2003 ANNUAL REPORT SINCERE INTEREST IN YOUR SUCCESS
Letter to Shareholders
[GRAPHIC OMMITTED]
"We thank all QNB personnel for their dedication and ongoing contribution to our
success" Dennis Helf, Chairman of the Board
Thomas J. Bisko, President & CEO
We are pleased to present the 2003 Annual Report for QNB Corp. and its
subsidiary, The Quakertown National Bank.
It was an incredible year. Your company once again achieved record earnings -
for the eighth consecutive time. Net income of $5,648,000 represents a 14
percent increase over net income for 2002 and equates to a return on average
assets of 1.07 percent and a return on average equity of 14.38 percent. Many
factors contributed to our financial success this past year, with fundamental
deposit growth having the greatest impact. Average deposits increased 12.7
percent during the year, partially as a result of our success in winning the
deposit relationships of several municipalities and school districts. Enhancing
the returns on those deposits was another solid year for loan demand. Average
loans outstanding increased 10.5 percent during the year in a slowly recovering
economy.
The record low interest rates which prevailed during the year also created an
opportunity for many of our customers to refinance their mortgage to either a
lower rate, shorter term or both. Due to both the volume of loans refinanced and
the continuing decline in interest rates, we recognized $923,000 in gains on the
sale of residential mortgages in 2003.
Your organization also continues to focus on booking quality assets which
contribute to profitability. Given the high quality of the loan portfolio, the
Allowance for Loan Losses remained adequate to protect against probable losses
without the need for an additional provision. Please refer to the "Management's
Discussion and Analysis" section of the report for more detail regarding
earnings.
We again took actions during the year to enhance the value of your investment in
QNB. During the first quarter of 2003, we increased the quarterly cash dividend
from $.15 to $.165 per share, an increase of 10 percent. The dividend increase
also marks the eighth consecutive year in which the cash dividend has been
increased by a minimum of 10 percent. During the third quarter, we announced a
two-for-one stock split in an effort to increase the liquidity of your shares.
Both actions were well received by investors as evidenced by the December 31,
2003 closing bid price of $33.60. The total return on a share of QNB stock for
2003 was approximately 55 percent.
As a result of the strong earnings performance, the company remained well
capitalized despite the significant growth in assets and the dividend increase.
The year end capital to asset ratio was 7.9 percent.
Our organization, however, doesn't judge our success solely on financial
results. It is part of our mission to enhance all the communities in which we
operate. This is partially achieved through corporate donations, but is
primarily accomplished through our employee volunteers. QNB employees are
involved in community events throughout the year and are also key volunteers for
many non-profit organizations. We recognize and applaud them for their
contributions to the total success of our company, and the communities they
help.
During the year, the talents of several employees were recognized and rewarded
with promotions: Stephen M. Rick, Commercial Loan Officer; Bruce D. Kenworthy,
Business Development Officer/Market Manager; Paul T. Dotzman, Vice President;
Lisa Otery, Assistant Vice President/ Deposit Services; and Thomas R. Klee, Vice
President. In addition to the promotions, we welcomed Debra A. Werkheiser to the
organization. Debra accepted the position of Senior Vice President/Director of
Wealth Management. In other news relating to QNB personnel, we are pleased to
note that two employees achieved national certifications in their respective
fields. Brian Schaffer, Vice President of Marketing, earned the designation of
Certified Financial Marketing Professional (CFMP) and Linda Helverson, an
employee in our Deposit Services Department earned the designation of Accredited
ACH Professional (AAP). Our congratulations and encouragement for continued
success go out to each employee. Unfortunately for the company, Ray Myers
announced his retirement and left in early 2004. Ray had been with QNB for over
32 years and was an integral part of our success during his tenure with the
company. We wish Ray good luck and thank him for his contributions to QNB.
As we turn our attention to the challenges of 2004 and beyond, we do so with
high expectations. We will continue to rely upon our strategic planning process
for guidance in the areas of technology, employee development, branching
strategies, and product development. Special attention will be paid to the net
interest margin which continued to constrict in 2003. Loan growth will remain a
primary focus; also, we will constantly evaluate product and market
opportunities which we believe may enhance the value of your investment over the
long term. One such exciting opportunity is our recently announced supermarket
branch in the new GIANT Food Store in Quakertown. The branch will be open seven
days a week with extended hours, thereby providing additional convenience for
our existing customers. It also positions the company well for prospective
customers as the GIANT Food Store is located in one of Quakertown's primary
growth areas.
QNB also measures itself through its customers' satisfaction and success. On the
following pages, we showcase three customer experiences that we feel exemplify
our corporate philosophy of "Sincere Interest In Your Success."
In closing, we thank all QNB personnel for their dedication and ongoing
contribution to our success. We also thank you, our shareholders, for your loyal
and continued support.
/ s / Thomas J. Bisko
Thomas J. Bisko, President & CEO
/ s / Dennis Helf
Dennis Helf
Chairman of the Board
QNB CORP. AND SUBSIDIARY
"People" People
Sincere Interest in Your Success. It's not a catchphrase. It's the way we do
business. On these pages are a few unsolicited comments from customers that
reveal how they feel about our willingness to go the extra mile for them.
"I am writing to tell you of the wonderful experience my family had at the
Country Square branch. I was in the Bank transacting business and talking with
Mary Lou about my grandchildren. She told me of the Bank's Youth Trek savings
program for kids. She gave me the paperwork and the money holder. She told me to
tell my grandson she would take him into the vault as a special treat. When my
grandson, who is four, came over that weekend, I told him all about the QNB
savings program. I told him he had to earn his quarters and when he had $5 we
would go to the Bank and open his own savings account. For the next three weeks
when he came to visit he asked to do jobs so he could earn his quarters as he
wanted to see the vault.
[When] we came to QNB to open his savings account... the ladies gave him the
royal treatment. Doreen opened up his account. She asked him questions and let
him pick out a special sticker. Mary Lou took him into the vault - he was
thrilled. He picked out the toy robot, he was given stickers and a bubble pen.
When we got home he told us that was the best and asked to do some jobs so he
could save more money and go back to the Bank. My daughter-in-law agrees that it
was a great learning experience for children.
I bank at QNB because it is a friendly hometown Bank and the service is
excellent. When you walk into the Bank everyone knows who you are and they all
welcome you. They put the customer first. Everyone is there to offer help and
assistance - always with a smile. They make banking fun. Mary Lou & Doreen's
professional demeanor is a credit to your banking institution. When my seven
month old grandson is old enough I will bring him to QNB to open up his savings
account." -- MRS. BARBARA COULTER
[GRAPHIC OMMITTED] ...the ladies gave him the royal treatment. Doreen opened up
his account. She asked him questions and let him pick out a special sticker.
[GRAPHIC OMMITTED]
I told him he had to earn his quarters and when he had $5 we would go to the
Bank and open his own savings account.
2003 ANNUAL REPORT SINCERE INTEREST IN YOUR SUCCESS
[GRAPHICS OMMITTED]
Mary Lou took him into the vault - he was thrilled. He picked out the toy robot,
he was given stickers and a bubble pen.
QNB CORP. AND SUBSIDIARY
Business Builders
Canaan Cabinetry was established in 1981. For the first 20 years of the firm's
existence Neal Hange worked "hands-on" as a company employee involved in every
aspect of the business. Not long ago the owner offered Neal the opportunity to
buy the company. He accepted.
"I knew everything about the company," Neal said. "But the one thing I was not
really prepared for was the feeling I experienced when I opened the door and
entered the business the first time as the owner. Suddenly I realized that I
couldn't call the boss if a tough decision had to be made. I was the boss."
One of his first decisions was to invite his wife Sue to join him. Shortly
afterward they began their search for a solid banking relationship. That's when
they discovered how the enthusiasm and expertise of Steve and Bruce at QNB could
help them grow the business.
Today this appealing husband-and-wife team is working to bring a new level of
quality cabinetry design to Bucks County homeowners.
[GRAPHICS OMMITTED]
"We were very impressed with the
service provided by Bruce Kenworthy
and Steve Rick. They made the financing
process simple and stress-free."
[GRAPHIC OMMITTED]
Pictured left to right, Steve Rick, Commercial Lender; Bruce Kenworthy,
Asst. Vice President/Business Development Manager; Neal and Sue Hange.
2003 ANNUAL REPORT SINCERE INTEREST IN YOUR SUCCESS
Customer Advocates
On a wintry day in 2003, QNB Banking Officer, Deb Keller, had an appointment on
her calendar to meet a customer who comes in once a year to sign IRA paperwork.
This customer plans a trip to a local garage to have his car serviced then walks
to the Bank to conduct his IRA business.
The day of his visit was particularly icy and cold. Deb became concerned for her
customer's well-being when the time for the appointment arrived but her customer
had not. Deb phoned his wife to find out what time he left and if he was really
going to attempt the walk. His wife confirmed that he was planning on making the
walk. Deb phoned the garage to find out if the customer was there or had already
left.
Because of the terrible ice, the customer took longer to walk the distance,
making him late for his appointment. After the customer arrived and completed
his IRA paperwork, Deb offered to drive him back to the garage instead of having
him risk the return walk. (She did this on her own time - her lunch hour.)
The customer was extremely grateful for the offer. He commented to Deb that "the
caring concern of Bank employees is why I continue to do business with QNB."
[GRAPHICS OMMITTED] The day of his visit was particularly icy and cold.
[GRAPHIC OMMITTED]
Deb offered to drive him back to the garage instead of having him risk the
return walk.
5
QNB CORP. AND SUBSIDIARY
TABLE OF CONTENTS
Financial Highlights 7
Management's Discussion and Analysis 8
Consolidated Balance Sheets 36
Consolidated Statements of Income 37
Consolidated Statements of Shareholders' Equity 38
Consolidated Statements of Cash Flows 39
Notes to Consolidated Financial Statements 40
Independent Auditors' Report 54
Corporate Information 55
Directors, Officers & Office Locations 56
6
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
FINANCIAL HIGHLIGHTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
- ---------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003 2002 2001 2000 1999
- ---------------------------------------------------------------------------------------------------------------
FINANCIAL PERFORMANCE
Net interest income ................................ $ 15,646 $ 15,115 $ 13,524 $ 12,691 $ 12,891
Provision for loan losses .......................... - - - - 240
Non-interest income ................................ 4,200 2,989 3,070 2,791 2,208
Non-interest expense ............................... 12,944 11,945 11,080 10,232 9,884
Net income ......................................... 5,648 4,955 4,436 4,106 3,801
PER SHARE DATA*
Net income - basic ................................. $ 1.83 $ 1.61 $ 1.44 $ 1.30 $ 1.20
Net income - diluted ............................... 1.79 1.59 1.43 1.30 1.20
Book value ......................................... 14.03 13.28 11.46 10.21 8.62
Cash dividends ..................................... .66 .60 .54 .46 .38
SELECTED AVERAGE BALANCES
Total assets ....................................... $526,774 $479,494 $412,899 $363,516 $344,543
Total earning assets ............................... 493,238 448,917 387,650 341,011 322,363
Investment securities .............................. 250,414 230,434 187,984 158,389 143,716
Loans held-for-sale ................................ 1,527 1,544 1,704 1,203 1,983
Loans, net of unearned income ...................... 229,001 207,238 190,290 177,678 172,929
Deposits ........................................... 419,098 371,718 312,509 292,273 284,516
Borrowed funds ..................................... 65,226 68,420 64,337 37,245 27,827
Shareholders' equity ............................... 39,286 35,707 32,756 30,991 28,880
BALANCE SHEET DATA
Total assets ....................................... $550,831 $503,430 $451,274 $371,671 $350,489
Investment securities available-for-sale ........... 264,441 214,741 168,102 114,245 97,609
Investment securities held-to-maturity ............. 12,012 29,736 42,798 42,982 48,302
Loans held-for-sale ................................ 1,439 4,159 2,122 1,642 1,235
Loans, net of unearned income ...................... 232,127 212,691 200,089 183,592 172,529
Deposits ........................................... 438,639 388,913 344,731 293,822 286,166
Borrowed funds ..................................... 65,416 69,485 66,451 42,819 33,925
Shareholders' equity ............................... 43,440 40,914 35,219 31,794 27,462
SELECTED RATIOS
Return on average assets ........................... 1.07% 1.03% 1.07% 1.13% 1.10%
Return on average shareholders' equity ............. 14.38 13.88 13.54 13.25 13.16
Net interest margin ................................ 3.45 3.68 3.81 4.02 4.23
Average shareholders' equity to average total assets 7.46 7.45 7.93 8.53 8.38
*ADJUSTED FOR TWO-FOR-ONE STOCK SPLIT DISTRIBUTED OCTOBER 14, 2003
Net Income Per Share - Diluted
[Bar chart omitted--plot points as follows:]
1999 $1.20
2000 $1.30
2001 $1.43
2002 $1.59
2003 $1.79
Cash Dividend
[Bar chart omitted--plot points as follows:]
1999 $0.38
2000 $0.46
2001 $0.54
2002 $0.60
2003 $0.66
Stock Price (12/31 CLOSING BID)
[Bar chart omitted--plot points as follows:]
1999 $13.16
2000 $13.34
2001 $16.13
2002 $20.00
2003 $33.60
7
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
AVERAGE BALANCES, RATES, AND INTEREST INCOME AND EXPENSE SUMMARY
(TAX-EQUIVALENT BASIS)
2003 2002
- ---------------------------------------------------------------------------------------------------------------
AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE RATE INTEREST BALANCE RATE INTEREST
- ---------------------------------------------------------------------------------------------------------------
ASSETS
Interest-bearing balances ........... $ 1,060 .57% $ 6 $ 338 1.53% $ 5
Federal funds sold .................. 11,236 1.12 126 9,363 1.63 152
Investment securities
available-for-sale:
Taxable .......................... 199,558 4.29 8,565 169,179 5.48 9,267
Tax-exempt ....................... 32,037 6.81 2,181 21,716 7.30 1,586
Investment securities held-to-maturity:
Taxable .......................... 4,224 4.86 205 19,020 5.39 1,026
Tax-exempt ....................... 14,595 6.98 1,018 20,519 6.88 1,412
- ---------------------------------------------------------------------------------------------------------------
Total investment securities .... 250,414 4.78 11,969 230,434 5.77 13,291
Loans, net of unearned income* ...... 230,528 6.37 14,684 208,782 7.26 15,155
- ---------------------------------------------------------------------------------------------------------------
Total earning assets ........... 493,238 5.43 26,785 448,917 6.37 28,603
Cash and due from banks ............. 18,207 15,495
Allowance for loan losses ........... (2,937) (2,887)
Other assets ........................ 18,266 17,969
- ---------------------------------------------------------------------------------------------------------------
Total assets ................... $526,774 5.08% $479,494 5.97%
===============================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
Interest-bearing deposits
Interest-bearing demand accounts .... $ 87,570 .63% 554 $ 61,006 .64% 393
Money market deposit accounts ....... 36,138 .83 298 37,171 1.51 559
Savings accounts .................... 50,616 .64 324 41,764 1.19 497
Time deposits ....................... 152,321 2.96 4,511 141,854 4.12 5,843
Time deposits of $100,000 or more ... 43,289 2.49 1,080 46,354 3.48 1,614
- ---------------------------------------------------------------------------------------------------------------
Total interest-bearing
deposits ...................... 369,934 1.83 6,767 328,149 2.71 8,906
Short-term borrowings ............... 10,226 1.04 106 13,880 1.90 264
Federal Home Loan Bank advances ..... 55,000 5.24 2,881 54,540 5.33 2,906
- ---------------------------------------------------------------------------------------------------------------
Total interest-bearing
liabilities ................... 435,160 2.24 9,754 396,569 3.05 12,076
- ---------------------------------------------------------------------------------------------------------------
Non-interest-bearing deposits ....... 49,164 43,569
Other liabilities ................... 3,164 3,649
Shareholders' equity ................ 39,286 35,707
- ---------------------------------------------------------------------------------------------------------------
Total liabilities and
shareholders' equity .......... $526,774 1.85% $479,494 2.52%
===============================================================================================================
Net interest rate spread ............ 3.19% 3.32%
===============================================================================================================
Margin/net interest income .......... 3.45% $ 17,031 3.68% $ 16,527
===============================================================================================================
2001
- ------------------------------------------------------------------------
AVERAGE AVERAGE
BALANCE RATE INTEREST
- ------------------------------------------------------------------------
ASSETS
Interest-bearing balances ........... $ 306 4.49% $ 14
Federal funds sold .................. 7,366 3.83 282
Investment securities
available-for-sale:
Taxable .......................... 129,284 6.51 8,411
Tax-exempt ....................... 15,828 7.36 1,165
Investment securities held-to-maturity:
Taxable .......................... 24,197 6.20 1,500
Tax-exempt ....................... 18,675 6.90 1,288
- ------------------------------------------------------------------------
Total investment securities .... 187,984 6.58 12,364
Loans, net of unearned income* ...... 191,994 8.08 15,512
- ------------------------------------------------------------------------
Total earning assets ........... 387,650 7.27 28,172
Cash and due from banks ............. 12,882
Allowance for loan losses ........... (2,931)
Other assets ........................ 15,298
- ------------------------------------------------------------------------
Total assets ................... $412,899 6.82%
========================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
Interest-bearing deposits
Interest-bearing demand accounts .... $ 50,106 .91% 455
Money market deposit accounts ....... 37,982 2.78 1,056
Savings accounts .................... 36,684 1.63 596
Time deposits ....................... 126,629 5.32 6,731
Time deposits of $100,000 or more ... 25,915 5.10 1,321
- ------------------------------------------------------------------------
Total interest-bearing
deposits ...................... 277,316 3.66 10,159
Short-term borrowings ............... 16,195 3.33 539
Federal Home Loan Bank advances ..... 48,142 5.62 2,706
- ------------------------------------------------------------------------
Total interest-bearing
liabilities ................... 341,653 3.92 13,404
- ------------------------------------------------------------------------
Non-interest-bearing deposits ....... 35,193
Other liabilities ................... 3,297
Shareholders' equity ................ 32,756
- ------------------------------------------------------------------------
Total liabilities and
shareholders' equity .......... $412,899 3.25%
========================================================================
Net interest rate spread ............ 3.35%
========================================================================
Margin/net interest income .......... 3.81% $14,768
========================================================================
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.
* Includes loans held-for-sale.
8
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
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
2003, 2002 and 2001. The results of operations and financial condition are
presented on a consolidated basis and the consolidated entity is referred to 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 36. Tabular information is
presented in thousands, except share data. Share and per share data have been
restated to reflect the two-for one stock split distributed October 14, 2003.
QNB Corp. (the "Corporation") is a bank holding company headquartered in
Quakertown, Pennsylvania. The Corporation through its wholly owned subsidiary,
The Quakertown National Bank (the "Bank"), has been serving the residents and
businesses of Upper Bucks, Northern Montgomery and Southern Lehigh Counties in
Pennsylvania since 1877. The Bank is locally managed and provides a full range
of commercial banking, retail banking, and trust and investment management
services.
FORWARD-LOOKING STATEMENTS
This report includes forward-looking statements within the meaning of the
Private Securities Litigation Reform Act with respect to financial performance
and other financial and business matters. Forward-looking statements are
typically identified by words or phrases such as "believe," "expect,"
"anticipate," "intend," "estimate," "position" and variations of such words and
similar expressions, or future or conditional verbs such as "will," "would,"
"should," "could," "may" or similar expressions. QNB cautions that these
forward-looking statements are subject to numerous assumptions, risks and
uncertainties, all of which change over time, and QNB assumes no duty to update
forward looking statements.
In addition to factors previously disclosed by the Corporation and those
identified elsewhere herein, the following factors, among others, could cause
actual results to differ materially from forward looking statements: increased
credit risk; the introduction, withdrawal, success and timing of business
initiatives and strategies; changes in competitive conditions; the inability to
sustain revenue and earnings growth; changes in economic conditions, interest
rates and financial and capital markets; inflation; changes in investment
performance; customer disintermediation; customer borrowing, repayment,
investment and deposit practices; customer acceptance of QNB products and
services; and, the impact, extent and timing of technological changes, capital
management activities, actions of the Federal Reserve Board and legislative and
regulatory actions and reforms.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Discussion and analysis of the financial condition and results of operations are
based on the consolidated financial statements of QNB, which are prepared in
accordance with accounting principles generally accepted in the United States of
America (GAAP). The preparation of these financial statements requires QNB to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. QNB evaluates estimates on an on-going basis, including those
related to the allowance for loan losses, non-accrual loans, other real estate
owned, other-than-temporary investment impairments, intangible assets, stock
option plan and income taxes. QNB bases its estimates on historical experience
and various other factors and assumptions that are believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
QNB believes the following critical accounting policies affect its more
significant judgments and estimates used in preparation of its consolidated
financial statements: allowance for loan losses, income taxes and
other-than-temporary investment security impairment. Each estimate is discussed
below. The financial impact of each estimate is discussed in the applicable
sections of Management's Discussion and Analysis.
ALLOWANCE FOR LOAN LOSSES
QNB maintains an allowance for loan losses which is intended to absorb probable
known and inherent losses in the outstanding loan portfolio. The allowance is
reduced by actual credit losses and is increased by the provision for loan
losses and recoveries of previous losses. The provisions for loan losses are
charged to earnings to bring the total allowance for loan losses to a level
considered necessary by management.
The allowance for loan losses is based on management's continuing review and
evaluation of the loan portfolio. The level of the allowance is determined by
assigning specific reserves to individually identified problem credits and
general reserves to all other loans. The portion of the allowance that is
allocated to internally criticized and non-accrual loans is determined by
estimating the inherent loss on each credit after giving consideration to the
value of underlying collateral. The general reserves are based on the
composition and risk characteristics of the loan portfolio, including the nature
of the loan portfolio, credit concentration trends, historic loss and
delinquency experience, as well as other qualitative factors such as current
economic trends.
Management emphasizes loan quality and close monitoring of potential problem
credits. Credit risk identification and review processes are utilized in order
to assess and monitor the degree of risk in the loan portfolio. QNB's lending
and loan administration staff are charged with reviewing the loan portfolio and
identifying changes in the economy or in a borrower's circumstances which may
affect the ability to repay debt or the value of pledged collateral. A loan
classification and review system exists that identifies those loans with a
higher than normal risk of collectibility. Each commercial loan is assigned a
grade based upon an
9
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
ALLOWANCE FOR LOAN LOSSES (CONTINUED)
assessment of the borrower's financial capacity to service the debt and the
presence and value of collateral for the loan. An independent loan review group
tests risk assessments and evaluates the adequacy of the allowance for loan
losses. Management meets monthly to review the credit quality of the loan
portfolio and quarterly to review the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their
examination process, periodically review QNB's allowance for losses on loans.
Such agencies may require QNB to recognize additions to the allowance based on
their judgments about information available to them at the time of their
examination.
Management believes that it uses the best information available to make
determinations about the adequacy of the allowance and that it has established
its existing allowance for loan losses in accordance with GAAP. If circumstances
differ substantially from the assumptions used in making determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be affected. Because future events affecting borrowers and
collateral cannot be predicted with certainty, there can be no assurance that
increases to the allowance will not be necessary should the quality of any loans
deteriorate as a result of the factors discussed above.
INCOME TAXES
QNB accounts for income taxes under the asset/liability method. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases, as well as
operating loss and tax credit carryforwards. Deferred tax assets and liabilities
are measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date. A
valuation allowance is established against deferred tax assets when, in the
judgment of management, it is more likely than not that such deferred tax assets
will not become available. Because the judgment about the level of future
taxable income is dependent to a great extent on matters that may, at least in
part go beyond QNB's control, it is at least reasonably possible that
management's judgment about the need for a valuation allowance for deferred
taxes could change in the near term. At December 31, 2002, QNB had a $95,000
valuation allowance for deferred taxes. This valuation allowance was reversed
during 2003 as a result of the ability to realize tax benefits associated with
certain impaired securities, due to the increase in unrealized gains of certain
equity securities.
OTHER THAN TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES
Securities are evaluated periodically to determine whether a decline in their
value is other than temporary. Management utilizes criteria such as the
magnitude and duration of the decline, in addition to the reasons underlying the
decline, to determine whether the loss in value is other than temporary. The
term "other than temporary" is not intended to indicate that the decline is
permanent, but indicates that the prospect for a near-term recovery of value is
not necessarily favorable, or that there is a lack of evidence to support
realizable value equal to or greater than carrying value of the investment. Once
a decline in value is determined to be other than temporary, the value of the
security is reduced and a corresponding charge to earnings is recognized.
