SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September, 30, 2004
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OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________________ to ______________________
Commission file number 0-17706
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QNB Corp.
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(Exact Name of Registrant as Specified in Its Charter)
Pennsylvania 23-2318082
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(State or Other Jurisdiction of Incorporation (I.R.S. Employer
or Organization) Identification No.)
15 North Third Street, Quakertown, PA 18951-9005
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(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (215)538-5600
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Not Applicable
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Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report.
Indicate by check X whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes_X_ No____
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes____ No_X_
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Outstanding at November 10, 2004
Common Stock, par value $.625 3,096,865
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QNB CORP. AND SUBSIDIARY
FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2004
INDEX
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED) PAGE
Consolidated Statements of Income for Three and Nine
Months Ended September 30, 2004 and 2003.....................................................1
Consolidated Balance Sheets at September 30, 2004
and December 31, 2003.........................................................................2
Consolidated Statements of Cash Flows for Nine
Months Ended September 30, 2004 and 2003......................................................3
Notes to Consolidated Financial Statements........................................................4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF
OPERATIONS AND FINANCIAL CONDITION................................................................9
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT
MARKET RISK .....................................................................................31
ITEM 4. CONTROLS AND PROCEDURES.............................................................................31
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ..................................................................................32
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND
USE OF PROCEEDS .................................................................................32
ITEM 3. DEFAULTS UPON SENIOR SECURITIES ....................................................................32
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITIES HOLDERS..............................................32
ITEM 5. OTHER INFORMATION ..................................................................................32
ITEM 6. EXHIBITS ...........................................................................................32
SIGNATURES
CERTIFICATIONS
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QNB Corp. and Subsidiary
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CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except share data)
(unaudited)
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THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
2004 2003 2004 2003
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INTEREST INCOME
Interest and fees on loans................................................... $ 3,665 $ 3,554 $ 10,423 $10,777
Interest and dividends on investment securities:
Taxable.................................................................. 2,243 2,075 6,630 6,248
Tax-exempt............................................................... 571 515 1,666 1,561
Interest on Federal funds sold............................................... 24 36 57 112
Other interest income........................................................ 16 23 51 79
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Total interest income.................................................... 6,519 6,203 18,827 18,777
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INTEREST EXPENSE
Interest on deposits
Interest-bearing demand accounts......................................... 179 136 449 374
Money market accounts.................................................... 108 60 226 225
Savings.................................................................. 55 66 161 273
Time .................................................................... 1,053 1,127 3,055 3,444
Time over $100,000....................................................... 267 265 715 830
Interest on short-term borrowings............................................ 32 26 82 79
Interest on Federal Home Loan Bank advances.................................. 731 725 2,166 2,156
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Total interest expense.............................................. 2,425 2,405 6,854 7,381
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Net interest income................................................. 4,094 3,798 11,973 11,396
Provision for loan losses.................................................... - - - -
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Net interest income after provision for loan losses................. 4,094 3,798 11,973 11,396
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NON-INTEREST INCOME
Fees for services to customers............................................... 528 496 1,500 1,371
ATM and debit card income.................................................... 153 134 433 416
Income on cash surrender value of insurance.................................. 62 74 200 229
Mortgage servicing income (loss)............................................. 29 84 92 (21)
Net gain (loss) on investment securities available-for-sale.................. 66 (73) 762 229
Net gain on sale of loans.................................................... 33 3 131 853
Other operating income....................................................... 120 220 416 525
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Total non-interest income........................................... 991 938 3,534 3,602
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NON-INTEREST EXPENSE
Salaries and employee benefits............................................... 1,846 1,826 5,352 5,363
Net occupancy expense........................................................ 262 217 751 642
Furniture and equipment expense.............................................. 313 265 830 804
Marketing expense............................................................ 114 153 369 368
Third party services......................................................... 180 184 510 543
Telephone, postage and supplies expense...................................... 126 138 382 401
State taxes.................................................................. 52 85 283 260
Other expense................................................................ 353 338 1,028 981
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Total non-interest expense.......................................... 3,246 3,206 9,505 9,362
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Income before income taxes ............................................. 1,839 1,530 6,002 5,636
Provision for income taxes................................................... 386 118 1,308 1,063
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NET INCOME............................................................... $ 1,453 $ 1,412 $ 4,694 $ 4,573
====================================================================================================================================
NET INCOME PER SHARE - BASIC............................................. $ .47 $ .46 $ 1.52 $ 1.48
====================================================================================================================================
NET INCOME PER SHARE - DILUTED........................................... $ .46 $ .45 $ 1.48 $ 1.46
====================================================================================================================================
CASH DIVIDENDS PER SHARE................................................. $ .185 $ .165 $ .555 $ .495
====================================================================================================================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE UNAUDITED CONSOLIDATED
FINANCIAL STATEMENTS.
Page 1
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QNB Corp. and Subsidiary
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CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)
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SEPTEMBER 30, DECEMBER 31,
2004 2003
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ASSETS
Cash and due from banks................................................................................. $ 21,756 $ 21,534
Federal funds sold...................................................................................... 11,779 4,532
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Total cash and cash equivalents................................................................ 33,535 26,066
Investment securities
Available-for-sale (cost $271,504 and $257,084).................................................... 273,555 260,631
Held-to-maturity (market value $7,343 and $12,334)................................................. 7,088 12,012
Non-marketable equity securities........................................................................ 3,975 3,810
Loans held-for-sale..................................................................................... 113 1,439
Total loans, net of unearned income of $23 and $153 .............................................. 261,196 232,127
Allowance for loan losses.......................................................................... (2,591) (2,929)
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Net loans...................................................................................... 258,605 229,198
Cash surrender value of insurance....................................................................... 7,806 7,585
Premises and equipment, net............................................................................. 5,844 5,090
Accrued interest receivable ............................................................................ 2,865 2,823
Other assets............................................................................................ 3,295 2,177
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Total assets............................................................................................ $ 596,681 $ 550,831
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LIABILITIES
Deposits
Demand, non-interest-bearing....................................................................... $ 56,001 $ 50,468
Interest-bearing demand accounts................................................................... 110,775 107,648
Money market accounts.............................................................................. 58,176 38,373
Savings............................................................................................ 54,225 52,008
Time............................................................................................... 159,721 151,304
Time over $100,000................................................................................. 45,176 38,838
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Total deposits................................................................................. 484,074 438,639
Short-term borrowings................................................................................... 9,460 10,416
Federal Home Loan Bank advances......................................................................... 55,000 55,000
Accrued interest payable................................................................................ 1,132 1,285
Other liabilities....................................................................................... 1,545 2,051
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Total liabilities....................................................................................... 551,211 507,391
====================================================================================================================================
Commitments and contingencies
SHAREHOLDERS' EQUITY
Common stock, par value $.625 per share;
authorized 10,000,000 shares; 3,203,551 shares and 3,202,065 shares issued;
3,096,865 and 3,095,379 shares outstanding......................................................... 2,002 2,001
Surplus ............................................................................................... 8,973 8,933
Retained earnings....................................................................................... 34,635 31,659
Accumulated other comprehensive gain, net............................................................... 1,354 2,341
Treasury stock, at cost; 106,686 shares at September 30, 2004 and December 31, 2003..................... (1,494) (1,494)
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Total shareholders' equity.............................................................................. 45,470 43,440
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Total liabilities and shareholders' equity $ 596,681 $ 550,831
====================================================================================================================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE UNAUDITED CONSOLIDATED
FINANCIAL STATEMENTS.
PAGE 2
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QNB Corp. and Subsidiary
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
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NINE MONTHS ENDED SEPTEMBER 30, 2004 2003
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OPERATING ACTIVITIES
Net income......................................................................................... $ 4,694 $ 4,573
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization.................................................................... 638 632
Securities gains ............................................................................... (762) (229)
Net gain on sale of loans ....................................................................... (131) (853)
Loss on disposal of premises and equipment....................................................... 3 9
Loss on equity investment in title company....................................................... 20 -
Proceeds from sales of residential mortgages..................................................... 7,737 39,534
Originations of residential mortgages held-for-sale.............................................. (6,428) (36,358)
Proceeds from sales of student loans............................................................. - 402
Originations of student loans.................................................................... - (160)
Income on cash surrender value of insurance...................................................... (200) (229)
Life insurance proceeds/premiums net ............................................................ (21) 141
Deferred income tax provision.................................................................... 386 71
Change in income taxes receivable................................................................ 169 (310)
Net (increase) decrease in interest receivable................................................... (42) 233
Net amortization of premiums and discounts....................................................... 652 1,136
Net decrease in interest payable................................................................. (153) (189)
Increase in other assets ........................................................................ (324) (248)
(Decrease) increase in other liabilities......................................................... (383) 82
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Net cash provided by operating activities........................................................ 5,855 8,237
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INVESTING ACTIVITIES
Proceeds from maturities and calls of investment securities
available-for-sale............................................................................... 46,174 72,235
held-to-maturity................................................................................. 4,925 15,063
Proceeds from sales of investment securities
available-for-sale............................................................................... 54,544 38,299
Purchase of investment securities
available-for-sale............................................................................... (114,927) (167,709)
Net change in non-marketable securities............................................................ (165) 4
Net increase in loans.............................................................................. (30,344) (16,616)
Net purchases of premises and equipment............................................................ (1,395) (323)
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Net cash used by investing activities............................................................ (41,188) (59,047)
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FINANCING ACTIVITIES
Net increase in non-interest-bearing deposits...................................................... 5,533 3,332
Net increase in interest-bearing non-maturity deposits ............................................ 25,147 39,966
Net increase in time deposits...................................................................... 14,755 13,637
Net decrease in short-term borrowings.............................................................. (956) (5,554)
Cash dividends paid................................................................................ (1,718) (1,531)
Proceeds from issuance of common stock............................................................. 41 109
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Net cash provided by financing activities........................................................ 42,802 49,959
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Increase (decrease) in cash and cash equivalents................................................. 7,469 (851)
Cash and cash equivalents at beginning of year................................................... 26,066 27,477
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Cash and cash equivalents at end of period....................................................... $ 33,535 $26,626
====================================================================================================================================
SUPPLEMENTAL CASH FLOW DISCLOSURES
Interest paid...................................................................................... $ 7,007 $ 7,570
Income taxes paid.................................................................................. 815 1,305
Non-Cash Transactions
Change in net unrealized holding gains, net of taxes, on available-for-sale securities........... (987) (649)
Transfer of loan to repossessed assets............................................................... 1,026 -
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE UNAUDITED CONSOLIDATED
FINANCIAL STATEMENTS.
Page 3
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
1. REPORTING AND ACCOUNTING POLICIES
The accompanying unaudited consolidated financial statements include the
accounts of QNB Corp. (QNB) and its wholly owned subsidiary, The Quakertown
National Bank. All significant intercompany accounts and transactions are
eliminated in the consolidated statements.
The consolidated balance sheet as of September 30, 2004, as well as the
statements of income for the three-month period and the statements of income and
cash flows for the nine-month periods ended September 30, 2004 and 2003, are
unaudited. These financial statements should be read in conjunction with the
audited financial statements and notes thereto included in QNB's 2003 Annual
Report incorporated in the Form 10-K.
The unaudited consolidated financial statements reflect all adjustments, which
in the opinion of management are necessary for a fair presentation of the
results of the interim periods and are of a normal and recurring nature. Certain
items in the 2003 financial statements have been reclassified to conform to the
2004 financial statement presentation format. These reclassifications had no
effect on net income. The results for the periods presented are not necessarily
indicative of the full year. Tabular information other than share data is
presented in thousands of dollars.
