities) in the amount of at least as much as its advances
from the Federal Home Loan Bank. The significant increase in both liquidity
sources and pledged amounts relate to the municipal deposits received during the
third quarter of 2003. These deposits were used to purchase available-for-sale
securities that were used to pledge against the deposits of the municipalities.
The consolidated statements of cash flows present the changes in cash and cash
equivalents from operating, investing and financing activities. QNB's cash and
cash equivalents decreased $851,000 to $26,626,000 at September 30, 2003. This
compares to an increase of $7,381,000 during the first nine months of 2002.
After adjusting net income for non-cash transactions, operating activities
provided $8,237,000 in cash flow in the first nine months of 2003, compared to
$3,532,000 in the same period of 2002. Higher net income, an increase in
mortgage activity and an increase in amortization of premiums on investment
securities accounted for the increase in net cash provided by operating
activities during the first nine months of 2003. Changes in other liabilities
also had an impact when comparing the two periods. The primary change in other
liabilities relates to the purchase of a security in December 2001, that the
broker failed to deliver until January 2002. The purchase was booked as an
investment during 2001, since QNB was the owner and a liability was recorded.
Net cash used by investing activities was $59,047,000 during the first nine
months of 2003. The purchase of investment securities, funded principally by the
growth in municipal deposits, during the third quarter of 2003 was the primary
use of cash. Investment securities activity was a net use of cash of $42,108,000
during the first nine months of 2003. The growth in loans during the first nine
months of 2003 was also a use of cash. Loans, excluding mortgage and student
loan activity increased $16,616,000 during the first nine months of 2003. Net
cash used by investing activities was $44,069,000 during the first nine months
of 2002. Loan growth created a net increase in loans and a use of cash of
$8,160,000. In addition, the purchase of investment securities exceeded the
maturity, call and sale of securities by $35,441,000 during the first nine
months of
LIQUIDITY (Continued)
2002. Most of the activity relates to the deployment of the deposit growth
experienced during the first nine months of 2002.
Net cash provided by financing activities was $49,959,000 during the first nine
months of 2003 and $47,918,000 during the same time frame in 2002. The increase
in deposits of $56,935,000 offset the decline in short-term borrowings of
$5,554,000 during the first nine months of 2003. The growth in municipal
interest bearing demand deposits accounts for $32,138,000 of the increase in
total deposits. The decrease in short-term borrowings is primarily the reduction
of balances held by one repurchase agreement customer. A $33,424,000 increase in
interest-bearing deposits and a $7,384,000 increase in non-interest bearing
demand deposits was the main source of funding during the first nine months of
2002. An additional $2,000,000 advance from the FHLB and an increase in
short-term borrowings, primarily cash management accounts, of $6,436,000 also
provided funding during 2002.
CAPITAL ADEQUACY
A strong capital position is fundamental to support continued growth and
profitability, to serve the needs of depositors, and to yield an attractive
return for shareholders. QNB's shareholders' equity at September 30, 2003 was
$43,416,000 or 7.80 percent of total assets compared to shareholders' equity of
$40,914,000 or 8.13 percent at December 31, 2002. Shareholders' equity at
September 30, 2003 includes a positive adjustment of $2,954,000 related to
unrealized holding gains, net of taxes, on investment securities
available-for-sale, while shareholders' equity at December 31, 2002 includes a
positive adjustment of $3,603,000. Without these adjustments shareholders'
equity to total assets would have been 7.27 percent and 7.41 percent at
September 30, 2003 and December 31, 2002. The decline in the ratio is a result
of the significant growth in assets during the third quarter of 2003.
Shareholders' equity averaged $38,843,000 for the first nine months of 2003 and
$35,707,000 during all of 2002, an increase of 8.9 percent. The ratio of average
total equity to average total assets increased slightly to 7.51 percent for
2003, compared to 7.45 percent for 2002.