RESULTS OF OPERATIONS
QNB had its eighth consecutive year of record earnings in 2003. QNB's earnings
for 2003 were $5,648,000, a 14.0 percent increase from the $4,955,000 reported
in 2002. This reported net income represents basic earnings per share of $1.83
and $1.61 for 2003 and 2002, an increase of 13.7 percent. On a diluted basis,
net income per share was $1.79 and $1.59 for 2003 and 2002. Net income for 2001
was $4,436,000 or $1.44 and $1.43 per share on a basic and diluted basis,
respectively.
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
1.07 percent and 14.38 percent, respectively, in 2003 compared with 1.03 percent
and 13.88 percent in 2002 and 1.07 percent and 13.54 percent in 2001.
Contributing to the results for 2003 were the following:
* $531,000 increase in net interest income, resulting from a 9.9 percent
increase in average earning assets, offsetting a 23 basis point reduction
in the net interest margin to 3.45 percent.
* Record low interest rate environment resulting in significant mortgage
refinance activity. Activity resulted in increased gain on sale of
residential mortgage loans, but also negatively impacts prepayment activity
in the investment portfolio.
* 12.7 percent increase in average deposits centered in growth of
interest-bearing demand accounts and savings accounts. Increase in
interest-bearing demand accounts was primarily a result of municipal and
school district deposits.
* 10.5 percent increase in average loans, primarily commercial.
* 8.7 percent increase in average investment securities.
* Non-interest income increased $1,211,000.
* Gain on the sale of loans was $923,000 in 2003 compared to $676,000 in
2002.
* Loss on investment securities was $134,000 in 2003 compared to loss of
$779,000 in 2002.
* Tax-exempt life insurance proceeds of $109,000.
* Non-interest expense increased $999,000.
* Personnel expense increased $803,000. New incentive compensation plan,
"Stakeholders", resulted in a payout of $457,000 in 2003 compared to
$200,000 under the previous incentive plan. Medical insurance premiums
increased $68,000.
* Reversal of a $95,000 tax valuation allowance recorded in 2002.
These items as well as others will be explained more thoroughly in the next
sections.
10
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
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.
For purposes of this discussion, interest income and the average yield earned on
loans and investment securities are adjusted to a tax-equivalent basis as
detailed in the table that appears on page 8. This adjustment to interest income
is made for analysis purposes only. Interest income is increased by the amount
of savings of Federal income taxes, which QNB realizes by investing in certain
tax-exempt State and municipal securities and by making loans to certain
tax-exempt organizations. In this way the ultimate economic impact of earnings
from various assets can be more easily compared.
The net interest rate spread is the difference between average rates received on
earning assets and average rates paid on interest-bearing liabilities, while the
net interest rate margin includes interest-free sources of funds.
On a fully tax-equivalent basis, net interest income for 2003 increased $504,000
or 3.0 percent to $17,031,000. As has been the trend for the past three years,
the ability to increase net interest income is a result of the tremendous growth
in deposits and the investment of these deposits into profitable loans and
investment securities. Deposit growth in 2003 was once again aided by economic
uncertainty, the conflict in Iraq and the threat of terrorism. Funds continued
to look to the safety of bank deposits and the U.S. Government bond market.
However, for the first time since 1999, stock indices finished the year higher
with funds beginning to flow back into stocks and mutual funds as evidence
slowly supported that the economy had hit bottom and began a recovery. Also
contributing to the growth in deposits in 2003 was significant increases in
deposits of local municipalities and school districts. The majority of the
growth in these deposits is seasonal and will likely be withdrawn during the
first and second quarters of 2004. These deposits were primarily invested in
securities whose cash flow will closely match the anticipated run-off of the
deposits.
Average earning assets increased 9.9 percent in 2003. This growth continues to
offset a declining net interest margin resulting from the historically low
interest rate environment of the past three years. The net interest margin
declined by 23 basis points, while the net interest rate spread declined by 13
basis points. The net interest rate spread decreased to 3.19 percent in 2003
from 3.32 percent in 2002, while the net interest rate margin decreased to 3.45
percent in 2003 from 3.68 percent in 2002. Included in net interest income for
2002 is the recognition of $200,000 in interest on non-accrual loans that have
been paid in full. Excluding the impact of the recognition of interest on
non-accrual loans, the net interest margin would have been 3.64 percent for
2002.
It is necessary to review the changes in market interest rates during the period
2001-2003 to understand the impact of changing interest rates on interest income
and interest expense. The year 2001 presented many unexpected events starting
with a .50 percent cut in the Federal funds target rate on January 3, 2001. This
would be the first of 11 rate cuts by the Federal Reserve Board during 2001. The
Federal funds rate declined 475 basis points during the year to 1.75 percent.
The economy that had slowed during the end of 2000 and early 2001, showed signs
of bottoming in the spring of 2001. In response, bond yields, which had fallen
sharply through late March, rose in April and May to the point that five-year
and longer yields were higher than at year-end 2000. During the summer however,
it became evident that the economy was still struggling, and the U.S. economy
was in recession. The Federal Reserve resumed its aggressive easing which was
made possible by the absence of inflationary pressures. In early September bond
yields were at their lowest of the year. Then the tragic events of September 11
occurred, and the already fragile economy was hit hard. Unemployment, which had
been historically low, rose sharply. The Federal Reserve continued to cut rates,
and interest rates declined sharply with the two-year Treasury, 10-year Treasury
and 30-year bond hitting lows of 2.29 percent, 4.18 percent and 4.80 percent,
respectively, in early November. The sharp decline in the 10-year Treasury rate
ignited a boom of residential mortgage loan refinancing. By the end of 2001, the
economic data showed signs of improvement. Consumer confidence, employment and
manufacturing appeared to be stabilizing. As a result, interest rates in the
10-year and longer part of the curve increased. This created a very steep yield
curve with shorter-term interest rates remaining well below end of 2000 levels.
However, 10-year and longer rates were nearly unchanged from where they were at
the end of 2000. The two-year Treasury, 10-year Treasury and 30-year bond ended
2001 at 3.06 percent, 5.03 percent and 5.47 percent, respectively.
The year 2002 began with most economists predicting a slow, steady recovery for
the U.S. economy. The growing expectation for a recovery sent interest rates
higher. The two-year, 10-year and 30-year Treasury bonds reached their highs for
the year at the end of the first quarter of 2002 at 3.73 percent, 5.43 percent
and 5.83 percent, respectively. As it turned out, the economic data showed mixed
results, corporate scandals came to light and the stock market tumbled again. As
a result, investors looked for the safety of U.S. bonds again sending yields
falling. The 10-year Treasury note hit a 44-year low in October 2002 of 3.57
percent before finishing the year at 3.81 percent. The rate on the 30-year bond
around the same time got as low as 4.63 percent before ending 2002 at 4.78
percent. In response to the uncertainty of the recovery, the lack of corporate
spending, and the decline in consumer confidence, all partially attributable to
heightened geopolitical risks, the Federal Reserve Board lowered the target
Federal funds rate in November by 50 basis points to 1.25 percent. The two-year
Treasury ended 2002 at its low of 1.60 percent.
11
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
NET INTEREST INCOME (CONTINUED)
Once again, 2003 began with expectations of a slowly improving economy and
rising interest rates. While the economy did show signs of growth, the
uncertainty created by the war in Iraq as well as concerns over the lack of job
growth and deflation kept interest rates at historically low levels. Interest
rates were extremely volatile over the course of 2003. The two-year, 10-year and
30-year Treasury bonds all reached historic lows on June 13, 2003 of 1.10
percent, 3.13 percent and 4.17 percent, respectively. At the end of June, the
Federal Reserve Board dropped the Federal funds rate by 25 basis points to 1.00
percent. One result of these record low rates was a sharp increase in
residential mortgage loan activity, both purchase mortgages and refinances.
Interest rates rebounded quickly with the 10-year hitting its high for the year
of 4.61 percent in early September and the 30-year hitting its high of 5.45
percent in August. The shorter end of the yield curve was slower to react as a
result of indications by the Federal Reserve Board that it would be patient in
raising the Federal funds rate. The two-year Treasury bond reached its high for
the year of 2.12 percent in early December before finishing the year at 1.82
percent. The 10-year and 30-year bonds ended the year at 4.25 percent and 5.07
percent, respectively.
The Rate-Volume Analysis table, as presented on a tax-equivalent basis, below,
highlights the impact of changing rates and volumes on total interest income and
interest expense. Total interest income decreased $1,818,000 or 6.4 percent in
2003 to $26,785,000. The extended period of low interest rates has resulted in
interest income decreasing by $4,650,000 in 2003 and the yield on earning assets
decreasing by 94 basis points to 5.43 percent for 2003. As a result of lower
interest rates, interest income on investment securities decreased by $2,534,000
in 2003, with the yield on investment securities decreasing 99 basis points to
4.78 percent. The decline in interest income and the yield from investment
securities is also a result of heavy cash flow from callable agency and
municipal securities, mortgage-backed securities and collateralized mortgage
obligations (CMOs). These funds as well as new funds from deposit growth were
reinvested in lower-yielding securities. Another result of the increase in
prepayments on mortgage backed securities and CMOs purchased at a premium was an
increase in the amortization of the premium on these securities. The net
amortization on investment securities was $1,204,000 in 2003 compared to
$793,000 in 2002. The increase in premium amortization has the impact of
reducing interest income and the yield on the portfolio. QNB has attempted to
manage the prepayment situation by selling certain faster paying CMOs and
mortgage-backed securities and purchasing lower coupon, lower premium
mortgage-backed securities and CMOs that will not pay as quickly should rates
stay low or decline further. During the fourth quarter of 2003, QNB sold some
lower yielding securities at a loss, reinvesting the proceeds into higher
yielding securities in an effort to increase the overall yield of the portfolio.
The yield on the portfolio as of December 31, 2003, was 4.67 percent, a decrease
of 70 basis points from the portfolio yield of 5.37 percent at December 31,
2002.
RATE-VOLUME ANALYSIS OF CHANGES IN NET INTEREST INCOME (TAX-EQUIVALENT BASIS)
- ----------------------------------------------------------------------------------------------------------------------------
2003 VS. 2002 2002 VS. 2001
- ----------------------------------------------------------------------------------------------------------------------------
CHANGE DUE TO TOTAL CHANGE DUE TO TOTAL
VOLUME RATE CHANGE VOLUME RATE CHANGE
- ----------------------------------------------------------------------------------------------------------------------------
Interest income:
Interest-bearing balances ....................... $ 11 $ (10) $ 1 $ 1 $ (10) $ (9)
Federal funds sold .............................. 31 (57) (26) 77 (207) (130)
Investment securities available-for-sale:
Taxable ..................................... 1,664 (2,366) (702) 2,595 (1,739) 856
Tax-exempt .................................. 754 (159) 595 434 (13) 421
Investment securities held-to-maturity:
Taxable ..................................... (798) (23) (821) (321) (153) (474)
Tax-exempt .................................. (408) 14 (394) 127 (3) 124
Loans ........................................... 1,578 (2,049) (471) 1,356 (1,713) (357)
- ----------------------------------------------------------------------------------------------------------------------------
Total interest income .................... 2,832 (4,650) (1,818) 4,269 (3,838) 431
- ----------------------------------------------------------------------------------------------------------------------------
Interest expense:
Interest-bearing demand accounts ................ 171 (10) 161 99 (161) (62)
Money market accounts ........................... (15) (246) (261) (23) (474) (497)
Savings ......................................... 106 (279) (173) 83 (182) (99)
Time ............................................ 431 (1,763) (1,332) 809 (1,697) (888)
Time over $100,000 .............................. (107) (427) (534) 1,041 (748) 293
Short-term borrowings ........................... (70) (88) (158) (77) (198) (275)
Federal Home Loan Bank advances ................. 24 (49) (25) 360 (160) 200
- ----------------------------------------------------------------------------------------------------------------------------
Total interest expense ................... 540 (2,862) (2,322) 2,292 (3,620) (1,328)
- ----------------------------------------------------------------------------------------------------------------------------
Net interest income ............................. $2,292 $(1,788) $ 504 $1,977 $ (218) $ 1,759
============================================================================================================================
Variances that 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.
12
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
Interest income on loans declined by $2,049,000 as a result of lower interest
rates. Contributing to the decline in interest income on loans was the reduction
in the prime rate. When the Federal Reserve Board lowered the Federal funds rate
at the end of June, banks lowered their prime lending rate by .25 percent to
4.00 percent. The prime rate on loans has dropped 13 times during the period
2001 through 2003 from 9.50 percent to 4.00 percent. The average prime rate,
when comparing 2003 to 2002, decreased 55 basis points from 4.67 percent for
2002 to 4.12 percent in 2003. A greater contributor to the decline in interest
income on loans was the impact of the refinancing of residential mortgage, home
equity and commercial loans into lower yielding loans. The average rate
decreased 89 basis points during 2003. The average yield decreased from 7.26
percent in 2002 to 6.37 percent in 2003. The yield on the loan portfolio may
continue to decline in 2004 as fixed rate loans continue to be refinanced at
lower rates, adjustable rate loans reprice down as they reach their reset date
and new loans are booked at the current lower rates. In anticipation of rising
rates in 2004 and 2005, QNB, particularly with regard to commercial loans, has
attempted to originate more floating rate loans indexed to the prime rate. This
should help increase the yield on the loan portfolio as the prime rate
increases.
Helping to partially offset the negative impact of lower interest rates on
interest income was strong growth in earning assets. An increase in earning
assets contributed an additional $2,832,000 to interest income, with higher
securities volume accounting for $1,212,000 of the increase and higher loan
volume accounting for $1,578,000 of the increase. Average investment securities
increased $19,980,000 or 8.7 percent, while average loans increased $21,746,000
or 10.4 percent. The increase in loans was primarily a result of growth in
commercial loans, both real estate secured and those secured by business assets.
This increase is significant given the slow growing economy and the current
competitive environment for commercial loans.
Non-accrual loans of $818,000 in 2003 and $650,000 in 2002 resulted in the
non-recognition of $40,000 and $19,000 in interest income for the respective
periods.
Total interest expense decreased $2,322,000 or 19.2 percent in 2003 to
$9,754,000. The impact of falling interest rates on interest expense offset the
impact of the growth in deposits. Volume growth resulted in interest expense
increasing by $540,000 while lower interest rates on deposits and borrowings
reduced interest expense by $2,862,000. A 12.7 percent increase in average
interest-bearing deposits resulted in an increase in interest expense of
$586,000. A $26,564,000 or 43.5 percent increase in average interest-bearing
demand accounts contributed $171,000 to the increase in interest expense while
an $8,852,000 or 21.2 percent increase in average savings accounts contributed
$106,000 in additional expense. As discussed previously, the majority of the
growth in interest bearing demand deposits can be attributed to the successful
development of relationships with several municipal organizations. The continued
growth in savings deposits can be attributed to consumers looking for the
relative safety of bank deposits despite the low interest rate environment.
Average balances on time deposits increased by 3.9 percent contributing $324,000
to the increase in interest expense. A $10,467,000 increase in average time
deposits with balances less than $100,000 offset a $3,065,000 decrease in
average time deposits with balances of $100,000 or more.
Net Interest Income
(TAX EQUIVALENT, IN THOUSANDS)
[Bar chart omitted--plot points as follows:]
1999 $13,649
2000 $13,696
2001 $14,768
2002 $16,527
2003 $17,031
The average rates paid on deposit accounts, short-term borrowings and Federal
Home Loan Bank (FHLB) advances decreased in 2003. The rate paid on total
interest-bearing liabilities, including the borrowings from the FHLB, decreased
to 2.24 percent in 2003 from 3.05 percent in 2002. The rate paid on
interest-bearing deposit accounts decreased to 1.83 percent in 2003 from 2.71
percent in 2002. Lower rates paid on money market accounts and savings accounts
decreased interest expense by $246,000 and $279,000, respectively in 2003. Among
these transaction accounts, the average rate paid on money market accounts was
impacted the most by the decline in interest rates. The yield on money market
accounts declined 68 basis points from 1.51 percent in 2002 to .83 percent in
2003. Contributing to the decline in the yield on money market accounts was the
sharp decline in the yield on the Treasury Select Money Market Account. This
product is a variable rate account, indexed to the monthly average of the 91-day
Treasury bill based on balances in the account. The continued decline in the
91-day Treasury rate in 2003 resulted in significantly lower rates on this
product as compared to 2002. The average rate paid on savings accounts decreased
from 1.19 percent in 2002 to .64 percent in 2003. Management does not expect the
yield on non-maturity interest-bearing deposits, which reprice immediately when
their rates are changed, to decline significantly as they have reached levels
where only minimal reduction in rates is possible.
13
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
NET INTEREST INCOME (CONTINUED)
The continuing low interest rate environment had a greater impact on time
deposits in 2003 as many time deposits with longer original maturities repriced
lower during the year. Interest expense on time deposits was $2,190,000 lower in
2003 as a result of lower interest rates. The average rate paid on time deposits
decreased from 3.96 percent in 2002 to 2.86 percent in 2003. Like fixed-rate
loans, certificates of deposit reprice over time and therefore have less of an
immediate impact on yield in either a rising or falling rate environment.
However, given the extended period of low interest rates, most time deposits
have already repriced lower and therefore the yield on time deposits will likely
not decline much further.
Interest expense on FHLB advances decreased only $49,000, as a result of lower
rates, between 2002 and 2003. The average rate paid on FHLB advances declined
from 5.33 percent in 2002 to 5.24 percent in 2003. The decline is primarily a
result of the lower rate paid on the $5,000,000 in advances that are variable in
nature and are tied to three-month LIBOR. Most of the advances from the FHLB
have fixed rates and; therefore, the rate paid on the FHLB advances will remain
relatively stable in either a rising or falling rate environment. Some of the
advances have convertible features; however, interest rates would have to
increase considerably for this conversion feature to be exercised and therefore
increase the cost of the borrowings.
When comparing 2002 to 2001, net interest income on a fully tax-equivalent basis
increased $1,759,000 or 11.9 percent to $16,527,000. The growth in net interest
income was the result of the tremendous growth in deposits and the investment of
these deposits into profitable loans and investment securities. Average earning
assets increased 15.8 percent in 2002. This growth helped minimize the impact on
net interest income resulting from a decline in the net interest margin. The net
interest margin declined by 13 basis points, while the net interest rate spread
declined by 3 basis points. The net interest rate spread decreased to 3.32
percent in 2002 from 3.35 percent in 2001, while the net interest rate margin
decreased to 3.68 percent in 2002 from 3.81 percent in 2001.
Total interest income increased $431,000 or 1.5 percent in 2002 to $28,603,000.
Growth in earning assets contributed $4,269,000 to the increase in interest
income, with higher securities volume accounting for $2,835,000 of the increase
and higher loan volume accounting for $1,356,000 of the increase. Average
investment securities increased $42,450,000 or 22.6 percent, while average loans
increased $16,788,000 or 8.7 percent. A $1,997,000 increase in average Federal
funds sold increased interest income by approximately $77,000 in 2002.
Management increased its balances of Federal funds sold and shorter maturity
amortizing investment securities in order to keep a higher level of liquidity in
light of the significant increase in deposits.
The low interest rate environment experienced in 2002 had a negative impact on
interest income and the yield on earning assets during 2002. The decrease in
interest income resulting from lower yields on earning assets was $3,838,000
during 2002, with loans and investment securities accounting for $1,713,000 and
$1,908,000 of the decrease. The impact of the 12 Federal Reserve rate cuts
during 2001 and 2002 reduced interest on Federal funds sold by approximately
$207,000.
The prime rate on loans also dropped 12 times during 2001 and 2002 from 9.50
percent to 4.25 percent. The average prime rate, when comparing 2002 to 2001,
decreased 224 basis points, from 6.91 percent for 2001 to 4.67 percent in 2002.
The yield on earning assets decreased 90 basis points to 6.37 percent with the
average rate on loans decreasing 82 basis points during 2002. The average yield
on loans decreased from 8.08 percent in 2001 to 7.26 percent in 2002. While QNB
was negatively impacted in 2002 from the decline in the prime rate, the overall
yield on the loan portfolio did not decrease proportionately, because only a
small percentage of the loan portfolio repriced immediately with changes in the
prime rate.
The yield on the total investment portfolio was 5.77 percent for 2002 and 6.58
percent in 2001. With the decline in interest rates, cash flow from callable
agency bonds, mortgage-backed securities and CMOs increased. These funds as well
as new funds from deposit growth were reinvested in lower-yielding securities.
Another result of the increase in the prepayments on mortgage backed securities
and CMOs purchased at a premium was an increase in the amortization of the
premium on these securities. The net amortization on investment securities was
$793,000 in 2002 compared with $51,000 in 2001. The increase in premium
amortization has the impact of reducing interest income and the yield on the
portfolio. The yield on the portfolio as of December 31, 2002, was 5.37 percent,
a decrease of 92 basis points from the portfolio yield of 6.29 percent at
December 31, 2001.
Total interest expense decreased $1,328,000 or 9.9 percent in 2002 to
$12,076,000. The impact of falling interest rates on interest expense offset the
impact of the growth in deposits and borrowings. Volume growth resulted in
interest expense increasing by $2,292,000 while lower interest rates on deposits
and borrowings reduced interest expense by $3,620,000. An 18.3 percent increase
in average interest-bearing deposits resulted in an increase in interest expense
of $2,009,000. This increase was primarily in the area of time deposits. Average
balances on time deposits increased by 23.4 percent contributing $1,850,000 to
the increase in interest expense. A $10,900,000 or 21.8 percent increase in
average interest-bearing demand accounts contributed $99,000 to the increase in
interest expense, while a $5,080,000 or 13.8 percent increase in average savings
accounts contributed $83,000 in additional expense. The impact of the volume
growth on interest expense was not greater because of the relatively low rates
currently being paid. Average advances from the FHLB increased $6,398,000 or
13.3 percent and resulted in an additional $360,000 in interest expense.
14
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
The average rates paid on deposit accounts, short-term borrowings and FHLB
advances decreased in 2002. The rate paid on total interest-bearing liabilities,
including the borrowings from the FHLB, decreased to 3.05 percent in 2002 from
3.92 percent in 2001. The rate paid on interest-bearing deposit accounts
decreased to 2.71 percent in 2002 from 3.66 percent in 2001. Lower rates paid on
interest-bearing demand accounts, money market accounts and savings accounts
decreased interest expense by $161,000, $474,000 and $182,000, respectively in
2002. Among these transaction accounts, the average rate paid on money market
accounts was impacted the most by the decline in interest rates. The yield on
money market accounts declined 127 basis points from 2.78 percent in 2001 to
1.51 percent in 2002. Contributing to the decline in the yield on money market
accounts was the sharp decline in the yield on the Treasury Select Money Market
Account. The sharp decline in the 91-day Treasury rate resulted in significantly
lower rates on this product as compared to 2001. The yield on interest-bearing
demand accounts decreased from .91 percent in 2001 to .64 percent in 2002.
Included in this type of account are the deposits of several municipalities that
have rates that are tied to the Federal funds target rate. The average rate paid
on savings accounts decreased from 1.63 percent in 2001 to 1.19 percent in 2002.
The lower interest rate environment had the greatest impact on time deposits in
2002 as many time deposits with longer original maturities repriced lower during
the year, particularly in the fourth quarter of 2002. Interest expense on time
deposits was $2,445,000 lower in 2002 as a result of lower interest rates. The
average rate paid on time deposits decreased from 5.28 percent in 2001 to 3.96
percent in 2002. Like fixed-rate loans, certificates of deposit reprice over
time and therefore have less of an immediate impact on yield in either a rising
or falling rate environment.
Interest expense on FHLB advances decreased only $160,000, as a result of lower
rates, between 2001 and 2002. The average rate paid on FHLB advances declined
from 5.62 percent in 2001 to 5.33 percent in 2002. The decline in expense and
rate is primarily a result of the lower rate paid on the $5,000,000 in advances
that are variable in nature and are tied to three-month LIBOR. Most of the
advances from the FHLB have fixed rates.
Management expects net interest income to increase slightly in 2004 as a result
of the growth in earning assets offsetting a net interest margin that will
likely be stable or decline slightly. Given the current structure of the balance
sheet with significant cash flow from the investment portfolio expected and the
amount of loans indexed to the prime rate in the loan portfolio, QNB, like many
financial institutions, would benefit from rising interest rates. As mentioned
previously, on the deposit side, interest-bearing transaction accounts have
little ability to reprice lower while the rates paid on time deposits may
decline slightly as some of the time deposits that have not matured and repriced
in the past year will do so. As discussed in the Interest Rate Sensitivity
section, an increase in rates should have a positive impact on net interest
income, as earning assets will reprice faster than interest-bearing liabilities
while a further reduction in rates should have a negative impact on net interest
income.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to be charged to operations to bring the allowance for loan
losses to a level that represents management's best estimate of the known and
inherent losses in the loan portfolio. Actual loan losses, net of recoveries,
serve to reduce the allowance. QNB's management determined no provision for loan
losses was necessary in 2003, 2002 or 2001 as charged off loans, non-performing
assets and delinquent loans remained at low levels relative to the allowance for
loan losses. QNB had net charge-offs of $9,000 in 2003. These charge-offs were
related to consumer loans. QNB had net recoveries of $93,000 during 2002. Most
of the recovery relates to a loan charged off in 2001. Net charge-offs were
$105,000 in 2001. Approximately $83,000 of the total loans charged off in 2001
represents a loan to one borrower. While QNB has not recorded a provision for
loan losses in the past four years, strong growth in the loan portfolio as well
as deterioration in credit quality could impact the need for a provision for
loan losses in the future.
