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 June 30, 2005
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OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission file number 0-17706
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QNB Corp.
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(Exact Name of Registrant as Specified in Its Charter)
Pennsylvania 23-2318082
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(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
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 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
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Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes X No
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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 August 5, 2005
Common Stock, par value $.625 3,102,635
QNB CORP. AND SUBSIDIARY
FORM 10-Q
QUARTER ENDED JUNE 30, 2005
INDEX
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) PAGE
Consolidated Statements of Income for Three and Six
Months Ended June 30, 2005 and 2004........................... 1
Consolidated Balance Sheets at June 30, 2005
and December 31, 2004......................................... 2
Consolidated Statements of Cash Flows for Six
Months Ended June 30, 2005 and 2004........................... 3
Notes to Consolidated Financial Statements......................... 4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF
OPERATIONS AND FINANCIAL CONDITION ........................... 10
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT
MARKET RISK ................................................. 34
ITEM 4. CONTROLS AND PROCEDURES............................................. 34
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS .................................................. 35
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS ........ 35
ITEM 3. DEFAULTS UPON SENIOR SECURITIES .................................... 35
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITIES HOLDERS.............. 35
ITEM 5. OTHER INFORMATION .................................................. 36
ITEM 6. EXHIBITS .................... ...................................... 36
SIGNATURES
CERTIFICATIONS
QNB CORP. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except share data)
(unaudited)
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THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
2005 2004 2005 2004
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INTEREST INCOME
Interest and fees on loans $ 4,072 $ 3,409 $ 7,963 $ 6,758
Interest and dividends on investment securities:
Taxable 2,216 2,186 4,472 4,387
Tax-exempt 567 546 1,131 1,095
Interest on Federal funds sold 68 12 86 33
Interest on interest-bearing balances and other interest income 33 19 63 35
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Total interest income 6,956 6,172 13,715 12,308
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INTEREST EXPENSE
Interest on deposits
Interest-bearing demand accounts 233 120 430 270
Money market accounts 236 57 488 118
Savings 55 54 109 106
Time 1,205 1,006 2,327 2,002
Time over $100,000 316 236 596 448
Interest on short-term borrowings 57 28 99 50
Interest on Federal Home Loan Bank advances 743 718 1,470 1,435
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Total interest expense 2,845 2,219 5,519 4,429
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Net interest income 4,111 3,953 8,196 7,879
Provision for loan losses - - - -
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Net interest income after provision for loan losses 4,111 3,953 8,196 7,879
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NON-INTEREST INCOME
Fees for services to customers 452 526 891 972
ATM and debit card income 171 152 330 280
Income on bank-owned life insurance 64 70 127 138
Mortgage servicing income 12 69 36 63
Net (loss) gain on investment securities available-for-sale (1,189) 217 (576) 696
Net gain (loss) on sale of loans 60 (2) 95 98
Other operating income 258 141 594 296
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Total non-interest income (172) 1,173 1,497 2,543
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NON-INTEREST EXPENSE
Salaries and employee benefits 1,863 1,712 3,700 3,506
Net occupancy expense 272 251 553 489
Furniture and equipment expense 291 274 573 517
Marketing expense 156 148 306 255
Third party services 168 175 309 330
Telephone, postage and supplies expense 113 140 236 256
State taxes 114 119 217 231
Other expense 339 362 658 675
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Total non-interest expense 3,316 3,181 6,552 6,259
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Income before income taxes 623 1,945 3,141 4,163
Provision for income taxes 140 426 739 922
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NET INCOME $ 483 $ 1,519 $ 2,402 $ 3,241
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NET INCOME PER SHARE - BASIC $ .16 $ .49 $ .77 $ 1.05
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NET INCOME PER SHARE - DILUTED $ .15 $ .48 $ .76 $ 1.02
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CASH DIVIDENDS PER SHARE $ .195 $ .185 $ .39 $ .37
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THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE UNAUDITED CONSOLIDATED
FINANCIAL STATEMENTS.
1
QNB CORP. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)
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JUNE 30, DECEMBER 31,
2005 2004
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ASSETS
Cash and due from banks $ 20,117 $ 19,026
Federal funds sold 2,442 3,159
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Total cash and cash equivalents 22,559 22,185
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Investment securities
Available-for-sale (cost $250,775 and $266,000) 252,050 267,561
Held-to-maturity (market value $6,127 and $6,432) 5,900 6,203
Non-marketable equity securities 3,455 3,947
Loans held-for-sale 433 312
Total loans, net of unearned income 273,002 268,048
Allowance for loan losses (2,585) (2,612)
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Net loans 270,417 265,436
Bank-owned life insurance 7,926 7,906
Premises and equipment, net 5,371 5,640
Accrued interest receivable 2,509 2,531
Other assets 3,924 1,923
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Total assets $ 574,544 $ 583,644
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LIABILITIES
Deposits
Demand, non-interest-bearing $ 57,878 $ 52,603
Interest-bearing demand accounts 88,591 95,120
Money market accounts 44,531 60,434
Savings 53,846 55,511
Time 166,980 160,845
Time over $100,000 46,127 41,975
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Total deposits 457,953 466,488
Short-term borrowings 12,313 13,374
Federal Home Loan Bank advances 55,000 55,000
Accrued interest payable 1,341 1,179
Other liabilities 852 1,828
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Total liabilities 527,459 537,869
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SHAREHOLDERS' EQUITY
Common stock, par value $.625 per share;
authorized 10,000,000 shares; 3,209,301 and 3,204,764 shares issued;
3,102,615 and 3,098,078 shares outstanding 2,006 2,003
Surplus 9,078 9,005
Retained earnings 36,762 35,570
Accumulated other comprehensive gain, net 733 691
Treasury stock, at cost; 106,686 shares (1,494) (1,494)
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Total shareholders' equity 47,085 45,775
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Total liabilities and shareholders' equity $ 574,544 $ 583,644
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THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE UNAUDITED CONSOLIDATED
FINANCIAL STATEMENTS.
2
QNB CORP. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
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SIX MONTHS ENDED JUNE 30, 2005 2004
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OPERATING ACTIVITIES
Net income $ 2,402 $ 3,241
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization 437 397
Securities gains (677) (696)
Impairment write-down of securities 1,253 -
Net gain on sale of repossessed assets (209) -
Proceeds from sale of repossessed assets 209 -
Net gain on sale of loans (95) (98)
Loss on disposal of premises and equipment 1 -
Proceeds from sales of residential mortgages 5,233 6,278
Originations of residential mortgages held-for-sale (5,346) (4,990)
Income on bank-owned life insurance (127) (138)
Life insurance proceeds/premiums, net 107 (5)
Deferred income tax provision (213) 227
Net (decrease) increase in income taxes payable (308) 123
Net decrease in accrued interest receivable 22 437
Net amortization of premiums and discounts 477 513
Net increase (decrease) in accrued interest payable 162 (139)
Increase in other assets (1,612) (310)
Decrease in other liabilities (562) (231)
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Net cash provided by operating activities 1,154 4,609
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INVESTING ACTIVITIES
Proceeds from maturities and calls of investment securities
available-for-sale 17,505 36,958
held-to-maturity 300 4,897
Proceeds from sales of investment securities
available-for-sale 36,793 42,820
Purchase of investment securities
available-for-sale (40,038) (72,901)
Net change in non-marketable equity securities 492 (70)
Net increase in loans (4,933) (28,021)
Net purchases of premises and equipment (169) (578)
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Net cash provided (used) by investing activities 9,950 (16,895)
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FINANCING ACTIVITIES
Net increase in non-interest-bearing deposits 5,275 8,030
Net decrease in interest-bearing non-maturity deposits (24,097) (11,722)
Net increase in time deposits 10,287 8,622
Net (decrease) increase in short-term borrowings (1,061) 4,627
Cash dividends paid (1,210) (1,145)
Proceeds from issuance of common stock 76 40
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Net cash (used) provided by financing activites (10,730) 8,452
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Increase (decrease) in cash and cash equivalents 374 (3,834)
Cash and cash equivalents at beginning of year 22,185 26,066
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Cash and cash equivalents at end of period $ 22,559 $22,232
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SUPPLEMENTAL CASH FLOW DISCLOSURES
Interest paid $ 5,357 $ 4,568
Income taxes paid 1,245 560
Non-Cash Transactions
Change in net unrealized holding (losses) gains, net of taxes, on investment
securities available-for-sale 42 (3,798)
Transfer of loans to repossessed assets 4 -
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE UNAUDITED CONSOLIDATED
FINANCIAL STATEMENTS.
3
<Page>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
1. REPORTING AND ACCOUNTING POLICIES
The accompanying unaudited consolidated financial statements include the
accounts of QNB Corp. (QNB) and its wholly-owned subsidiary, The Quakertown
National Bank (the Bank). All significant intercompany accounts and transactions
are eliminated in the consolidated statements.
The consolidated balance sheet as of June 30, 2005, as well as the statements of
income for the three-month and six-month periods ended June 30, 2005 and 2004,
and the statements of cash flows for the six-month periods ended June 30, 2005
and 2004, is unaudited. These consolidated financial statements should be read
in conjunction with the audited consolidated financial statements and notes
thereto included in QNB's 2004 Annual Report incorporated in the Form 10-K.
The unaudited consolidated financial statements reflect all adjustments which,
in the opinion of management, are necessary for a fair presentation of the
results of the interim periods and are of a normal and recurring nature. Certain
items in the 2004 consolidated financial statements have been reclassified to
conform to the 2005 financial statement presentation format. These
reclassifications had no effect on net income. The results for the periods
presented are not necessarily indicative of the full year. Tabular information
other than share data is presented in thousands of dollars.
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amount of assets and
liabilities at the date of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from such estimates.
STOCK BASED COMPENSATION
At June 30, 2005, QNB has stock-based employee compensation plans that are
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 plans had an
exercise price equal to the market value of the underlying common stock on the
date of grant. The "fair value" approach under Financial Accounting Standards
Board (FASB) Statement No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, takes
into account the time value of the option and will generally result in
compensation expense being recorded. Each year since the inception of Statement
No. 123, QNB has disclosed, in the notes to the consolidated financial
statements contained in its annual report to shareholders, what the earnings
impact would have been had QNB elected the "fair value" approach under Statement
No. 123. Such disclosure is now required on a quarterly basis in accordance with
Statement No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION - TRANSITION AND
DISCLOSURE - AN AMENDMENT OF FASB STATEMENT NO. 123.
Form 10-Q
4
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
The following table illustrates the effect of net income and earnings per share
if the company had applied the fair value recognition provisions of FASB
Statement No. 123 to stock-based employee compensation.
For the Three Months For the Six Months
Ended June 30, Ended June 30,
2005 2004 2005 2004
---- ---- ---- ----
Net income, as reported $483 $1,519 $2,402 $3,241
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net related tax effects 25 26 51 44
Pro forma net income $458 $1,493 $2,351 $3,197
Earnings per share
Basic - as reported $.16 $.49 $.77 $1.05
Basic - pro forma $.15 $.48 $.76 $1.03
Diluted - as reported $.15 $.48 $.76 $1.02
Diluted - pro forma $.14 $.47 $.74 $1.01
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 Six Months Ended
Ended June 30, June 30,
2005 2004 2005 2004
---- ---- ---- ----
Numerator for basic and diluted earnings
per share-net income $483 $1,519 $2,402 $3,241
Denominator for basic earnings per share-
weighted average shares outstanding 3,101,194 3,095,927 3,100,624 3,095,653
Effect of dilutive securities-employee
stock options 75,836 82,305 76,571 83,531
Denominator for diluted earnings per
share- adjusted weighted average
shares outstanding 3,177,030 3,178,232 3,177,195 3,179,184
Earnings per share-basic $.16 $.49 $.77 $1.05
Earnings per share-diluted $.15 $.48 $.76 $1.02
Form 10-Q
5
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
2. PER SHARE DATA (Continued):
There were 40,000 stock options that were anti-dilutive for the three and
six-month periods ended June 30, 2005. There were 20,000 stock options that were
anti-dilutive for the three-month period June 30, 2004. These stock options were
not included in the above calculation. There were no stock options that were
anti-dilutive for the six-month period ended June 30, 2004.
