QNB Corp. and Subsidiary
FINANCIAL HIGHLIGHTS
(in thousands, except per share data)
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Year Ended December 31, 1998 1997 1996 1995 1994
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Financial Performance
Net interest income ................................ $ 12,621 $ 12,056 $ 11,403 $ 11,379 $ 11,406
Provision for loan losses .......................... 400 400 400 1,010 600
Non-interest income ................................ 2,247 1,995 1,850 1,393 1,598
Non-interest expense ............................... 9,748 9,267 9,004 9,539 9,719
Net income ......................................... 3,448 3,131 2,801 1,687 2,004
Per Share Data
Net income - basic ................................. 2.41 2.19 1.97 1.19 1.41
Net income - diluted ............................... 2.39 2.18 1.95 1.18 1.41
Book value ......................................... 19.77 18.05 15.97 14.66 12.53
Cash dividends ..................................... .72 .64 .56 .50 .50
Selected Average Balances
Total assets ....................................... $310,492 $288,698 $274,533 $269,833 $259,344
Total earning assets ............................... 292,000 272,226 258,308 253,503 241,478
Investment securities .............................. 116,241 107,087 98,376 96,042 84,027
Loans, net of unearned income ...................... 169,800 161,096 155,175 151,839 151,726
Deposits ........................................... 271,690 253,366 242,082 239,513 232,705
Shareholders' equity ............................... 26,323 23,886 21,653 19,933 18,980
Balance Sheet Data
Total assets ....................................... $324,672 $305,772 $280,447 $276,049 $268,260
Investment securities available-for-sale ........... 70,088 75,920 52,779 55,380 49,838
Investment securities held-to-maturity ............. 50,065 40,400 42,699 42,515 35,636
Loans, net of unearned income ...................... 176,443 167,720 159,278 155,957 153,993
Deposits ........................................... 279,223 267,166 246,744 242,887 240,896
Shareholders' equity ............................... 28,338 25,832 22,775 20,866 17,784
Selected Ratios
Return on average assets ........................... 1.11% 1.08% 1.02% .63% .77%
Return on average shareholders' equity ............. 13.10 13.11 12.94 8.46 10.56
Net interest margin ................................ 4.51 4.60 4.58 4.64 4.89
Average shareholders' equity to average total assets 8.48 8.27 7.89 7.39 7.32
[GRAPHIC]
In the printed version, there appears a bar graph, depicting the following plot
points:
Net Income Per Share - Diluted
1994 $1.41
1995 $1.18
1996 $1.95
1997 $2.18
1998 $2.39
[GRAPHIC]
In the printed version, there appears a bar graph, depicting the following plot
points:
Book Value Per Share
1994 $12.53
1995 $14.66
1996 $15.97
1997 $18.05
1998 $19.77
[GRAPHIC]
In the printed version, there appears a bar graph, depicting the following plot
points:
Average Shareholders' Equity to Average Total Assets
1994 7.32%
1995 7.39%
1996 7.89%
1997 8.27%
1998 8.48%
QNB CORP. AND SUBSIDIARY
PRESIDENT'S MESSAGE
It was a year of tremendous achievement for QNB Corp. and its subsidiary, The
Quakertown National Bank. Highlights included record financial performance and a
strategic commitment to technology.
As stated in the previous report, it was our goal to increase net income by at
least 10% over the 1997 level. I am pleased to report that we reached our goal.
Net income of $3,448,000 represents an increase of 10.1% over the $3,131,000
reported in 1997. This converts to a return on average assets and return on
average equity of 1.11% and 13.10% respectively. As a result, your dividend was
increased by 12.5% to $.72 per share. I am also pleased to inform you that our
financial performance was reflected in the enhanced value of your shares. The
year end bid price as quoted by Ryan, Beck and Co. was $37 compared to $32 a
year ago, an increase of 15.6%. The price equates to 15.5 times diluted earnings
per share and 1.9 times the book value of a share. We also experienced a growth
rate of 7.5% while remaining a well capitalized institution.
There were several reasons for our financial success. These included: increased
net interest income, gains on the sale of residential mortgages and improvements
in asset quality. Our growth can be attributed, in large part, to the ongoing
consolidation trend among financial services companies. We continue to benefit
from the fallout from mergers involving larger institutions. Small businesses
and consumers who value personal service along with an excellent menu of
products and services have chosen our institution as their principal financial
services provider.
During 1998 we intensified our commitment to technology. We are acutely aware of
the strategic importance of being in a position to operate as efficiently as
possible and being able to provide cutting edge products and services being
demanded by our current customers and prospective customers. During the year we
installed a new telephone system, a wide area network and an interactive web
site. We also decided to install a check imaging system which will become fully
operational in early 1999. Each of these improvements is highlighted in the
pages which follow. I encourage you to take the time to read about them.
Another major technological issue facing all of us today is the "Year 2000"
computer bug. Many computer systems process transactions based on two digits
representing the year of the transaction. Some systems may not recognize "00" as
the year 2000 and as a result, may malfunction. I can assure you we have
addressed the Year 2000 as one of our highest corporate priorities. We have been
working on identifying and correcting those affected systems since January 1997.
We are in the final stages of testing and intend to be ready for the Year 2000
by June 30, 1999.
The year was marked by another very significant event; the retirement of Philip
D. Miller as a Director Emeritus of the Bank and the Corporation. Mr. Miller's
illustrious career with the organization spanned over thirty years. He was the
chief executive officer of the bank from 1966 to 1988. He retained the title of
Chairman of the Board until his retirement. I would personally like to thank him
for his advice, counsel and friendship during the years we worked together. On
behalf of the Board of Directors and all of the employees, we wish him health
and happiness in retirement.
President's Photo appears in the printed copy
We look forward to 1999 with optimism and will continue to seek opportunities to
add products and services which we believe will add value to the franchise.
As always, none of the achievements of the company would be possible without our
skilled and dedicated employee base. I sincerely thank them and you, the
shareholder, for your ongoing support. We are dedicated to the principles of
community banking and to remaining a strong, profitable and independent
financial institution.
/s/ Thomas J. Bisko
Thomas J. Bisko
President & CEO
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QNB CORP. AND SUBSIDIARY
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QNB CORP. AND SUBSIDIARY
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QNB CORP. AND SUBSIDIARY
Management's Discussion and Analysis 7
Consolidated Balance Sheets 29
Consolidated Statements of Income 30
Consolidated Statements of Shareholders' Equity 31
Consolidated Statements of Cash Flows 32
Notes to Consolidated Financial Statements 33
Independent Auditor's Report 44
Corporate Information 44
Directors, Officers & Office Locations 45
MANAGEMENT'S DISCUSSION AND ANALYSIS
Average Balances, Rates, and Interest Income and Expense Summary (TAX-EQUIVALENT BASIS)
1998 1997 1996
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Average Average Average Average Average Average
Balance Rate Interest Balance Rate Interest Balance Rate Interest
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Assets
Interest-bearing balances............$ 87 4.83% $ 4 $ 40 3.70% $ 2 $ 26 2.35% $ 1
Federal funds sold................... 5,872 5.34 314 4,003 5.50 220 4,731 5.31 252
Investment securities available-for-sale:
Taxable........................... 71,040 6.51 4,624 64,272 6.52 4,190 54,810 6.28 3,449
Tax-exempt........................ 491 8.21 40 404 8.17 33 - - -
Investment securities held-to-maturity:
Taxable........................... 31,778 6.44 2,048 31,862 6.39 2,038 33,035 6.46 2,140
Tax-exempt........................ 12,932 7.17 926 10,549 7.33 773 10,531 7.30 771
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Total investment securities..... 116,241 6.57 7,638 107,087 6.57 7,034 98,376 6.45 6,360
Loans, net of unearned income........ 169,800 8.71 14,796 161,096 8.90 14,342 155,175 8.79 13,671
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Total earning assets............ 292,000 7.79 22,752 272,226 7.93 21,598 258,308 7.83 20,284
Cash and due from banks.............. 10,395 9,584 9,011
Allowance for loan losses............ (2,861) (2,673) (2,499)
Other assets......................... 10,958 9,561 9,713
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Total assets....................$ 310,492 7.33% $ 288,698 7.48% $274,533 7.37%
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Liabilities and
Shareholders' Equity
Interest-bearing deposits
Interest-bearing demand accounts.....$ 41,988 1.37% 576 $ 40,262 1.75% 706 $ 38,936 1.81% 707
Money market deposit accounts........ 32,981 2.79 921 33,218 2.86 951 36,301 2.78 1,011
Savings accounts..................... 37,216 2.12 789 35,215 2.17 765 34,932 2.20 772
Time deposits........................ 106,324 5.48 5,824 97,944 5.48 5,365 89,208 5.36 4,799
Time deposits of $100,000 or more.... 19,502 5.73 1,117 16,502 5.86 968 14,633 5.88 863
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Total interest-bearing deposits. 238,011 3.88 9,227 223,141 3.92 8,755 214,010 3.80 8,152
Short-term borrowings................ 9,468 3.66 347 8,911 3.48 311 8,317 3.13 261
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Total interest-bearing liabilities 247,479 3.87 9,574 232,052 3.91 9,066 222,327 3.77 8,413
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Non-interest-bearing deposits........ 33,679 30,225 28,072
Other liabilities.................... 3,011 2,535 2,481
Shareholders' equity................. 26,323 23,886 21,653
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Total liabilities and
shareholders' equity..........$ 310,492 3.08% $ 288,698 3.14% $274,533 3.06%
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Net interest rate spread............. 3.92% 4.02% 4.06%
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Margin/net interest income........... 4.51% $13,178 4.60% $12,532 4.58% $11,871
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Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are
based on the marginal Federal corporate tax rate of 34 percent.
Non-accrual loans are included in earning assets.
7
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
CONSOLIDATED FINANCIAL REVIEW
The intent of this section is to provide the reader with a better understanding
of the consolidated results of operations and financial condition of QNB Corp.
and its wholly owned subsidiary, The Quakertown National Bank, for the years
1998, 1997 and 1996. The results of operations and financial condition discussed
herein are presented on a consolidated basis and the consolidated entity is
referred to herein as "QNB." QNB's consolidated financial condition and results
of operations consist almost entirely of The Quakertown National Bank's
financial condition and results of operations. This section should be read in
conjunction with the financial statements and notes beginning on page 29.
Current performance may not be indicative of future performance. Tabular
information is presented in thousands, except share data.
QNB Corp. (the "Corporation") is a bank holding company headquartered in
Quakertown, Pennsylvania, which provides a full range of commercial and retail
banking services through its banking subsidiary, The Quakertown National Bank
(the "Bank"), a 121 year old community bank with locations in Upper Bucks,
Northern Montgomery and Southern Lehigh Counties.
In addition to historical information, this management discussion and analysis
contains forward-looking statements. The forward-looking statements contained
herein are subject to certain risks and uncertainties that could cause actual
results to differ materially from those projected in the forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect management's analysis only as of the
date hereof. The Corporation undertakes no obligation to publicly revise or
update these forward-looking statements to reflect events or circumstances that
arise after the date hereof. Readers should carefully review the risk factors
described in other documents the Corporation files from time to time with the
Securities and Exchange Commission, including Quarterly Reports on Form 10-Q to
be filed by the Corporation in 1999, and any Current Reports on Form 8-K filed
by the Corporation.
RESULTS OF OPERATIONS
QNB's performance for 1998 was highlighted by the third consecutive year of
record earnings, strong asset and deposit growth, continued improvement in asset
quality and appreciation in the stock price. QNB's earnings for 1998 were
$3,448,000, a 10.1 percent increase from the $3,131,000 reported in 1997. This
represents basic earnings per share of $2.41 for 1998, compared to $2.19 for
1997. On a diluted basis, earnings per share was $2.39 and $2.18 for 1998 and
1997, respectively. The results for 1998 reflect higher net interest income
achieved through growth in earning assets. A 12.6 percent increase in
non-interest income, primarily gains on the sale of residential mortgages, also
positively contributed to the results. Despite a 5.2 percent increase in
non-interest expense in 1998, QNB's overhead efficiency ratio, which represents
non-interest expense divided by net operating revenue on a tax equivalent basis,
continues to improve. Net income for 1996 was $2,801,000 or $1.97 per share
basic and $1.95 per share on a diluted basis.
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
1.11 percent and 13.10 percent, respectively, in 1998 compared with 1.08 percent
and 13.11 percent in 1997 and 1.02 percent and 12.94 percent in 1996.
NET INTEREST INCOME
Net interest income is the primary source of operating income for QNB. Net
interest income is interest income, dividends, and fees on earning assets, less
interest expense incurred for funding sources. Earning assets primarily include
loans, investment securities and Federal funds sold. Sources used to fund these
assets include deposits, borrowed funds and shareholders' equity. Net interest
income is affected by changes in interest rates, the volume and mix of earning
assets and interest-bearing liabilities, and the amount of earning assets funded
by non-interest-bearing deposits and shareholders' equity.
For purposes of this discussion, interest income and the average yield earned on
loans and investment securities is adjusted to a tax-equivalent basis as
detailed in the Average Balances, Rates, and Interest Income and Expense Summary
that appears on page 7. This provides a basis for comparison of tax-exempt loans
and investments with taxable loans and investments by giving effect to interest
earned on tax-exempt loans and investments by an amount equivalent to the
Federal income taxes which would have been paid if the interest earned on those
assets were taxable at the statutory tax rate of 34 percent.
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.
On a fully tax-equivalent basis, net interest income for 1998 increased $646,000
or 5.2 percent to $13,178,000. A 7.3 percent increase in average earning assets
offset a decrease in the net interest margin. The net interest margin declined
by nine basis points, while the net interest rate spread declined by ten basis
points. The net interest rate spread decreased to 3.92 percent in 1998 from 4.02
percent in 1997, while the net interest rate margin decreased to 4.51 percent in
1998 from 4.60 percent in 1997. The impact of rates paid on interest-bearing
liabilities declining to a lesser degree than the rates earned on assets,
especially loans, was reduced by an 11.4 percent increase in
non-interest-bearing deposits.
It is necessary to review the changes in market interest rates during 1998 and
1997 to understand the impact of interest rates on interest income. Market
interest rates, as represented by the U.S. Treasury yield curve, declined
dramatically during 1998 as signs of a global economic crisis created a flight
to quality in the U.S. Treasury market. Adding fuel to this decline was an
environment of low inflation in the U.S. economy. In response to these events
the Federal Reserve Bank lowered the Federal funds rate three times and 75 basis
points between the end of September and the middle of November, from 5.50
percent to 4.75 percent. As rates declined during the year, the yield curve
continued to flatten and even became inverted in the short-end. For example, at
the end of June, 1998, the spread between the two-year Treasury bond and the
30-year Treasury bond was only 15 basis points, and the rate on the two-year
bond was higher than the five and ten year bond. At the end of September, the
30-year bond was at 4.97 percent before finishing the year at 5.09 percent. One
result of the decline in rates and the flattening of the yield curve was the
widening of the spread on other investment securities, especially
mortgage-backed securities. The yield on these securities did not decline to
nearly the degree that Treasury securities declined. In response, QNB increased
its purchase of mortgage-backed securities.
Market interest rates were volatile during 1997 as expectations regarding
interest rates changed. The yield on the 30-year Treasury bond began 1997 at
6.64 percent and rose during much of the spring, reaching 7.17 percent in early
8
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
April on concern that the Federal Reserve would raise interest rates repeatedly
during the year to combat inflation caused by the economy's strong growth and
low unemployment rate. In fact, the Federal Reserve only raised rates once at
the end of March, increasing the Federal funds rate 25 basis points to 5.50
percent, taking back the decrease of January 1996. At the same time the prime
rate increased 25 basis points to 8.50 percent. The interest rate levels
achieved in April 1997 were as high as they would go for the year, as future
inflation reports showed that despite the economy's strength and the tight labor
market, inflation was falling. The result was declining interest rates and a
flattening of the yield curve. The 30-year Treasury bond ended the year at 5.92
percent, only a 27 basis point spread from the two-year Treasury bond which
finished the year at 5.65 percent. This spread was 76 basis points at the end of
1996 when the yield on the two-year bond was 5.88 percent.
Total interest income increased $1,154,000 in 1998 to $22,752,000. The
Rate-Volume Analysis table below highlights the impact of changing rates and
volumes on total interest income and interest expense. Growth in earning assets
contributed $1,498,000 to the increase in interest income, with higher
securities volume accounting for $617,000 of the increase and higher loan volume
accounting for $775,000 of the increase. Average investments increased
$9,154,000 or 8.5 percent, while average loans increased $8,704,000 or 5.4
percent.
Declining interest rates had a negative impact on interest income and the yield
on earning assets, particularly loans. The decline in interest income resulting
from lower yields on earning assets was $344,000 during 1998. The yield on
earning assets decreased 14 basis points to 7.79 percent with the average rate
on Federal funds sold and loans declining 16 basis points and 19 basis points,
respectively, during 1998. The decline in the average yield on Federal funds
sold is a direct result of the action taken by the Federal Reserve Bank in
reducing the Federal funds rate. The yield on loans declined from 8.90 percent
in 1997 to 8.71 percent in 1998, partially as a result of falling market
interest rates. The prime rate dropped 75 basis points during the course of
1998, with the average prime rate for the year declining 8 basis points from
8.44 percent for 1997 to 8.36 percent in 1998. QNB's yield on its loan portfolio
did not decrease proportionately, since only approximately 20 percent of the
portfolio re-prices immediately with changes in the prime rate. Another factor
in the decline in the yield on loans was the reduction in rates for existing
commercial loan customers. The extreme competition for loans is causing the
pricing of loans to decline significantly. Another result of the lower interest
rate environment is the continuing trend for customers to select fixed rate
rather than variable rate loans, both in the residential mortgage and commercial
loan sectors.
The yield on the total investment portfolio was 6.57 percent for both 1998 and
1997. QNB was able to maintain the yield on the investment portfolio for the
year despite falling interest rates. The sale of approximately $9,000,000 in
securities with a weighted average yield of 5.80 percent at the end of 1997 and
the beginning of 1998 assisted in the maintenance of the yield. These funds were
reinvested in higher yielding securities with slightly longer maturities. Also
helping to maintain the yield on the portfolio was the increase in the
percentage of mortgage-backed securities and tax-exempt municipal securities in
the portfolio. These types of securities tend to have higher yields. The yields
Rate-Volume Analysis of Changes in Net Interest Income (Tax-Equivalent Basis)
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1998 vs. 1997 1997 vs. 1996
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Change due to Total Change due to Total
Volume Rate Change Volume Rate Change
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Interest income:
Interest-bearing balances ............... $ 2 -- $ 2 -- $ 1 $ 1
Federal funds sold ...................... 104 $ (10) 94 $ (40) 8 (32)
Investment securities available-for-sale:
Taxable .......................... 441 (7) 434 587 154 741
Tax-exempt ....................... 7 -- 7 33 -- 33
Investment securities held-to-maturity:
Taxable .......................... (5) 15 10 (80) (22) (102)
Tax-exempt ....................... 174 (21) 153 -- 2 2
Loans ................................... 775 (321) 454 491 180 671
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Total interest income .......... 1,498 (344) 1,154 991 323 1,314
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Interest expense:
Interest-bearing demand accounts ........ 30 (160) (130) 23 (24) (1)
Money market accounts ................... (7) (23) (30) (88) 28 (60)
Savings ................................. 44 (20) 24 5 (12) (7)
Time .................................... 459 -- 459 458 108 566
Time over $100,000 ...................... 176 (27) 149 108 (3) 105
Short-term borrowings ................... 19 17 36 19 31 50
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Total interest expense ......... 721 (213) 508 525 128 653
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Net interest income ..................... $ 777 $ (131) $ 646 $ 466 $ 195 $ 661
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Variances which were not specifically attributed to volume or rate were
allocated proportionately between volume and rate. Tax-exempt securities and
loans were adjusted to a tax-equivalent basis and are based on the marginal
Federal corporate tax rate of 34 percent. Non-performing assets are treated as a
change due to rate.
9
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
NET INTEREST INCOME (CONTINUED)
on these types of securities also did not decline to the same magnitude as
Treasury securities during the year. The yield on the portfolio did decline
throughout the year as the lower interest rate environment increased the
prepayments on mortgage-backed securities and callable agency securities. The
reinvestment of these proceeds has been at lower rates. QNB expects the yield on
the portfolio to decline during 1999 as it anticipates that approximately
$50,000,000 in investments currently yielding an average of 6.49 percent will
mature or prepay and will be reinvested at lower rates.
Non-accrual loans of $506,000 in 1998 and $1,209,000 in 1997 resulted in the
non-recognition of $70,000 and $154,000 in interest income for the respective
periods. Non-accrual loans are included in the impact of rate changes.
Total interest expense increased $508,000 or 5.6 percent in 1998 to $9,574,000.
A 6.6 percent increase in average interest-bearing liabilities resulted in an
increase in interest expense of $721,000. This increase was primarily in the
area of time deposits with average balances increasing by 9.9 percent and
interest expense increasing by $635,000. A 4.3 percent increase in
interest-bearing demand accounts and a 5.7 percent increase in average savings
accounts contributed approximately $30,000 and $44,000 to the increase in
interest expense.