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amount of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from such estimates.
STOCK SPLIT
On August 19, 2003 the Board of Directors authorized a two-for-one split of the
Company's common stock, effected by a distribution on October 14, 2003 of one
share for each one share held of record at the close of business on September
30, 2003. All earnings per share and common stock information is presented as if
the stock split occurred prior to the earliest year included in these
consolidated financial statements.
STOCK BASED COMPENSATION
At September 30, 2004, QNB has a stock-based employee compensation plan that is
accounted for under the recognition and measurement principles of Accounting
Principles Bulletin (APB) Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES, and related interpretations. No stock-based employee compensation
cost is reflected in net income, as all options granted under the plan had an
exercise price equal to the market value of the underlying common stock on the
date of grant. The "fair value" approach under Statement of Financial Accounting
Standards (SFAS) No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, takes into
account the time value of the option and will generally result in compensation
expense being recorded. Each year since the inception of SFAS No. 123, QNB has
disclosed, in the notes to the consolidated financial statements contained in
its annual report to shareholders, what the earnings impact would have been had
QNB elected the "fair value" approach under SFAS No. 123. Such disclosure is now
required on a quarterly basis in accordance with SFAS No. 148, ACCOUNTING FOR
STOCK-BASED COMPENSATION - TRANSITION AND DISCLOSURE - AN AMENDMENT OF SFAS
STATEMENT NO. 123.
Page 4
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
The following table illustrates the effect of net income and earnings per share
if the company had applied the fair value recognition provisions of FASB
Statement No. 123 to stock-based employee compensation.
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
2004 2003 2004 2003
---- ---- ---- ----
Net income, as reported $1,453 $1,412 $4,694 $4,573
Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of related tax effects 25 26 69 78
Pro forma net income $1,428 $1,386 $4,625 $4,495
Earnings per share
Basic - as reported $0.47 $0.46 $1.52 $1.48
Basic - pro forma $0.46 $0.45 $1.49 $1.45
Diluted - as reported $0.46 $0.45 $1.48 $1.46
Diluted - pro forma $0.45 $0.44 $1.46 $1.44
2. PER SHARE DATA
The following sets forth the computation of basic and diluted earnings per share
(share and per share data are not in thousands):
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
2004 2003 2004 2003
---- ---- ---- ----
Numerator for basic and diluted earnings
per share-net income $1,453 $1,412 $4,694 $4,573
Denominator for basic earnings per share-
weighted average shares outstanding 3,096,857 3,093,722 3,096,057 3,090,721
Effect of dilutive securities-employee
stock options 79,689 64,610 82,214 50,088
Denominator for diluted earnings per
share- adjusted weighted average
shares outstanding 3,176,546 3,158,332 3,178,271 3,140,809
Earnings per share-basic $0.47 $0.46 $1.52 $1.48
Earnings per share-diluted $0.46 $0.45 $1.48 $1.46
Page 5
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
2. PER SHARE DATA (Continued):
There were 20,000 stock options that were anti-dilutive for the three-month and
nine-month periods ended September 30, 2004. There were no stock options that
were anti-dilutive for the three-month or the nine-month periods ended September
30, 2003.
3. COMPREHENSIVE INCOME
Comprehensive income is defined as the change in equity of a business entity
during a period from transactions and other events and circumstances, excluding
those resulting from investments by and distributions to owners. For QNB, the
sole component of other comprehensive income is the unrealized holding gains and
losses on available-for-sale investment securities.
The following shows the components and activity of comprehensive income during
the periods ended September 30, 2004 and 2003 (net of the income tax effect):
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
2004 2003 2004 2003
---- ---- ---- ----
Unrealized holding gains (losses) arising during
the period on securities held $2,855 $(995) $(484) $(498)
Reclassification adjustment for sold securities,
(gains) losses (44) 48 (503) (151)
---- -- ----- -----
(139)22 (139)22
Net change in unrealized gains (losses) during
the period 2,811 (947) (987) (649)
Unrealized holding (losses) gains, beginning of
period (1,457) 3,901 2,341 3,603
------- ----- ----- -----
Unrealized holding gains, end of period
$1,354 $2,954 $1,354 $2,954
====== ====== ====== ======
Net income $1,453 $1,412 $4,694 $4,573
Other comprehensive income, net of tax:
Unrealized holding gains (losses) arising during
the period 2,811 (947) (987) (649)
----- ----- ----- -----
Comprehensive income $4,264 $465 $3,707 $3,924
====== ==== ====== ======
Page 6
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
4. LOANS
The following table presents Loans by category as of September 30, 2004 and
December 31, 2003:
September 30, December 31,
2004 2003
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Commercial and industrial $52,362 $47,196
Agricultural 10 14
Construction 5,571 9,056
Real estate-commercial 100,289 86,707
Real estate-residential 97,220 83,703
Consumer 5,766 5,604
----- -----
Total loans 261,218 232,280
Less unearned income 22 153
-- ---
Total loans net of unearned income $261,196 $232,127
======== ========
5. INTANGIBLE ASSETS
The following table presents Intangible Asset information as of September 30,
2004:
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Amortized Intangible Assets Gross Carrying Accumulated Net Carrying
Amount Amortization Amount
- ------------------------------------ ----------------------- ------------------------- ----------------------
Purchased deposit premium $511 $353 $158
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Mortgage servicing asset 728 152 576
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Total $1,239 $505 $734
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The following table presents Intangible Asset information as of December 31,
2003:
- ------------------------------------ ----------------------- ------------------------- ----------------------
Amortized Intangible Assets Gross Carrying Accumulated Net Carrying
Amount Amortization Amount
- ------------------------------------ ----------------------- ------------------------- ----------------------
Purchased deposit premium $511 $315 $196
- ------------------------------------ ----------------------- ------------------------- ----------------------
Mortgage servicing asset 741 159 582
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Total $1,252 $474 $778
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AGGREGATE AMORTIZATION EXPENSE
For the Nine Months ended September 30, 2004 $133
ESTIMATED AMORTIZATION EXPENSE
For the Year Ended 12/31/04 $170
For the Year Ended 12/31/05 145
For the Year Ended 12/31/06 135
For the Year Ended 12/31/07 114
For the Year Ended 12/31/08 60
Page 7
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
6. RELATED PARTY TRANSACTION
On July 21, 2004, QNB Corp.'s wholly owned subsidiary, The Quakertown National
Bank (the "Bank"), entered into an agreement with a director of QNB Corp. for
the purchase by the Bank of a two story building for a purchase price of
$600,000. The price was determined through an independent third party appraisal.
Management of QNB Corp. and the Bank believe that the transaction reflects
arm's-length, negotiated terms. The Bank intends to use the acquired property
for additional office space.
7. RECENT ACCOUNTING PRONOUNCEMENTS
STOCK-BASED COMPENSATION
On March 31, 2004, the FASB issued a proposed Statement, SHARE-BASED PAYMENT AN
AMENDMENT OF FASB STATEMENTS NO. 123 AND APB NO. 95, that addresses the
accounting for share-based payment transactions in which an enterprise receives
services in exchange for (a) equity instruments of the enterprise or (b)
liabilities that are based on the fair value of the enterprise's equity
instruments or that may be settled by the issuance of such equity instruments.
Under the FASB's proposal, all forms of share-based payments to employees,
including employee stock options, would be treated the same as other forms of
compensation by recognizing the related cost in the income statement. The
expense of the award would generally be measured at fair value at the grant
date. Current accounting guidance requires that the expense relating to
so-called fixed plan employee stock options only be disclosed in the footnotes
to the financial statements. The proposed Statement would eliminate the ability
to account for share-based compensation transactions using APB Opinion No. 25,
ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES. QNB is currently evaluating this
proposed statement and its effects on its results of operations.
OTHER-THAN-TEMPORARY IMPAIRMENT
In November 2003, the Emerging Issues Task Force (EITF) of the FASB issued EITF
Abstract 03-1, THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS
APPLICATION TO CERTAIN INVESTMENTS (EITF 03-1). The quantitative and qualitative
disclosure provisions of EITF 03-1 were effective for years ending after
December 15, 2003 and were included in QNB's 2003 Form 10-K. In March 2004, the
EITF issued a Consensus on Issue 03-1 requiring that the provisions of EITF 03-1
be applied for reporting periods beginning after June 15, 2004 to investments
accounted for under SFAS No. 115 and 124. EITF 03-1 establishes a three-step
approach for determining whether an investment is considered impaired, whether
that impairment is other-than-temporary, and the measurement of an impairment
loss. In September 2004, the FASB issued a proposed Staff Position, EITF Issue
03-1-a, IMPLEMENTATION GUIDANCE FOR THE APPLICATION OF PARAGRAPH 16 OF EITF 03-1
(EITF 03-1-a). EITF 03-1-a would provide implementation guidance with respect to
debt securities that are impaired solely due to interest rates and/or sector
spreads and analyzed for other-than-temporary impairment under paragraph 16 of
EITF 03-1. In September 2004, the FASB issued a Staff Position, EITF Issue
03-1-1, EFFECTIVE DATE OF PARAGRAPHS 10-20 OF EITF ISSUE NO. 03-1 (EITF 03-1-1).
EITF 03-1-1 delays the effective date for the measurement and recognition
guidance contained in paragraphs 10-20 of EITF 03-1. The delay of the effective
date will be superseded concurrent with the final issuance of EITF 03-1-a. QNB
is in the process of determining the impact that this EITF will have on its
financial statements.
Page 8
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
QNB Corp. (the "Corporation") is a bank holding company headquartered in
Quakertown, Pennsylvania. The Corporation through its wholly owned subsidiary,
The Quakertown National Bank (the "Bank"), has been serving the residents and
businesses of Upper Bucks, Northern Montgomery and Southern Lehigh Counties in
Pennsylvania since 1877. The Bank is a locally managed community bank that
provides a full range of commercial, retail banking and trust and investment
management services. The consolidated entity is referred to herein as "QNB".
THIS REPORT INCLUDES FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT WITH RESPECT TO FINANCIAL PERFORMANCE
AND OTHER FINANCIAL AND BUSINESS MATTERS. FORWARD-LOOKING STATEMENTS ARE
TYPICALLY IDENTIFIED BY WORDS OR PHRASES SUCH AS "BELIEVE," "EXPECT,"
"ANTICIPATE," "INTEND," "ESTIMATE," "POSITION" AND VARIATIONS OF SUCH WORDS AND
SIMILAR EXPRESSIONS, OR FUTURE OR CONDITIONAL VERBS SUCH AS "WILL," "WOULD,"
"SHOULD," "COULD," "MAY" OR SIMILAR EXPRESSIONS. THE CORPORATION CAUTIONS THAT
THESE FORWARD-LOOKING STATEMENTS ARE SUBJECT TO NUMEROUS ASSUMPTIONS, RISKS AND
UNCERTAINTIES, ALL OF WHICH CHANGE OVER TIME, AND THE CORPORATION ASSUMES NO
DUTY TO UPDATE FORWARD LOOKING STATEMENTS. ACTUAL RESULTS COULD DIFFER
MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS.