QNB Corp. and the Quakertown National Bank are subject to various regulatory
capital requirements as issued by Federal regulatory authorities. Regulatory
capital is defined in terms of Tier I capital (shareholders' equity excluding
unrealized gains or losses on available-for-sale securities and disallowed
intangible assets), Tier II capital which includes a portion of the allowance
for loan losses, and total capital (Tier I plus II). Risk-based capital ratios
are expressed as a percentage of risk-weighted assets. Risk-weighted assets are
determined by assigning various weights to all assets and off-balance sheet
arrangements, such as letters of credit and loan commitments, based on
associated risk. Regulators have also adopted minimum Tier I leverage ratio
standards, which measure the ratio of Tier I capital to total quarterly average
assets.
The minimum regulatory capital ratios are 4.00 percent for Tier I, 8.00 percent
for the total risk-based and 4.00 percent for leverage. Under the requirements,
QNB has a Tier I capital ratio of 12.31 percent and 12.40 percent, a total
risk-based ratio of 13.21 percent and 13.39 percent and a leverage ratio of 7.49
percent and 7.44 percent at September 30, 2003 and December 31, 2002,
respectively.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established
five capital level designations ranging from "well capitalized" to "critically
undercapitalized." At September 30, 2003 and December 31, 2002
CAPITAL ADEQUACY (Continued)
QNB met the "well capitalized" criteria which requires minimum Tier I and total
risk-based capital ratios of 6.00 percent and 10.00 percent, respectively, and a
Tier I leverage ratio of 5.00 percent.
INTEREST RATE SENSITIVITY
Since the assets and liabilities of QNB have diverse repricing characteristics
that influence net interest income, management analyzes interest sensitivity
through the use of gap analysis and simulation models. Interest rate sensitivity
management seeks to minimize the effect of interest rate changes on net interest
margins and interest rate spreads and to provide growth in net interest income
through periods of changing interest rates. The Asset/Liability Management
Committee (ALCO) is responsible for managing interest rate risk and for
evaluating the impact of changing interest rate conditions on net interest
income.
Gap analysis measures the difference between volumes of rate-sensitive assets
and liabilities and quantifies these repricing differences for various time
intervals. Static gap analysis describes interest rate sensitivity at a point in
time. However, it alone does not accurately measure the magnitude of changes in
net interest income since changes in interest rates do not impact all categories
of assets and liabilities equally or simultaneously. Interest rate sensitivity
analysis also involves assumptions on certain categories of assets and deposits.
For purposes of interest rate sensitivity analysis, assets and liabilities are
stated at their contractual maturity, estimated likely call date, or earliest
repricing opportunity. Mortgage-backed securities, CMOs and amortizing loans are
scheduled based on their anticipated cash flow. Savings accounts, including
passbook, statement savings, money market, and interest-bearing demand accounts,
do not have a stated maturity or repricing term and can be withdrawn or repriced
at any time. This may impact QNB's margin if more expensive alternative sources
of deposits are required to fund loans or deposit runoff. Management projects
the repricing characteristics of these accounts based on historical performance
and assumptions that it believes reflect their rate sensitivity. The Treasury
Select Indexed Money Market account reprices monthly based on a percentage of
the average of the 91-day Treasury bill.
A positive gap results when the amount of interest rate sensitive assets exceeds
interest rate sensitive liabilities. A negative gap results when the amount of
interest rate sensitive liabilities exceeds interest rate sensitive assets.
QNB primarily focuses on the management of the one-year interest rate
sensitivity gap. At September 30, 2003, interest-earning assets scheduled to
mature or likely to be called, repriced or repaid in one year were $239,964,000.
Interest-sensitive liabilities scheduled to mature or reprice within one year
were $201,911,000. The one-year cumulative gap, which reflects QNB's interest
sensitivity over a period of time, was a positive $38,053,000 at September 30,
2003. The cumulative one-year gap equals 7.2 percent of total rate sensitive
assets. This positive or asset sensitive gap will generally benefit QNB in a
rising interest rate environment, while falling interest rates could negatively
impact QNB. At June 30, 2003 the cumulative one-year gap was 18.2 percent of
total rate sensitive assets. The decrease in the positive gap position from June
2003 to September 2003, reflects the impact of rising rates during the third
quarter on the prepayment assumptions for loans and investment securities. The
increase in municipal deposits, which are assumed to be short-term in nature,
during the quarter also had the impact of reducing the positive gap position.