3. COMPREHENSIVE INCOME
Comprehensive income is defined as the change in equity of a business entity
during a period from transactions and other events and circumstances, excluding
those resulting from investments by and distributions to owners. For QNB, the
sole component of other comprehensive income is the unrealized holding gains and
losses on available-for-sale investment securities.
The following shows the components and activity of comprehensive income during
the periods ended June 30, 2005 and 2004 (net of the income tax effect):
For the Three Months For the Six Months
Ended June 30, Ended June 30,
2005 2004 2005 2004
---- ---- ---- ----
Unrealized holding gains (losses) arising during
the period on securities held $1,928 $(4,964) $(528) $(3,339)
Reclassification adjustment for losses (gains)
included in net income 975 (143) 570 (459)
------- ------- ----- -----
Net change in unrealized gains (losses) during
the period 2,903 (5,107) 42 (3,798)
Unrealized holding (losses) gains, beginning of
period (2,170 3,650 691 2,341
------- ------- ------ -------
Unrealized holding gains (losses), end of period $733 $(1,457) $733 $(1,457)
==== ======== ====== =======
Net income $483 $1,519 $2,402 $3,241
Other comprehensive income, net of tax:
Unrealized holding gains (losses) arising during
the period 2,903 (5,107) 42 (3,798)
----- ------- ------ -------
Comprehensive income (loss) $3,386 $(3,588) $2,444 $ (557)
====== ======== ====== =======
Form 10-Q
6
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
4. LOANS
The following table presents loans by category as of June 30, 2005 and December
31, 2004:
June 30, December 31,
2005 2004
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Commercial and industrial $59,929 $57,364
Agricultural 6 8
Construction 8,734 7,027
Real estate-commercial 94,447 98,397
Real estate-residential 104,407 99,893
Consumer 5,468 5,376
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Total loans 272,991 268,065
Less unearned costs (income) 11 (17)
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Total loans net of unearned income $273,002 $268,048
======== ========
5. INTANGIBLE ASSETS
As a result of a purchase of deposits in 1997, QNB recorded a deposit premium of
$511,000. This premium is being amortized, for book purposes, over ten years and
is reviewed annually for impairment. The net carrying amount was $119,000 and
$145,000 at June 30, 2005 and December 31, 2004, respectively. Amortization
expense for core deposit intangibles was $13,000 for both three-month periods
ended June 30, 2005 and 2004 and $26,000 for both six-month periods ended June
30, 2005 and 2004.
The following table reflects the components of mortgage servicing rights as of
the periods indicated:
June 30, December 31,
2005 2004
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Mortgage servicing rights beginning balance $552 $582
Mortgage servicing rights capitalized 39 66
Mortgage servicing rights amortized (59) (122)
Fair market value adjustments (1) 26
------- --------
Mortgage servicing rights ending balance $ 531 $ 552
======= ========
Mortgage loans serviced for others $77,610 $78,904
Amortization expense of intangibles 85 173
Form 10-Q
7
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
5. INTANGIBLE ASSETS (Continued):
The annual estimated amortization expense of intangible assets for each of the
five succeeding fiscal years is as follows:
ESTIMATED AMORTIZATION EXPENSE
For the Year Ended 12/31/05 $165
For the Year Ended 12/31/06 151
For the Year Ended 12/31/07 126
For the Year Ended 12/31/08 68
For the Year Ended 12/31/09 55
6. RELATED PARTY TRANSACTIONS
As of June 30, 2005, amounts due from directors, principal officers, and their
related interests totaled $3,594,000. All of these transactions were made in the
ordinary course of business on substantially the same terms, including interest
rates and collateral, as those prevailing at the time for comparable
transactions with other persons. Also, they did not involve a more than normal
risk of collectibility or present any other unfavorable features.
7. RECENT ACCOUNTING PRONOUNCEMENTS
STOCK-BASED COMPENSATION AND SHARE-BASED PAYMENT
In April, the Securities and Exchange Commission adopted a new rule that amends
the compliance dates for FASB Statement No. 123 (revised 2004), SHARE-BASED
PAYMENT (FAS No. 123R). The Statement requires that compensation cost, relating
to share-based payment transactions, be recognized in financial statements and
that this cost be measured based on the fair value of the equity or liability
instruments issued. FAS No. 123 (Revised 2004) covers a wide range of
share-based compensation arrangements including share options, restricted share
plans, performance-based awards, share appreciation rights, and employee share
purchase plans. QNB will adopt FAS No. 123 (Revised 2004) on January 1, 2006 and
is currently evaluating the impact the adoption of the standard will have on
QNB's results of operations.
In March 2005, the Securities and Exchange Commission ("SEC") issued Staff
Accounting Bulletin No. 107 ("SAB No. 107"), SHARE-BASED PAYMENT, providing
guidance on option valuation methods, the accounting for income tax effects of
share-based payment arrangements upon adoption of FAS No. 123R, and the
disclosures in Management's Discussion and Analysis subsequent to the adoption.
QNB will provide SAB No. 107 required disclosures upon adoption of FAS No. 123R
on January 1, 2006 and is currently evaluating the impact the adoption of the
standard will have on QNB's financial condition, results of operations, and cash
flows.
Form 10-Q
8
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2005 AND 2004, AND DECEMBER 31, 2004
(UNAUDITED)
7. RECENT ACCOUNTING PRONOUNCEMENTS (Continued):
ACCOUNTING CHANGES AND ERRORS CORRECTIONS
In June 2005, the FASB issued FAS No. 154, ACCOUNTING CHANGES AND ERRORS
CORRECTIONS, A REPLACEMENT OF APB OPINION NO. 20 AND FAS NO. 3. The Statement
applies to all voluntary changes in accounting principle, and changes the
requirements for accounting for and reporting of a change in accounting
principle. FAS No. 154 requires retrospective application to prior periods'
financial statements of a voluntary change in accounting principle unless it is
impractical. APB Opinion No. 20 previously required that most voluntary changes
in accounting principle be recognized by including in net income of the period
of the change the cumulative effect of changing to the new accounting principle.
FAS No.154 improves the financial reporting because its requirements enhance the
consistency of financial reporting between periods.
Form 10-Q
9
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
QNB Corp. (the Corporation) is a bank holding company headquartered in
Quakertown, Pennsylvania. The Corporation, through its wholly-owned subsidiary,
The Quakertown National Bank (the Bank), has been serving the residents and
businesses of Upper Bucks, Northern Montgomery and Southern Lehigh Counties in
Pennsylvania since 1877. The Bank is a locally managed community bank that
provides a full range of commercial, retail banking and trust and investment
management services. The consolidated entity is referred to herein as "QNB".
FORWARD-LOOKING STATEMENTS
In addition to historical information, this document contains forward-looking
statements. Forward-looking statements are typically identified by words or
phrases such as "believe," "expect," "anticipate," "intend," "estimate,"
"project" and variations of such words and similar expressions, or future or
conditional verbs such as "will," "would," "should," "could," "may" or similar
expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides
safe harbor in regard to the inclusion of forward-looking statements in this
document and documents incorporated by reference.
Shareholders should note that many factors, some of which are discussed
elsewhere in this document and in the documents that are incorporated by
reference, could affect the future financial results of the Corporation and its
subsidiary and could cause those results to differ materially from those
expressed in forward-looking statements contained or incorporated by reference
in this document. These factors include, but are not limited, to the following:
o Operating, legal and regulatory risks
o Economic, political and competitive forces affecting the Corporation's
line of business
o The risk that the analysis of these risks and forces could be
incorrect, and/or that the strategies developed to address them could
be unsuccessful
o Volatility in interest rates
o Increased credit risk
QNB cautions that these forward-looking statements are subject to numerous
assumptions, risks and uncertainties, all of which change over time, and QNB
assumes no duty to update forward-looking statements. Management cautions
readers not to place undue reliance on any forward-looking statements. These
statements speak only as of the date made, and they advise readers that various
factors, including those described above, could affect QNB's financial
performance and could cause actual results or circumstances for future periods
to differ materially from those anticipated or projected. Except as required by
law, we do not undertake, and specifically disclaim any obligation, to publicly
release any revisions to any forward-looking statements to reflect the
occurrence of anticipated or unanticipated events or circumstances after the
date of such statements.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Discussion and analysis of the financial condition and results of operations are
based on the consolidated financial statements of QNB, which are prepared in
accordance with U.S. generally accepted accounting principles (GAAP) and
predominant practices within the banking industry. The preparation of these
consolidated financial statements requires QNB to make estimates and judgments
that affect the reported amounts of assets, liabilities, revenues and expenses,
and related disclosure of contingent assets and liabilities.
Form 10-Q
10
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
CRITICAL ACCOUNTING POLICIES AND ESTIMATES (CONTINUED)
QNB evaluates estimates on an on-going basis, including those related to the
allowance for loan losses, non-accrual loans, other real estate owned,
other-than-temporary investment impairments, intangible assets, stock option
plan and income taxes. QNB bases its estimates on historical experience and
various other factors and assumptions that are believed to be reasonable under
the circumstances, the results of which form the basis for making judgments
about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from these estimates
under different assumptions or conditions.
QNB believes the following critical accounting policies affect its more
significant judgments and estimates used in preparation of its consolidated
financial statements: allowance for loan losses, income taxes and
other-than-temporary investment security impairment. Each estimate is discussed
below. The financial impact of each estimate is discussed in the applicable
sections of Management's Discussion and Analysis.
ALLOWANCE FOR LOAN LOSSES
QNB maintains an allowance for loan losses, which is intended to absorb probable
known and inherent losses in the outstanding loan portfolio. The allowance is
reduced by actual credit losses and is increased by the provision for loan
losses and recoveries of previous losses. The provisions for loan losses are
charged to earnings to bring the total allowance for loan losses to a level
considered necessary by management.
The allowance for loan losses is based on management's continuing review and
evaluation of the loan portfolio. The level of the allowance is determined by
assigning specific reserves to individually identified problem credits and
general reserves to all other loans. The portion of the allowance that is
allocated to internally criticized and non-accrual loans is determined by
estimating the inherent loss on each credit after giving consideration to the
value of underlying collateral. The general reserves are based on the
composition and risk characteristics of the loan portfolio, including the nature
of the loan portfolio, credit concentration trends, historic and anticipated
delinquency and loss experience, as well as other qualitative factors such as
current economic trends.
Management emphasizes loan quality and close monitoring of potential problem
credits. Credit risk identification and review processes are utilized in order
to assess and monitor the degree of risk in the loan portfolio. QNB's lending
and loan administration staff are charged with reviewing the loan portfolio and
identifying changes in the economy or in a borrower's circumstances which may
affect the ability to repay debt or the value of pledged collateral. A loan
classification and review system exists that identifies those loans with a
higher than normal risk of uncollectibility. Each commercial loan is assigned a
grade based upon an assessment of the borrower's financial capacity to service
the debt and the presence and value of collateral for the loan. An independent
loan review group tests risk assessments and evaluates the adequacy of the
allowance for loan losses. Management meets monthly to review the credit quality
of the loan portfolio and quarterly to review the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their
examination process, periodically review QNB's allowance for losses on loans.
Such agencies may require QNB to recognize additions to the allowance based on
their judgments about information available to them at the time of their
examination.