Management, in determining the allowance for loan losses, makes significant
estimates. Consideration is given to a variety of factors in establishing these
estimates including current economic conditions, diversification of the loan
portfolio, delinquency statistics, results of loan reviews, borrowers' financial
and managerial strengths, the adequacy of underlying collateral if collateral
dependent, or the present value of future cash flows. The allowance for loan
losses is dependent, to a great extent, on conditions that are beyond QNB's
control; therefore, it is at least reasonably possible that management's
estimates of the allowance for loan losses and actual results could differ in
the near term. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review QNB's allowance for losses on
loans. These agencies may require QNB to recognize additions to the allowance
based on their judgments about information available to them at the time of
their examination.
NON-INTEREST INCOME
QNB, through its core banking business, generates various fees and service
charges. Total non-interest income is composed of service charges on deposit
accounts, ATM and check card income, income on bank owned life insurance,
mortgage servicing fees, gains or losses on the sale of investment securities,
gains on the sale of residential mortgage loans and 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. In December 2001, QNB
implemented "Free Checking" for personal non-interest bearing checking accounts
and "No-Bounce", an overdraft protection service that will pay overdrafts up to
a predetermined level on all eligible checking accounts. During the third
quarter of 2002, QNB increased its overdraft fee by 7.1 percent.
Total non-interest income was $4,200,000 in 2003 compared to $2,989,000 in 2002,
an increase of 40.5 percent. Excluding gains and losses on the sale of
investment securities and loans in both years, non-interest income increased
$319,000 or 10.3 percent. Included in the results for 2003 was the recognition
of $109,000 from life insurance proceeds.
15
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
NON-INTEREST INCOME (CONTINUED)
When comparing 2002 to 2001, non-interest income decreased 2.6 percent from
$3,070,000 to $2,989,000. Excluding gains and losses on the sale of securities
and loans, non-interest income increased 22.0 percent between 2001 and 2002.
Fees for services to customers, the largest component of non-interest income,
are primarily comprised of service charges on deposit accounts. These fees
increased $215,000 or 13.2 percent during 2003 to $1,849,000. Overdraft income
increased 16.1 percent and accounted for $213,000 of the total increase in
service charge income. The increase in the overdraft fee mentioned earlier, as
well as an increase in the volume of overdrafts, partially as a result of
"No-Bounce", contributed to the increase in overdraft income.
When comparing 2002 to 2001, fees for services to customers increased $197,000
or 13.7 percent during 2002 to $1,634,000. Overdraft income increased $233,000
or 21.4 percent during 2002. Fees for services to customers was also positively
impacted by a $51,000 or 31.6 percent increase in service charges on business
checking accounts. This increase is a function of the lower earnings credit
rate, resulting from the decline in interest rates, applied against balances to
offset service charges incurred, as well as an increase in the number of
business checking accounts.
Partially offsetting these positive variances was a $70,000 reduction in service
charges on personal non-interest bearing checking accounts resulting from the
implementation of "Free Checking". Management believes that the impact of the
loss of this income in 2002 was reduced by the benefit of an increase in low
costing deposit balances and an increase in fees as a result of "No-Bounce".
Average personal non-interest bearing checking account balances increased 11.5
percent when comparing 2002 to 2001 while average business non-interest bearing
checking account balances increased $7,413,000 or 27.7 percent during the same
period.
ATM and check card income is primarily comprised of income on debit cards and
ATM surcharge income for the use of QNB ATM machines by non-QNB customers. ATM
and debit card income was $541,000 for 2003, an increase of $32,000 or 6.3
percent from the amount recorded in 2002. This followed an increase of $40,000
or 8.5 percent between 2001 and 2002. Debit card income increased $36,000 or
10.1 percent to $391,000 in 2003. Debit card income was $355,000 in 2002 and
$299,000 in 2001. The increase in debit card income is a result of increased
acceptance by consumers of the card as a means of paying for goods and services.
Debit card income was negatively impacted in the second half of 2003 as a result
of the legal settlement between the card companies and the retailers. This
settlement resulted in a reduction in the amount earned per transaction. QNB
expects to see a further reduction in debit card income in 2004 as a result of
this settlement. In the first quarter of 2004, QNB introduced a commercial debit
card that will be issued to businesses. This should help generate additional
income to offset the reduction of income on the consumer card.
After increasing for two years, ATM transaction surcharge income decreased
$14,000 or 10.5 percent in 2002 and $19,000 or 15.2 percent in 2003. ATM
transaction surcharge income was $106,000, $125,000 and $139,000 in 2003, 2002
and 2001, respectively. The decline in ATM transaction surcharge income in the
past two years is a result of a reduction in the number of transactions by
non-QNB customers at QNB machines. The increased use of the debit card, the
ability to get cash back at some retailers and the availability of
surcharge-free machines at a convenience store chain, all contribute to the
reduction in the number of transactions.
Income on cash surrender value of insurance represents the earnings on life
insurance policies in which the Bank is the beneficiary. The earnings on these
policies were $330,000, $372,000 and $206,000 for 2003, 2002 and 2001,
respectively. The insurance carriers reset the rates on these policies annually.
The decline in income during 2003 is a result of a lower earnings rate resulting
from the lower interest rate environment. The increase between 2001 and 2002 is
primarily the result of the purchase of an additional $3,000,000 of insurance
during the fourth quarter of 2001. An increase in the earnings rate on another
policy also contributed to the increase in income in 2002.
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. 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
CHANGE FROM PRIOR YEAR
----------------------
NON-INTEREST INCOME COMPARISON 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
2003 2002 2001 AMOUNT PERCENT AMOUNT PERCENT
- ---------------------------------------------------------------------------------------------------------------------------------
Fees for services to customers ................ $1,849 $1,634 $1,437 $ 215 13.2% $ 197 13.7%
ATM and debit card income ..................... 541 509 469 32 6.3 40 8.5
Income on cash surrender value of insurance ... 330 372 206 (42) (11.3) 166 80.6
Mortgage servicing fees ....................... 12 97 36 (85) (87.6) 61 169.4
Net (loss) gain on investment securities ...... (134) (779) 292 645 82.8 (1,071) (366.8)
Net gain on sale of loans ..................... 923 676 244 247 36.5 432 177.0
Other operating income ........................ 679 480 386 199 41.5 94 24.4
- ---------------------------------------------------------------------------------------------------------------------------------
Total ......................................... $4,200 $2,989 $3,070 $1,211 40.5% $ (81) (2.6)%
=================================================================================================================================
16
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
asset is amortized in proportion to and over the period of net servicing income
or loss. Servicing assets are assessed for impairment based on their fair value.
Mortgage servicing fees were $12,000 in 2003 compared to $97,000 in 2002 and
$36,000 in 2001. Included in mortgage servicing income in 2003 and 2001 was a
valuation allowance of $18,000 and $48,000 for the impairment of mortgage
servicing rights. In 2002, QNB realized a partial reversal of $34,000 of the
valuation allowance recorded in 2001. A valuation allowance is usually a result
of an increase in prepayment speeds on residential mortgage loans caused by
declining interest rates and an increase in mortgage refinancing activity.
Excluding the valuation adjustments, mortgage servicing income was $30,000 in
2003, $63,000 in 2002 and $84,000 in 2001. The decline over the past three years
is a result of an increase in amortization expense resulting from the
significant amount of refinancing activity. When a loan is paid off, the
servicing asset related to that mortgage must be expensed. Amortization expense
was $174,000, $91,000 and $62,000 in 2003, 2002 and 2001, respectively.
The volume of mortgages serviced, as well as the timing of mortgage payments and
the level of delinquent mortgages, also impacts the amount of servicing fees
recorded. Another result of the significant refinancing activity is an increase
in the amount of mortgages serviced. The amount of mortgages serviced for others
increased $13,236,000 or 18.5 percent to $84,857,000 at December 31, 2003. The
average balance of mortgages serviced increased $14,532,000 or 21.6 percent to
$81,934,000 when comparing 2003 to 2002. This followed an increase in average
balances of mortgages serviced of 12.7 percent between 2002 and 2001.
QNB recorded a net loss on investment securities of $134,000 in 2003. Included
in this loss was a $105,000 write-down of marketable equity securities whose
decline in market value below cost was deemed to be other than temporary. These
securities were determined to be impaired. During 2003, QNB realized net gains
of $128,000 on the sale of equity securities. In the fixed income portfolio, QNB
recorded losses of $157,000 during 2003. Over the course of the year, several
transactions were entered into in an effort to reposition the portfolio. The
goals of these transactions are to reduce the amount of current cash flow from
the portfolio, reduce the impact of premium amortization and to increase the
overall yield in the portfolio. Management will continue to evaluate strategies
that will result in an increase in the yield on the portfolio.
QNB recorded a net loss on investment securities of $779,000 in 2002. Included
in this loss was a $702,000 write-down of marketable equity securities whose
decline in market value below cost was deemed to be other than temporary. These
securities were determined to be impaired. During 2002, QNB realized net gains
of $39,000 on the sale of equity securities. In the fixed income portfolio, QNB
recorded losses of $116,000 during 2002. During the third quarter of 2002, QNB
sold approximately $3,000,000 in corporate bonds at a net loss of $67,000. These
bonds were sold because of concerns over credit quality. During the fourth
quarter, QNB sold $12,500,000 in collateralized mortgage obligations (CMO) at a
loss of $49,000. These securities were originally purchased at a premium. The
increase in prepayment speeds resulting from the increase in mortgage
refinancing activity caused the premium to be amortized quicker. This has the
impact of reducing the yield on the security. To combat the increase in cashflow
and reduction in yield, QNB sold these securities and used the proceeds to
purchase lower coupon mortgage-backed securities and CMOs.
Net gains on the sale of investment securities were $292,000 in 2001. Included
in the net gains in 2001 is a loss of $683,000 related to the impairment of
marketable equity securities. Several of these securities were subsequently sold
during the fourth quarter of 2001. Offsetting this loss were net gains on
marketable equity securities of $613,000 in 2001. In addition, QNB sold
approximately $15,000,000 in callable agency securities and CMOs at a gain of
$362,000. Mortgage-backed securities were purchased with the proceeds from this
transaction. The purpose of this transaction was to reduce the exposure to
callable agency securities and increased cash flow from the CMOs, in a falling
interest rate environment.
Student and residential mortgage loans to be sold are identified at origination.
The net gain on the sale of loans was $923,000, $676,000 and $244,000 in 2003,
2002 and 2001, respectively. Included within these amounts are gains on the sale
of student loans of $7,000, $35,000 and $49,000, respectively. The decrease in
the gain on the sale relates to the lower volume of loans sold. QNB sold
approximately $403,000, $1,896,000 and $2,680,000 of loans to the Student Loan
Marketing Association (SLMA) during these three years. Effective June 30, 2002,
QNB terminated its agreement with SLMA. QNB no longer originates student loans
for sale, but originates on a referral basis. The balance in the portfolio was
sold during the second quarter of 2003.
The net gain on residential mortgage sales is directly related to the volume of
mortgages sold and the timing of the sales relative to the interest rate
environment. Net gains on the sale of residential mortgages were $916,000 in
2003, $641,000 in 2002 and $195,000 in 2001. Included in the gains on the sale
of residential mortgages in these years were $345,000, $245,000 and $159,000
related to the recognition of mortgage servicing assets. Also included in the
net gain for 2001 was an unrealized loss of $24,000 for loans classified as
held-for-sale as of December 31, 2001.
As discussed earlier, the historically low interest rate environment experienced
over the past three years has provided an opportunity for consumers to purchase
homes or to refinance existing mortgages at significantly lower interest rates.
QNB sold $41,904,000, $24,472,000 and $15,598,000 of residential mortgages in
the secondary market in 2003, 2002 and 2001, respectively. QNB originated
$39,244,000 in mortgage loans held-for-sale in 2003 compared to $27,276,000 and
17
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
NON-INTEREST INCOME (CONTINUED)
$16,830,000 in 2002 and 2001. Selling into a falling interest rate market tends
to increase the gains recorded while selling into a rising interest rate
environment reduces the profitability of the sales.
As of December 31, 2003 and 2002, there were $1,439,000 and $3,924,000 of
residential mortgage loans held-for-sale. These loans are accounted for at lower
of cost or market.
Other operating income was $679,000, $480,000 and $386,000 in 2003, 2002 and
2001, respectively. Included in the results for 2003 was the recognition of
$109,000 from life insurance proceeds. These proceeds are also exempt from
Federal income taxes. In 2001, QNB began offering two new services: trust and
investment management, through an affiliation with the Trust Company of The
Lehigh Valley, and title insurance, through its partnership in Bankers
Settlement Services of Eastern Pennsylvania. Also in 2001, QNB strengthened its
retail non-deposit program by affiliating with Raymond James Financial Services,
Inc. and by retaining its own in-house licensed employee. When comparing 2003 to
2002, retail brokerage income increased $38,000 while dividends from the title
insurance company increased $41,000. Merchant processing income increased
$43,000 when comparing 2003 to 2002. This is a result from an increase in both
the number of merchants and the number of transactions processed. Partially
offsetting these positive variances was a $35,000 decrease in commissions from
consumer loan insurance premiums, the result of rebates on early payoffs.
When comparing 2002 to 2001, trust income and retail brokerage income increased
$26,000 and $50,000, respectively. Income from QNB's investment in Banker's
Settlement Services, Inc. increased $13,000. Included in other operating income
in 2002 was a $21,000 recovery of a check card transaction that had been charged
off in 2001. Partially offsetting these positive variances was a $30,000 decline
in income from official checks. This decline is a function of the lower interest
rate environment.
Financial service organizations, including QNB, are challenged to demonstrate
that they can generate an increased contribution to revenue from non-interest
sources. QNB will continue to analyze other opportunities and products that
could enhance its fee-based businesses.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee
benefits, net occupancy, furniture and equipment, marketing, third party
services and various other operating expenses. Total non-interest expense in
2003 increased $999,000 or 8.4 percent to $12,944,000. This followed an increase
in non-interest expense of $865,000 or 7.8 percent between 2001 and 2002. Total
non-interest expense for 2002 and 2001 was $11,945,000 and $11,080,000,
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, declined from approximately 62.1 percent in
2001 to 61.0 percent in 2003.
Salaries and benefits expense is the largest component of non-interest expense.
Salary and benefits expense for 2003 was $7,334,000, an increase of $803,000 or
12.3 percent over 2002. Salary expense for 2003 increased $597,000 or 11.2
percent to $5,939,000. A significant portion of the increase relates to the
implementation of a new bank-wide incentive compensation plan called
"Stakeholders". This plan provides for the sharing with all employees (excluding
senior management) of incremental income above a Board determined level. This
incremental income is created by increasing net interest income by growing
deposits and originating quality loans at rates that will improve the net
interest margin, or by increasing non-interest income or decreasing non-interest
expense. This plan resulted in a payout of $457,000 or 10.5 percent of eligible
salary. This compares to a payout of $200,000 in 2002 under the previous
incentive plan. Merit increases and an increase in the number of employees also
contributed to the increase in salary expense. The number of full time
equivalent employees increased by five when comparing 2003 to 2002. QNB
monitors, through the use of various surveys, the competitive salary information
in its markets and makes adjustments where appropriate. In addition, in 2002
with the assistance of a consultant, QNB performed a complete analysis of its
compensation program, resulting in pay adjustments for certain positions.
Non-Interest Income
[Bar chart omitted--plot points as follows:]
1999 $ 9,884
2000 $10,232
2001 $11,080
2002 $11,945
2003 $12,944
Non-Interest Expense (IN THOUSANDS)
[Bar chart omitted--plot points as follows:]
1999 $2,208
2000 $2,791
2001 $3,070
2002 $2,989
2003 $4,200
Benefits expense increased by $206,000 or 17.3 percent to $1,395,000 in 2003.
Payroll taxes increased $56,000 or 13.9 percent primarily as a result of the
increase in salary expense. Medical and dental premiums increased $68,000 or
17.9 percent. This is a result of the general increase in medical insurance cost
as well as increase in the number of employees covered by the plan. Retirement
plan expense increased $63,000 or 18.9 percent between 2002 and 2003. This
expense was impacted by an extra pay period in 2003. There were 27 pay periods
in 2003 compared to 26 pay periods in a normal year. This accounts for
approximately $15,000 of the increase. Also impacting retirement plan expense
was the increase in eligible salary. When comparing 2003 to 2002, workers
compensation insurance premiums increased $12,000 or 47.2 percent.
18
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
Salary and benefits expense for 2002 was $6,531,000, an increase of $357,000 or
5.8 percent over 2001. Salary expense for 2002 increased $293,000 or 5.8 percent
to $5,342,000. The increase in salary expense is related to merit increases, an
increase in the number of employees and the impact of an incentive-based sales
program. The number of full time equivalent employees increased by four when
comparing 2002 to 2001.
Benefits expense increased by $64,000 or 5.7% to $1,189,000 in 2002. Payroll
taxes increased $33,000 and retirement plan expense increased $7,000 primarily
as a result of the increase in salary expense. Also contributing to the increase
in benefits expense, when comparing 2002 to 2001, was a $14,000 increase in
dental insurance premiums and a $7,000 increase in tuition reimbursement
programs. Partially offsetting these increases was a decline in medical
insurance premiums of $14,000. The decline in medical insurance premiums is a
result of employees either opting out of coverage or switching to lower cost
coverage.
Furniture and equipment expense was $1,111,000 in 2003, $1,060,000 in 2002 and
$1,008,000 in 2001. Depreciation and amortization expense increased $38,000
between 2003 and 2002 and $47,000 when comparing 2002 to 2001. QNB uses an
accelerated method of depreciation that results in a higher expense the year
after an item is put in service. Contributing to the increase in depreciation
expense in 2003 and 2002 was the installation of a new air conditioning system,
in the main operations building, the implementation of a document imaging
system, the furnishing of a new boardroom and the ongoing replacement of desktop
computers. The Souderton branch was opened in 2001 with the resulting higher
depreciation expense occurring in 2002.
Marketing expense decreased $62,000 or 10.4 percent in 2003 to $536,000. This
followed an increase of $161,000 or 36.8 percent between 2001 and 2002. These
variances are primarily a result of the timing of long-term pledges. During
2002, QNB made several large long-term charitable pledges as well as other
contributions and sponsorships to not-for-profit organizations, clubs and
community events in the local communities we serve. These additional
contributions resulted in a $140,000 increase in expense between 2001 and 2002.
This expense decreased $90,000 between 2002 and 2003. In 2003, QNB increased its
use of outdoor and direct mail advertising to promote its products and services
resulting in an increase of $22,000 in advertising expense. Advertising and
research expense increased $11,000 when comparing 2002 to 2001. The increase in
research expense is the result of additional customer survey activities and the
purchase of data for use in the Marketing Customer Information System (MCIF).
The MCIF system provides valuable information that can be used to target market
existing and potential customers.
Third party services are comprised of professional services including legal,
accounting and auditing, and consulting services, as well as fees paid to
outside vendors for support services of day-to-day operations. These support
services include trust services, retail non-deposit services, correspondent
banking services, statement printing and mailing, investment security
safekeeping and supply management services, to name a few. Third party services
expense was $741,000 in 2003 compared to $640,000 in 2002 and $502,000 in 2001.
Contributing to the increase in third party services between 2002 and 2003 was
the outsourcing of the statement printing and mailing function beginning in the
second quarter of 2003.
Also contributing to the increase in 2003 were consulting and training costs
related to the installation of an upgrade to the item processing system. The use
of an executive search firm to fill an open Trust officer position was also a
major contributor to the increase in third party services when comparing the two
years. The increase in corporate governance as required under the Sarbanes-Oxley
Act of 2002 has also resulted in an increase in both auditing and legal costs.
When comparing 2002 to 2001, consultant expense increased $98,000. QNB used a
consultant to assist in the implementation of a bank-wide sales initiative that
is focused on sales training. In conjunction with this program is a service
initiative that will work to enhance the exceptional personal service that our
customers deserve. As mentioned previously, consultants were used to help review
QNB's base compensation program as well as assist in the implementation of the
"Stakeholders" incentive compensation program in 2003. Increased expenses
related to correspondent banking activity, security safekeeping and auditing and
accounting fees also contributed to the increase in third party services between
2002 and 2001.
CHANGE FROM PRIOR YEAR
----------------------
NON-INTEREST EXPENSE COMPARISON 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------
2003 2002 2001 AMOUNT PERCENT AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------
Salaries and employee benefits ..... $ 7,334 $ 6,531 $ 6,174 $ 803 12.3% $357 5.8%
Net occupancy expense .............. 859 861 854 (2) (.2) 7 .8
Furniture and equipment expense .... 1,111 1,060 1,008 51 4.8 52 5.2
Marketing expense .................. 536 598 437 (62) (10.4) 161 36.8
Third party services ............... 741 640 502 101 15.8 138 27.5
Telephone, postage and supplies .... 556 545 525 11 2.0 20 3.8
State taxes ........................ 331 335 294 (4) (1.2) 41 13.9
Other expense ...................... 1,476 1,375 1,286 101 7.3 89 6.9
- -----------------------------------------------------------------------------------------------------------------------------
Total .............................. $12,944 $11,945 $11,080 $ 999 8.4% $865 7.8%
=============================================================================================================================
19
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
NON-INTEREST EXPENSE (CONTINUED)
The major components of other expense are regulatory costs, insurance costs,
membership fees, courier expense, ATM and debit card expense and directors fees.
Other expense for 2003 was $1,476,000, an increase of $101,000 or 7.3 percent.
Contributing to the variance was a $41,000 increase in debit card expense
related to both costs associated with the production of cards as well as costs
related to increased usage. Expense for directors fees and a director deferred
compensation plan increased $41,000 when comparing 2003 to 2002. Federal Deposit
Insurance premiums and Comptroller of the Currency assessment increased $13,000
in 2003. These costs are calculated on deposit and asset size and increased as a
result of the growth achieved in both.
Other expense increased $89,000 or 6.9 percent to $1,375,000 in 2002.
Contributing to this increase was a $26,000 increase in charged-off deposit
accounts, an $18,000 increase in the Comptroller of the Currency assessment, a
$26,000 increase in ATM and debit card expenses, an $18,000 increase in
membership fees and an $11,000 increase in employee training. Partially
offsetting these increases was a $26,000 decrease in expense related to a
director deferred compensation plan.
INCOME TAXES
Applicable income taxes and effective tax rates were $1,254,000 or 18.2 percent
for 2003 compared to $1,204,000 or 19.5 percent for 2002, and $1,078,000 or 19.6
percent for 2001. Positively impacting the effective tax rate in 2003 was the
reversal of a $95,000 tax valuation recorded in previous periods. The reversal
of the valuation allowance was a result of the ability to realize tax benefits
associated with certain impaired securities, due to the increase in unrealized
gains of certain equity securities held by QNB Corp. The receipt of $109,000 in
tax-exempt life insurance proceeds also had a positive impact on the effective
tax rate in 2003.
FINANCIAL CONDITION
Financial service organizations today are challenged to demonstrate that they
can generate sustainable and consistent earnings growth in an increasingly
competitive and volatile environment. Managing the balance sheet in a
dramatically declining, sometimes volatile, low interest rate environment has
been a major challenge during the past three years. This challenge will likely
continue during 2004, as indications are that interest rates may remain low for
the entire year. It appears that the Federal Reserve Board will remain patient
and not increase the Federal funds rate until they see sustainable employment
growth. Market interest rates will likely move within a range of 50 to 75 basis
points, with the yield curve remaining steep.
QNB's primary competition in the banking segment of the financial services
industry ranges from a mutual thrift institution, to several large community
banks, to a super regional bank. The landscape in which QNB operates continues
to change as several community banks in the area have merged with larger locally
or regionally headquartered community banks. In addition, other strong
competitors continue to move into QNB's market area. The weak economy, which has
reduced the demand for loans, and the increased availability of loans from a
variety of financial service providers has led to increased price competition
for loans. Deposit growth, which for years was a concern of the banking
industry, remained strong. The challenge in 2004 will be to retain and grow
these deposits in a low interest rate environment, particularly if the stock
market continues its rebound. Another challenge will be to maintain or improve
the net interest margin in this extended period of low interest rates.
