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 March 31, 1999
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OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________________ to ______________________
Commission file number 0-17706
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QNB Corp.
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(Exact Name of Registrant as Specified in Its Charter)
Pennsylvania 23-2318082
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
10 North Third Street, Quakertown, PA 18951-9005
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(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (215) 538-5600
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Not Applicable
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Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report.
Indicate by check /X/ whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No
--- ---
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Class Outstanding at May 14, 1999
- ----------------------------- ---------------------------
Common Stock, par value $1.25 1,435,678
<PAGE>
QNB CORP. AND SUBSIDIARY
FORM 10-Q
QUARTER ENDED MARCH 31, 1999
INDEX
PART I - FINANCIAL INFORMATION
PAGE
----
ITEM 1. FINANCIAL STATEMENTS
Consolidated Statements of Income for Three Months Ended
March 31, 1999 and 1998 ...................................... 1
Consolidated Balance Sheets at March 31, 1999 and
December 31, 1998 ............................................ 2
Consolidated Statements of Cash Flows for Three Months Ended
March 31, 1999 and 1998 ...................................... 3
Notes to Consolidated Financial Statements ...................... 4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF
OPERATIONS AND FINANCIAL CONDITION ........................... 6
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT
MARKET RISK .................................................. 19
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS ............................................... 20
(See Regulation S-K Item 305)
ITEM 2. CHANGES IN SECURITIES ........................................... 20
ITEM 3. DEFAULTS UPON SENIOR SECURITIES ................................. 20
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITIES HOLDERS .......... 20
ITEM 5. OTHER INFORMATION ............................................... 20
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ................................ 20
<PAGE>
QNB Corp. and Subsidiary
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
(in thousands, except share data)
(unaudited)
- ------------------------------------------------------------------------------------
Three Months Ended March 31, 1999 1998
- ------------------------------------------------------------------------------------
<S> <C> <C>
Interest Income
Interest and fees on loans ................................. $3,595 $3,625
Interest and dividends on investment securities:
Taxable ................................................ 1,679 1,625
Tax-exempt ............................................. 192 140
Interest on Federal funds sold ............................. 47 65
- ------------------------------------------------------------------------------------
Total interest income ............................. 5,513 5,455
- ------------------------------------------------------------------------------------
Interest Expense
Interest on deposits
Interest-bearing demand accounts ....................... 93 143
Money market accounts .................................. 191 235
Savings ................................................ 169 198
Time ................................................... 1,437 1,392
Time over $100,000 ..................................... 293 277
Interest on short-term borrowings .......................... 96 75
- ------------------------------------------------------------------------------------
Total interest expense ............................ 2,279 2,320
- ------------------------------------------------------------------------------------
Net interest income ............................... 3,234 3,135
Provision for loan losses .................................. 60 100
- ------------------------------------------------------------------------------------
Net interest income after provision for loan losses 3,174 3,035
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Non-Interest Income
Fees for services to customers ............................. 266 231
Mortgage servicing fees .................................... 34 42
Net gain on investment securities available-for-sale ....... 86 68
Net gain on sale of loans .................................. 105 54
Other operating income ..................................... 183 218
- ------------------------------------------------------------------------------------
Total non-interest income ......................... 674 613
- ------------------------------------------------------------------------------------
Non-Interest Expense
Salaries and employee benefits ............................. 1,438 1,361
Net occupancy expense ...................................... 162 156
Furniture and equipment expense ............................ 207 157
Marketing expense .......................................... 91 64
Other real estate owned expense ............................ 19 46
Other expense .............................................. 501 484
- ------------------------------------------------------------------------------------
Total non-interest expense ........................ 2,418 2,268
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Income before income taxes ............................. 1,430 1,380
Provision for income taxes ................................. 386 403
====================================================================================
Net Income ............................................. $1,044 $ 977
====================================================================================
Net Income Per Share - Basic ........................... $ .73 $ .68
====================================================================================
Net Income Per Share - Diluted ......................... $ .72 $ .68
====================================================================================
Cash Dividends Per Share ............................... $ .21 $ .18
====================================================================================
</TABLE>
The accompanying notes are an integral part of
the consolidated financial statements.