Management believes that it uses the best information available to make
determinations about the adequacy of the allowance and that it has established
its existing allowance for loan losses in accordance with GAAP. If circumstances
differ substantially from the assumptions used in making determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be affected. Because future events
Form 10-Q
11
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
CRITICAL ACCOUNTING POLICIES AND ESTIMATES (CONTINUED):
affecting borrowers and collateral cannot be predicted with certainty, increases
to the allowance may be necessary should the quality of any loans deteriorate as
a result of the factors discussed above.
INCOME TAXES.
QNB accounts for income taxes under the asset/liability method. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases, as well as
operating loss, capital loss and tax credit carryforwards. Deferred tax assets
and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date. A valuation allowance is established against deferred tax assets
when in the judgment of management, it is more likely than not that such
deferred tax assets will not become available. During the second quarter of
2005, QNB established a valuation allowance of $190,000 to offset a portion of
the tax benefits associated with certain impaired securities that management
believes may not be realizable. Because the judgment about the level of future
taxable income is dependent to a great extent on matters that may, at least in
part, go beyond QNB's control, it is at least reasonably possible that
management's judgment about the need for a valuation allowance for deferred
taxes could change in the near term.
OTHER-THAN-TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES
Securities are evaluated periodically to determine whether a decline in their
value is other-than-temporary. Management utilizes criteria such as the
magnitude and duration of the decline, in addition to the reasons underlying the
decline, to determine whether the loss in value is other-than-temporary. The
term "other-than-temporary" is not intended to indicate that the decline is
permanent, but indicates that the prospects for a near-term recovery of value
are not necessarily favorable, or that there is a lack of evidence to support
realizable value equal to or greater than carrying value of the investment. Once
a decline in value is determined to be other-than-temporary, the value of the
security is reduced and a corresponding charge to earnings is recognized.
OVERVIEW
QNB reported net income for the second quarter of 2005 of $483,000, or $.15 per
common share on a diluted basis. The second quarter 2005 results compare to
$1,519,000, or $.48 per share diluted, for the same period in 2004. Net income
for the first six months of 2005 was $2,402,000, or $.76 per diluted share, a
decrease from the $3,241,000, or $1.02 per diluted share, for the comparable
period in 2004.
The results for the 2005 quarter and six-month periods were significantly
impacted by a $1,253,000 unrealized loss as an other-than-temporary impairment
related to certain Fannie Mae (FNMA) and Freddie Mac (FHLMC) preferred stock
issues recorded in accordance with U.S. generally accepted accounting principles
(GAAP). On an after-tax basis, the non-cash, non-operating impairment charge was
approximately $1,017,000, or $.32 per diluted share. These investment grade
securities are held as part of the available for sale portfolio; therefore, the
unrealized losses have already been recorded as a reduction in other
comprehensive income and no additional charge to capital is required. The
after-tax impact of the write-down was greater than 66 percent of the gross
write-down because QNB established a $190,000 valuation allowance to offset a
portion of the tax benefits associated with the write-down of these securities
that may not be realizable. Excluding the non-cash securities write-down, second
quarter earnings were $1,500,000, or $.47 per share diluted, and net income for
the six-month period was $3,419,000, or $1.08 per share on a diluted basis.
Form 10-Q
12
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
OVERVIEW (CONTINUED)
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 .33% and 1.12%, while the return on average
equity was 4.15% and 14.39% for the three months ended June 30, 2005 and 2004,
respectively. For the six-month periods ended June 30, 2005 and 2004, return on
average assets was .83% and 1.20%, and the return on average equity was 10.49%
and 15.50%, respectively. Excluding the impact of the impairment charge, the
return on average assets for the three and six month periods ended June 30, 2005
was 1.03% and 1.18%, respectively, and the return on average equity was 12.89%
and 14.93%, respectively.
In addition to the impairment charge, the results for the second quarter of 2005
compared with the same period in 2004 included the following significant
components:
Net interest income increased $158,000, or 4.0%, to $4,111,000.
o Contributing to the increase in net interest income was a 7.1%
increase in average earning assets. The average balance of loans
increased by 11.9%, while average deposits increased 7.9%.
o The net interest margin declined 11 basis points, to 3.28%, for the
second quarter of 2005. The decline in the margin was a result of
funding costs, particularly money market and time deposit rates,
increasing to a greater degree than rates on earning assets.
o The Federal Reserve Bank Board continued to raise interest rates, with
two additional 25 basis point increases during the second quarter of
2005. The Federal funds rate has increased from 1.00% at the end of
June 2004 to 3.25% at June 30, 2005. The yield curve flattened further
during the second quarter as mid and longer term interest rates
declined as short-term rates were increasing.
o Asset quality continued to improve as non-performing assets declined
from $469,000 at June 30, 2004 to $5,000 at June 30, 2005. QNB had no
non-accrual loans at June 30, 2005. As a result of the continued low
level of non-performing assets, no provision for loan losses was
recorded during the first half of 2005.
Non-interest income, excluding the impairment charge of $1,253,000,
decreased $92,000, or 7.8%, to $1,081,000.
o Gains on the sales of investment securities declined by $153,000,
while gains on the sale of residential mortgages increased by $62,000.
o Fees for services to customers declined by $74,000 to $452,000 for the
second quarter of 2005.
o Other operating income includes $61,000 of income related to proceeds
from bank-owned life insurance and $45,000 resulting from a refund of
prior years' sales taxes paid.
Non-interest expense increased $135,000, or 4.2%, to $3,316,000.
o Salary and benefit expense increased by $151,000, or 8.8%, primarily
related to an increase in staffing levels, merit and promotional
increases and higher retirement plan costs.
These items as well as others will be explained more thoroughly in the next
sections.
Form 10-Q
13
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
Average Balances, Rate, and Interest Income and Expense Summary
(Tax-Equivalent Basis)
Three Months Ended
June 30, 2005 June 30, 2004
Average Average Average Average
Balance Rate Interest Balance Rate Interest
- -----------------------------------------------------------------------------------------------------------------------------------
Assets
Federal Funds Sold $ 9,213 2.98% $ 68 $ 4,923 0.98% $ 12
- -----------------------------------------------------------------------------------------------------------------------------------
Investment securities:
U.S. Treasury 6,114 2.04% 31 6,754 1.89% 32
U.S. Government agencies 38,273 3.77% 361 24,581 3.83% 235
State and municipal 52,851 6.50% 859 50,678 6.53% 827
Mortgage-backed and CMOs 134,782 4.19% 1,413 147,373 4.20% 1,548
Other 30,146 5.79% 436 29,557 5.27% 390
- -----------------------------------------------------------------------------------------------------------------------------------
Total investment securities 262,166 4.73% 3,100 258,943 4.68% 3,032
- -----------------------------------------------------------------------------------------------------------------------------------
Loans:
Commercial real estate 122,520 6.19% 1,892 109,386 5.88% 1,601
Residential real estate 25,534 5.85% 373 19,926 6.13% 305
Home equity loans 59,938 5.87% 878 53,828 5.67% 758
Commercial and industrial 46,223 6.09% 702 41,784 4.81% 500
Consumer loans 5,293 8.74% 115 5,675 9.66% 136
Tax-exempt loans 12,846 5.28% 169 12,827 5.21% 166
- -----------------------------------------------------------------------------------------------------------------------------------
Total loans, net of unearned income* 272,354 6.08% 4,129 243,426 5.73% 3,466
- -----------------------------------------------------------------------------------------------------------------------------------
Other earning assets 4,514 2.91% 33 4,813 1.55% 19
- -----------------------------------------------------------------------------------------------------------------------------------
Total earning assets 548,247 5.36% 7,330 512,105 5.13% 6,529
- -----------------------------------------------------------------------------------------------------------------------------------
Cash and due from banks 19,388 19,697
Allowance for loan losses (2,597) (2,918)
Other assets 19,000 18,145
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $ 584,038 5.03% $ 547,029 4.80%
- -----------------------------------------------------------------------------------------------------------------------------------
Liabilities and Shareholders' Equity
- -----------------------------------------------------------------------------------------------------------------------------------
Interest-bearing deposits:
Interest-bearing demand accounts $ 91,585 1.02% $ 233 $ 93,103 0.52% $ 120
Money market accounts 56,839 1.67% 236 37,138 0.62% 57
Savings 55,475 0.39% 55 55,245 0.39% 54
Time 164,801 2.93% 1,205 155,401 2.60% 1,006
Time over $100,000 43,332 2.93% 316 40,188 2.36% 236
- -----------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits 412,032 1.99% 2,045 381,075 1.56% 1,473
- -----------------------------------------------------------------------------------------------------------------------------------
Short-term borrowings 11,580 1.96% 57 12,545 0.90% 28
Federal Home Loan Bank advances 55,000 5.42% 743 55,000 5.25% 718
- -----------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities 478,612 2.38% 2,845 448,620 1.99% 2,219
- -----------------------------------------------------------------------------------------------------------------------------------
Non-interest-bearing deposits 56,118 52,944
Other liabilities 2,647 3,003
Shareholders' equity 46,661 42,462
- -----------------------------------------------------------------------------------------------------------------------------------
Total liabilities and
shareholders' equity $ 584,038 1.95% $ 547,029 1.63%
- -----------------------------------------------------------------------------------------------------------------------------------
Net interest rate spread 2.98% 3.14%
- -----------------------------------------------------------------------------------------------------------------------------------
Margin/net interest income 3.28% 4,485 3.39% 4,310
- -----------------------------------------------------------------------------------------------------------------------------------
Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are
based on the marginal Federal corporate tax rate of 34%.
Non-accrual loans are included in earning assets.
* Includes loans held-for-sale
Form 10-Q
14
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
Average Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent
Basis)
Six Months Ended
June 30, 2005 June 30, 2004
Average Average Average Average
Balance Rate Interest Balance Rate Interest
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
- ------------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 6,075 2.85% $ 86 $ 6,679 0.98% $ 33
- ------------------------------------------------------------------------------------------------------------------------------------
Investment securities:
U.S. Treasury 6,132 2.05% 62 6,762 1.94% 65
U.S. Government agencies 43,048 3.66% 788 29,423 3.86% 567
State and municipal 52,692 6.50% 1,714 50,715 6.54% 1,659
Mortgage-backed and CMOs 134,989 4.19% 2,830 141,398 4.23% 2,991
Other 30,011 5.55% 833 30,067 5.35% 804
- ------------------------------------------------------------------------------------------------------------------------------------
Total investment securities 266,872 4.67% 6,227 258,365 4.71% 6,086
- ------------------------------------------------------------------------------------------------------------------------------------
Loans:
Commercial real estate 122,501 6.10% 3,708 107,907 5.87% 3,148
Residential real estate 24,595 5.88% 723 20,215 6.43% 650
Home equity loans 59,614 5.81% 1,719 52,190 5.79% 1,504
Commercial and industrial 44,921 6.09% 1,356 40,438 4.82% 970
Consumer loans 5,229 8.91% 231 5,568 9.78% 271
Tax-exempt loans 13,062 5.27% 342 12,365 5.28% 325
- ------------------------------------------------------------------------------------------------------------------------------------
Total loans, net of unearned income* 269,922 6.04% 8,079 238,683 5.79% 6,868
- ------------------------------------------------------------------------------------------------------------------------------------
Other earning assets 4,675 2.70% 63 4,807 1.47% 35
- ------------------------------------------------------------------------------------------------------------------------------------
Total earning assets 547,544 5.32% 14,455 508,534 5.15% 13,022
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and due from banks 18,821 19,435
Allowance for loan losses (2,602) (2,919)
Other assets 19,007 18,268
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets $ 582,770 5.00% $ 543,318 4.82%
- ------------------------------------------------------------------------------------------------------------------------------------
Liabilities and Shareholders' Equity
- ------------------------------------------------------------------------------------------------------------------------------------
Interest-bearing deposits:
Interest-bearing demand accounts $ 91,471 0.95% $ 430 $ 96,671 0.56% $ 270
Money market accounts 60,100 1.64% 488 36,696 0.65% 118
Savings 55,491 0.39% 109 54,350 0.39% 106
Time 163,596 2.87% 2,327 153,606 2.62% 2,002
Time over $100,000 42,595 2.82% 596 39,043 2.31% 448
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits 413,253 1.93% 3,950 380,366 1.56% 2,944
- ------------------------------------------------------------------------------------------------------------------------------------
Short-term borrowings 11,112 1.79% 99 11,613 0.87% 50
Federal Home Loan Bank advances 55,000 5.39% 1,470 55,000 5.25% 1,435
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities 479,365 2.32% 5,519 446,979 1.99% 4,429
- ------------------------------------------------------------------------------------------------------------------------------------
Non-interest-bearing deposits 54,358 51,241
Other liabilities 2,882 3,058
Shareholders' equity 46,165 42,040
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities and
shareholders' equity $ 582,770 1.91% $ 543,318 1.64%
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest rate spread 3.00% 3.16%
- ------------------------------------------------------------------------------------------------------------------------------------
Margin/net interest income 3.29% 8,936 3.40% 8,593
- ------------------------------------------------------------------------------------------------------------------------------------
Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are
based on the marginal Federal corporate tax rate of 34%.
