ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Statements Are Subject to Change
We make certain statements in this document as to what we expect may happen in the future. These statements usually contain the words “believe,” “estimate,” “project,” “expect,” “anticipate,” “intend” or similar expressions. Because these statements look to the future, they are based on our current expectations and beliefs. Actual results or events may differ materially from those reflected in the forward-looking statements. You should be aware that our current expectations and beliefs as to future events are subject to change at any time, and we can give you no assurances that the future events will actually occur.
General
The Company was formed in connection with the Bank’s conversion to a stock savings bank completed on July 3, 2007. The Company’s results of operations are dependent primarily on the results of the Bank, which is a wholly owned subsidiary of the Company. The Bank’s results of operations depend, to a large extent, on net interest income, which is the difference between the income earned on its loan and investment portfolios and the cost of funds, consisting of the interest paid on deposits and borrowings. Results of operations are also affected by provisions for loan losses, fee income and other non-interest income and non-interest expense. Non-interest expense principally consists of compensation, directors’ fees and expenses, office occupancy and equipment expense, data processing expense, professional fees, advertising expense, FDIC deposit insurance assessment, and other expenses. Our results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities. Future changes in applicable law, regulations or government policies may materially impact our financial condition and results of operations.
At June 30, 2019, the Bank has five wholly-owned subsidiaries, Quaint Oak Mortgage, LLC, Quaint Oak Real Estate, LLC, Quaint Oak Abstract, LLC, QOB Properties, LLC, and Quaint Oak Insurance Agency, LLC, each a Pennsylvania limited liability company. The mortgage, real estate and abstract companies offer mortgage banking, real estate sales and title abstract services, respectively, in the Lehigh Valley region of Pennsylvania, and began operation in July 2009. In February 2019, Quaint Oak Mortgage opened a mortgage banking office in Philadelphia, Pennsylvania. QOB Properties, LLC began operations in July 2012 and holds Bank properties acquired through a foreclosure proceeding or acceptance of a deed in lieu of foreclosure. Quaint Oak Insurance Agency, LLC, located in Chalfont, Pennsylvania, began operations in August 2016 and provides a broad range of personal and commercial insurance coverage solutions.
Critical Accounting Policies
The accounting and financial reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. Accordingly, the consolidated financial statements require certain estimates, judgments, and assumptions, which are believed to be reasonable, based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the periods presented. The following accounting policies comprise those that management believes are the most critical to aid in fully understanding and evaluating our reported financial results. These policies require numerous estimates or economic assumptions that may prove inaccurate or may be subject to variations which may significantly affect our reported results and financial condition for the period or in future periods.
Allowance for Loan Losses. The allowance for loan losses represents management’s estimate of losses inherent in the loan portfolio as of the balance sheet date and is recorded as a reduction to loans receivable. The allowance for loan losses is increased by the provision for loan losses, and decreased by charge-offs, net of recoveries. Loans deemed to be uncollectible are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance. All, or part, of the principal balance of loans receivable are charged off to the allowance as soon as it is determined that the repayment of all, or part, of the principal balance is highly unlikely. Because all identified losses are immediately charged off, no portion of the allowance for loan losses is restricted to any individual loan or groups of loans, and the entire allowance is available to absorb any and all loan losses.
The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management performs a quarterly evaluation of the adequacy of the allowance. The allowance is based on the Company’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision as more information becomes available.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are designated as impaired. For loans that are designated as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers pools of loans by loan class. These pools of loans are evaluated for loss exposure based upon historical loss rates for each of these categories of loans, adjusted for qualitative factors. These significant factors may include changes in lending policies and procedures, changes in existing general economic and business conditions affecting our primary lending areas, credit quality trends, collateral value, loan volumes and concentrations, seasoning of the loan portfolio, recent loss experience in particular segments of the portfolio, duration of the current business cycle and bank regulatory examination results. The applied loss factors are reevaluated quarterly to ensure their relevance in the current economic environment. Residential owner occupied mortgage lending generally entails a lower risk of default than other types of lending. Consumer loans and commercial real estate loans generally involve more risk of collectability because of the type and nature of the collateral and, in certain cases, the absence of collateral. It is the Company’s policy to establish a specific reserve for loss on any delinquent loan when it determines that a loss is probable. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not considered impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent. An allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of substantially all of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral.