1
<PAGE>
QNB Corp. and Subsidiary
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
(in thousands)
(unaudited)
- ----------------------------------------------------------------------------------------
March 31, December 31,
1999 1998
- ----------------------------------------------------------------------------------------
<S> <C> <C>
Assets
Cash and due from banks ............................... $ 11,764 $ 14,020
Federal funds sold .................................... 8,486 4,869
Investment securities
available-for-sale ................................ 73,090 70,088
held-to-maturity (market value $49,913 and $50,473) 49,696 50,065
Total loans, net of unearned income of $309 and $412 .. 178,791 176,443
Allowance for loan losses ......................... (3,016) (2,951)
- --------------------------------------------------------------------------------------
Net loans .................................... 175,775 173,492
Premises and equipment, net ........................... 4,488 4,520
Other real estate owned ............................... 696 696
Accrued interest receivable ........................... 1,943 1,900
Other assets .......................................... 5,642 5,022
- --------------------------------------------------------------------------------------
Total assets .......................................... $ 331,580 $ 324,672
======================================================================================
Liabilities
Deposits
Demand, non-interest-bearing ...................... $ 39,120 $ 39,083
Interest-bearing demand accounts .................. 42,757 46,411
Money market accounts ............................. 29,882 29,918
Savings ........................................... 37,563 36,770
Time .............................................. 110,717 109,464
Time over $100,000 ................................ 25,479 17,577
- --------------------------------------------------------------------------------------
Total deposits ............................... 285,518 279,223
Short-term borrowings ................................. 12,884 14,491
Accrued interest payable .............................. 1,425 1,185
Other liabilities ..................................... 3,283 1,435
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Total liabilities ..................................... 303,110 296,334
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Commitments and contingencies
Shareholders' Equity
Common stock, par value $1.25 per share;
authorized 5,000,000 shares; issued
1,435,678 shares and 1,433,066 .................... 1,795 1,791
Surplus ............................................... 4,412 4,413
Retained earnings ..................................... 21,961 21,218
Accumulated other comprehensive income ................ 302 916
- --------------------------------------------------------------------------------------
Total shareholders' equity ............................ 28,470 28,338
- --------------------------------------------------------------------------------------
Total liabilities and shareholders' equity ............ $ 331,580 $ 324,672
======================================================================================
</TABLE>
The accompanying notes are an integral part of the
consolidated financial statements.
2
<PAGE>
QNB Corp. and Subsidiary
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
(in thousands)
(unaudited)
- ---------------------------------------------------------------------------------------------------------------
Three Months Ended March 31, 1999 1998
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Operating Activities
Net income ..................................................................... $ 1,044 $ 977
Adjustments to reconcile net income to net cash provided by operating activities
Provision for loan losses .................................................... 60 100
Depreciation and amortization ................................................ 143 100
Securities gains ............................................................. (86) (68)
Net gain on sale of loans .................................................... (105) (54)
Proceeds from sales of residential mortgages ................................. 7,426 2,051
Originations of residential mortgages held-for-sale .......................... (4,632) (1,631)
Net gains on sales or writedowns of other real estate owned .................. -- (41)
Deferred income tax provision .................................................. 10 (23)
Change in income taxes payable ................................................. 376 419
Net (decrease) increase in interest and dividends receivable ................... (43) 86
Net amortization of premiums and discounts ..................................... (6) (1)
Net increase in interest payable ............................................... 240 96
Increase in other assets ....................................................... (347) (142)
Increase (decrease) in other liabilities ..................................... 1,510 (117)
- ---------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities .................................... 5,590 1,752
- ---------------------------------------------------------------------------------------------------------------
Investing Activities
Proceeds from maturities and calls of investment securities
available-for-sale ........................................................... 12,645 9,222
held-to-maturity ............................................................. 4,306 3,082
Proceeds from sales of investment securities
available-for-sale ........................................................... 183 5,114
Purchase of investment securities
available-for-sale ........................................................... (16,596) (11,906)