Non-accrual loans are included in earning assets.
* Includes loans held-for-sale
Form 10-Q
15
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
Three Months Ended Six Months Ended
June 30, 2005 compared to June 30, 2005 compared to
June 30, 2004 June 30, 2004
Due to change in: Due to change in:
Total ----------------------- Total ---------------------
Change Volume Rate Change Volume Rate
- ----------------------------------- ---------------------------------------- -----------------------------------------
Interest income:
Federal Funds Sold 56 10 46 53 (3) 56
Investment securities:
U.S. Treasury (1) (3) 2 (3) (6) 3
U.S. Government agencies 126 131 (5) 221 263 (42)
State and municipal 32 35 (3) 55 65 (10)
Mortgage-backed and CMOs (135) (132) (3) (161) (136) (25)
Other 46 8 38 29 (2) 31
Loans:
Commercial real estate 291 196 95 560 416 144
Residential real estate 68 86 (18) 73 141 (68)
Home equity loans 120 89 31 215 209 6
Commercial and industrial 202 53 149 386 107 279
Consumer loans (21) (9) (12) (40) (17) (23)
Tax-exempt loans 3 1 2 17 18 (1)
Other earning assets 14 (1) 15 28 (1) 29
- ----------------------------------- ---------------------------------------- -----------------------------------------
Total interest income 801 464 337 1,433 1,054 379
- ----------------------------------- ---------------------------------------- -----------------------------------------
Interest expense:
Interest-bearing demand accounts 113 (2) 115 160 (14) 174
Money market accounts 179 30 149 370 75 295
Savings 1 1 0 3 3 0
Time 199 61 138 325 130 195
Time over $100,000 80 18 62 148 41 107
Short-term borrowings 29 (2) 31 49 (2) 51
Federal Home Loan Bank advances 25 - 25 35 - 35
- ----------------------------------- ---------------------------------------- -----------------------------------------
Total interest expense 626 106 520 1,090 233 857
- ----------------------------------- ---------------------------------------- -----------------------------------------
Net interest income 175 358 (183) 343 821 (478)
- ----------------------------------- ---------------------------------------- -----------------------------------------
Form 10-Q
16
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME
The following table presents the adjustment to convert net interest income to
net interest income on a fully taxable equivalent basis for the three and six
month periods ended June 30, 2005 and 2004.
For the Three Months For the Six Months
Ended June 30, Ended June 30,
2005 2004 2005 2004
---- ---- ---- ----
Total interest income $6,956 $6,172 $13,715 $12,308
Total interest expense 2,845 2,219 5,519 4,429
------ ------ ------- -------
Net interest income 4,111 3,953 8,196 7,879
Tax equivalent adjustment 374 357 740 714
------ ------ ------ -------
Net interest income
(fully taxable equivalent) $4,485 $4,310 $8,936 $ 8,593
====== ====== ====== =======
Net interest income is the primary source of operating income for QNB. Net
interest income is interest income, dividends, and fees on earning assets, less
interest expense incurred for funding sources. Earning assets primarily include
loans, investment securities and Federal funds sold. Sources used to fund these
assets include deposits, borrowed funds and shareholders' equity. Net interest
income is affected by changes in interest rates, the volume and mix of earning
assets and interest-bearing liabilities, and the amount of earning assets funded
by non-interest-bearing deposits.
For purposes of this discussion, interest income and the average yield earned on
loans and investment securities are adjusted to a tax-equivalent basis as
detailed in the tables that appear on page 13 and 14. This adjustment to
interest income is made for analysis purposes only. Interest income is increased
by the amount of savings of Federal income taxes, which QNB realizes by
investing in certain tax-exempt State and municipal securities and by making
loans to certain tax-exempt organizations. In this way, the ultimate economic
impact of earnings from various assets can be more easily compared.
The net interest rate spread is the difference between average rates received on
earning assets and average rates paid on interest-bearing liabilities, while the
net interest rate margin includes interest-free sources of funds.
Net interest income increased 4.0%, to $4,111,000, for the quarter ended June
30, 2005, as compared to $3,953,000 for the quarter ended June 30, 2004. On a
tax-equivalent basis, net interest income increased by 4.1% from $4,310,000 for
the three months ended June 30, 2004 to $4,485,000 for the same period ended
June 30, 2005. As has been the trend, the ability of QNB to increase net
interest income has been a result of the growth in deposits and the investment
of these deposits into profitable loans and investment securities. This growth
in earning assets has been able to offset the continued decline in the net
interest margin resulting from the low interest rate environment of the past few
years and the flattening of the yield curve over the past year. While core
deposits continue to increase, a significant contributor to the growth in
average deposits, were additional deposits of local municipalities and school
districts. The majority of these deposits are seasonal and were withdrawn during
the first half of 2005. While these deposits, because of their short-term nature
and the
Form 10-Q
17
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (CONTINUED)
competition for these deposits, add to net interest income, they provide a
significantly lower spread than core deposits and, therefore, have a negative
impact on the net interest margin.
Average deposits increased $34,131,000, or 7.9%, when comparing the second
quarters of 2005 and 2004. Included in this increase in average deposits was
approximately $13,571,000 of additional municipal money market and
interest-bearing demand deposits. On a comparison of balances at June 30, 2005
and 2004, municipal money market and interest-bearing demand accounts increased
$1,743,000 to approximately $33,287,000 at June 30, 2005. The growth in total
average deposits was used to fund the $28,928,000, or 11.9%, increase in average
loans and the $3,223,000, or 1.2%, increase in average investment securities.
When comparing the second quarters of 2005 and 2004, the net interest margin and
net interest rate spread declined by 11 basis points and 16 basis points,
respectively. The net interest margin decreased to 3.28% for the second quarter
of 2005 from 3.39% for the second quarter of 2004, while the net interest rate
spread decreased to 2.98% from 3.14% during the same period.
As mentioned previously, the Federal Reserve Board continued its "measured pace"
strategy of tightening by increasing the Federal funds rate four times by 25
basis points each time during the first half of 2005. Since June 29, 2004, it
has increased the rate nine times by an aggregate of 225 basis points, from
1.00% to 3.25%. Despite the increase in market interest rates off their historic
lows, the long period of historically low interest rates has had different
impacts on the yield on earning assets and the rates paid on interest-bearing
liabilities. While the yield on earning assets on a tax-equivalent basis has
increased from 5.13% for the second quarter of 2004 to 5.36% for the second
quarter of 2005, the rate of increase was slowed because of the fixed rate
nature of the investment and loan portfolio, the flatness of the yield curve and
the strong price competition for loans. The yield on the investment portfolio
increased slightly from 4.68% for the second quarter of 2004 to 4.73% for the
second quarter of 2005. The increase in the yield was constrained by the impact
of the municipal deposits being invested in short-term, lower yielding U.S.
Government agency securities and by limited cash flow to reinvest at higher
interest rates. The yield on U.S. Government agency securities declined from
3.83% for the second quarter of 2004 to 3.77% for the second quarter of 2005.
The yield on the investment portfolio should continue to increase in 2005 and
2006 as most of these lower yielding securities purchased to match the
short-term seasonal municipal deposits have been called or sold and as cash flow
from the portfolio is reinvested at higher rates.
The yield on loans increased 35 basis points to 6.08% when comparing the second
quarter of 2004 to the second quarter of 2005. The average prime rate when
comparing these same periods increased 191 basis points, from 4.00% to 5.91%.
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 reprices immediately with changes in the prime
rate. The benefits from an increase in the prime rate were partially offset by
the long period of historically low interest rates which resulted in the
refinancing of residential mortgage, home equity and commercial real estate
loans into lower yielding fixed rate loans. The commercial and industrial
category of loans benefited the most from the increase in the prime rate, as
many of these loans are indexed to that rate. The yield on this category
increased 128 basis points when comparing the two quarters. The yield on home
equity lines of credit has also increased as these loans are indexed to the
prime rate. The rate of increase in loan yields will be determined by how
quickly and to what degree the Federal Reserve Board continues to increase
interest rates, the shape of the yield curve and how much the competitive nature
of the business keeps loan rates down.
Form 10-Q
18
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (CONTINUED)
While total interest income on a tax-equivalent basis increased $801,000 when
comparing the second quarter of 2005 to the second quarter of 2004, total
interest expense increased $626,000. The increase in interest expense was a
result of both an increase in deposit balances and more significantly an
increase in interest rates paid on deposits and short-term borrowings. The rate
paid on interest-bearing liabilities increased from 1.99% for the second quarter
of 2004 to 2.38% for the second quarter of 2005, with the rate paid on
interest-bearing deposits increasing from 1.56% to 1.99% during this same
period. Interest expense and the rate paid on money market accounts and time
deposit accounts increased the most as these accounts were more reactive to the
increase in market interest rates. Interest expense on money market accounts
increased $179,000, and the rate paid increased from .62% to 1.67% when
comparing the two quarters. The increase in the rate paid was primarily the
result of two events. First, QNB had to pay a higher rate to attract the
municipal deposits; second, rising short-term interest rates impacted QNB's
Treasury Select Money Market Account. This product is a variable rate account,
indexed to the monthly average of the 91-day Treasury bill based on balances in
the account. The yield on this product has increased as short-term interest
rates have increased. The average balance of money market accounts increased
$19,701,000 when comparing the second quarter of 2005 to the same period in
2004. The additional deposits of a school district contributed approximately
$14,449,000 to the increase, while growth in the Treasury Select accounts
contributed approximately $6,404,000.
Interest expense on time deposits increased $279,000, while the average rate
paid on time deposits increased from 2.55% to 2.93% when comparing the two
periods. Like fixed-rate loans and investment securities, certificates of
deposit reprice over time and, therefore, have less of an immediate impact on
costs in either a rising or falling rate environment. Unlike loans and
investment securities, the maturity and repricing characteristics tend to be
shorter. This feature, combined with the strong rate competition for these
deposits, will likely result in the continued increase in the rates on time
deposits in 2005. Average time deposits increased $12,544,000, or 6.4%, when
comparing the second quarter of 2005 to the second quarter of 2004. The higher
rates being offered on time deposits compared to other deposit accounts seems to
be the impetus for the growth.
Interest expense on interest-bearing demand accounts increased $113,000 when
comparing the two quarters while the rate paid increased from .52% to 1.02%.
