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 March 31, 2005
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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.
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(Exact Name of Registrant as Specified in Its Charter)
Pennsylvania 23-2318082
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(State or Other Jurisdiction of Incorporation or Organization) (I.R.S. Employer Identification No.)
15 North Third Street, Quakertown, PA 18951-9005
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(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (215)538-5600
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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 |X| No ____
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 May 5, 2005
Common Stock, par value $.625 3,100,302
QNB CORP. AND SUBSIDIARY
FORM 10-Q
QUARTER ENDED MARCH 31, 2005
INDEX
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) PAGE
Consolidated Statements of Income for Three
Months Ended March 31, 2005 and 2004...............................................1
Consolidated Balance Sheets at March 31, 2005
and December 31, 2004..............................................................2
Consolidated Statements of Cash Flows for Three
Months Ended March 31, 2005 and 2004...............................................3
Notes to Consolidated Financial Statements..................................................4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF
OPERATIONS AND FINANCIAL CONDITION.....................................................9
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK .................................28
ITEM 4. CONTROLS AND PROCEDURES....................................................................28
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS .........................................................................29
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS ...............................29
ITEM 3. DEFAULTS UPON SENIOR SECURITIES ...........................................................29
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITIES HOLDERS.....................................29
ITEM 5. OTHER INFORMATION .........................................................................29
ITEM 6. EXHIBITS ..................................................................................29
SIGNATURES
CERTIFICATIONS
QNB Corp. and Subsidiary
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CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except share data)
(unaudited)
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THREE MONTHS ENDED MARCH 31, 2005 2004
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INTEREST INCOME
Interest and fees on loans ........................................ $3,891 $3,349
Interest and dividends on investment securities:
Taxable ................................................... 2,256 2,201
Tax-exempt ................................................ 564 549
Interest on Federal funds sold .................................... 18 21
Interest on interest-bearing balances and other interest income ... 30 16
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Total interest income ..................................... 6,759 6,136
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INTEREST EXPENSE
Interest on deposits
Interest-bearing demand accounts .......................... 197 149
Money market accounts ..................................... 252 61
Savings ................................................... 54 52
Time ...................................................... 1,122 996
Time over $100,000 ........................................ 280 212
Interest on short-term borrowings ................................. 42 22
Interest on Federal Home Loan Bank advances ....................... 727 718
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Total interest expense ............................ 2,674 2,210
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Net interest income ............................... 4,085 3,926
Provision for loan losses ......................................... -- --
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Net interest income after provision for loan losses 4,085 3,926
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NON-INTEREST INCOME
Fees for services to customers .................................... 439 446
ATM and debit card income ......................................... 159 128
Income on bank-owned life insurance ............................... 63 68
Mortgage servicing income (loss) .................................. 24 (6)
Net gain on investment securities available-for-sale .............. 613 479
Net gain on sale of loans ......................................... 35 100
Other operating income ............................................ 336 155
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Total non-interest income ......................... 1,669 1,370
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NON-INTEREST EXPENSE
Salaries and employee benefits .................................... 1,837 1,794
Net occupancy expense ............................................. 281 238
Furniture and equipment expense ................................... 282 243
Marketing expense ................................................. 150 107
Third party services .............................................. 141 155
Telephone, postage and supplies expense ........................... 123 116
State taxes ....................................................... 103 112
Other expense ..................................................... 319 313
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Total non-interest expense ........................ 3,236 3,078
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Income before income taxes ................................ 2,518 2,218
Provision for income taxes ........................................ 599 496
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NET INCOME ........................................................ $1,919 $1,722
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NET INCOME PER SHARE-BASIC ........................................ $ .62 $ .56
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NET INCOME PER SHARE-DILUTED ...................................... $ .60 $ .54
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CASH DIVIDENDS PER SHARE $ .195 $ .185
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The accompanying notes are an integral part of the unaudited consolidated financial statements.
Page 1
QNB Corp. and Subsidiary
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CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)
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MARCH 31, DECEMBER 31,
2005 2004
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ASSETS
Cash and due from banks ................................. $ 18,102 $ 19,026
Federal funds sold ...................................... -- 3,159
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Total cash and cash equivalents ......... 18,102 22,185
Investment securities
Available-for-sale (cost $268,647 and $266,000) . 265,917 267,561
Held-to-maturity (market value $6,375 and $6,432) 6,202 6,203
Non-marketable equity securities ................ 3,525 3,947
Loans held-for-sale ..................................... 489 312
Total loans, net of unearned income ..................... 269,524 268,048
Allowance for loan losses ....................... (2,606) (2,612)
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Net loans ............................... 266,918 265,436
Bank-owned life insurance ............................... 7,974 7,906
Premises and equipment, net ............................. 5,539 5,640
Accrued interest receivable ............................. 2,901 2,531
Other assets ............................................ 3,559 1,923
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Total assets ............................................ $ 581,126 $ 583,644
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LIABILITIES
Deposits
Demand, non-interest-bearing .................... $ 53,803 $ 52,603
Interest-bearing demand accounts ................ 88,436 95,120
Money market accounts ........................... 65,506 60,434
Savings ......................................... 56,456 55,511
Time ............................................ 162,930 160,845
Time over $100,000 .............................. 41,939 41,975
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Total deposits .......................... 469,070 466,488
Short-term borrowings ................................... 10,015 13,374
Federal Home Loan Bank advances ......................... 55,000 55,000
Accrued interest payable ................................ 1,220 1,179
Other liabilities ....................................... 1,555 1,828
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Total liabilities ....................................... 536,860 537,869
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SHAREHOLDERS' EQUITY
Common stock, par value $.625 per share;
authorized 10,000,000 shares; 3,206,988 and
3,204,764 shares issued; 3,100,302 and 3,098,078
shares outstanding .............................. 2,004 2,003
Surplus ................................................. 9,041 9,005
Retained earnings ....................................... 36,885 35,570
Accumulated other comprehensive (loss) gain, net ........ (2,170) 691
Treasury stock, at cost; 106,686 shares ................. (1,494) (1,494)
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Total shareholders' equity .............................. 44,266 45,775
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Total liabilities and shareholders' equity .............. $ 581,126 $ 583,644
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The accompanying notes are an integral part of the unaudited consolidated financial statements.