Despite dramatically falling market interest rates as indicated by the Treasury
yield curve, the rates paid on deposits and short-term borrowings did not
decline to the same degree as rates on earning assets. This is a function of the
strong competition among financial institutions for funding sources. The rate
paid on total interest-bearing liabilities decreased to 3.87 percent in 1998
from 3.91 percent in 1997. The impact of changing interest rates resulted in
interest expense declining by approximately $213,000 during 1998. The majority
of this decline was in interest-bearing demand accounts which accounted for
$160,000 of the savings. QNB was able to reduce the rate on these accounts as
they are deemed to be relatively insensitive to changing interest rates. The
average rate paid on interest-bearing demand accounts decreased from 1.75
percent in 1997 to 1.37 percent in 1998. The competition for funds is evidenced
by the inability to reduce interest rates on certificates of deposit and
short-term borrowings. The yield on time deposits less than $100,000 remained
stable at 5.48 percent while the yield on short-term borrowings, primarily cash
management accounts, actually increased from 3.48 percent in 1997 to 3.66
percent in 1998. During the third quarter of 1997, QNB changed the rate
structure on money market accounts and cash management accounts to a tiered
structure that pays a higher rate of interest on higher balances. The largest
impact was on the cash management account, which was increased significantly to
compete with brokerage accounts and mutual fund money market products.
When comparing 1997 to 1996, net interest income on a fully tax-equivalent basis
increased $661,000 or 5.6 percent to $12,532,000. A 5.4 percent increase in
average earning assets in conjunction with a slight increase in the net interest
margin account for the growth in net interest income. While the net interest
margin increased by two basis points, the net interest rate spread declined by
four basis points. The net interest rate spread decreased to 4.02 percent in
1997 from 4.06 percent in 1996 while the net interest rate margin increased to
4.60 percent in 1997 from 4.58 percent in 1996. The impact of rates paid on
interest-bearing liabilities increasing to a greater degree than the rates
earned on assets was reduced by a 7.7 percent increase in non-interest-bearing
deposits.
Total interest income increased $1,314,000 in 1997 to $21,598,000. Growth in
earning assets contributed $991,000 to the increase in interest income, with
higher securities volume accounting for $540,000 of the increase and higher loan
volume accounting for $491,000 of the increase. Average investments increased
$8,711,000 or 8.9 percent, while average loans increased $5,921,000 or 3.8
percent. Higher interest rates contributed $323,000 to the increase in interest
income. The yield on earning assets increased 10 basis points to 7.93 percent
with the average rates on investment securities and loans increasing 12 basis
points and 11 basis points, respectively, during 1997. The increase in the yield
on investment securities occurred primarily in the available-for-sale portfolio.
The yield on this portfolio increased 25 basis points to 6.53 percent. The
purchase of approximately $500,000 of 15 year municipal securities and some five
to ten year callable agency bonds with two to three years of call protection
contributed to the increase in yield. Many of these bonds were purchased in the
first half of the year when interest rates were higher and had yields over 7.00
percent. A slight lengthening of the available-for-sale portfolio also occurred
as a result of these purchases. The yield on the taxable portion of the
held-to-maturity portfolio decreased by approximately seven basis points
resulting from maturities and pay-downs on some higher yielding mortgage-backed
securities.
The 11 basis point increase in the yield on loans can be attributed in part to
the increase in the prime rate. The average prime rate for 1997 was 8.44
percent, an increase of 17 basis points from the average prime rate for 1996.
[GRAPHIC]
In the printed version, there appears a bar graph, depicting the following plot
points:
NET INTEREST INCOME
(tax equivalent, in thousands)
1994 $11,807
1995 $11,772
1996 $11,871
1997 $12,532
1998 $13,178
Total interest expense in 1997 increased $653,000 or 7.8 percent to $9,066,000.
A 4.4 percent increase in average interest-bearing liabilities resulted in an
increase in interest expense of $525,000. This increase was primarily in the
area of time deposits with average balances increasing by 10.2 percent and
interest expense increasing by $566,000. An 8.5 percent decline in average money
market account balances caused interest expense on money market accounts to
decline by approximately $88,000 during 1997.
10
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
The impact of changing interest rates accounted for approximately a $128,000
increase in interest expense. The rate paid on total interest-bearing
liabilities increased to 3.91 percent in 1997 from 3.77 percent in 1996. The
increase in the rate paid on interest-bearing liabilities was the result of
higher rates on time deposits and a change in rate structure on money market
accounts and cash management accounts, described previously. During the first
quarter of 1997, QNB introduced a 30-month certificate of deposit that enables
the holder to increase the interest rate twice during the term of the
certificate, should rates offered on the 30-month time deposits increase. As a
result of this promotion, QNB experienced a small shift of funds from lower
yielding non-maturity deposits to higher yielding time deposits. The rate on
time deposit accounts increased to 5.53 percent in 1997 from 5.44 percent in
1996, while the rate paid on short-term borrowings increased to 3.48 percent
from 3.13 percent during the same time period. While Treasury rates declined
during the second half of 1997, rates on certificates of deposit remained stable
as the competition for funding sources remained fierce.
As a result of lower yields on earning assets, particularly investment
securities and loans, Management expects the net interest margin to decline
slightly during 1999. As mentioned previously, approximately $50,000,000 of
investment securities may re-price at lower interest rates during 1999. In
addition, the impact from the drop in the prime rate in the latter part of 1998,
as well as the impact from the reduction in rates for existing commercial loan
customers, will create more downward pressure on the total yield on loans. If
QNB can achieve its primary goals of loan growth and an increase in the
loan-to-deposit ratio, the impact on interest income and the net interest margin
of lower rates may be lessened, as QNB can generally yield more on its loans
than on its investment securities. On the deposit side, management anticipates
that rates will remain near current levels as the competition for funding
sources remains strong.
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 considered adequate in relation to the risk of possible losses
in the loan portfolio. Actual loan losses, net of recoveries, serve to reduce
the allowance. The provision for loan losses was $400,000 for each of the three
years ending December 31, 1998, 1997 and 1996. QNB had been able to maintain the
provision at this amount as a result of negligible charge-offs, low levels of
delinquency and continued improvement in asset quality. Net charge-offs amounted
to $119,000 during 1998 compared to $315,000 in 1997 and $199,000 in 1996. This
amounts to .07 percent, .20 percent and .13 percent of average loans during the
corresponding three years.
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, mortgage servicing fees, gains on the sale of investment securities,
gains on the sale of residential mortgage loans and student loans, and other
miscellaneous fee income. QNB reviews all service charges and fee schedules
related to its products and services on an annual basis. QNB has not materially
changed these schedules during 1998, 1997 or 1996. QNB prices its products and
services competitively. The continual development of new products and services
should help generate additional non-interest income. Total non-interest income
was $2,247,000 in 1998 compared to $1,995,000 in 1997, an increase of 12.6
percent. This followed an increase of 7.8 percent from the $1,850,000 recorded
in 1996.
Fees for services to customers, the largest component of total non-interest
income, are primarily comprised of service charges on deposit accounts. These
fees increased $12,000 or 1.1 percent during 1998 to $1,088,000. This increase
is primarily related to the collection of fees on check orders. During the third
quarter of 1998, QNB restructured some of the features of its deposit products.
One of the changes included the collection of fees on check reorders.
Previously, most customers received free checks upon reorder. Also, as part of
the product restructuring, many customers will now receive a free QNB Check
Card. These customers previously paid an annual fee of $15. This will result in
a reduction in the category of other non-interest income. Also positively
impacting fee income in 1998 was an increase in income related to low balance
savings accounts and an increase in income for charges related to the use of
out-of-network Automated Teller Machines (ATMs). QNB does not currently
surcharge for the use of its ATMs. Partially offsetting these increases was a
decline in overdraft charges resulting from a lower volume of overdrafts.
Overdraft income decreased approximately $26,000.
Fees for services to customers declined $19,000 or 1.7 percent to $1,076,000
when comparing 1997 to 1996. A lower volume of overdraft charges and a decrease
in fees related to reduced volume usage of out-of-network ATMs were the primary
reasons for the decline during the year.
To date, when QNB sells its residential mortgages in the secondary market, it
retains servicing rights. A normal servicing fee is retained on all loans sold
and serviced. Mortgage servicing fees decreased $25,000 or 13.8 percent in 1998,
to $156,000. This followed a decrease of $27,000 or 13.0 percent in 1997, to
$181,000. The level of mortgages serviced decreased $1,984,000 to $65,800,000 at
December 31, 1998. This 2.9 percent decrease in mortgages serviced from year-end
1997 to year-end 1998 followed a 7.7 percent decline between 1996 and 1997. The
average balance of mortgages serviced for others decreased 4.7 percent in 1998
to $67,046,000 and 7.7 percent in 1997 to $70,370,000. The decrease in the
volume of mortgages serviced for others during 1998 is a result of payments,
both recurring and from refinances, outpacing the origination and sale of new
residential mortgages. The volume of mortgages serviced for others declined in
1998 despite a significant increase in the amount of mortgages sold during the
year. QNB sold approximately $13,667,000 in mortgages during 1998 compared to
only $2,493,000 during 1997. Management's decision to retain more 15 year
mortgages, which would have been sold in prior years, has also reduced the
amount of mortgages sold and serviced.
The amortization and impairment of the mortgage servicing asset recorded upon
the sale of mortgages also contributed to the decrease in mortgage servicing
fees during the year. 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. The impact of amortization and impairment of the mortgage
servicing asset was $36,000 in 1998 compared to $6,000 in 1997.
11
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
NON-INTEREST INCOME (continued)
Management anticipates that mortgage-servicing fees may continue to decline as
principal reductions outpace loans sold and the amount of amortization of the
mortgage servicing asset increases. The volume of mortgage originations and
sales may decrease during 1999 as a result of a slowdown in refinancing activity
if mortgage interest rates increase. In addition, the amount of mortgages sold
may also decrease if management decides to retain more 15 year mortgage
originations.
The net gain on the sale of investment securities was $66,000 in 1998. This
represents a decline of $68,000 from the gain recorded in 1997. Net gains on the
sale of equity securities were $38,000, while net gains on debt securities were
approximately $28,000 in 1998. The prepayment of agency securities that were
originally purchased at a discount contributed approximately $22,000 to the gain
on debt securities recorded in 1998. In addition, during the first quarter of
1998, QNB sold approximately $5,000,000 in lower yielding agency securities at a
gain of $6,000. These securities had a weighted average yield of 5.81 percent.
They were sold for liquidity purposes and to continue the repositioning of the
portfolio that had begun during late 1997.
The net gain on the sale of investment securities was $134,000 in 1997. This
amount represents gains on the sale of marketable equity securities of $159,000
netted against a net loss of $25,000 on the sale of debt securities. During the
fourth quarter of 1997, QNB sold approximately $4,000,000 in lower yielding
securities at a loss of $31,000. These securities had an average yield of 5.29
percent. The proceeds of this sale were used to fund higher yielding loans which
were booked near the end of the year. Earlier in 1997, approximately $9,500,000
of U.S. Treasury and agency securities were sold for liquidity purposes at a
gain of $6,000.
QNB recorded net gains on the sale of investment securities of $102,000 in 1996.
Sales of equity securities, with a cost of $75,000, netted a $77,000 gain. Sales
of approximately $18,350,000 in available-for-sale debt securities netted a gain
of $25,000. During the second quarter of 1996, QNB sold approximately $5,500,000
in U.S. Treasury and agency securities. QNB took advantage of a steep slope in
the short end of the Treasury yield curve to "pre-fund" bonds that were maturing
over the next year and a half and reinvested in bonds in the three to four year
range. This allowed QNB to record a profit on the sale of $23,000, and also to
increase the overall book yield of the portfolio. During the third and fourth
quarters, QNB sold approximately $12,850,000 of U.S. Treasury and agency
securities and netted a gain of $2,000. These sales were for liquidity purposes
and were in direct response to the seasonality of one customer's deposits.
The Corporation owns a portfolio of marketable equity securities, consisting of
stocks of other financial institutions. At December 31, 1998, these securities
had an amortized cost of $2,143,000 and a market value of $2,696,000.
Student and residential mortgage loans to be sold are identified at origination.
The net gain on the sale of loans was $290,000, $81,000 and $89,000 in 1998,
1997 and 1996, respectively. Included within these amounts are gains on the sale
of student loans of $38,000, $35,000 and $32,000, respectively. QNB sold
approximately $1,599,000, $1,464,000 and $1,495,000 of loans to SallieMae during
these three years. The amount of the gain depends upon the size and type of
loans originated. The amount of income, both interest income and gains on the
sale, may decline in the future depending upon action taken by the U.S.
Government with regard to the allowable interest rate charged on student loans.
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. Net gains on the sale of residential mortgages were $252,000 in
1998, $46,000 in 1997 and $57,000 in 1996. Significant interest rate swings have
had a major impact on the volume of mortgages originated and the gains recorded
on the sale of these mortgages. QNB sold approximately $13,667,000, $2,493,000
and $3,512,000 of residential mortgages in the secondary market in 1998, 1997
and 1996, respectively. Declining interest rates to record low levels during
1998 presented an opportunity for many borrowers to refinance their mortgages at
lower rates. This provided an opportunity for QNB to originate and sell more
mortgages. During 1998, QNB originated approximately $15,321,000 in mortgages
held-for-sale. This compares to $1,052,000 in 1997 and $3,069,000 in 1996. The
implementation of SFAS No. 122 as superceded by SFAS No. 125 increased the gain
on the sale of residential mortgages in 1998, 1997 and 1996 by approximately
$137,000, $25,000 and $41,000, respectively.
During the third quarter of 1997, declining interest rates provided an
opportunity to sell, at a gain, some lower yielding 15 and 20 year mortgages
that had been in the portfolio since 1995.
As of December 31, 1998 and 1997, residential mortgages held for sale were
approximately $3,601,000 and $481,000, respectively. These loans are accounted
for at the lower of cost or market. If mortgage rates remain low or decline
further, the volume of mortgage refinancing activity may continue. However, if
rates were to increase two events could occur; the amount of mortgage
originations and sales could decline and a loss could occur if rates increased
prior to the sale of the originated mortgages.
Other operating income was $647,000, $523,000 and $356,000 in 1998, 1997 and
1996, respectively. The $124,000 or 23.7 percent increase in 1998 is primarily
the result of earnings on the cash surrender value of single premium life
insurance policies that went into effect in September, 1998. These policies
Change from Prior Year
NON-INTEREST INCOME COMPARISON 1998 1997
- ---------------------------------------------------------------------------------------------------------------------------
1998 1997 1996 Amount Percent Amount Percent
- ---------------------------------------------------------------------------------------------------------------------------
Fees for services to customers .. $1,088 $1,076 $1,095 $ 12 1.1 % $ (19) (1.7)%
Mortgage servicing fees ......... 156 181 208 (25) (13.8) (27) (13.0)
Net gain on investment securities 66 134 102 (68) (50.7) 32 31.4
Net gain on sale of loans ....... 290 81 89 209 258.0 (8) (9.0)
Other operating income .......... 647 523 356 124 23.7 167 46.9
- ---------------------------------------------------------------------------------------------------------------------------
Total ...................... $2,247 $1,995 $1,850 $ 252 12.6 % $ 145 7.8 %
- ---------------------------------------------------------------------------------------------------------------------------
12
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
Change from Prior Year
Non-Interest Expense Comparison 1998 1997
- --------------------------------------------------------------------------------------------------------------------
1998 1997 1996 Amount Percent Amount Percent
- --------------------------------------------------------------------------------------------------------------------
Salaries and employee benefits $5,561 $5,411 $5,185 $ 150 2.8% $ 226 4.4 %
Net occupancy expense ......... 666 666 687 -- -- (21) (3.1)
Furniture and equipment expense 735 697 697 38 5.5 -- --
Marketing expense ............. 371 303 287 68 22.4 16 5.6
Other real estate owned expense 312 273 253 39 14.3 20 7.9
Other expense ................. 2,103 1,917 1,895 186 9.7 22 1.2
- --------------------------------------------------------------------------------------------------------------------
Total .................... $9,748 $9,267 $9,004 $ 481 5.2% $ 263 2.9 %
- --------------------------------------------------------------------------------------------------------------------
provided approximately $38,000 in tax-exempt income in 1998. Also contributing
to the increase in other operating income were increases in Check Card and ATM
interchange income of $39,000 and $16,000, respectively. These increases relate
to higher usage of the Check Card and an increased usage of QNB's ATMs by
non-QNB customers. QNB does not currently surcharge for the use of its machines
and as a result has experienced increased activity. Most other banks in QNB's
market area surcharge for the use of ATMs by non-customers. QNB receives a fee
from the non-customer's bank when non-customers use a QNB machine. The
recognition of fees from official checks increased approximately $18,000 when
comparing 1998 to 1997. QNB entered an arrangement with a third party vendor for
official check services in the latter part of 1997. A refund of State sales tax
of $21,000, based on an appeal of previous years payments, and a reimbursement
of prior years costs of approximately $15,000 related to a terminated bill pay
product, also contributed to the increase in other operating income. Partially
offsetting these increases is a decline in rental income on other real estate
owned of $28,000. Most of the properties that generated rental income were
disposed of during 1998.
The $167,000 or 46.9 percent increase between 1997 and 1996 is primarily the
result of increases in the following areas: rental income on other real estate
owned, check card fee income, ATM interchange income and merchant processing
income. Rental income on other real estate owned increased $113,000 from 1996.
Most of the properties foreclosed on at the end of 1996 and during 1997 provided
rental income. Income on the check card introduced in December 1996 accounted
for an additional $67,000 of the increase in other income. Merchant processing
income provided an additional $26,000 in income during 1997. At the end of 1996,
QNB analyzed its merchant processing operations and adjusted the pricing of the
service to make it more profitable. Partially offsetting these increases was the
impact of the gain on the sale of other real estate owned of $67,000 recorded in
1996. During 1997, QNB had losses of $25,000 on the sale of other real estate
owned. These losses are included in other real estate owned expense.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee
benefits, net occupancy, furniture and equipment, marketing, other real estate
owned and various other operating expenses. Total non-interest expense in 1998
increased $481,000 or 5.2 percent to $9,748,000. This followed an increase of
2.9 percent between 1996 and 1997. Total non-interest expense for 1997 and 1996
was $9,267,000 and $9,004,000, respectively. Despite the increase in
non-interest expense, QNB's overhead efficiency ratio, which represents
non-interest expense divided by net operating revenue on a tax equivalent basis,
continues to improve.
Salaries and benefits expense is the largest component of non-interest expense.
Salaries and benefits expense for 1998 increased $150,000 or 2.8 percent to
$5,561,000. Salary expense for 1998 increased by $182,000 or 4.2 percent to
$4,494,000, while benefits expense decreased by $32,000 to $1,067,000. The
increase in base salary expense is primarily related to performance increases
and a slight increase in the number of full-time equivalent employees during
1998.
The decline in benefits expense during 1998 is a result of a decrease in
employer paid health costs, a decline in the State unemployment tax rate and a
reduction in expense related to employee education. With regard to health costs,
savings related to lower medical and hospitalization premiums of $30,000 were
partially offset by increases in dental and vision premiums of $11,000 in 1998.
QNB expects health care expense in 1999 to remain near 1998 levels as increased
premiums are offset by higher cost sharing by the employees. State unemployment
taxes decreased by $24,000 in 1998 as a result of a reduction in the tax rate.
The rate is based on unemployment experience and should continue to decline in
1999. Education expense decreased $12,000 or 42.6 percent in 1998. This is a
result of the completion of courses of study by several employees in 1997 or
early 1998. Partially offsetting these savings were higher employer paid Social
Security and Medicare taxes resulting from an increase in salary expense and a
small increase in life insurance premiums and pension expense.
Salary and benefits expense for 1997 increased $226,000 or 4.4 percent to
$5,411,000. Salary expense for 1997 increased by $192,000 or 4.7 percent to
$4,312,000, while benefits expense increased by $34,000 to $1,099,000. If the
impact of bank-wide performance bonuses and severance pay are excluded, the
increase to salary expense for 1997 was $19,000 or .5 percent.
The increase in benefits expense in 1997 is partially a result of higher payroll
related taxes. Social Security and Medicare taxes increased approximately
$15,000, while State unemployment taxes increased by approximately $26,000. The
increase in State unemployment taxes is the outcome of a higher rate resulting
from the corporate reorganizations of 1994 and 1995. Another factor in the
increase in benefits expense relates to QNB's retirement plans, whose costs
increased by approximately $18,000 in 1997. This increase was a result of an
increase in eligible wages and the costs of converting the plans to new
investment funds and a new record-keeper. Partially offsetting these increases
were lower costs related to disability and life insurance premiums, which
declined by approximately $17,000. A change in insurance carrier accounted for
the decrease. Expense for employee education also decreased by $13,000 in 1997
as a result of several employees completing their programs in 1996.
13
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
NON-INTEREST EXPENSE (continued)
Net occupancy expense was $666,000 for both 1998 and 1997. When comparing 1998
to 1997, utility costs declined by approximately $13,000 or 9.1 percent. These
savings were a function of the relatively mild temperatures experienced during
1998. These savings were offset by small increases in branch rent expense,
building taxes, maintenance and insurance.
When comparing 1997 to 1996, net occupancy expense decreased $21,000 or 3.1
percent from the $687,000 reported in 1996. Declines in building depreciation
expense and building repairs and maintenance expense offset the impact of higher
utility costs. Depreciation expense and repairs and maintenance costs declined
by $17,000 and $21,000, respectively, while utility costs increased by $12,000.
Net occupancy expense will likely increase in 1999 as a result of costs related
to the renovation and expansion of an existing branch location as well as the
opening of a new branch location anticipated in the fall of 1999.
Furniture and equipment expense was $735,000 for 1998, an increase of $38,000 or
5.5 percent. The increase is a result of higher depreciation expense of $18,000
resulting primarily from the implementation of the first three phases of the
wide-area network and the conversion to a new telephone system. Purchases of
equipment amounted to approximately $957,000 in 1998. Also contributing to the
increase in furniture and equipment expense were higher equipment maintenance
costs of $23,000 or 7.8 percent. Some of this increase is a result of
maintenance costs on a used mainframe system purchased for use in Year 2000
testing.
Furniture and equipment expense was $697,000 for both 1997 and 1996.