Total assets at year-end 2003 were $550,831,000, compared with $503,430,000 at
December 31, 2002, an increase of $47,401,000 or 9.4 percent. This followed
growth during 2002 of 11.6 percent. The growth in assets during both years was
fueled by the continued strong inflow of deposits that began in 2001. Lackluster
performance of the stock market since 2000, a slow growing United States
economy, and geopolitical uncertainty have contributed to the inflow of funds
into the banking system. Consumers are looking for the relative safety of bank
deposits despite the low interest rate environment. Also, in 2003, QNB was able
to increase its deposit relationships with several school districts.
Average total assets increased 9.9 percent or $47,280,000 in 2003 to
$526,774,000 and 16.1 percent or $66,595,000 in 2002. Total loans, excluding
loans held-for-sale at December 31, 2003 were $232,127,000, an increase of 9.1
percent from December 31, 2002. This followed a 6.3 percent increase from
December 31, 2002 to December 31, 2001. Average total loans increased 10.5
percent in 2003 and 8.9 percent in 2002. This loan growth was achieved despite
the slow growing economy and the extreme competitive environment for both
commercial and consumer loans. Loan growth remains one of the primary goals of
QNB. Funding sources, which include deposits and borrowed money, increased 10.0
percent from year-end 2002 to year-end 2003 and 11.5 percent from year-end 2001
to year-end 2002. Average funding sources increased 10.0 percent in 2003 and
16.8 percent in 2002. The following discussion will further detail QNB's
financial condition during 2003 and 2002.
20
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
INVESTMENT SECURITIES AND OTHER SHORT-TERM INVESTMENTS
Investment policies, approved by QNB's Board of Directors, include standards
regarding permissible investment categories, credit quality, maturity intervals
and investment concentrations. Total investment securities at December 31, 2003
and 2002 were $276,453,000 and $244,477,000. For the same periods, approximately
65.0 percent and 63.2 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 or collateralized mortgage obligation
securities (CMO).
As of December 31, 2003, QNB held no securities of any one issue or any one
issuer (excluding the U.S. Government and its agencies) that 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, and are short-term
in nature and were only sold to banks with a minimum Sheshunoff rating of "B" at
the date of the sale.
Average investment securities increased $19,980,000 or 8.7 percent to
$250,414,000 in 2003 compared with a $42,450,000 or a 22.6 percent increase in
2002. The significant increase in the investment portfolio in both years was
primarily the result of average deposits growing at a faster rate than average
loans. Approximately $6,398,000 of the average growth in 2002 was the result of
wholesale funding from the FHLB in 2001. These borrowings were used to fund
specific investment strategies.
Average Federal funds sold increased 20.0 percent in 2003 to $11,236,000. This
followed a 27.1 percent increase during 2002 to $9,363,000. The increase in
Federal funds sold is a result of the desire to have more liquidity in light of
the large increase in deposits, particularly short-term time deposits and
transaction accounts.
There was a significant amount of activity in the investment portfolio during
both 2003 and 2002. The historically low interest rate environment has resulted
in a significant amount of prepayments on mortgage-backed securities and CMOs
and increased the calls on agency securities. Proceeds from maturities,
prepayments and calls of investment securities provided $105,086,000 in funds to
invest, while the sale of securities provided another $54,591,000. These funds,
along with the growth in deposits, were used to purchase $194,968,000 in
investment securities during 2003. The strategy entering 2003 was to purchase
mortgage-backed securities and CMOs that would provide cash flow in anticipation
of rising rates. While rates did rise briefly in the beginning of 2003, they
quickly turned around and headed to record lows in June. With this drop in
rates, prepayments on CMOs and mortgage-backed securities increased
substantially resulting in a significant increase in proceeds to invest at lower
interest rates and a large amount of amortization on bonds purchased at a
premium, with a corresponding drop in yield. QNB has attempted to manage the
prepayment situation over the course of the year with several transactions in an
effort to reposition the portfolio. QNB sold certain faster paying CMOs and
mortgage-backed securities and purchased lower coupon, lower premium
mortgage-backed securities and CMOs that will not pay as quickly should rates
stay low or decline further. QNB also sold some 20 and 30 year mortgage-backed
securities whose average life could extend should rates increase. CMOs were
purchased with characteristics that would not produce current cash flow, but
would still have limited extension risk and an average life and duration profile
of less than five years. The goal of these transactions was to reduce the amount
of current cash flow from the portfolio, reduce the impact of premium
amortization, reduce average life extension risk and to increase the overall
yield in the portfolio. In addition, callable agency securities and short
average life CMOs were purchased in an attempt to closely match the anticipated
run-off of municipal deposits received during the third quarter of 2003.
In light of this activity, the composition of the portfolio changed slightly
between 2002 and 2003. Mortgage-backed securities decreased to 24.0 percent of
the portfolio at December 31, 2003, from 28.9 percent while CMOs increased to
25.2 percent of the portfolio from 22.3 percent at December 31, 2002. U.S.
Government agency securities increased to 15.7 percent of the portfolio at
December 31, 2003, from 12.1 percent of the portfolio at December 31, 2002.
Investment Portfolio
[Pie chart omitted--breakdown as follows:]
Mortgage backed
Collateralized mortgage obligations (CMOs)
U.S. Government Agencies
Other Debt Securities
State and Municipal
Equity Securites
U.S. Treasuries
Management anticipates that investment portfolio activity will slow during 2004
as a result of the restructuring transactions previously discussed, as well as
the slowdown in prepayment activity as interest rates have increased from their
lows and refinance activity has slowed. Based on prepayment projections, QNB
estimates that approximately $57,000,000 in cash flow from the portfolio will be
reinvested. These securities have a book yield of approximately 4.27 percent.
This amount could increase if rates decline again and prepayment activity
increases. The anticipated strategy entering 2004, in light of the low interest
rate environment, is to continue to purchase mortgage-backed securities and CMOs
with short average lives and duration. These will provide cash flow to reinvest
when interest rates increase. QNB will also continue to purchase tax-exempt
State and municipal securities with 10 to 15 year maturities because of the
relative value of this sector. The low interest rate environment experienced
over
21
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
INVESTMENT SECURITIES AND OTHER SHORT-TERM INVESTMENTS (CONTINUED)
the past three years has resulted in a significant decline in the yield on the
investment portfolio. The portfolio yield will likely continue to decline in
2004, but at a slower rate, as higher yielding bonds continue to be replaced
with ones having lower yields.
At December 31, 2003 and 2002, investment securities totaling $84,425,000 and
$65,871,000 were pledged as collateral to secure repurchase agreements and
public deposits. The significant increase is a result of successfully acquiring
large deposit relationships from municipalities and school districts.
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. During the second quarter of 2002, management and the
Board of Directors approved that all future purchases of investment securities
will be categorized as available-for-sale. While there is the potential for
increased volatility of shareholders' equity due to market value changes,
management believes it will provide for more flexibility in managing the
portfolio. QNB held no trading securities as of December 31, 2003 and 2002.
INVESTMENTS AVAILABLE-FOR-SALE
Available-for-sale investment securities include securities that management
intends to use as part of its asset/liability management strategy. These
securities may be sold in response to changes in market interest rates and
related changes in the securities prepayment risk or in response to the need for
liquidity. At December 31, 2003, the fair value of investment securities
available-for-sale was $264,441,000 or $3,547,000 above the amortized cost of
$260,894,000. This compares to a fair value of $214,741,000 or $5,524,000 above
the amortized cost of $209,217,000 at December 31, 2002. An unrealized holding
gain of $2,341,000 was recorded as an increase to shareholders' equity as of
December 31, 2003, while an unrealized holding gain of $3,603,000 was recorded
as an increase to shareholders' equity as of December 31, 2002. The
available-for-sale portfolio had a weighted average maturity of approximately 4
years, 1 month at December 31, 2003, and 4 years, 7 months at December 31, 2002.
The weighted average tax-equivalent yield was 4.61 percent and 5.35 percent at
December 31, 2003 and 2002.
The weighted average maturity is based on the stated contractual maturity of all
securities except for mortgage-backed securities and CMOs, which are based on
estimated average life. The maturity of the portfolio may be shorter because of
call features in many of the debt securities and because of prepayments on
mortgage-backed securities and CMOs. However, the estimated average life could
be longer if rates were to increase and principal payments on mortgage-backed
securities and CMOs would slow. The interest rate sensitivity analysis on page
33 reflects the repricing term of the securities portfolio based upon estimated
call dates and anticipated cash flows assuming management's most likely interest
rate environment. The expected repricing term of the available-for-sale
portfolio was 3 years, 7 months at December 31, 2003, and 2 years, 11 months at
December 31, 2002, based on these assumptions.
INVESTMENTS HELD-TO-MATURITY
Investment securities held-to-maturity are recorded at amortized cost. Included
in this portfolio are State and municipal securities and CMOs. They are
designated as held-to-maturity as they are purchased with the intent and ability
to hold to maturity. At December 31, 2003 and 2002, the amortized cost of
investment securities held-to-maturity was $12,012,000 and $29,736,000, and the
fair value was $12,334,000 and $30,386,000, respectively. The held-to-maturity
portfolio had a weighted average maturity of approximately 2 years, 11 months at
December 31, 2003, and 2 years, 1 month at December 31, 2002. The weighted
average tax-equivalent yield was 6.59 percent and 6.14 percent at December 31,
2003 and 2002. The increase in the weighted average maturity and the yield is
primarily a result of the principal reductions on the CMOs during 2003.
Approximately 93.1 percent of the held-to-maturity portfolio is comprised of
State and municipal securities at December 31, 2003.
22
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
INVESTMENT PORTFOLIO HISTORY
- --------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2003 2002 2001
- --------------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES AVAILABLE-FOR-SALE
U.S. Treasuries ................................................... $ 6,792 $ 6,641 $ 6,693
U.S. Government agencies .......................................... 43,279 29,480 29,367
State and municipal securities .................................... 41,076 26,783 17,751
Mortgage-backed securities ........................................ 66,476 70,748 49,055
Collateralized mortgage obligations (CMO) ......................... 68,761 44,409 32,316
Other debt securities ............................................. 25,214 24,530 20,486
Equity securities ................................................. 12,843 12,150 12,434
- --------------------------------------------------------------------------------------------------------------
Total investment securities available-for-sale ................. $ 264,441 $ 214,741 $ 168,102
- --------------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES HELD-TO-MATURITY
State and municipal securities .................................... $ 11,180 $ 19,745 $ 18,629
Collateralized mortgage obligations (CMO) ......................... 832 9,991 24,169
- --------------------------------------------------------------------------------------------------------------
Total investment securities held-to-maturity ................... $ 12,012 $ 29,736 $ 42,798
- --------------------------------------------------------------------------------------------------------------
Total investment securities .................................... $ 276,453 $ 244,477 $ 210,900
==============================================================================================================
INVESTMENT PORTFOLIO WEIGHTED AVERAGE YIELDS
- --------------------------------------------------------------------------------------------------------------------
UNDER 1-5 5-10 OVER 10
DECEMBER 31, 2003 1 YEAR YEARS YEARS YEARS TOTAL
- --------------------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES AVAILABLE-FOR-SALE
U.S. Treasuries:
Fair value ................................... $ 2,519 $ 4,273 - - $ 6,792
Weighted average yield ....................... 2.02% 1.94% - - 1.97%
U.S. Government agencies:
Fair value ................................... - $ 16,703 $ 26,576 - $ 43,279
Weighted average yield ....................... - 3.98% 3.67% - 3.79%
State and municipal securities:
Fair value ................................... - - $ 9,239 $ 31,837 $ 41,076
Weighted average yield ....................... - - 4.79% 6.65% 6.22%
Mortgage-backed securities:
Fair value ................................... - $ 53,164 $ 13,312 - $ 66,476
Weighted average yield ....................... - 4.91% 4.55% - 4.84%
Collateralized mortgage obligations (CMO):
Fair value ................................... $ 417 $ 57,763 $ 10,581 - $ 68,761
Weighted average yield ....................... 6.03% 4.25% 3.74% - 4.18%
Other debt securities:
Fair value ................................... - $ 2,860 $ 17,339 $ 5,015 $ 25,214
Weighted average yield ....................... - 4.13% 7.38% 3.25% 6.09%
Equity securities:
Fair value ................................... - - - $ 12,843 $ 12,843
Weighted average yield ....................... - - - 2.78% 2.78%
- --------------------------------------------------------------------------------------------------------------------
Total fair value ............................... $ 2,936 $ 134,763 $ 77,047 $ 49,695 $264,441
Weighted average yield ......................... 2.59% 4.40% 4.72% 5.28% 4.61%
- --------------------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES HELD-TO-MATURITY
State and municipal securities:
Amortized cost ............................... $ 225 $ 3,494 $ 2,669 $ 4,792 $ 11,180
Weighted average yield ....................... 6.96% 6.27% 6.48% 6.99% 6.64%
Collateralized mortgage obligations (CMO):
Amortized cost ............................... $ 832 - - - $ 832
Weighted average yield ....................... 5.91% - - - 5.91%
- --------------------------------------------------------------------------------------------------------------------
Total amortized cost ........................... $ 1,057 $ 3,494 $ 2,669 $ 4,792 $ 12,012
Weighted average yield ......................... 6.13% 6.27% 6.48% 6.99% 6.59%
- --------------------------------------------------------------------------------------------------------------------
Securities are assigned to categories based on stated contractual maturity
except for mortgage-backed securities and CMOs 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 and a TEFRA adjustment of .13%. Weighted average yields on investment
securities available-for-sale are based on historical cost.
23
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
LOANS
QNB's primary functions and responsibilities are to accept deposits and to make
loans to meet the credit needs of the communities it serves. Loans are a
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 that 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 non-payment 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.
QNB 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. In addition, a bank loan committee and a committee of
the Board of Directors review certain loan requests on a weekly basis.
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. 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 fixed rate home equity loans, floating rate home equity lines of credit,
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. At
December 31, 2003 and 2002, real estate residential loans held-for-sale were
$1,439,000 and $3,924,000. These loans are carried at the lower of aggregate
cost or market.
As mentioned previously, loan growth remains a major objective for 2004. Loan
growth is to be achieved through the use of a formal business development and
calling program encompassing lending personnel, branch personnel and executive
management. This program was strengthened in 2003 by the appointment of a
business development officer. The focus of this program is to both develop new
lending and deposit relationships as well as to strengthen existing
relationships. The initial business development process was enhanced in 2002
with the development of a bank-wide sales initiative that concentrated on sales
training, particularly with regard to identifying lending opportunities. This
program was further expanded in 2003 to include the new incentive compensation
program that rewards employees not only for loan growth, but also for asset
quality and profitability. Despite the weak economy and extremely competitive
environment, QNB was successful in increasing total loans. Loans, net of
unearned income, increased $19,436,000 or 9.1 percent to $232,127,000 at
December 31, 2003. This followed growth of 6.3 percent in 2002. The addition of
the new branch location and geographic market as well as renewed activity, both
commercial and residential, in the Quakertown market have been key to the growth
in loans, especially commercial loans. The entrance into the Souderton market
has provided an opportunity to develop new relationships. QNB will continue to
cultivate all of its market areas for new opportunities.
Total Loans (IN THOUSANDS)
[Bar chart omitted--plot points as follows:]
1999 $172,529
2000 $183,592
2001 $200,089
2002 $212,691
2003 $232,127
The loan portfolio composition changed slightly from year-end 2002. Commercial
and industrial loans increased to 20.3 percent of the portfolio at year-end 2003
from 18.6 percent at December 31, 2002. Construction loans increased from 3.6
percent of the portfolio at December 31, 2002 to 3.9 percent of the portfolio at
December 31, 2003. Loans collateralized by commercial properties increased to
37.3 percent of the portfolio from 34.8 percent, while loans secured by
residential properties decreased to 36.1 percent of the portfolio from 39.9
percent. Consumer loans decreased slightly from 3.0 percent at year-end 2002 to
2.4 percent at December 31, 2003. Consumer loans, especially auto loans, remain
difficult to originate profitably because of the zero rate or low rate loans
offered by the automobile manufacturers.
24
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
LOAN PORTFOLIO
- ---------------------------------------------------------------------------------------------
DECEMBER 31, 2003 2002 2001 2000 1999
- ---------------------------------------------------------------------------------------------
Commercial and industrial ............ $ 47,196 $ 39,546 $ 39,694 $ 39,100 $ 32,003
Agricultural ......................... 14 176 2,622 3,027 1,935
Construction ......................... 9,056 7,687 3,989 380 258
Real estate-commercial ............... 86,707 74,125 71,112 65,271 64,853
Real estate-residential .............. 83,703 84,907 77,273 70,745 68,945
Consumer ............................. 5,604 6,513 5,669 5,264 4,770
- ---------------------------------------------------------------------------------------------
Total loans ....................... 232,280 212,954 200,359 183,787 172,764
Less unearned income ................. 153 263 270 195 235
- ---------------------------------------------------------------------------------------------
Total loans, net of unearned income $232,127 $212,691 $200,089 $183,592 $172,529
=============================================================================================
LOAN MATURITIES AND INTEREST SENSITIVITY
- ---------------------------------------------------------------------
UNDER 1-5 OVER
DECEMBER 31, 2003 1 YEAR YEARS 5 YEARS TOTAL
- ---------------------------------------------------------------------
Commercial and industrial $ 21,763 $ 21,336 $ 4,097 $ 47,196
Agricultural ............ -- 14 -- 14
Construction ............ 2,152 6,904 -- 9,056
Real estate-commercial .. 7,498 9,734 69,475 86,707
Real estate-residential . 8,746 16,621 58,336 83,703
Consumer ................ 1,001 4,410 193 5,604
- ---------------------------------------------------------------------
Total ............... $ 41,160 $ 59,019 $132,101 $232,280
=====================================================================
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, 2003:
Loans with fixed predetermined interest rates $ 72,796
Loans with variable or adjustable interest rates $118,324
NON-PERFORMING ASSETS
- ---------------------------------------------------------------------------------------------------------
DECEMBER 31, 2003 2002 2001 2000 1999
- ---------------------------------------------------------------------------------------------------------
Loans past due 90 days or more not on non-accrual status
Commercial and industrial .......................... $ - $ - $ - $ - $ -
Construction ....................................... - - - - -
Real estate-commercial ............................. - - - - -
Real estate-residential ............................ - - 305 - 33
Consumer ........................................... 11 7 11 4 6
- ---------------------------------------------------------------------------------------------------------
Total loans past due 90 days or more and accruing 11 7 316 4 39
Loans accounted for on a non-accrual basis
Commercial and industrial .......................... 392 - - 42 54
Construction ....................................... - - - - -
Real estate-commercial ............................. 17 - - - 171
Real estate-residential ............................ 409 650 280 163 259
Consumer ........................................... - - - - -
- ---------------------------------------------------------------------------------------------------------
Total non-accrual loans ......................... 818 650 280 205 484
Other real estate owned ............................... - - - - 348
Repossessed assets .................................... - 11 - - -
- ---------------------------------------------------------------------------------------------------------
Total non-performing assets ..................... $829 $668 $596 $209 $871
=========================================================================================================
Total as a percent of total assets .................... .15% .13% .13% .06% .25%
25
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
LOANS (CONTINUED)
The commercial and industrial loan category experienced strong growth,
increasing $7,650,000 or 19.3 percent to end the year 2003 at $47,196,000.
Although a certain number of these loans are considered unsecured, the majority
are secured by non-real estate collateral such as equipment, vehicles, accounts
receivable and inventory. Loans secured by commercial real estate increased by
$12,582,000 or 17.0 percent in 2003, following a 4.2 percent increase between
December 31, 2001 and 2002. QNB's commercial loans are not considered to be
concentrated within any one industry, except those loans to real estate
developers and investors that account for $40,106,000 or 17.3 percent of the
loan portfolio at December 31, 2003. This is an increase from the $28,914,000 or
13.6 percent of the loan portfolio at December 31, 2002. Concentration is based
upon Standard Industrial Classification codes used for bank regulatory purposes
and is considered to be 10.0 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.
Residential real estate loans decreased by $1,204,000 or 1.4 percent to
$83,703,000 at December 31, 2003. The growth in home equity loans of $5,180,000,
both fixed rate and lines of credit, while strong, could not offset the
reduction of residential mortgage loans of $8,849,000 during the year. Home
equity loans have been popular with consumers; especially those refinancing
existing residential mortgage loans, because they have lower origination costs
than residential mortgage loans. The decrease in loans secured by residential
properties is a result of the decision by management to sell most residential
mortgage loan production in the secondary market because of the interest rate
risk associated with the low rates.
NON-PERFORMING ASSETS
Non-performing assets include accruing loans past due 90 days or more,
non-accruing loans, restructured loans, other real estate owned and other
repossessed assets. The chart on page 25 shows the history of non-performing
assets over the past five years. Total non-performing assets were $829,000 at
December 31, 2003, or .15 percent of total assets. This represents a slight
increase from the December 31, 2002 balance of $668,000. Non-performing assets
at December 31, 2002 represented .13 percent of total assets. Despite the small
increase in 2003, non-performing assets as a percent of total assets remain at
low levels historically and compared to peer groups.
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.
Included in the loan portfolio are loans on non-accrual status of $818,000 and
$650,000 at December 31, 2003 and 2002. If interest on non-accrual loans had
been accrued throughout the period, interest income for the years ended December
31, 2003, 2002 and 2001 would have increased approximately $40,000, $19,000 and
$21,000, respectively. The amount of interest income on these loans included in
net income in 2003, 2002 and 2001 was $55,000, $31,000 and $19,000,
respectively. There were no restructured loans as of December 31, 2003 or 2002,
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 in non-accrual loans. There was no other real estate owned as of
December 31, 2003 or 2002. Repossessed assets at December 31, 2002 amounted to
$11,000. There were no repossessed assets at December 31, 2003.
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 $5,348,000 and $6,373,000 at December 31, 2003 and
2002, respectively.
The economic data during 2003, while mixed, showed signs of an improving
economy. However, with the continued threat of terrorism and the reluctance of
corporations to spend or hire, the economy could continue to be sluggish in
2004. Therefore, the potential exists for an increase in non-performing loans if
the economy does not improve in 2004.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses represents management's best estimate of the known
and inherent losses in the existing loan portfolio. The determination of an
appropriate level of the allowance for loan losses is based upon an analysis of
the risks inherent in QNB's loan portfolio. Management uses various tools to
assess the appropriateness of the allowance for loan losses. One tool is a model
recommended by the Office of the Comptroller of the Currency. This model
considers a number of relevant factors including: historical loan loss
experience, the assigned risk rating of the credit, current and projected credit
worthiness of the borrower, current value of the underlying collateral, levels
of and trends in delinquencies and non-accrual loans, trends in volume and terms
of loans, concentrations of credit, and national and local economic trends and
conditions. This model is supplemented with another analysis that also
incorporates commercial loan risk ratings, exceptions to QNB's loan policy, and
QNB's portfolio exposure to borrowers with large dollar concentration. Other
tools include ratio analysis and peer group analysis.
26
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
ALLOWANCE FOR LOAN LOSS ALLOCATION
- --------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2003 2002 2001 2000 1999
- --------------------------------------------------------------------------------------------------------------------------------
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 .... $ 685 20.3% $ 521 18.6% $ 531 19.8% $ 892 21.3% $ 684 18.5%
Agricultural ................. - - 2 .1 32 1.3 41 1.6 31 1.1
Construction ................. 123 3.9 103 3.6 62 2.0 10 .2 42 .2
Real estate-commercial ....... 1,277 37.3 1,140 34.8 1,148 35.5 975 35.5 902 37.5
Real estate-residential ...... 256 36.1 358 39.9 306 38.6 412 38.5 494 39.9
Consumer ..................... 21 2.4 25 3.0 23 2.8 42 2.9 64 2.8
Unallocated .................. 567 789 743 578 979
- --------------------------------------------------------------------------------------------------------------------------------
Total ..................... $ 2,929 100.0% $2,938 100.0% $ 2,845 100.0% $2,950 100.0% $3,196 100.0%
================================================================================================================================
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
- ----------------------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
- ----------------------------------------------------------------------------------------------------------------
Allowance for loan losses:
Balance, January 1 ......................... $ 2,938 $ 2,845 $ 2,950 $ 3,196 $ 2,951
Charge-offs
Commercial and industrial ............... - - 86 163 3
Construction ............................ - - - - -
Real estate-commercial .................. - - - 67 -
Real estate-residential ................. - 6 32 27 4
Consumer ................................ 28 33 31 7 15
- ----------------------------------------------------------------------------------------------------------------
Total charge-offs ....................... 28 39 149 264 22
Recoveries
Commercial and industrial ............... - 83 6 2 -
Construction ............................ - - - - -
Real estate-commercial .................. - - 22 10 8
Real estate-residential ................. 1 35 8 4 12
Consumer ................................ 18 14 8 2 7
- ----------------------------------------------------------------------------------------------------------------
Total recoveries ........................ 19 132 44 18 27
- ----------------------------------------------------------------------------------------------------------------
Net recoveries (charge-offs) ............... (9) 93 (105) (246) 5
Provision for loan losses .................. - - - - 240
- ----------------------------------------------------------------------------------------------------------------
Balance, December 31 ....................... $ 2,929 $ 2,938 $ 2,845 $ 2,950 $ 3,196
================================================================================================================
TOTAL LOANS:
Average ................................. $229,001 207,238 190,290 177,678 172,929
Year-end ................................ 232,127 212,691 200,089 183,592 172,529
RATIOS:
Net charge-offs (recoveries) to:
Average loans ........................... - (.04)% .06% .14% -
Loans at year-end ....................... - (.04) .05 .13 -
Allowance for loan losses ............... .3% (3.17) 3.69 8.34 (.16)%
Provision for loan losses ............... - - - - (2.08)
Allowance for loan losses to:
Average loans ........................... 1.28% 1.42% 1.50% 1.66% 1.88%
Loans at year-end ....................... 1.26 1.38 1.42 1.61 1.85
Non-performing loans .................... 353.32 447.18 477.35 1411.48 611.09
27
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
ALLOWANCE FOR LOAN LOSSES (CONTINUED)
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 during the loan review function. In
addition, QNB has a committee that meets quarterly to review the appropriateness
of the allowance for loan losses based on the current and projected status of
all relevant factors pertaining to the loan portfolio.