Approximately one-third of the average balance of $91,585,000 for the second
quarter of 2005 is municipal deposits which reprice with changes in the Federal
funds rate.
For the six-month period ended June 30, 2005, net interest income increased
$317,000, or 4.0%, to $8,196,000. On a tax-equivalent basis net interest income
increased $343,000, or 4.0%. Included in net interest income for the first six
months of 2005 and 2004 was $40,000 and $65,000, respectively, in interest and
fees recognized on the pay-off of loans that had not been accruing interest or
had previously been charged off. Similar to the quarter, 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 7.7%
while the net interest margin declined 11 basis points. The net interest margin
on a tax-equivalent basis was 3.29% for the six-month period ended June 30, 2005
compared with 3.40% for the same period in 2004.
Total interest income on a tax-equivalent basis increased $1,433,000, from
$13,022,000 to $14,455,000, when comparing the six-month periods ended June 30,
2004 to June 30, 2005. The increase in interest income was mostly a result of
volume increases. Approximately $1,054,000 of the increase in interest income
was related to volume. Average loans increased 13.1%, to $269,922,000, while
average investment securities increased 3.3%, to $266,872,000. Total interest
income benefited some from the increase in short-term interest rates and
Form 10-Q
19
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (CONTINUED)
the prime rate as the yield on earning assets increased from 5.15% to 5.32% for
the six-month periods. The yield on loans increased from 5.79% to 6.04% during
this time. As mentioned previously, the yield on investments has been
constrained and actually decreased from 4.71% to 4.67% when comparing the
six-month periods.
Total interest expense increased $1,090,000, from $4,429,000 to $5,519,000, for
the six-month periods with interest on demand accounts, money market accounts,
and time deposits accounting for $160,000, $370,000 and $473,000, respectively,
of the increase. Unlike interest income, interest expense was impacted more by
an increase in rates paid than by volume increases. Approximately $857,000 of
the increase in interest expense is a result of higher interest rates. The yield
on interest-bearing demand accounts, money market accounts and time deposits
increased 39 basis points, 99 basis points and 30 basis points, respectively,
when comparing the average rate paid for the six-month periods ended June 30,
2005 and 2004. Interest expense on short-term borrowings increased by $49,000 as
the average rate paid on these accounts increased from .87% to 1.79%. Average
money market balances and average time deposit balances increased $23,404,000
and $13,542,000, respectively, while average interest-bearing demand accounts
decreased $5,200,000 when comparing the six-month periods.
Management expects interest expense and the rate paid on interest-bearing
liabilities to increase throughout 2005 as higher short-term market rates of
interest result in higher rates paid initially on money market accounts and time
deposits. This will be followed by higher rates paid on interest-bearing demand
accounts and savings accounts, accounts that tend to lag as rates increase.
Management also expects net interest income to increase slightly in 2005 as a
result of the growth in earning assets offsetting a net interest margin that may
continue to decline. The yield curve may continue to flatten further in 2005, as
the Federal Reserve Board continues to increase short-term interest rates to a
greater magnitude than mid and longer term rates increase. A flat yield curve
will continue to put pressure on the net interest margin.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to be charged to operations to bring the allowance for loan
losses to a level that represents management's best estimate of the known and
inherent losses in the existing loan portfolio. Actual loan losses, net of
recoveries, serve to reduce the allowance.
The determination of an appropriate level of the allowance for loan losses is
based upon an analysis of the risk inherent in QNB's loan portfolio. Management
uses various tools to assess the adequacy of the allowance for loan losses. One
tool is a model recommended by the Office of the Comptroller of the Currency.
This model considers a number of relevant factors including: historical loan
loss experience, the assigned risk rating of the credit, current and projected
credit worthiness of the borrower, current value of the underlying collateral,
levels of and trends in delinquencies and non-accrual loans, trends in volume
and terms of loans, concentrations of credit, and national and local economic
trends and conditions. This model is supplemented with another analysis that
also incorporates exceptions to QNB's loan policy and QNB's portfolio exposure
to borrowers with large dollar concentration. Other tools include ratio analysis
and peer group analysis.
QNB's management determined no provision for loan losses was necessary for
either the three or six-month periods ended June 30, 2005 or 2004 as the results
of the analysis described above resulted in an allowance for loan losses that
was adequate in relation to the estimate of known and inherent losses in the
portfolio. In
Form 10-Q
20
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
PROVISION FOR LOAN LOSSES (CONTINUED)
addition, charge-offs and non-performing assets remain at low levels. QNB had
net charge-offs of $21,000 during both the second quarter of 2005 and 2004. For
the six-month periods ended June 30, 2005 and 2004 QNB had net charge-offs of
$27,000 and $31,000, respectively.
Non-performing assets (non-accruing loans, loans past due 90 days or more, other
real estate owned and other repossessed assets) amounted to .00% and .08% of
total assets, respectively, at June 30, 2005 and 2004. This compares to .08% at
December 31, 2004. There were no non-accrual loans at June 30, 2005. Non-accrual
loans were $373,000 and $384,000 at December 31, 2004 and June 30, 2004,
respectively. QNB did not have any other real estate owned as of June 30, 2005,
December 31, 2004 or June 30, 2004. Repossessed assets were $4,000 at both June
30, 2005 and 2004. The book value of repossessed assets at December 31, 2004 was
zero.
There were no restructured loans as of June 30, 2005, December 31, 2004 or June
30, 2004 as defined in FASB Statement 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 $2,585,000 and $2,612,000 at June 30, 2005 and
December 31, 2004, respectively. The ratio of the allowance to total loans was
..95% and .97% at the respective period end dates. While QNB believes that its
allowance is adequate to cover losses in the loan portfolio, there remain
inherent uncertainties regarding future economic events and their potential
impact on asset quality.
A loan is considered impaired, based on current information and events, if it is
probable that QNB will be unable to collect the scheduled payments of principal
or interest when due according to the contractual terms of the loan agreement.
The measurement of impaired loans is generally based on the present value of
expected future cash flows discounted at the historical effective interest rate,
except that all collateral-dependent loans are measured for impairment based on
the fair value of the collateral.
There were no loans considered impaired at June 30, 2005. At June 30, 2004, the
recorded investment in loans for which impairment has been recognized in
accordance with FASB Statement No. 114, ACCOUNTING BY CREDITORS FOR IMPAIRMENT
OF A LOAN--AN AMENDMENT OF FASB STATEMENTS NO. 5 AND 15, totaled $382,000. The
loans identified as impaired were collateral-dependent, with no valuation
allowance necessary.
Management in determining the allowance for loan losses makes significant
estimates. Consideration is given to a variety of factors in establishing these
estimates including current economic conditions, diversification of the loan
portfolio, delinquency statistics, results of loan reviews, borrowers' perceived
financial and managerial strengths, the adequacy of underlying collateral if
collateral dependent, or the present value of future cash flows.
Since the allowance for loan losses is dependent, to a great extent, on
conditions that may be beyond QNB's control, it is at least reasonably possible
that management's estimates of the allowance for loan losses and actual results
could differ in the near term. In addition, various regulatory agencies, as an
integral part of their examination process, periodically review QNB's allowance
for losses on loans. Such agencies may require QNB to recognize additions to the
allowance based on their judgments about information available to them at the
time of their examination.
Form 10-Q
21
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST INCOME
QNB, through its core banking business, generates various fees and service
charges. Total non-interest income is composed of service charges on deposit
accounts, ATM and check card income, income on bank-owned life insurance,
mortgage servicing fees, gains or losses on the sale of investment securities,
gains on the sale of residential mortgage loans, and other miscellaneous fee
income.
Total non-interest income decreased $1,345,000 to $(172,000) for the quarter
ended June 30, 2005 when compared to June 30, 2004. For the six-month period
total non-interest income decreased $1,046,000 to $1,497,000. Excluding gains
and losses on the sale of securities and loans, non-interest income for the
three month period decreased $1,000 and for the six month period increased
$229,000, or 13.1%.
Fees for services to customers are primarily comprised of service charges on
deposit accounts. These fees decreased $74,000, or 14.1%, to $452,000 when
comparing the two quarters and $81,000, or 8.3%, to $891,000 when comparing the
six-month periods. Contributing to the decline in fee income was an $18,000
reduction for the quarter and a reduction of $36,000 for the six-month period,
in service charge income on non-interest bearing business checking accounts. The
decline in the service charges on business accounts reflects the impact of a
higher earnings credit rate, resulting from the increases in short-term interest
rates, applied against balances to offset service charges incurred. Also,
negatively impacting service charge income was the elimination of the monthly
fee on an interest-bearing checking account product. This fee change resulted in
the reduction of approximately $9,000 for the quarter and $19,000 for the
six-month period. In addition, overdraft income decreased $45,000 for the
three-month period and $27,000 for the six-month period. This decrease was a
result of a decline in the volume of overdrafts during the second quarter of
2005, as well as an increase in the amount of these fees waived or charged-off
as uncollectible during both the three and six month periods ended June 30,
2005.
ATM and debit card income is primarily comprised of income on debit cards and
ATM surcharge income for the use of QNB ATM machines by non-QNB customers. ATM
and debit card income was $171,000 for the second quarter of 2005, an increase
of $19,000, or 12.5%, from the amount recorded during the second quarter of
2004. Income from ATM and debit cards was $330,000 and $280,000 for the six
months ended June 30, 2005 and 2004, respectively. Debit card income increased
$11,000, or 9.8%, and $29,000, or 14.1%, for the three-month and six-month
periods, respectively. The increase in debit card income was a result of the
increased reliance on the card as a means of paying for goods and services by
both consumers and business cardholders. Increased usage of QNB ATM machines and
the resulting surcharge and interchange income resulted in $7,000 and $18,000
increases in ATM income when comparing the three and six-month periods,
respectively.
Income on bank-owned life insurance represents the earnings on life insurance
policies in which the Bank is the beneficiary. The earnings on these policies
were $64,000 and $70,000 for the three months ended June 30, 2005 and 2004,
respectively. For the six-month period, earnings on these policies decreased
$11,000, to $127,000. The insurance carriers reset the rates on these policies
annually. The decline in income is a result of a lower earnings rate resulting
from the lower interest rate environment at the last reset date.
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 six-month periods ended June 30, 2005
were $12,000 and $36,000, respectively. Included in these amounts is a $6,000
and $1,000
Form 10-Q
22
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST INCOME (CONTINUED)
negative adjustment to the valuation allowance for impairment resulting from the
decline in long-term interest rates. Mortgage servicing fees for the three month
and six month periods ended June 30, 2004 were $69,000 and $63,000,
respectively. Included in these amounts is a $51,000 and $29,000 positive
adjustment to the valuation allowance for impairment resulting from the increase
in interest rates in the second quarter of 2004. Excluding the valuation
allowance adjustments, mortgage servicing income would have been $18,000 for
both the second quarter of 2005 and 2004 and $37,000 for the six-month period
ended June 30, 2005, compared to $34,000 for the six-month periods ended June
30, 2004.
Also impacting mortgage servicing income was the decline in amortization expense
and a decrease in the amount of mortgages serviced. Amortization expense for the
three-month periods ended June 30, 2005 and 2004 was $30,000 and $35,000,
respectively. For the respective six-month periods, amortization expense was
$59,000 and $71,000. The average balance of mortgages serviced for others was
$77,445,000 for the second quarter of 2005 compared to $83,677,000 for the
second quarter of 2004, a decrease of 7.4%. The average balance of mortgages
serviced was approximately $77,916,000 for the six-month period ended June 30,
2005, compared to $84,362,000 for the first six months of 2004, a decrease of
7.6%. The timing of mortgage payments and delinquencies also impacts the amount
of servicing fees recorded.