Depreciation expense on furniture and equipment continued to decline during this
period. Depreciation expense on furniture and equipment decreased $13,000 in
1997 to $359,000. This followed a decrease of $74,000 in 1996. QNB uses an
accelerated method of depreciation on its furniture and equipment. This provides
for higher expense in the earlier years of an asset's life. QNB purchased
approximately $200,000 of furniture and equipment in 1997 compared to $326,000
in 1996 and $143,000 in 1995. Furniture and equipment purchases for 1994 and
1993 totaled $1,108,000. The smaller amounts of furniture and equipment
purchased between 1995 and 1997, along with lower depreciation expense as an
asset ages, account for the decline in depreciation expense during these years.
Offsetting the reduction in depreciation expense in both 1997 and 1996 was an
increase in equipment maintenance costs, which increased $18,000 in 1997 after
increasing $44,000 in 1996. These costs have increased as a result of more
equipment being placed under maintenance agreements, as well as an increase in
maintenance needed as the equipment ages.
Furniture and equipment expense will increase significantly in 1999 as a result
of higher depreciation expense associated with QNB's continued expansion of its
investment in new technology. This will include the completion of the final
phases of the wide-area network as well as implementation of a check imaging
system during the first quarter of 1999. The expansion of the existing branch as
well as the addition of a new branch location will also result in higher
furniture and equipment expense.
Marketing expense increased $68,000 or 22.4 percent in 1998 to $371,000.
Included within this variance is an increase in donations expense of 96.1
percent. This increase in donations resulted from two significant pledges made
during 1998, including a $40,000 donation to the Main Street Program, a program
designed for the revitalization of downtown Quakertown. Also contributing to the
increase in marketing expense was higher advertising expense of $18,000 or 14.7
percent. During 1998, QNB used additional print, radio and billboard advertising
to promote specific products and QNB's image of being an independent community
bank, in light of the merger activity taking place in the industry and
specifically within our marketplace. Marketing expense increased $16,000 or 5.6
percent in 1997 to $303,000. A significant donation to a local non-profit
organization accounted for most of the increase.
Other real estate owned expense increased $39,000 or 14.3 percent to $312,000 in
1998. This followed an increase of $20,000 or 7.9 percent in 1997. The increase
is primarily the result of the net losses on the disposition or write-down of
properties during the year. Net losses amounted to $152,000 in 1998 compared to
$25,000 in 1997. The loss in 1998 was primarily related to the write-down of two
properties, one of which is currently under agreement of sale. Partially
offsetting these losses were lower costs related to taxes, insurance and
maintenance of the properties. These costs decreased $88,000 from 1997 to 1998
as a result of owning fewer properties. The increase in other real estate owned
expense between 1996 and 1997 was primarily the result of net losses of $25,000
on the disposition or write-down of properties during 1997. Expenses related to
the maintenance of the properties decreased by $5,000 in 1997.
[GRAPHIC]
In the printed version, there appears a bar graph, depicting the following plot
points:
EFFICIENCY RATIO
1994 72.50%
1995 72.46%
1996 65.62%
1997 63.79%
1998 63.20%
Management anticipates a substantial reduction in expenses related to other real
estate owned during 1999, as these costs are eliminated as properties are sold.
QNB owns significantly fewer properties than it did at the beginning of 1998.
Other real estate owned at December 31, 1998 was $696,000 compared to $1,564,000
at December 31, 1997.
14
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
The major categories that comprise other expense are postage, supplies,
professional services, telecommunications costs, insurance expense, state taxes
and loan related costs. Other expense was $2,103,000 in 1998, $1,917,000 in 1997
and $1,895,000 in 1996. One of the reasons for the increase between 1997 and
1998 was an $81,000 increase in the accrual for a director's deferred
compensation plan. This increase reflects an adjustment to the interest rate
assumption caused by the decline in market interest rates. The amortization of
the deposit premium, relating to the acquisition completed during the fourth
quarter of 1997, accounted for $43,000 of the increase. Increased supplies and
postage expense accounted for $20,000 and $22,000, respectively, of the increase
between 1997 and 1998.
The 1.1 percent increase in other expense between 1996 and 1997 was a result of
a number of factors including an increase in directors fees, state taxes, ATM
and check card expense and fraud losses. The increase in directors fees of
$28,000 resulted from an increase in the number of Bank directors and the fees
paid per meeting. Costs related to the start-up, distribution and maintenance of
the check card account for $12,000 of the increase. The amortization of the
deposit premium also contributed to the increase in other expense. These
increases were partially offset by lower supplies expense of $29,000. A more
aggressive competitive bidding process in addition to improved monitoring
procedures contributed to this decline.
INCOME TAXES
QNB uses the asset and liability method to provide for income taxes. 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. 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 of a change in tax rates on deferred tax
assets and liabilities is recognized in income in the period that includes the
enactment date.
Applicable income taxes and effective tax rates were $1,272,000 or 26.9 percent
for 1998 compared to $1,253,000 or 28.6 percent for 1997, and $1,048,000 or 27.2
percent for 1996. The reduction in the effective tax rate when comparing 1998 to
1997 is a result of an increase in income from tax-exempt municipal securities
and loans, an increase in tax-exempt income from earnings on single premium life
insurance and a larger tax credit from QNB's investment in a low income housing
project. The increase in the effective tax rate between 1996 and 1997 was a
result of higher pre-tax income and a decrease in the percentage of income
derived from non-taxable loans and investments.
FINANCIAL CONDITION
The consolidation of the financial services industry that began in the mid
1990's took a different turn in 1998 with the announcement of several mergers
that will dramatically change the landscape of the industry. What had initially
started primarily as regional bank mergers, broadened to include the
consolidation of banks with brokerage houses, savings institutions, credit card
companies and mortgage banking firms, expanded to the next level in 1998. The
mergers in 1999 moved to the national and international level with the
announcement and completion of several huge events. The combination of Nations
Bank with Bank America, Banker's Trust with Deutsche Bank AG and Citicorp with
Travelers Group were a few of the more significant events of 1998. The Citigroup
merger represents the combination of banking and insurance. The largest merger
that impacted QNB was the combination of CoreStates Bank with First Union Bank.
CoreStates had locations in every market in which QNB operates. QNB will
continue to use this merger as an opportunity to attract former CoreStates
customers by stressing the advantages of banking with a locally owned community
bank. These mergers have changed the landscape in which QNB operates. QNB's
primary competition in the banking segment of the financial services industry is
comprised of a large super regional bank, several large community banks and a
thrift institution. The consolidation of the banking industry and the increased
availability of loans from all types of companies in the financial services
industry have led to increased price competition for both deposits and loans.
Insurance companies have become a major competitor in the lending arena.
Continued strong performance of the stock markets as well as record inflows of
cash into mutual funds have also had a direct impact on the competition for
deposits.
In spite of this increased competition, QNB was able to experience significant
balance sheet growth in 1998 and 1997. Total assets at year-end 1998 were
$324,672,000, compared with $305,772,000 at December 31, 1997, an increase of
6.2 percent. This followed growth rates of 9.0 percent and 1.6 percent in 1997
and 1996. The growth in 1997 was enhanced by the purchase of approximately
$6,800,000 of deposits from the Quakertown office of First Lehigh Bank on
October 30, 1997. Excluding this purchase, assets would have increased by 6.6
percent in 1997. Other Assets increased as a result of the purchase of
approximately $2,557,000 in single premium life insurance policies for executive
officers and some directors of QNB. These policies earn between 5.85 percent and
6.00 percent tax free and replace the group term life insurance policies of the
executive officers and enhance the funding side of the directors deferred
compensation plan.
Average total assets increased 7.5 percent or $21,794,000 in 1998 to
$310,492,000. This followed an increase in average total assets of 5.2 percent
or $14,165,000 in 1997. Total loans at December 31, 1998 were $176,443,000, an
increase of 5.2 percent from December 31, 1997. This followed a 5.3 percent
increase from December 31, 1996 to December 31, 1997. Average total loans
increased 5.4 percent in 1998 and 3.8 percent in 1997. Loan growth was and
remains one of the primary goals of QNB. Funding sources, which include deposits
and short-term borrowings, increased 5.8 percent from year-end 1997 to year-end
1998 and 8.7 percent from year-end 1996 to year-end 1997. Excluding the purchase
of deposits, funding sources would have increased by 6.0 percent in 1997.
Average funding sources increased 7.2 percent in 1998 and 4.7 percent in 1997.
The following discussion will further detail QNB's financial condition during
1998 and 1997.
15
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
INVESTMENT PORTFOLIO HISTORY
- ------------------------------------------------------------------------------------------------------------------------------
December 31, 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------------------
Investment Securities Available-for-Sale
U.S. Treasuries ..................................................... $ 9,180 $ 9,633 $ 9,555
U.S. Government agencies ............................................ 47,356 55,586 39,422
State and municipal securities ...................................... 518 511 --
Mortgage-backed securities .......................................... 9,338 8,152 3,045
Equity and other debt securities .................................... 3,696 2,038 757
- ------------------------------------------------------------------------------------------------------------------------------
Total investment securities available-for-sale ................... $ 70,088 $ 75,920 $ 52,779
- ------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
State and municipal securities ...................................... $ 14,668 $ 10,136 $ 10,563
Mortgage-backed securities .......................................... 35,319 30,186 32,058
Equity securities ................................................... 78 78 78
- ------------------------------------------------------------------------------------------------------------------------------
Total investment securities held-to-maturity ..................... $ 50,065 $ 40,400 $ 42,699
- ------------------------------------------------------------------------------------------------------------------------------
Total investment securities ...................................... $120,153 $116,320 $ 95,478
==============================================================================================================================
INVESTMENT PORTFOLIO WEIGHTED AVERAGE YIELDS
- ----------------------------------------------------------------------------------------------------------------------------
Under 1-5 5-10 Over 10
December 31, 1998 1 Year Years Years Years Total
- ----------------------------------------------------------------------------------------------------------------------------
Investment Securities Available-for-Sale
U.S. Treasuries:
Fair value .................................. $ 4,550 $ 4,630 -- -- $ 9,180
Weighted average yield ...................... 6.04% 6.33% 6.19%
U.S. Government agencies:
Fair value .................................. -- $ 14,624 $ 32,732 -- $47,356
Weighted average yield ...................... 6.63% 6.67% 6.66%
State and municipal securities:
Fair value .................................. -- -- -- $ 518 $ 518
Weighted average yield ...................... 8.21% 8.21%
Mortgage-backed securities:
Fair value .................................. $ 2,915 $ 3,472 $ 2,951 -- $ 9,338
Weighted average yield ...................... 6.12% 6.62% 6.11% 6.66%
Equity and other debt securities:
Fair value .................................. $ 3,644 $ 52 -- -- $ 3,696
Weighted average yield ...................... 4.74% 7.87% 4.80%
- ----------------------------------------------------------------------------------------------------------------------------
Total fair value ............................... $ 11,109 $ 22,778 $ 35,683 $ 518 $70,088
Weighted average yield ......................... 5.68% 6.57% 6.62% 8.21% 6.52%
- ----------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
State and municipal securities:
Amortized cost .............................. -- $ 5,108 $ 9,391 $ 169 $14,668
Weighted average yield ...................... 8.21% 6.95% 6.52% 7.09%
Mortgage-backed securities:
Amortized cost .............................. $ 14,581 $ 19,738 $ 1,000 -- $35,319
Weighted average yield ...................... 6.60% 6.51% 6.20% 6.54%
Equity securities:
Amortized cost .............................. $ 78 -- -- -- $ 78
Weighted average yield ...................... 6.00% 6.00%
- ----------------------------------------------------------------------------------------------------------------------------
Total amortized cost ........................... $ 14,659 $ 24,846 $ 10,391 $ 169 $50,065
Weighted average yield ......................... 6.60% 6.86% 6.88% 6.52% 6.70%
- ----------------------------------------------------------------------------------------------------------------------------
Securities are assigned to categories based on stated contractual maturity
except for mortgage-backed securities which are based on anticipated payment
periods. See interest rate sensitivity section for practical payment and
repricing characteristics. Tax-exempt securities were adjusted to a
tax-equivalent basis and are based on the marginal Federal corporate tax rate of
34 percent. Weighted average yields on investment securities available-for-sale
are based on historical cost.
16
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
INVESTMENT SECURITIES AND OTHER
SHORT-TERM INVESTMENTS
Investment policies, approved by QNB's Board of Directors, include strict
standards regarding permissible investment categories, credit quality, maturity
intervals and investment concentrations. Total investment securities at December
31, 1998 and 1997 were $120,153,000 and $116,320,000. At December 31, 1998 and
1997, approximately 85.1 percent and 89.1 percent of QNB's investment securities
were either U.S. Government or U.S. Government agency debt securities, or U.S.
Government agency issued mortgage-backed securities, primarily collateralized
mortgage obligations.
QNB did not hold any securities which, in the aggregate from any issuer
(excluding the U.S. Government and its agencies), were in excess of 10 percent
of shareholders' equity. In addition, Federal funds sold, which would be
affected by the economic status of the banking industry, are short-term in
nature and sold to banks with a minimum "A" rating at the date of the sale.
Average investment securities increased $9,154,000 or 8.5 percent to
$116,241,000 in 1998 compared with an $8,711,000 or 8.9 percent increase in
1997. Average Federal funds sold increased 47.7 percent in 1998 to $5,872,000,
after decreasing 15.4 percent between 1997 and 1996. The increase in the size of
the investment portfolio in both 1998 and 1997 was fueled by the growth in
average funding sources, which increased by $18,881,000 and $11,878,000,
respectively. This growth was enhanced by the previously discussed purchase of
approximately $6,800,000 in deposits from another financial institution during
the fourth quarter of 1997. The amount of activity in the investment portfolio
remained high with over $49,100,000 in maturities, calls or sales and over
$52,800,000 in purchases during 1998.
Despite the amount of activity during 1998, the composition of the portfolio did
not change significantly. U.S. Government agency securities decreased to 39.4
percent of the portfolio at December 31, 1998, from 47.8 percent of the
portfolio at December 31, 1997. The percentage of U.S. Treasury securities
declined to approximately 7.6 percent of the portfolio from 8.3 percent, while
agency issued mortgage-backed securities increased to 37.2 percent from 33.0
percent. State and municipal securities increased to 12.6 percent from 9.2
percent of the portfolio at December 31, 1998 and 1997, respectively. The
decrease in the percentage of the portfolio in U.S. Government agency securities
and the offsetting increase in mortgage-backed securities is a result of
management's opinion that the mortgage-backed sector provided more value than
the callable agency sector as rates declined in 1998. Management anticipates
that investment portfolio activity will remain high during 1999 due to the
relatively low interest rate environment, as some callable agency bonds are
called and prepayments remain strong on mortgage-backed securities. The
anticipated strategy entering 1999 is to continue to focus on the purchase of
mortgage-backed securities and tax-exempt State and municipal securities. The
growth in the investment portfolio should be minimal in 1999 as anticipated loan
growth replaces some of the incoming cash flow from the securities.
At December 31, 1998 and 1997, investment securities totaling $44,715,000 and
$36,510,000 were pledged as collateral for repurchase agreements, public
deposits and other deposits as provided by law.
QNB accounts for its investments by classifying its securities into three
categories. Securities that QNB has the positive intent and ability to hold to
maturity are classified as held-to-maturity securities and reported at amortized
cost. Debt and equity securities that are bought and held principally for the
purpose of selling them in the near term are classified as trading securities
and reported at fair value, with unrealized gains and losses included in
earnings. Debt and equity securities not classified as either held-to-maturity
securities or trading securities are classified as available-for-sale securities
and reported at fair value, with unrealized gains and losses, net of tax,
excluded from earnings and reported as a separate component of shareholders'
equity. Management determines the appropriate classification of securities at
the time of purchase. QNB held no trading securities as of December 31, 1998 and
1997.
[GRAPHIC]
In the printed version, there appears a pie chart, depicting the
following percentages:
INVESTMENT PORTFOLIO
U.S. Treasuries 7.6%
Equity securities 3.2%
State and municipal 12.6%
Mortgage-backed
securities 37.2%
U.S. Government
agencies 39.4%
17
QNB Corp. and Subsidiary
MANAGEMENT'S DISCUSSION AND ANALYSIS
INVESTMENTS AVAILABLE-FOR-SALE
Investment securities available-for-sale include securities that management
intends to use as part of its asset/liability management strategy. They may be
sold in response to changes in market interest rates and related changes in the
security's prepayment risk or in response to the need for liquidity. The
available-for-sale portfolio is primarily comprised of U.S. Treasuries and U.S.
Government agencies due to their high degree of liquidity. Also included are
certain mortgage-backed securities to ensure QNB's ability to react to changes
in prepayment activity. At December 31, 1998, the fair value of investment
securities available-for-sale was $70,088,000 or $1,387,000 above the amortized
cost of $68,701,000. This compares to a fair value of $75,920,000 or $1,323,000
above the amortized cost of $74,597,000 at December 31, 1997. An unrealized
holding gain, net of taxes, of $916,000 and $873,000 was recorded as an increase
to shareholders' equity at December 31, 1998 and 1997, respectively. The
available-for-sale portfolio had a weighted average maturity of approximately 4
years, 10 months and 5 years, and a weighted average tax-equivalent yield of
6.52 percent and 6.66 percent at December 31, 1998 and 1997, respectively.
The weighted average maturity is based on the stated contractual maturity of all
securities except for mortgage-backed securities, which are based on estimated
average life. The maturity of the portfolio may be shorter because of call
features in many of the debt securities and because of prepayments on
mortgage-backed securities. The interest rate sensitivity analysis on page 25
reflects the expected maturity distribution of the securities portfolio based
upon estimated call dates and anticipated cash flows assuming management's most
likely interest rate environment. The expected weighted average life of the
available-for-sale portfolio was 1 year and 2 months at December 31, 1998, and 1
year and 10 months at December 31, 1997, based on these assumptions. The
expected weighted average life declined to a greater degree than the weighted
average maturity because of the callable nature of the securities and the
decline in interest rates during 1998, which makes these call features more
likely to be exercised.
INVESTMENTS HELD-TO-MATURITY
Investment securities held-to-maturity are recorded at amortized cost. Included
in this portfolio are State and municipal securities with original maturities
primarily of 10 years or less and most mortgage-backed securities. They are
designated as held-to-maturity as they represent a large component of QNB's core
investment earnings and are purchased with the intent and ability to hold to
maturity. At December 31, 1998 and 1997, the amortized cost of investment
securities held-to-maturity was $50,065,000 and $40,400,000, and the fair value
was $50,473,000 and $40,713,000, respectively. The held-to-maturity portfolio
had a weighted average maturity of approximately 3 years, 10 months and 2 years,
10 months, and a weighted average tax-equivalent yield of 6.70 percent and 6.69
percent at December 31, 1998 and 1997, respectively.
LOANS
QNB's primary function and responsibility is to accept deposits and to make
loans to meet the credit needs of the communities it serves. Loans are the most
significant component of earning assets. Inherent within the lending function is
the evaluation and acceptance of credit risk and interest rate risk along with
the opportunity cost of alternative deployment of funds. QNB manages credit risk
associated with its lending activities through portfolio diversification,
underwriting policies and procedures, and loan monitoring practices.
QNB has comprehensive policies and procedures which define and govern both
commercial and retail loan origination and management of risk. All loans are
underwritten in a manner that emphasizes the borrowers' capacity to pay. The
measurement of capacity to pay delineates the potential risk of nonpayment or
default. The higher potential for default determines the need for and amount of
collateral required. QNB makes unsecured loans when the capacity to pay is
considered substantial. As capacity lessens, collateral is required to provide a
secondary source of repayment and to mitigate the risk of loss. Various policies
and procedures provide guidance to the lenders on such factors as amount, terms,
price, maturity and appropriate collateral levels. Each risk factor is
considered critical to assuring that QNB receives an adequate return for the
risk undertaken, and that the risk of loss is minimized.
[GRAPHIC]
In the printed version, there appears a bar chart, depicting the
following percentages:
TOTAL LOANS
(in thousands)
1994 153,993
1995 155,957
1996 159,278
1997 167,720
1998 176,443
QNB effectively manages the risk associated with commercial loans, which
generally have balances larger than retail loans, by having lenders work in
tandem with credit underwriting personnel. To further assess loan portfolio
quality, a Loan Committee and the Board of Directors approve loans that meet
certain qualifications.
QNB's commercial lending activity is focused on small businesses within the
local community. Commercial and industrial loans represent commercial purpose
loans that are either secured by collateral other than real estate or unsecured.
Real estate commercial loans include commercial purpose loans collateralized at
least in part by commercial real estate.
18
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
LOAN PORTFOLIO
- ---------------------------------------------------------------------------------------------------------------------------------
December 31, 1998 1997 1996 1995 1994
- ---------------------------------------------------------------------------------------------------------------------------------
Commercial and industrial .......................... $ 35,003 $ 32,794 $ 22,973 $ 27,002 $ 24,599
Agricultural ....................................... 3,446 2,845 2,828 2,451 2,823
Construction ....................................... 782 813 3,640 6,641 5,253
Real estate-commercial ............................. 60,708 58,783 57,589 51,368 54,015
Real estate-residential ............................ 71,052 67,621 66,203 61,339 57,486
Consumer ........................................... 5,864 5,312 6,477 7,538 10,208
- ---------------------------------------------------------------------------------------------------------------------------------
Total loans ..................................... 176,855 168,168 159,710 156,339 154,384
Less unearned income ............................... 412 448 432 382 391
- ---------------------------------------------------------------------------------------------------------------------------------
Total loans, net of unearned income ............. $176,443 $167,720 $159,278 $155,957 $153,993
=================================================================================================================================
LOAN MATURITIES AND INTEREST SENSITIVITY
- -----------------------------------------------------------------------------------------------------------------------
Under 1-5 Over
December 31, 1998 1 Year Years 5 Years Total
- -----------------------------------------------------------------------------------------------------------------------
Commercial and industrial .................. $ 16,963 $ 14,831 $ 3,209 $ 35,003
Agricultural ............................... 1,385 316 1,745 3,446
Construction ............................... 782 -- -- 782
Real estate-commercial ..................... 9,936 9,789 40,983 60,708
Real estate-residential .................... 7,390 18,920 44,742 71,052
Consumer ................................... 2,521 3,164 179 5,864
- -----------------------------------------------------------------------------------------------------------------------
Total ................................... $ 38,977 $ 47,020 $ 90,858 $176,855
=======================================================================================================================
Demand loans, loans having no stated schedule of repayment and no stated
maturity, are included in under one year.