INTEREST RATE SENSITIVITY (Continued)
QNB also uses a simulation model to assess the impact of changes in interest
rates on net interest income. The model reflects management's assumptions
related to asset yields and rates paid on liabilities, deposit sensitivity, and
the size, composition and maturity or repricing characteristics of the balance
sheet. The assumptions are based on what management believes at that time to be
the most likely interest rate environment. Management also evaluates the impact
of higher and lower interest rates.
Actual results may differ from simulated results due to various factors
including time, magnitude and frequency of interest rate changes, the
relationship or spread between various rates, loan pricing and deposit
sensitivity, and asset/liability strategies. Based on the simulation model, net
interest income for the next twelve months is expected to increase slightly
compared to the prior twelve months. The projected increase in net interest
income is principally a result of the growth in earning assets offsetting the
impact of a lower net interest margin.
If interest rates are 100 basis points higher than management's most likely
interest rate environment, the simulation model projects net interest income for
the next twelve months to be higher than the most likely scenario. If interest
rates are 100 basis points lower than management's most likely interest rate
environment, the model projects net interest income for the next twelve months
to be lower than the most likely scenario. These results are consistent with the
results indicated by the gap analysis.
Management believes that the assumptions utilized in evaluating the
vulnerability of QNB's net interest income to changes in interest rates
approximate actual experience. However, the interest rate sensitivity of QNB's
assets and liabilities as well as the estimated effect of changes in interest
rates on net interest income could vary substantially if different assumptions
are used or actual experience differs from the experience on which the
assumptions were based.
In the event QNB should experience a mismatch in its desired gap ranges or an
excessive decline in its net interest income subsequent to an immediate and
sustained change in interest rates, it has a number of options that it could
utilize to remedy such a mismatch. QNB could restructure its investment
portfolio through the sale or purchase of securities with more favorable
repricing attributes. It could also emphasize loan products with appropriate
maturities or repricing attributes, or it could attract deposits or obtain
borrowings with desired maturities.
The nature of QNB's current operation is such that it is not subject to foreign
currency exchange or commodity price risk. Additionally, neither the Corporation
nor the Bank owns trading assets. At September 30, 2003, QNB did not have any
hedging transactions in place such as interest rate swaps, caps or floors.
INTEREST RATE SENSITIVITY (Continued)
The table below summarizes estimated changes in net interest income over a
twelve-month period, under alternative interest rate scenarios.
- ------------------------------------------------------------ ---------------------- -------------------- ---------------------
Change in Interest Rates Net Interest Income Dollar Change Percent Change
- ------------------------------------------------------------ ---------------------- -------------------- ---------------------
+300 Basis Points........................................... $15,478 $80 .52%
+200 Basis Points........................................... 15,724 326 2.12
+100 Basis Points........................................... 15,707 309 2.01
FLAT RATE................................................... 15,398 - -
- -100 Basis Points........................................... 13,818 (1,580) (10.26)
- -200 Basis Points........................................... 12,268 (3,130) (20.33)
- -300 Basis Points........................................... 11,076 (4,322) (28.07)
Management believes, given the current interest rate environment that it is
unlikely that interest rates would decline by 200 or 300 basis points.
OTHER ITEMS
Management is not aware of any current specific recommendations by regulatory
authorities or proposed legislation, which if they were implemented, would have
a material adverse effect upon the liquidity, capital resources, or results of
operations, although the general cost of compliance with numerous and multiple
federal and state laws and regulations does have, and in the future may have, a
negative impact on QNB's results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The information required herein is set forth in Item 2, above.