held-to-maturity ............................................................. (4,008) (3,167)
Net increase in Federal funds sold ............................................. (3,617) (8,225)
Proceeds from sales of student loans ........................................... 143 211
Net increase in loans .......................................................... (5,180) (4,516)
Net purchases of premises and equipment ........................................ (112) (138)
Proceeds from the sale of other real estate owned .............................. -- 783
- ---------------------------------------------------------------------------------------------------------------
Net cash used by investing activities ........................................ (12,236) (9,540)
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Financing Activities
Net increase (decrease) in non-interest-bearing deposits ....................... 37 (2,984)
Net increase in interest-bearing deposits ...................................... 6,258 9,229
Net (decrease) increase in short-term borrowings ............................... (1,607) 966
Cash dividends paid ............................................................ (301) (257)
Proceeds from issuance of common stock ......................................... 3 --
- ---------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities .................................... 4,390 6,954
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Decrease in cash and cash equivalents ........................................ (2,256) (834)
Cash and cash equivalents at beginning of year ............................... 14,020 12,574
- ---------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period ................................... $ 11,764 $ 11,740
===============================================================================================================
Supplemental Cash Flow Disclosures
Interest paid .................................................................. $ 2,039 $ 2,224
Income taxes paid .............................................................. -- --
Non-Cash Transactions
Change in net unrealized holding gains (losses),
net of taxes, on investment securities ..................................... (614) 133
</TABLE>
The accompanying notes are an integral part of
the consolidated financial statements.
3
<PAGE>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 1999 AND 1998, AND DECEMBER 31, 1998
(Unaudited)
1. REPORTING AND ACCOUNTING POLICIES
The accompanying consolidated financial statements include the accounts of QNB
Corp. and its wholly owned subsidiary, The Quakertown National Bank, (QNB). All
significant intercompany accounts and transactions are eliminated in the
consolidated statements.
The consolidated balance sheet as of March 31, 1999, as well as the respective
statements of income and cash flows for the three month period ended March 31,
1999 and 1998, are unaudited. These financial statements should be read in
conjunction with the audited financial statements and notes thereto included in
QNB's 1998 Annual Report incorporated in the Form 10-K.
The 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. The results for the periods
presented are not necessarily indicative of the full year. Certain accounts in
last year's financial statements have been reclassified to conform to the
current year's presentation. These reclassifications had no effect on net
income.
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
Ended March 31,
--------------------------
1999 1998
---------- ----------
Numerator for basic and diluted earnings
per share-net income $ 1,044 $ 977
Denominator for basic earnings per share-
weighted average shares outstanding 1,434,459 1,431,240
Effect of dilutive securities-employee
stock options 9,689 7,845
Denominator for diluted earnings per
share-adjusted weighted average
shares outstanding 1,444,148 1,439,085
Earnings per share-basic $ .73 $ .68
Earnings per share-diluted $ .72 $ .68
4
<PAGE>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1999 AND 1998, AND DECEMBER 31, 1998
(Unaudited)
3. COMPREHENSIVE INCOME
In September 1997, the Financial Accounting Standards Board (FASB) issued SFAS
No. 130, "Reporting Comprehensive Income." SFAS No. 130 requires the inclusion
of comprehensive income, either in a separate statement, or as part of a
combined statement of income and comprehensive income in a full set of
general-purpose financial statements.
Comprehensive income is defined as the change in equity of a business entity
during a period from transactions and other events and circumstances, excluding
those resulting from investments by and distributions to owners. For QNB, the
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 period (net of the income tax effect):
Unrealized holding losses arising during the period on securities
held at March 31, 1999 $ (557)
Reclassification adjustment equal to beginning unrealized for all
sold securities (57)
------
Net change in unrealized during the period (614)
Unrealized, beginning of period 916
------
Unrealized, end of period $ 302
Net income $1,044
Other comprehensive income, net of tax:
Unrealized holding losses arising during the period (614)
------
Comprehensive Income $ 430
======
5
<PAGE>
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 which provides a full range of commercial and retail
banking services through its banking subsidiary, The Quakertown National Bank
(the "Bank"), a 121 year old community bank with locations in Upper Bucks,
Northern Montgomery and Southern Lehigh Counties. The results of operations and
financial condition discussed herein are presented on a consolidated basis and
the consolidated entity is referred to herein as "QNB."