The following shows the amount of loans due after one year that have fixed,
variable or adjustable interest rates at December 31, 1998:
Loans with fixed predetermined interest rates $80,769
Loans with variable or adjustable interest rates $57,109
NON-PERFORMING ASSETS
- ----------------------------------------------------------------------------------------------------------------------
December 31, 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------------
Loans past due 90 days or more not on non-accrual status
Commercial and industrial ............................ -- $ 99 -- $ 66 $ 5
Construction ......................................... -- -- -- -- 299
Real estate-commercial ............................... -- -- -- 107 100
Real estate-residential .............................. $ 4 60 $ 162 96 313
Consumer ............................................. 1 -- 3 3 4
- ----------------------------------------------------------------------------------------------------------------------
Total loans past due 90 days or more and accruing .. 5 159 165 272 721
Loans accounted for on a non-accrual basis
Commercial and industrial ............................ 9 25 43 120 123
Construction ......................................... -- -- -- 686 846
Real estate-commercial ............................... 220 744 1,790 2,588 1,157
Real estate-residential .............................. 277 440 867 1,084 1,755
Consumer ............................................. -- -- -- 10 24
- ----------------------------------------------------------------------------------------------------------------------
Total non-accrual loans ............................ 506 1,209 2,700 4,488 3,905
Other real estate owned ................................. 696 1,564 1,395 775 1,973
- ----------------------------------------------------------------------------------------------------------------------
Total non-performing assets ........................ $1,207 $2,932 $4,260 $5,535 $6,599
======================================================================================================================
Total as a percent of total assets ...................... .37% .96% 1.52% 2.01% 2.46%
19
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
ALLOWANCE FOR LOAN LOSS ALLOCATION
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------------------------------------------------
Percent Percent Percent Percent Percent
Gross Gross Gross Gross Gross
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at end of period applicable to:
Commercial and industrial .......... $ 269 19.8% $ 205 19.5% $ 115 14.4% $ 792 17.3% $ 749 15.9%
Agricultural ....................... 14 2.0 13 1.7 13 1.8 13 1.6 12 1.8
Construction ....................... 3 .4 3 .5 34 2.3 43 4.2 56 3.4
Real estate-commercial ............. 262 34.3 354 34.9 643 36.1 363 32.9 535 35.0
Real estate-residential ............ 273 40.2 215 40.2 378 41.4 547 39.2 289 37.3
Consumer ........................... 33 3.3 37 3.2 39 4.0 44 4.8 36 6.6
Unallocated ........................ 2,097 1,843 1,363 582 347
- ------------------------------------------------------------------------------------------------------------------------------------
Total ............................ $2,951 100.0% $2,670 100.0% $2,585 100.0% $2,384 100.0% $2,024 100.0%
====================================================================================================================================
Gross loans represent loans before unamortized net loan fees. Percent gross
loans lists the percentage of each loan type to total loans.
ALLOWANCE FOR LOAN LOSSES
- ------------------------------------------------------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------------------------------------------------
Allowance for loan losses:
Balance, January 1 ....................... $ 2,670 $ 2,585 $ 2,384 $ 2,024 $ 2,221
Charge-offs
Commercial and industrial ............. 8 16 44 4 567
Construction .......................... -- 10 -- -- --
Real estate-commercial ................ 50 99 115 320 222
Real estate-residential ............... 81 189 52 325 62
Consumer .............................. 13 30 48 54 38
- ------------------------------------------------------------------------------------------------------------------------------------
Total charge-offs ..................... 152 344 259 703 889
Recoveries
Commercial and industrial ............. 8 7 35 12 55
Construction .......................... -- 1 -- -- --
Real estate-commercial ................ 6 -- -- 10 11
Real estate-residential ............... 10 9 8 4 3
Consumer .............................. 9 12 17 27 23
- ------------------------------------------------------------------------------------------------------------------------------------
Total recoveries ...................... 33 29 60 53 92
- ------------------------------------------------------------------------------------------------------------------------------------
Net charge-offs .......................... (119) (315) (199) (650) (797)
Provision for loan losses ................ 400 400 400 1,010 600
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31 ..................... $ 2,951 $ 2,670 $ 2,585 $ 2,384 $ 2,024
====================================================================================================================================
Total loans:
Average ............................... $ 169,800 $ 161,096 $ 155,175 $ 151,839 $ 151,726
Year-end .............................. 176,443 167,720 159,278 155,957 153,993
Ratios:
Net charge-offs to:
Average loans ......................... .07% .20% .13% .43% .53%
Loans at year-end ..................... .07 .19 .12 .42 .52
Allowance for loan losses ............. 4.03 11.80 7.70 27.27 39.38
Provision for loan losses ............. 29.75 78.75 49.75 64.36 132.83
Allowance for loan losses to:
Average loans ......................... 1.74% 1.66% 1.67% 1.57% 1.33%
Loans at year-end ..................... 1.67 1.59 1.62 1.53 1.31
Non-performing loans .................. 577.50 195.20 90.20 50.10 43.80
20
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
LOANS (CONTINUED)
These loans may not be for the express purpose of conducting commercial real
estate transactions. Real estate residential loans include loans secured by
one-to-four family units. These loans include home equity loans, loans to
individuals for residential mortgages, and commercial purpose loans.
Substantially all originations of loans to individuals for residential mortgages
with maturities of 20 years or greater are sold in the secondary market.
Included in real estate residential loans at December 31, 1998 and 1997 are
$3,601,000 and $481,000 of residential mortgage loans held-for-sale.
These loans are carried at the lower of aggregate cost or market.
The loan portfolio composition changed slightly from year-end 1997. Loans
collateralized by commercial and residential properties decreased to 74.5
percent of the portfolio at December 31, 1998 from 75.1 percent of the portfolio
at December 31, 1997. Commercial and industrial loans increased to 19.8 percent
of the portfolio at year-end 1998 from 19.5 percent at December 31, 1997.
Agricultural and consumer loans increased slightly from 1.7 and 3.2 percent at
year-end 1997 to 2.0 percent and 3.3 percent at December 31, 1998, respectively.
QNB's commercial loans are not considered to be concentrated, except those loans
to real estate developers and investors which account for $25,289,000 or 14.3
percent of the loan portfolio at December 31, 1998. This is down slightly from
15.3 percent at December 31, 1997. Concentration is based upon Standard
Industrial Classification codes used for bank regulatory purposes, and is
considered to be 10 percent or more of total loans. Diversification is achieved
through lending to various industries located within the market area. This
diversification is believed to reduce risk associated with changes in economic
conditions.
Loans, net of unearned income, increased $8,723,000 to $176,443,000 at December
31, 1998. The commercial and industrial loan category continues to show growth,
increasing $2,209,000 or 6.7 percent to $35,003,000 at December 31, 1998. This
follows an increase of $9,821,000 or 42.8 percent between 1996 and 1997. Loans
secured by commercial real estate and residential real estate increased
$1,925,000 and $3,431,000, respectively from December 31, 1997 to 1998.
Agricultural loans and consumer loans increased $601,000 and $552,000,
respectively. Growth in loans during both 1998 and 1997 was primarily focused
upon increasing loans for commercial purposes. The increase in the commercial
and industrial category is a direct result of this focus. Although a certain
amount of these loans are considered unsecured, the majority are secured by
non-real estate collateral such as equipment, vehicles, accounts receivable and
inventory.
The increase in residential real estate loans that began in 1995 is the result
of a change in strategy with respect to selling loans in the secondary market,
and a new plan to accept a small percentage of quality loans that are
nonconforming to Freddie Mac standards and therefore are not salable to them.
These include loans that have excess land value, loans that exceed a dollar
threshold or loans where the debt to income ratio slightly exceeds Freddie Mac's
guidelines but where QNB has had an ongoing relationship with the customer.
Included in residential real estate loans are residential mortgage loans
held-for-sale of $3,601,000 and $481,000 at December 31, 1998 and 1997,
respectively. Excluding these loans held-for-sale, residential real estate loans
increased $311,000 or .5 percent between 1997 and 1998.
Aggressive fixed rate home equity loan promotions and pricing during the past
three years has also impacted the growth of loans secured by residential real
estate. The increase in home equity loans has had a negative impact on the
amount of consumer loans outstanding. Customers chose to benefit from the
competitive rate of home equity loans as well as the tax deductibility of the
interest by paying off other loans with home equity loans. Additionally, up
until 1998, consumer loans outstanding had declined as a result of the decision
made in 1995 to discontinue indirect vehicle lending through automobile dealers.
The increase in consumer loans in 1998 is primarily the result of an increase in
five year automobile loans. QNB has priced these loans aggressively to compete
with other financial institutions and directly with automobile dealers.
Management's primary focus during recent years has been asset quality and the
reduction of non-performing assets. With the successful achievement of this goal
in 1997 and 1998, management's focus switched to loan and deposit growth. To
help achieve these goals an aggressive business development and calling program
encompassing lending personnel, branch personnel and executive management was
developed and implemented. The focus of this program is to both develop new
lending and deposit relationships as well as to strengthen existing
relationships. The purchase of deposits in the fourth quarter of 1997 as well as
the anticipated opening of a branch in a new geographic market in 1999 are other
strategies that will help achieve these targets.
NON-PERFORMING ASSETS
Non-performing assets are defined as accruing loans past due 90 days or more,
non-accruing loans, restructured loans and other real estate owned. QNB
continues to make significant progress in reducing its level of non-performing
assets. The table on page 19 shows the dramatic improvement in non-performing
assets over the past five years. Total non-performing assets were $1,207,000 at
December 31, 1998, or .37 percent of total assets. This represents a reduction
of 58.8 percent from the December 31, 1997 balance of $2,932,000. Non-performing
assets at December 31, 1997 represented .96 percent of total assets. The
percentage of non-performing assets at December 31, 1998 are at historically low
levels for QNB. It is management's goal to continue to maintain or even reduce
the level of non-performing assets in 1999 through the sale of other real estate
owned.
Non-accrual loans are those on which the accrual of interest has ceased.
Commercial loans are placed on non-accrual status immediately if, in the opinion
of management, collection is doubtful, or when principal or interest is past due
90 days or more and collateral is insufficient to protect principal and
interest. Interest accrued but not collected at the date a loan is placed on
non-accrual status is reversed and charged against interest income. Subsequent
cash receipts are applied either to the outstanding principal or recorded as
interest income, depending on management's assessment of ultimate collectibility
of principal and interest. Loans are returned to an accrual status when the
borrower's ability to make periodic principal and interest payments has returned
to normal (i.e. - brought current with respect to principal and interest, or
restructured) and the paying capacity of the borrower and/or the underlying
collateral is deemed sufficient to protect principal and interest. Consumer
loans are not automatically placed on non-accrual status when principal or
interest payments are 90 days past due, but in most instances are charged-off
when deemed uncollectible or after reaching 120 days past due.
21
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
NON-PERFORMING ASSETS (CONTINUED)
Included in the loan portfolio are loans on non-accrual status of $506,000 and
$1,209,000 at December 31, 1998 and 1997. The significant decline in non-accrual
loans is a result of a few factors including the repayment of loans by borrowers
and the foreclosure and movement to other real estate owned of other loans.
These activities were performed with minimal loss to QNB. If interest had been
accrued throughout the period, interest income for the years ended December 31,
1998, 1997 and 1996 would have increased approximately $70,000, $154,000 and
$265,000, respectively. The amount of interest income on these loans included in
net income in 1998, 1997 and 1996 was $17,000, $7,000 and $50,000, respectively.
There were no restructured loans as of December 31, 1998 or 1997, 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.
Other real estate owned totaled $696,000 at December 31, 1998 and $1,564,000 at
December 31, 1997. This real estate is recorded at the fair value of the
property less estimated costs to sell. At December 31, 1998, $92,000 of the
balance is under agreement of sale and is expected to settle in the first
quarter of 1999.
Loans not included in past due, non-accrual or restructured categories, but
where known information about possible credit problems causes management to be
uncertain as to the ability of the borrowers to comply with the present loan
repayment terms totaled $1,225,000 and $2,022,000 at December 31, 1998 and 1997,
respectively.
ALLOWANCE FOR LOAN LOSSES
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. Other tools include ratio analysis and peer group
analysis.
QNB utilizes a risk weighting system that assigns a risk code to every
commercial loan. This risk weighting system is supplemented with a program that
encourages account officers to identify potentially deteriorating loan
situations. The officer analysis program is used to complement the on-going
analysis of the loan portfolio performed by the loan review officer. In
addition, QNB has a committee that meets quarterly to review the adequacy of the
allowance for loan losses based on the current and projected status of all
relevant factors pertaining to the loan portfolio. In addition, regulatory
authorities, as an integral part of their examinations, periodically review the
allowance for loan losses. They may require additions to the allowance based
upon their judgements about information available to them at the time of
examination.
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 effective interest rate, except
that all collateral-dependent loans are measured for impairment based on the
fair value of the collateral.
At December 31, 1998 and 1997, the recorded investment in loans for which
impairment has been recognized totaled $439,000 and $1,123,000, respectively.
The entire balance of loans defined as impaired as of December 31, 1997 required
no valuation allowance, while $430,000 of the loans identified as of December
31, 1998 required no valuation allowance. As of December 31, 1998, $9,000 of
loans required a valuation allowance of approximately $9,000. Most of the loans
identified as impaired are collateral-dependent. For the years ended December
31, 1998, 1997 and 1996, the average recorded investment in impaired loans was
approximately $945,000, $2,105,000 and $4,288,000, respectively. QNB recognized
$133,000, $86,000 and $50,000 of interest income on these loans in 1998, 1997
and 1996, respectively.
Net charge-offs were $119,000 in 1998, compared with $315,000 in 1997 and
$199,000 in 1996. This level of charge-offs represents .07 percent of average
loans in 1998, compared with .20 percent and .13 percent in 1997 and 1996,
respectively. Gross charge-offs in 1998 were $152,000. Approximately $81,000 of
these charge-offs relate to a loan to one borrower. This loan is now in other
real estate owned. The decline in net charge-offs in 1998 is a function of the
dramatic improvement in loan quality. Non-performing loans, including delinquent
loans, are at historically low levels for QNB. The increase in the level of
charge-offs between 1996 and 1997 relates to the charge-off and write-down on
transfer of loans to other real estate owned of two groups of investment
property loans to two different borrowers. These loans accounted for $204,000 of
the charge-offs in 1997.
The allowance for loan losses was $2,951,000 at December 31, 1998, which
represents 1.67 percent of total loans, compared to $2,670,000 and 1.59 percent
of total loans at December 31, 1997. While the allowance is allocated to
specific loans or loan categories, the total allowance is considered available
for losses in the entire loan portfolio. While QNB believes that its allowance
is adequate to cover losses in the loan portfolio, inherent uncertainties remain
regarding future economic events and their potential impact on asset quality.
22
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
AVERAGE DEPOSITS BY MAJOR CLASSIFICATION
- -------------------------------------------------------------------------------------------------------------------------------
1998 1997 1996
- -------------------------------------------------------------------------------------------------------------------------------
Balance Rate Balance Rate Balance Rate
- -------------------------------------------------------------------------------------------------------------------------------
Non-interest-bearing deposits ............... $ 33,679 -- $ 30,225 -- $ 28,072 --
Interest-bearing demand accounts ............ 41,988 1.37% 40,262 1.75% 38,936 1.81%
Money market accounts ....................... 32,981 2.79 33,218 2.86 36,301 2.78
Savings ..................................... 37,216 2.12 35,215 2.17 34,932 2.20
Time ........................................ 106,324 5.48 97,944 5.48 89,208 5.36
Time deposits of $100,000 or more ........... 19,502 5.73 16,502 5.86 14,633 5.88
- -------------------------------------------------------------------------------------------------------------------------------
Total .................................. $271,690 3.40% $253,366 3.46% $242,082 3.36%
===============================================================================================================================
MATURITY OF TIME DEPOSITS OF $100,000 OR MORE
- ---------------------------------------------------------------------------------------------------------------
Year Ended December 31, 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
Three months or less ....................................... $ 3,204 $ 3,189 $ 3,083
Over three months through six months ....................... 3,610 3,396 3,615
Over six months through twelve months ...................... 6,445 4,665 1,797
Over twelve months ......................................... 4,318 4,452 5,638
- ---------------------------------------------------------------------------------------------------------------
Total ................................................. $17,577 $15,702 $14,133
===============================================================================================================
DEPOSITS
QNB primarily attracts deposits from within its market area by offering various
deposit products, including demand deposits, interest-bearing demand accounts,
money market accounts, savings accounts and certificates of deposit.
Total deposits increased 4.5 percent to $279,223,000 at December 31, 1998. The
increase was centered primarily in time deposits, which increased $9,892,000 or
8.4 percent between 1997 and 1998. Attractive rates on time deposits relative to
rates on other interest-bearing accounts along with the introduction of the
"Flex12" certificate of deposit contributed to the increase in time deposits.
The "Flex12" has a twelve month maturity, allows for one no-penalty withdrawal,
enables the holder to add funds to the account and pays a competitive rate. As
of December 31, 1998, balances in the "Flex12" account totaled approximately
$17,517,000. Total deposits increased 8.3 percent to $267,166,000 at December
31, 1997, from $246,744,000 at year-end 1996. The purchase of approximately
$6,800,000 in deposits from First Lehigh Bank during the fourth quarter of 1997
contributed to this increase.
An analysis of the change in average deposits provides a more meaningful measure
of deposit change. Average total deposits increased 7.2 percent in 1998 and 4.7
percent in 1997. Average non-interest-bearing deposits increased 11.4 percent to
$33,679,000 in 1998. This followed a 7.7 percent increase in 1997.
Non-interest-bearing deposits are an important source of funds for QNB because
they are low cost. Average interest-bearing demand accounts increased 4.3
percent in 1998 to $41,988,000 and 3.4 percent in 1997 to $40,262,000. The
increase in non-interest-bearing deposit accounts and interest-bearing demand
accounts is a result of a number of factors, including: the purchase of deposits
noted previously, the successful results of the business development program, as
well as the addition of new customers resulting from the recent merger activity.
QNB has been able to capitalize on the frustration of some former CoreStates
customers, many of whom were going through their second transition in a matter
of a few years with the merger with First Union. Many of these customers wanted
to return to a community bank for personalized customer service and reasonable
fees.
Average savings account balances were $37,216,000 for 1998, an increase of 5.7
percent from 1997. The popularity of the "YouthTrek" children's savings program
contributed to the increase in total savings accounts. This program stresses the
importance of saving money and uses the motto "Your Future is Bright, When You
Save For It." The program features are fun yet educational and have been
embraced by numerous children in the community. As of December 31, 1998, there
were 3,222 children participating in the program.
Average time deposits increased 9.9 percent in 1998 and 10.2 percent in 1997.
Average time deposits represent approximately 46.3 percent of total average
deposits for 1998. Included within the purchase of deposits in 1997 was
approximately $4,600,000 of time deposits. As mentioned previously, the
introduction of the "Flex12" certificate of deposit had a significant impact on
the growth in time deposits in 1998. Positively impacting time deposit balances
during 1997 was a promotion introduced during the first quarter that enabled the
holder of a 30-month certificate of deposit to increase the interest rate twice
during the term of the certificate, should rates offered on the 30-month time
deposit increase. To continue to attract and retain deposits, QNB will have to
be competitive with respect to rates and will have to continuously develop new
products that appeal to customers.
LIQUIDITY
Liquidity represents an institution's ability to generate cash or otherwise
obtain funds at reasonable rates to satisfy commitments to borrowers and demands
of depositors. QNB manages its mix of cash, Federal funds sold, investment
securities and loans in order to match the volatility, seasonality, interest
sensitivity and growth trends of its deposit funds. Liquidity is provided from
asset sources through maturities and repayments of loans and investment
securities, net interest income and fee income. The portfolio of investment
securities available-for-sale and QNB's policy of selling certain residential
mortgage originations and student loans in the secondary market also provide
sources of liquidity.
23
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
LIQUIDITY (continued)
Cash and due from banks, Federal funds sold, available-for-sale securities and
loans held-for-sale totaled $93,860,000 at December 31, 1998 and $91,915,000 at
December 31, 1997. These sources were adequate to meet seasonal deposit
withdrawals during 1998 and should be adequate to meet normal fluctuations in
loan demand and deposit withdrawals. Approximately $44,715,000 and $36,510,000
of available-for-sale securities at December 31, 1998 and 1997 were pledged as
collateral for repurchase agreements, public deposits and other deposits as
provided by law. Additional sources of liquidity are provided by the Bank's
membership in the Federal Home Loan Bank and a $5,000,000 unsecured Federal
funds line granted by the Bank's correspondent.
The consolidated statements of cash flows present the changes in cash and cash
equivalents from operating, investing and financing activities. QNB's cash and
cash equivalents increased $1,446,000 to $14,020,000 at December 31, 1998. This
follows an increase in 1997 of $115,000 and a decrease in 1996 of $491,000.
After adjusting net income for non-cash transactions, operating activities
provided $2,427,000 in cash flow in 1998, compared to $4,521,000 in 1997 and
$3,953,000 in 1996. The origination of residential mortgages held-for-sale in
excess of the proceeds from the sale of residential mortgages account for
approximately $1,718,000 of the decline in cash provided by operating activities
in 1998. This cash will be realized during the first quarter of 1999 with the
sale of the $3,601,000 in mortgages held-for-sale as of December 31, 1998.