IN ADDITION TO FACTORS PREVIOUSLY DISCLOSED BY THE CORPORATION AND THOSE
IDENTIFIED ELSEWHERE HEREIN, THE FOLLOWING FACTORS, AMONG OTHERS, COULD CAUSE
ACTUAL RESULTS TO DIFFER MATERIALLY FROM FORWARD LOOKING STATEMENTS: INCREASED
CREDIT RISK; THE INTRODUCTION, WITHDRAWAL, SUCCESS AND TIMING OF BUSINESS
INITIATIVES AND STRATEGIES; CHANGES IN COMPETITIVE CONDITIONS; THE INABILITY TO
SUSTAIN REVENUE AND EARNINGS GROWTH; CHANGES IN ECONOMIC CONDITIONS, INTEREST
RATES AND FINANCIAL AND CAPITAL MARKETS; INFLATION; CHANGES IN INVESTMENT
PERFORMANCE; CUSTOMER DISINTERMEDIATION; CUSTOMER BORROWING, REPAYMENT,
INVESTMENT AND DEPOSIT PRACTICES; CUSTOMER ACCEPTANCE OF QNB PRODUCTS AND
SERVICES; AND THE IMPACT, EXTENT AND TIMING OF TECHNOLOGICAL CHANGES, CAPITAL
MANAGEMENT ACTIVITIES, ACTIONS OF THE FEDERAL RESERVE BOARD AND LEGISLATIVE AND
REGULATORY ACTIONS AND REFORMS.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Discussion and analysis of the financial condition and results of operations are
based on the consolidated financial statements of QNB, which are prepared in
accordance with accounting principals 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-
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
CRITICAL ACCOUNTING POLICIES AND ESTIMATES (CONTINUED)
temporary investment security impairment. Each estimate is discussed below. The
financial impact of each estimate is discussed in the applicable sections of
Management's Discussion and Analysis.
ALLOWANCE FOR LOAN LOSSES
QNB maintains an allowance for loan losses, which is intended to absorb probable
known and inherent losses in the outstanding loan portfolio. The allowance is
reduced by actual credit losses and is increased by the provision for loan
losses and recoveries of previous losses. The provisions for loan losses are
charged to earnings to bring the total allowance for loan losses to a level
considered necessary by management.
The allowance for loan losses is based on management's continuing review and
evaluation of the loan portfolio. The level of the allowance is determined by
assigning specific reserves to individually identified problem credits and
general reserves to all other loans. The portion of the allowance that is
allocated to internally criticized and non-accrual loans is determined by
estimating the inherent loss on each credit after giving consideration to the
value of underlying collateral. The general reserves are based on the
composition and risk characteristics of the loan portfolio, including the nature
of the loan portfolio, credit concentration trends, historic and anticipated
delinquency and loss experience, as well as other qualitative factors such as
current economic trends.
Management emphasizes loan quality and close monitoring of potential problem
credits. Credit risk identification and review processes are utilized in order
to assess and monitor the degree of risk in the loan portfolio. QNB's lending
and loan administration staff are charged with reviewing the loan portfolio and
identifying changes in the economy or in a borrower's circumstances which may
affect the ability to repay debt or the value of pledged collateral. A loan
classification and review system exists that identifies those loans with a
higher than normal risk of uncollectibility. Each commercial loan is assigned a
grade based upon an assessment of the borrower's financial capacity to service
the debt and the presence and value of collateral for the loan. An independent
loan review group tests risk assessments and evaluates the adequacy of the
allowance for loan losses. Management meets monthly to review the credit quality
of the loan portfolio and quarterly to review the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their
examination process, periodically review QNB's allowance for losses on loans.
Such agencies may require QNB to recognize additions to the allowance based on
their judgments about information available to them at the time of their
examination.
Management believes that it uses the best information available to make
determinations about the adequacy of the allowance and that it has established
its existing allowance for loan losses in accordance with GAAP. If circumstances
differ substantially from the assumptions used in making determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be affected. Because future events affecting borrowers and
collateral cannot be predicted with certainty, increases to the allowance may be
necessary should the quality of any loans deteriorate as a result of the factors
discussed above.
INCOME TAXES. QNB accounts for income taxes under the asset/liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases, as well as operating loss and tax credit carryforwards. Deferred tax
assets and liabilities are measured using enacted tax rates
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
CRITICAL ACCOUNTING POLICIES AND ESTIMATES (CONTINUED):
INCOME TAXES (CONTINUED)
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date. A valuation allowance is established
against deferred tax assets when in the judgment of management, it is more
likely than not that such deferred tax assets will not become available. Because
the judgment about the level of future taxable income is dependent to a great
extent on matters that may, at least in part, go beyond QNB's control, it is at
least reasonably possible that management's judgment about the need for a
valuation allowance for deferred taxes could change in the near term.
OTHER THAN TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES
Securities are evaluated periodically to determine whether a decline in their
value is other than temporary. Management utilizes criteria such as the
magnitude and duration of the decline, in addition to the reasons underlying the
decline, to determine whether the loss in value is other than temporary. The
term "other than temporary" is not intended to indicate that the decline is
permanent, but indicates that the prospects for a near-term recovery of value is
not necessarily favorable, or that there is a lack of evidence to support
realizable value equal to or greater than carrying value of the investment. Once
a decline in value is determined to be other than temporary, the value of the
security is reduced and a corresponding charge to earnings is recognized.
OVERVIEW
QNB reported net income for the third quarter 2004 of $1,453,000, or $.46 per
common share on a diluted basis. This compares to $1,412,000, or $.45 per share
diluted, for the same period in 2003. Net income for the first nine months of
2004 was $4,694,000, or $1.48 per diluted share, a 2.6 percent increase over the
$4,573,000, or $1.46 per diluted share, for the comparable period in 2003.
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 was 1.01 percent and 1.04 percent while the
return on average equity was 13.30 percent and 14.09 percent for the three
months ended September 30, 2004 and 2003, respectively. For the nine-month
periods ended September 30, 2004 and 2003, return on average assets was 1.13
percent and 1.18 percent and the return on average equity was 14.75 percent and
15.74 percent, respectively.
The results for the third quarter of 2004 represent an improvement in the core
earnings of QNB, as the third quarter of 2003 included several nonrecurring
items that positively affected net income during the 2003 period. Included in
the results for the third quarter of 2003 was the recognition of $109,000 in
tax-free proceeds from life insurance contracts, a $96,000 reversal of a
valuation allowance for mortgage servicing rights and a $137,000 reversal of a
tax valuation allowance recorded in previous periods. The reversal of the tax
valuation allowance was a result of the ability to realize tax benefits
associated with certain impaired securities, due to the increase in unrealized
gains of certain equity securities held by the company. These three items
account for approximately $309,000 of the net income reported in the third
quarter of 2003.
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
OVERVIEW (CONTINUED)
Also contributing to the results for the third quarter of 2004 compared with the
third quarter of 2003 were the following:
Net Interest Income
o $296,000, or 7.8 percent, increase in net interest income resulting
from a 6.9 percent increase in average earning assets and a 3 basis
point increase in the net interest margin to 3.30 percent for the third
quarter of 2004 from 3.27 percent for the third quarter of 2003.
o Reversal of $10,000 of interest on two loans, one transferred to other
assets as a repossessed asset and the other paid off with a small
charge-off. This reversal had a negative impact on the net interest
margin of approximately 1 basis point.
o Interest rates remained volatile during the quarter, with the yield
curve flattening as short-term interest rates increased while mid-term
and longer-term rates declined significantly during the quarter.
Federal Reserve Bank Board raises Federal funds rate twice during the
quarter, .25 percent each time. Federal funds target rate at 1.75
percent on September 30, 2004.
Non-interest Income
o Mortgage servicing income $29,000 for the third quarter of 2004
compared with $84,000 for the third quarter of 2003. Servicing income
for the 2003 quarter includes the $96,000 recovery of the valuation
allowance mentioned above. Servicing income for the third quarter of
2004 includes a recovery of $3,000.
o Gain on investment securities of $66,000 in 2004 compared to a $73,000
loss 2003. The gain in 2004 resulting primarily from sales of equity
securities. The loss in 2003 was a result of transactions to reposition
the fixed income portfolio to reduce the impact of premium amortization
and increase the yield on the investment portfolio.
o Higher interest rates reduced residential mortgage loan activity. Gain
on sale of loans $33,000 in the 2004 quarter compared to $3,000 in
2003. The larger gain in 2004, despite the significantly lower volume,
was a function of the interest rate environment between the time of
application and the time of sale.
o Loss on an equity investment in Bankers Settlement Services of Eastern
Pennsylvania, LLC, a title insurance company of $20,000.
Non-interest Expense
o Non-interest expense increases 1.3 percent; some of the increase
related to the opening of QNB's first
supermarket branch.
o Salary expense increased 1.6 percent, including a $65,000 reduction in
incentive compensation accrual. o Provision for income taxes and
effective tax rates were $386,000, or 21.0 percent, in the third
quarter of 2004 compared to $118,000, or 7.7 percent, in 2003. Lower
expense and rate in 2003 was a result of reversal of tax valuation
allowance and tax-free proceeds from life insurance contracts noted
above.
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
OVERVIEW (CONTINUED)
Balance Sheet
o 12.0 percent increase in average loans, primarily commercial.
o 5.9 percent increase in average investment securities.
o 7.4 percent increase in average deposits centered in growth of
interest-bearing demand accounts and money market accounts. Total
deposits increased $38,226,000, or 8.6 percent, between September 30,
2003 and September 30, 2004. Approximately $18,000,000 resulted from an
increase in municipal and school district deposits.
o Non-performing assets increased to $1,552,000 at September 30, 2004.
This compares to $68,000 at September 30, 2003. Transfer of loan to
repossessed asset account for $1,026,000. $350,000 charged-off through
the allowance for loan losses at time of transfer. Despite the
charge-off, the analysis of the allowance for loan losses determined
that no additional provision for loan losses was needed.
These items as well as others will be explained more thoroughly in the next
sections.
NET INTEREST INCOME
Net interest income is the primary source of operating income for QNB. Net
interest income is interest income, dividends, and fees on earning assets, less
interest expense incurred for funding sources. Earning assets primarily include
loans, investment securities and Federal funds sold. Sources used to fund these
assets include deposits, borrowed funds and shareholders' equity. Net interest
income is affected by changes in interest rates, the volume and mix of earning
assets and interest-bearing liabilities, and the amount of earning assets funded
by non-interest-bearing deposits.
Net interest income increased 7.8 percent, to $4,094,000, for the quarter ended
September 30, 2004 as compared to $3,798,000 for the quarter ended September 30,
2003. On a tax-equivalent basis, which allows for the comparison of tax-exempt
loans and investments to taxable loans and investments, net interest income also
increased by 7.8 percent from $4,136,000 for the three months ended September
30, 2003 to $4,459,000 for the same period ended September 30, 2004. As has been
the trend for the past three years, the ability to increase net interest income
has primarily been as a result of the growth in deposits and the investment of
these deposits into loans and investment securities. This deposit growth was
once again aided by economic uncertainty, the conflict in Iraq and the threat of
terrorism. Investors continued to look to the safety of bank deposits and the
U.S. Government bond market. Also contributing to the growth in deposits during
both 2004 and 2003, with an impact on third quarter and nine-month averages for
2004, was a significant increase in deposits of local municipalities and school
districts. The majority of these deposits are seasonal with the funds being
deposited during the third quarter and withdrawn over the next nine months.
These deposits were primarily invested in securities whose cash flow will
closely match the anticipated run-off of the deposits.
Average deposits increased $31,813,000, or 7.4 percent, when comparing the third
quarters of 2004 and 2003. These deposits were used to fund the $27,827,000, or
12.0 percent, increase in average loans and the $14,727,000, or 5.9 percent,
increase in average investment securities.