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, 2003 and 2002, the recorded investment in loans for which
impairment has been recognized totaled $796,000 and $579,000 of which $404,000
and $579,000 required no allowance for loan loss. As of December 31, 2003,
$392,000 of loans required an allowance for loan loss of $100,000. Most of the
loans identified as impaired are collateral-dependent. For the years ended
December 31, 2003, 2002 and 2001, the average recorded investment in impaired
loans was approximately $508,000, $699,000 and $207,000, respectively. QNB
recognized $56,000, $68,000 and $100,000 of interest income on these loans in
those years.
QNB had net charge-offs related to consumer loans of $9,000 in 2003. QNB had net
recoveries of $93,000 during 2002. Most of the recovery relates to a loan
charged off in 2001. Net charge-offs were $105,000 in 2001. Approximately
$83,000 of the total loans charged off in 2001 represents a loan to one
borrower.
The allowance for loan losses was $2,929,000 at December 31, 2003, which
represents 1.26 percent of total loans, compared to $2,938,000 or 1.38 percent
of total loans at December 31, 2002. QNB did not add to the allowance for loan
losses, with a provision for loan losses, during any of the past four years
because of the continued low levels of non-performing assets, delinquent loans,
and charge-offs.
Management, in determining the allowance for loan losses, makes significant
estimates. Consideration is given to a variety of factors in establishing these
estimates including current economic conditions, diversification of the loan
portfolio, delinquency statistics, results of loan reviews, borrowers' perceived
financial and managerial strengths, the adequacy of underlying collateral, if
collateral dependent, or the present value of future cash flows. The allowance
for loan losses is dependent, to a great extent, on conditions beyond QNB's
control. It is therefore possible that management's estimates of the allowance
for loan losses and actual results could differ in the near term. In addition,
various regulatory agencies, as an integral part of their examination process,
periodically review QNB's allowance for losses on loans. These agencies may
require QNB to recognize additions to the allowance based on their judgments
using information available to them at the time of their examination.
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 $49,726,000 or 12.8 percent to $438,639,000 at December
31, 2003. This marked the third consecutive year of double-digit growth as
deposits in 2002 and 2001 increased by 12.8 percent and 17.3 percent,
respectively. The growth achieved in 2003 was somewhat different than what
occurred in 2002 and 2001. A significant portion of the growth in 2003 was a
result of the ability of QNB to increase its relationships with several school
districts. Deposit growth in both 2002 and 2001 was more consumer driven and was
aided by continued lackluster performance in the stock market. Consumers were
looking for the relative safety of bank deposits despite the relatively low
interest rate environment. The tragic events of September 11 may have played a
part in the growth in 2001, as approximately 40.0 percent of the growth in
deposits occurred during the fourth quarter. Growth in deposits during 2002
occurred across all product lines while most of the growth in 2003 was in
non-interest bearing demand accounts and savings accounts.
Interest bearing demand accounts increased $37,170,000 or 52.7 percent to
$107,648,000 at December 31, 2003. This followed growth of 27.9 percent between
December 31, 2001 and 2002. Much of the growth over the past two years can be
attributed to the development of relationships with several school districts and
municipalities. Most of these deposits are seasonal and will likely be withdrawn
during the first half of 2004. It is anticipated that these funds will flow back
in during the third quarter of 2004.
Savings accounts increased $6,670,000 or 14.7 percent to $52,008,000 at December
31, 2003 and $8,178,000 or 22.0 percent during 2002. It appears that consumers
are looking for the relative safety of bank deposits and the flexibility of
savings accounts despite the low interest rates.
The "Free Checking" promotion, as well as the acquisition of new business
accounts were significant factors in the increase in non-interest bearing
deposits over the past two years. Non-interest bearing demand accounts increased
7.2 percent in 2003 to $50,468,000. When comparing 2002 to 2001, non-interest
bearing demand deposits increased $7,001,000 or 17.5 percent to $47,079,000.
28
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
Average Deposits (IN THOUSANDS)
[Bar chart omitted--plot points as follows:]
1999 $284,516
2000 $292,273
2001 $312,509
2002 $371,718
2003 $419,089
Time deposit accounts continued to increase in 2003 but at a much slower rate
than in either 2002 or 2001. Total time deposits increased only 1.9 percent or
$3,465,000 to $190,142,000 at December 31, 2003. This compares to a 5.6 percent
or $9,866,000 increase in 2002 and 30.7 percent or $41,530,000 increase in
2001. Another difference in the growth pattern of time deposits between the
past two years and 2001 was the maturity time frame selected by customers. In
2001, the majority of the new time deposits were opened with maturities under
one year, while in 2002 and 2003 customers extended the maturities and opened
accounts with three to five year maturities. It appears that customers were
looking to achieve the highest yields possible in this low interest rate
environment.
An analysis of the change in average deposits provides a more meaningful measure
of deposit change. Average total deposits increased 12.7 percent in 2003 and
18.9 percent in 2002. Average non-interest bearing deposits increased 12.8
percent to $49,164,000 in 2003. This followed a 23.8 percent increase in 2002.
Average interest-bearing demand accounts increased 43.5 percent in 2003 to
$87,570,000 and 21.8 percent in 2002 to $61,006,000. Most of the growth in
non-interest bearing demand deposits occurred during the third quarter of 2003.
Non-interest bearing and interest-bearing demand deposits are important sources
of funds for QNB because they are low cost. Average money market accounts
decreased 2.8 percent in 2003. This followed a decrease of 2.1 percent when
comparing 2002 to 2001. Average time deposits increased 3.9 percent in 2003
compared to an increase of 23.4 percent in 2002. The growth in time deposits at
the end of 2001 had a significant impact on the averages for 2002.
Attracting and retaining deposits, while not a significant concern in any of the
past three years, may once again become an issue facing the banking industry.
The equity markets rebounded in 2003 from three down years and may once again be
an attractive alternative to low rate bank deposits. To continue to attract and
retain deposits, QNB plans to be competitive with respect to rates and to
continue to deliver products that appeal to customers.
AVERAGE DEPOSITS BY MAJOR CLASSIFICATION
- ---------------------------------------------------------------------------------------------------
2003 2002 2001
- ---------------------------------------------------------------------------------------------------
BALANCE RATE BALANCE RATE BALANCE RATE
- ---------------------------------------------------------------------------------------------------
Non-interest bearing deposits ... $ 49,164 - $ 43,569 - $ 35,193 -
Interest-bearing demand accounts 87,570 .63% 61,006 .64% 50,106 .91%
Money market accounts ........... 36,138 .83 37,171 1.51 37,982 2.78
Savings ......................... 50,616 .64 41,764 1.19 36,684 1.63
Time ............................ 152,321 2.96 141,854 4.12 126,629 5.32
Time deposits of $100,000
or more ....................... 43,289 2.49 46,354 3.48 25,915 5.10
- ---------------------------------------------------------------------------------------------------
Total ........................ $419,098 1.61% $371,718 2.40% $312,509 3.25%
===================================================================================================
MATURITY OF TIME DEPOSITS OF $100,000 OR MORE
- -------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003 2002 2001
- -------------------------------------------------------------------
Three months or less ................ $11,004 $13,322 $ 8,769
Over three months through six months 4,949 7,074 8,845
Over six months through twelve months 7,906 11,667 19,360
Over twelve months .................. 14,979 8,765 4,870
- -------------------------------------------------------------------
Total ............................ $38,838 $40,828 $41,844
===================================================================
29
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
LIQUIDITY
Liquidity represents an institution's ability to generate cash or otherwise
obtain funds at reasonable rates to satisfy our commitments to borrowers and
demands of our depositors. QNB manages its mix of cash, Federal funds sold,
investment securities and loans, in order to match the volatility, seasonality
and growth trends of its deposit funds. Liquidity is provided from asset sources
through maturities and repayments of loans and investment securities, net
interest income and fee income. The portfolio of investment securities
available-for-sale and QNB's policy of selling certain residential mortgage
originations and student loans in the secondary market also provide sources of
liquidity. Additional sources of liquidity are provided by the Bank's membership
in the Federal Home Loan Bank and a $5,000,000 unsecured Federal funds line
granted by a correspondent bank.
Cash and due from banks, Federal funds sold, available-for-sale securities and
loans held-for-sale totaled $291,946,000 at December 31, 2003 and $246,377,000
at December 31, 2002. These sources were adequate to meet seasonal deposit
withdrawals during the year 2003 and should be adequate to meet normal
fluctuations in loan demand and deposit withdrawals. QNB has been able to fund
the growth in earning assets during 2003 and 2002 through increased deposits.
QNB used its Federal funds line several times during the month of December 2003,
but did not require any overnight borrowings from either the FHLB or the Federal
Reserve discount window to fund loan growth or deposit withdrawals during 2003.
The overnight borrowings in December 2003 resulted from some short-term timing
differences between the receipt of cash flow from investment securities and
deposit withdrawals from both time deposit accounts with balances greater than
$100,000 and municipal deposits.
Approximately $82,982,000 and $65,871,000 of available-for-sale securities at
December 31, 2003 and 2002 were pledged as collateral for repurchase agreements
and deposits of public funds. In addition, under terms of its agreement with the
Federal Home Loan Bank, QNB maintains otherwise unencumbered qualifying assets
(principally 1-4 family residential mortgage loans and U.S. Government and
Agency notes, bonds, and mortgage-backed securities) in the amount of at least
as much as its advances from the Federal Home Loan Bank. The significant
increase in both liquidity sources and pledged amounts relate to the municipal
deposits received during the third quarter of 2003. These deposits were used to
purchase available-for-sale securities that were used to pledge against the
deposits of the municipalities.
The consolidated statements of cash flows present the changes in cash and cash
equivalents from operating, investing and financing activities. QNB's cash and
cash equivalents decreased $1,411,000 to $26,066,000 at December 31, 2003. This
follows an increase in 2002 of $3,596,000.
After adjusting net income for non-cash transactions, operating activities
provided $9,652,000 in cash flow in 2003, compared to $2,089,000 in 2002. The
primary difference between the two years relates to the held-for-sale mortgage
activity. Net mortgage activity of $2,660,000 was a source of cash in 2003 but a
use of $2,804,000 in 2002. This is partially a function of the timing of loan
originations and sales as the amount of mortgages held-for-sale at the end of
2003 decreased by $2,485,000 compared to the end of 2002. A decrease in other
liabilities of $1,336,000 was a use of cash in 2002. The decrease in other
liabilities relates to the purchase of a security in December 2001 that the
broker failed to deliver until January 2002. The purchase was booked as an
investment since QNB was the owner and a liability was recorded.
Net cash used by investing activities was $54,820,000 in 2003 compared to
$43,945,000 in 2002. The purchase of investment securities exceeded the
maturity, call and sale of securities by $35,291,000 in 2003 and $31,291,000 in
2002. Most of the investment activity in 2003 and 2002 was funded by deposit
growth. An increase in loans, excluding loans held-for-sale, of $19,050,000 and
$11,934,000 was also a use of cash during 2003 and 2002.
Cash provided by financing activities was $43,757,000 and $45,452,000 in 2003
and 2002. Increases in non-interest bearing and interest-bearing non-maturity
deposits provided $3,389,000 and $42,872,000 in cash during 2003 and $7,001,000
and $27,315,000 during 2002. Total time deposits increased $3,465,000 during
2003 with time deposits less than $100,000 increasing $5,455,000 and time
deposits greater than $100,000 decreasing $1,990,000. In 2002, total time
deposits increased $9,866,000 with time deposits less than $100,000 increasing
$10,882,000. Time deposits provide the highest yielding alternative for QNB's
customers. Short-term borrowings, primarily cash management accounts, decreased
$4,069,000 in 2003. The decrease in short-term borrowings is primarily the
reduction of balances held by one repurchase agreement customer. An additional
$2,000,000 advance from the FHLB was a source of cash in 2002. The cash dividend
of $2,042,000 in 2003 and $1,848,000 in 2002 were both uses of cash and
reductions to shareholders' equity in 2003 and 2002.
CAPITAL ADEQUACY
A strong capital position is fundamental to support continued growth and
profitability, to serve the needs of depositors, and to yield an attractive
return for shareholders. QNB's shareholders' equity at December 31, 2003 was
$43,440,000 or 7.89 percent of total assets, compared to shareholders' equity
of $40,914,000 or 8.13 percent at December 31, 2002. At December 31, 2003,
shareholders' equity included a positive adjustment of $2,341,000 related to
the unrealized holding gain, net of taxes, on investment securities
available-for-sale,
30
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
while shareholders' equity at December 31, 2002 included a positive adjustment
of $3,603,000. Without these adjustments, shareholders' equity to total assets
would have been 7.46 percent and 7.41 percent at December 31, 2003 and 2002,
respectively. The increase in the ratio is a result of the rate of capital
retention exceeding the rate of asset growth. Total assets increased 9.4 percent
between December 31, 2002 and December 31, 2003 while shareholders' equity,
excluding the net unrealized holding gains, increased 10.2 percent.
Average shareholders' equity and average total assets were $39,286,000 and
$526,774,000 during 2003, an increase of 10.0 percent and 9.9 percent compared
to 2002. The ratio of average total equity to average total assets was 7.46
percent for 2003, compared to 7.45 percent for 2002.
Shareholders' Equity (IN THOUSANDS)
[Bar chart omitted--plot points as follows:]
1999 $27,462
2000 $31,794
2001 $35,219
2002 $40,914
2003 $43,440
The Corporation is subject to restrictions on the payment of dividends to its
shareholders 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 in the
National Bank Act. Generally, the National Bank Act permits the Bank to declare
dividends in 2003 of approximately $7,171,000, plus an amount equal to the net
profits of the Bank in 2004 up to the date of any such dividend declaration. QNB
Corp. paid dividends to its shareholders of $.66 per share in 2003, an increase
of 10.0 percent from the $.60 per share paid in 2002.
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
average 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.
Based on the requirements, QNB has a Tier I capital ratio of 12.49 percent and
12.40 percent, a total risk-based ratio of 13.39 percent and 13.39 percent, and
a leverage ratio of 7.38 percent and 7.44 percent at December 31, 2003 and 2002,
respectively. The decrease in the leverage ratio is a result of average assets
increasing at a faster rate than Tier I capital.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established
five capital level designations ranging from "well capitalized" to "critically
undercapitalized." At December 31, 2003 and 2002, 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.
CAPITAL ANALYSIS
- --------------------------------------------------------------
DECEMBER 31, 2003 2002
- --------------------------------------------------------------
TIER I
Shareholders' equity ..................... $43,440 $40,914
Net unrealized securities gains .......... (2,341) (3,603)
Net unrealized losses equity securities .. (14) (321)
Intangible assets ........................ (208) (275)
- --------------------------------------------------------------
Total Tier I risk-based capital .......... 40,877 36,715
TIER II
Allowable portion of the allowance
for loan losses ........................ $ 2,929 $ 2,938
- --------------------------------------------------------------
Total risk-based capital ................. $ 43,806 $ 39,653
==============================================================
Risk-weighted assets ..................... $327,243 $296,146
==============================================================
CAPITAL RATIOS
- --------------------------------------------------------------
DECEMBER 31, 2003 2002
- --------------------------------------------------------------
Tier I capital/risk-weighted assets ...... 12.49% 12.40%
Total risk-based capital/
risk-weighted assets ................... 13.39 13.39
Tier I capital/average assets
(leverage ratio) ....................... 7.38 7.44
31
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
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 because changes in interest rates do not impact all
categories of assets and liabilities equally or simultaneously. Interest rate
sensitivity analysis also involves assumptions on certain categories of assets
and deposits. For purposes of interest rate sensitivity analysis, assets and
liabilities are stated at their contractual maturity, estimated likely call
date, or earliest repricing opportunity. Mortgage-backed securities, CMOs and
amortizing loans are scheduled based on their anticipated cash flow. Savings
accounts, including passbook, statement savings, money market, and
interest-bearing demand accounts, do not have a stated maturity or repricing
term and can be withdrawn or repriced at any time. This may impact QNB's margin,
if more expensive alternative sources of deposits are required to fund loans or
deposit run-off. Management projects the repricing characteristics of these
accounts based on historical performance and assumptions that it believes
reflect their rate sensitivity. The Treasury Select Indexed Money Market account
reprices monthly, based on a percentage of the average of the 91-day Treasury
bill.
A positive gap results when the amount of interest rate sensitive assets exceeds
interest rate sensitive liabilities. A negative gap results when the amount of
interest rate sensitive liabilities exceeds interest rate sensitive assets.
QNB primarily focuses on the management of the one-year interest rate
sensitivity gap. At December 31, 2003, interest earning assets scheduled to
mature or likely to be called, repriced or repaid in one year were $228,699,000.
Interest sensitive liabilities scheduled to mature or reprice within one year
were $187,010,000. The one-year cumulative gap, which reflects QNB's interest
sensitivity over a period of time, was a positive $31,796,000 at December 31,
2003. The cumulative one-year gap equals 8.03 percent of total rate sensitive
assets. This positive or asset sensitive gap will generally benefit QNB in a
rising interest rate environment, while falling interest rates could negatively
impact QNB. QNB's one-year cumulative gap position at December 31, 2002 was a
positive $56,001,000. This reduction in the positive gap position is primarily a
result of repositioning of the investment portfolio to reduce current cash flow.
The increase in municipal deposits in 2003, which are assumed to be short-term
also had the impact of reducing the positive gap position. Partially offsetting
this was the continued lengthening of the maturities of time deposits. As of
December 31, 2003, $93,807,000 or 49.3 percent of time deposits mature or
reprice within the next twelve months. This compares to $113,024,000 or 60.5
percent at December 31, 2002. QNB has been able to extend the maturity of its
time deposits by promoting time deposits with maturities of 30 months or longer.
It appears that customers are looking to achieve the highest yields possible in
this low interest rate environment.
QNB also uses a simulation model to assess the impact of changes in interest
rates on net interest income. The model reflects management's assumptions
related to asset yields and rates paid on liabilities, deposit sensitivity, and
the size, composition and maturity or repricing characteristics of the balance
sheet. The assumptions are based on what management believes, at that time, to
be the most likely interest rate environment. Management also evaluates the
impact of higher and lower interest rates by simulating the impact on net
interest income of changing rates 100, 200 and 300 basis points.
Actual results may differ from simulated results due to various factors
including time, magnitude and frequency of interest rate changes, the
relationship or spread between various rates, loan pricing and deposit
sensitivity, and asset/liability strategies. Based on the simulation model, net
interest income in 2004 is expected to increase slightly compared to amounts
reported in 2003. The projected increase in net interest income is principally
the result of the growth in earning assets offsetting the impact of a further
decline in the net interest margin.
If interest rates are 100 basis points higher than management's most likely
interest rate environment, the simulation model projects net interest income for
the next twelve months to be higher than the most likely scenario. If interest
rates are 100 basis points lower than management's most likely interest rate
environment, the model projects net interest income to be significantly lower
for the next twelve months than the most likely scenario. The reduction in net
interest income is a result of floors built into the deposit assumptions because
management believes it would be difficult to reduce rates paid on deposits much
further. However, rates on earning assets would reprice lower. The direction of
these results is consistent with the results anticipated from the gap analysis.
While management performs a downward rate shock of 100, 200 and 300 basis
points, it believes, given the current level of interest rates, that it is
unlikely that interest rates would decline by 200 or 300 basis points.
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.
32
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
INTEREST RATE SENSITIVITY
- -------------------------------------------------------------------------------------------------------------------------
WITHIN 3 TO 6 6 MONTHS 1 TO 3 3 TO 5 AFTER
DECEMBER 31, 2003 3 MONTHS MONTHS TO 1 YEAR YEARS YEARS 5 YEARS TOTAL
- -------------------------------------------------------------------------------------------------------------------------
Assets
Interest-bearing balances ............ $ 849 - - - - - $ 849
Federal funds sold ................... 4,532 - - - - - 4,532
Investment securities* ............... 28,727 $ 13,949 $ 22,983 $ 63,086 $ 67,847 $ 76,314 272,906
Loans, including loans held-for-sale . 87,766 20,639 41,669 61,083 17,426 4,983 233,566
Cash surrender value of life insurance - - 7,585 - - - 7,585
- -------------------------------------------------------------------------------------------------------------------------
Total rate sensitive assets .......... 121,874 34,588 72,237 124,169 85,273 81,297 $519,438
Total cumulative assets .............. $121,874 $156,462 $228,699 $352,868 $438,141 $519,438
=========================================================================================================================
Liabilities
Interest-bearing non-maturing deposits $ 70,343 $ 3,218 $ 4,226 $ 6,231 $ 2,774 $111,237 $198,029
Time deposits less than $100,000 ..... 24,922 16,717 28,309 63,790 17,566 - 151,304
Time deposits over $100,000 .......... 11,004 4,949 7,906 11,059 3,920 - 38,838
Short-term borrowings ................ 10,416 - - - - - 10,416
Federal Home Loan Bank advances ...... 5,000 - - - - 50,000 55,000
- -------------------------------------------------------------------------------------------------------------------------
Total rate sensitive liabilities ..... 121,685 24,884 40,441 81,080 24,260 161,237 $453,587
Total cumulative liabilities ......... $121,685 $146,569 $187,010 $268,090 $292,350 $453,587
=========================================================================================================================
Gap during period .................... $ 189 $ 9,704 $ 31,796 $ 43,089 $ 61,013 $ (79,940) $ 65,851
=========================================================================================================================
Cumulative gap ....................... $ 189 $ 9,893 $ 41,689 $ 84,778 $145,791 $ 65,851
=========================================================================================================================
Cumulative gap/rate sensitive assets . 0.04% 1.90% 8.03% 16.32% 28.07% 12.68%
=========================================================================================================================
Cumulative gap ratio ................. 1.00 1.07 1.22 1.32 1.50 1.15
=========================================================================================================================
* Excludes unrealized holding gain on available-for-sale securities of $3,547.
The table below summarizes estimated changes in net interest income over the
next twelve-month period, under various interest rate scenarios.
- --------------------------------------------------------------------------------
CHANGE IN INTEREST RATES NET INTEREST INCOME DOLLAR CHANGE PERCENT CHANGE
================================================================================
DECEMBER 31, 2003
- --------------------------------------------------------------------------------
+300 Basis Points .............. $15,887 $ 146 .93%
+200 Basis Points .............. 16,209 468 2.97
+100 Basis Points .............. 16,182 441 2.80
FLAT RATE ...................... 15,741 - -
- -100 Basis Points .............. 13,890 (1,851) (11.76)
- -200 Basis Points .............. 11,802 (3,939) (25.02)
- -300 Basis Points .............. 10,076 (5,665) (35.99)
================================================================================
DECEMBER 31, 2002
- --------------------------------------------------------------------------------
+300 Basis Points .............. $16,804 $ 1,719 11.40%
+200 Basis Points .............. 16,646 1,561 10.35
+100 Basis Points .............. 16,480 1,395 9.25
FLAT RATE ...................... 15,085 - -
- -100 Basis Points .............. 14,250 (835) (5.54)
- -200 Basis Points .............. 13,459 (1,626) (10.78)
- -300 Basis Points .............. 12,476 (2,609) (17.30)
33
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS
INTEREST RATE SENSITIVITY (CONTINUED)
In the event QNB should experience a mismatch in its desired gap ranges or an
excessive decline in its net interest income subsequent to an immediate and
sustained change in interest rates, it has a number of options that it could
utilize to remedy such a mismatch. QNB could restructure its investment
portfolio through the sale or purchase of securities with more favorable
repricing attributes. It could also emphasize loan products with appropriate
maturities or repricing attributes, or it could attract deposits or obtain
borrowings with desired maturities.