Proceeds from the sale of residential mortgages in excess of originations of
mortgages held-for-sale of $1,487,000 contributed to the increase in cash
provided by operating activities in 1997. Partially offsetting this inflow of
cash was an increase in interest receivable and an increase in other assets,
primarily the deposit premium.
Net cash used by investing activities of $16,196,000 in 1998 was primarily the
result of loan growth. The net increase in loans was $8,771,000 in 1998. The
purchase of investment securities exceeding the maturity, call or sale of
securities totaled $3,317,000 in 1998. An increase in Federal funds sold of
$2,847,000 and the purchase of single premium life insurance for $2,557,000 were
additional uses of cash. Proceeds from the sale of student loans and other real
estate owned provided $1,637,000 and $1,016,000 in cash during 1998. Net cash
used by investing activities of $25,658,000 in 1997 was primarily a result of
the purchase of investment securities exceeding the maturity, call or sale of
securities, and loan growth. Purchases of investment securities totaled over
$51,000,000 while proceeds from securities were only $31,595,000. The net
increase in loans was over $12,000,000. A decrease in Federal funds sold of
$4,458,000 funded some of this activity in 1997. Net cash used by investing
activities of $6,095,000 in 1996 was primarily a result of loan growth and an
increase in Federal funds sold. Net activity in the investment portfolio
provided $2,305,000, while the sale of student loans and other real estate owned
provided cash of $1,527,000 and $1,072,000, respectively. QNB anticipates a high
volume of cash activity from investing activities in 1999 as a result of
significant anticipated cash flow from calls and prepayments on investment
securities.
Cash provided by financing activities of $15,215,000 in 1998 was primarily the
result of an increase in time deposits and repurchase agreements during the
year. Time deposits increased $9,892,000, while outstanding balances on
repurchase agreements increased $4,501,000. The popularity of the "Flex12"
certificate of deposit, as discussed previously, was the catalyst for the growth
in time deposits. A more competitive interest rate on the repurchase agreements
provided the impetus for the growth in this product. A 12.5 percent increase in
the cash dividend from $.64 to $.72 per share decreased the cash provided by
financing activities. Cash provided by financing activities of $21,252,000 in
1997 was a result of strong deposit growth. Non-interest-bearing deposits
increased $6,659,000 while interest-bearing deposits increased $13,763,000.
Increased marketing and business development activities along with competitive
rates and products contributed to the growth in deposits. The purchase of
$6,800,000 in deposits also contributed to the increase in cash provided by
financing activities. A 14.3 percent increase in the cash dividend from $.56 to
$.64 per share decreased the cash provided by financing activities. Cash
provided by financing activities of $1,651,000 in 1996 was a result of growth in
time deposits of $8,177,000. This offset withdrawals from money market accounts
of $5,006,000, a decrease in short-term borrowings of $1,424,000 and the payment
of $797,000 in common stock dividends.
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 December 31, 1998 was
$28,338,000 or 8.73 percent of total assets, compared to shareholders' equity of
$25,832,000 or 8.45 percent at December 31, 1997. At December 31, 1998,
shareholders' equity included a positive adjustment of $916,000 related to the
unrealized holding gains, net of taxes, on investment securities
available-for-sale, while shareholders' equity at December 31, 1997 included a
positive adjustment of $873,000. Without these adjustments, shareholders' equity
to total assets would have been 8.45 percent and 8.16 percent at December 31,
1998 and 1997, respectively.
CAPITAL ANALYSIS
- ------------------------------------------------------------------
December 31, 1998 1997
- ------------------------------------------------------------------
Tier I
Shareholders' equity ............. $ 28,338 $ 25,832
Net unrealized securities gains .. (916) (873)
Intangible assets ................ (451) (505)
- ------------------------------------------------------------------
Total Tier I risk-based capital .. 26,971 24,454
Tier II
Allowable portion of the allowance
for loan losses ................ 2,411 2,271
- ------------------------------------------------------------------
Total risk-based capital ......... $ 29,382 $ 26,725
==================================================================
Risk-weighted assets ............. $ 192,344 $ 181,249
==================================================================
Capital Ratios
- -----------------------------------------------------------------------
December 31, 1998 1997
- -----------------------------------------------------------------------
Tier I capital/risk-weighted assets 14.02% 13.49%
Total risk-based capital/risk-weighted assets 15.28 14.74
Tier I capital/average assets (leverage ratio) 8.58 8.23
Shareholders' equity averaged $26,323,000 during 1998, an increase of 10.2
percent compared to 1997. The ratio of average total equity to average total
assets improved to 8.48 percent for 1998, compared to 8.27 percent for 1997. The
increase in the equity to asset ratio is a function of a significantly higher
net income, an increase in capital retention despite a 12.5 percent increase in
the cash dividend, and modest growth in average assets.
24
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
INTEREST RATE SENSITIVITY
- ------------------------------------------------------------------------------------------------------------------------------
Within 3 to 6 6 months 1 to 3 3 to 5 After
December 31, 1998 3 months months to 1 year years years 5 years Total
- ------------------------------------------------------------------------------------------------------------------------------
Assets
Interest-bearing balances .......... $ 117 -- -- -- -- -- $ 117
Federal funds sold ................. 4,869 -- -- -- -- -- 4,869
Investment securities* ............. 18,447 $10,467 $ 21,895 $ 45,169 $ 12,266 $ 10,523 118,767
Loans .............................. 43,764 10,901 16,448 49,377 33,258 22,695 176,443
- ------------------------------------------------------------------------------------------------------------------------------
Total rate sensitive assets ........ 67,197 21,368 38,343 94,546 45,524 33,218 $300,196
Total cumulative assets ............ $67,197 $88,565 $126,908 $221,454 $266,978 $300,196
==============================================================================================================================
Liabilities
Interest-bearing non-maturing
deposits ......................... $12,170 $ 4,477 $ 8,889 $ 57,031 $ 15,409 $ 15,123 $113,099
Time deposits less than $100,000.... 19,188 17,049 38,541 21,371 13,315 -- 109,464
Time deposits over $100,000 ........ 3,314 3,610 6,335 1,947 2,371 -- 17,577
Short-term borrowings .............. 14,491 -- -- -- -- -- 14,491
==============================================================================================================================
Total rate sensitive
liabilities ...................... 49,163 25,136 53,765 80,349 31,095 15,123 $254,631
Total cumulative liabilities ....... $49,163 $74,299 $128,064 $208,413 $239,508 $254,631
==============================================================================================================================
Gap during period .................. $18,034 $(3,768) $(15,422) $ 14,197 $ 14,429 $ 18,095 $ 45,565
==============================================================================================================================
Cumulative gap ..................... $18,034 $14,266 $ (1,156) $ 13,041 $ 27,470 $ 45,565
==============================================================================================================================
Cumulative gap/earning assets ...... 6.01% 4.75% (.39)% 4.34% 9.15% 15.18%
==============================================================================================================================
Cumulative gap ratio ............... 1.37 1.19 .99 1.06 1.11 1.18
==============================================================================================================================
* Excludes unrealized holding gains on available-for-sale securities of $1,386.
The Corporation is subject to restrictions on the payment of dividends to its
stockholders pursuant to the Pennsylvania Business Corporation Law as amended
(the "BCL"). The BCL operates generally to preclude dividend payments if the
effect thereof would render the Corporation insolvent, as defined. As a
practical matter, the Corporation's payment of dividends is contingent upon its
ability to obtain funding in the form of dividends from the Bank. Payment of
dividends to the Corporation by the Bank is subject to the restrictions set
forth in the National Bank Act. Generally, the National Bank Act would permit
the Bank to declare dividends in 1999 of approximately $2,945,000, plus an
amount equal to the net profits of the Bank in 1999 up to the date of any such
dividend declaration.
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, and intangible assets), Tier II capital which 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 percent for Tier I, 8.00
percent for total risk-based capital and 4.00 percent for leverage. Under the
requirements, QNB has a Tier I capital ratio of 14.02 percent and 13.49 percent,
a total risk-based ratio of 15.28 percent and 14.74 percent, and a leverage
ratio of 8.58 percent and 8.23 percent at December 31, 1998 and 1997,
respectively.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established
five capital level designations ranging from "well capitalized" to "critically
undercapitalized." At December 31, 1998 and 1997 QNB met the "well capitalized"
criteria, which requires minimum Tier I and total risk-based capital ratios of
6.00 percent and 10.00 percent, respectively, and a leverage ratio of 5.00
percent.
INTEREST RATE SENSITIVITY
Since the assets and liabilities of QNB have diverse repricing characteristics
that influence net interest income, management analyzes interest sensitivity
through the use of gap analysis and simulation models. Interest rate sensitivity
management seeks to minimize the effect of interest rate changes on net interest
margins and interest rate spreads, and to provide growth in net interest income
through periods of changing interest rates. The Asset/Liability Management
Committee (ALCO) is responsible for managing interest rate risk and for
evaluating the impact of changing interest rate conditions on net interest
income.
Gap analysis measures the difference between volumes of rate-sensitive assets
and liabilities and quantifies these repricing differences for various time
intervals. Static gap analysis describes interest rate sensitivity at a point in
time. However, it alone does not accurately measure the magnitude of changes in
net interest income since changes in interest rates do not impact all categories
of assets and liabilities equally or simultaneously. Interest rate sensitivity
analysis also involves assumptions on certain categories of assets and deposits.
For purposes of interest rate sensitivity analysis, assets and liabilities are
stated at their contractual maturity, estimated likely call date, or earliest
repricing opportunity. Mortgage-backed securities 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.
25
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
INTEREST RATE SENSITIVITY (CONTINUED)
Management projects the repricing characteristics of these accounts based on
historical performance and assumptions that it believes reflect their rate
sensitivity. 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 December 31, 1998, interest-earning assets scheduled to
mature or likely to be called, repriced or repaid in one year were $126,908,000.
Interest-sensitive liabilities scheduled to mature or reprice within one year
were $128,064,000. The one year cumulative gap, which reflects QNB's interest
sensitivity over a period of time, was a negative $1,156,000 at December 31,
1998. The cumulative one-year gap equals -.39 percent of total earning assets.
This slightly negative or liability sensitive gap will generally benefit QNB in
a falling interest rate environment, while rising interest rates could
negatively impact QNB.
QNB also uses a simulation model to assess the impact of changes in interest
rates on net interest income. The model reflects management's assumptions
related to asset yields and rates paid on liabilities, deposit sensitivity, and
the size, composition and maturity or repricing characteristics of the balance
sheet. The assumptions are based on what management believes at that time to be
the most likely interest rate environment. Management also evaluates the impact
of higher and lower interest rates.
Actual results may differ from simulated results due to various factors
including time, magnitude and frequency of interest rate changes, the
relationship or spread between various rates, loan pricing and deposit
sensitivity, and asset/liability strategies. Based on management's estimate of
balance sheet growth and composition and interest rates for the next year, net
interest income in 1999 is expected to modestly increase compared with 1998 net
interest income. The projected increase in net interest income is primarily the
result of forecasted growth in total assets and a change in the composition of
earning assets, with the loan-to-earning assets ratio increasing. These factors
will be partially offset by a slight decrease in the net interest margin.
If interest rates are 100 basis points lower than management's most likely
interest rate environment, the simulation model projects net interest income for
the next twelve months to slightly exceed the most likely scenario. Conversely,
if interest rates were 100 basis points higher, net interest income for the most
likely scenario would decline slightly. These results are consistent with the
results of the gap analysis described above.
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 which it could
utilize to remedy such a mismatch. QNB could restructure its investment
portfolio through the sale or purchase of securities with more favorable
repricing attributes. It could also emphasize loan products with appropriate
maturities or repricing attributes, or it could attract deposits or obtain
borrowings with desired maturities.
The nature of QNB's current operation is such that it is not subject to foreign
currency exchange or commodity price risk. Additionally, neither the Corporation
nor the Bank owns trading assets. At December 31, 1998, QNB did not have any
hedging transactions in place such as interest rate swaps, caps or floors.
The table below summarizes estimated changes in net interest income over a
twelve month period, under various interest rate scenarios.
- -------------------------------------------------------------------------------------------------------------------------
Change in Interest Rates Net Interest Income Dollar Change Percent Change
- -------------------------------------------------------------------------------------------------------------------------
December 31, 1998
+300 Basis Points ................................. $11,651 $(1,180) (9.20)%
+200 Basis Points ................................. 12,079 (752) (5.86)
+100 Basis Points ................................. 12,507 (324) (2.53)
FLAT RATE ......................................... 12,831 -- --
- -100 Basis Points ................................. 13,018 187 1.46
- -200 Basis Points ................................. 12,940 109 .85
- -300 Basis Points ................................. 12,653 (178) (1.39)
- -------------------------------------------------------------------------------------------------------------------------
December 31, 1997
- -------------------------------------------------------------------------------------------------------------------------
+300 Basis Points ................................. $11,692 $ (927) (7.35)%
+200 Basis Points ................................. 12,023 (596) (4.72)
+100 Basis Points ................................. 12,351 (268) (2.12)
FLAT RATE ......................................... 12,619 -- --
- -100 Basis Points ................................. 12,757 138 1.10
- -200 Basis Points ................................. 12,810 191 1.51
- -300 Basis Points ................................. 12,658 39 .31
- -------------------------------------------------------------------------------------------------------------------------
26
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
IMPACT OF YEAR 2000
At the close of 1998, QNB continued to actively address all issues surrounding
the Year 2000. The Year 2000 challenge faces all users of automated systems,
including information systems. Many computer systems process data using only two
digits to represent the year of a transaction, rather than storing the full
four-digit year. If renovations are not done to these systems, they may not
operate properly when the last two digits become "00," as will occur on January
1, 2000. The problem could affect a wide variety of automated systems, including
mainframe systems, personal computers, application processing systems, resource
allocation systems, communications systems, environmental systems, and other
information systems.
In 1997, QNB developed a five phase plan to address the Year 2000. The five
phases include Awareness, Assessment, Renovation, Validation and Implementation.
The Awareness phase included the establishment of a team of employees, including
Senior Management. The focus of this team was development and sharing of
information to insure that our employees, systems providers, and customers were
aware of the Bank's Year 2000 strategies. This team provides updates to the
Bank's Board of Directors on a quarterly basis. While the initial Awareness
effort was completed in 1997, the Bank continues to promote awareness by
maintaining close contact with systems providers, key customers, vendors, and
other stakeholders.
The Assessment phase included the identification of all systems on which QNB
relies to provide the services our stakeholders rely upon. These systems were
risk ranked according to their importance to providing uninterrupted services;
they were further ranked to identify those systems that are mission critical for
delivery of products and services. This phase also included the inventory of all
hardware, software, and systems, as well as customer and vendor
interdependencies. The Assessment phase has been completed.
The Renovation phase includes code enhancement, vendor validation, and hardware
and software upgrades as needed. Largely, the systems used by QNB are purchased
from outside vendors. The vendors are responsible for maintenance and upgrades
to the systems as part of systems maintenance agreements; these upgrades include
the modifications necessary to enable uninterrupted usage after December 31,
1999. In a few instances, vendors did not provide the Bank with assurance that
their systems would be Year 2000-ready or available for the testing we required
in a timely manner. In those cases, the Bank elected to replace those systems
with others that were already Year 2000 certified. At year-end, anticipated
replacements were scheduled for installation in early 1999. Renovation was about
75% complete and on target for completion during 1999.
The Validation phase includes testing of all impacted applications, both
internally developed and third-party provided. Testing of systems began in 1998.
A test system was purchased to replicate the mainframe hardware used to
facilitate our mission critical core account processing systems. A test plan
detailing plans to `validate' all inventoried systems was developed, reviewed by
Senior Management and internal audit, adopted by the Board of Directors, and
reviewed by the Office of the Comptroller of Currency for completeness,
thoroughness, and value in validating the Year 2000 compliant nature of tested
products.
Validation involves not only extensive in-house testing, but also interpretation
and evaluation of vendor proxy tests and/or vendor certifications. Where
appropriate, validation expands to testing systems that must integrate with
other systems to effectively process. The Year 2000 team, including Senior
Management in each division of the Bank, reviews the various components of each
validation to measure its reliability and completeness. Only after passing this
thorough review is a product deemed `compliant' with QNB's definition of Year
2000-ready. Mission critical systems are given the greatest scrutiny in this
validation process.
Testing is anticipated to be nearly complete in the first quarter of 1999. As of
year-end 1998, testing was substantially complete on all in-house mission
critical systems. The Bank continues to review progress with utility companies
providing services to the Bank to measure their progress for Year 2000
readiness.
Contingency plans for systems that are not expected to be Year 2000 ready by
December 31, 1999 will be developed as necessary. As of year-end 1998, there
were no systems for which contingency plans were necessary. In addition,
business resumption plans are being developed to handle any unexpected
situations that may arise on January 1, 2000.
The Implementation phase includes incorporating all changes, achieving
certification of Year 2000 compliance, and implementing contingency plans, if
necessary. QNB's plan also includes reviewing any potential risks associated
with the loan, deposit, and investment portfolios due to Year 2000 issues.
Based on currently available information, management does not anticipate that
the cost to address Year 2000 issues will have a significant impact on QNB's
financial condition, results of operations, liquidity or capital resources. The
total anticipated cost for Year 2000 compliance is under $100,000. A significant
portion of the Bank's costs are not incremental, but rather represent the
redeployment of existing information technology and management resources. The
only major investment in technology made partially as a result of the Year 2000,
is the purchase of an imaging system for item processing. QNB's item processing
system was deemed not to be Year 2000 compliant after QNB had previously adopted
a long range technology plan which included migrating to imaging during 1999.
The new system is scheduled to be installed during the first quarter of 1999.
The estimated cost of the imaging system is approximately $325,000.
Through QNB's Year 2000 team efforts, three areas of Year 2000 exposure have
been identified: 1) customer uncertainty; 2) utility and communications
companies; and 3) indirect debit and ATM gateways. QNB is addressing these areas
through its business resumption plans. A Year 2000 business resumption program
is being prepared and scheduled to be published in the first quarter of 1999.
OTHER ITEMS
Management is not aware of any current specific recommendations by regulatory
authorities, or proposed legislation, which if they were implemented, would have
a material adverse effect upon the liquidity, capital resources, or results of
operations; although the general cost of compliance with numerous and multiple
Federal and State laws and regulations does have, and in the future may have, a
negative impact on QNB's results of operations.