ITEM 4. CONTROLS AND PROCEDURES
We maintain a system of controls and procedures designed to provide reasonable
assurance as to the reliability of the financial statements and other
disclosures included in this report, as well as to safeguard assets from
unauthorized use or disposition. We evaluated the effectiveness of the design
and operation of our disclosure controls and procedures under the supervision
and with the participation of management, including our Chief Executive Officer
and Chief Financial Officer, within 90 days prior to the filing date of this
report. Based upon that evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are
effective in timely alerting them to material information required to be
included in our periodic Securities and Exchange Commission filings. No
significant changes were made to our internal controls or other factors that
could significantly affect these controls subsequent to the date of their
evaluation.
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
SEPTEMBER 30, 2003
Item 1. Legal Proceedings
None.
Item 2. Changes in Securities
None.
Item 3. Default Upon Senior Securities
None.
Item 4. Submission of Matters to Vote of Securities Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
The following Exhibits are included in this Report:
Exhibit 3(i) Articles of Incorporation of Registrant, as amended.
(Incorporated by reference to Exhibit 3(i) of Registrants
Form 10-Q filed with the Commission on August 13,1998).
Exhibit 3(ii) Bylaws of Registrant, as amended. (Incorporated by
reference to Exhibit 3(ii) of Registrants Form 10-Q filed
with the Commission on August 13,1998).
Exhibit 10.1 Employment Agreement between the Registrant and Thomas
J. Bisko. (Incorporated by reference to Exhibit 10.1 of
Registrants Form 10-K filed with the Commission on March
31, 1999 and amended on April 3, 2002 on Form 8-K filed
with the Commission on April 11, 2002).
Exhibit 10.2 Salary Continuation Agreement between the Registrant
and Thomas J. Bisko. (Incorporated by reference to Exhibit
10.2 of Registrants Form 10-K filed with the Commission on
March 31, 1999).
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
SEPTEMBER 30, 2003
Item 6. Exhibits and Reports on Form 8-K (Continued)
---------------------------------------------
Exhibit 10.3 QNB Corp. 1998 Stock Incentive Plan. (Incorporated by
reference to Exhibit 4.3 to Registration Statement No.
333-91201 on Form S-8, filed with the Commission on
November 18, 1999).
Exhibit 10.4 The Quakertown National Bank Retirement Savings Plan.
(Incorporated by reference to Exhibit 10.4 of Registrants
Form 10-Q filed with the Commission on August 14, 2003).
Exhibit 10.5 Change of Control Agreement between Registrant and
Robert C. Werner (Incorporated by reference to Exhibit
10.7 of Registrants Form 10-Q filed with the Commission on
November 13, 2000.)
Exhibit 10.6 Change of Control Agreement between Registrant and
Bret H. Krevolin (Incorporated by reference to Exhibit
10.8 of Registrants Form 10-Q filed with the Commission on
November 13, 2000.)
Exhibit 10.7 QNB Corp. 2001 Employee Stock Purchase Plan.
(Incorporated by reference to Exhibit 99.1 to
Registration Statement No. 333-67588 on Form S-8, filed
with the Commission on August 15, 2001.)
Exhibit 11 Statement Re: Computation of Earnings Per Share.
(Included in Part I, Item I, hereof.)
Exhibit 32.1 Certification of Principal Executive Officer
Exhibit 32.2 Certification of Principal Financial Officer
(b) Reports on Form 8-K
i. Filed August 20, 2003, Press release dated August 19,
2003 reporting declaration of quarterly cash dividend
and two-for-one stock split.
ii. Filed August 26, 2003, Press release dated August 25,
2003 announcing payable date and record date for
previously announced two-for-one stock split.
iii. Filed October 22, 2003, Press release dated October
22, 2003 reporting third quarter 2003 net income.
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.
QNB Corp.
Date: November 13, 2003 By:
--------------------------
/s/ Thomas J. Bisko
-------------------------
Thomas J. Bisko
President/CEO
Date: November 13, 2003 By:
-----------------------------
/s/ Robert C. Werner
-------------------------
Robert C. Werner
Vice President
Date: November 13, 2003 By:
-----------------------------
/s/ Bret H. Krevolin
-------------------------
Bret H. Krevolin
Chief Financial Officer