A loan is identified as a troubled debt restructuring (“TDR”) if the Company, for economic or legal reasons related to a debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. Concessions granted under a TDR typically involve a temporary or permanent reduction in payments or interest rate or an extension of a loan’s stated maturity date at less than a current market rate of interest. Loans identified as TDRs are designated as impaired.
For loans secured by real estate, estimated fair values are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.
The allowance calculation methodology includes further segregation of loan classes into risk rating categories. The borrower’s overall financial condition, repayment sources, guarantors and value of collateral, if appropriate, are evaluated annually for all loans (except one-to-four family residential owner-occupied loans) where the total amount outstanding to any borrower or group of borrowers exceeds $500,000, or when credit deficiencies arise, such as delinquent loan payments. Credit quality risk ratings include regulatory classifications of special mention, substandard, doubtful and loss. Loans criticized special mention have potential weaknesses that deserve management’s close attention. If uncorrected, the potential weaknesses may result in deterioration of the repayment prospects. Loans classified substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They include loans that are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified doubtful have all the weaknesses inherent in loans classified substandard with the added characteristic that collection or liquidation in full, on the basis of current conditions and facts, is highly improbable. Loans classified as a loss are considered uncollectible and are charged to the allowance for loan losses. Loans not classified are rated pass. In addition, Federal regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses and may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management. Based on management’s comprehensive analysis of the loan portfolio, management believes the current level of the allowance for loan losses is adequate.
Income Taxes. Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various assets and liabilities and net operating loss carryforwards and gives current recognition to changes in tax rates and laws. The realization of our deferred tax assets principally depends upon our achieving projected future taxable income. We may change our judgments regarding future profitability due to future market conditions and other factors. We may adjust our deferred tax asset balances if our judgments change.
Comparison of Financial Condition at June 30, 2019 and December 31, 2018
General. The Company’s total assets at June 30, 2019 were $284.9 million, an increase of $13.5 million, or 5.0%, from $271.4 million at December 31, 2018. This growth in total assets was primarily due to a $9.3 million, or 4.3%, increase in loans receivable, net, a $5.2 million, or 106.2%, increase in investment in interest-earning time deposits, a $4.3 million, or 84.2%, increase in loans held for sale, a $2.2 million, or 32.2%, increase in investment securities available for sale, and a $1.9 million, or 178.5% increase in prepaid expenses and other assets. These increases were partially offset by a $9.8 million, or 37.5%, decrease in cash and cash equivalents.
Cash and Cash Equivalents. Cash and cash equivalents decreased $9.8 million, or 37.5%, from $26.0 million at December 31, 2018 to $16.3 million at June 30, 2019 as excess liquidity was used primarily to fund the increase of $9.3 million of loans receivable, net.
Investment in Interest-Earning Time Deposits. Investment in interest-earning time deposits increased $5.2 million, or 106.1%, from $4.9 million at December 31, 2018 to $10.2 million at June 30, 2019 as the Company invested excess liquidity into higher yielding interest-earning assets.
Investment Securities Available for Sale. Investment securities available for sale increased $2.2 million, or 32.2%, from $6.7 million at December 31, 2018 to $8.8 million at June 30, 2019, as the Company invested excess liquidity into higher yielding interest-earning assets.
Loans Held for Sale. Loans held for sale increased $4.3 million or 84.2%, from $5.1 million at December 31, 2018 to $9.4 million at June 30, 2019 as the Bank’s mortgage banking subsidiary, Quaint Oak Mortgage, LLC, originated $53.4 million of one-to-four family residential loans during the six months ended June 30, 2019 and sold $48.9 million of loans in the secondary market during this same period. The Bank did not originate any equipment loans held for sale during the six months ended June 30, 2019 but sold $258,000 of equipment loans during this same period.
Loans Receivable, Net. Loans receivable, net, increased $9.3 million, or 4.3%, to $226.2 million at June 30, 2019 from $216.9 million December 31, 2018. This increase was funded primarily from deposits and excess liquidity. Increases within the portfolio occurred in commercial business loans which increased $10.4 million, or 44.0%, and commercial real estate loans which increased $4.5 million, or 4.3%. These increases were partially offset by decreases of $4.0 million, 8.5%, in one-to-four family residential non-owner occupied loans, $469,000, 2.0%, in multi-family residential loans, $377,000, or 8.7%, in home equity loans, $299,000, or 4.5%, in one-to-four family residential owner occupied loans, $279,000, or 2.8%, in construction loans, and $8,000, or 42.1%, in other consumer loans. The Company continues its strategy of diversifying its loan portfolio with higher yielding and shorter-term loan products and selling substantially all of its newly originated one-to-four family owner-occupied loans into the secondary market.