In addition to historical information, this management discussion and analysis
contains forward-looking statements. The forward-looking statements contained
herein are subject to certain risks and uncertainties that could cause actual
results to differ materially from those projected in the forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect management's analysis only as of the
date hereof. The Corporation undertakes no obligation to publicly revise or
update these forward-looking statements to reflect events or circumstances that
arise after the date hereof. Readers should carefully review the risk factors
described in other documents the Corporation files from time to time with the
Securities and Exchange Commission, including the quarterly reports on Form 10-Q
filed by the Corporation in 1999, and any Current Reports on Form 8-K filed by
the Corporation.
RESULTS OF OPERATIONS
QNB recorded record earnings of $1,044,000 or $.72 per share on a diluted basis
for the three month period ending March 31, 1999. This represents a 6.9 percent
increase from net income of $977,000 or $.68 per share-diluted reported for the
first quarter of 1998.
Higher net interest income and non-interest income contributed to the increase
in net income. Net interest income which represents interest income, dividends,
and fees on earning assets, less interest expense incurred on funding sources,
increased 3.2 percent to $3,234,000 for the quarter ending March 31, 1999 as
compared to $3,135,000 for the period ending March 31, 1998. Growth in average
earning assets accounted for the improvement in net interest income. Average
earning assets increased 5.7 percent when comparing the two quarters. Net
interest income was negatively impacted by a decrease in the net interest margin
from 4.67 percent to 4.58 percent for the first quarter of 1999. As a result of
continued improvement in asset quality, QNB was able to reduce the provision for
loan losses by $40,000 when comparing the two quarters.
Non-interest income increased $61,000 or 10.0 percent to $674,000 for the
quarter ended March 31, 1999. Gains on the sale of loans and securities
increased $51,000 and $18,000, respectively, when comparing the two quarters.
Also positively impacting non-interest income was a 19.7 percent increase in fee
income.
Non-interest expense increased $150,000 or 6.6 percent when comparing the two
periods. Increased investment in technology, which began during 1998, was a
major contributor to the increase in non-interest expense. Depreciation expense
resulting from this investment increased $45,000 when comparing the two
quarters. Salary and benefits expense increased 5.7 percent or $77,000 to
$1,438,000 for the first quarter of
6
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
RESULTS OF OPERATIONS (Continued)
1999. Merit increases as well as an increase in hours worked resulting from the
installation of a new item processing system and Year 2000 testing, contributed
to the increase in salary expense.
Return on average assets was 1.32 percent and 1.31 percent while the return on
average equity was 15.18 percent and 15.63 percent for the quarters ending March
31, 1999 and 1998, respectively.
NET INTEREST INCOME
Net interest income is the primary source of operating income for QNB. Net
interest income is interest income, dividends, and fees on earning assets, less
interest expense incurred for funding sources. Earning assets primarily include
loans, investment securities and Federal funds sold. Sources used to fund these
assets include deposits, borrowed funds and shareholders' equity. Net interest
income is affected by changes in interest rates, the volume and mix of earning
assets and interest-bearing liabilities, and the amount of earning assets funded
by non-interest-bearing deposits and shareholders' equity.
Net interest income for the three months ended March 31, 1999 was $3,234,000
compared to $3,135,000 for the period ending March 31, 1998. On a tax-equivalent
basis net interest income was $3,384,000 and $3,263,000 for the respective
quarters. A 5.7 percent increase in average earning assets was partially offset
by a 9 basis point decrease in the net interest margin. The yield on earning
assets on a fully taxable equivalent basis was 7.67 percent for the first
quarter of 1999 versus 7.99 percent for the first quarter of 1998, while the
rate paid on interest-bearing liabilities was 3.63 percent and 3.89 percent for
the same periods. The net interest margin on a fully taxable equivalent basis
for the three month period ended March 31, 1999 was 4.58 percent compared to
4.67 percent for the same period in 1998.