Interest rates have been volatile during the first nine months of 2004. The
historically low interest rate environment of the past three years ended during
the second quarter of 2004 as interest rates turned higher in anticipation of
strong growth in the U.S economy and fears of inflation caused by higher oil
prices. However, interest rates headed lower during the third quarter as some
economic and employment reports were not as strong as anticipated. The yield
curve continued to flatten during the quarter as short-term rates declined to a
smaller degree than mid and longer-term rates. Since June 30, 2004 the Federal
Reserve Board has raised the
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
NET INTEREST INCOME (CONTINUED)
target Federal funds rate by .75 percent to 1.75 percent. The two-year treasury
security, which started 2004 at 1.82 percent, hit a low for 2004 of 1.46 percent
in mid March and a high of 2.93 percent in mid June before ending the second
quarter at 2.68 percent. The two-year treasury hit a low of 2.38 percent during
the third quarter and finished at 2.61 percent on September 30, 2004. The
10-year treasury had a similar pattern, starting the year at 4.25 percent,
reaching a low of 3.68 percent and a high of 4.87 percent before ending the
second quarter at 4.58 percent. The ten-year treasury hit a low of 3.98 percent
during the third quarter and finished at 4.12 percent on September 30, 2004.
This flatter yield curve tends to have a negative impact on the net interest
margin as deposits are usually priced off the shorter end of the curve while
banks tend to purchase investment securities priced off the mid-term part of the
curve. Despite the increase in market interest rates off their historic lows,
the long period of historically low interest rates has had the impact of
lowering the yield on earning assets and the rate paid on interest-bearing
liabilities, as loans, investment securities and time deposits either repriced
at lower rates or were originated at lower interest rates. The yield on earning
assets on a tax-equivalent basis was 5.10 percent for the third quarter of 2004
versus 5.17 percent for the third quarter of 2003, while the rate paid on
interest-bearing liabilities was 2.04 percent and 2.16 percent for the same
periods. The net interest margin, on a tax-equivalent basis, increased 3 basis
points to 3.30 percent for the three-month period ended September 30, 2004
compared with 3.27 percent for the same period in 2003.
The yield on loans decreased 47 basis points to 5.68 percent when comparing the
third quarter of 2003 to the third quarter of 2004. The average prime rate when
comparing the third quarter of 2003 to the third quarter of 2004 increased 42
basis points, from 4.00 percent to 4.42 percent. This has helped slow the
decline in the yield on the loan portfolio. The yield on the loan portfolio,
excluding the recognition and reversal of nonaccrual interest in both periods,
was flat when comparing the second and third quarters of 2004. While QNB was
positively impacted from the increases in prime rate, the overall yield on the
loan portfolio did not increase proportionately, since only a percentage of the
loan portfolio re-prices immediately with changes in the prime rate. The
short-term benefits from an increase in the prime rate were offset by the long
period of historically low interest rates which resulted in the refinancing of
residential mortgage, home equity and commercial loans into lower yielding
loans. The yield on the loan portfolio may continue to decline slightly during
2004 as fixed rate loans are refinanced at lower rates, adjustable rate loans
re-price down as they reach their reset date and new loans are booked at the
current low rates. The rate of decline or increase in loan yields will also be
determined by how quickly and to what degree the Federal Reserve Board continues
to increase interest rates. In anticipation of rising rates during 2004, QNB,
particularly with regard to commercial loans, has attempted to originate
floating rate loans indexed to the prime rate. This should help increase the
yield on the loan portfolio as interest rates increase.
When comparing the third quarter of 2004 to the third quarter of 2003, the yield
on investment securities increased 14 basis points to 4.69 percent from 4.55
percent. The increase in the yield on the portfolio is a result of both higher
interest rates and the active management of the portfolio. During the fourth
quarter of 2003 and the first half of 2004, QNB entered into several
transactions in an effort to reposition the portfolio in anticipation of rising
rates during 2004. These transactions were performed in an effort to reduce
extension risk on mortgage backed securities and collateralized mortgage
obligations (CMOs) should interest rates rise and also to increase the overall
yield on the portfolio.
The increase in interest rates in 2004 from their lows in 2003, in conjunction
with management's attempt to manage prepayments by selling certain faster paying
CMOs and mortgage backed securities and purchasing lower coupon, lower premium
mortgage backed securities and CMOs had the impact of slowing the prepayments on
mortgage backed securities and CMOs. This reduced the amount of amortization of
premiums on these bonds resulting in higher interest income and a higher yield.
Amortization expense on investment
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
NET INTEREST INCOME (CONTINUED)
securities for the third quarter of 2004 was $134,000 compared to $323,000 for
the same period in 2003. The yield on the investment portfolio will likely
decline during the fourth quarter as the deposits received from the school
districts were invested in short-term investments which have a lower yield than
the overall portfolio.
While total interest income on a tax-equivalent basis increased $343,000 when
comparing the third quarter of 2004 to the third quarter of 2003, total interest
expense increased $20,000. The increase in interest expense was a result of an
increase in deposit balances offsetting a decline in the rate paid on total
interest bearing deposits. The rate paid on interest bearing deposits decreased
from 1.74 percent to 1.63 percent for the quarters ended September 30, 2003 and
2004. The impact of lower rates on time deposits was the greatest contributor to
the decline in the rate paid on interest bearing deposits. Total interest
expense on time deposits decreased $72,000 when comparing the two quarters. The
average rate paid on time deposits declined from 2.78 percent to 2.61 percent
when comparing the two periods. Like fixed-rate loans, certificates of deposit
reprice over time and therefore have less of an immediate impact on costs 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 costs of time deposits will likely not decline further. In fact,
the yields on time deposits have already increased as the competition for these
deposits has pushed rates higher. The yield on time deposits during the second
quarter of 2004 was 2.55 percent, compared to 2.61 percent during the third
quarter of 2004. Average time deposits increased $2,738,000 to $201,329,000 when
comparing the third quarter of 2004 to the same period in 2003. A $4,002,000
increase in average time deposits with balances less than $100,000 offset a
$1,264,000 decrease in average time deposits with balances of $100,000 or more.
In response to lower market rates of interest in 2003, QNB lowered the rates
paid on savings accounts. Interest expense on saving accounts declined $11,000
when comparing the third quarter of 2003 to the third quarter of 2004. The
average rate paid on savings accounts declined 11 basis points to .39 percent
when comparing the same time periods. Since savings accounts tend to be less
sensitive to interest rate changes, QNB has been able to maintain the average
yield at .39 percent for the first nine months of 2004, compared to .72 percent
for the first nine months of 2003, while increasing average balances. Average
savings accounts increased $3,166,000. The continued growth in savings deposits
can be attributed to consumers looking for the relative safety of bank deposits
despite the low interest rate environment. The challenge will be to retain these
deposits as interest rates increase and confidence in the equity markets
improves.
Offsetting the lower expense from time deposits and savings accounts was
increased expense of interest- bearing demand accounts and money market
accounts. The higher balances resulting from the school district relationships
and the higher rates paid on these deposits contributed to the increase in both
interest expense and the yield on both interest-bearing demand accounts and
money market accounts. Interest expense on interest-bearing demand accounts and
money market accounts increased $43,000 and $48,000, respectively. The average
rate paid on interest-bearing demand accounts increased 8 basis points to .68
percent when comparing the third quarter of 2003 to the third quarter of 2004.
The average rate paid on money market accounts increased 29 basis points to .97
percent when comparing the same periods. Also contributing to the increase in
the cost of money market accounts was the increase in the rate paid on the
Treasury Select Money Market Account. This product is a variable rate account
indexed to the monthly average of the 91-day Treasury bill based on balances in
the account. The yield on this product has increased as short-term interest
rates have increased. The average balances on interest bearing demand accounts
increased from $90,669,000 to $104,388,000 when comparing the third quarter of
2003 to the third quarter of 2004, while the average balances on money market
accounts increased from $35,164,000 to $44,164,000 during the same time frame.
Page 15
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
NET INTEREST INCOME (CONTINUED)
Management expects interest expense and the rate paid on interest-bearing
deposits to increase during the last quarter of 2004 and into 2005 as
competition for deposits, particularly money market and time deposits,
increases. The additional deposits received during the third quarter from the
school districts will also result in an increase in interest expense and the
rate paid on interest-bearing deposits during the fourth quarter.
For the nine-month period ended September 30, 2004, net interest income
increased $577,000, or 5.1 percent, to $11,973,000. On a tax-equivalent basis
net interest income increased $624,000, or 5.0 percent. Included in net interest
income for the first nine months of 2004 was $65,000 in interest and fees
recognized on the pay-off of three loans that had not been accruing interest.
The increase in net interest income is a result of the increase in average
earning assets offsetting the decline in the net interest margin. Average
earning assets increased 6.9 percent while the net interest margin declined 6
basis points. The net interest margin on a tax-equivalent basis was 3.37 percent
for the nine-month period ended September 30, 2004 compared with 3.43 percent
for the same period in 2003. The recognition of interest and fees on non-accrual
loans during the first nine-months of 2004 had the impact of increasing the net
interest margin by two basis points.
Total interest income increased $50,000 from $18,777,000 to $18,827,000 when
comparing the nine-month periods ended September 30, 2003 and September 30,
2004. The increase in interest income is a result of the growth in earning
assets offsetting the decline in the yield on these assets. The yield on earning
assets decreased from 5.46 percent to 5.13 percent, with the yield on investment
securities declining from 4.90 percent to 4.72 percent and the yield on loans
declining from 6.36 percent to 5.75 percent between the nine-month periods.
Average loans increased 7.0 percent to $246,049,000 while average investment
securities increased 10.1 percent to $260,647,000.
Total interest expense decreased $527,000 from $7,381,000 to $6,854,000 for the
nine-month periods with interest on savings accounts and time deposits
accounting for $112,000 and $504,000 of the decrease. The yield on these
accounts declined 33 basis points and 34 basis points when comparing the average
rate paid for the nine-month periods ended September 30, 2004 and 2003. Interest
expense on interest-bearing demand accounts increased $75,000 to $449,000 as
average balances increased $18,189,000 to $99,262,000 for the nine-month period
ended September 30, 2004.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to be charged to operations to bring the allowance for loan
losses to a level that represents management's best estimate of the known and
inherent losses in the existing loan portfolio. Actual loan losses, net of
recoveries, serve to reduce the allowance.
The determination of an appropriate level of the allowance for loan losses is
based upon an analysis of the risk inherent in QNB's loan portfolio. Management
uses various tools to assess the adequacy of the allowance for loan losses. One
tool is a model recommended by the Office of the Comptroller of the Currency.
This model considers a number of relevant factors including: historical loan
loss experience, the assigned risk rating of the credit, current and projected
credit worthiness of the borrower, current value of the underlying collateral,
levels of and trends in delinquencies and non-accrual loans, trends in volume
and terms of loans, concentrations of credit, and national and local economic
trends and conditions. This model is supplemented with another analysis that
also incorporates exceptions to QNB's loan policy and QNB's portfolio exposure
to borrowers with large dollar concentration. Other tools include ratio analysis
and peer group analysis.
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
PROVISION FOR LOAN LOSSES (CONTINUED)
QNB's management determined no provision for loan losses was necessary for
either the three or nine-month periods ended September 30, 2004 or 2003 as the
results of the analysis described above resulted in an allowance for loan losses
that was adequate in relation to the estimate of known and inherent losses in
the portfolio. While non-performing assets and delinquent loans increased, they
still remained at reasonable levels relative to the allowance for loan losses.
QNB had net charge-offs of $307,000 and $2,000 during the third quarters of 2004
and 2003, respectively. For the nine-month periods ended September 30, 2004 and
2003, QNB had net charge-offs of $338,000 and $3,000, respectively. Included in
net charge-offs in the third quarter of 2004, was a $350,000 charge-off related
to the relinquishment of assets by a borrower to the Bank, as its secured
creditor, and the transfer of this loan to other assets as a repossessed asset.