27
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
CONSOLIDATED QUARTERLY FINANCIAL DATA
- -------------------------------------------------------------------------------------------------------------------------------
Quarters Ending 1998 Quarters Ending 1997
March 31 June 30 Sept. 30 Dec. 31 March 31 June 30 Sept. 30 Dec. 31
- -------------------------------------------------------------------------------------------------------------------------------
Interest income ....................... $5,455 $5,688 $5,582 $5,470 $5,063 $5,252 $5,398 $5,409
Interest expense ...................... 2,320 2,412 2,491 2,351 2,162 2,247 2,301 2,356
- -------------------------------------------------------------------------------------------------------------------------------
Net interest income ................... 3,135 3,276 3,091 3,119 2,901 3,005 3,097 3,053
Provision for loan losses ............. 100 100 100 100 100 100 100 100
Non-interest income ................... 613 519 548 583 627 449 482 445
Non-interest expense .................. 2,268 2,408 2,348 2,740 2,279 2,254 2,238 2,504
- -------------------------------------------------------------------------------------------------------------------------------
Income before income taxes ............ 1,380 1,287 1,191 862 1,149 1,100 1,241 894
Provision for income taxes ............ 403 346 327 196 328 319 361 245
- -------------------------------------------------------------------------------------------------------------------------------
Net Income ............................ $ 977 $ 941 $ 864 $ 666 $ 821 $ 781 $ 880 $ 649
===============================================================================================================================
Net Income Per Share - basic .......... $ .68 $ .66 $ .60 $ .47 $ .58 $ .55 $ .62 $ .45
===============================================================================================================================
Net Income Per Share - diluted ........ $ .68 $ .65 $ .60 $ .46 $ .57 $ .54 $ .61 $ .45
===============================================================================================================================
SELECTED FINANCIAL AND OTHER DATA
- -------------------------------------------------------------------------------------------------------------------------
Year Ended December 31, 1998 1997 1996 1995 1994
- -------------------------------------------------------------------------------------------------------------------------
Income and Expense
Interest income .......................... $22,195 $21,122 $19,816 $19,716 $17,865
Interest expense ......................... 9,574 9,066 8,413 8,337 6,459
- -------------------------------------------------------------------------------------------------------------------------
Net interest income ...................... 12,621 12,056 11,403 11,379 11,406
Provision for loan losses ................ 400 400 400 1,010 600
Non-interest income ...................... 2,247 1,995 1,850 1,393 1,598
Non-interest expense ..................... 9,748 9,267 9,004 9,539 9,719
- -------------------------------------------------------------------------------------------------------------------------
Income before income taxes ............... 4,720 4,384 3,849 2,223 2,685
Provision for income taxes ............... 1,272 1,253 1,048 536 681
- -------------------------------------------------------------------------------------------------------------------------
Net income ............................... $ 3,448 $ 3,131 $ 2,801 $ 1,687 $ 2,004
=========================================================================================================================
Per Share Data
Net income - basic ................................. $ 2.41 $ 2.19 $ 1.97 $ 1.19 $ 1.41
Net income - diluted ............................... 2.39 2.18 1.95 1.18 1.41
Book value ......................................... 19.77 18.05 15.97 14.66 12.53
Cash dividends ..................................... .72 .64 .56 .50 .50
Average common shares outstanding - basic .......... 1,431,724 1,427,981 1,424,112 1,421,378 1,417,395
Average common shares outstanding - diluted ........ 1,441,436 1,433,943 1,433,179 1,426,720 1,419,958
Balance Sheet at Year-end
Loans, net of unearned income ...................... $ 176,443 $ 167,720 $ 159,278 $ 155,957 $ 153,993
Investment securities available-for-sale ........... 70,088 75,920 52,779 55,380 49,838
Investment securities held-to-maturity ............. 50,065 40,400 42,699 42,515 35,636
Other earning assets ............................... 4,986 2,151 6,488 2,915 8,439
Total assets ....................................... 324,672 305,772 280,447 276,049 268,260
Deposits ........................................... 279,223 267,166 246,744 242,887 240,896
Short-term borrowings .............................. 14,491 10,342 8,675 10,099 7,537
Shareholders' equity ............................... 28,338 25,832 22,775 20,866 17,784
Selected Financial Ratios
Net interest margin ................................ 4.51% 4.60% 4.58% 4.64% 4.89%
Net income as a percentage of:
Average total assets ............................ 1.11 1.08 1.02 .63 .77
Average shareholders' equity .................... 13.10 13.11 12.94 8.46 10.56
Average shareholders' equity to average
total assets .................................. 8.48 8.27 7.89 7.39 7.32
Dividend payout ratio .............................. 29.90 29.22 28.47 42.13 35.36
28
QNB CORP. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(in thousands)
- -------------------------------------------------------------------------------------------------------
December 31, 1998 1997
- -------------------------------------------------------------------------------------------------------
Assets
Cash and due from banks ...................................................... $ 14,020 $ 12,574
Federal funds sold ........................................................... 4,869 2,022
Investment securities
available-for-sale ...................................................... 70,088 75,920
held-to-maturity (market value $50,473 and $40,713) ..................... 50,065 40,400
Total loans, net of unearned income of $412 and $448 ......................... 176,443 167,720
Allowance for loan losses ............................................... (2,951) (2,670)
- -------------------------------------------------------------------------------------------------------
Net loans ........................................................... 173,492 165,050
Premises and equipment, net .................................................. 4,520 4,066
Other real estate owned ...................................................... 696 1,564
Accrued interest receivable .................................................. 1,900 2,007
Other assets ................................................................. 5,022 2,169
- -------------------------------------------------------------------------------------------------------
Total assets ................................................................. $ 324,672 $ 305,772
=======================================================================================================
Liabilities
Deposits
Demand, non-interest-bearing ............................................ $ 39,083 $ 38,692
Interest-bearing demand accounts ........................................ 46,411 42,176
Money market accounts ................................................... 29,918 32,520
Savings ................................................................. 36,770 36,629
Time .................................................................... 109,464 101,447
Time over $100,000....................................................... 17,577 15,702
- -------------------------------------------------------------------------------------------------------
Total deposits ...................................................... 279,223 267,166
Short-term borrowings ........................................................ 14,491 10,342
Accrued interest payable ..................................................... 1,185 1,057
Other liabilities ............................................................ 1,435 1,375
- -------------------------------------------------------------------------------------------------------
Total liabilities ............................................................ 296,334 279,940
=======================================================================================================
Commitments and contingencies
Shareholders' Equity
Common stock, par value $1.25 per share;
authorized 5,000,000 shares; issued 1,433,066 shares and 1,431,240 shares 1,791 1,789
Surplus ...................................................................... 4,413 4,369
Retained earnings ............................................................ 21,218 18,801
Accumulated other comprehensive income ....................................... 916 873
- -------------------------------------------------------------------------------------------------------
Total shareholders' equity ................................................... 28,338 25,832
- -------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity ................................... $ 324,672 $ 305,772
=======================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
29
QNB CORP. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except share data)
- ------------------------------------------------------------------------------------------
Year Ended December 31, .................................... 1998 1997 1996
- ------------------------------------------------------------------------------------------
Interest Income
Interest and fees on loans ................................. $14,568 $14,141 $13,470
Interest and dividends on investment securities:
Taxable ............................................... 6,671 6,227 5,584
Tax-exempt ............................................ 638 532 509
Interest on Federal funds sold ............................. 314 220 252
Interest on interest-bearing balances ...................... 4 2 1
- ------------------------------------------------------------------------------------------
Total interest income ............................. 22,195 21,122 19,816
- ------------------------------------------------------------------------------------------
Interest Expense
Interest on deposits
Interest-bearing demand accounts ...................... 576 706 707
Money market accounts ................................. 921 951 1,011
Savings ............................................... 789 765 772
Time .................................................. 5,824 5,365 4,799
Time over $100,000 .................................... 1,117 968 863
Interest on short-term borrowings .......................... 347 311 261
- ------------------------------------------------------------------------------------------
Total interest expense ............................ 9,574 9,066 8,413
- ------------------------------------------------------------------------------------------
Net interest income ............................... 12,621 12,056 11,403
Provision for loan losses .................................. 400 400 400
- ------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 12,221 11,656 11,003
- ------------------------------------------------------------------------------------------
Non-Interest Income
Fees for services to customers ............................. 1,088 1,076 1,095
Mortgage servicing fees .................................... 156 181 208
Net gain on investment securities available-for-sale ....... 66 134 102
Net gain on sale of loans .................................. 290 81 89
Other operating income ..................................... 647 523 356
- ------------------------------------------------------------------------------------------
Total non-interest income ......................... 2,247 1,995 1,850
- ------------------------------------------------------------------------------------------
Non-Interest Expense
Salaries and employee benefits ............................. 5,561 5,411 5,185
Net occupancy expense ...................................... 666 666 687
Furniture and equipment expense ............................ 735 697 697
Marketing expense .......................................... 371 303 287
Other real estate owned expense ............................ 312 273 253
Other expense .............................................. 2,103 1,917 1,895
- ------------------------------------------------------------------------------------------
Total non-interest expense ........................ 9,748 9,267 9,004
- ------------------------------------------------------------------------------------------
Income before income taxes ............................ 4,720 4,384 3,849
Provision for income taxes ................................. 1,272 1,253 1,048
- ------------------------------------------------------------------------------------------
Net Income ............................................ $ 3,448 $ 3,131 $ 2,801
==========================================================================================
Net Income Per Share - Basic .......................... $ 2.41 $ 2.19 $ 1.97
==========================================================================================
Net Income Per Share - Diluted ........................ $ 2.39 $ 2.18 $ 1.95
==========================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
30
QNB CORP. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
- ---------------------------------------------------------------------------------------------------------------------
Accumulated
Other
Number Comprehensive Comprehensive Common
(in thousands, except share data) of Shares Income Income Stock Surplus
- ---------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1995........................ 1,423,838 $ 222 $ 1,780 $ 4,283
Net income........................................ -- $ 2,801 -- -- --
Other comprehensive income, net of tax
Unrealized holding (losses) on
investment securities available-for-sale... -- (43) -- -- --
Reclassification adjustment for
gains included in net income............... -- (67)
-----
Other comprehensive income................... -- (110) (110) -- --
-----
Comprehensive income.............................. $ 2,691
========
Cash dividends paid
($.56 per share)............................. -- -- -- -- --
Stock issue - 401(k) plan......................... 435 -- -- -- 14
Stock issued for options exercised................ 1,678 -- -- 2 (1)
- ---------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 ....................... 1,425,951 -- 112 1,782 4,296
- ---------------------------------------------------------------------------------------------------------------------
Net income........................................ -- $ 3,131 -- -- --
Other comprehensive income, net of tax
Unrealized holding gains on
investment securities available-for-sale... -- 849 -- -- --
Reclassification adjustment for
gains included in net income............... -- (88)
----
Other comprehensive income................... -- 761 761 -- --
----
Comprehensive income.............................. $ 3,892
========
Cash dividends paid
($.64 per share)............................. -- -- -- -- --
Stock issued - 401(k) plan........................ 311 -- -- -- 9
Stock issued - Employee stock purchase plan....... 1,154 -- -- 2 34
--
Stock issued for options exercised................ 3,824 -- -- 5 30
- ---------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997........................ 1,431,240 -- 873 1,789 4,369
- ---------------------------------------------------------------------------------------------------------------------
Net income........................................ -- $ 3,448 -- -- --
Other comprehensive income, net of tax
Unrealized holding gains on
investment securities available-for-sale... -- 87 -- -- --
Reclassification adjustment for
gains included in net income............... -- (44)
----
Other comprehensive income................... -- 43 43 -- --
----
Comprehensive income.............................. $ 3,491
========
Cash dividends paid
($.72 per share)............................. -- -- -- -- --
Stock issue -Employee stock purchase plan......... 1,226 -- -- 1 44
Stock issued for options exercised................ 600 -- -- 1 --
- ---------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 ....................... 1,433,066 -- $ 916 $ 1,791 $ 4,413
- ---------------------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
- -----------------------------------------------------------------------------------
Retained
(in thousands, except share data) Earnings Total
- -----------------------------------------------------------------------------------
Balance, December 31, 1995........................ $ 14,581 $ 20,866
Net income........................................ 2,801 2,801
Other comprehensive income, net of tax
Unrealized holding (losses) on
investment securities available-for-sale... -- --
Reclassification adjustment for
gains included in net income...............
Other comprehensive income................... -- (110)
Comprehensive income..............................
Cash dividends paid
($.56 per share)............................. (797) (797)
Stock issue - 401(k) plan......................... -- 14
Stock issued for options exercised................ -- 1
- -----------------------------------------------------------------------------------
Balance, December 31, 1996 ....................... 16,585 22,775
- -----------------------------------------------------------------------------------
Net income........................................ 3,131 3,131
Other comprehensive income, net of tax
Unrealized holding gains on
investment securities available-for-sale... -- --
Reclassification adjustment for
gains included in net income...............
Other comprehensive income................... -- 761
Comprehensive income..............................
Cash dividends paid
($.64 per share)............................. (915) (915)
Stock issued - 401(k) plan........................ --
-- 9
Stock issued - Employee stock purchase plan.......
-- 36
Stock issued for options exercised................ -- 35
- -----------------------------------------------------------------------------------
Balance, December 31, 1997........................ 18,801 25,832
- -----------------------------------------------------------------------------------
Net income........................................ 3,448 3,448
Other comprehensive income, net of tax
Unrealized holding gains on
investment securities available-for-sale... -- --
Reclassification adjustment for
gains included in net income...............
Other comprehensive income................... -- 43
Comprehensive income..............................
Cash dividends paid
($.72 per share)............................. (1,031) (1,031)
Stock issue -Employee stock purchase plan......... -- 45
Stock issued for options exercised................ -- 1
- -----------------------------------------------------------------------------------
Balance, December 31, 1998 ....................... $ 21,218 $ 28,338
- -----------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
31
QNB CORP. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
- ------------------------------------------------------------------------------------------------------------------------
Year Ended December 31, 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------------
Net income ...................................................................... $ 3,448 $ 3,131 $ 2,801
Adjustments to reconcile net income to net cash provided by operating activities
Provision for loan losses ..................................................... 400 400 400
Depreciation and amortization ................................................. 505 491 521
Securities gains .............................................................. (66) (134) (102)
Net gain on sale of loans ..................................................... (290) (81) (89)
Proceeds from sales of residential mortgages .................................. 13,603 2,539 3,569
Originations of residential mortgages held-for-sale ........................... (15,321) (1,052) (3,069)
(Gain) loss on disposal of premises and equipment ............................. (2) 1 --
Writedowns, net of losses (gains) on sales of other real estate owned ......... 152 25 (67)
Deferred income tax provision ................................................. (164) (24) (69)
Change in income taxes payable ................................................ 28 (10) (183)
Net decrease (increase) in accrued interest receivable ........................ 107 (318) 254
Net amortization of premiums and discounts .................................... 14 4 48
Net increase (decrease) in accrued interest payable ........................... 128 45 (28)
Increase in other assets ...................................................... (181) (632) (196)
Increase in other liabilities ................................................. 60 134 163
Other ......................................................................... 6 2 --
- ------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities ..................................... 2,427 4,521 3,953
- ------------------------------------------------------------------------------------------------------------------------
Investing Activities
Proceeds from maturities and calls of investment securities
available-for-sale ............................................................ 26,332 11,506 16,170
held-to-maturity .............................................................. 16,578 6,170 7,531
Proceeds from sales of investment securities
available-for-sale ............................................................ 6,227 13,919 18,526
Purchase of investment securities
available-for-sale ............................................................ (26,650) (47,310) (32,233
held-to-maturity .............................................................. (26,204) (3,844) (7,689)
Net (increase) decrease in Federal funds sold ................................... (2,847) 4,458 (3,573)
Proceeds from sales of student loans ............................................ 1,637 1,499 1,527
Net increase in loans ........................................................... (8,771) (12,284) (7,083)
Net purchases of premises and equipment ......................................... (957) (200) (343)
Proceeds from the sale of other real estate owned ............................... 1,016 428 1,072
Purchase of single premium life insurance ....................................... (2,557) -- --
- ------------------------------------------------------------------------------------------------------------------------
Net cash used by investing activities ......................................... (16,196) (25,658) (6,095)
- ------------------------------------------------------------------------------------------------------------------------
Financing Activities
Net increase in non-interest-bearing deposits ................................... 391 6,659 151
Net increase (decrease) in interest-bearing deposits ............................ 11,666 13,763 3,706
Net increase (decrease) in short-term borrowings ................................ 4,149 1,667 (1,424)
Cash dividends paid ............................................................. (1,031) (915) (797)
Proceeds from issuance of common stock .......................................... 40 78 15
- ------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities ..................................... 15,215 21,252 1,651
- ------------------------------------------------------------------------------------------------------------------------
Increase (decrease) in cash and cash equivalents .............................. 1,446 115 (491)
Cash and cash equivalents at beginning of year ................................ 12,574 12,459 12,950
- ------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year ...................................... $ 14,020 $ 12,574 $ 12,459
========================================================================================================================
Supplemental Cash Flow Disclosures
Interest paid ................................................................... $ 9,446 $ 9,021 $ 8,441
Income taxes paid ............................................................... 1,395 1,280 1,250
Non-Cash Transactions
Transfer of loans to other real estate owned .................................. 300 622 1,625
Change in net unrealized holding gains (losses), net of taxes,
on investment securities ..................................................... 43 761 (110)
The accompanying notes are an integral part of the consolidated financial
statements.
32
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Summary of Significant Accounting Policies
Business
QNB Corp. through its subsidiary bank, The Quakertown National Bank, provides a
full range of banking services to individual and corporate customers through its
branch banking system located in Upper Bucks, Northern Montgomery and Southern
Lehigh Counties in Pennsylvania. QNB Corp. manages its business as a single
operating segment. The Quakertown National Bank is subject to competition from
other financial institutions and other financial services companies with respect
to these services and customers. QNB Corp. is also subject to the regulations of
certain federal agencies and undergoes periodic examinations by such regulatory
authorities.
Basis of Financial Statement Presentation
The consolidated financial statements include the accounts of QNB Corp. and its
wholly owned subsidiary, The Quakertown National Bank (QNB). Such statements
have been prepared in accordance with generally accepted accounting principles
and general practice within the banking industry. All significant intercompany
accounts and transactions have been eliminated in the consolidated financial
statements. Tabular information other than share data is presented in thousands
of dollars. Certain previously reported amounts have been reclassified to
conform to current presentation standards. These reclassifications had no effect
on net income.
Use of Estimates
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from such estimates.
Investment Securities
Investment securities that QNB has the positive intent and ability to hold to
maturity are classified as held-to-maturity securities and reported at amortized
cost. Debt and equity securities that are bought and held principally for the
purpose of selling in the near term are classified as trading securities and
reported at fair value, with unrealized gains and losses included in earnings.
Debt and equity securities not classified as either held-to-maturity securities
or trading securities are classified as available-for-sale securities and
reported at fair value, with unrealized gains and losses, net of tax, excluded
from earnings and reported as a separate component of shareholders' equity.
Management determines the appropriate classification of securities at the time
of purchase.
Available-for-sale securities include securities that management intends to use
as part of its asset/liability management strategy and that may be sold in
response to changes in market interest rates and related changes in the
securities' prepayment risk or to meet liquidity needs. Premiums and discounts
on debt securities are recognized in interest income using a constant yield
method. Gains and losses on sales of investment securities are computed on the
specific identification method and included in non-interest income.
Loans
Loans are stated at the principal amount outstanding, net of deferred loan fees
and costs. Interest income is accrued on the principal amount outstanding. Loan
origination and commitment fees and related direct costs are deferred and
amortized to income over the term of the respective loan and loan commitment
period as a yield adjustment.
Loans held-for-sale primarily consist of residential mortgages and are carried
at the lower of aggregate cost or market value. Gains and losses on residential
mortgages held-for-sale are included in non-interest income.
Non-Performing Assets
Non-performing assets are comprised of non-accrual loans and other real estate
owned. Non-accrual loans are those on which the accrual of interest has ceased.
Commercial loans are placed on non-accrual status immediately if, in the opinion
of management, collection is doubtful, or when principal or interest is past due
90 days or more and collateral is insufficient to cover principal and interest.
Interest accrued, but not collected at the date a loan is placed on non-accrual
status, is reversed and charged against interest income. Subsequent cash
receipts are applied either to the outstanding principal or recorded as interest
income, depending on management's assessment of ultimate collectibility of
principal and interest. Loans are returned to an accrual status when the
borrower's ability to make periodic principal and interest payments has returned
to normal (i.e. - brought current with respect to principal or interest or
restructured) and the paying capacity of the borrower and/or the underlying
collateral is deemed sufficient to cover principal and interest. Consumer loans
are not automatically placed on non-accrual status when principal or interest
payments are 90 days past due, but; in most instances, are charged-off when
deemed uncollectible or after reaching 120 days past due.
Other real estate owned is comprised of properties acquired through
foreclosure proceedings or acceptance of a deed in lieu of foreclosure. Other
real estate owned is recorded at the lower of the carrying value of the loan or
the fair value of the property. Loan losses arising from the acquisition of such
properties are charged against the allowance for possible loan losses. Holding
expenses related to the operation and maintenance of properties are expensed as
incurred. Gains and losses upon disposition are reflected in earnings as
realized.
33
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Allowance for Loan Losses
The provision for loan losses charged to operating expense reflects the
amount deemed appropriate by management to produce an adequate reserve to meet
the present and foreseeable risk characteristics of the existing loan portfolio.
Management's judgement is based on the evaluation of individual loans, past
experience, the assessment of current economic conditions, and other relevant
factors. Loan losses are charged directly against the allowance for loan losses
and recoveries on previously charged-off loans are added to the allowance.
Significant estimates are made by management in determining the
allowance for loan losses. 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
internal 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, regulatory authorities, as an integral part of their
examinations, periodically review the allowance for loan losses. They may
require additions to the allowance based upon their judgements about information
available to them at the time of examination.
Accounting for impairment in the performance of a loan is required when
it is probable that all amounts, including both principal and interest, will not
be collected in accordance with the loan agreement. Impaired loans are measured
based on the present value of expected future cash flows discounted at the
loan's effective interest rate or, as a practical expedient, at the loan's
observable market price or the fair value of the collateral if the loan is
collateral dependent. Impairment criteria are applied to the loan portfolio
exclusive of smaller homogeneous loans such as residential mortgage and consumer
loans which are evaluated collectively for impairment.
Transfers and Servicing of Financial Assets
QNB continues to carry servicing assets, relating to mortgage loans it has sold.
Such servicing assets are recorded based on the relative fair values of the
servicing assets and loans sold at the date of transfer. The servicing asset is
amortized in proportion to and over the period of net servicing income.
Servicing assets are assessed for impairment based on their fair value.
Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and
amortization. Depreciation and amortization are calculated principally on an
accelerated or straight-line basis over the estimated useful lives of the assets
as follows: buildings--10 to 40 years, and equipment--3 to 10 years, or, in the
case of leasehold improvements, over the term of the lease. Expenditures for
maintenance and repairs are charged to operations as incurred. Gains or losses
upon disposition are reflected in earnings as realized.
Income Taxes
QNB Corp. and its subsidiary file a consolidated Federal income tax return and
the amount of income tax expense or benefit is computed and allocated on a
separate return basis. To provide for income taxes, QNB uses the asset and
liability method under which deferred tax assets and liabilities are recognized
for the future tax consequences attributable to the difference between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. 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 of a change in tax rates on deferred tax assets and liabilities is
recognized in income in the period which includes the enactment date.
Net Income Per Share
Basic earnings per share excludes any dilutive effects of options and is
computed by dividing net income by the weighted average number of shares
outstanding during the period. Diluted earnings per share gives effect to all
dilutive potential common shares that were outstanding during the period.
Comprehensive Income
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income."
SFAS No. 130 requires the inclusion of comprehensive income, either in a
separate statement, or as part of a combined statement of income and
comprehensive income in a full set of general-purpose financial statements.
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
primary component of comprehensive income is the unrealized holding gains or
losses on available-for-sale investment securities.
SFAS No. 130 is effective for fiscal years beginning after December 15, 1997.
The requirements of this Statement are disclosed in the Statements of
Shareholders' Equity and in Note 17.
34
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Segment Reporting
In June 1997, the FASB also issued SFAS No. 131, "Disclosures About
Segments of an Enterprise and Related Information." SFAS No. 131 establishes
standards for the reporting of information about operating segments by public
business enterprises in their annual and interim reports issued to shareholders.
SFAS No. 131 requires that a public business enterprise report financial
and descriptive information including profit or loss, certain revenue and
expense items, and segment assets, about its reportable operating segments.
Operating segments are defined as components of an enterprise about which
separate financial information is available that is evaluated regularly by
the chief operating decision-maker in deciding how to allocate resources
and in assessing performance.
SFAS No. 131 is effective for financial statements for periods beginning after
December 15, 1997. This Statement is a disclosure requirement and does not have
an effect on QNB's financial position or results of operations. Since QNB
operates its business as a single operating segment, no additional disclosure is
required.