The lower yield on earning assets and rate paid on interest-bearing liabilities
was a result of a general decline in market interest rates, as represented by
the U.S. Treasury yield curve. These rates declined dramatically during 1998 as
signs of a global economic crisis created a flight to quality in the U.S.
Treasury market. Adding fuel to this decline was an environment of low inflation
in the U.S. economy. In response to these events the Federal Reserve Bank
lowered the Federal funds rate three times and 75 basis points between the end
of September 1998 and the middle of November 1998, from 5.50 percent to 4.75
percent. The prime rate, the rate which some of QNB's loans are based, also
declined 75 basis points during this time. This general decline in interest
rates ended during the first quarter of 1999, as the U.S. economy continued to
show strength and the fear of inflation reentered the economic picture. Treasury
rates have increased approximately 50 basis points from the end of 1998 to the
end of the first quarter of 1999.
When comparing the first quarter of 1999 to the first quarter of 1998, the yield
on investment securities decreased slightly to 6.69 percent from 6.73 percent
while the yield on loans decreased to 8.37 percent from 8.89 percent. QNB was
able to maintain the yield on its investment portfolio by purchasing
mortgage-backed securities, whose yields did not decline to the same degree as
Treasury securities and by slightly lengthening the average life of the
portfolio with the purchase of some higher yielding but longer term callable
agency securities and tax-exempt municipal securities. The 52 basis point
decline in the yield on loans was a result of both the drop in the prime rate
and the continued downward pressure on commercial loan rates resulting from the
fierce competition for loans. Another result of the lower interest rate
environment is the continuing trend for customers to select fixed rather than
variable rate loans, both in the residential mortgage and commercial loan
sectors.
7
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (Continued)
Despite dramatically falling market interest rates as indicated by the Treasury
yield curve, the rates paid on deposits and short-term borrowings did not
decline to the same degree as rates on earning assets. This is a function of the
strong competition among financial institutions for funding sources. The average
rate paid on interest bearing demand accounts showed the largest decline,
falling to .87 percent for the first quarter of 1999 compared to 1.40 percent
for the first quarter of 1998. QNB was able to reduce the rate on these accounts
as they are deemed to be relatively insensitive to changing interest rates. The
average rate paid on savings accounts, money market accounts and time deposits
decreased 33 basis points, 30 basis points and 27 basis points, respectively.
The rate on time deposits should continue to decline over the next few quarters
as higher paying time deposits, primarily promotional one year time deposits,
reprice at lower rates. The yield on short-term borrowings declined to 3.37
percent for the period ended March 31, 1999 from 3.72 percent for the period
ended March 31, 1998. This was primarily the result of a decline in rates paid
on the cash management accounts.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to be charged to operations to bring the allowance for loan
losses to a level considered adequate in relation to the risk of possible losses
in the loan portfolio. Actual loan losses, net of recoveries, serve to reduce
the allowance.
Management uses various tools to assess the adequacy of the allowance for loan
losses. One tool is a methodology recommended by the Office of the Comptroller
of the Currency. This methodology considers a number of relevant factors
including: historical loan loss experience, the assigned risk rating of the
credit, current and projected credit worthiness of the borrower, current value
of the underlying collateral, levels of and trends in delinquencies and
non-accrual loans, trends in volume and terms of loans, concentrations of credit
and national and local economic trends and conditions. Other tools include ratio
analysis and peer group analysis.
The provision for loan losses was $60,000 for the quarter ending March 31, 1999
compared to $100,000 for the first quarter of 1998. QNB was able to reduce the
provision for loan losses as a result of continued improvement in asset quality,
low levels of delinquency and net loan recoveries. QNB had net recoveries of
$5,000 and $17,000 for the first quarter of 1999 and 1998, respectively.