Other Real Estate Owned. Other real estate owned (OREO) amounted to $1.8 million at June 30, 2019, consisting of four properties that were collateral for a construction loan. During the six months ended June 30, 2019, the Company made a total of $168,000 in capital improvements to the properties. The balance of OREO totaled $1.7 million at December 31, 2018, consisting of the same four properties. Non-performing assets amounted to $2.4 million, or 0.85% of total assets at June 30, 2019 compared to $2.8 million, or 1.04% of total assets at December 31, 2018.
Prepaid Expenses and Other Assets. Prepaid expenses and other assets increased $1.9 million, or 178.5%, due primarily to the adoption of Financial Accounting Standards Board accounting standard ASU 2016-02, Leases (Topic 842) by the Company on January 1, 2019. This standard requires a lessee to recognize the assets and liabilities that arise from leases on the balance sheet by recognizing a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. The impact of adopting this accounting standard on the Company’s balance sheet was $1.3 million at June 30, 2019.
Deposits. Total deposits increased $12.6 million, or 5.9%, to $224.5 million at June 30, 2019 from $211.9 million at December 31, 2018. This increase in deposits was primarily attributable to increases of $12.2 million, or 7.3%, in certificates of deposit, $665,000 or 59.4%, in savings accounts, and $65,000, or 0.24%, in money market accounts. These increases were partially offset by a $196,000, or 1.1%, decrease in non-interest bearing checking accounts and a $119,000, or 62.0%, decrease in passbook accounts.
Federal Home Loan Bank Advances. Short-term Federal Home Loan Bank (FHLB) advances declined from $9.0 million at December 31, 2018 to none at June 30, 2019 as the Company termed-out $9.0 million of advances at varying maturities. Long-term FHLB borrowings increased $8.0 million, or 53.3%, from $15.0 million at December 31, 2018 to $23.0 million at June 30, 2019, as a result of the $9.0 million term-out of short-term borrowings and the repayment of $1.0 million of a long-term borrowing that matured in June 2019.
Subordinated Debt. On December 27, 2018, the Company issued $8.0 million in subordinated notes. These notes have a maturity date of December 31, 2028, and bear interest at a fixed rate of 6.50%. The Company may, at its option, at any time on an interest payment date on or after December 31, 2023, redeem the notes, in whole or in part, at par plus accrued interest to the date of redemption. The balance of subordinated debt, net of unamortized debt issuance costs, was $7.8 million at June 30, 2019 and December 31, 2018.
Stockholders’ Equity. Total stockholders’ equity increased $992,000, or 4.2%, to $24.8 million at June 30, 2019 from $23.8 million at December 31, 2018. Contributing to the increase was net income for the six months ended June 30, 2019 of $1.1 million, the reissuance of treasury stock for exercised stock options of $190,000, common stock earned by participants in the employee stock ownership plan of $90,000, amortization of stock awards and options under our stock compensation plans of $87,000, the reissuance of treasury stock under the Bank’s 401(k) Plan of $21,000, and other comprehensive income, net of $17,000. These increases were partially offset by dividends paid of $317,000 and by the purchase of treasury stock of $174,000.
Comparison of Operating Results for the Three Months Ended June 30, 2019 and 2018
General. Net income amounted to $665,000 for the three months ended June 30, 2019, an increase of $130,000, or 24.3%, compared to net income of $535,000 for three months ended June 30, 2018. The increase in net income on a comparative quarterly basis was primarily the result of an increase in non-interest income of $426,000, an increase in net interest income of $38,000, and a decrease in the provision for loan losses of $18,000, partially offset by an increase in non-interest expense of $246,000 and an increase in the provision for income taxes of $106,000.
Net Interest Income. Net interest income increased $38,000, or 1.8%, to $2.10 million for the three months ended June 30, 2019 from $2.06 million for the three months ended June 30, 2018. The increase was driven by a $478,000, or 15.9%, increase in interest income, partially offset by a $440,000, or 46.9%, increase in interest expense.