QNB recorded a net (loss)/gain on investment securities of $(1,189,000) and
$217,000 for the three-month periods ended June 30, 2005 and 2004, respectively.
In the second quarter of 2005, QNB determined that certain unrealized losses on
perpetual preferred stock of FNMA and FHLMC was other-than-temporary in
accordance with SFAS 115 "Accounting for Certain Investments in Debt and Equity
Securities" and the SEC's Staff Accounting Bulletin No. 59 "Accounting for
Non-current Marketable Equity Securities". The securities that were subject to
the impairment charge are $4,500,000 of variable rate securities that are rated
AA- and Aa3 by S&P and Moody's, respectively. These investment grade securities
are held as part of the available for sale portfolio; therefore, the unrealized
losses have already been recorded as a reduction in other comprehensive income,
and no additional charges to capital are required. QNB's assessment considered
the duration and severity of the unrealized loss, the financial condition and
near term prospects of the issuers, and the likelihood of the market value of
these instruments increasing to the initial cost basis within a reasonable
period of time. Based on the recent events at these issuers and the anticipated
interest rate environment expected in the near term, it was concluded that the
unrealized losses were other-than-temporary, and an impairment charge of
$1,253,000 was recorded to write-down these investments to their fair values.
In addition to the impairment charge for the second quarter of 2005, QNB
recorded net losses on the sale of fixed income securities of $26,000 and net
gains from the equity portfolio of $90,000. For the second quarter of 2004, QNB
recorded net losses on the sale of fixed income securities of $95,000 and net
gains from the equity portfolio of $312,000. During the second quarter of 2004,
QNB entered into two significant bond transactions. The objective of the first
transaction was to increase interest income and the yield on the portfolio by
taking advantage of the 100+ increase in rates that occurred during the quarter
and the steepness of the yield curve that existed at that time. QNB sold
approximately $22,000,000 of bonds at a loss of $165,000. These bonds had an
average book yield of 3.46%. With the proceeds, QNB purchased bonds with an
average yield of 5.13% for a pickup of 167 basis points. It is estimated that
the pre-tax income pickup to the average life of the bonds sold, 2.2 years, is
approximately $477,000. The breakeven period on recouping the loss on the sale
was approximately 7.5 months. The transaction did result in a slight increase in
duration. The second transaction was entered into to sell some CMO pools that
had small balances. QNB sold approximately $2,100,000, contained in 15 pools, at
a gain of $69,000.
Form 10-Q
23
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST INCOME (CONTINUED)
Net security (losses)/gains were $(576,000) and $696,000 for the six-month
periods ended June 30, 2005 and 2004, respectively. Along with the impairment
charge discussed above for the six-month period 2005, QNB recorded $244,000 of
gains from sales from the fixed income securities portfolio and $433,000 of
gains from the equity portfolio. The fixed income securities portfolio
represents a significant portion of QNB's earning assets and is also a primary
tool in liquidity and asset/liability management. QNB actively manages its fixed
income portfolio in an effort to take advantage of changes in the shape of the
yield curve, changes in spread relationships in different sectors and for
liquidity purposes as needed. Management will continue to look at strategies
that will result in an increase in the yield or improvement in the structure of
the investment portfolio.
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. The net gain on the sale of residential mortgage loans was $60,000
for the quarter ended June 30, 2005. QNB recorded a net loss of $2,000 on the
sale of loans during the second quarter of 2004. For the six-month periods ended
June 30, 2005 and 2004, net gains on the sale of loans were $95,000 and $98,000,
respectively. Residential mortgage loans to be sold are identified at
origination. Included in the gains on the sale of residential mortgages in
three-month periods were $25,000 and $18,000 related to the recognition of
mortgage servicing assets. Included in the gains on the sale of residential
mortgages in the six-month periods were $39,000 and $47,000 related to the
recognition of mortgage servicing assets. The decline in longer term interest
rates, particularly the 10-year Treasury rate, during the second quarter of 2005
provided consumers another opportunity to refinance their mortgages. This rate
environment also provided an environment for QNB to sell these loans at a
profit. This contrasts to the environment experienced during the second quarter
of 2004, where mortgage rates were increasing, and QNB was selling loans at a
loss. Proceeds from the sale of mortgages were $3,328,000 and $2,355,000 for the
second quarter of 2005 and 2004, respectively. For the six-month periods,
proceeds from the sale of residential mortgage loans amounted to $5,233,000 and
$6,278,000, respectively.
Other operating income increased $117,000, to $258,000, during the second
quarter of 2005. The increase in other operating income for the quarter was the
result of $9,000 of income from QNB's membership in Laurel Abstract Company LLC,
a title insurance company, $61,000 of income from the proceeds of bank owned
life insurance and a $45,000 refund of prior years' sales tax payments. This
income offset an $11,000 decline in merchant processing income.
For the six-month period, other operating income increased $298,000, or 100.1%,
to $594,000. In addition to the items mentioned above for the quarter ended June
30, 2005, the six-month period also included $209,000 in gains from the sale of
repossessed assets. This income was offset by a decline in merchant processing
income of $23,000.
Financial service organizations, including QNB, are challenged to demonstrate
that they can generate an increased contribution to revenue from non-interest
sources. QNB will continue to analyze other opportunities and products that
could enhance its fee-based businesses.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee
benefits, net occupancy, furniture and equipment, marketing, third party
services and various other operating expenses. Total non-interest expense of
$3,316,000 for the quarter ended June 30, 2005 represents an increase of
$135,000, or 4.2%, from
Form 10-Q
24
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST EXPENSE (CONTINUED)
levels reported in the second quarter of 2004. Total non-interest expense for
the six months ended June 30, 2005 was $6,552,000, an increase of $293,000, or
4.7%, over 2004 levels.
Salaries and benefits is the largest component of non-interest expense. Salaries
and benefits expense increased $151,000, or 8.8%, to $1,863,000 for the quarter
ended June 30, 2005 compared to the same quarter in 2004. Salary expense
increased $126,000, or 9.3%, during the period to $1,485,000, while benefits
expense increased $25,000, or 7.1%, to $378,000. There was no accrual in the
three month period ended June 30, 2005 or 2004 related to the incentive
compensation plan. Merit and promotional 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 five when comparing the second quarters
of 2005 and 2004. Contributing to the increase in full time-equivalent employees
was the opening of a supermarket branch in June, 2004.
For the six-month period ended June 30, 2005 salaries and benefits expense
increased $194,000, to $3,700,000, compared to the same period in 2004. Salary
expense increased by $160,000, or 5.7%, while benefits expense increased by
$34,000, or 4.8%, when comparing the two periods. Included in salary expense for
the six months ended June 30, 2005 and 2004 were accruals of $40,000 and
$100,000 related to the incentive compensation plan. Excluding the impact of the
accruals for the incentive compensation plan, salary expense increased 8.2% for
the six-month period. Merit and promotional 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 seven when comparing the six-month
periods.
Higher payroll tax expense and retirement plan expense, as a result of the
increase in compensation, were the primary contributors to the increase in
benefits expense when comparing the three and six month periods ended June 30,
2005 and 2004. The timing of the pay periods was also a factor in the increase
in both of these categories as there was one additional pay in the second
quarter of 2005 compared to 2004. This timing factor will even out in the second
half of the year.
Net occupancy expense increased $21,000, to $272,000, when comparing the second
quarter of 2005 to the second quarter of 2004. For the six-month period, net
occupancy expense increased $64,000, to $553,000. Contributing to the increase
in both the three and six-month periods was higher costs related to building
maintenance, utilities and rent expense. The addition of a new supermarket
branch, which opened late June 2004, contributed to the increase in net
occupancy expense. In addition, building maintenance costs included repairs to
several air conditioning units and higher snow removal costs.
Furniture and equipment expense increased $17,000, or 6.2%, to $291,000 when
comparing the three-month periods ended June 30, 2005 and 2004 and increased
$56,000, or 10.8%, to $573,000 when comparing the six-month periods. For the
three-month periods, depreciation and amortization expense increased $10,000 due
to several larger technology and software items purchased. For the six-month
periods, depreciation expense increased $35,000, while equipment maintenance
costs increased by $18,000. The equipment maintenance costs relate primarily to
maintenance contracts on new equipment or increases in rates on old contracts.
Marketing expense increased $8,000, to $156,000, for the quarter ended June 30,
2005 and $51,000, to $306,000, for the six-month period. Sales promotion expense
increased $12,000 and $18,000 when comparing the quarters and six-month periods,
respectively. QNB purchased several items for use and distribution in the
community to promote various products and services offered. Also, for the
six-month period, advertising expense increased $7,000 as QNB increased its use
of billboards for product advertising. Advertising expense
Form 10-Q
25
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST EXPENSE (CONTINUED)
will likely continue to increase as QNB has made a strategic decision to
increase its advertising efforts, including television advertising. Donations
increased $34,000 when comparing the six-month periods. QNB contributes to many
not-for-profit organizations, clubs and community events in the local
communities it serves.
Third party services are comprised of professional services including legal,
accounting and auditing and consulting services as well as fees paid to outside
vendors for support services of day-to-day operations. These support services
include trust services, retail non-deposit services, correspondent banking
services, statement printing and mailing, investment security safekeeping and
supply management services. Third party services expense was $168,000 in the
second quarter of 2005 compared to $175,000 for the second quarter of 2004. For
the six-month period, third party services decreased $21,000, to $309,000. Third
party services in 2004 included expenses to a marketing firm that provided
benefits to certain QNB deposit customers. This contract ended in October 2004.
These cost savings offset the loss of fee income described in the fees for
services to customers. Higher costs associated with internal and external audits
and tax services partially offset these savings.
Telephone, postage and supplies expense decreased $27,000 for the quarter to
$113,000 as telephone expense decreased $20,000 and supplies expense decreased
$9,000. The reduction in telephone expense relates to refunds of overcharges
incurred in late 2004 and early 2005 as well as costs incurred in the second
quarter of 2004 for an additional T-1 line and costs associated with the new
branch. Contributing to the higher supply costs in the second quarter of 2004
was the setup of the new branch.
INCOME TAXES
QNB utilizes an asset and liability approach for financial accounting and
reporting of income taxes. As of June 30, 2005, QNB's net deferred tax asset was
$292,000. The primary components of deferred taxes are a deferred tax asset of
$729,000 relating to the allowance for loan losses and a deferred tax asset of
$481,000 related to impaired equity securities. Partially offsetting this was a
deferred tax liability of $542,000 resulting from the SFAS No.115 adjustment for
available-for-sale investment securities. As of June 30, 2004, QNB's net
deferred tax asset was $1,443,000 comprised of deferred tax assets of $739,000
related to the allowance for loan losses and $751,000 resulting from the SFAS
No. 115 adjustment for available-for-sale investment securities.
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 $190,000 was established as of June 30,
2005 to offset a portion of the tax benefits associated with certain impaired
securities that management believed may not be realizable. 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 asset is included in other assets on the consolidated balance sheet.
Applicable income taxes and effective tax rates were $140,000, or 22.5%, for the
three-month period ended June 30, 2005, and $426,000, or 21.9%, for the same
period in 2004. The higher rate for the second quarter of 2005 compared to the
second quarter of 2004 is a result of the $190,000 valuation allowance
established for the impairment of securities discussed above. For the six-month
period, applicable income taxes and effective tax rates were $739,000, or 23.5%,
and $922,000, or 22.1%.
Form 10-Q
26
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION ANALYSIS
The balance sheet analysis compares average balance sheet data for the six
months ended June 30, 2005 and 2004, as well as the period ended balances as of
June 30, 2005 and December 31, 2004.