Non-performing assets (non-accruing loans, loans past due 90 days or more, and
other real estate owned) continued their positive trend downward during the
first quarter of 1999 and amounted to .34 percent of total assets at March 31,
1999. This compares to .74 percent at March 31, 1998 and .37 percent at December
31, 1998. Non-accrual loans were $379,000 and $1,172,000 at March 31, 1999 and
1998. Non-accrual loans at December 31, 1998 were $506,000. Other real estate
owned was $696,000 at both March 31, 1999 and December 31, 1998 compared to
$822,000 at March 31, 1998. Management anticipates non-performing assets to
decline slightly as a result of the sale of some properties within other real
estate owned during the second and third quarters of 1999.
There were no restructured loans as of March 31, 1999, December 31, 1998 or
March 31, 1998 as defined in Statement of Financial Accounting Standards 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.
8
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
PROVISION FOR LOAN LOSSES (Continued)
The allowance for loan losses was $3,016,000 and $2,951,000 at March 31, 1999
and December 31, 1998, respectively. The ratio of the allowance to total loans
was 1.69 percent and 1.67 percent for the respective periods. While QNB believes
that its allowance is adequate to cover losses in the loan portfolio, there
remain inherent uncertainties regarding future economic events and their
potential impact on asset quality.
A loan is considered impaired, based on current information and events, if it is
probable that QNB will be unable to collect the scheduled payments of principal
or interest when due according to the contractual terms of the loan agreement.
The measurement of impaired loans is generally based on the present value of
expected future cash flows discounted at the historical effective interest rate,
except that all collateral-dependent loans are measured for impairment based on
the fair value of the collateral.
At March 31, 1999 and 1998, the recorded investment in loans for which
impairment has been recognized in accordance with SFAS No. 114 totaled $315,000
and $1,098,000, respectively, of which $306,000 and $1,089,000 related to loans
with no valuation allowance. At both March 31, 1999 and 1998 there were $9,000
in impaired loans that had a valuation allowance against the entire amount. Most
of the loans identified as impaired are collateral-dependent.
NON-INTEREST INCOME
QNB, through its core banking business, generates various fees and service
charges. Total non-interest income is composed of service charges on deposit
accounts, mortgage servicing fees, gains on the sale of investment securities,
gains on the sale of residential mortgages and student loans, and other
miscellaneous fee income. Total non-interest income decreased $61,000 or 10.0
percent to $674,000 for the quarter ending March 31, 1999 when compared to March
31, 1998.
Fees for services to customers, the largest component of total non-interest
income, is primarily comprised of service charges on deposit accounts. These
fees increased 15.2 percent, to $266,000 from $231,000, when comparing the two
quarters. An increase in overdraft fee income accounts for approximately $19,000
of the increase. During the first quarter of 1999, QNB increased its fee for
overdrafts by 12.0 percent. An increase in fees related to the use of
out-of-network ATMs contributed $8,000 to the overall increase.
To 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. Mortgage servicing fees for the quarter ending March
31, 1999 were $34,000 which represents an $8,000 decline from the same period in
1998. The decrease in mortgage servicing fees for the quarter is primarily a
result of an increase in the amortization of the mortgage servicing asset booked
at the time the loan is sold. 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 a period of
net servicing income or loss. Servicing assets are assessed for impairment based
on their fair value. During the first quarter of 1999, QNB amortized
approximately $10,000 of the mortgage servicing asset compared to $3,000 during
the first quarter of 1998. The average balance of mortgages serviced for others
was $67,527,000 for the first quarter of 1999 compared to $67,650,000 for the
first quarter of 1998. The timing of mortgage payments and delinquencies also
impacts the amount of servicing fees recorded.
9
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST INCOME (Continued)
Gains on the sale of investment securities were $86,000 for the first quarter of
1999, compared to $68,000 for the first three months of 1998. QNB owns a small
portfolio of marketable equity securities, bank stocks. During the first quarter
of 1999, QNB sold a holding with a cost basis of $97,000 at a gain of $86,000.
This compares to a similar sale during the first quarter of 1998 when QNB sold
securities with a cost basis of $28,000 for a gain of $62,000. During the first
quarter of 1998, QNB sold approximately $5,000,000 in lower yielding agency
securities at a gain of $6,000. These securities had a weighted average yield of
5.81 percent and were sold for both liquidity purposes and to reposition the
portfolio. There were no sales of debt securities during the first quarter of
1999.