Page 2
QNB Corp. and Subsidiary
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
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THREE MONTHS ENDED MARCH 31, 2005 2004
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OPERATING ACTIVITIES
Net income ........................................................................... $ 1,919 $ 1,722
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization ................................................ 217 189
Securities gains ............................................................. (613) (479)
Net gain on sale of repossessed assets ....................................... (209) --
Proceeds from sale of repossessed assets ..................................... 209 --
Net gain on sale of loans .................................................... (35) (100)
Loss on disposal of premises and equipment ................................... 1 --
Proceeds from sales of residential mortgages ................................. 1,905 3,923
Originations of residential mortgages held-for-sale .......................... (2,087) (2,678)
Income on bank-owned life insurance .......................................... (63) (68)
Life insurance premiums, net ................................................. (5) (3)
Deferred income tax provision ................................................ 43 107
Change in income taxes payable ............................................... 397 377
Net (increase) decrease in interest receivable ............................... (370) 541
Net amortization of premiums and discounts ................................... 254 303
Net increase (decrease) in accrued interest payable .......................... 41 (96)
Increase in other assets ..................................................... (277) (434)
Decrease in other liabilities ................................................ (670) (415)
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Net cash provided by operating activities .................................... 657 2,889
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INVESTING ACTIVITIES
Proceeds from maturities and calls of investment securities
available-for-sale ........................................................... 4,861 25,154
held-to-maturity ............................................................. -- 2,349
Proceeds from sales of investment securities
available-for-sale ........................................................... 12,639 17,954
Purchase of investment securities
available-for-sale ........................................................... (19,745) (28,239)
Net increase in loans ................................................................ (1,456) (2,742)
Net change in non-marketable securities .............................................. 422 --
Net purchases of premises and equipment .............................................. (117) (187)
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Net cash (used) provided by investing activities ............................. (3,396) 14,289
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FINANCING ACTIVITIES
Net increase in non-interest-bearing deposits ........................................ 1,200 1,412
Net decrease in interest-bearing non-maturity deposits ............................... (667) (15,138)
Net increase in time deposits ........................................................ 2,049 1,321
Net decrease in short-term borrowings ................................................ (3,359) (702)
Cash dividends paid .................................................................. (604) (573)
Proceeds from issuance of common stock ............................................... 37 --
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Net cash used by financing activites ......................................... (1,344) (13,680)
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(Decrease) increase in cash and cash equivalents ............................. (4,083) 3,498
Cash and cash equivalents at beginning of year ............................... 22,185 26,066
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Cash and cash equivalents at end of period ................................... $ 18,102 $ 29,564
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SUPPLEMENTAL CASH FLOW DISCLOSURES
Interest paid ........................................................................ $ 2,633 $ 2,307
Income taxes paid .................................................................... 125 150
Non-Cash Transactions
Change in net unrealized holding gains, net of taxes, on investment securities (2,861) 1,309
Transfer of loans to repossessed assets .............................................. 4 --
The accompanying notes are an integral part of the unaudited consolidated financial statements.
Page 3
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
1. REPORTING AND ACCOUNTING POLICIES
The accompanying unaudited consolidated financial statements include the
accounts of QNB Corp. (QNB) and its wholly-owned subsidiary, The Quakertown
National Bank (the Bank). All significant intercompany accounts and transactions
are eliminated in the consolidated statements.
The consolidated balance sheet as of March 31, 2005, as well as the respective
statements of income and cash flows for the three-month period ended March 31,
2005 and 2004, is unaudited. These consolidated financial statements should be
read in conjunction with the audited consolidated financial statements and notes
thereto included in QNB's 2004 Annual Report incorporated in the Form 10-K.
The unaudited consolidated 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. Certain
items in the 2004 consolidated financial statements have been reclassified to
conform to the 2005 financial statement presentation format. These
reclassifications had no effect on net income. The results for the periods
presented are not necessarily indicative of the full year. Tabular information
other than share data 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 consolidated financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from such estimates.
STOCK BASED COMPENSATION
At March 31, 2005, QNB had a stock-based employee compensation plan that is
accounted for under the recognition and measurement principles of Accounting
Principles Bulletin (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 Financial Accounting Standards
Board (FASB) Statement 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 Statement
No. 123, QNB has disclosed, in the notes to the consolidated financial
statements contained in its annual report to shareholders, what the earnings
impact would have been had QNB elected the "fair value" approach under Statement
No. 123. Such disclosure is now required on a quarterly basis in accordance with
Statement No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION - TRANSITION AND
DISCLOSURE - AN AMENDMENT OF FASB STATEMENT NO. 123.
Form 10-Q
Page 4
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005 AND 2004, AND DECEMBER 31, 2004
(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
Ended March 31,
2005 2004
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Net income, as reported $1,919 $1,722
Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax effects 25 18
Pro forma net income $1,894 $1,704
Earnings per share
Basic - as reported $.62 $.56
Basic - pro forma $.61 $.55
Diluted - as reported $.60 $.54
Diluted - pro forma $.60 $.54
2. PER SHARE DATA
The following sets forth the computation of basic and diluted earnings per share
(share and per share data are not in thousands):
For the Three Months
Ended March 31,
2005 2004
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Numerator for basic and diluted earnings
per share-net income $1,919 $1,722
Denominator for basic earnings per share-
weighted average shares outstanding 3,100,048 3,095,379
Effect of dilutive securities-employee
stock options 78,262 84,549
Denominator for diluted earnings per
share- adjusted weighted average
shares outstanding 3,178,310 3,179,928
Earnings per share-basic $.62 $.56
Earnings per share-diluted $.60 $.54
Form 10-Q
Page 5
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
2. PER SHARE DATA (Continued):
There were 40,000 stock options that were anti-dilutive as of March 31, 2005.
These stock options were not included in the above calculation. There were no
stock options that were anti-dilutive for the three-month period ended March 31,
2004.
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 March 31, 2005 and 2004 (net of the income tax effect):
For the Three Months
Ended March 31,
2005 2004
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Unrealized holding (losses) gains arising during
the period on securities held $(2,456) $1,625
Reclassification adjustment for gains included
in net income (405) (316)
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Net change in unrealized (losses) gains during
the period (2,861) 1,309
Unrealized holding gains, beginning of period
691 2,341
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Unrealized holding (losses) gains, end of period
$(2,170) $3,650
======= ======
Net income $ 1,919 $1,722
Other comprehensive income, net of tax:
Unrealized holding (losses) gains arising during
the period (2,861) 1,309
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Comprehensive (loss) income $ (942) $3,031
======= ======
Form 10-Q
Page 6
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
4. LOANS
The following table presents loans by category as of March 31, 2005 and December
31, 2004:
March 31, December 31,
2005 2004
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Commercial and industrial $57,466 $57,364
Agricultural 7 8
Construction 8,211 7,027
Real estate-commercial 94,534 98,397
Real estate-residential 104,092 99,893
Consumer 5,210 5,376
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Total loans 269,520 268,065
Less unearned costs (income) 4 (17)
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Total loans net of unearned income $269,524 $268,048
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5. INTANGIBLE ASSETS
As a result of a purchase of deposits in 1997, QNB recorded a deposit premium of
$511,000. This premium is being amortized, for book purposes, over ten years and
is reviewed annually for impairment. The net accumulated amortization was
$158,000 and $145,000 at March 31, 2005 and December 31, 2004, respectively.
Amortization expense for core deposit intangibles was $13,000 for both periods
ended March 31, 2005 and 2004.
The following table reflects the components of mortgage servicing rights as of
the periods indicated:
March 31, December 31,
2005 2004
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Mortgage servicing rights beginning balance $ 552 $ 582
Mortgage servicing rights capitalized 14 66
Mortgage servicing rights amortized (29) (122)
Fair market value adjustments 5 26
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Mortgage servicing rights ending balance $ 542 $ 552
======== ========
Mortgage loans serviced for others $ 77,549 $ 78,904
Amortization expense of intangibles 42 173
Form 10-Q
Page 7
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
5. INTANGIBLE ASSETS (Continued):
The annual estimated amortization expense of intangible assets for each of the
five succeeding fiscal years is as follows:
ESTIMATED AMORTIZATION EXPENSE
For the Year Ended 12/31/05 $155
For the Year Ended 12/31/06 141
For the Year Ended 12/31/07 118
For the Year Ended 12/31/08 63
For the Year Ended 12/31/09 51
6. RECENT ACCOUNTING PRONOUNCEMENTS
STOCK-BASED COMPENSATION
In April, the Securities and Exchange Commission adopted a new rule that amends
the compliance dates for FASB Statement No. 123 (revised 2004), SHARE-BASED
PAYMENT (FAS No. 123R). The Statement requires that compensation cost, relating
to share-based payment transactions, be recognized in financial statements and
that this cost be measured based on the fair value of the equity or liability
instruments issued. FAS No. 123 (Revised 2004) covers a wide range of
share-based compensation arrangements including share options, restricted share
plans, performance-based awards, share appreciation rights, and employee share
purchase plans. QNB will adopt FAS No. 123 (Revised 2004) on January 1, 2006 and
is currently evaluating the impact the adoption of the standard will have on
QNB's results of operations.