This amount could increase or decrease during the fourth quarter as the assets
are liquidated. Partially offsetting this charge-off was a $50,000 recovery on a
loan that had been charged-off in 1998.
Non-performing assets (non-accruing loans, loans past due 90 days or more, other
real estate owned and other repossessed assets) amounted to .26 percent and .01
percent of total assets at September 30, 2004 and 2003. This compares to .15
percent at December 31, 2003. The percentage increase when comparing September
2003 and September 2004 relates to the repossessed asset discussed previously as
well as a loan placed on non-accrual status during the fourth quarter of 2003.
Non-accrual loans were $377,000 and $57,000 at September 30, 2004 and 2003.
Non-accrual loans at December 31, 2003 were $818,000. QNB did not have any other
real estate owned as of September 30, 2004, December 31, 2003 or September 30,
2003. Repossessed assets were $1,026,000 at September 30, 2004. There were no
repossessed assets as of December 31, 2003 or September 30, 2003.
There were no restructured loans as of September 30, 2004, December 31, 2003 or
September 30, 2003 as defined in SFAS No. 15, "Accounting by Debtors and
Creditors for Troubled Debt Restructurings," that have not already been included
in loans past due 90 days or more or non-accrual loans.
The allowance for loan losses was $2,591,000 and $2,929,000 at September 30,
2004 and December 31, 2003, respectively. The ratio of the allowance to total
loans was .99 percent and 1.26 percent at the respective period end dates. The
decline in the ratio between December 31, 2003 and September 30, 2004 was a
result of both the net charge-offs and the 11.9 percent increase in total loans.
While QNB believes that its allowance is adequate to cover losses in the loan
portfolio, there remain inherent uncertainties regarding future economic events
and their potential impact on asset quality.
A loan is considered impaired, based on current information and events, if it is
probable that QNB will be unable to collect the scheduled payments of principal
or interest when due according to the contractual terms of the loan agreement.
The measurement of impaired loans is generally based on the present value of
expected future cash flows discounted at the historical effective interest rate,
except that all collateral-dependent loans are measured for impairment based on
the fair value of the collateral.
At September 30, 2004 and 2003, the recorded investment in loans for which
impairment has been recognized in accordance with SFAS No. 114 totaled $376,000
and $34,000, respectively. The loans identified as impaired are
collateral-dependent, with no valuation allowance necessary.
Management, in determining the allowance for loan losses, makes significant
estimates. Consideration is given to a variety of factors in establishing these
estimates including current economic conditions, diversification of the loan
portfolio, delinquency statistics, results of loan reviews, borrowers' perceived
financial and managerial strengths, the adequacy of underlying collateral if
collateral dependent, or the present value of future cash flows.
Page 17
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
PROVISION FOR LOAN LOSSES (CONTINUED)
Since the allowance for loan losses is dependent, to a great extent, on
conditions that may be beyond QNB's control, it is at least reasonably possible
that management's estimates of the allowance for loan losses and actual results
could differ in the near term. In addition, various regulatory agencies, as an
integral part of their examination process, periodically review QNB's allowance
for losses on loans. Such agencies may require QNB to recognize additions to the
allowance based on their judgments about information available to them at the
time of their examination.
NON-INTEREST INCOME
QNB, through its core banking business, generates various fees and service
charges. Total non-interest income is composed of service charges on deposit
accounts, ATM and debit card income, income on bank owned life insurance,
mortgage servicing fees, gains or losses on the sale of investment securities,
gains on the sale of residential mortgage loans, and other miscellaneous fee
income. QNB reviews all service charges and fee schedules related to its
products and services on an annual basis. Except for an increase to the
overdraft fee effective March 1, 2004, QNB has not materially changed these fee
schedules during 2003 or the first nine months of 2004.
Total non-interest income increased $53,000, or 5.7 percent, to $991,000 for the
quarter ended September 30, 2004 when compared to September 30, 2003. Included
in non-interest income during the third quarter of 2003 was the recognition of
$109,000 in tax-free proceeds from life insurance contracts and a $96,000
reversal of a valuation allowance for mortgage servicing rights. Partially
offsetting the impact of these two items were net gains on investment securities
and loans. QNB recorded securities and loan gains of $66,000 and $33,000,
respectively, during the third quarter of 2004. This compares to securities
losses of $73,000 and loan gains of $3,000 during the third quarter of 2003.
For the nine-month period, total non-interest income decreased $68,000, or 1.9
percent, to $3,534,000. Included in non-interest income for the nine-month
periods ended September 30, 2004 and 2003 were securities gains of $762,000 and
$229,000 and loan gains of $131,000 and $853,000, respectively. Also included in
the nine-month period ended September 30, 2003 was the $109,000 in life
insurance proceeds. Non-interest income, excluding these items, increased
$230,000, or 9.5 percent, when comparing the nine-month periods.
Fees for services to customers, the largest component of total non-interest
income, is primarily comprised of service charges on deposit accounts. These
fees increased 6.5 percent, to $528,000 from $496,000, when comparing the two
quarters and 9.4 percent or $129,000 to $1,500,000 when comparing the nine-month
periods. The increase in the overdraft fee in March 2004, as well as an increase
in the volume of overdrafts contributed to the $68,000, or 16.6 percent,
increase in overdraft income when comparing the three month periods and
$183,000, or 16.2 percent, increase when comparing the nine month periods ended
September 30, 2004 and 2003. Partially offsetting the increase when comparing
the three-month and nine-month periods were $17,000 and $28,000 reductions in
service charge income on non-interest bearing and interest-bearing checking
accounts, respectively. This decline primarily reflects the impact of a higher
earnings credit rate on business non-interest bearing checking accounts
resulting from increases in short-term interest rates. This earnings credit rate
is applied against service charges incurred. A $21,000 and $33,000 increase in
service charge reversals also partially offset the increase in overdraft income
when comparing the three and nine month periods.
Page 18
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
NON-INTEREST INCOME (CONTINUED)
ATM and debit card income is primarily comprised of interchange income on debit
cards and ATM surcharge income for the use of QNB ATM machines by non-QNB
customers. ATM and debit card income was $153,000 for the third quarter of 2004,
an increase of $19,000, or 14.2 percent, from the amount recorded during the
third quarter of 2003. For the nine-month periods ATM and debit card income
increased 4.1 percent to $433,000. Debit card income increased $14,000, or 14.5
percent, for the three-month period and $15,000, or 4.9 percent, when comparing
the nine-month periods ended September 30, 2004 and 2003. The increase in debit
card income when comparing the three-month periods is a result of both increased
acceptance by consumers of the card as a means of paying for goods and services
and an increase in the amount earned per transaction. In the second quarter of
2003, a legal settlement between credit card companies and retailers was reached
which reduced the amount earned per transaction beginning in the third quarter
of 2003. This per transaction charge was increased in early 2004, but not back
to the levels earned during the first half of 2003. For the three-month period,
ATM surcharge income and ATM interchange income increased by $3,000 and $7,000,
respectively. For the nine-month period, ATM interchange income increased
$18,000 resulting from both an increase in usage and an increase in amount
earned per transaction. Partially offsetting these positive variances was a
reduction in annual card fee income of $5,000 for the three-month period and
$19,000 for the nine-month period. In September 2003, QNB eliminated the annual
fee on its debit card.
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 $62,000 and $74,000 for the three months ended September 30, 2004
and 2003, respectively. For the nine-month period, earnings on these policies
decreased $29,000 to $200,000. The insurance carriers reset the rates on these
policies annually. The decline in income is a result of both adjustments to the
accrual rate used during the previous twelve months and a lower projected rate
going forward, resulting from the low interest rate environment.
When QNB sells its residential mortgages in the secondary market, it retains
servicing rights. A normal servicing fee is retained on all mortgage loans sold
and serviced. QNB recognizes its obligation to service financial assets that are
retained in a transfer of assets in the form of a servicing asset. The servicing
asset is amortized in proportion to and over the period of net servicing income
or loss. Servicing assets are assessed for impairment based on their fair value.
Mortgage servicing fees for the three and nine-month periods ended September 30,
2004 were $29,000 and $92,000, respectively. Included in these amounts are a
$2,000 and a $31,000 positive adjustment to the valuation allowance for
impairment resulting from the increase in interest rates and the slowdown in
mortgage prepayments in 2004.
Mortgage servicing fees for the quarter ended September 30, 2003 were $84,000.
Included in this amount is a $96,000 reversal of a valuation allowance for
impairment of mortgage servicing rights. The fair market value of the
mortgage-servicing asset increased during the third quarter of 2003 as a result
of the increase in interest rates and the slow down in estimated mortgage
prepayment speeds. For the nine-month period ended September 30, 2003, the net
mortgage servicing income was a loss of $21,000 of which $32,000 was a result of
a valuation allowance. This impairment was a result of the historically high
prepayment speeds on mortgages resulting from the record level of mortgage
refinancing activity created by the low interest rate environment during the
first half of 2003. Excluding the valuation allowance adjustments, mortgage
servicing income would have been $27,000 for the third quarter of 2004 compared
to a loss of $12,000 for the third quarter of 2003 and $61,000 compared to
$11,000 for nine-month periods ended September 30, 2004 and 2003, respectively.
Other factors impacting mortgage servicing income is the amount of amortization
of the mortgage servicing asset and the amount of mortgages serviced. When
mortgage refinancing activity is high, amortization
Page 19
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
NON-INTEREST INCOME (CONTINUED)
expense tends to increase because when a loan is paid off, the servicing asset
related to that mortgage must be expensed. Amortization expense for the
three-month periods ended September 30, 2004 and 2003 was $24,000 and $65,000,
respectively. For the respective nine-month periods, amortization expense was
$95,000 and $139,000. The average balance of mortgages serviced for others was
$81,728,000 for the third quarter of 2004 compared to $86,013,000 for the third
quarter of 2003, a decrease of 5.0 percent. The average balance of mortgages
serviced was approximately $83,477,000 for the nine-month period ended September
30, 2004 compared to $80,311,000 for the first nine months of 2003, an increase
of 3.9 percent. The timing of mortgage payments and delinquencies also impacts
the amount of servicing fees recorded.
The fixed income securities portfolio represents a significant portion of QNB's
earning assets and is also a primary tool in liquidity and asset and liability
management. QNB actively manages its fixed income portfolio and has entered into
several transactions during both the first nine-months of 2004 and 2003 in an
effort to take advantage of changes in the shape of the yield curve as well as
changes in spread relationships in different sectors and also for liquidity
purposes as needed. Net gains on the sale of investment securities were $66,000
for the third quarter of 2004. Gain on the sale of equity securities contributed
$58,000, while the sale of some fixed income securities for liquidity purposes
resulted in a gain of $8,000. During the third quarter of 2003, in an effort to
reposition the balance sheet and reduce the banks exposure to premiums and
increased amortization expense, QNB performed two transactions. These
transactions resulted in a loss of $73,000 on the sale of approximately
$9,500,000 in securities, but also resulted in a significant increase in yield
and a reduction in prepayment and premium risk.
Net securities gains were $762,000 and $229,000 for the nine-month periods ended
September 30, 2004 and 2003. For the nine-month period, 2004 gains from the
equity portfolio were $639,000 while gains from the fixed income portfolio were
$123,000. Included in net securities gains for the nine-month period ended
September 30, 2003 were gains of $204,000 from the sale of debt securities and
$25,000 related to activity in the marketable equity securities portfolio.