QNB recorded a gain of $105,000 on the sale of loans during the first quarter of
1999. This compares to a $54,000 gain for the same period in 1998. The sale of
residential mortgages and the sale of student loans accounts for $102,000 and
$3,000 of the gains, respectively, in 1999. For the same period in 1998 the sale
of residential mortgage loans accounted for $52,000 of the gain while the sale
of student loans represented $2,000 of the gain. QNB sold approximately $140,000
and $209,000 in student loans during the first quarter of 1999 and 1998.
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 larger gain in 1999 is a result of an increase in the amount of
loans sold. Proceeds from the sale of residential mortgages were approximately
$7,426,000 and $2,051,000 during the first quarter of 1999 and 1998. Declining
interest rates presented an opportunity for many borrowers to refinance their
mortgages at lower rates. This provided an opportunity for QNB to originate and
sell more mortgages. The increase in interest rates during the first quarter of
1999, prevented QNB from selling these loans at even a larger gain. As of March
31, 1999 QNB had approximately $741,000 in mortgage loans classified as held for
sale. These loans are accounted for at lower of cost or market and were written
down by approximately $3,000 at March 31, 1999.
Other operating income decreased $35,000 to $183,000 when comparing the three
month periods ending March 31, 1999 and 1998. The results for 1998 included a
$41,000 gain on the sale of other real estate owned. A decline in the
recognition of rental income on other real estate owned of $26,000 also
contributed to the decrease. The rental income decreased as a result of the sale
of some revenue generating properties. Partially offsetting these declines was
the recognition of $38,000 in earnings on the cash surrender value of single
premium life insurance policies that went into effect in September 1998. Higher
check card and mutual fund income offset a decline in ATM card income. QNB
restructured its deposit products during the third quarter of 1998. As a result
of this restructure, more customers are eligible for free ATM cards.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee
benefits, net occupancy, furniture and equipment, marketing, other real estate
owned expense and various other operating expenses. Total non-interest expense
of $2,418,000 for the quarter ending March 31, 1999 represents an increase of
$150,000 or 6.6 percent from levels reported in the first quarter of 1998.
10
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST EXPENSE (Continued)
Salaries and benefits, the largest component of non-interest expense, increased
$77,000 or 5.7 percent to $1,438,000 for the quarter ending March 31, 1999
compared to the same quarter in 1998. Salaries expense increased $85,000 or 8.0
percent during the period to $1,144,000 while benefits expense decreased $8,000
or 2.6 percent to $294,000. Excluding the accrual for bonuses in both years,
salary expense increased 3.8 percent. Merit increases as well as an increase in
hours worked resulting from the installation of a new item processing system and
Year 2000 testing, contributed to this increase. The decrease in benefits
expense is primarily the result of a reduction in QNB's State unemployment tax
rate.
Net occupancy expense increased $6,000 or 4.0 percent while furniture and
equipment expense increased $50,000 or 31.8 percent when comparing the three
month periods ending March 31, 1999 and 1998, respectively. An increase in
building repairs and maintenance costs and building security expense contributed
to the increase in net occupancy expense. Increased investment in technology,
which began during 1998, was a major contributor to the increase in furniture
and equipment expense during the first quarter of 1999. Depreciation expense
resulting from this investment increased $45,000 when comparing the two
quarters. The implementation of the check imaging system was completed at the
end of the first quarter of 1999. Higher equipment maintenance costs of $7,000
also contributed to the increase in furniture and equipment expense. Furniture
and equipment expense will continue to increase in 1999 as a result of higher
depreciation expense associated with QNB's continued expansion of its investment
in new technology. This will include the completion of the final phases of the
wide-area network, as well as the impact of the check imaging system. The
expansion of an existing branch will also result in higher furniture and
equipment expense in 1999.
Marketing expense increased $27,000 or 42.2 percent to $91,000 for the quarter
ending March 31, 1999 while other real estate owned expense decreased $27,000 to
$19,000 for the same period. A $13,000 increase in donations as well as
increases in advertising and public relation expense contributed to the
increase. The reduction in other real estate owned expense is a function of
owning fewer properties and the related taxes, insurance and maintenance related
to the properties.