NONMONETARY ASSETS
In December 2004, FASB issued FAS No. 153, "Exchanges of Nonmonetary Assets - An
Amendment of APB Opinion No. 29". The guidance in APB Opinion No. 29,
"Accounting for Nonmonetary Transactions", is based on the principle that
exchanges of nonmonetary assets should be measured based on the fair value of
the assets exchanged. The guidance in that Opinion, however, included certain
exceptions to that principle. FAS No. 153 amends Opinion No. 29 to eliminate the
exception for nonmonetary exchanges of similar productive assets and replaces it
with a general exception for exchanges of nonmonetary assets that do not have
commercial substance. A nonmonetary exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. The provisions of FAS No. 153 are effective for nonmonetary
asset exchanges occurring in fiscal periods beginning after June 15, 2005. Early
application is permitted and companies must apply the standard prospectively.
The adoption of this standard is not expected to have a material effect on QNB's
results of operations or financial position.
Form 10-Q
Page 8
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".
FORWARD-LOOKING STATEMENTS
In addition to historical information, this document contains forward-looking
statements. Forward-looking statements are typically identified by words or
phrases such as "believe," "expect," "anticipate," "intend," "estimate,"
"project" and variations of such words and similar expressions, or future or
conditional verbs such as "will," "would," "should," "could," "may" or similar
expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides
safe harbor in regard to the inclusion of forward-looking statements in this
document and documents incorporated by reference.
Shareholders should note that many factors, some of which are discussed
elsewhere in this document and in the documents that we incorporate by
reference, could affect the future financial results of the Corporation and its
subsidiary and could cause those results to differ materially from those
expressed in our forward-looking statements contained or incorporated by
reference in this document. These factors include, but are not limited, to the
following:
o Operating, legal and regulatory risks
o Economic, political and competitive forces affecting our line of
business
o The risk that our analysis of these risks and forces could be
incorrect, and/or that the strategies developed to address them could
be unsuccessful
o Volatility in interest rates
o Increased credit risk
QNB cautions that these forward-looking statements are subject to numerous
assumptions, risks and uncertainties, all of which change over time, and QNB
assumes no duty to update forward-looking statements. Management cautions
readers not to place undue reliance on any forward-looking statements. These
statements speak only as of the date made, and they advise readers that various
factors, including those described above, could affect QNB's financial
performance and could cause our actual results or circumstances for future
periods to differ materially from those anticipated or projected. Except as
required by law, we do not undertake, and specifically disclaim any obligation,
to publicly release any revisions to any forward-looking statements to reflect
the occurrence of anticipated or unanticipated events or circumstances after the
date of such statements.
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 U.S. generally accepted accounting principles (GAAP) and
predominant practices within the banking industry. The preparation of these
consolidated 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.
Form 10-Q
Page 9
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
CRITICAL ACCOUNTING POLICIES AND ESTIMATES (CONTINUED)
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-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
Form 10-Q
Page 10
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
CRITICAL ACCOUNTING POLICIES AND ESTIMATES (CONTINUED):
affecting borrowers and collateral cannot be predicted with certainty, increases
to the allowance may 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 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
are 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.
OVERVIEW
QNB reported net income for the first quarter of 2005 of $1,919,000, or $.60 per
common share on a diluted basis. This represents an 11.4% increase over the
$1,722,000, or $.54 per share diluted, for the same period in 2004. The results
for the first quarter of 2005 represent a record quarter for QNB.
Two important measures of profitability in the banking industry are an
institution's return on average assets and return on average shareholders'
equity. Return on average assets and return on average shareholders' equity were
1.34% and 17.04%, respectively, for the first quarter of 2005 compared with
1.28% and 16.64%, respectively, for the first quarter of 2004.
The results for the first quarter of 2005 compared to the same period in 2004
included the following significant components:
Net interest income increased $159,000, or 4.0%, to $4,085,000.
o Contributing to the increase in net interest income was an 8.3%
increase in average earning assets. The average balance of loans
increased by 14.3%, while average deposits increased 8.8%.
o Included in net interest income for the first quarter of 2005 is
$40,000 of interest income recovered on non-accrual and previously
charged off loans. This compares to $44,000 recovered during the first
quarter of 2004.
Form 10-Q
Page 11
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
OVERVIEW (CONTINUED)
o The net interest margin declined 11 basis points to 3.30% for the
first quarter of 2005. The decline in the margin was a result of
funding costs, particularly money market and time deposit rates,
increasing to a greater degree than rates on earning assets. However,
net interest margin of 3.30% for the first quarter of 2005 represented
an increase from the 3.21% reported for the fourth quarter of 2004.
o The Federal Reserve Bank Board continued to raise interest rates, with
two additional 25 basis point increases during the first quarter of
2005. The Federal funds rate has increased from 1.00% at the end of
March 2004 to 2.75% at March 31, 2005. The yield curve continues to
flatten as short-term rates increase more than mid- and longer-term
interest rates.
o Asset quality continued to improve as non-performing assets declined
from $639,000 at March 31, 2004 to $60,000 at March 31, 2005. QNB had
no non-accrual loans at March 31, 2005. As a result of the continued
low level of non-performing assets, no provision for loan losses was
recorded during the first quarter of 2005.
Non-interest income increased $299,000, or 21.8%, to $1,669,000.
o The net gain on the sale of investment securities increased $134,000,
while the net gain on the sale of loans decreased $65,000. The gain on
the sale of investment securities is primarily from the sales of
equity securities. The decline in the gain on the sale of loans is a
result of the decline in mortgage activity resulting from higher
interest rates.
o A $209,000 gain on the liquidation of the remaining assets
relinquished by a borrower during the third quarter of 2005 was the
primary increase in other operating income. This gain, combined with
the gain in the fourth quarter of 2004, resulted in the full recovery
of the $350,000 charge-off recorded through the allowance for loan
losses during the third quarter of 2004 related to this loan.
Non-interest expense increased $158,000, or 5.1%, to $3,236,000.
o Salary and benefit expense increased by $43,000, or 2.4%. The accrual
for incentive compensation decreased by $60,000 when comparing the two
quarters. This decline was offset by merit and promotional increases,
additional employee costs associated with the opening of QNB's first
supermarket branch during the second quarter of 2004 and continued
increases in medical premiums.
o The supermarket branch also contributed to the $82,000 increase in net
occupancy and furniture and equipment expense when comparing the two
quarters.
o Marketing costs, including donations, increased $43,000, to $150,000,
during the first quarter of 2005.
o The effective tax rate was 23.8% for the first quarter of 2005
compared to 22.4% for the first quarter of 2004.
These items as well as others will be explained more thoroughly in the next
sections.