Average earning assets for the six-month period ended June 30, 2005 increased
$39,010,000, or 7.7%, to $547,544,000 from $508,534,000 for the six months ended
June 30, 2004. Average investments increased $8,507,000, or 3.3%, while average
loans increased $31,239,000, or 13.1%. Average Federal funds sold decreased
$604,000 when comparing these same periods.
Increasing loan balances has been, and remains, a major focus of QNB. Despite
the slow growing economy and extremely competitive environment, QNB was
successful in increasing total loans, while maintaining excellent asset quality.
Total loans have increased 4.9% between June 30, 2005 and June 30, 2004 and 1.8%
since December 31, 2004. The year over year comparison takes out some of the
seasonality of commercial line of credit borrowings. The significantly higher
average growth rate as compared to the period to period growth rate is a result
of the amount of growth that was achieved late in the second quarter of 2004.
Total loans increased $25,283,000 between March 31, 2004 and June 30, 2004. A
major factor in the growth in total loans was the use of a formal business
development and calling program encompassing lending personnel, branch personnel
and senior management. This program was strengthened in 2003 by the appointment
of a business development officer. The focus of this program is to both develop
new lending and deposit relationships, as well as to strengthen existing
relationships.
Average commercial loans and average home equity loans increased $19,774,000 and
$7,424,000, respectively, when comparing the first half of 2005 to the first
half of 2004, while average residential mortgage loans increased $4,380,000.
During this same time frame, average consumer loans decreased $339,000. The
12.3% increase in average commercial loans reflects the success of the business
development program mentioned above. Most of the growth in commercial loans is
in variable rate loans secured by real estate, either commercial or residential
properties. While variable rate, these loans could have a fixed rate for a
period of time, such as three or five years, before the rate adjusts.
The 14.2% increase in home equity loans reflects their popularity with
consumers, especially those refinancing existing residential mortgage loans,
because they have lower origination costs than residential mortgage loans. Most
of the growth in home equity loans in the past year has been in the variable
rate home equity line of credit. This product's interest rate floats at prime
minus .50% and became extremely attractive when prime dropped to 4.0%. QNB
anticipates that as the prime rate increases customers will refinance these
floating rate loans into fixed rate home equity loans. The increase in
residential mortgage loans is primarily the result of the introduction of
several hybrid adjustable rate mortgage products. These products have a fixed
rate for a five to ten year period of time, and then adjust annually after the
fixed period is over. QNB holds these loans in portfolio. On a year over year
basis, variable rate residential mortgage loans have increased from $11,019,000
at June 30, 2004 to $16,729,000 at June 30, 2005.
The growth in average earning assets was funded primarily by deposit growth.
Total average deposits increased $36,004,000, or 8.3%, to $467,611,000 for the
first six months of 2005 compared to the first six months of 2004. Most of the
growth was in money market accounts, which increased $23,404,000 on average. The
increase in money market balances reflects both the growth in the relationship
with a school district and the increase in the Treasury Select money market
balances as short-term interest rates have risen. The average balance with the
school district increased by approximately $17,305,000, when comparing the
six-month periods, while Treasury Select average balances have increased by
$6,244,000 over the same timeframe.
Form 10-Q
27
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION ANALYSIS (CONTINUED)
Also contributing to the growth in average deposits were time deposits, which
increased $13,542,000, or 7.0%, when comparing the six month periods. Average
time deposits with balances under $100,000 increased $9,990,000, to
$163,596,000, while average time deposits equal to or greater than $100,000
increased $3,552,000, to $42,595,000. Most of the growth occurred in the
maturity range of greater than one year to three years categories, which QNB
promoted heavily in 2004 and the first half of 2005 in an effort to lock in
funding costs in anticipation of rising rates. During the second quarter of
2005, QNB offered a 20-month time deposit at a rate of 3.44%, which allows for
one penalty free withdrawal over the term. Increasing time deposit balances will
be a challenge because of the strong rate competition, particularly with
maturities between eight months through two years. Matching or beating
competitors' rates could have a negative impact on the net interest margin.
Average non-interest bearing demand accounts increased $3,117,000, or 6.1%, to
$54,358,000. A "Free Checking" promotion, as well as the acquisition of new
business accounts, was a significant factor in the increase in non-interest
bearing deposits.
Average savings accounts increased $1,141,000, or 2.1%. The slower growth in
savings deposits may be attributable to consumers looking to obtain higher
yields currently being offered in time deposits and money market accounts.
Average interest-bearing demand deposit accounts declined $5,200,000, or 5.4%,
when comparing the six month periods. Average municipal balances declined
$6,065,000 when comparing the two periods. This was partially offset by growth
in personal interest bearing accounts.
Total assets at June 30, 2005 were $574,544,000, compared with $583,644,000 at
December 31, 2004, a decrease of 1.6%. Total deposits declined $8,535,000, or
1.8%, during this same period. The decline, as expected, is primarily the result
of the seasonal nature of the municipal deposits. Municipal interest bearing
transaction balances declined approximately $5,000,000, while municipal money
market balances declined approximately $18,000,000 between December 31, 2004 and
June 30, 2005. Total interest-bearing transaction accounts and money market
accounts declined $6,529,000 and $15,903,000, respectively, between these dates.
Total time deposits increased $10,287,000, or 5.1%, to $213,107,000 at June 30,
2005, while total non-interest bearing demand accounts increased $5,275,000, or
10.0%, to $57,878,000 at June 30, 2005. On the asset side, total loans increased
$4,954,000, or 1.8%, while total investment securities decreased $15,814,000
since December 31, 2004. The decline in investment securities relates directly
to the withdrawal of the municipal funds.
The increase in other assets relates to a $1,100,000 loan participation
receivable at June 30, 2005, an increase in prepaid expenses and an increase in
deferred taxes as compared to December 31, 2005. The funds from the loan
participation were received on July 1, 2005. The decline in other liabilities is
primarily related to a payment of accrued directors deferred compensation, the
payment of the accrued 2004 incentive compensation and the reduction in deferred
tax liability.
At June 30, 2005, the fair value of investment securities available-for-sale was
$252,050,000, or $1,275,000 above the amortized cost of $250,775,000. This
compares to a fair value of $267,561,000, or $1,561,000 above the amortized cost
of $266,000,000 at December 31, 2004. An unrealized holding gain, net of taxes,
of $733,000 was recorded as an increase to shareholders' equity at June 30,
2005, while an unrealized holding gain of $691,000 was recorded as an increase
to shareholders' equity at December 31, 2004.
Form 10-Q
28
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
FINANCIAL CONDITION ANALYSIS (CONTINUED)
As a result of the seasonal withdrawal of the municipal deposits, there was a
corresponding decline in U.S. Government agency securities which were purchased
to match these deposits. As a result of this, as well as purchases and sales
during the six month period, the composition of the portfolio changed since
December 31, 2004. The percentage of agency securities declined from 17% of the
portfolio at December 31, 2004 to 10% at June 30, 2005. During this same period,
the percentage of CMO's increased from 27% to 31% of the portfolio, and
municipal securities increased from 19% to 21% of the portfolio.
The available-for-sale portfolio had a weighted average maturity of
approximately 3 years and 10 months at June 30, 2005 and 3 years, 7 months at
December 31, 2004. The weighted average tax-equivalent yield was 4.78% and
4.59%, respectively, at June 30, 2005 and December 31, 2004. The weighted
average maturity is based on the stated contractual maturity of all securities
except for mortgage-backed securities and CMOs, which are based on estimated
average life. The maturity of the portfolio may be shorter because of call
features in many debt securities and because of prepayments on mortgage-backed
securities and CMOs. However, the estimated average life could be longer if
rates were to increase and principal payments on mortgage-backed securities and
CMOs would slow. The interest rate sensitivity analysis reflects the repricing
term of the securities portfolio based upon estimated call dates and anticipated
cash flows, assuming management's most likely interest rate environment.
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 June 30, 2005 and December 31, 2004, QNB had securities
classified as held-to-maturity with an amortized cost of $5,900,000 and
$6,203,000 and a market value of $6,127,000 and $6,432,000, respectively. The
held-to-maturity portfolio had a weighted average maturity of approximately 4
years, 1 month at June 30, 2005 and 4 years, 5 months at December 31, 2004. The
weighted average tax-equivalent yield was 6.80% at June 30, 2005 and 6.79% at
December 31, 2004.
LIQUIDITY
Liquidity represents an institution's ability to generate cash or otherwise
obtain funds at reasonable rates to satisfy commitments to borrowers and demands
of depositors. QNB manages its mix of cash, Federal funds sold, investment
securities and loans in order to match the volatility, seasonality, interest
sensitivity and growth trends of its deposit funds. Liquidity is provided from
asset sources through maturities and repayments of loans and investment
securities, net interest income and fee income. The portfolio of investment
securities available-for-sale and QNB's policy of selling certain residential
mortgage originations in the secondary market also provide sources of liquidity.
Additional sources of liquidity are provided by the Bank's membership in the
Federal Home Loan Bank of Pittsburgh (FHLB) and a $10,000,000 unsecured Federal
funds line granted by a correspondent bank. The Bank has a maximum borrowing
capacity with the FHLB of approximately $250,236,000. At June 30, 2005, QNB's
outstanding borrowings under the FHLB credit facilities totaled $55,000,000.
Cash and due from banks, Federal funds sold, available-for-sale securities and
loans held-for-sale totaled $275,042,000 and $290,058,000 at June 30, 2005 and
December 31, 2004, respectively. These sources should be adequate to meet normal
fluctuations in loan demand and deposit withdrawals. For the most part, QNB has
been able to fund the growth in earning assets through increased deposits.
During the second quarter of 2005, QNB used its Federal funds line on a few
occasions to help fund timing differences between the withdrawal of funds by
municipalities and the receipt of the proceeds from the securities matched
against these deposits.
Form 10-Q
29
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
LIQUIDITY (CONTINUED)
Average Federal funds purchased were $156,000 for the second quarter of 2005.
This compares to $1,353,000 for the same period in 2004. At June 30, 2005, QNB
had no Federal funds purchased.
Approximately $70,430,000 and $103,305,000 of available-for-sale securities at
June 30, 2005 and December 31, 2004, respectively, were pledged as collateral
for repurchase agreements and deposits of public funds. In addition, under terms
of its agreement with the FHLB, QNB maintains otherwise unencumbered qualifying
assets (principally 1-4 family residential mortgage loans and U.S. Government
and Agency notes, bonds, and mortgage-backed securities) in the amount of at
least as much as its advances from the FHLB. The decrease in pledged amounts
relates to the seasonal nature of the municipal deposits. These deposits were
used to purchase available-for-sale securities that were used to pledge against
the deposits of the municipalities. The securities were purchased with cash flow
characteristics that would closely match the anticipated run-off of the
municipal deposits. As these deposits are withdrawn, the pledging is released.
Entering the second quarter QNB's near-term liquidity concern was the ability to
meet the expected withdrawal of $20,000,000 by a school district. These funds
were matched with callable agency securities with call dates that closely
matched the anticipated withdrawal dates. Approximately $18,000,000 of the
deposits were withdrawn and were funded either with proceeds of the bonds that
were called or through the sale of the securities at small losses.
CAPITAL ADEQUACY
A strong capital position is fundamental to support continued growth and
profitability and to serve the needs of depositors. QNB's shareholders' equity
at June 30, 2005 was $47,085,000, or 8.20% of total assets. This compares to
shareholders' equity of $45,775,000, or 7.84% of total assets, at December 31,
2004. Shareholders' equity at June 30, 2005 includes a positive adjustment of
$733,000 related to unrealized holding gains, net of taxes, on investment
securities available-for-sale, while shareholders' equity at December 31, 2004
includes a positive adjustment of $691,000. Without these adjustments
shareholders' equity to total assets would have been 8.07% and 7.72% at June 30,
2005 and December 31, 2004. The increase in the ratio was a result of an
increase in retained earnings combined with a decline in total assets. Total
assets decreased 1.56% between December 31, 2004 and June 30, 2005, while
shareholders' equity, excluding the net unrealized holding gains and losses,
increased 2.81%.