Employers' Disclosure about Pension
and Other Postretirement Benefits
In February 1998, the FASB issued Statement No. 132, "Employers' Disclosure
about Pension and Other Postretirement Benefits," (SFAS No. 132) which amends
the disclosure requirements of SFAS No. 87, "Employers' Accounting for
Pensions", SFAS No. 88, "Employers' Accounting for Settlements and Curtailments
of Defined Benefit Pension Plans and for Termination Benefits", and SFAS No.
106, "Employers' Accounting for Postretirement Benefits Other than Pensions".
SFAS No. 132 is applicable to all entities. This Statement standardizes the
disclosure requirements of SFAS Nos. 87 and 106 to the extent practicable and
recommends a parallel format for presenting information about pensions and other
postretirement benefits. SFAS No. 132 only addresses disclosure and does not
change any of the measurement recognition provisions of Statement Nos. 87, 88,
and 106. This Statement is effective for fiscal years beginning after December
15, 1997. Restatement of comparative period disclosures is required unless the
information is not readily available, in which case the notes to the financial
statements shall include all available information and a description of
information not available. No additional disclosures were required since QNB
does not currently offer postretirement benefits.
Derivative Instruments and Hedging Activities
In June 1998 the FASB issued Statement No. 133 "Accounting for Derivative
Instruments and Hedging Activities" (SFAS No. 133). This Statement standardizes
the accounting for derivative instruments, including certain derivative
instruments imbedded in other contracts, and those used for hedging activities,
by requiring that an entity recognize those items as assets or liabilities in
the statement of financial position and measure them at fair value. The
Statement categorizes derivatives used for hedging purposes as either fair value
hedges, cash flow hedges, foreign currency fair value hedges, foreign currency
cash flow hedges, or hedges of net investments in foreign operations. The
Statement generally provides for matching of gain or loss recognition on the
hedging instrument with the recognition of the changes in the fair value of the
hedged asset or liability that are attributable to the hedged risk, so long as
the hedge is effective. QNB has not yet determined the impact, if any, of this
Statement, including its provisions for the potential reclassifications of
investment securities on earnings, financial condition or equity.
Statement of Cash Flows
Cash and cash equivalents for purposes of this statement consist of cash and due
from banks.
NOTE 2 - EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per
share (share and per share data not in thousands):
- --------------------------------------------------------------------------------
1998 1997 1996
- --------------------------------------------------------------------------------
Numerator for basic
and diluted earnings
per share - net income ..... $ 3,448 $ 3,131 $ 2,801
================================================================================
Denominator for basic
earnings per share - weighted
average shares outstanding . 1,431,724 1,427,981 1,424,112
Effect of dilutive securities -
employee stock options ....... 9,712 5,962 9,067
- --------------------------------------------------------------------------------
Denominator for diluted earnings
per share - adjusted weighted
average shares outstanding . 1,441,436 1,433,943 1,433,179
================================================================================
Earnings per share - basic ..... $ 2.41 $ 2.19 $ 1.97
Earnings per share - diluted ... $ 2.39 $ 2.18 $ 1.95
- --------------------------------------------------------------------------------
NOTE 3 - ACQUISITION
On October 30, 1997, QNB completed its purchase of certain assets and
liabilities of the Quakertown office of First Lehigh Bank. Included in the
purchase were approximately $6,800,000 of deposits. The transaction was
accounted for using the purchase method of accounting. The premium on deposits
is being amortized over a 10 year period.
NOTE 4 - CASH AND DUE FROM BANKS
Included in cash and due from banks are reserves in the form of deposits with
the Federal Reserve Bank of $2,212,000 and $1,481,000 to satisfy federal
regulatory requirements as of December 31, 1998 and 1997.
35
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - INVESTMENT SECURITIES
Available-For-Sale
The amortized cost and estimated fair values of investment securities
available-for-sale at December 31, 1998 and 1997 were as follows:
- -----------------------------------------------------------------------------------------------------------------------
December 31, 1998 1997
Gross Gross Gross Gross
Aggregate unrealized unrealized Aggregate unrealized unrealized
fair holding holding Amortized fair holding holding Amortized
value gains losses cost value gains losses cost
- -----------------------------------------------------------------------------------------------------------------------
U.S. Treasury .................. $ 9,180 $ 162 -- $ 9,018 $ 9,633 $ 99 -- $ 9,534
U.S. Government agencies ....... 47,356 620 $ 20 46,756 55,586 497 $ 42 55,131
State and municipal securities . 518 27 -- 491 511 21 -- 490
Mortgage-backed securities ..... 9,338 53 9 9,294 8,152 55 17 8,114
Equity and other debt securities 3,696 554 -- 3,142 2,038 710 -- 1,328
- -----------------------------------------------------------------------------------------------------------------------
Total investment securities
available-for-sale .......... $70,088 $ 1,416 $ 29 $68,701 $75,920 $ 1,382 $ 59 $74,597
=======================================================================================================================
The amortized cost and estimated fair value of securities available-for-sale by
contractual maturity at December 31, 1998 are shown in the following table.
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties. Mortgage-backed securities are shown separately due to the
amortization and prepayment of principal occurring throughout the life of these
instruments.
- --------------------------------------------------------------------------------
Aggregate
fair Amortized
December 31, 1998 value cost
- --------------------------------------------------------------------------------
Due in one year or less .............. $ 4,550 $ 4,512
Due after one year through five years 19,306 19,019
Due after five years through ten years 32,732 32,293
Due after ten years .................. 518 491
Mortgage-backed securities ........... 9,338 9,294
Equity securities .................... 3,644 3,092
- --------------------------------------------------------------------------------
Total securities available-for-sale... $70,088 $68,701
================================================================================
Proceeds from sales of investment securities available-for-sale are as follows:
- ----------------------------------------------
1998 1997 1996
- ----------------------------------------------
Proceeds ....... $ 6,227 $13,919 $18,526
Gross gains .... 106 181 122
Gross losses ... 40 47 20
Held-To-Maturity
The amortized cost and estimated fair values of investment securities
held-to-maturity at December 31, 1998 and 1997 were as follows:
- ------------------------------------------------------------------------------------------------------------------------
December 31, 1998 1997
Gross Gross Gross Gross
unrealized unrealized Aggregate unrealized unrealized Aggregate
Amortized holding holding fair Amortized holding holding fair
cost gains losses value cost gains losses value
- ------------------------------------------------------------------------------------------------------------------------
State and municipal securities $14,668 $ 360 -- $15,028 $10,136 $ 171 $ 1 $10,306
Mortgage-backed securities ... 35,319 110 $ 62 35,367 30,186 193 50 30,329
Equity securities ............ 78 -- -- 78 78 -- -- 78
- ------------------------------------------------------------------------------------------------------------------------
Total investment securities
held-to-maturity .......... $50,065 $ 470 $ 62 $50,473 $40,400 $ 364 $ 51 $40,713
========================================================================================================================
36
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The amortized cost and estimated fair values of securities held-to-maturity by
contractual maturity at December 31, 1998 are shown in the following table.
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without penalties.
Mortgage-backed securities are shown separately due to the amortization and
prepayment of principal occurring throughout the life of these instruments.
- --------------------------------------------------------------------------------
Aggregate
Amortized fair
December 31, 1998 cost value
- --------------------------------------------------------------------------------
Due in one year or less ................. -- --
Due after one year through five years.... $ 5,108 $ 5,240
Due after five years through ten years... 9,391 9,619
Due after ten years ..................... 169 169
Mortgage-backed securities .............. 35,319 35,367
Equity securities ....................... 78 78
- --------------------------------------------------------------------------------
Total securities held-to-maturity ....... $50,065 $50,473
================================================================================
There were no sales of investment securities classified as held-to-maturity
during 1998, 1997 or 1996. At December 31, 1998 and 1997, investment securities
totaling $44,715,000 and $36,510,000 were pledged as collateral for repurchase
agreements, public deposits and other deposits as provided by law.
NOTE 6 - LOANS
- --------------------------------------------------------------------------------
December 31, 1998 1997
- --------------------------------------------------------------------------------
Commercial and industrial ............ $ 35,003 $ 32,794
Agricultural ......................... 3,446 2,845
Construction ......................... 782 813
Real estate-commercial ............... 60,708 58,783
Real estate-residential .............. 71,052 67,621
Consumer ............................. 5,864 5,312
- --------------------------------------------------------------------------------
Total loans .......................... 176,855 168,168
Less unearned income ................. 412 448
- --------------------------------------------------------------------------------
Total loans, net of unearned income... $176,443 $167,720
================================================================================
Real estate commercial loans include all loans collateralized at least in part
by commercial real estate. These loans may not be for the expressed purpose of
conducting commercial real estate transactions.
Included in real estate residential loans at December 31, 1998 and 1997, are
$3,601,000 and $481,000 of residential mortgage loans held-for-sale. Included in
consumer loans at these same dates are $1,282,000 and $918,000 of student loans
held-for-sale.
At December 31, 1998 and 1997, the recorded investment in loans for which
impairment has been recognized totaled $439,000 and $1,123,000, respectively.
The entire balance of loans defined as impaired as of December 31, 1997 required
no valuation allowance while $430,000 of the loans identified as of December 31,
1998 required no valuation allowance. As of December 31, 1998, $9,000 of loans
required a valuation allowance of approximately $9,000. Most of the loans
identified as impaired are collateral-dependent. For the years ended December
31, 1998, 1997 and 1996, the average recorded investment in impaired loans was
approximately $945,000, $2,105,000 and $4,288,000, respectively. QNB recognized
$133,000, $86,000 and $50,000 of interest income on these loans in 1998, 1997
and 1996, respectively.
Included within the loan portfolio are loans on non-accrual status of $506,000
and $1,209,000 at December 31, 1998 and 1997, respectively. If interest on
non-accrual loans had been accrued throughout the period, interest income for
the years ended December 31, 1998, 1997 and 1996, would have increased
approximately $70,000, $154,000 and $265,000, respectively. The amount of
interest income on these loans that was included in net income in 1998, 1997 and
1996 was $17,000, $7,000 and $50,000, respectively.
QNB generally lends in its trade area which is comprised of Quakertown and
surrounding communities. To a large extent QNB makes loans collateralized at
least in part by real estate. Its lending activities could be affected by
changes in the general economy, the regional economy, or real estate values.
QNB's commercial loans are not considered to be concentrated, except those loans
to real estate developers and investors which account for $25,289,000 or 14.3
percent of the loan portfolio at December 31, 1998. This is down slightly from
15.3 percent at December 31, 1997. Concentration is based upon Standard
Industrial Classification codes used for bank regulatory purposes, and is
considered to be 10 percent or more of total loans.
NOTE 7 - ALLOWANCE FOR LOAN LOSSES
Activity in the allowance for loan losses is shown below:
- --------------------------------------------------------------------------------
December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Balance at beginning of year $ 2,670 $ 2,585 $ 2,384
- --------------------------------------------------------------------------------
Charge-offs ................ (152) (344) (259)
Recoveries ................. 33 29 60
- --------------------------------------------------------------------------------
Net charge-offs ............ (119) (315) (199)
Provision for loan losses .. 400 400 400
- --------------------------------------------------------------------------------
Balance at end of year ..... $ 2,951 $ 2,670 $ 2,585
================================================================================
NOTE 8 - PREMISES AND EQUIPMENT
Premises and equipment, stated at cost less accumulated depreciation and
amortization, are summarized below:
- --------------------------------------------------------------------------------
December 31, 1998 1997
- --------------------------------------------------------------------------------
Land and buildings ..... $ 4,838 $ 4,844
Furniture and equipment 5,535 4,835
Leasehold improvements . 469 469
- --------------------------------------------------------------------------------
Book value ............. 10,842 10,148
Accumulated depreciation
and amortization .... (6,322) (6,082)
- --------------------------------------------------------------------------------
Net book value ......... $ 4,520 $ 4,066
================================================================================
Depreciation and amortization expense on premises and equipment amounted to
$505,000, $491,000 and $521,000, for the years ended December 31, 1998, 1997 and
1996, respectively.
Rental expense on operating leases amounted to approximately $135,000, $131,000
and $131,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
Most leases have options for renewal. Future minimum annual rental payments due
on non-cancelable leases for each of the years 1999 through 2003 are
approximately $108,000, $72,000, $64,000, $30,000 and $0 respectively.
37
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9 - MORTGAGE SERVICING RIGHTS
The changes in mortgage servicing assets are as follows:
- --------------------------------------------------------------------------------
December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Balance, beginning of year $ 57 $38 --
Additions ................ 137 25 $40
Less: amortization ....... (35) (6) (2)
- --------------------------------------------------------------------------------
Balance, end of year ..... $159 $57 $38
================================================================================
NOTE 10 - TIME DEPOSITS
The aggregate amount of time deposits including deposits in denominations of
$100,000 or more was $127,041,000 and $117,149,000 at December 31, 1998 and
1997, respectively. The scheduled maturities of time deposits as of December 31,
1998 for the years 1999 through 2003 and thereafter are approximately
$86,114,000, $18,416,000, $6,816,000, $15,297,000, $389,000 and $9,000,
respectively.
NOTE 11 - SHORT-TERM BORROWINGS
- --------------------------------------------------------------------------------
Securities
Sold under Other
Agreements Short-term
December 31, to Repurchase(a) Borrowings(b)
- --------------------------------------------------------------------------------
1998
Balance .............................. $14,243 $ 248
Maximum indebtedness at any month end 14,243 633
Daily average indebtedness outstanding 8,842 626
Average rate paid for the year ....... 3.54% 5.41%
Average rate on period-end borrowings 3.37 4.11
- --------------------------------------------------------------------------------
1997
Balance .............................. $ 9,742 $ 600
Maximum indebtedness at any month end 10,405 653
Daily average indebtedness outstanding 8,307 603
Average rate paid for the year ....... 3.36% 5.20%
Average rate on period-end borrowings 3.59 5.25
- --------------------------------------------------------------------------------
(a) Securities sold under agreements to repurchase mature within 30 days. The
repurchase agreements were collateralized by U.S. Treasury and U.S. Government
agency securities with an amortized cost of $17,388,000 and $11,060,000 and a
fair value of $17,664,000 and $11,151,000 at December 31, 1998 and 1997,
respectively.
(b) Other short-term borrowings include Treasury tax and loan notes and Federal
Reserve borrowings.
NOTE 12 - INCOME TAXES
The components of the provision for income taxes are as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Federal income taxes
currently payable . .................... $1,436 $1,277 $1,117
Deferred income taxes .................... (164) (24) (69)
- --------------------------------------------------------------------------------
Net provision ............................ $1,272 $1,253 $1,048
================================================================================
At December 31, 1998, 1997 and 1996, the tax effects of temporary differences
that represent the significant portion of deferred tax assets and liabilities
are as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Deferred tax assets
Allowance for loan losses ............. $ 762 $ 666 $ 637
Other real estate owned reserves ...... 86 35 21
Deferred compensation ................. 171 142 143
Deferred loan fees .................... 19 32 40
Other ................................. 42 5 --
- --------------------------------------------------------------------------------
Total deferred tax assets ........... 1,080 880 841
Deferred tax liabilities
Net unrealized holding gains on
investment securities available-
for-sale ............................. 472 450 58
Other .................................. 102 66 51
- --------------------------------------------------------------------------------
Total deferred tax liabilities ......... 574 516 109
- --------------------------------------------------------------------------------
Net deferred tax asset ................... $ 506 $ 364 $ 732
================================================================================
The realizability of deferred tax assets is dependent upon a variety of factors,
including the generation of future taxable income, the existence of taxes paid
and recoverable, the reversal of deferred tax liabilities and tax planning
strategies. Based upon these and other factors, management believes it is more
likely than not that QNB will realize the benefits of these deferred tax assets.
The net deferred tax asset is included in other assets on the consolidated
balance sheet.
A reconciliation between the statutory and effective tax rate for net income was
as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Provision at statutory rate .............. 1,605 $1,491 $1,309
Tax-exempt interest income ............... (323) (276) (270)
Other .................................... (10) 38 9
- --------------------------------------------------------------------------------
Total provision .......................... $1,272 $1,253 $1,048
================================================================================
NOTE 13 - EMPLOYEE BENEFIT PLANS
QNB maintains a money purchase defined contribution plan which covers all
employees who meet the age and service requirements. QNB makes contributions to
the money purchase plan equivalent to 5 percent of total compensation (as
defined by the plan). QNB contributed and expensed $201,776, $191,633 and
$187,595 to this plan in 1998, 1997 and 1996, respectively. QNB also has a
401(k) profit sharing plan pursuant to the provisions of 401(k) of the Internal
Revenue Code. The plan covers substantially all employees who meet the age and
service requirements. The 401(k) plan provides for elective employee
contributions up to 9 percent of compensation and a matching company
contribution limited to 3 percent. QNB makes contributions to the profit sharing
plan as directed by its Board of Directors. For 1998, 1997 and 1996, QNB
contributed and expensed $106,567, $114,000 and $100,792, respectively, to the
401(k) profit sharing plan.
QNB's Employee Stock Purchase Plan (the "Plan") offers eligible employees an
opportunity to purchase from the Corporation shares of QNB Corp. Common Stock at
a 5 percent discount from the lesser of fair market value on the first or last
day of each offering period (as defined by the plan). The Plan authorizes the
issuance of 25,000 shares. In 1998, 672 shares were issued at $30.40 per share
and 554 shares were issued at $35.15 per share. During 1997, 1,154 shares were
issued at $29.69 per share.
38
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The initial offering period of the Plan commenced on December 1, 1996 and no
shares were issued during 1996. The Plan is considered compensatory as defined
by SFAS No. 123, "Accounting for Stock-Based Compensation," and as such, a
charge to earnings of approximately $6,000 and $2,000 was recorded for the
difference between the purchase price and the fair value on the date of issue in
1998 and 1997, respectively.
NOTE 14 - STOCK OPTION PLAN
QNB sponsors a Stock Option Plan (the "1988 Plan") administered by a committee
which consists of three or more members of QNB's Board of Directors. The Plan
provides to key employees the granting of either (i) Non-Qualified Stock Options
(NQSOs) or (ii) Incentive Stock Options (ISOs). The exercise price of an option
is the fair market value of QNB's common stock at the date of grant. The plan
authorizes the issuance of 82,000 shares. ISOs expire 5 years from the date of
grant. The 1988 Plan expired on February 23, 1998. No additional shares may be
granted under the plan.
At QNB's 1998 Annual Meeting the shareholders approved the 1998 Stock Incentive
Plan (the "1998 Plan"). The 1998 Plan, administered by the Board of Directors or
a committee of two or more members of the Board, authorizes the issuance of
100,000 shares. The awards may be made in the form of either (i) Qualified
Options or (ii) Non-Qualified Options. The exercise price of an option is the
fair market value of QNB's common stock at the date of grant, as defined in the
1998 Plan. The time periods by which any Option is exercisable is determined by
the Committee but shall not commence before the expiration of six months or
continue beyond the expiration of ten years after the date the option is
awarded. No options have been granted under the 1998 plan as of December 31,
1998.
Changes in total options outstanding during 1998, 1997 and 1996, were as
follows:
- --------------------------------------------------------------------------------
Number Exercise Price Average
of Options per Option Exercise Price
- --------------------------------------------------------------------------------
December 31, 1995 22,960 $16.88 - $21.00 $19.17
ISOs Exercised (3,410) 16.88 - 17.63 16.89
ISOs Granted 9,200 29.50 29.50
- --------------------------------------------------------------------------------
December 31, 1996 28,750 17.63 - 29.50 22.75
ISOs Exercised (6,150) 17.63 - 29.50 18.09
ISOs Granted 10,000 32.00 32.00
- --------------------------------------------------------------------------------
December 31, 1997 32,600 19.50 - 32.00 26.46
ISOs Exercised (1,200) 19.50 19.50
ISOs Granted 12,000 34.00 34.00
- --------------------------------------------------------------------------------
December 31, 1998 43,400 $19.50 - $34.00 $28.74
================================================================================
The following table summarizes information about stock options outstanding at
December 31, 1998:
Exercisable
-------------------------------------------
Average
Exercise Price Range Options Average Life(1) Exercise Price
- --------------------------------------------------------------------------------
$19.50 - $ 21.00 12,300 .64 $ 20.39
29.50 - 34.00 31,100 3.15 32.04
- --------------------------------------------------------------------------------
Total 43,400 2.44 $ 28.74
================================================================================
(1) Average contractual life remaining in years
SFAS No. 123 provides an alternative method of accounting for stock-based
compensation arrangements. This method is based on fair value of the stock-based
compensation determined by an option pricing model utilizing various assumptions
regarding the underlying attributes of the options and QNB's stock, rather than
the existing method of accounting for stock-based compensation which is provided
in Accounting Principles Board Opinion No. 25 (APB No. 25), "Accounting for
Stock Issued to Employees." The Financial Accounting Standards Board encourages
entities to adopt the fair value based method, but does not require the adoption
of this method.
QNB applies APB No. 25 and related Interpretations in accounting for the Plan.
The following table sets forth pro forma net income and earnings per share as if
compensation expense was recognized for stock options in accordance with SFAS
No.123.
- --------------------------------------------------------------------------------
Reported Pro forma
- --------------------------------------------------------------------------------
Net income: 1998..............$ 3,448 $ 3,385
1997.............. 3,131 3,082
1996.............. 2,801 2,763
Basic earnings per share: 1998..............$ 2.41 $2.36
1997.............. 2.19 2.16
1996.............. 1.97 1.94
Diluted earnings per share: 1998..............$ 2.39 $2.35
1997.............. 2.18 2.15
1996.............. 1.95 1.93
- --------------------------------------------------------------------------------
For purposes of computing pro forma results QNB estimated the fair value of
stock options on the date of the grant using the Black-Scholes option pricing
model. The model requires the use of numerous assumptions, many of which are
highly subjective in nature. Therefore, the pro forma results are, of a
necessity, estimates of results of operations as if compensation expense had
been recognized for all stock-based compensation plans and are not indicative of
the impact on future periods. The following assumptions were used in the option
pricing model for purposes of estimating pro forma results.