Form 10-Q
Page 12
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
AVERAGE BALANCES, RATE, AND INTEREST INCOME AND EXPENSE SUMMARY (TAX-EQUIVALENT BASIS)
THREE MONTHS ENDED
MARCH 31, 2005 MARCH 31, 2004
AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE RATE INTEREST BALANCE RATE INTEREST
- ---------------------------------------------------------------------------------------------------------------------------
ASSETS
- ---------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 2,902 2.45% $ 18 $ 8,435 0.99% $ 21
- ---------------------------------------------------------------------------------------------------------------------------
Investment securities:
U.S. Treasury 6,152 2.05% 31 6,770 1.99% 34
U.S. Government agencies 47,876 3.57% 427 34,266 3.87% 332
State and municipal 52,531 6.51% 854 50,752 6.55% 831
Mortgage-backed and CMOs 135,198 4.19% 1,418 135,422 4.26% 1,443
Other 29,874 5.32% 397 30,578 5.42% 414
- ---------------------------------------------------------------------------------------------------------------------------
Total investment securities 271,631 4.61% 3,127 257,788 4.74% 3,054
- ---------------------------------------------------------------------------------------------------------------------------
Loans:
Commercial real estate 122,482 6.01% 1,816 106,430 5.85% 1,548
Residential real estate 23,646 5.92% 350 20,505 6.73% 345
Home equity loans 59,286 5.76% 842 50,551 5.94% 747
Commercial and industrial 43,604 6.08% 653 39,092 4.83% 469
Consumer loans 5,165 9.09% 116 5,460 9.91% 135
Tax-exempt loans 13,280 5.27% 173 11,903 5.39% 159
- ---------------------------------------------------------------------------------------------------------------------------
Total loans, net of unearned income* 267,463 5.99% 3,950 233,941 5.85% 3,403
- ---------------------------------------------------------------------------------------------------------------------------
Other earning assets 4,837 2.48% 30 4,800 1.38% 16
- ---------------------------------------------------------------------------------------------------------------------------
Total earning assets 546,833 5.28% 7,125 504,964 5.17% 6,494
- ---------------------------------------------------------------------------------------------------------------------------
Cash and due from banks 18,248 19,173
Allowance for loan losses (2,607) (2,921)
Other assets 19,022 18,391
- ---------------------------------------------------------------------------------------------------------------------------
Total assets $ 581,496 4.97% $ 539,607 4.84%
===========================================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
- ---------------------------------------------------------------------------------------------------------------------------
Interest-bearing deposits:
Interest-bearing demand accounts $ 91,355 0.87% $ 197 $ 100,239 0.60% $ 149
Money market accounts 63,398 1.61% 252 36,254 0.67% 61
Savings 55,507 0.39% 54 53,456 0.39% 52
Time 162,378 2.80% 1,122 151,811 2.64% 996
Time over $100,000 41,850 2.71% 280 37,897 2.25% 212
- ---------------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits 414,488 1.86% 1,905 379,657 1.56% 1,470
- ---------------------------------------------------------------------------------------------------------------------------
Short-term borrowings 10,639 1.61% 42 10,681 0.81% 22
Federal Home Loan Bank advances 55,000 5.36% 727 55,000 5.25% 718
- ---------------------------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities 480,127 2.26% 2,674 445,338 2.00% 2,210
- ---------------------------------------------------------------------------------------------------------------------------
Non-interest-bearing deposits 52,579 49,537
Other liabilities 3,126 3,115
Shareholders' equity 45,664 41,617
- ---------------------------------------------------------------------------------------------------------------------------
Total liabilities and
shareholders' equity $ 581,496 1.87% $ 539,607 1.65%
===========================================================================================================================
Net interest rate spread 3.02% 3.18%
===========================================================================================================================
Margin/net interest income 3.30% 4,451 3.41% 4,284
===========================================================================================================================
Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are
based on the marginal Federal corporate tax rate rate of 34 percent.
Non-accrual loans are included in earning assets.
* Includes loans held-for-sale
Form 10-Q
Page 13
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME
The following table presents the adjustment to convert net interest income to
net interest income on a fully taxable equivalent basis for the periods ended
March 31, 2005 and 2004.
For the Three Months
Ended March 31,
2005 2004
------- -------
Total interest income $ 6,759 $ 6,136
Total interest expense 2,674 2,210
------- -------
Net interest income 4,085 3,926
Tax equivalent adjustment 366 357
------- -------
Net interest income (fully taxable equivalent) $ 4,451 $ 4,283
======= =======
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.
For purposes of this discussion, interest income and the average yield earned on
loans and investment securities are adjusted to a tax-equivalent basis as
detailed in the table that appears on page 14. This adjustment to interest
income is made for analysis purposes only. Interest income is increased by the
amount of savings of Federal income taxes, which QNB realizes by investing in
certain tax-exempt State and municipal securities and by making loans to certain
tax-exempt organizations. In this way, the ultimate economic impact of earnings
from various assets can be more easily compared.
The net interest rate spread is the difference between average rates received on
earning assets and average rates paid on interest-bearing liabilities, while the
net interest rate margin includes interest-free sources of funds.
Net interest income increased 4.0%, to $4,085,000, for the quarter ended March
31, 2005 as compared to $3,926,000 for the quarter ended March 31, 2004. On a
tax-equivalent basis, net interest income increased by 3.9% from $4,284,000 for
the three months ended March 31, 2004 to $4,451,000 for the same period ended
March 31, 2005. As has been the trend, the ability to increase net interest
income is a result of the growth in deposits and the investment of these
deposits into profitable loans and investment securities. This growth in earning
assets has been able to offset the continued decline in the net interest margin
resulting from the low interest rate environment of the past few years. While
core deposits continue to increase, a significant contributor to the growth in
deposits, both period-end and average, were additional deposits of local
municipalities and school districts. The majority of the growth in these
deposits is seasonal and has been withdrawn during the first quarter of 2005 or
will be withdrawn during the second quarter of 2005. While these deposits,
because of their
Form 10-Q
Page 14
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (CONTINUED)
short-term nature and the competition for these deposits, add to net interest
income, they provide a significantly lower spread than core deposits and,
therefore, have a negative impact on the net interest margin.
Average deposits increased $37,873,000, or 8.8%, when comparing the first
quarters of 2005 and 2004. Included in this increase in average deposits was
approximately $5,600,000 of additional municipal deposits. On a comparison of
period-end to period-end balances, municipal deposits increased approximately
$14,800,000. Average earning assets increased 8.3% during this same period with
average loans increasing $33,522,000, or 14.3%, and average investment
securities increasing $13,843,000, or 5.4%. When comparing the first quarters of
2005 and 2004, the net interest margin and net interest rate spread declined by
11 basis points and 16 basis points, respectively. The net interest margin
decreased to 3.30% for the first quarter of 2005 from 3.41% for the first
quarter of 2004, while the net interest rate spread decreased to 3.02% from
3.18% during the same period.
As mentioned previously, the Federal Reserve Board continued its "measured pace"
strategy of tightening by increasing the Federal funds rate twice by 25 basis
points each time during the first quarter of 2005. Since March 2004, they have
increased the rate seven times and 175 basis points from 1.00% to 2.75%. Despite
the increase in market interest rates off their historic lows, the long period
of historically low interest rates has had an impact on the yield on earning
assets and the rates paid on interest-bearing liabilities. While the yield on
earning assets on a tax-equivalent basis has increased from 5.17% for the first
quarter of 2004 to 5.28% for the first quarter of 2005, the rate of increase was
slowed because of the fixed rate nature of the investment and loan portfolio as
well as the price competition for loans. The yield on the investment portfolio
actually declined from 4.74% for the first quarter of 2004 to 4.61% for the
first quarter of 2005. Some of this decline was the result of the municipal
deposits being invested in short-term, lower yielding U.S. Government agency
securities. The yield on this category of investments declined from 3.87% for
the first quarter of 2004 to 3.57% for the first quarter of 2005. The yield on
the investment portfolio should increase in 2005 as these lower yielding
securities are called or sold and as new funds are invested at higher rates.
The yield on loans increased 14 basis points to 5.99% when comparing the first
quarter of 2005 to the first quarter of 2004. The average prime rate when
comparing these same periods increased 144 basis points, from 4.00% to 5.44%.