QNB's business is not subject to foreign currency exchange or commodity price
risk. Neither the Corporation nor the Bank owns trading assets. At December 31,
2003, QNB did not have any hedging transactions in place such as interest rate
swaps, caps or floors.
CONTRACTUAL OBLIGATIONS, COMMITMENTS, AND OFF-BALANCE SHEET ARRANGEMENTS
QNB has various financial obligations, including contractual obligations and
commitments, that may require future cash payments.
CONTRACTUAL OBLIGATIONS:
The following table presents, as of December 31, 2003, significant contractual
obligations to third parties by payment date. Further discussion of the nature
of each obligation can be found in the notes to the consolidated financial
statements
- ----------------------------------------------------------------------------------------------------------
UNDER 1 YEAR 1 TO 3 YEARS 3 TO 5 YEARS OVER 5 YEARS TOTAL
- ----------------------------------------------------------------------------------------------------------
Time Deposits ..................... $ 92,903 $ 75,736 $ 21,503 - $190,142
Short-term borrowings ............. 10,416 - - - 10,416
Federal Home Loan Bank advances.... 3,000 2,000 - $50,000 55,000
Operating leases .................. 234 454 420 2,286 3,394
- ----------------------------------------------------------------------------------------------------------
Total ............................. $106,553 $ 78,190 $ 21,923 $52,286 $258,952
==========================================================================================================
COMMITMENTS:
The following table presents, as of December 31, 2003, the amounts and expected
maturities of significant commitments. Discussion of the obligations can be
found in the notes to the consolidated financial statements.
- ----------------------------------------------------------------------------------------------------------
UNDER 1 YEAR 1 TO 3 YEARS 3 TO 5 YEARS OVER 5 YEARS TOTAL
- ----------------------------------------------------------------------------------------------------------
Commitments to extend credit
Commercial ...................... $39,706 $ 3,871 $ - $ - $43,577
Residential real estate ......... 660 - - - 660
Other ........................... - - - 15,169 15,169
Standby letters of credit ......... 4,930 676 26 - 5,632
- ----------------------------------------------------------------------------------------------------------
Total ............................. $45,296 $ 4,547 $ 26 $15,169 $65,038
==========================================================================================================
Commitments to extend credit, inclulding loan commitments, standby letters of
credit, and commercial letters of credit do not necessarily represent future
cash requirements, as these commitments often expire without being drawn upon.
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 Federal and
State laws and regulations does have, and in the future may have, a negative
impact on QNB's results of operations.
34
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
MANAGEMENT'S DISCUSSION AND ANALYSIS
CONSOLIDATED QUARTERLY FINANCIAL DATA
- -----------------------------------------------------------------------------------------------------------------------
QUARTERS ENDED 2003 QUARTERS ENDED 2002
MARCH 31 JUNE 30 SEPT. 30 DEC. 31 MARCH 31 JUNE 30 SEPT. 30 DEC. 31
- -----------------------------------------------------------------------------------------------------------------------
Interest income ................ $6,392 $6,307 $6,261 $6,440 $6,796 $6,974 $6,900 $6,521
Interest expense ............... 2,505 2,471 2,405 2,373 3,171 3,102 3,026 2,777
- -----------------------------------------------------------------------------------------------------------------------
Net interest income ............ 3,887 3,836 3,856 4,067 3,625 3,872 3,874 3,744
Provision for loan losses ...... - - - - - - - -
Non-interest income ............ 1,238 1,426 938 598 734 709 525 1,021
Non-interest expense ........... 3,138 3,143 3,264 3,399 2,794 2,886 2,861 3,404
- -----------------------------------------------------------------------------------------------------------------------
Income before income taxes ..... 1,987 2,119 1,530 1,266 1,565 1,695 1,538 1,361
Provision for income taxes ..... 456 489 118 191 290 341 282 291
- -----------------------------------------------------------------------------------------------------------------------
NET INCOME ..................... $1,531 $1,630 $1,412 $1,075 $1,275 $1,354 $1,256 $1,070
=======================================================================================================================
NET INCOME PER SHARE - BASIC ... $ .50 $ .53 $ .46 $ .35 $ .41 $ .44 $ .41 $ .35
=======================================================================================================================
NET INCOME PER SHARE - DILUTED.. $ .49 $ .52 $ .45 $ .34 $ .41 $ .44 $ .40 $ .34
=======================================================================================================================
SELECTED FINANCIAL AND OTHER DATA
- -------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003 2002 2001 2000 1999
- -------------------------------------------------------------------------------------------------------------------------
INCOME AND EXPENSE
Interest income .................................... $ 25,400 $ 27,191 $ 26,928 $ 24,698 $ 23,195
Interest expense ................................... 9,754 12,076 13,404 12,007 10,304
- -------------------------------------------------------------------------------------------------------------------------
Net interest income ................................ 15,646 15,115 13,524 12,691 12,891
Provision for loan losses .......................... - - - - 240
Non-interest income ................................ 4,200 2,989 3,070 2,791 2,208
Non-interest expense ............................... 12,944 11,945 11,080 10,232 9,884
- -------------------------------------------------------------------------------------------------------------------------
Income before income taxes ......................... 6,902 6,159 5,514 5,250 4,975
Provision for income taxes ......................... 1,254 1,204 1,078 1,144 1,174
- -------------------------------------------------------------------------------------------------------------------------
Net income ......................................... $ 5,648 $ 4,955 $ 4,436 $ 4,106 $ 3,801
=========================================================================================================================
PER SHARE DATA
Net income - basic ................................. $ 1.83 $ 1.61 $ 1.44 $ 1.30 $ 1.20
Net income - diluted ............................... 1.79 1.59 1.43 1.30 1.20
Book value ......................................... 14.03 13.28 11.46 10.21 8.62
Cash dividends ..................................... .66 .60 .54 .46 .38
Average common shares outstanding - basic .......... 3,091,640 3,078,550 3,088,020 3,146,642 3,166,044
Average common shares outstanding - diluted ........ 3,153,305 3,109,353 3,094,735 3,147,239 3,177,571
BALANCE SHEET AT YEAR-END
Investment securities available-for-sale ........... $ 264,441 $ 214,741 $ 168,102 $ 114,245 $ 97,609
Investment securities held-to-maturity ............. 12,012 29,736 42,798 42,982 48,302
Loans held-for-sale ................................ 1,439 4,159 2,122 1,642 1,235
Loans, net of unearned income ...................... 232,127 212,691 200,089 183,592 172,529
Other earning assets ............................... 5,381 10,310 5,888 3,226 281
Total assets ....................................... 550,831 503,430 451,274 371,671 350,489
Deposits ........................................... 438,639 388,913 344,731 293,822 286,166
Borrowed funds ..................................... 65,416 69,485 66,541 42,819 33,925
Shareholders' equity ............................... 43,440 40,914 35,219 31,794 27,462
SELECTED FINANCIAL RATIOS
Net interest margin ................................ 3.45% 3.68% 3.81% 4.02% 4.23%
Net income as a percentage of:
Average total assets ............................. 1.07 1.03 1.07 1.13 1.10
Average shareholders' equity ..................... 14.38 13.88 13.54 13.25 13.16
Average shareholders' equity to
average total assets 7.46 7.45 7.93 8.53 8.38
Dividend payout ratio .............................. 36.15 37.29 37.32 34.75 31.74
35
QNB CORP. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(in thousands)
- -------------------------------------------------------------------------------
DECEMBER 31, 2003 2002
- -------------------------------------------------------------------------------
ASSETS
Cash and due from banks ............................... $ 21,534 $ 17,476
Federal funds sold .................................... 4,532 10,001
- -------------------------------------------------------------------------------
Total cash and cash equivalents ............... 26,066 27,477
Investment securities
Available-for-sale (cost $260,894 and $209,217) ... 264,441 214,741
Held-to-maturity (market value $12,334 and $30,386) 12,012 29,736
Loans held-for-sale ................................... 1,439 4,159
Total loans, net of unearned income of $153 and $263 .. 232,127 212,691
Allowance for loan losses ......................... (2,929) (2,938)
- -------------------------------------------------------------------------------
Net loans ..................................... 229,198 209,753
Cash surrender value of insurance ..................... 7,585 7,397
Premises and equipment, net ........................... 5,090 5,497
Accrued interest receivable ........................... 2,823 2,710
Other assets .......................................... 2,177 1,960
- -------------------------------------------------------------------------------
Total assets .......................................... $ 550,831 $ 503,430
===============================================================================
LIABILITIES
Deposits
Demand, non-interest-bearing ...................... $ 50,468 $ 47,079
Interest-bearing demand accounts .................. 107,648 70,478
Money market accounts ............................. 38,373 39,341
Savings ........................................... 52,008 45,338
Time .............................................. 151,304 145,849
Time over $100,000 ................................ 38,838 40,828
- -------------------------------------------------------------------------------
Total deposits ................................ 438,639 388,913
Short-term borrowings ................................. 10,416 14,485
Federal Home Loan Bank advances ....................... 55,000 55,000
Accrued interest payable .............................. 1,285 1,555
Other liabilities ..................................... 2,051 2,563
- -------------------------------------------------------------------------------
Total liabilities ..................................... 507,391 462,516
- -------------------------------------------------------------------------------
Commitments and contingencies
SHAREHOLDERS' EQUITY
Common stock, par value $0.625 per share;
authorized 10,000,000 shares; 3,202,065 shares and
3,188,280 shares issued; 3,095,379 and 3,081,594
shares outstanding ................................ 2,001 1,993
Surplus ............................................... 8,933 8,759
Retained earnings ..................................... 31,659 28,053
Accumulated other comprehensive income, net ........... 2,341 3,603
Treasury stock, at cost; 106,686 shares ............... (1,494) (1,494)
- -------------------------------------------------------------------------------
Total shareholders' equity ............................ 43,440 40,914
- -------------------------------------------------------------------------------
Total liabilities and shareholders' equity ............ $ 550,831 $ 503,430
===============================================================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL
STATEMENTS.
36
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except share data)
- ------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003 2002 2001
- ------------------------------------------------------------------------------------
INTEREST INCOME
Interest and fees on loans ..................... $ 14,469 $ 14,892 $ 15,250
Interest and dividends on investment securities:
Taxable .................................... 8,687 10,163 9,763
Tax-exempt ................................. 2,112 1,979 1,619
Interest on Federal funds sold ................. 126 152 282
Interest on interest-bearing balances .......... 6 5 14
- ------------------------------------------------------------------------------------
Total interest income .................. 25,400 27,191 26,928
- ------------------------------------------------------------------------------------
INTEREST EXPENSE
Interest on deposits
Interest-bearing demand accounts ........... 554 393 455
Money market accounts ...................... 298 559 1,056
Savings .................................... 324 497 596
Time ....................................... 4,511 5,843 6,731
Time over $100,000 ......................... 1,080 1,614 1,321
Interest on short-term borrowings .............. 106 264 539
Interest on Federal Home Loan Bank advances .... 2,881 2,906 2,706
- ------------------------------------------------------------------------------------
Total interest expense ................. 9,754 12,076 13,404
- ------------------------------------------------------------------------------------
Net interest income .................... 15,646 15,115 13,524
Provision for loan losses ...................... - - -
- ------------------------------------------------------------------------------------
Net interest income after provision
for loan losses ..................... 15,646 15,115 13,524
- ------------------------------------------------------------------------------------
NON-INTEREST INCOME
Fees for services to customers ................. 1,849 1,634 1,437
ATM and debit card income ...................... 541 509 469
Income on cash surrender value of insurance .... 330 372 206
Mortgage servicing fees ........................ 12 97 36
Net (loss) gain on investment securities
available-for-sale .......................... (134) (779) 292
Net gain on sale of loans ...................... 923 676 244
Other operating income ......................... 679 480 386
- ------------------------------------------------------------------------------------
Total non-interest income .............. 4,200 2,989 3,070
- ------------------------------------------------------------------------------------
NON-INTEREST EXPENSE
Salaries and employee benefits ................. 7,334 6,531 6,174
Net occupancy expense .......................... 859 861 854
Furniture and equipment expense ................ 1,111 1,060 1,008
Marketing expense .............................. 536 598 437
Third party services ........................... 741 640 502
Telephone, postage and supplies expense ........ 556 545 525
State taxes .................................... 331 335 294
Other expense .................................. 1,476 1,375 1,286
- ------------------------------------------------------------------------------------
Total non-interest expense ............. 12,944 11,945 11,080
- ------------------------------------------------------------------------------------
Income before income taxes ................. 6,902 6,159 5,514
Provision for income taxes ..................... 1,254 1,204 1,078
- ------------------------------------------------------------------------------------
NET INCOME ................................. $ 5,648 $ 4,955 $ 4,436
====================================================================================
NET INCOME PER SHARE - BASIC ............... $ 1.83 $ 1.61 $ 1.44
====================================================================================
NET INCOME PER SHARE - DILUTED ............. $ 1.79 $ 1.59 $ 1.43
====================================================================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL
STATEMENTS.
37
QNB CORP. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
- ------------------------------------------------------------------------------------------------------------------------------------
ACCUMULATED
OTHER
NUMBER COMPREHENSIVE COMPREHENSIVE COMMON RETAINED TREASURY
(in thousands, except share data) OF SHARES INCOME INCOME (LOSS) STOCK SURPLUS EARNINGS STOCK TOTAL
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2000 .............. 2,960,218 - $ (64) $ 1,891 $ 6,491 $ 24,409 $ (933) $ 31,794
- ------------------------------------------------------------------------------------------------------------------------------------
Net income .............................. - $ 4,436 - - - 4,436 - 4,436
Other comprehensive income, net of tax
Unrealized holding gains on
investment securities available-
for-sale ....................... - 1,356 - - - - - -
-------
Reclassification adjustment for
gains included in net income ...... - (193)
-------
Other comprehensive income ........... - 1,163 1,163 - - - - 1,163
Comprehensive income .................... $ 5,599
=======
Cash dividends paid
($.54 per share) ..................... - - - - - (1,655) - (1,655)
Stock dividend 5% ....................... 150,728 - - 94 2,150 (2,244) - -
Stock issue - Employee stock purchase
plan ........................... 3,166 - - 2 40 - - 42
Treasury stock purchased ................ (41,394) - - - - - (561) (561)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2001 .............. 3,072,718 - 1,099 1,987 8,681 24,946 (1,494) 35,219
====================================================================================================================================
Net income .............................. - $ 4,955 - - - 4,955 - 4,955
Other comprehensive income, net of tax
Unrealized holding gains on
investment securities available-
for-sale ....................... - 1,990 - - - - - -
Reclassification adjustment for
losses included in net income ..... - 514
-------
Other comprehensive income ........... - 2,504 2,504 - - - - 2,504
-------
Comprehensive income .................... $ 7,459
=======
Cash dividends paid
($.60 per share) ..................... - - - - - (1,848) - (1,848)
Stock issue - Employee stock purchase
plan ........................... 3,304 - - 2 50 - - 52
Stock issued for options exercised ...... 5,572 - - 4 28 - - 32
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2002 .............. 3,081,594 - 3,603 1,993 8,759 28,053 (1,494) 40,914
====================================================================================================================================
Net income .............................. - $ 5,648 - - - 5,648 - 5,648
Other comprehensive income, net of tax
Unrealized holding losses on
investment securities available-
for-sale ....................... - (1,350) - - - - - -
Reclassification adjustment for
losses included in net income ..... - 88
-------
Other comprehensive income ........... - (1,262) (1,262) - - - - (1,262)
-------
Comprehensive income .................... $ 4,386
=======
Cash dividends paid
($.66 per share) ..................... - - - - - (2,042) - (2,042)
Stock issue - Employee stock purchase
plan ........................... 3,415 - - 2 62 - - 64
Stock issued for options exercised ...... 10,370 - - 6 72 - - 78
Tax benefits from stock plans ........... - - - 40 - 40
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2003 .............. 3,095,379 - $2,341 $ 2,001 $ 8,933 $31,659 $ (1,494) $43,440
====================================================================================================================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL
STATEMENTS.
38
<page>
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
- ------------------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income .......................................................................... $ 5,648 $ 4,955 $ 4,436
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization .................................................... 873 835 788
Securities losses (gains) ........................................................ 134 779 (292)
Net gain on sale of loans ........................................................ (923) (676) (244)
Loss on disposal of premises and equipment ....................................... 13 2 12
Proceeds from sales of residential mortgages ..................................... 41,904 24,472 15,598
Originations of residential mortgages held-for-sale .............................. (39,244) (27,276) (16,830)
Proceeds from sales of student loans ............................................. 403 1,896 2,680
Originations of student loans .................................................... (160) (1,121) (2,163)
Income on cash surrender value of insurance ...................................... (330) (372) (206)
Life insurance proceeds/premiums, net ............................................ 142 (27) (29)
Deferred income tax provision .................................................... (2) (79) 6
Change in income taxes payable ................................................... (121) (132) 125
Net increase in accrued interest receivable ...................................... (113) (213) (284)
Net amortization of premiums and discounts ....................................... 1,447 901 211
Net (decrease) increase in accrued interest payable .............................. (270) (588) 734
Decrease in other assets ......................................................... 45 69 65
Increase (decrease) in other liabilities ......................................... 206 (1,336) 797
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities ........................................ 9,652 2,089 5,404
- ------------------------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Proceeds from maturities and calls of investment securities
available-for-sale .............................................................. 87,380 63,296 47,809
held-to-maturity ................................................................ 17,706 18,877 15,757
Proceeds from sales of investment securities
available-for-sale .............................................................. 54,591 17,245 17,484
Purchase of investment securities
available-for-sale .............................................................. (194,968 (124,754) (117,104)
held-to-maturity ................................................................ - (5,955) (15,615)
Net increase in loans ............................................................. (19,050) (11,934) (16,123)
Net purchases of premises and equipment ........................................... (479) (720) (242)
Purchase of single premium life insurance ......................................... - - (3,000)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used by investing activities ............................................. (54,820) (43,945) (71,034)
- ------------------------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Net increase in non-interest-bearing deposits ..................................... 3,389 7,001 5,305
Net increase in interest-bearing non-maturity deposits ............................ 42,872 27,315 4,074
Net increase in time deposits ..................................................... 3,465 9,866 41,530
Net (decrease) increase in short-term borrowings .................................. (4,069) 1,034 (4,368)
Proceeds from Federal Home Loan Bank advances ..................................... - 2,000 28,000
Cash dividends paid ............................................................... (2,042) (1,848) (1,655)
Proceeds from issuance of common stock ............................................ 142 84 42
Purchases of treasury stock ....................................................... - - (561)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities ...................................... 43,757 45,452 72,367
- ------------------------------------------------------------------------------------------------------------------------------------
(Decrease) increase in cash and cash equivalents ............................... (1,411) 3,596 6,737
Cash and cash equivalents at beginning of year ................................. 27,477 23,881 17,144
Cash and cash equivalents at end of year ....................................... $ 26,066 $ 27,477 $ 23,881
====================================================================================================================================
SUPPLEMENTAL CASH FLOW DISCLOSURES
Interest paid ..................................................................... $ 10,024 $ 12,664 $ 12,670
Income taxes paid ................................................................. 1,430 1,400 930
Non-Cash Transactions
Change in net unrealized holding gains, net of taxes, on investment securities . (1,262) 2,504 1,163
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE CONSOLIDATED FINANCIAL
STATEMENTS.
39
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS
- --------------------------------------------------------------------------------
QNB Corp. (the "Corporation"), through its wholly-owned subsidiary, The
Quakertown National Bank (the "Bank"), has been serving the residents and
businesses of Upper Bucks, Northern Montgomery and Southern Lehigh Counties in
Pennsylvania since 1877. The Bank is a locally managed community bank that
provides a full range of commercial, retail banking and trust and investment
management services. The Bank encounters vigorous competition for market share
in the communities it serves from bank holding companies, other community banks,
thrift institutions, credit unions and other non-bank financial organizations
such as mutual fund companies, insurance companies and brokerage companies. QNB
Corp. manages its business as a single operating segment.
The Corporation and the Bank are subject to regulations of certain state and
federal agencies. These regulatory agencies periodically examine the Corporation
and the Bank for adherence to laws and regulations.
USE OF ESTIMATES
- --------------------------------------------------------------------------------
The consolidated financial statements include the accounts of the Corporation
and its wholly owned subsidiary, the "Bank". The consolidated entity is referred
to herein as "QNB". These statements are prepared in accordance with accounting
principles generally accepted in the United States of America (GAAP) and
predominant practices within the banking industry. The preparation of these
financial statements requires QNB to make estimates and judgments that affect
the reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities. QNB evaluates estimates on an
on-going basis, including those related to the allowance for loan losses,
non-accrual loans, other real estate owned, other-than-temporary investment
impairments, intangible assets, stock option plans and income taxes. QNB bases
its estimates on historical experience and various other factors and assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ from these estimates under different assumptions or conditions.
All significant inter-company accounts and transactions have been eliminated in
the consolidated financial statements. Tabular information other than share data
is presented in thousands of dollars.
STOCK SPLIT
- --------------------------------------------------------------------------------
On August 19, 2003, the Board of Directors authorized a two-for-one split of the
Corporation's common stock, effected by a distribution on October 14, 2003 of
one share for each one share held of record at the close of business on
September 30, 2003. All earnings per share and common stock information is
presented as if the stock split occurred prior to the earliest year included in
these financial statements.
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 accumulated other comprehensive gain, 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.
OTHER THAN TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES
- --------------------------------------------------------------------------------
Securities are evaluated periodically to determine whether a decline in their
value is other than temporary. Management utilizes criteria such as the
magnitude and duration of the decline, in addition to the reasons underlying the
decline, to determine whether the loss in value is other than temporary. The
term "other than temporary" is not intended to indicate that the decline is
permanent, but indicates that the prospects for a near-term recovery of value is
not necessarily favorable, or that there is a lack of evidence to support
realizable value equal to or greater than carrying value of the investment. Once
a decline in value is determined to be other than temporary, the value of the
security is reduced and a corresponding charge to earnings is recognized.
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 mortgage loans and student
loans 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
40
<page>
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 the
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.
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 loans are
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.
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 less disposal costs. Loan losses arising from the
acquisition of such properties are charged against the allowance for 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.
ALLOWANCE FOR LOAN LOSSES
- --------------------------------------------------------------------------------
QNB maintains an allowance for loan losses, which is intended to absorb probable
known and inherent losses in the outstanding loan portfolio. The allowance is
reduced by actual credit losses and is increased by the provision for loan
losses and recoveries of previous losses. The provisions for loan losses are
charged to earnings to bring the total allowance for loan losses to a level
considered necessary by management.
The allowance for loan losses is based on management's continuing review and
evaluation of the loan portfolio. The level of the allowance is determined by
assigning specific reserves to individually identified problem credits and
general reserves to all other loans. The portion of the allowance that is
allocated to internally criticized and non-accrual loans is determined by
estimating the inherent loss on each credit after giving consideration to the
value of underlying collateral. The general reserves are based on the
composition and risk characteristics of the loan portfolio, including the nature
of the loan portfolio, credit concentration trends, historic and anticipated
delinquency and loss experience, as well as other qualitative factors such as
current economic trends.
Management emphasizes loan quality and close monitoring of potential problem
credits. Credit risk identification and review processes are utilized in order
to assess and monitor the degree of risk in the loan portfolio. QNB's lending
and loan administration staff are charged with reviewing the loan portfolio and
identifying changes in the economy or in a borrower's circumstances which may
affect the ability to repay debt or the value of pledged collateral. A loan
classification and review system exists that identifies those loans with a
higher than normal risk of uncollectibility. Each commercial loan is assigned a
grade based upon an assessment of the borrower's financial capacity to service
the debt and the presence and value of collateral for the loan. An independent
loan review group tests risk assessments and evaluates the adequacy of the
allowance for loan losses. Management meets monthly to review the credit quality
of the loan portfolio and quarterly to review the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their
examination process, periodically review QNB's allowance for losses on loans.
Such agencies may require QNB to recognize additions to the allowance based on
their judgments using information available to them at the time of their
examination.
Management believes that it uses the best information available to make
determinations about the adequacy of the allowance and that it has established
its existing allowance for loan losses in accordance with GAAP. If circumstances
differ substantially from the assumptions used in making determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be affected. Because future events affecting borrowers and
collateral cannot be predicted with certainty, there can be no assurance that
increases to the allowance will not be necessary should the quality of any loans
deteriorate as a result of the factors discussed above.
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 disaggregated 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.
Expenditures for maintenance and repairs are charged to operations as incurred.