- --------------------------------------------------------------------------------
Year ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Risk free interest rate ............. 5.49% 6.29% 5.32%
Dividend yield ...................... 2.50 2.50 2.50
Volatility .......................... 23.00 20.00 20.00
Expected life ....................... 5 yrs. 5 yrs. 5 yrs.
================================================================================
The weighted average fair value of options granted during 1998, 1997 and 1996
was $7.94, $7.34 and $6.19, respectively.
39
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 15 - RELATED PARTY TRANSACTIONS
The following table presents activity in the amounts due from directors,
principal officers, and their related interests. All of these transactions were
made in the ordinary course of business on substantially the same terms,
including interest rates and collateral, as those prevailing at the time for
comparable transactions with other persons. Also, they did not involve a more
than normal risk of collectibility or present any other unfavorable features.
- --------------------------------------------------------------------------------
Balance, December 31, 1997 ....................... $ 6,734
New loans ........................................ 13,335
Repayments and other changes ..................... 13,517
- --------------------------------------------------------------------------------
Balance, December 31, 1998 ....................... $ 6,552
================================================================================
QNB allowed its directors to defer a portion of their compensation. The amount
of deferred compensation accrued as of December 31, 1998 and 1997, was $504,000
and $419,000, respectively.
NOTE 16 - COMMITMENTS AND CONTINGENCIES
In the normal course of business there are various legal proceedings,
commitments, and contingent liabilities which are not reflected in the financial
statements. Management does not anticipate any material losses as a result of
these transactions and activities. They include, among other things, commitments
to extend credit and standby letters of credit. Outstanding standby letters of
credit amounted to $1,657,000 and $2,196,000 and commitments to extend credit
totaled $36,422,000 and $34,925,000 at December 31, 1998 and 1997, respectively.
The maximum exposure to credit loss, which represents the possibility of
sustaining a loss due to the failure of the other parties to a financial
instrument to perform according to the terms of the contract, is represented by
the contractual amount of these instruments. QNB uses the same lending standards
and policies in making credit commitments as it does for on-balance sheet
instruments. The activity is controlled through credit approvals, control
limits, and monitoring procedures.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require the payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. QNB evaluates each customer's
creditworthiness on a case-by-case basis.
Standby letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party. The credit risk and collateral
policy involved in issuing letters of credit are essentially the same as those
involved in extending loan commitments.
The amount of collateral obtained for letters of credit and commitments to
extend credit is based on management's credit evaluation of the customer.
Collateral varies but may include real estate, accounts receivable, marketable
securities, pledged deposits, inventory or equipment.
NOTE 17 - OTHER COMPREHENSIVE INCOME
The tax effects allocated to each component of "Other Comprehensive Income" are
as follows:
- --------------------------------------------------------------------------------
Tax
Before-Tax (Expense) Net-of-tax
Year Ended December 31, 1998 Amount Benefit Amount
- --------------------------------------------------------------------------------
Unrealized gains on securities
Unrealized holding gains arising
during the period ............ $ 131 $ (45) $ 86
Reclassification adjustment for
gains included in net income . (66) 23 (43)
- --------------------------------------------------------------------------------
Other comprehensive income ........ $ 65 $ (22) $ 43
================================================================================
Year Ended December 31, 1997
- ----------------------------
Unrealized gains on securities
Unrealized holding gains arising
during the period ............ $ 1,287 $ 438) $ 849
Reclassification adjustment for
gains included in net income . (134) 46 (88)
- --------------------------------------------------------------------------------
Other comprehensive income ........ $ 1,153 $(392) $ 761
================================================================================
Year Ended December 31, 1996
- ----------------------------
Unrealized gains on securities
Unrealized holding losses arising
during the period ....................... $ (65) $ 22 $ (43)
Reclassification adjustment for
gains included in net income ............ (102) 35 (67)
- --------------------------------------------------------------------------------
Other comprehensive income ................... $ (167) $ 57 $(110)
================================================================================
40
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
All entities are required to disclose estimated fair values for their financial
instruments, whether or not recognized in the balance sheet. For QNB, as for
most financial institutions, substantially all of its assets and liabilities are
considered financial instruments.
Estimates of fair value are made at a specific point in time, based upon, where
available, relevant market prices and information about the financial
instrument. Such estimates do not include any premium or discount that could
result from offering for sale at one time the Company's entire holdings of a
particular financial instrument. For a substantial portion of the Company's
financial instruments, no quoted market exists. Therefore, estimates of fair
value are necessarily based on a number of significant assumptions regarding the
amount and timing of estimated future cash flows which are discounted to reflect
varying degrees of risk. Given the uncertainties surrounding these assumptions,
the reported fair values may not represent actual values of financial
instruments that could have been realized as of year-end or that will be
realized in the future. Use of different assumptions or methodologies is likely
to result in significantly different fair value estimates.
The fair value of non-interest bearing demand deposits, interest-bearing demand
accounts, money market accounts and savings accounts is equal to the carrying
amount because these deposits have no stated maturity. This approach to
estimating fair value excludes the significant benefit that results from the
low-cost funding provided by such deposit liabilities, as compared to
alternative sources of funding. As a consequence, the amounts disclosed may
distort the actual fair value of a banking organization that is a going concern.
The estimated fair values and carrying amounts are summarized as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 1998 1997
- ------------------------------------------------------------------------------------------------------------------------------------
Estimated Carrying Estimated Carrying
Fair Value Amount Fair Value Amount
- ------------------------------------------------------------------------------------------------------------------------------------
Financial Assets
Cash and due from banks .......................... $ 14,020 $ 14,020 $ 12,574 $ 12,574
Federal funds sold ............................... 4,869 4,869 2,022 2,022
Investment securities available-for-sale ......... 70,088 70,088 75,920 75,920
Investment securities held-to-maturity ........... 50,473 50,065 40,713 40,400
Net loans ........................................ 179,015 173,492 166,449 165,050
Accrued interest receivable ...................... 1,900 1,900 2,007 2,007
Financial Liabilities
Deposits with no stated maturities ............... 152,182 152,182 150,017 150,017
Deposits with stated maturities .................. 128,735 127,041 117,474 117,149
Short-term borrowings ............................ 14,490 14,491 10,339 10,342
Accrued interest payable ......................... 1,185 1,185 1,057 1,057
The following methods and assumptions were used to estimate the fair value of
each major classification of financial instruments at December 31, 1998 and
1997.
Cash and due from banks and Federal funds sold: Current carrying amounts
approximate estimated fair value.
Investment securities:
Current quoted market prices were used to determine fair value.
Loans:
Fair values were estimated using the present value of the estimated cash flows,
using interest rates currently being offered for loans with similar terms to
borrowers of similar credit quality.
Deposit liabilities:
The fair value of deposits with no stated maturity (e.g. demand deposits,
interest-bearing demand accounts, money market accounts and savings accounts)
are by definition, equal to the amount payable on demand at the reporting date
(i.e. their carrying amounts). Deposits with a stated maturity (time deposits)
have been valued using the present value of cash flows discounted at rates
approximating the current market for similar deposits.
Short-term borrowings:
Short-term borrowings have been valued using the present value of cash flows
discounted at rates approximating the current market for similar liabilities.
Off-balance-sheet instruments:
Off-balance-sheet instruments are primarily comprised of loan commitments which
are generally priced at market at the time of funding. Fees on commitments to
extend credit and standby letters of credit are deemed to be immaterial and
these instruments are expected to be settled at face value or expire unused. It
is impractical to assign any fair value to these instruments.
41
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 19 - PARENT COMPANY FINANCIAL INFORMATION
Condensed financial statements of QNB Corp. only:
Balance Sheets
- -------------------------------------------------------------
December 31, 1998 1997
- -------------------------------------------------------------
Assets
Cash and due from banks ................ $ 97 $ 129
Investment securities available-for-sale 2,696 1,975
Investment in subsidiary ............... 25,706 24,000
Other assets............................ 27 --
- ------------------------------------------------------------
Total assets............................ $28,526 $26,104
============================================================
Liabilities
Other liabilities ........................ $ 188 $ 272
Shareholders' equity
Common stock ............................. 1,791 1,789
Surplus .................................. 4,413 4,369
Retained earnings ........................ 21,218 18,801
Accumulated other comprehensive income ... 916 873
- ------------------------------------------------------------
Total liabilities and shareholders' equity $28,526 $26,104
============================================================
Statements of Income
- --------------------------------------------------------------------
Year Ended December 31, 1998 1997 1996
- --------------------------------------------------------------------
Dividends from subsidiary ........... $ 1,911 $ 1,664 $ 1,098
Interest and dividend income ........ 56 31 14
Securities gains .................... 39 159 77
Other income ........................ -- 1 2
- --------------------------------------------------------------------
Total income ..................... 2,006 1,855 1,191
Expenses ......................... 121 106 99
- --------------------------------------------------------------------
Income before applicable income
taxes and equity in undistributed
income of subsidiary ........... 1,885 1,749 1,092
Income taxes (benefit) .............. (22) 22 (5)
- --------------------------------------------------------------------
Income before equity in undistributed
income of subsidiary ............. 1,907 1,727 1,097
Equity in undistributed
income of subsidiary ............. 1,541 1,404 1,704
- --------------------------------------------------------------------
Net income ....................... $ 3,448 $ 3,131 $ 2,801
====================================================================
Statements of Cash Flows
- -----------------------------------------------------------------------------------------
Year Ended December 31, 1998 1997 1996
- -----------------------------------------------------------------------------------------
Operating Activities
Net income ......................................... $ 3,448 $ 3,131 $ 2,801
Adjustments to reconcile net income to net cash
provided by operating activities:
Equity in undistributed income from subsidiary ... (1,541) (1,404) (1,704)
Securities gains ................................. (39) (159) (77)
(Increase) decrease in other assets .............. (46) 5 5
(Decrease) increase in other liabilities ......... (30) 20 9
Other ............................................ 6 3 --
- -----------------------------------------------------------------------------------------
Net cash provided by operating activities ...... 1,798 1,596 1,034
- -----------------------------------------------------------------------------------------
Investing Activities
Purchase of investment securities .................. (1,044) (1,126) (404)
Proceeds from sale of investment securities ........ 205 488 152
- -----------------------------------------------------------------------------------------
Net cash used by investing activities .......... (839) (638) (252)
- -----------------------------------------------------------------------------------------
Financing Activities
Cash dividends paid ................................ (1,031) (915) (797)
Stock issue ........................................ 40 78 15
- -----------------------------------------------------------------------------------------
Net cash used by financing activities .......... (991) (837) (782)
- -----------------------------------------------------------------------------------------
(Decrease) increase in cash and cash equivalents (32) 121 --
Cash and cash equivalents at beginning of year . 129 8 8
- -----------------------------------------------------------------------------------------
Cash and cash equivalents at end of year ....... $ 97 $ 129 $ 8
=========================================================================================
42
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 20 - REGULATORY RESTRICTIONS
Dividends payable by QNB Corp. and its bank subsidiary are subject to various
limitations imposed by statutes, regulations and policies adopted by bank
regulatory agencies. Under current regulations regarding dividend availability,
the bank subsidiary may declare dividends in 1999 to the holding company
totaling $2,945,000, plus additional amounts equal to the net profit earned by
the bank subsidiary for the period from January 1, 1999, through the date of
declaration, less dividends previously declared in 1999.
QNB is subject to regulatory capital requirements administered by Federal
banking agencies. Failure to meet minimum capital requirements can initiate
actions by regulators that could have an effect on the company's financial
statements. Under the framework for prompt corrective action, the company must
meet capital guidelines that involve quantitative measures of the company's
assets, liabilities, and certain off-balance-sheet items. The company's capital
amounts and classification are also subject to qualitative judgements by the
regulators. Management believes, as of December 31, 1997, that the company meets
all capital adequacy requirements to which it is subject.
As of the most recent notification, the Federal Reserve Bank and the Comptroller
of the Currency considered the company to be "well capitalized" under the
regulatory framework. There are no conditions or events since that notification
that management believes have changed the company's category. To be categorized
as well capitalized, the company must maintain minimum ratios set forth in the
table. The company's actual capital amounts and ratios are presented below:
Capital Levels
- ------------------------------------------------------------------------------------------------------------------------------------
Actual Adequately Capitalized Well Capitalized
As of December 31, 1997 Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------------------------
Total risk-based capital (to risk weighted assets):(1)
Consolidated .............................................. $29,382 15.28% $15,388 8.00 $19,234 10.00%
Bank ...................................................... 27,069 14.24 15,211 8.00 19,014 10.00
Tier I capital (to risk weighted assets):(1)
Consolidated .............................................. 26,971 14.02 7,694 4.00 11,541 6.00
Bank ...................................................... 24,685 12.98 7,605 4.00 11,408 6.00
Tier I capital (to average assets):(1)
Consolidated .............................................. 26,971 8.58 12,575 4.00 15,719 5.00
Bank ...................................................... 24,685 7.91 12,484 4.00 15,606 5.00
- ------------------------------------------------------------------------------------------------------------------------------------
Capital Levels
- ------------------------------------------------------------------------------------------------------------------------------------
Actual Adequately Capitalized Well Capitalized
As of December 31, 1997 Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------------------------
Total risk-based capital (to risk weighted assets):(1)
Consolidated .............................................. $26,725 14.74 $14,500 8.00% $18,125 10.00%
Bank ...................................................... 25,348 14.07 14,417 8.00 18,022 10.00
Tier I capital (to risk weighted assets):(1)
Consolidated .............................................. 24,454 13.49 7,250 4.00 10,875 6.00
Bank ...................................................... 23,090 12.81 7,209 4.00 10,813 6.00
Tier I capital (to average assets):(1)
Consolidated .............................................. 24,454 8.23 11,879 4.00 14,848 5.00
Bank ...................................................... 23,090 7.81 11,829 4.00 14,786 5.00
- ------------------------------------------------------------------------------------------------------------------------------------
(1) As defined by the regulators
43
QNB CORP. AND SUBSIDIARY
[LOGO]
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of QNB Corp:
We have audited the accompanying consolidated balance sheets of QNB Corp. and
subsidiary as of December 31, 1998 and 1997, and the related consolidated
statements of income, shareholders' equity, and cash flows for each of the years
in the three-year period ended December 31, 1998. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of QNB Corp. and
subsidiary as of December 31, 1998 and 1997, and the results of their operations
and their cash flows for each of the years in the three-year period ended
December 31, 1998 in conformity with generally accepted accounting principles.
KPMG LLP
January 21, 1999
- --------------------------------------------------------------------------------
CORPORATE INFORMATION
ANNUAL MEETING
The Annual Meeting of Shareholders of QNB Corp. will be held at the offices of
The Quakertown National Bank, 320 West Broad Street, Quakertown, PA on May 4,
1999, at 11:00 a.m.
MARKET MAKERS
As of December 31, 1998, the following firms made a market in QNB Corp. common
stock:
Legg Mason Wood Walker, Inc. Ryan, Beck & Company
Allentown, PA 18105 Shrewsbury, NJ 07702
Wheat First Union
Quakertown, PA 18951
TRANSFER AGENT
Registrar and Transfer Company
311 Cox Street
Roselle, NJ 07203
(800) 368-5948
FORM 10-K
A copy of QNB Corp.'s Annual Report on Form 10-K, as filed with the Securities
and Exchange Commission, is available, without charge to shareholders, by
writing L. Jane Mann, QNB Corp., P.O. Box 9005, Quakertown, PA 18951-9005.
The Annual Report and other Company reports are also filed electronically
through the Electronic Data Gathering, Analysis, and Retrieval System ("EDGAR")
which performs automated collection, validation, indexing, acceptance, and
forwarding of submissions to the Securities and Exchange Commission (SEC) and is
accessible by the public using the Internet at http://www.sec.gov./edgarhp.htm.
AUDITORS
KPMG LLP
1600 Market Street
Philadelphia, PA 19103
STOCK INFORMATION
QNB Corp. common stock is traded in the over-the-counter market. Quotations for
QNB Corp. common stock appear in the pink sheets published by the National
Quotations Bureau, Inc.
The following table sets forth representative high and low bid and ask stock
prices for QNB Corp. common stock on a quarterly basis during 1998 and 1997:
- --------------------------------------------------------------------------
Cash
High Low Dividend
Bid Ask Bid Ask Per Share
- --------------------------------------------------------------------------
1998
First Quarter $32 $34 $32 $34 $.18
Second Quarter 37 39 32 34 .18
Third Quarter 37 39 37 39 .18
Fourth Quarter 37 42 37 39 .18
1997
First Quarter $32 $33 $31 $32 $.16
Second Quarter 31 1/4 33 1/4 31 32 .16
Third Quarter 32 33 3/4 31 1/4 33 .16
Fourth Quarter 32 34 29 1/2 33 .16
- --------------------------------------------------------------------------
DIRECT DEPOSIT OF DIVIDENDS
Shareholders of record may elect to have dividends deposited directly to a
checking or savings account at their financial institution. For additional
information about Direct Deposit of Dividends, please write to:
L. Jane Mann, QNB Corp., P.O. Box 9005, Quakertown, PA 18951-9005.
44
QNB CORP. AND SUBSIDIARY
DIRECTORS, OFFICERS & OFFICE LOCATIONS
DIRECTORS OF QNB CORP. AND
THE QUAKERTOWN NATIONAL BANK
Norman L. Baringer
Thomas J. Bisko
Kenneth F. Brown, Jr.
Dennis Helf
Donald T. Knauss
G. Arden Link*
Charles M. Meredith, III
Gary S. Parzych
Henry L. Rosenberger
Edgar L. Stauffer
* Director of The Quakertown National Bank only.
OFFICERS OF QNB CORP.
Thomas J. Bisko, President/Treasurer/CEO
Robert C. Werner, Vice President
Bret H. Krevolin, Chief Accounting Officer
Charles M. Meredith, III, Secretary
L. Jane Mann, Assistant Secretary
EXECUTIVE MANAGEMENT
OF THE QUAKERTOWN NATIONAL BANK
Thomas J. Bisko, President/Chief Executive Officer
Robert C. Werner, Executive Vice President/Chief Operating Officer
Bret H. Krevolin, Senior Vice President/Chief Financial Officer/Cashier
Bryan S. Lebo, Senior Vice President/Senior Lending Officer
Mary Ann Smith, Senior Vice President/Chief Information Officer
OFFICERS OF THE QUAKERTOWN NATIONAL BANK
Mary A. Ackerman, Technical Services Officer
Stephen W. Bauder, Assistant Vice President, Commercial Lending
Robert D. Beck, Assistant Vice President, Information Technology
Barbara A. Crafton, Mortgage Loan Originator
Jane S. Cygan, Loan Origination Officer
Walter C. Derr, Senior Vice President, Commercial Lending
Paul T. Dotzman, Assistant Vice President, Commercial Lending
Michael J. Fina, Esq., Vice President/Special Assets Officer
Lynn C. Geesaman, Assistant Vice President, Loan Services
Joseph C. Giacini, Programmer/Analyst, Technical Operations Officer
Heather J. Gossler, Vice President, Branch Administration
Linda A. Grawe, Vice President, Retail Lending
Scott W. Groner, Director, Technical Services
Thomas S. Hartman, Credit Department Manager
Patrick D. Iampietro, Controller
Shari L. Jarrell, Loan Services Officer
Deborah E. Keller, Banking Officer, IRA/Savings
Carl P. Kessler, Assistant Vice President, Security/Compliance
Thomas R. Klee, Assistant Vice President, Commercial Lending
Christine S. Knerr, Banking Officer, Electronic Banking
Stacy A. Moyer, Human Resources Administrator
Ray C. Myers, Loan Review Officer
Scott G. Orzehoski, Vice President, Commercial Lending
Lisa A. Otery, Banking Officer, Deposit Services
David W. Quinn, Assistant Vice President/Internal Auditor
Charles E. Rairdon, Collection Officer
Shirley A. Rhodes, Assistant Cashier, General Ledger
Brian K. Schaffer, Marketing Director
Maryann S. Thompson, Commercial Documentation Officer
Cameron B. Wentzel, Retail Loan Officer
Robert L. Wieand, Vice President, Commercial Lending
OFFICE LOCATIONS
DOWNTOWN OFFICE
10 North Third Street
Quakertown, PA 18951
215-538-5651
Carol J. Schroding, Assistant Vice President/Branch Manager
April B. Donahue, Banking Officer
COUNTRY SQUARE OFFICE
Country Square Shopping Center
240 South West End Boulevard
Quakertown, PA 18951
215-538-5692
Jacquelin N. Kunsman, Assistant Vice President/Branch Manager
DUBLIN VILLAGE OFFICE
Dublin Village Plaza
161 North Main Street
Dublin, PA 18917
215-249-9600
Jeanette M. Shurow, Branch Manager
COOPERSBURG OFFICE
51 South Third Street
Coopersburg, PA 18036
610-282-1697
Sharon L. Rotenberger, Branch Manager
PENNSBURG OFFICE
Pennsburg Square Shopping Center
410-420 Pottstown Avenue
Pennsburg, PA 18073
215-679-0401
Brian L. Heilman, Branch Manager
PERKASIE OFFICE
607 Chestnut Street
Perkasie, PA 18944
215-257-0126
Deborah K. McDonald, Branch Manager
TOWNE BANK CENTER
320 West Broad Street
Quakertown, PA 18951
215-538-5600
320 West Broad Street
P.O. Box 9005
Quakertown, PA 18951-9005
215-538-5600 or 800-491-9070
www.QNB.com
Concept, design by R&D Communications
Photography by David Aretz
Cover Photo by Bill Moyer, QNB
45