While QNB was positively impacted from the increases in prime rate, the overall
yield on the loan portfolio did not increase proportionately, since only a
percentage of the loan portfolio re-prices immediately with changes in the prime
rate. The benefits from an increase in the prime rate were partially offset by
the long period of historically low interest rates which resulted in the
refinancing of residential mortgage, home equity and commercial loans into lower
yielding fixed rate loans. The commercial and industrial category of loans
benefited the most from the increase in the prime rate, as many of these loans
are indexed to that rate. The yield on this category increased 125 basis points
when comparing the two quarters. The rate of increase in loan yields will be
determined by how quickly and to what degree the Federal Reserve Board continues
to increase interest rates, the shape of the yield curve and how much the
competitive nature of the business will keep loan rates down.
While total interest income on a tax-equivalent basis increased $631,000 when
comparing the first quarter of 2005 to the first quarter of 2004, total interest
expense increased $464,000. The increase in interest expense was a result of an
increase in deposit balances and an increase in interest rates paid on both
deposits and short-term borrowings. The rate paid on interest-bearing
liabilities increased from 2.00% for the first quarter of 2004 to 2.26% for the
first quarter of 2005, with the rate paid on interest-bearing deposits
increasing from 1.56% to 1.86% during this same period. Interest expense and the
rate paid on money market accounts and time deposit accounts increased the most
as these accounts were more reactive to the increase in market
Form 10-Q
Page 15
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (CONTINUED)
interest rates. Interest expense on money market accounts increased $191,000,
and the rate paid increased from .67% to 1.61% when comparing the two quarters.
The increase in the rate paid was primarily the result of two events. First, QNB
had to pay a higher rate to attract the municipal deposits; second, rising
short-term interest rates impacted QNB's 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 yield on this product
has increased as short-term interest rates have increased. The average balance
of money market accounts increased $27,144,000 when comparing the first quarter
of 2005 to the same period in 2004. The additional deposits of a school district
contributed approximately $16,900,000 to the increase, while growth in the
Treasury Select accounts contributed approximately $6,078,000.
Interest expense on time deposits increased $194,000, while the average rate
paid on time deposits increased from 2.56% to 2.78% when comparing the two
periods. Like fixed-rate loans and investment securities, certificates of
deposit reprice over time and, therefore, have less of an immediate impact on
costs in either a rising or falling rate environment. Unlike loans and
investment securities, the maturity and repricing characteristics tend to be
shorter. This feature, combined with the strong rate competition for these
deposits, will likely result in the continued increase in the yield on time
deposits in 2005. Average time deposits increased $14,520,000, or 7.7%, when
comparing the first quarter of 2005 to the first quarter of 2004. The higher
rates being offered on time deposits compared to other deposit accounts seems to
be the impetus for the growth.
Management expects interest expense and the rate paid on interest-bearing
liabilities to increase throughout 2005 as higher short-term market rates of
interest result in higher rates paid initially on money market accounts and time
deposits. This will be followed by higher rates paid on interest-bearing demand
accounts and savings accounts, accounts that tend to lag as rates increase.
Management also expects net interest income to increase slightly in 2005 as a
result of the growth in earning assets offsetting a net interest margin that
will likely be stable or decline slightly. The yield curve is expected to
flatten further in 2005, as the Federal Reserve Board continues to increase
short-term interest rates. A flat yield curve will continue to put pressure on
the net interest margin.
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 existing loan portfolio. Actual loan losses, net of
recoveries, serve to reduce the allowance.
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. Other tools include ratio analysis
and peer group analysis.
Form 10-Q
Page 16
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
PROVISION FOR LOAN LOSSES (CONTINUED)
QNB's management determined no provision for loan losses was necessary for
either three-month periods ended March 31, 2005 or 2004 as the results of the
analysis described above resulted in an allowance for loan losses that was
adequate in relation to the estimate of known and inherent losses in the
portfolio. In addition, charge-offs and non-performing assets remain at low
levels. QNB had net charge-offs of $6,000 and $10,000 during the first quarter
of 2005 and 2004, respectively.
Non-performing assets (non-accruing loans, loans past due 90 days or more, other
real estate owned and other repossessed assets) amounted to .01% and .12% of
total assets at March 31, 2005 and 2004. This compares to .08% at December 31,
2004. There were no non-accrual loans at March 31, 2005. Non-accrual loans were
$373,000 and $562,000 at December 31, 2004 and March 31, 2004, respectively. QNB
did not have any other real estate owned as of March 31, 2005, December 31, 2004
or March 31, 2004. Repossessed assets were $4,000 at March 31, 2005. The book
value of repossessed assets at December 31, 2004 was zero. There were no
repossessed assets at March 31, 2004.
There were no restructured loans as of March 31, 2005, December 31, 2004 or
March 31, 2004 as defined in SFAS 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 $2,606,000 and $2,612,000 at March 31, 2005
and December 31, 2004, respectively. The ratio of the allowance to total loans
was .97% at both respective period end dates. 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 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.
There were no loans considered impaired at March 31, 2005. At March 31, 2004,
the recorded investment in loans for which impairment has been recognized in
accordance with SFAS No. 114 totaled $560,000. The loans identified as impaired
were collateral-dependent, with no valuation allowance necessary.
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.
Form 10-Q
Page 17
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
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 check 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 other miscellaneous fee
income.
Total non-interest income increased $299,000, or 21.8%, to $1,669,000 for the
quarter ended March 31, 2005 when compared to March 31, 2004. Excluding gains on
the sale of securities and loans, non-interest income increased $230,000, or
29.1%.
Fees for services to customers, the largest component of total non-interest
income, are comprised of service charges on deposit accounts. These fees
decreased 1.6%, to $439,000, from $446,000 when comparing the two quarters.
Contributing to the decline in fee income was a $17,000 reduction in service
charge income on non-interest bearing business checking accounts. The decline in
the service charges on business accounts reflects the impact of a higher
earnings credit rate, resulting from the increases in short-term interest rates,
applied against balances to offset service charges incurred. Also, negatively
impacting service charge income was the elimination of the monthly fee on an
interest-bearing checking account product. This resulted in the loss of
approximately $10,000 for the quarter. Partially offsetting these declines was
an increase in overdraft income of approximately $19,000 which was the result of
an increase in the fee effective March 1, 2004.
ATM and debit card income is primarily comprised of 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 $159,000 for the first quarter of 2005, an increase of
$31,000, or 24.2%, from the amount recorded during the first quarter of 2005.
Debit card income increased $18,000, or 19.3%, for the three-month period. The
increase in debit card income is a result of the increased acceptance by
consumers of the card as a means of paying for goods and services. Increased
usage of QNB ATM machines and the resulting surcharge and interchange income
resulted in an $11,000 increase in ATM income when comparing the two quarters.
Income on bank-owned life insurance represents the earnings on life insurance
policies in which the Bank is the beneficiary. The earnings on these policies
were $63,000 and $68,000 for the three months ended March 31, 2005 and 2004,
respectively. The insurance carriers reset the rates on these policies annually.
The decline in income is a result of a lower earnings rate resulting from the
lower interest rate environment at the last reset period.
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 (costs) for the three month periods ended March 31, 2005
and 2004 were $24,000 and ($6,000), respectively. Included in the first quarter
of 2005 was a $5,000 positive adjustment to the valuation allowance for
impairment resulting from the increase in interest rates and the slowdown in
mortgage prepayments in 2004. Included in the first quarter of 2004 amount is a
$23,000 valuation allowance for impairment. 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 in
2003 and early 2004. Excluding the valuation allowance adjustments, mortgage
servicing income would have been $19,000 for the first quarter of 2005, compared
to $17,000 for the first quarter of 2004.