Gains or losses upon disposition are reflected in earnings as realized.
41
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
STOCK BASED COMPENSATION
- --------------------------------------------------------------------------------
At December 31, 2003, QNB has a stock-based employee compensation plan, which is
described more fully in Note 14. QNB accounts for this plan under the
recognition and measurement principles of APB Opinion No. 25, ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES, and related interpretations. No stock-based employee
compensation cost is reflected in net income, as all options granted under this
plan had an exercise price equal to the market value of the underlying common
stock on the date of grant. The following table illustrates the effect of net
income and earnings per share if the Corporation had applied the fair value
recognition provisions of FASB Statement No. 123, ACCOUNTING FOR STOCK-BASED
COMPENSATION, to stock-based employee compensation.
- --------------------------------------------------------------------------------
DECEMBER 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Net income, as reported ................ $5,648 $4,955 $4,436
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all
awards, net of related tax effects ... 104 91 98
- --------------------------------------------------------------------------------
Pro forma net income ................... $5,544 $4,864 $4,338
================================================================================
Earnings per share
Basic - as reported .................. $ 1.83 $ 1.61 $ 1.44
================================================================================
Basic - pro forma .................... $ 1.79 $ 1.58 $ 1.41
================================================================================
Diluted - as reported ................ $ 1.79 $ 1.59 $ 1.43
================================================================================
Diluted - pro forma .................. $ 1.76 $ 1.57 $ 1.40
================================================================================
INCOME TAXES
- --------------------------------------------------------------------------------
QNB accounts for income taxes under the asset/liability method. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases, as well as
operating loss and tax credit carryforwards. Deferred tax assets and liabilities
are measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date. A
valuation allowance is established against deferred tax assets when, in the
judgment of management, it is more likely than not that such deferred tax assets
will not become available. Because the judgment about the level of future
taxable income is dependent to a great extent on matters that may, at least in
part, go beyond QNB's control, it is at least reasonably possible that
management's judgment about the need for a valuation allowance for deferred
taxes could change in the near term.
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. For
the purpose of earnings per share, share and per share data, for all periods
presented, have been restated to reflect the two-for-one stock split distributed
October 14, 2003.
COMPREHENSIVE INCOME
- --------------------------------------------------------------------------------
Comprehensive income is defined as the change in equity of a business entity
during a period due to transactions and other events and circumstances,
excluding those resulting from investments by and distributions to owners. For
QNB, the primary component of other comprehensive income is the unrealized
holding gains or losses on available-for-sale investment securities.
RECENT ACCOUNTING PRONOUNCEMENTS
- --------------------------------------------------------------------------------
STOCK-BASED COMPENSATION
In December, 2002, the FASB issued SFAS No. 148, ACCOUNTING FOR STOCK-BASED
COMPENSATION- TRANSITION AND DISCLOSURE. This Statement amends SFAS No. 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION, to provide alternative methods of
transition for an entity that voluntarily changes to the fair value based method
of accounting for stock-based compensation. It also amends the disclosure
provisions of that Statement to require prominent disclosure about the effects
on reported net income of an entity's accounting policy decisions with respect
to stock-based employee compensation. Finally, this statement amends APB Opinion
No. 28, INTERIM FINANCIAL REPORTING, to require disclosure about those effects
in interim financial information. The requirements for SFAS No. 148 are
effective for financial statements for fiscal years ended and interim periods
beginning after December 15, 2002. QNB uses the "intrinsic value" approach to
accounting for stock-based compensation to account for stock-based compensation
as permitted under APB Opinion No. 25. QNB has adopted the disclosure provisions
of SFAS No. 148. The disclosure provisions had no impact on QNB's consolidated
earnings, financial condition, or equity.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
In April 2003, the FASB issued SFAS No. 149, AMENDMENTS OF STATEMENT 133 ON
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, which establishes accounting and
reporting standards for derivative instruments, including derivatives embedded
in other contracts and hedging activities. This Statement amends Statement No.
133 for decisions made by the FASB as part of its Derivative Implementations
Group process. The Statement also amends Statement No. 133 to incorporate
clarifications of the definition of a derivative. The Statement is effective for
contracts entered into or modified and hedging relationships designated after
June 30, 2003. The provisions of this Statement did not have a material impact
on QNB's consolidated earnings, financial condition, or equity.
CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS
OF BOTH LIABILITIES AND EQUITY
In May 2003, the FASB issued FASB No. 150, ACCOUNTING FOR CERTAIN FINANCIAL
INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY. This Statement
establishes standards for how an issuer classifies financial instruments with
characteristics of both liabilities and equity. It requires that an issuer
classify these financial instruments as a liability (or, in certain
circumstances, an asset). Previously, these financial instruments would have
been classified entirely as equity, or between the liabilities section and
42
<page>
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
equity section of the statement of financial condition. This Statement also
addresses questions about the classification of certain financial instruments
that embody obligations to issue equity shares. The provisions of this Statement
are effective for interim periods beginning after June 15, 2003. The adoption of
this Statement did not have an impact on QNB's consolidated earnings, financial
condition, or equity.
GUARANTOR'S ACCOUNTING AND DISCLOSURE REQUIREMENTS FOR GUARANTEES In November
2002, the FASB issued Interpretation No. 45, GUARANTOR'S ACCOUNTING AND
DISCLOSURE REQUIREMENTS FOR GUARANTEES, INCLUDING INDIRECT GUARANTEES OF
INDEBTEDNESS TO OTHERS, an interpretation of FASB Statements No. 5, 57 and 107
and a rescission of FASB Interpretation No. 34. This Interpretation elaborates
on the disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under guarantees issued. The Interpretation
also clarifies that a guarantor is required to recognize, at inception of a
guarantee, a liability for the fair value of the obligation undertaken. The
initial recognition and measurement provisions of the Interpretation are
applicable to guarantees issued or modified after December 31, 2002 and the
disclosure requirements are effective for financial statements of interim or
annual periods ending after December 15, 2002. QNB adopted the recognition and
measurement provisions of this Interpretation effective on January 1, 2003, with
an immaterial impact on QNB's financial condition or results of operations.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES
In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46),
CONSOLIDATION OF VARIABLE INTEREST ENTITIES, which addresses how a business
enterprise should evaluate whether it has a controlling financial interest in an
entity through means other than voting rights and accordingly should consolidate
the entity. FIN 46 Revised (FIN 46R), issued in December 2003, replaces FIN 46.
FIN 46R requires public entities to apply FIN 46 or FIN 46R to all entities that
are considered special-purpose entities in practice and under the FASB
literature that was applied before the issuance of FIN 46 by the end of the
first reporting period that ends after December 15, 2003. For any variable
interest entities (VIE) that must be consolidated under FIN 46R, the assets,
liabilities and noncontrolling interests of the VIE initially would be measured
at their carrying amounts with any difference between the net amount added to
the balance sheet and any previously recognized interest being recognized as the
cumulative effect of an accounting change. If determining the carrying amounts
is not practicable, fair value at the date FIN 46R first applies may be used to
measure the assets, liabilities and noncontrolling interest of the VIE. The
adoption of FIN 46R did not have a material impact on QNB's consolidated
earnings, financial condition, or equity, nor has there been any additional
requirement for disclosure.
OTHER-THAN-TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES
In December 2003, the Emerging Issues Task Force issued EITF 03-1, THE MEANING
OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS.
The EITF addresses disclosure requirements regarding information about
temporarily impaired investments. The requirements are effective for fiscal
years ending after December 15, 2003 for all entities that have debt or
marketable equity securities with market values below carrying values. The
requirements apply to investments in debt and marketable equity securities that
are accounted for under SFAS No. 115, ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT
AND EQUITY SECURITIES. The requirements apply only to annual financial
statements. As of December 31, 2003, QNB has included the required disclosures
in their financial statements.
STATEMENT OF CASH FLOWS
- --------------------------------------------------------------------------------
Cash and cash equivalents for purposes of this statement consist of cash on
hand, cash items in process of collection, amounts due from banks, interest
earning deposits in other financial institutions and Federal funds sold.
NOTE 2 - EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per
share (share and per share data have been restated to reflect the two-for-one
stock split paid October 14, 2003 and are not in thousands):
- --------------------------------------------------------------------------------
2003 2002 2001
- --------------------------------------------------------------------------------
Numerator for basic
and diluted earnings
per share - net income .......... $5,648 $4,955 $4,436
================================================================================
Denominator for basic
earnings per share - weighted
average shares outstanding .... 3,091,640 3,078,550 3,088,020
Effect of dilutive securities -
employee stock options .......... 61,665 30,803 6,715
- --------------------------------------------------------------------------------
Denominator for diluted earnings
per share - adjusted weighted ... 3,153,305 3,109,353 3,094,735
================================================================================
Earnings per share - basic ........ $ 1.83 $ 1.61 $ 1.44
Earnings per share - diluted ...... 1.79 1.59 1.43
- --------------------------------------------------------------------------------
There were 54,890 stock options that were anti-dilutive as of December
31, 2001.
NOTE 3 - 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 $9,165,000 and $5,032,000 to satisfy federal
regulatory requirements as of December 31, 2003 and 2002.
43
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - INVESTMENT SECURITIES AVAILABLE-FOR-SALE
The amortized cost and estimated fair values of investment securities
available-for-sale at December 31, 2003 and 2002 were as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2003 2002
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 ..................... $ 6,792 $ 19 $ 1 $ 6,774 $ 6,641 $ 90 $ 3 $ 6,554
U.S. Government agencies .......... 43,279 339 67 43,007 29,480 728 - 28,752
State and municipal securities .... 41,076 1,162 217 40,131 26,783 970 70 25,883
Mortgage-backed securities ........ 66,476 835 159 65,800 70,748 1,820 - 68,928
Collateralized mortgage obligations 68,761 364 1,086 69,483 44,409 759 - 43,650
(CMOs)
Other debt securities ............. 25,214 2,379 - 22,835 24,530 1,705 53 22,878
Equity securities ................. 12,843 951 972 12,864 12,150 118 540 12,572
- ------------------------------------------------------------------------------------------------------------------------------------
Total investment securities
available-for-sale .............. $264,441 $6,049 $2,502 $260,894 $214,741 $6,190 $666 $209,217
====================================================================================================================================
Included in equity securities at December 31, 2003 and 2002 are $3,810,000 and
$3,585,000 of equity securities that do not have readily determinable fair
values. These equity securities are primarily comprised of Federal Home Loan
Bank stock. Fair value is recorded at cost.
The amortized cost and estimated fair value of securities available-for-sale by
contractual maturity at December 31, 2003 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 and CMOs are shown separately
due to the amortization and prepayment of principal occurring throughout the
life of these instruments.
- --------------------------------------------------------------------------------
Aggregate Amortized
DECEMBER 31, 2003 fair value cost
- --------------------------------------------------------------------------------
Due in one year or less .............................. $ 2,519 $ 2,509
Due after one year through five years ................ 23,836 23,594
Due after five years through ten years ............... 53,154 50,799
Due after ten years .................................. 36,852 35,845
Mortgage-backed securities
and CMOs ............................................. 135,237 135,283
Equity securities .................................... 12,843 12,864
- --------------------------------------------------------------------------------
Total securities available-for-sale .................. $ 264,441 $ 260,894
================================================================================
Proceeds from sales of investment securities available-for-sale are as follows:
- --------------------------------------------------------------------------------
2003 2002 2001
- --------------------------------------------------------------------------------
Proceeds ....................... $54,591 $17,245 $17,484
Gross gains .................... 455 165 979
Gross losses ................... 589 944 687
Included in gross losses for 2003, 2002 and 2001 were other than temporary
impairment charges of $126,000, $702,000 and $684,000.
HELD-TO-MATURITY
The amortized cost and estimated fair values of investment securities
held-to-maturity at December 31, 2003 and 2002 were as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2003 2002
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 .... $11,180 $317 $ - $11,497 $19,745 $439 $1 $20,183
Collateralized mortgage obligations
(CMOs) .......................... 832 5 - 837 9,991 212 - 10,203
- ------------------------------------------------------------------------------------------------------------------------------------
Total investment securities
held-to-maturity ................ $12,012 $322 $ - $12,334 $29,736 $651 $1 $30,386
====================================================================================================================================
44
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The amortized cost and estimated fair values of securities held-to-maturity by
contractual maturity at December 31, 2003, 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. CMOs
are shown separately due to the amortization and prepayment of principal
occurring throughout the life of these instruments.
AGGREGATE
AMORTIZED FAIR
DECEMBER 31, 2003 COST VALUE
- ------------------------------------------------------------------
Due in one year or less .................... $ 225 $ 228
Due after one year through five years ...... 3,494 3,589
Due after five years through ten years ..... 2,669 2,693
Due after ten years ........................ 4,792 4,987
Collateralized mortgage obligations (CMOs) . 832 837
- ------------------------------------------------------------------
Total securities held-to-maturity $ 12,012 $ 12,334
==================================================================
There were no sales of investment securities classified as held-to-maturity
during 2003, 2002 or 2001. At December 31, 2003 and 2002, investment securities
totaling $84,425,000 and $65,871,000 were pledged as collateral for repurchase
agreements and deposits of public funds.
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
VALUE LOSSES VALUE LOSSES VALUE LOSSES
- ---------------------------------------------------------------------------------------------------------
U.S. Treasury ............................ $ 2,121 $ 1 $ - $ - $ 2,121 $ 1
U.S. Government agencies ................. 2,227 67 - - 2,227 67
State and municipal securities ........... 9,199 184 1,075 33 10,274 217
Mortgage-backed securities ............... 14,017 159 - - 14,017 159
Collateralized mortgage obligations (CMOs) 40,083 1,086 - - 40,083 1,086
Other debt securities .................... - - - - - -
Equity securities ........................ - - 4,528 972 4,528 972
- ---------------------------------------------------------------------------------------------------------
Total temporary impaired securities ...... $67,647 $1,497 $5,603 $1,005 $73,250 $2,502
=========================================================================================================
The unrealized losses in QNB's investment holdings are related to the dynamic
nature of interest rates. One of QNB's prime objectives with the investment
portfolio is to invest excess liquidity that is not needed to fund loans. As a
result, QNB adds new investments throughout the year as they become available
through deposit inflows or roll-off from loans and securities. The unrealized
losses in certain holdings are the result of these being purchased when market
interest rates were lower than at year end. As interest rates increase, fixed
rate securities generally fall in market price to reflect the higher market
yield. If held to maturity, all of the bonds will mature at par and QNB will not
realize a loss.
A portion of the unrealized losses is also related to four adjustable rate
Fannie Mae and Freddie Mac preferred stocks. The dividend on these holdings
resets at regular intervals at a specific spread to a predetermined index (such
as the two year Treasury yield). The dividend is also eligible for the dividend
received deduction (DRD), which exempts 70% of the dividend from federal taxes.
As interest rates fell sharply and the dividends on these decreased, the benefit
of the DRD decreased as well. As a result, the market price fell to compensate
buyers for the decreased tax benefit. As interest rates rise and the tax benefit
widens, we expect the market price of these stocks to rise as well.
45
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - LOANS
- --------------------------------------------------------------------------------
DECEMBER 31, 2003 2002
- --------------------------------------------------------------------------------
Commercial and industrial .................. $ 47,196 $ 39,546
Agricultural ............................... 14 176
Construction ............................... 9,056 7,687
Real estate-commercial ..................... 86,707 74,125
Real estate-residential .................... 83,703 84,907
Consumer ................................... 5,604 6,513
- --------------------------------------------------------------------------------
Total loans ................................ 232,280 212,954
Less unearned income ....................... 153 263
- --------------------------------------------------------------------------------
Total loans, net of unearned income ........ $232,127 $212,691
================================================================================
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.
At December 31, 2003 and 2002, the recorded investment in loans for which
impairment has been recognized totaled $796,000 and $579,000 of which $404,000
and $579,000 required no allowance for loan loss. As of December 31, 2003,
$392,000 of loans required an allowance for loan loss of $100,000. Most of the
loans identified as impaired are collateral-dependent. For the years ended
December 31, 2003, 2002 and 2001, the average recorded investment in impaired
loans was approximately $508,000, $699,000 and $207,000, respectively. QNB
recognized $56,000, $68,000 and $100,000 of interest income on these loans in
2003, 2002 and 2001, respectively.
Included within the loan portfolio are loans on non-accrual status of $818,000
and $650,000 at December 31, 2003 and 2002, respectively. If interest on
non-accrual loans had been accrued throughout the period, interest income for
the years ended December 31, 2003, 2002 and 2001, would have increased
approximately $40,000, $19,000 and $21,000, respectively. The amount of interest
income on these loans that was included in net income in 2003, 2002 and 2001 was
$55,000, $31,000 and $19,000, respectively.
QNB generally lends in its trade area which is comprised of Quakertown and the
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 within any one
industry, except those loans to real estate developers and investors which
account for $40,106,000 or 17.3 percent of the loan portfolio at December 31,
2003. This is an increase from the $28,914,000 or 13.6 percent at December 31,
2002. 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 6 - ALLOWANCE FOR LOAN LOSSES
Activity in the allowance for loan losses is shown below:
- --------------------------------------------------------------------------------
DECEMBER 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Balance at beginning of year ......... $ 2,938 $ 2,845 $ 2,950
- --------------------------------------------------------------------------------
Charge-offs .......................... (28) (39) (149)
Recoveries ........................... 19 132 44
- --------------------------------------------------------------------------------
Net (charge-offs) recoveries ......... (9) 93 (105)
Provision for loan losses ............ - - -
- --------------------------------------------------------------------------------
Balance at end of year ............... $ 2,929 $ 2,938 $ 2,845
================================================================================
NOTE 7 - PREMISES AND EQUIPMENT
Premises and equipment, stated at cost less accumulated depreciation
and amortization, are summarized below:
- --------------------------------------------------------------------------------
DECEMBER 31, 2003 2002
- --------------------------------------------------------------------------------
Land and buildings ......................... $ 4,928 $ 4,877
Furniture and equipment .................... 7,162 6,889
Leasehold improvements ..................... 1,593 1,593
- --------------------------------------------------------------------------------
Book value ................................. 13,683 13,359
Accumulated depreciation
and amortization ......................... (8,593) (7,862)
- --------------------------------------------------------------------------------
Net book value ............................. $ 5,090 $ 5,497
================================================================================
Depreciation and amortization expense on premises and equipment amounted to
$873,000, $835,000 and $788,000, for the years ended December 31, 2003,
2002 and 2001, respectively.
NOTE 8 - INTANGIBLE ASSETS
A summary of intangible assets at December 31, is as follows:
- -----------------------------------------------------------------------
2003
- -----------------------------------------------------------------------
GROSS NET
CARRYING ACCUMULATED CARRYING
AMOUNT AMORTIZATION AMOUNT
- -----------------------------------------------------------------------
Amortizing
Purchased deposit premium ....... $ 511 $315 $196
Mortgage servicing rights ....... 741 159 582
- -----------------------------------------------------------------------
Total other intangibles ....... $1,252 $474 $778
=======================================================================
- -----------------------------------------------------------------------
2002
- -----------------------------------------------------------------------
GROSS NET
CARRYING ACCUMULATED CARRYING
AMOUNT AMORTIZATION AMOUNT
- -----------------------------------------------------------------------
Amortizing
Purchased deposit premium ....... $ 511 $264 $247
Mortgage servicing rights ....... 679 250 429
- -----------------------------------------------------------------------
Total other intangibles ....... $1,190 $514 $676
=======================================================================
46
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Amortizing expense of intangible assets for the years ended December 31 is
as follows:
- -------------------------------------------------
2003 2002 2001
- -------------------------------------------------
Amortization expense $243 $142 $161
=================================================
The estimated amortization expense of intangible asets for each of the five
succeeding fiscal years is as follows:
Estimated annual amortization expense
for the year ended December 31, 2004 $186
for the year ended December 31, 2005 159
for the year ended December 31, 2006 137
for the year ended December 31, 2007 111
for the year ended December 31, 2008 54
Intangible assets acquired during the year ended December 31, 2003 are as
follows:
Weighted
Average
Amount Residual amortization
Assigned Value period in years
- -------------------------------------------------------------------
Mortgage servicing rights $345 $ - 4.8
===================================================================
The amount of mortgages serviced was $84,857,000 and $71,621,000 at December 31,
2003 and 2002, respectively.
NOTE 9 - TIME DEPOSITS
The aggregate amount of time deposits including deposits in denominations of
$100,000 or more was $190,142,000 and $186,677,000 at December 31, 2003 and
2002, respectively. The scheduled maturities of time deposits as of December 31,
2003 for the years 2004 through 2008 and thereafter are approximately
$92,903,000, $53,265,000, $22,471,000, $17,320,000, $4,167,000 and $16,000,
respectively.
NOTE 10 - SHORT-TERM BORROWINGS
- --------------------------------------------------------------------------------
SECURITIES SOLD UNDER OTHER
AGREEMENTS SHORT-TERM
DECEMBER 31, TO REPURCHASE(A) BORROWINGS (B)
- -------------------------------------------------------------------------------
2003
Balance ............................................ $ 9,816 $600
Maximum indebtedness at any month end .............. 11,550 600
Daily average indebtedness outstanding ............. 9,802 424
Average rate paid for the year ..................... 1.04% 1.10%
Average rate on period-end borrowings .............. .85 .73
- -------------------------------------------------------------------------------
2002
Balance ............................................ $13,885 $600
Maximum indebtedness at any month end .............. 19,287 600
Daily average indebtedness outstanding ............. 13,461 419
Average rate paid for the year ..................... 1.91% 1.68%
Average rate on period-end borrowings .............. 1.53 .99
===============================================================================
(a) Securities sold under agreements to repurchase mature within 30 days. The
repurchase agreements were collateralized by U.S. Government agency securities,
mortgage-backed securities and CMOs with an amortized cost of $14,827,000 and
$16,457,000 and a fair value of $14,814,000 and $16,776,000 at December 31, 2003
and 2002, respectively. These securities are held in safekeeping at the Federal
Reserve Bank.
(b) Other short-term borrowings include Federal funds purchased and Treasury tax
and loan notes.
NOTE 11 - FHLB ADVANCES
Under terms of its agreement with the FHLB, QNB maintains otherwise unencumbered
qualifying assets (principally 1-4 family residential mortgage loans and U.S.
Government and Agency notes, bonds, and mortgage-backed securities) in the
amount of at least as much as its advances from the FHLB. QNB's FHLB stock of
$3,720,000 and $3,495,000 at December 31, 2003 and 2002 is also pledged to
secure these advances.
At December 31, 2003 and 2002, there were $55,000,000 in outstanding advances
with a weighted average rate of 5.16% and 5.18%, respectively. Advances are made
pursuant to several different credit programs offered by the FHLB. At December
31, 2003, $35,000,000 of these advances are convertible, whereby the FHLB has
the option at a predetermined time to convert the fixed interest rate to an
adjustable rate tied to LIBOR. QNB then has the option to prepay these advances
if the FHLB converts the interest rate.
Outstanding borrowings as of December 31, 2003 mature as follows:
- ------------------------------------------------
2004 .................................. $ 3,000
2005 .................................. 2,000
2006 .................................. -
2007 .................................. -
2008 .................................. -
2009 - 2011 ........................... 50,000
- ------------------------------------------------
Total FHLB advances ................... $55,000
================================================
47
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12 - INCOME TAXES
The components of the provision for income taxes are as follows:
- --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Current:
Federal income taxes ................. $ 1,256 $ 1,283 $1,064
State income taxes ................... - - 8
Deferred Federal income taxes .......... (2) (79) 6
- --------------------------------------------------------------------------------
Net provision .......................... $ 1,254 $ 1,204 $1,078
================================================================================
At December 31, 2003, 2002 and 2001, the tax effects of temporary differences
that represent the significant portion of deferred tax assets and liabilities
are as follows:
- --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003 2002
- --------------------------------------------------------------------------------
DEFERRED TAX ASSETS
Allowance for loan losses .................... $ 750 $ 726
Impaired equity securities ................... 272 341
Deferred compensation ........................ 202 195
Deposit premium .............................. 36 30
Other ........................................ 35 68
Total deferred tax assets .................. 1,295 1,360
Valuation allowance .......................... - (95)
- --------------------------------------------------------------------------------
Net deferred tax assets ...................... 1,295 1,265
DEFERRED TAX LIABILITIES
Depreciation ................................. 138 143
Mortgage servicing rights .................... 198 146
Net unrealized holding gains on
investment securities available-for-sale .... 1,206 1,921
Other ........................................ 39 58
- --------------------------------------------------------------------------------
Total deferred tax liabilities ............. 1,581 2,268
- --------------------------------------------------------------------------------
Net deferred tax (liability) asset ........... $ (286) $(1,003)
================================================================================
The realizability of deferred tax assets is dependent upon a variety of factors,
including the generation of future taxable income, the existence of taxes paid
and recoverable, the reversal of deferred tax liabilities and tax planning
strategies. A valuation allowance of $95,000 was established during the year
ended December 31, 2002 to offset a portion of the tax benefits associated with
certain impaired securities that management believed may not be realizable. This
valuation allowance was reversed during 2003 as a result of the ability to
realize tax benefits associated with certain impaired securities, due to the
increase in unrealized gains of certain equity securities. Based upon these and
other factors, management believes it is more likely than not that QNB will
realize the benefits of these remaining deferred tax assets. The net deferred
tax (liability) asset is included in other (liabilities) 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, 2003 2002 2001
- -----------------------------------------------------------------------------
Provision at statutory rate .......... $2,347 $2,094 $1,875
Tax-exempt interest income ........... (843) (840) (724)
Cash surrender value insurance ....... (112) (126) (70)
Life insurance proceeds .............. (37) - -
Change in valuation allowance ........ (95) 95 -
Other ................................ (6) (19) (3)
- -----------------------------------------------------------------------------
Total provision ...................... $1,254 $1,204 $1,078
=============================================================================
NOTE 13 - EMPLOYEE BENEFIT PLANS
Until December 31, 2002, QNB maintained a money purchase defined contribution
plan which covered all employees who met the age and service requirements. QNB
made contributions to the money purchase plan equivalent to 5 percent of total
compensation (as defined by the plan). QNB contributed and expensed $217,039 and
$215,639 to this plan in 2002 and 2001. QNB also had a 401(k) profit sharing
plan pursuant to the provisions of 401(k) of the Internal Revenue Code. The plan
covered substantially all employees who met the age and service requirements.