Included in the net gain on the equity portfolio for the nine-month period was a
$126,000 write-down of securities whose decline in market value below cost was
deemed to be other than temporary. These securities were determined to be
impaired. Management will continue to look at strategies that will result in an
increase in the yield or improvement in the structure of the investment
portfolio.
QNB recorded a net gain of $33,000 on the sale of loans during the third quarter
of 2004. This compares to a $3,000 gain for the same period in 2003. For the
nine-month periods ended September 30, 2004 and 2003 net gains on the sale of
loans were $131,000 and $853,000, respectively. The sale of residential
mortgages accounts for the entire gain in 2004 and for the third quarter of 2003
and $846,000 of the gain for the nine-month period 2003. The sale of student
loans accounts for $7,000 of the gain in the nine-month period of 2003. QNB sold
approximately $395,000 in student loans during the first half of 2003. Effective
June 30, 2003, QNB terminated its agreement with the Student Loan Marketing
Association (SLMA). QNB no longer originates student loans for sale but works on
a fee based referral basis instead. The remaining balance in the portfolio was
sold during the second quarter of 2003.
The net gain on residential mortgage sales is directly related to the volume of
mortgages sold and the timing of the sales relative to the interest rate
environment. As mentioned previously, the decline in interest rates during 2003
to historically low levels resulted in record mortgage refinancing activity and
significant gains on the sale of these loans in 2003. With the increase in rates
during 2004, mortgage activity has slowed significantly. Gains are usually
recorded as rates fall while rising rates tend to result in losses. QNB
originated $1,438,000 and $12,812,000 in mortgages held for sale during the
third quarter of 2004 and 2003 and
Page 20
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
NON-INTEREST INCOME (CONTINUED)
$6,428,000 and $36,358,000 during the respective nine-month periods. Proceeds
from the sale of residential mortgages were approximately $1,459,000 and
$13,841,000 during the third quarters of 2004 and 2003, respectively. For the
nine-month periods proceeds from the sale of residential mortgage loans amounted
to $7,737,000 and $39,534,000, respectively. The larger gain on the sale of
residential mortgage loans during the third quarter of 2004, despite the
significant decrease in activity is a result of the impact of rapidly changing
interest rates. There was a rapid, short-term, increase in interest rates during
the third quarter of 2003. This had a negative impact on the sale of mortgage
loans as loans that were originated when rates had reached their lows were sold
into a higher rate environment, resulting in losses. QNB does not hedge its
mortgage pipeline. As of September 30, 2004 and 2003, QNB had $113,000 and
$889,000 in mortgage loans classified as held for sale. These loans are
accounted for at lower of cost or market.
Other operating income decreased $100,000 to $120,000 during the third quarter
of 2004. Included in other operating income during the third quarter of 2003 was
$109,000 from the proceeds of life insurance. An $11,000 increase in retail
brokerage income and a $5,000 increase in trust department income were offset by
a $13,000 decrease in dividend income from QNB's minority ownership of Bankers
Settlement Services of Eastern Pennsylvania, LLC, a title insurance company. The
dividend decrease reflects the sharp decline in residential mortgage refinance
activity in 2004. In addition, QNB recorded a $20,000 write-down of its equity
investment in the title insurance company during the third quarter of 2004. This
write-down is a result of the liquidation of the company.
For the nine-month period, other operating income decreased $109,000, or 20.8
percent, to $416,000. Included in other operating income in 2003 were the life
insurance proceeds and $39,000 in dividends from the title insurance company.
This loss of income was partially offset by a $34,000 increase in retail
brokerage income, a $9,000 increase in trust department income, a $13,000
increase in safe deposit box income and an $8,000 increase in the commission on
the sale of checks to customers.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee
benefits, net occupancy, furniture and equipment, marketing, third party
services and various other operating expenses. Total non-interest expense of
$3,246,000 for the quarter ended September 30, 2004 represents an increase of
$40,000, or 1.2 percent, from levels reported in the third quarter of 2003.
Total non-interest expense for the nine months ended September 30, 2004 was
$9,505,000, an increase of $143,000, or 1.5 percent, over 2003 levels
Salaries and benefits, the largest component of non-interest expense, increased
$20,000, or 1.1 percent, to $1,846,000 for the quarter ended September 30, 2004
compared to the same quarter in 2003. Salary expense increased $24,000, or 1.6,
percent during the period to $1,496,000 while benefits expense decreased $4,000,
or 1.1 percent, to $350,000. Included in salary expense for the three months
ended September 30, 2004 and 2003 was an accrual of $80,000 and $145,000,
respectively, related to the incentive compensation plan. Excluding the impact
of the accrual for the incentive compensation plan, salary expense increased 6.7
percent for the three-month period. Merit increases and an increase in the
number of employees contributed to the increase in salary expense. The number of
full time-equivalent employees increased by nine when comparing the third
quarters of 2004 and 2003. Contributing to the increase in full time-equivalent
employees was the opening of a supermarket branch during the second quarter of
2004.
Page 21
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
NON-INTEREST EXPENSE (CONTINUED)
For the nine-month period ended September 30, 2004, salaries and benefits
expense decreased $11,000 to $5,352,000 compared to the same period in 2003.
Salary expense decreased by $35,000, or .8 percent, while benefits expense
increased by $24,000, or 2.3 percent, when comparing the two periods. Included
in salary expense for the nine months ended September 30, 2004 and 2003 were
accruals of $180,000 and $361,000 related to the incentive compensation plan.
Excluding the impact of the accruals for the incentive compensation plan, salary
expense increased 3.7 percent for the nine-month period. The number of full
time-equivalent employees increased by six when comparing the nine-month
periods. QNB monitors, through the use of various surveys, the competitive
salary information in its markets and makes adjustments where appropriate.
Net occupancy expense increased $45,000 to $262,000 when comparing the third
quarter of 2004 to the third quarter of 2003. For the nine-month period, net
occupancy expense increased $109,000 to $751,000. Contributing to the increase
in both the three and nine-month periods was higher costs related to building
maintenance, utilities and rent expense. The addition of the new supermarket
branch as well as some repairs to existing branch locations contributed to the
increase in net occupancy expense.
Furniture and equipment expense increased $48,000, or 18.1 percent, to $313,000
when comparing the three-month periods ended September 30, 2004 and 2003. For
the nine-month periods, furniture and equipment expense increased $26,000, or
3.2 percent, to $830,000. Timing of the completion of projects had an impact on
the results for both the three and nine-month periods. Contributing to the
increase for the three-month period were $29,000 and $17,000 increases in
depreciation and equipment maintenance expense. The increase in depreciation
expense is due to the completion of several technology projects during the third
quarter. When comparing the nine-month periods, equipment maintenance costs
increased by $27,000, while depreciation expense increased by $4,000.
Marketing expense decreased $39,000, to $114,000, for the quarter ended
September 30, 2004 and increased $1,000, to $369,000, for the nine-month period.
The timing of advertising, pubic relation campaigns and sales promotions has
been a major factor in the fluctuation in expenses when comparing the periods.
Advertising expense decreased $21,000 when comparing the two quarters but only
decreased $2,000 when comparing the nine-month periods. Public relations expense
decreased $5,000 when comparing the quarters but increased $10,000 when
comparing the nine-month periods and sales promotion expense increased $2,000
for the three-month period and $8,000 for the nine-month period. The use of
billboards for product advertising and costs associated with the opening of the
new branch contributed to an increase in marketing expense in 2004. These higher
costs were offset by a reduction in donation expense, also a timing event as
these costs will likely increase during the fourth quarter of 2004.
Third party services are comprised of professional services including legal,
accounting and auditing and consulting services as well as fees paid to outside
vendors for support services of day-to-day operations. These include Trust
services, retail non-deposit services, correspondent banking services,
investment security safekeeping and supply management services, to name a few.
Third party services expense was $180,000 in the third quarter of 2004 compared
to $184,000 for the third quarter of 2003. An increase in auditing costs was
offset by lower legal and consulting costs. Included in the third quarter of
2003 were $17,000 in costs related to the use of a consultant for a telephone
and technology project implemented in 2004. For the nine-month period, third
party services decreased $33,000 to $510,000. The use of an executive search
firm in 2003 to fill an open Trust officer position was the primary contributor
to the higher third party service expense in 2003. Also contributing to the
higher costs in 2003 were consulting and training costs related to the
installation of an upgrade to the item processing system and consulting costs
for the telephone and
Page 22
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
NON-INTEREST EXPENSE (CONTINUED)
technology project mentioned previously. Partially offsetting these items were
higher internal and external auditing costs and costs associated with the
outsourcing of the statement printing and mailing function which began in the
second quarter of 2003.
Telephone, postage and supplies expense decreased $12,000 to $126,000 for the
three months ended September 30, 2004 compared to $138,000 for the same period
ended September 30, 2003. For the nine-month periods these categories decreased
$19,000 to $382,000. The outsourcing of the statement mail function mentioned
above, contributed to the $8,000 and $36,000 decrease in postage expense for the
three and nine month periods. Telephone expense increased $4,000 when comparing
the three-month periods and $18,000 when comparing the nine-month periods. The
increase in telephone expense relates to costs associated with an additional T-1
line as well as costs associated with the new branch.
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 the third quarter of 2004 was $353,000, an increase of
$15,000, or 4.4 percent. Contributing to the increase was an $11,000 increase in
charge offs of checking accounts, a $5,000 increase in ATM and debit card
expense, and a $5,000 increase in directors and officers insurance premiums.
These increases were partially offset by a $4,000 decrease in check and coupon
book charges. For the nine-month period other expense increased $47,000, or 4.8
percent, to $1,028,000. These same categories increased $4,000, $28,000 and
$14,000, respectively, while check and coupon book charges decreased $13,000.
The increase in the ATM and debit card expense relates to both an increase in
rates by the processor and an increase in usage by customers. The increase in
insurance costs relates primarily to an increase in coverage. For the nine-month
period, classified advertising expense increased $7,000. This cost relates to
filling open staff positions as well as positions for the new branch.
INCOME TAXES
QNB utilizes an asset and liability approach for financial accounting and
reporting of income taxes. As of September 30, 2004 QNB's net deferred tax
liability was $163,000. The primary components of deferred taxes are a deferred
tax asset of $635,000 relating to the allowance for loan losses and a deferred
tax liability of $697,000 resulting from the SFAS No.115 adjustment for
available-for-sale investment securities. As of September 30, 2003, QNB's net
deferred tax liability was $724,000. A deferred tax asset of $725,000 related to
the allowance for loan losses was offset by a deferred tax liability of
$1,522,000 resulting from the SFAS No. 115 adjustment for available-for-sale
investment securities. The decrease in the market value of the
available-for-sale investment portfolio resulting from increasing interest rates
is the primary reason for the reduction in the deferred tax liability.
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 $138,000 was established as of March 31,
2003 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 the third quarter of 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 is included in other liabilities on the consolidated
balance sheet.
Page 23
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
INCOME TAXES (CONTINUED):
Applicable income taxes and effective tax rates were $386,000, or 21.0 percent,
for the three-month period ended September 30, 2004, and $118,000, or 7.7
percent, for the same period in 2003. For the nine-month period, applicable
income taxes and effective tax rates were $1,308,000, or 21.8 percent, and
$1,063,000, or 18.9 percent, for the same period in 2003. The lower rate for
both the three and nine month periods of 2003 is a result of the reversal of the
tax valuation discussed above as well as the receipt of $109,000 in tax-exempt
life insurance proceeds during the third quarter of 2003. The impact of these
items on the effective tax rate was 10.3 percent for the three-month period and
2.1 percent for the nine-month period.