Form 10-Q
Page 18
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST INCOME (CONTINUED)
Also impacting mortgage servicing income was the decline in amortization expense
and a decrease in the amount of mortgages serviced. Amortization expense for the
three-month periods ended March 31, 2005 and 2004 was $29,000 and $36,000,
respectively. The average balance of mortgages serviced for others was
$78,392,000 for the first quarter of 2005 compared to $85,047,000 for the first
quarter of 2004, a decrease of 7.8%. The timing of mortgage payments and
delinquencies also impacts the amount of servicing fees recorded
QNB recorded a net gain on investment securities of $613,000 and $479,000 for
the three-month periods ended March 31, 2005 and 2004, respectively. Included in
net securities gains for the three-month period ended March 31, 2005 were gains
of $270,000 from the sale of debt securities and $343,000 related to activity in
the marketable equity securities portfolio at the Corporation. The gains
recorded during the first quarter of 2004 represent $210,000 related to the sale
of fixed income securities at the Bank and $269,000 as a result of sales from
the equity portfolio at the Corporation. The fixed income securities portfolio
represents a significant portion of QNB's earning assets and is also a primary
tool in liquidity and asset/liability management. QNB actively manages its fixed
income portfolio in an effort to take advantage of changes in the shape of the
yield curve, changes in spread relationships in different sectors and for
liquidity purposes as needed. Management will continue to look at strategies
that will result in an increase in the yield or improvement in the structure of
the investment portfolio. These strategies could result in net losses.
The net gain on the sale of residential mortgage loans was $35,000 and $100,000
for the quarters ended March 31, 2005 and 2004, respectively. Residential
mortgage loans to be sold are identified at origination. 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. Included
in the gains on the sale of residential mortgages in these periods were $14,000
and $29,000 related to the recognition of mortgage servicing assets. With the
increase in interest rates the volume of mortgage activity has slowed and the
gains from sales have declined. Proceeds from the sale of mortgages were
$1,905,000 and $3,923,000 for the first quarter of 2005 and 2004, respectively.
Other operating income increased $181,000 to $336,000 during the first quarter
of 2005. Included in other operating income during the first quarter of 2005 was
$209,000 in gains from the sale of repossessed assets.
Financial service organizations, including QNB, are challenged to demonstrate
that they can generate an increased contribution to revenue from non-interest
sources. QNB will continue to analyze other opportunities and products that
could enhance its fee-based businesses.
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
$3,236,000 for the quarter ended March 31, 2005 represents an increase of
$158,000, or 5.1%, from levels reported in the first quarter of 2004.
Salaries and benefits is the largest component of non-interest expense. Salary
and benefits expense increased $43,000, or 2.4%, to $1,837,000 for the quarter
ended March 31, 2005 compared to the same quarter in 2004. Salary expense
increased $33,000, or 2.3%, during the period to $1,467,000 while benefits
expense increased $10,000, or 2.8%, to $370,000. Included in salary expense for
the three months ended March 31, 2005 and 2004 was an accrual of $40,000 and
$100,000, respectively, related to the incentive compensation plan.
Form 10-Q
Page 19
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST EXPENSE (CONTINUED)
Excluding the impact of the accrual for the incentive compensation plan, salary
expense increased 7.0% for the three-month period. Merit increases and an
increase in the number of employees contributed to the increase in salary
expense. The number of full time-equivalent employees increased by eight when
comparing the first quarter of 2005 and 2004. Contributing to the increase in
full time-equivalent employees was the opening of a supermarket branch during
the second quarter of 2004.
Net occupancy expense increased $43,000, to $281,000, when comparing the first
quarter of 2005 to the first quarter of 2004. Contributing to the increase was
higher costs related to building maintenance, utilities, taxes and rent expense.
The addition of the new supermarket branch contributed to the increase in real
estate taxes and rent expense, while repairs to existing buildings and snow
removal contributed to the increase in building maintenance expense.
Furniture and equipment expense increased $39,000, to $282,000, when comparing
the two quarters. Increases in depreciation expense and the cost of maintenance
contracts were the primary contributors to the increase in furniture and
equipment expense.
Marketing expense increased $43,000, to $150,000, for the quarter ended March
31, 2005. Advertising expense increased $10,000 when comparing the two quarters
as QNB increased its use of billboards for product advertising. Advertising
expense will likely continue to increase as QNB has made a strategic decision to
increase its advertising efforts, including television advertising. Sales
promotion expense increased $7,000 for the three-month period and donations
increased $33,000 for the same period. QNB contributes to not-for-profit
organizations, clubs and community events in the local communities it serves.
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 support services
include trust services, retail non-deposit services, correspondent banking
services, statement printing and mailing, investment security safekeeping and
supply management services. Third party services expense was $141,000 for the
first quarter of 2005 compared to $155,000 for the first quarter of 2004. The
decline in expense is primarily related to the elimination of the costs
associated with the discontinuation of a deposit product that offered ancillary
benefits to customers.
INCOME TAXES
QNB utilizes an asset and liability approach for financial accounting and
reporting of income taxes. As of March 31, 2005, QNB's net deferred tax asset
was $1,119,000. The primary components of deferred taxes are a deferred tax
asset of $715,000 relating to the allowance for loan losses and a deferred tax
asset of $560,000 resulting from the SFAS No.115 adjustment for
available-for-sale investment securities. As of March 31, 2004, QNB's net
deferred tax liability was $1,067,000. A deferred tax asset of $747,000 related
to the allowance for loan losses was offset by a deferred tax liability of
$1,880,000 resulting from the SFAS No. 115 adjustment for available-for-sale
investment securities. The decrease in the market value of the
available-for-sale investment portfolio resulting from increasing interest rates
is the primary reason for the switch from a deferred tax liability to a deferred
tax asset.
Applicable income taxes and effective tax rates were $599,000, or 23.8%, for the
three-month period ended March 31, 2005 and $496,000, or 22.4%, for the same
period in 2004. The higher effective tax rate in the first quarter of 2005 was a
result of a decrease in the proportion of tax-exempt income from investment
securities, loans and bank-owned life insurance to pretax income.
Form 10-Q
Page 20
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION ANALYSIS
The balance sheet analysis compares average balance sheet data for the three
months ended March 31, 2005 and 2004, as well as the period ended balances as of
March 31, 2005 and December 31, 2004.
Average earning assets for the three-month period ended March 31, 2005 increased
$41,869,000, or 8.3%, to $546,833,000 from $504,964,000 for the three months
ended March 31, 2004. Average loans increased $33,522,000, or 14.3%, while
average investments increased $13,843,000, or 5.4%. Average Federal funds sold
decreased $5,533,000 when comparing these same periods.
Increasing loan balances have been, and remain a major focus of QNB. Despite the
slow growing economy and extremely competitive environment, QNB was successful
in increasing total loans, while maintaining excellent asset quality. Total
loans have increased 14.8% between March 31, 2005 and March 31, 2004 and .6%
since December 31, 2004. The year over year comparison takes out some of the
seasonality of commercial line of credit borrowings. A major factor in the
growth in total loans is the use of a formal business development and calling
program encompassing lending personnel, branch personnel and senior management.
This program was strengthened in 2003 by the appointment of a business
development officer. The focus of this program is to both develop new lending
and deposit relationships as well as to strengthen existing relationships.