Shareholders' equity averaged $46,165,000 for the first six months of 2005 and
$42,975,000 during all of 2004, an increase of 7.42%. The ratio of average total
equity to average total assets increased to 7.92% for the first half of 2005,
compared to 7.64% for all of 2004. The increase in the equity to asset ratio is
a function of the growth in average equity outpacing the growth in total average
assets.
QNB is subject to various regulatory capital requirements as issued by Federal
regulatory authorities. Regulatory capital is defined in terms of Tier I capital
(shareholders' equity excluding unrealized gains or losses on available-for-sale
securities), Tier II capital that includes a portion of the allowance for loan
losses, and total capital (Tier I plus Tier II). Risk-based capital ratios are
expressed as a percentage of risk-weighted assets. Risk-weighted assets are
determined by assigning various weights to all assets and off-balance sheet
arrangements, such as letters of credit and loan commitments, based on
associated risk. Regulators have also adopted minimum Tier I leverage ratio
standards, which measure the ratio of Tier I capital to total assets.
Form 10-Q
30
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
CAPITAL ADEQUACY (CONTINUED)
The minimum regulatory capital ratios are 4.00% for Tier I, 8.00% for the total
risk-based and 4.00% for leverage. Under the requirements, QNB had a Tier I
capital ratio of 13.11% and 12.25%, a total risk-based ratio of 13.85% and
12.98% and a leverage ratio of 7.91% and 7.44% at June 30, 2005 and December 31,
2004, respectively. The increase in capital ratios reflects the increase in
capital from retained earnings during the first half of 2005 and a reduction in
risk-weighted assets between December 31, 2004 and June 30, 2005. Contributing
to the decline in risk-weighted assets was the reclassification of some
tax-exempt loans to states and political subdivisions from the 100% category to
either the 50% or 20% category based on the source of repayment.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established
five capital level designations ranging from "well capitalized" to "critically
undercapitalized." At June 30, 2005 and December 31, 2004, QNB met the "well
capitalized" criteria, which requires minimum Tier I and total risk-based
capital ratios of 6.00% and 10.00%, respectively, and a Tier I leverage ratio of
5.00%.
INTEREST RATE SENSITIVITY
Since the assets and liabilities of QNB have diverse repricing characteristics
that influence net interest income, management analyzes interest sensitivity
through the use of gap analysis and simulation models. Interest rate sensitivity
management seeks to minimize the effect of interest rate changes on net interest
margins and interest rate spreads and to provide growth in net interest income
through periods of changing interest rates. The Asset/Liability Management
Committee (ALCO) is responsible for managing interest rate risk and for
evaluating the impact of changing interest rate conditions on net interest
income.
Gap analysis measures the difference between volumes of rate-sensitive assets
and liabilities and quantifies these repricing differences for various time
intervals. Static gap analysis describes interest rate sensitivity at a point in
time. However, it alone does not accurately measure the magnitude of changes in
net interest income since changes in interest rates do not impact all categories
of assets and liabilities equally or simultaneously.
Interest rate sensitivity analysis also involves assumptions on certain
categories of assets and deposits. For purposes of interest rate sensitivity
analysis, assets and liabilities are stated at their contractual maturity,
estimated likely call date, or earliest repricing opportunity. Mortgage-backed
securities, CMOs and amortizing loans are scheduled based on their anticipated
cash flow. Savings accounts, including passbook, statement savings, money
market, and interest-bearing demand accounts, do not have a stated maturity or
repricing term and can be withdrawn or repriced at any time. This may impact
QNB's margin if more expensive alternative sources of deposits are required to
fund loans or deposit runoff. Management projects the repricing characteristics
of these accounts based on historical performance and assumptions that it
believes reflect their rate sensitivity. QNB also has another money market
account which reprices monthly based on a percentage of the average of the
91-day Treasury bill.
A positive gap results when the amount of interest rate sensitive assets exceeds
interest rate sensitive liabilities. A negative gap results when the amount of
interest rate sensitive liabilities exceeds interest rate sensitive assets.
QNB primarily focuses on the management of the one-year interest rate
sensitivity gap. At June 30, 2005, interest-earning assets scheduled to mature
or likely to be called, repriced or repaid in one year were $188,040,000.
Interest-sensitive liabilities scheduled to mature or reprice within one year
were $213,882,000. The one-year cumulative gap, which reflects QNB's interest
sensitivity over a period of time, was a negative
Form 10-Q
31
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INTEREST RATE SENSITIVITY (CONTINUED)
$25,842,000 at June 30, 2005. The cumulative one-year gap equals -4.74% of total
rate sensitive assets. This compares to a negative gap position of $12,285,000,
or -2.21% of total rate sensitive assets at December 31, 2004 and a negative gap
position of $64,334,000 or -11.5% of total rate sensitive assets at March 31,
2005.
QNB also uses a simulation model to assess the impact of changes in interest
rates on net interest income. The model reflects management's assumptions
related to asset yields and rates paid on liabilities, deposit sensitivity, and
the size, composition and maturity or repricing characteristics of the balance
sheet. The assumptions are based on what management believes at that time to be
the most likely interest rate environment. Management also evaluates the impact
of higher and lower interest rates by simulating the impact on net interest
income of changing rates. While management performs rate shocks of 100, 200 and
300 basis points, it believes, that given the level of interest rates at June
30, 2005, that it is unlikely that interest rates would decline by 300 basis
points.
Actual results may differ from simulated results due to various factors
including time, magnitude and frequency of interest rate changes, the
relationship or spread between various rates, loan pricing and deposit
sensitivity, and asset/liability strategies.
Management believes that the assumptions utilized in evaluating the
vulnerability of QNB's net interest income to changes in interest rates
approximate actual experience. However, the interest rate sensitivity of QNB's
assets and liabilities as well as the estimated effect of changes in interest
rates on net interest income could vary substantially if different assumptions
are used or actual experience differs from the experience on which the
assumptions were based.
In the event QNB should experience a mismatch in its desired gap ranges or an
excessive decline in its net interest income subsequent to an immediate and
sustained change in interest rates, it has a number of options that it could
utilize to remedy such a mismatch. QNB could restructure its investment
portfolio through the sale or purchase of securities with more favorable
repricing attributes. It could also emphasize loan products with appropriate
maturities or repricing attributes, or it could 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 June 30, 2005, 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 % Change
- ------------------------------------------------------------------------------------------
+300 Basis Points $15,379 $(465) (2.93)%
+200 Basis Points 15,625 (219) (1.40)
+100 Basis Points 15,760 (84) (.53)
FLAT RATE 15,844 - -
- -100 Basis Points 15,074 (770) (4.86)
- -200 Basis Points 13,878 (1,966) (12.40)
Form 10-Q
32
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INTEREST RATE SENSITIVITY (CONTINUED)
The decline in net interest income in a rising rate environment reflects the
fixed rate nature of the investment and loan portfolio and the increased expense
associated with higher cost funding sources. The decline in net interest income
in a falling rate environment reflects the interest rate floors on interest
bearing transaction accounts, regular money market accounts and savings
accounts. Interest rates on these products do not have the ability to decline
100 basis points. Management may attempt to reduce the size of the negative gap
position and the impact of rising interest rates by increasing the amount of
cash flow from the investment portfolio through some restructuring of the
investment portfolio and by promoting longer-term time deposits.
Form 10-Q
33
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The information required herein is set forth in Item 2, above.
ITEM 4. CONTROLS AND PROCEDURES
We maintain a system of controls and procedures designed to provide reasonable
assurance as to the reliability of the consolidated financial statements and
other disclosures included in this report, as well as to safeguard assets from
unauthorized use or disposition. We evaluated the effectiveness of the design
and operation of our disclosure controls and procedures under the supervision
and with the participation of management, including our Chief Executive Officer
and Chief Financial Officer, within 90 days prior to the filing date of this
report. Based upon that evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are
effective. No significant changes were made to our internal controls or other
factors that could significantly affect these controls subsequent to the date of
their evaluation.
Form 10-Q
34
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
JUNE 30, 2005
Item 1. Legal Proceedings
None.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Default Upon Senior Securities
None.
Item 4. Submission of Matters to Vote of Securities Holders
The 2005 Annual Meeting (the "Meeting") of the shareholders of QNB
Corp. (the Registrant") was held on May 17, 2005. Notice of the
Meeting was mailed to shareholders of record on or about April 18,
2004, together with proxy solicitation materials prepared in
accordance with Section 14(a) of the Securities Exchange Act of 1934,
as amended, and the regulations promulgated thereunder.
The Meeting was held for the following purposes:
(1) To elect four (4) Directors
(2) To approve amendments to the Corporation's Articles of
Incorporation
(3) To approve the 2005 Stock Incentive Plan
There was no solicitation in opposition to the nominees of the Board
of Directors for election to the Board of Directors and all such
nominees were elected. The number of votes cast for or withheld for
each of the nominees for election to the Board of Directors were as
follows:
Nominee For Withhold
------------------------------------------------------------
Kenneth F. Brown, Jr. 2,399,271 103,350
Anna Mae Papso 2,484,824 17,797
Henry L. Rosenberger 2,484,885 17,736
Edgar L. Stauffer 2,483,998 18,623
The continuing directors of the Registrant are:
Dennis Helf, G. Arden Link, Thomas J. Bisko, Gary S. Parzych,
Norman L. Baringer and Charles M. Meredith, III
Form 10-Q
35
Item 4. Submission of Matters to Vote of Securities Holders (continued)
---------------------------------------------------
The amendments to the Corporation's Articles of Incorporation were
approved as presented. The number of votes cast for, against or
withheld, as well as the number of abstentions and broker non-votes
for each of the amendments were as follows:
Amendment For Abstain Withhold
-------------------------------------------------------------------------------------------
2.A. Delete Article VII(A) 2,275,655 218,826 8,140
2.B. Delete Article VII(A) 2,304,033 193,528 5,060
2.C. Delete Article VII(B) 1,926,919 207,539 10,877
2.D. Delete Article VII(C) 2,294,020 192,095 16,506
2.E. Delete Article XIII 2,224,234 242,195 36,192
2.F. Delete Article IX 2,024,827 103,716 16,792
2.G. Delete Article XI 2,318,840 170,038 13,743
The 2005 Stock Incentive Plan was approved as presented. The number
of votes cast for, against or withheld, as well as the number of
abstentions and broker non-votes for the adoption of the plan were
as follows:
Adoption For Abstain Withhold
-------------------------------------------------------------------------------------------
2005 Stock Incentive Plan 2,042,656 94,669 8,010
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 DEF 14-A filed with the Commission on April 15,
2005).
Exhibit 3(ii) Bylaws of Registrant, as amended.
Exhibit 10.8 QNB Corp. 2005 Stock Incentive Plan. (Incorporated by
reference to Exhibit 99.1 to Registration Statement No.
333-125998 on Form S-8, filed with the Commission on June
21, 2005.)
Exhibit 11 Statement Re: Computation of Earnings Per Share.
(Included in Part I, Item I, hereof.)
Exhibit 32.1 Certification of Principal Executive Officer
Exhibit 32.2 Certification of Principal Financial Officer
Form 10-Q
36
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: August 9, 2005 By:
--------------------------------- ------------------------
Thomas J. Bisko
President/CEO
Date: August 9, 2005 By:
--------------------------------- ------------------------
Robert C. Werner
Vice President
Date: August 9, 2005 By:
--------------------------------- ------------------------
Bret H. Krevolin
Chief Financial Officer
Form 10-Q
37