The 401(k) plan provided for elective employee contributions up to 9 percent of
compensation and a matching company contribution limited to 3 percent. QNB made
contributions to the profit sharing plan as directed by its Board of Directors.
For 2002 and 2001, QNB contributed and expensed $119,063 and $113,798 to the
401(k) profit sharing plan.
Effective January 1, 2003, these two plans were merged and restated into the
Quakertown National Bank Retirement Savings Plan. The plan provides for elective
employee contributions up to 15 percent of compensation and a matching company
contribution limited to 3 percent. In addition, the plan provides for Safe
Harbor Nonelective Contributions of 5 percent of total compensation by QNB. For
2003, QNB contributed $141,597 as a matching contribution and $257,927 as a Safe
Harbor contribution to the plan.
QNB's Employee Stock Purchase Plan (the "Plan") offers eligible employees an
opportunity to purchase shares of QNB Corp. Common Stock at a 10 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
42,000 shares. As of December 31, 2003, 8,433 shares were issued under the plan.
48
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Shares issued pursuant to the Plan, were as follows:
- ----------------------------------------------------------
YEAR ENDED DEC. 31, SHARES PRICE PER SHARE
- ----------------------------------------------------------
2003 ........................ 3,415 $18.00 and $19.82
2002 ........................ 3,304 14.85 and 17.10
2001 ........................ 3,166 13.05 and 13.30
==========================================================
NOTE 14 - STOCK OPTION PLAN
QNB has a stock option plan (the "Plan") administered by a committee which
consists of three or more members of QNB's Board of Directors. The Plan provides
for 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, as defined by the Plan.
The Plan provides for the exercise either in cash or in securites of the
Corporation or in any combination thereof.
The Plan authorizes the issuance of 220,500 shares. The time period by which any
option is exercisable under the Plan 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. As of December 31,
2003, there were 176,558 options granted and 162,412 options outstanding under
the Plan.
Changes in total options outstanding during 2003, 2002 and 2001, were as
follows:
NUMBER EXERCISE PRICE AVERAGE
OF OPTIONS PER OPTION EXERCISE PRICE
- --------------------------------------------------------------------
December 31, 2000 133,816 $13.09-$16.70 $14.67
Expired (27,228) 13.30- 16.70 13.79
Granted 31,372 13.30 13.30
- --------------------------------------------------------------------
December 31, 2001 137,960 13.09- 16.70 14.53
Exercised (28,100) 13.09- 16.70 14.58
Expired (1,654) 13.30 13.30
Granted 40,000 16.13 16.13
- --------------------------------------------------------------------
December 31, 2002 148,206 13.09- 16.70 14.97
Exercised (25,794) 13.09- 16.70 15.30
Granted 40,000 20.00 20.00
- --------------------------------------------------------------------
December 31, 2003 162,412 $13.09-$20.00 $16.15
====================================================================
The following table summarizes information about stock options
outstanding at December 31, 2003:
EXERCISABLE
------------------------------------------
AVERAGE
EXERCISE PRICE RANGE OPTIONS AVERAGE LIFE1 EXERCISE PRICE
- ---------------------------------------------------------------------
$13.09 - $ 13.30 56,398 6.55 $13.20
16.13 - 20.00 106,014 7.68 17.73
- ---------------------------------------------------------------------
Total 162,412 7.29 $16.15
=====================================================================
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.
For purposes of computing pro forma results, as presented in Note 1, 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 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, 2003 2002 2001
- ----------------------------------------------------------------------
Risk free interest rate ......... 3.97% 4.83% 5.23%
Dividend yield .................. 3.30% 3.72% 3.50%
Volatility ...................... 24.53% 21.63% 38.56%
Expected life ................... 10 yrs. 10 yrs. 10 yrs.
======================================================================
The weighted average fair value per share of options granted during 2003,
2002 and 2001 was $4.67, $3.43 and $4.72, respectively.
49
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, 2002 ................. $1,450
New loans .................................. 6,409
Repayments ................................. 6,119
- ---------------------------------------------------
Balance, December 31, 2003 ................. $1,740
===================================================
QNB allowed its directors to defer a portion of their compensation. The amount
of deferred compensation accrued as of December 31, 2003 and 2002, was $593,000
and $572,000, respectively.
During 2003, QNB entered into an agreement with a Director for the renovation of
the Bank's operation center. This agreement was approved by the Board of
Directors. The total paid during 2003 was $62,000.
NOTE 16 - COMMITMENTS AND CONTINGENCIES
Financial instruments with off-balance-sheet risk: 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
$5,632,000 and $2,093,000 and commitments to extend credit and unused lines of
credit totaled $59,406,000 and $57,913,000 at December 31, 2003 and 2002,
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.
Other commitments: QNB has committed to various operating leases for several of
their branch and office facilities. The minimum annual rental commitments under
these leases outstanding at December 31, 2003 are as follows:
Minimum Lease Payments
- ------------------------------------------------------------------
2004 ..................................................... $ 234
2005 ..................................................... 228
2006 ..................................................... 226
2007 ..................................................... 210
2008 ..................................................... 210
Thereafter ............................................... 2,286
- ------------------------------------------------------------------
Rent expense under leases for each of the years ended December 31, 2003, 2002
and 2001, was $264,000, $273,000 and $250,000, respectively.
QNB has an employment agreement with one executive officer and change in control
agreements with two other executive officers that provides severance pay
benefits if there is a change in control of QNB. Upon a change in control and
termination, QNB shall continue to pay the executive's salary as provided in the
agreements. The maximum contingent liability under the agreements at December
31, 2003 was approximately $1,226,000 and at December 31, 2002 was approximately
$1,154,000.
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
AMOUNT BENEFIT AMOUNT
- --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003
- ----------------------------
Unrealized losses on securities
Unrealized holding losses arising
during the period ..................... $(2,111) $ 761 $(1,350)
Reclassification adjustment for
losses included in net income ......... 134 (46) 88
- --------------------------------------------------------------------------------
Other comprehensive income .............. $(1,977) $ 715 $(1,262)
================================================================================
YEAR ENDED DECEMBER 31, 2002
- ----------------------------
Unrealized gains on securities
Unrealized holding gains arising
during the period ..................... $ 3,079 $(1,089) $ 1,990
Reclassification adjustment for
losses included in net income ......... 779 (265) 514
- --------------------------------------------------------------------------------
Other comprehensive income .............. $ 3,858 $(1,354) $ 2,504
================================================================================
YEAR ENDED DECEMBER 31, 2001
- ----------------------------
Unrealized gains on securities
Unrealized holding gains arising
during the period ..................... $ 2,055 $ (699) $ 1,356
Reclassification adjustment for
gains included in net income .......... (292) 99 (193)
- --------------------------------------------------------------------------------
Other comprehensive income .............. $ 1,763 $ (600) $ 1,163
================================================================================
50
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
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 QNB's entire holdings of a particular
financial instrument. For a substantial portion of QNB'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 estimated fair values and carrying amounts are summarized as follows:
- ----------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2003 2002
- ----------------------------------------------------------------------------------------------------------------------------
CARRYING AMOUNT ESTIMATED FAIR VALUE CARRYING AMOUNT ESTIMATED FAIR VALUE
- ----------------------------------------------------------------------------------------------------------------------------
Financial Assets
Cash and due from banks ................ $ 21,534 $ 21,534 $ 17,476 $ 17,476
Federal funds sold ..................... 4,532 4,532 10,001 10,001
Investment securities available-for-sale 264,441 264,441 214,741 214,741
Investment securities held-to-maturity . 12,012 12,334 29,736 30,386
Loans held-for-sale .................... 1,439 1,462 4,159 4,254
Net loans .............................. 229,198 232,404 209,753 214,498
Accrued interest receivable ............ 2,823 2,823 2,710 2,710
Financial Liabilities
Deposits with no stated maturities ..... 248,497 248,497 202,236 202,236
Deposits with stated maturities ........ 190,142 193,253 186,677 192,622
Short-term borrowings .................. 10,416 10,416 14,485 14,485
Federal Home Loan Bank advances ........ 55,000 58,751 55,000 61,927
Accrued interest payable ............... 1,285 1,285 1,555 1,555
The estimated fair value of QNB's off-balance sheet financial instruments is
as follows:
- -----------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------------
NOTIONAL AMOUNT ESTIMATED FAIR VALUE NOTIONAL AMOUNT ESTIMATED FAIR VALUE
- -----------------------------------------------------------------------------------------------------------------------------------
Commitments to extend credit ..................... 58,770 - $57,913 -
Standby letters of credit ........................ 5,632 - 2,093 -
The following methods and assumptions were used to estimate the fair value of
each major classification of financial instruments at December 31, 2003 and
2002.
CASH AND DUE FROM BANKS, FEDERAL FUNDS SOLD, ACCRUED INTEREST RECEIVABLE AND
ACCRUED INTEREST PAYABLE: Current carrying amounts approximate estimated fair
value.
INVESTMENT SECURITIES: 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). 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. 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 AND FEDERAL HOME LOAN BANK ADVANCES: Short-term borrowings
and advances from the Federal Home Loan Bank 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.
51
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, 2003 2002
- --------------------------------------------------------------------------------
Assets
Cash and due from banks ............................ $ 26 $ 32
Investment securities available-for-sale ........... 3,501 2,595
Investment in subsidiary ........................... 39,864 38,169
Other assets ....................................... 173 167
- --------------------------------------------------------------------------------
Total assets ....................................... $ 43,564 $40,963
================================================================================
Liabilities
Other liabilities .................................. $ 124 $ 49
Shareholders' equity
Common stock ....................................... 2,001 1,993
Surplus ............................................ 8,933 8,759
Retained earnings .................................. 31,659 28,053
Accumulated other comprehensive income ............. 2,341 3,603
Treasury stock ..................................... (1,494) (1,494
- --------------------------------------------------------------------------------
Total liabilities and shareholders' equity ......... $ 43,564 $40,963
================================================================================
STATEMENTS OF INCOME
- --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Dividends from subsidiary .................. $ 2,050 $ 1,913 $ 2,275
Interest and dividend income ............... 39 40 49
Securities gains (losses) .................. 23 (663) (124)
- --------------------------------------------------------------------------------
Total income ............................. 2,112 1,290 2,200
Expenses ................................. 153 149 154
- --------------------------------------------------------------------------------
Income before applicable income
taxes and equity in undistributed
income of subsidiary .................... 1,959 1,141 2,046
Income taxes (benefit) ..................... (135) (197) (89)
- --------------------------------------------------------------------------------
Income before equity in undistributed
income of subsidiary ..................... 2,094 1,338 2,135
Equity in undistributed
income of subsidiary ..................... 3,554 3,617 2,301
- --------------------------------------------------------------------------------
Net income ................................. $ 5,648 $ 4,955 $ 4,436
================================================================================
STATEMENTS OF CASH FLOWS
- ----------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2003 2002 2001
- ----------------------------------------------------------------------------------------------------------------------------
Operating Activities
Net income .............................................................................. $ 5,648 $ 4,955 $ 4,436
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed income from subsidiary ........................................ (3,554) (3,617) (2,301)
Securities (gains) losses ............................................................. (23) 663 124
Increase in other assets .............................................................. (173) - -
(Decrease) increase in other liabilities .............................................. (9) (61) 75
Deferred income tax provision ......................................................... 50 (136) (110)
- ----------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities ........................................... 1,939 1,804 2,224
- ----------------------------------------------------------------------------------------------------------------------------
Investing Activities
Purchase of investment securities ....................................................... (744) (695) (1,886)
Proceeds from sale of investment securities ............................................. 699 686 1,780
- ----------------------------------------------------------------------------------------------------------------------------
Net cash used by investing activities ................................................ (45) (9) (106)
- ----------------------------------------------------------------------------------------------------------------------------
Financing Activities
Cash dividends paid ..................................................................... (2,042) (1,848) (1,655)
Stock issue ............................................................................. 142 84 42
Treasury stock purchased ................................................................ - - (561)
- ----------------------------------------------------------------------------------------------------------------------------
Net cash used by financing activities ................................................ (1,900) (1,764) (2,174)
- ----------------------------------------------------------------------------------------------------------------------------
(Decrease) increase in cash and cash equivalents ..................................... (6) 31 (56)
Cash and cash equivalents at beginning of year ....................................... 32 1 57
- ----------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year ............................................. $ 26 $ 32 $ 1
============================================================================================================================
Supplemental Cash Flow Disclosure
Non-Cash Transactions
Change in net unrealized holding gains or losses, net of taxes on investment securities $ 596 $ (51) $ 109
52
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 20 - REGULATORY RESTRICTIONS
Dividends payable by the Corporation and the Bank are subject to various
limitations imposed by statutes, regulations and policies adopted by bank
regulatory agencies. Under current regulations regarding dividend availability,
the Bank may declare dividends in 2004 to the Corporation totaling $7,171,000,
plus additional amounts equal to the net profit earned by the Bank for the
period from January 1, 2004, through the date of declaration, less dividends
previously declared in 2004.
Both the Corporation and the Bank are 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
financial statements. Under the framework for prompt corrective action, both the
Corporation and the Bank must meet capital guidelines that involve quantitative
measures of their assets, liabilities, and certain off-balance-sheet items. The
capital amounts and classification are also subject to qualitative judgments by
the regulators. Management believes, as of December 31, 2003, that both the
Corporation and the Bank meet 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 Corporation and the Bank to be "well capitalized"
under the regulatory framework. There are no conditions or events since that
notification that management believes have changed the classification. To be
categorized as well capitalized, the Corporation and the Bank must maintain
minimum ratios set forth in the table below. The Corporation and the Bank's
actual capital amounts and ratios are presented below:
CAPITAL LEVELS
- ------------------------------------------------------------------------------------------------------------------------------------
ACTUAL ADEQUATELY CAPITALIZED WELL CAPITALIZED
AS OF DECEMBER 31, 2003 AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
- ------------------------------------------------------------------------------------------------------------------------------------
Total risk-based capital (to risk weighted assets):1
Consolidated .................................... $43,806 13.39% $26,179 8.00% $32,724 10.00%
Bank ............................................ 40,230 12.43 25,885 8.00 32,356 10.00
Tier I capital (to risk weighted assets):1
Consolidated .................................... 40,877 12.49 13,090 4.00 19,635 6.00
Bank ............................................ 37,301 11.53 12,943 4.00 19,414 6.00
Tier I capital (to average assets):1
Consolidated .................................... 40,877 7.38 22,169 4.00 27,711 5.00
Bank ............................................ 37,301 6.77 22,045 4.00 27,556 5.00
- ------------------------------------------------------------------------------------------------------------------------------------
CAPITAL LEVELS
- ------------------------------------------------------------------------------------------------------------------------------------
ACTUAL ADEQUATELY CAPITALIZED WELL CAPITALIZED
AS OF DECEMBER 31, 2002 AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
- ------------------------------------------------------------------------------------------------------------------------------------
Total risk-based capital (to risk weighted assets):1
Consolidated .................................... $39,653 13.39% $23,692 8.00% $29,615 10.00%
Bank ............................................ 36,908 12.57 23,487 8.00 29,359 10.00
Tier I capital (to risk weighted assets):1
Consolidated .................................... 36,715 12.40 11,846 4.00 17,769 6.00
Bank ............................................ 33,970 11.57 11,744 4.00 17,616 6.00
Tier I capital (to average assets):1
Consolidated .................................... 36,715 7.44 19,728 4.00 24,659 5.00
Bank ............................................ 33,970 6.93 19,614 4.00 24,517 5.00
- ------------------------------------------------------------------------------------------------------------------------------------
1 As defined by the regulators
53
<page>
QNB CORP. AND SUBSIDIARY
INDEPENDENT AUDITORS' REPORT
The Board of Directors QNB Corp:
We have audited the accompanying consolidated balance sheets of QNB Corp. and
subsidiary (the "Company") as of December 31, 2003 and 2002, 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, 2003. 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 auditing standards generally accepted
in the United States of America. 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, 2003 and 2002, and the results of their operations
and their cash flows for each of the years in the three-year period ended
December 31, 2003 in conformity with accounting principles generally accepted in
the United States of America.
/S/KPMG LLP
KPMG LLP
February 20, 2004
Philadelphia, Pennsylvania
54
<page>
SINCERE INTEREST IN YOUR SUCCESS 2003 ANNUAL REPORT
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 18, 2004, at 11:00 a.m.
MARKET MAKERS
As of December 31, 2003, the following firms made a market in QNB Corp.
common stock:
Janney Montgomery Scott, LLC Ryan, Beck & Company
Philadelphia, PA 19103 Livingston, NJ 07039
Monroe Securities, Inc. F.J. Morrissey & Co., Inc.
Rochester, NY 14614 West Conshohocken, PA 19428
TRANSFER AGENT
Registrar and Transfer Company
10 Commerce Drive
Cranford, NJ 07016-3572
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 Jean Scholl, 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
are accessible by the public using the Internet at
HTTP://WWW.SEC.GOV./EDGAR.SHTML.
AUDITORS
KPMG LLP
1601 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 2003 and 2002:
- --------------------------------------------------------------------------------
CASH
HIGH LOW DIVIDEND
BID ASK BID ASK PER SHARE
- --------------------------------------------------------------------------------
2003
First Quarter $ 20.500 $ 24.500 $ 20.000 $ 20.625 $ .165
Second Quarter 22.750 24.500 20.300 21.500 .165
Third Quarter 31.375 35.000 22.750 23.375 .165
Fourth Quarter 34.750 39.000 31.000 32.000 .165
2002
First Quarter $ 16.625 $ 17.430 $ 16.125 $ 16.750 $ .15
Second Quarter 19.000 20.000 16.375 17.000 .15
Third Quarter 19.125 20.000 18.375 19.375 .15
Fourth Quarter 20.000 22.500 19.250 20.000 .15
- --------------------------------------------------------------------------------
DIRECT DEPOSIT OF DIVIDENDS
Shareholders of record may elect to have dividends deposited directly to a
checking or savings account at their financial institutions. For additional
information about Direct Deposit of Dividends, please write to: Jean Scholl,
QNB Corp., P.O. Box 9005, Quakertown, PA 18951-9005.
55
<page>
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
G. Arden Link
Charles M. Meredith, III
Gary S. Parzych
Henry L. Rosenberger
Edgar L. Stauffer
OFFICERS OF QNB CORP.
Dennis Helf, CHAIRMAN
Thomas J. Bisko, PRESIDENT/TREASURER/CEO
Robert C. Werner, VICE PRESIDENT
Bret H. Krevolin, CHIEF FINANCIAL OFFICER
Charles M. Meredith, III, SECRETARY
Jean M. Scholl, 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, EXECUTIVE VICE PRESIDENT/CHIEF FINANCIAL OFFICER/CASHIER Bryan S.
Lebo, SENIOR VICE PRESIDENT/SENIOR LENDING OFFICER Mary Ann Smith, SENIOR
VICE PRESIDENT/CHIEF INFORMATION OFFICER Heather J. Gossler, SENIOR VICE
PRESIDENT, SALES/BRANCH ADMINISTRATOR Scott G. Orzehoski, SENIOR VICE
PRESIDENT, COMMERCIAL LENDING
OFFICERS OF THE QUAKERTOWN NATIONAL BANK
Stephen W. Bauder, VICE PRESIDENT, COMMERCIAL LENDING
Robert D. Beck, VICE PRESIDENT, INFORMATIONTECHNOLOGY
Steven T. Cobb, NETWORK ADMINISTRATOR
Jane S. Cygan, LOAN ORIGINATION OFFICER
Stephen R. Donchez, ASSISTANT VICE PRESIDENT/ACCOUNTING OPERATIONS
Paul T. Dotzman, VICE PRESIDENT, COMMERCIAL LENDING
Dolores A. Fesmire, BANKING OFFICER
Michael J. Fina, Esq., VICE PRESIDENT
Lynn C. Geesaman, ASSISTANT VICE PRESIDENT, LOAN SERVICES
Joseph C. Giacini, PROGRAMMER/ANALYST, TECHNICAL OPERATIONS SUPERVISOR
Linda A. Grawe, VICE PRESIDENT, RETAIL LENDING
Dennis Helf, CHAIRMAN
Patrick D. Iampietro, ASSISTANT VICE PRESIDENT/SENIOR FINANCIAL ANALYST
Deborah E. Keller, BANKING OFFICER, IRA/SAVINGS
Bruce D. Kenworthy, ASSISTANT VICE PRESIDENT/BUSINESS DEVELOPMENT MANAGER
Carl P. Kessler, VICE PRESIDENT, SECURITY/COMPLIANCE
Thomas R. Klee, VICE PRESIDENT, COMMERCIAL LENDING
Christine S. Knerr, BANKING OFFICER, ELECTRONIC BANKING
Stacy A. Moyer, HUMAN RESOURCES ADMINISTRATOR
Shari L. Orzehoski, MORTGAGE LOAN ORIGINATOR
Lisa A. Otery, ASSISTANT VICE PRESIDENT/DEPOSIT SERVICES
Stephen M. Rick, COMMERCIAL LENDER
Brian K. Schaffer, VICE PRESIDENT, MARKETING
Jean M. Scholl, GENERAL LEDGER SUPERVISOR
Connie S. Stepan, VICE PRESIDENT/FINANCIAL ADVISOR
Maryann S. Thompson, COMMERCIAL DOCUMENTATION SUPERVISOR
Cameron B. Wentzel, RETAIL LOAN OFFICER/SUPERVISOR
Debra A. Werkheiser, SENIOR VICE PRESIDENT, DIRECTOR OF WEALTH MANAGEMENT
Robert L. Wieand, SENIOR VICE PRESIDENT, COMMERCIAL LENDING
BRANCH LOCATIONS
DOWNTOWN OFFICE
3rd & West Broad Streets, Quakertown
Carol J. Schroding, ASSISTANT VICE PRESIDENT/BRANCH MANAGER
Denise R. Landis, BANKING OFFICER
COUNTRY SQUARE OFFICE
Country Square Shopping Center, Quakertown
Sharon L. Rotenberger, ASSISTANT VICE PRESIDENT/BRANCH MANAGER
Doreen L. Little, BANKING OFFICER
DUBLIN VILLAGE OFFICE
Dublin Village
Plaza, Dublin
April B. Donahue, ASSISTANT VICE PRESIDENT/BRANCH MANAGER
COOPERSBURG OFFICE Route 309, Coopersburg
Deborah K. McDonald, ASSISTANT VICE PRESIDENT/BRANCH MANAGER
PENNSBURG OFFICE
Pennsburg Square Shopping Center, Pennsburg
Brian L. Heilman, ASSISTANT VICE PRESIDENT/BRANCH MANAGER
PERKASIE OFFICE
6th & Chestnut Streets, Perkasie
April B. Donahue, ASSISTANT VICE PRESIDENT/BRANCH MANAGER
SOUDERTON OFFICE
Hilltown Plaza Shopping Center, Souderton Lisa S.
Heffentrager, BANKING OFFICER
CUSTOMER SERVICE CENTER 215-538-5605 or
800-491-9070
QNB ON THE WEB
www.QNB.com
ACCOUNT ACCESS 24-HOUR TELEPHONE BANKING
215-538-5760 or 800-491-9070
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