Average commercial loans and average home equity loans increased $21,941,000 and
$8,735,000, respectively, when comparing the first three months of 2005 to the
first three months of 2004, while average residential mortgage loans increased
$3,141,000. During this same time frame, average consumer loans decreased
$295,000. The 12.2% increase in average commercial loans reflects the success of
the business development program mentioned above. Most of the growth in
commercial loans is in variable rate loans secured by real estate, either
commercial or residential properties. While variable rate, these loans could
have a fixed rate for a period of time, such as three or five years, before the
rate becomes adjustable.
The 17.3% increase in home equity loans reflects their popularity with
consumers, especially those refinancing existing residential mortgage loans,
because they have lower origination costs than residential mortgage loans. Most
of the growth in home equity loans in the past year has been in the variable
rate home equity line of credit. This product's interest rate floats at prime
minus .50% and became extremely attractive when prime dropped to 4.0%. QNB
anticipates that as prime increases customers will refinance these floating rate
loans into fixed rate home equity loans. The increase in residential mortgage
loans is primarily the result of the introduction of several hybrid adjustable
rate mortgage products. These products have a fixed rate for a five to ten year
period of time, and then adjust annually after the fixed period is over. QNB
holds these loans in portfolio. On a year over year basis, variable rate
residential mortgage loans have increased from $10,533,000 at March 31, 2004 to
$16,327,000 at March 31, 2005.
The growth in average earning assets was funded primarily by deposit growth.
Total average deposits increased $37,873,000, or 8.8%, to $467,067,000 for the
first quarter of 2005 compared to the first quarter of 2004. Most of the growth
was in money market accounts, which increased $27,144,000 on average. The
increase in money market balances reflects both the growth in the relationship
with a school district and the increase in the Treasury Select money market
balances as short-term interest rates have risen. The average balance with the
school district increased by $16,900,000, when comparing the three-month
periods, while Treasury Select average balances have increased by $6,078,000
over the same timeframe.
Form 10-Q
Page 21
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION ANALYSIS (CONTINUED)
Also contributing to the growth in average deposits were time deposits, which
increased $14,520,000, or 7.7%, when comparing the two quarters. Time deposits
with balances under $100,000 increased $10,567,000, to $162,378,000, while time
deposits equal to or greater than $100,000 increased $3,953,000, to $41,850,000.
Most of the growth occurred in the 36-month category, which QNB promoted heavily
in 2004 in an effort to lock in funding costs in anticipation of rising rates.
Increasing time deposit balances will be a challenge because of the extreme rate
competition for time deposits, particularly with maturities between eight months
through two years. Matching or beating competitors' rates could have a negative
impact on the net interest margin.
Average non-interest bearing demand accounts increased $3,042,000, or 6.1%, to
$52,579,000. The "Free Checking" promotion, as well as the acquisition of new
business accounts, was a significant factor in the increase in non-interest
bearing deposits.
Average savings accounts increased $2,051,000, or 3.8%. The continued growth in
savings deposits can be attributed to consumers looking for the relative safety
of bank deposits despite the low interest rate environment. The challenge will
be to retain these deposits as interest rates increase and confidence in the
equity markets improves.
Average interest-bearing demand deposit accounts declined $8,884,000, or 8.9%,
when comparing the two quarters. Average municipal balances declined $11,254,000
when comparing the two periods as one school district reduced their balances
earlier in 2005 than they did in 2004. Some of this decline was offset by a 6.9%
increase in personal interest bearing demand accounts.
Total assets at March 31, 2005 were $581,126,000, compared with $583,644,000 at
December 31, 2004, a decrease of .4%. There were no significant changes in the
asset composition during the first three months of the year. On the liability
side the composition of the deposits changed slightly as the decline in interest
bearing demand balances was offset by increases in money market and time deposit
balances.
At March 31, 2005, the fair value of investment securities available-for-sale
was $265,917,000, or $2,730,000 below the amortized cost of $268,647,000. This
compares to a fair value of $267,561,000, or $1,561,000 above the amortized cost
of $266,000,000 at December 31, 2004. An unrealized holding loss, net of taxes,
of $2,170,000 was recorded as a decrease to shareholders' equity at March 31,
2005 while an unrealized holding gain of $691,000 was recorded as an increase to
shareholders' equity at December 31, 2004. The increase in interest rates since
December 31, 2004 along with the flattening of the yield curve has contributed
to the decline in the market value of the investment portfolio and the
recognition of an unrealized loss.
In light of the minimal number of transactions in the investment portfolio
during the first quarter, there were only minor changes to the composition of
the portfolio since December 31, 2004.
The available-for-sale portfolio had a weighted average maturity of
approximately 4 years and 7 months at March 31, 2005 and 3 years, 7 months at
December 31, 2004. The weighted average tax-equivalent yield was 4.63% and 4.59%
at March 31, 2005 and December 31, 2004. The weighted average maturity is based
on the stated contractual maturity of all securities except for mortgage-backed
securities and CMOs, which are based on estimated average life. The maturity of
the portfolio may be shorter because of call features in many debt securities
and because of prepayments on mortgage-backed securities and CMOs. However, the
estimated average life could be longer if rates were to increase and principal
payments on mortgage-backed securities and CMOs would slow. The interest rate
sensitivity analysis reflects the repricing term of the securities portfolio
Form 10-Q
Page 22
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION ANALYSIS (CONTINUED)
based upon estimated call dates and anticipated cash flows assuming management's
most likely interest rate environment. The extension in average life of the
portfolio is a function of the increase in interest rates. Some agency bonds
that were anticipated to be called will now likely go to maturity. The repricing
term of the agency portfolio increased from 1 year, 1 month at December 31, 2004
to 3 years, 4 months at March 31, 2005. In addition, the prepayments on
mortgage-backed securities and CMOs are anticipated to slow because of the
increase in rates.
Investment securities held-to-maturity are reported at amortized cost. The
held-to-maturity portfolio is comprised solely of tax-exempt municipal
securities. As of March 31, 2005 and December 31, 2004, QNB had securities
classified as held-to-maturity with an amortized cost of $6,202,000 and
$6,203,000 and a market value of $6,375,000 and $6,432,000, respectively. The
held-to-maturity portfolio had a weighted average maturity of approximately 4
years, 2 months at March 31, 2005 and 4 years, 5 months at December 31, 2004.
The weighted average tax-equivalent yield was 6.79% at both March 31, 2005 and
December 31, 2004.
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 in the secondary market also provide sources of liquidity.
Additional sources of liquidity are provided by the Bank's membership in the
Federal Home Loan Bank of Pittsburgh (FHLB) and a $10,000,000 unsecured Federal
funds line granted by a correspondent bank. The Bank has a maximum borrowing
capacity with the FHLB of approximately $221,974,000. At March 31, 2005, QNB's
outstanding borrowings under the FHLB credit facilities totaled $55,000,000.
Cash and due from banks, Federal funds sold, available-for-sale securities and
loans held-for-sale totaled $284,508,000 and $290,058,000 at March 31, 2005 and
December 31, 2004, respectively. These sources should be adequate to meet normal
fluctuations in loan demand and or deposit withdrawals. For the most part, QNB
has been able to fund the growth in earning assets through increased deposits.
During the first quarter of 2005, QNB used its Federal funds line to help fund
timing differences between the withdrawal of funds by municipalities and the
receipt of the proceeds from the securities matched against these deposits.
Average Federal funds purchased were $425,000 for the first quarter of 2005.
This compares to $95,000 for the same period in 2004. At March 31, 2005, QNB had
a Federal funds purchased of $810,000.