FINANCIAL CONDITION ANALYSIS
The Balance Sheet Analysis compares average balance sheet data for the nine
months ended September 30, 2004 and 2003, as well as the period ended balances
as of September 30, 2004 and December 31, 2003.
Average earning assets for the nine-month period ended September 30, 2004
increased $33,439,000, or 6.9 percent, to $518,061,000 from $484,622 for the
nine months ended September 30, 2003. Average investments increased $23,957,000,
or 10.1 percent, while average loans increased $16,114,000, or 7.0 percent.
Average Federal funds sold decreased $6,566,000 when comparing these same
periods.
Total loans have increased 13.3 percent between September 30, 2003 and September
30, 2004 and 11.9 percent since December 31, 2003. The year over year comparison
takes out some of the seasonality of commercial line of credit borrowings. A
major factor in the growth in total loans is the use of a formal business
development and calling program encompassing lending personnel, branch personnel
and executive management. This program was strengthened in 2003 by the
appointment of a business development officer. The focus of this program is to
develop new lending and deposit relationships as well as 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 an 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, while maintaining
excellent asset quality.
Average commercial loans and average home equity loans increased $15,341,000 and
$6,839,000, when comparing the first nine months of 2004 to the first nine
months of 2003, while average residential mortgage loans and average consumer
type loans decreased $5,332,000 and $734,000 during this same period. The
increase in average commercial loans reflects the success of the business
development program mentioned above. The 14.6 percent increase in home equity
loans reflects their popularity with consumers, especially those refinancing
existing residential mortgage loans, because they have lower origination costs
than residential mortgage loans. It also reflects the introduction of a more
competitive variable rate home equity line of credit priced at prime minus .50
percent introduced in late 2003. The decrease in residential mortgage loans 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 interest rates and also by the slowdown in the residential mortgage
market in 2004.
The growth in average earning assets was funded by increases in
non-interest-bearing deposit accounts and interest-bearing deposit accounts.
Average non-interest bearing demand accounts increased $3,312,000, or 6.8
percent, while average interest-bearing deposit accounts increased $26,644,000,
or 7.4 percent. The "Free
Page 24
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
FINANCIAL CONDITION ANALYSIS (CONTINUED)
Checking" promotion, as well as the acquisition of new business accounts, was a
significant factor in the increase in non-interest bearing deposits.
The growth in average interest-bearing deposit accounts is primarily centered in
interest bearing demand deposit accounts, which increased $18,189,000, or 22.4
percent. As mentioned previously, the majority of this growth can be attributed
to the development of relationships with several school districts and
municipalities. Average money market accounts were also influenced by the growth
in municipal deposits. Average money market accounts increased by $4,042,000, or
11.5 percent, when comparing the two periods.
Average savings accounts increased $4,345,000, or 8.6 percent. The continued
growth in savings deposits can be attributed to consumers looking for the
relative safety of bank deposits despite the low interest rate environment. The
challenge will be to retain these deposits as interest rates increase and
confidence in the equity markets improves.
Average time deposits increased $68,000 to $195,563,000 when comparing the first
nine months of 2004 to the same period in 2003. A $2,986,000 increase in average
time deposits with balances less than $100,000 offset a $2,918,000 decrease in
average time deposits with balances of $100,000 or more. Increasing time deposit
balances will be a challenge because of the extreme rate competition for time
deposits, particularly with maturities over two years. Matching or beating
competitor's rates could have a negative impact on the net interest margin.
Total assets at September 30, 2004 were $596,681,000, compared with $550,831,000
at December 31, 2003, an increase of 8.3 percent. The increase in assets from
December 31, 2003 to September 30, 2004 was primarily centered in loans, which
increased $27,743,000. Total investment securities increased $8,000,000 while
Federal funds sold increased $7,247,000 between December 31, 2003 and September
30, 2004. The increase in Federal funds reflects the desire to increase
liquidity in light of the growth in short-term deposits and loan demand. The
increase in total assets was funded by deposit growth, both core growth and the
seasonal deposits of the municipalities. The increase in other assets reflects
the transfer of one loan to repossessed assets.
Total deposits increased $45,435,000 from $438,639,000 at December 31, 2003 to
$484,074,000 at September 30, 2004. While all major categories of deposits
increased between the two periods, most of the growth was in money market and
time deposit accounts. Money market accounts increased $19,803,000, with
municipal deposits representing $15,000,000 of the increase. Time deposits
increased $14,755,000 with time deposits over $100,000 increasing $6,338,000.
Non-interest bearing demand accounts increased $5,533,000, or 11.0 percent, to
$56,001,000 at September 30, 2004, while interest bearing demand accounts
increased $3,127,000, with municipal deposits representing $3,381,000 of the
increase.
At September 30, 2004, the fair value of investment securities
available-for-sale was $273,555,000, or $2,051,000 above the amortized cost of
$271,504,000. This compares to a fair value of $260,631,000, or $3,547,000 above
the amortized cost of $257,084,000 at December 31, 2003. An unrealized holding
gain, net of taxes, of $1,354,000 was recorded as an increase to shareholders'
equity at September 30, 2004 while an unrealized holding gain of $2,341,000 was
recorded as an increase to shareholders' equity at December 31, 2003. The
increase in interest rates since December 31, 2003 along with the flattening of
the yield curve has contributed to the decline in the unrealized gain.
Page 25
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
FINANCIAL CONDITION ANALYSIS (CONTINUED)
As a result of the transactions mentioned earlier as well as the investment of
the municipal deposits, the composition of the portfolio has changed since
December 31, 2003. Agency securities have increased from 16.1 percent of the
fixed income portfolio at December 31, 2003 to 19.6 percent of the portfolio at
September 30, 2004, while CMO's have increased from 26.4 percent of the
portfolio to 28.9 percent of the portfolio. The increase in the agency portfolio
reflects the investment of the municipal deposits. While the CMO portfolio has
increased from December 31, 2003, it does reflect a reduction from the 35.0
percent at March 31, 2004. Mortgage backed securities have decreased from 24.7
percent to 23.2 percent of the portfolio during this same time period.
The available-for-sale portfolio had a weighted average maturity of
approximately 4 years and 3 months at September 30, 2004 and 4 years, 1 month at
December 31, 2003. The weighted average tax-equivalent yield was 4.53 percent
and 4.61 percent at September 30, 2004 and December 31, 2003. The weighted
average maturity is based on the stated contractual maturity of all securities
except for mortgage-backed securities and CMOs, which are based on estimated
average life. The maturity of the portfolio may be shorter because of call
features in many debt securities and because of prepayments on mortgage-backed
securities and CMOs. However, the estimated average life could be longer if
rates were to increase and principal payments on mortgage-backed securities and
CMOs would slow. The interest rate sensitivity analysis reflects the repricing
term of the securities portfolio 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, 4
months at September 30, 2004 and 3 years, 7 months at December 31, 2003, based
on these assumptions. QNB rate shocks the investment portfolio to analyze the
impact of rising and falling interest rates. A 100 basis point increase in
interest rates would extend the average life of the available-for-sale portfolio
to approximately 5 years, 4 months and reduce the market value by approximately
4.1 percent while a 100 basis point decrease in interest rates would shorten the
average life by to approximately 3 years, 0 months and increase the market value
by approximately 2.2 percent.
During the second quarter of 2002, management and the Board of Directors
approved that all future purchases of investment securities will be categorized
as available-for-sale. While there is the potential for increased volatility of
shareholder's equity due to market value changes, management believes it will
provide for more flexibility in managing the portfolio. Investment securities
held-to-maturity are reported at amortized cost. The held-to-maturity portfolio
is comprised solely of tax-exempt municipal securities. As of September 30, 2004
and December 31, 2003, QNB had securities classified as held-to-maturity with an
amortized cost of $7,088,000 and $12,012,000 and a market value of $7,343,000
and $12,334,000, respectively. The held-to-maturity portfolio had a weighted
average maturity of approximately 4 years, 1 month at September 30, 2004 and 2
years, 11 months at December 31, 2003. The weighted average tax-equivalent yield
was 6.76 percent at September 30, 2004 and 6.59 percent at December 31, 2003.
LIQUIDITY
Liquidity represents an institution's ability to generate cash or otherwise
obtain funds at reasonable rates to satisfy commitments to borrowers and demands
of depositors. QNB manages its mix of cash, Federal funds sold, investment
securities and loans in order to match the volatility, seasonality, interest
sensitivity and growth trends of its deposit funds. Liquidity is provided from
asset sources through maturities and repayments of loans and investment
securities, net interest income and fee income. The portfolio of investment
securities available-for-sale and QNB's policy of selling certain residential
mortgage originations in the secondary market also provide sources of liquidity.
Additional sources of liquidity are provided by the Bank's
Page 26
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QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
LIQUIDITY (CONTINUED)
membership in the Federal Home Loan Bank and a $10,000,000 unsecured Federal
funds line granted by the Bank's correspondent.
Cash and due from banks, Federal funds sold, available-for-sale securities and
loans held-for-sale were $307,203,000 and $288,136,000 at September 30, 2004 and
December 31, 2003. These sources should be adequate to meet normal fluctuations
in loan demand and or deposit withdrawals. During the second quarter of 2004,
QNB used overnight borrowings from the FHLB and its Federal funds line to help
fund the significant loan growth at the end of the quarter. QNB could have sold
investment securities instead of using short-term borrowings to fund the loan
growth, but decided it made financial sense to use low cost funds as opposed to
selling higher yielding investment securities. In addition, the Federal funds
line had been used during the first half of 2004 because of small timing
differences between the withdrawal of funds by the municipalities and the
receipt of the proceeds from the securities matched against these deposits. By
early August 2004 all overnight borrowings from the Federal Home Loan Bank and
its correspondent had been paid and at September 30, 2004, QNB had $11,779,000
in Federal funds sold. QNB did sell some securities at the end of the third
quarter of 2004 for liquidity purposes. These were sold in response to the
withdrawal of $10,000,000 by one school district.
Approximately $96,211,000 and $84,425,000 of available-for-sale securities at
September 30, 2004 and December 31, 2003 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 increase in both liquidity sources and pledged amounts
relate to the higher amount of municipal deposits received during the third
quarter of 2004. These deposits were used to purchase available-for-sale
securities that were used to pledge against the deposits of the municipalities.
The securities were purchased with cash flow characteristics that would closely
match the anticipated run-off of the municipal deposits.
The consolidated statements of cash flows present the changes in cash and cash
equivalents from operating, investing and financing activities. QNB's cash and
cash equivalents increased $7,469,000 to $33,535,000 at September 30, 2004. This
compares to an $851,000 decrease during the nine months of 2003. Operating
activities provided $5,855,000 in cash flow in the first nine months of 2004,
compared to $8,237,000 in the same period of 2003. Net income and the net
activities associated with the origination and sale of residential mortgages
account for most of the net cash provided by operating activities during the
first nine months of 2004 and 2003. The reduction in net cash provided by
operating income when comparing the two periods is primarily the result of the
slowdown in residential mortgage activity.
Net cash used by investing activities was $41,188,000 and $59,047,000 during the
first nine months of 2004 and 2003, respectively. The net increase in loans of
$30,344,000 was the primary use of cash during 2004 and represented a use of
$16,616,000 during 2003. The purchase of investment securities exceeded the
proceeds from calls, maturities and sale by $9,284,000 and $42,112,000 during
the first nine months of 2004 and 2003, respectively. The significant increase
in the school district relationships began during the third quarter of 2003.