Approximately $75,741,000 and $103,305,000 of available-for-sale securities at
March 31, 2005 and December 31, 2004, respectively, were pledged as collateral
for repurchase agreements and deposits of public funds. In addition, under terms
of its agreement with the FHLB, 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 FHLB. The decrease in pledged amounts
relates to the seasonal nature of the municipal deposits. These deposits were
used to purchase available-for-sale securities that were used to pledge against
the deposits of the municipalities. The securities were purchased with cash flow
characteristics that would closely match the anticipated run-off of the
municipal deposits. As these deposits are withdrawn the pledging is released.
This
Form 10-Q
Page 23
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
LIQUIDITY (CONTINUED)
pledged balance should continue to decline during the second quarter of 2005 as
the municipal deposits reach their low balances.
QNB's near-term liquidity concern is the ability to meet the expected withdrawal
of $20,000,000 by a school district during the second quarter of 2005. These
funds are matched with callable agency securities with call dates that closely
match the anticipated withdrawal dates. As of April 30, 2005, $5,000,000 was
called and $5,000,000 was sold at a small loss. This $10,000,000 is available to
fund the anticipated withdrawal in the middle of May. Currently, because of the
increase in interest rates, the remaining $10,000,000 in investment securities
matched with the remaining deposits would not be called. If this situation would
exist when the funds were withdrawn, QNB could use its Federal funds sold
balance if available, use its credit facilities, sell these callable securities
at a loss, sell other investment securities or fund with additional deposits. A
longer-term liquidity concern is that the equity markets strengthen and the Bank
suffers disintermediation back to the equity market.
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 March 31, 2005 was
$44,266,000, or 7.62% of total assets, compared to shareholders' equity of
$45,775,000, or 7.84%, at December 31, 2004. Shareholders' equity at March 31,
2005 includes a negative adjustment of $2,170,000 related to unrealized holding
losses, net of taxes, on investment securities available-for-sale, while
shareholders' equity at December 31, 2004 includes a positive adjustment of
$691,000. Without these adjustments shareholders' equity to total assets would
have been 7.99% and 7.72% at March 31, 2005 and December 31, 2004, respectively.
The increase in the ratio is a result of the rate of capital retention exceeding
the rate of asset growth. Total assets decreased .43% between December 31, 2004
and March 31, 2005, while shareholders' equity, excluding the net unrealized
holding gains and losses, increased 3.0%.
Shareholders' equity averaged $45,664,000 for the first three months of 2005 and
$42,975,000 during all of 2004, an increase of 6.3%. The ratio of average total
equity to average total assets increased to 7.85% for the first quarter of 2005,
compared to 7.64% for all of 2004. The increase in the equity to asset ratio is
a function of the growth in average equity outpacing the growth in total average
assets.
QNB is 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), Tier II capital that includes a portion of the allowance for loan
losses, and total capital (Tier I plus Tier 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 assets.
The minimum regulatory capital ratios are 4.00% for Tier I, 8.00% for the total
risk-based capital and 4.00% for leverage. Under the requirements, QNB had a
Tier I capital ratio of 12.90% and 12.25%, a total risk-based ratio of 13.65%
and 12.98% and a leverage ratio of 7.76% and 7.44% at March 31, 2005 and
December 31, 2004, respectively. The increase in both the Tier I capital ratio
and total risk-based ratio reflects the increase in capital from retained
earnings during the first quarter of 2005 and a reduction in risk-weighted
assets between December 31, 2004 and March 31, 2005. Contributing to the decline
in risk-weighted assets was the reclassification of some
Form 10-Q
Page 24
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
CAPITAL ADEQUACY (CONTINUED)
tax-exempt loans to states and political subdivisions from the 100% category to
either the 50% or 20% category based on the source of repayment.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established
five capital level designations ranging from "well capitalized" to "critically
undercapitalized." At March 31, 2005 and December 31, 2004, QNB met the "well
capitalized" criteria which requires minimum Tier I and total risk-based capital
ratios of 6.00% and 10.00%, respectively, and a Tier I leverage ratio of 5.00%.
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 about 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. QNB also has another money market
account which 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 March 31, 2005, interest-earning assets scheduled to mature
or likely to be called, repriced or repaid in one year were $178,590,000.
Interest-sensitive liabilities scheduled to mature or reprice within one year
were $242,924,000. The one-year cumulative gap, which reflects QNB's interest
sensitivity over a period of time, was a negative $64,334,000 at March 31, 2005.
The cumulative one-year gap equals -11.54% of total rate sensitive assets. This
compares to a negative gap position of $12,285,000, or -2.21% of total rate
sensitive assets, at December 31, 2004. The increase in the negative gap
position in the one-year time frame reflects the extension of the investment and
loan portfolio since December 31, 2004. Higher interest rates since December 31,
2004 have resulted in some of the callable agency bonds that were likely to be
called within one year at December 31,
Form 10-Q
Page 25
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INTEREST RATE SENSITIVITY (CONTINUED)
2004 now being reflected as going to maturity. In addition, the increase in
interest rates has resulted in the anticipated slowdown in prepayments on
mortgage-backed securities, CMO's and loans. Also impacting loans was the
origination of more loans with fixed rates in the three to seven year horizons.
Customers were seeking to take advantage of the flat yield curve and the concern
over rising short-term interest rates by selecting fixed rate loans and variable
rate loans (loans with a fixed rate for a period of time that adjust for another
period of time) over floating rate loans. This was particularly true with regard
to home equity loans and residential mortgage loans.
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 by simulating the impact on net interest
income of changing rates. While management performs rate shocks of 100, 200 and
300 basis points, it believes, that given the level of interest rates at March
31, 2005, that it is unlikely that interest rates would decline by 200 or 300
basis points.
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.
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 attempt to 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 March 31, 2005, QNB did not have any
hedging transactions in place such as interest rate swaps, caps or floors.
Form 10-Q
Page 26
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
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 $15,099 $(1,334) (8.12)%
+200 Basis Points 15,616 (816) (4.97)
+100 Basis Points 16,070 (363) (2.21)
FLAT RATE 16,433 -- --
- -100 Basis Points 16,132 (301) (1.83)
The decline in net interest income in a rising rate environment reflects the
fixed rate nature of the investment and loan portfolio and the increased expense
associated with higher cost funding sources. The decline in net interest income
in a falling rate environment reflects the interest rate floors on interest
bearing transaction accounts, regular money market accounts and savings
accounts. Interest rates on these products do not have the ability to decline
100 basis points. Management may attempt to reduce the size of the negative gap
position and the impact of rising interest rates by increasing the amount of
cash flow from the investment portfolio through some restructuring of the
investment portfolio and by promoting longer-term time deposits.
Form 10-Q
Page 27
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
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 consolidated 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.
Form 10-Q
Page 28
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
MARCH 31, 2005
Item 1. LEGAL PROCEEDINGS
None.
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
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
Exhibit 3(i) Articles of Incorporation of Registrant, as amended.
(Incorporated by reference to Exhibit 3(i) of Registrants
Form 10-K filed with the Commission on March 30, 2004).
Exhibit 3(ii) Bylaws of Registrant, as amended. (Incorporated by
reference to Exhibit 3(ii) of Registrants Form 10-K filed
with the Commission on March 30, 2004).
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
Form 10-Q
Page 29
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: May 6, 2005 By: /s/ Thomas J. Bisko
------------------------------ ---------------------------
Thomas J. Bisko
President/CEO
Date: May 6, 2005 By: /s/ Robert C. Werner
------------------------------ ---------------------------
Robert C. Werner
Vice President
Date: May 6, 2005 By: /s/ Bret H. Krevolin
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Bret H. Krevolin
Chief Financial Officer
Form 10-Q
Page 30