These additional deposits were used to purchase investment securities with cash
flows that closely matched the anticipated cash flow out of these deposits. Most
of these deposits are withdrawn during the first six months of the year. During
the third quarter of 2004, these funds were re-deposited and investments were
once again purchased to match the anticipated cash flow.
Page 27
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
LIQUIDITY (CONTINUED)
Net cash provided by financing activities was $42,802,000 and $49,959,000 during
the first nine months of 2004 and 2003, respectively. Non-interest bearing
deposits increased $5,533,000, money market accounts increased $19,803,000 and
time deposits increased $14,755,000 during the first nine months of 2004. Of the
increase in money market balances, $15,000,000 relates to increased balances
with one school district. With regard to 2003, the increase in deposits of
$56,935,000 offset the decline in short-term borrowings of $5,554,000 during the
first nine months of 2003. The growth in municipal interest bearing demand
deposits accounts for $32,138,000 of the increase in total deposits while growth
in time deposits accounts for $13,637,000. The decrease in short-term borrowings
is primarily the reduction of balances held by one repurchase agreement
customer.
CAPITAL ADEQUACY
A strong capital position is fundamental to support continued growth and
profitability, to serve the needs of depositors, and to yield an attractive
return for shareholders. QNB's shareholders' equity at September 30, 2004 was
$45,470,000, or 7.62 percent, of total assets compared to shareholders' equity
of $43,440,000, or 7.89 percent, at December 31, 2003. Shareholders' equity at
September 30, 2004 includes a positive adjustment of $1,354,000 related to
unrealized holding gains, net of taxes, on investment securities
available-for-sale, while shareholders' equity at December 31, 2003 includes a
positive adjustment of $2,341,000. Without these adjustments shareholders'
equity to total assets would have been 7.39 percent and 7.46 percent at
September 30, 2004 and December 31, 2003, respectively.
Shareholders' equity averaged $42,515,000 for the first nine months of 2004 and
$39,286,000 during all of 2003, an increase of 8.2 percent. The ratio of average
total equity to average total assets increased to 7.69 percent for 2004,
compared to 7.46 percent for 2003. The increase in the equity to asset ratio is
a function of the growth in average equity outpacing the growth in total average
assets.
QNB Corp. and the Quakertown National Bank are subject to various regulatory
capital requirements as issued by Federal regulatory authorities. Regulatory
capital is defined in terms of Tier I capital (shareholders' equity excluding
unrealized gains or losses on available-for-sale securities), Tier II capital
that includes a portion of the allowance for loan losses, and total capital
(Tier I plus II). Risk-based capital ratios are expressed as a percentage of
risk-weighted assets. Risk-weighted assets are determined by assigning various
weights to all assets and off-balance sheet arrangements, such as letters of
credit and loan commitments, based on associated risk. Regulators have also
adopted minimum Tier I leverage ratio standards, which measure the ratio of Tier
I capital to total assets.
The minimum regulatory capital ratios are 4.00 percent for Tier I, 8.00 percent
for the total risk-based and 4.00 percent for leverage. Under the requirements,
QNB had a Tier I capital ratio of 12.10 percent and 12.49 percent, a total
risk-based ratio of 12.82 percent and 13.39 percent and a leverage ratio of 7.55
percent and 7.38 percent at September 30, 2004 and December 31, 2003,
respectively. The decline in both the Tier I capital ratio and total risk-based
ratio reflects both the change in the balance sheet composition with growth in
loans, primarily commercial loans, outpacing the growth in investment securities
and the growth in investments resulting from the increase in municipal deposits.
Loans are usually assigned a higher risk weighting than investment securities.
The total risk-based capital ratio was also negatively impacted by the net
charge-offs during the third quarter of 2004, which reduced the allowance for
loan losses included in Tier 2 capital.
Page 28
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
CAPITAL (CONTINUED)
The Federal Deposit Insurance Corporation Improvement Act of 1991 established
five capital level designations ranging from "well capitalized" to "critically
undercapitalized." At September 30, 2004 and December 31, 2003 QNB met the "well
capitalized" criteria which requires minimum Tier I and total risk-based capital
ratios of 6.00 percent and 10.00 percent, respectively; and a Tier I leverage
ratio of 5.00 percent.
INTEREST RATE SENSITIVITY
Since the assets and liabilities of QNB have diverse repricing characteristics
that influence net interest income, management analyzes interest sensitivity
through the use of gap analysis and simulation models. Interest rate sensitivity
management seeks to minimize the effect of interest rate changes on net interest
margins and interest rate spreads and to provide growth in net interest income
through periods of changing interest rates. The Asset/Liability Management
Committee (ALCO) is responsible for managing interest rate risk and for
evaluating the impact of changing interest rate conditions on net interest
income.
Gap analysis measures the difference between volumes of rate-sensitive assets
and liabilities and quantifies these repricing differences for various time
intervals. Static gap analysis describes interest rate sensitivity at a point in
time. However, it alone does not accurately measure the magnitude of changes in
net interest income since changes in interest rates do not impact all categories
of assets and liabilities equally or simultaneously.
Interest rate sensitivity analysis also involves assumptions about certain
categories of assets and deposits. For purposes of interest rate sensitivity
analysis, assets and liabilities are stated at their contractual maturity,
estimated likely call date, or earliest repricing opportunity. Mortgage-backed
securities, CMOs and amortizing loans are scheduled based on their anticipated
cash flow. Savings accounts, including passbook, statement savings, money
market, and interest-bearing demand accounts, do not have a stated maturity or
repricing term and can be withdrawn or repriced at any time. This may impact
QNB's margin if more expensive alternative sources of deposits are required to
fund loans or deposit runoff. Management projects the repricing characteristics
of these accounts based on historical performance and assumptions that it
believes reflect their rate sensitivity. The Treasury Select Indexed Money
Market account reprices monthly based on a percentage of the average of the
91-day Treasury bill.
A positive gap results when the amount of interest rate sensitive assets exceeds
interest rate sensitive liabilities. A negative gap results when the amount of
interest rate sensitive liabilities exceeds interest rate sensitive assets.
QNB primarily focuses on the management of the one-year interest rate
sensitivity gap. At September 30, 2004, interest-earning assets scheduled to
mature or likely to be called, repriced or repaid in one year were $260,631,000.
Interest-sensitive liabilities scheduled to mature or reprice within one year
were $251,199,000. The one-year cumulative gap, which reflects QNB's interest
sensitivity over a period of time, was a positive $9,432,000 at September 30,
2004. The cumulative one-year gap equals 1.67 percent of total rate sensitive
assets.
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.
Page 29
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
INTEREST RATE SENSITIVITY (CONTINUED)
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.
While management performs a downward rate shock of 100, 200 and 300 basis
points, it believes, given the level of interest rates at September 30, 2004,
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.
In the event QNB should experience a mismatch in its desired gap ranges or an
excessive decline in its net interest income subsequent to an immediate and
sustained change in interest rates, it has a number of options that it could
utilize to remedy such a mismatch. QNB could restructure its investment
portfolio through the sale or purchase of securities with more favorable
repricing attributes. It could also emphasize loan products with appropriate
maturities or repricing attributes, or it could attract deposits or obtain
borrowings with desired maturities.
The nature of QNB's current operation is such that it is not subject to foreign
currency exchange or commodity price risk. Additionally, neither the Corporation
nor the Bank owns trading assets. At September 30, 2004, QNB did not have any
hedging transactions in place such as interest rate swaps, caps or floors.
The table below summarizes estimated changes in net interest income over a
twelve-month period, under alternative interest rate scenarios.
- -------------------------------------------------- ---------------------- -------------------- ---------------------
Change in Interest Rates Net Interest Income Dollar Change Percent Change
- -------------------------------------------------- ---------------------- -------------------- ---------------------
+300 Basis Points................................. $16,113 $628 4.06%
+200 Basis Points................................. 16,248 763 4.93
+100 Basis Points................................. 16,193 708 4.57
FLAT RATE......................................... 15,485 - -
- -100 Basis Points................................. 14,010 (1,475) (9.53)
Management believes, given the current interest rate environment that it is
unlikely that interest rates would decline by 200 or 300 basis points.
Page 30
<page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004 AND 2003, AND DECEMBER 31, 2003
(UNAUDITED)
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The information required herein is set forth in Item 2, above.
ITEM 4. CONTROLS AND PROCEDURES
We maintain a system of controls and procedures designed to provide reasonable
assurance as to the reliability of the consolidated financial statements and
other disclosures included in this report, as well as to safeguard assets from
unauthorized use or disposition. We evaluated the effectiveness of the design
and operation of our disclosure controls and procedures under the supervision
and with the participation of management, including our Chief Executive Officer
and Chief Financial Officer, within 90 days prior to the filing date of this
report. Based upon that evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are
effective in timely alerting them to material information required to be
included in our periodic Securities and Exchange Commission filings. No
significant changes were made to our internal controls or other factors that
could significantly affect these controls subsequent to the date of their
evaluation.
Page 31
<page>
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
SEPTEMBER 30, 2004
Item 1. Legal Proceedings
None.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Default Upon Senior Securities
None.
Item 4. Submission of Matters to Vote of Securities Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits
Exhibit 3(i) Articles of Incorporation of Registrant, as amended.
(Incorporated by reference to Exhibit 3(i) of Registrants
Form 10-K filed with the Commission on March 30, 2004).
Exhibit 3(ii) Bylaws of Registrant, as amended. (Incorporated by
reference to Exhibit 3(ii) of Registrants Form 10-K filed
with the Commission on March 30, 2004).
Exhibit 10.1 Employment Agreement between the Registrant and Thomas J.
Bisko, as amended.
Exhibit 10.2 Salary Continuation Agreement between the Registrant and
Thomas J. Bisko.
Exhibit 10.3 QNB Corp. 1998 Stock Incentive Plan. (Incorporated by
reference to Exhibit 4.3 to Registration Statement
No. 333-91201 on Form S-8, filed with the Commission on
November 18, 1999).
Exhibit 10.4 The Quakertown National Bank Retirement Savings Plan.
(Incorporated by reference to Exhibit 10.4 of Registrants
Form 10-Q filed with the Commission on August 14, 2003).
Exhibit 10.5 Change of Control Agreement between Registrant and
Robert C. Werner (Incorporated by reference to Exhibit
10.7 of Registrants Form 10-Q filed with the Commission on
November 13, 2000.)
Page 32
<page>
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
SEPTEMBER 30, 2004
Item 6. Exhibits (Continued)
Exhibit 10.6 Change of Control Agreement between Registrant and
Bret H. Krevolin (Incorporated by reference to Exhibit
10.8 of Registrants Form 10-Q filed with the Commission on
November 13, 2000.)
Exhibit 10.7 QNB Corp. 2001 Employee Stock Purchase Plan. (Incorporated
by reference to Exhibit 99.1 to Registration Statement No.
333-67588 on Form S-8, filed with the Commission on August
15, 2001.)
Exhibit 11 Statement Re: Computation of Earnings Per Share.
(Included in Part I, Item I, hereof.)
Exhibit 32.1 Certification of Principal Executive Officer
Exhibit 32.2 Certification of Principal Financial Officer
Page 33
<page>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized.
QNB Corp.
Date: November 12, 2004 By: /s/ Thomas J. Bisko
------------------------ ---------------------------
Thomas J. Bisko
President/CEO
Date: November 12, 2004 By: /s/ Robert C. Werner
------------------------ ---------------------------
Robert C. Werner
Vice President
Date: November 12, 2004 By: /s/ Bret H. Krevolin
------------------------ ---------------------------
Bret H. Krevolin
Chief Financial Officer