Total other expense for the three months ending March 31, 1999 was $501,000, an
increase of $17,000 or 3.5 percent over the same period in 1998. The major
categories that comprise other expense are postage, supplies, professional
services, telecommunications costs, insurance expense and state taxes. Small
increases in a number of categories including check card expense, supply expense
and state taxes, offset a decrease in postage expense.
INCOME TAXES
Applicable income taxes and effective tax rates were $386,000 or 27.0 percent
for the three month period ending March 31, 1999, and $403,000 or 29.2 percent
for the same period in 1998. The reduction in the effective tax rate when
comparing 1999 to 1998 is a result of an increase in income from tax-exempt
municipal securities and loans and an increase in tax-exempt income from
earnings on single premium life insurance.
11
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QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INCOME TAXES (Continued)
QNB utilizes an asset and liability approach for financial accounting and
reporting of income taxes. As of March 31, 1999, QNB's net deferred tax asset
was $814,000. A deferred tax asset of $782,000 relating to the allowance for
loan losses was partially offset by a deferred tax liability of $156,000
resulting from the SFAS No.115 adjustment for available-for-sale investment
securities. As of March 31, 1998, QNB's net deferred tax asset was $319,000. A
deferred tax asset of $699,000 related to the allowance for loan losses was
partially offset by a deferred tax liability of $518,000 resulting from the SFAS
No. 115 adjustment.
BALANCE SHEET ANALYSIS
The Balance Sheet Analysis reviews average balance sheet data for the three
months ended March 31, 1999 and 1998, as well as the period ending balances as
of March 31, 1999 and December 31, 1998.
Average earning assets for the three month period ended March 31, 1999 increased
$16,056,000 or 5.7 percent to $299,595,000 from $283,539,000 for the quarter
ending March 31, 1998. Average loans and average investments increased
$8,755,000 and $8,800,000, respectively while Federal funds sold decreased
$1,525,000. The increase in average loans is a result of the business
development program developed over the past couple of years, competitive pricing
on commercial and home equity loans and participation relationships with other
local community banks. Average consumer loans, primarily home equity loans
increased $3,493,000 and average residential mortgage loans increased
$2,166,000. The increase in residential mortgage loans is a function of the
refinancing boom caused by lower interest rates and the decision to retain some
15 year mortgages in portfolio. Commercial loans increased $2,297,000 when
comparing the two quarters.
The growth in average earning assets was primarily funded by increases in
non-interest bearing demand deposits, time deposits and short-term borrowings,
primarily cash management accounts. Average non-interest bearing demand accounts
increased $3,278,000, while average time-deposits increased $10,700,000.
Attractive rates on time deposits relative to rates on other interest-bearing
accounts along with the introduction of the "Flex12" certificate of deposit
contributed to the increase in time deposits. The "Flex12" has a twelve month
maturity, allows one no-penalty withdrawal, enables the holder to add funds to
the account and pays a competitive rate. Average cash management balances
increased $3,497,000 when comparing the two quarters. Average interest-bearing
transaction accounts which includes interest-bearing demand deposits, money
market accounts and savings accounts decreased $1,156,000 between the two
quarters. Average shareholders' equity increased $2,543,000 to $27,899,000.
Total assets at March 31, 1999 were $331,580,000, compared with $324,672,000 at
December 31, 1998, an increase of 2.1 percent for the quarter. Total deposits
increased from $279,223,000 at December 31, 1998 to $285,518,000 at March 31,
1999. This trend is encouraging as QNB historically has experienced deposit
run-off during the first half of the year. The increase in assets from December
31, 1998 to March 31, 1999 is primarily centered in Federal funds sold,
investment securities and loans, which increased $3,617,000, $2,633,000 and
$2,348,000, respectively, during the period. The higher balance of Federal funds
sold at March 31, 1999 is in response to the increase in short-term $100,000
time deposits. Total time deposits increased $9,155,000, with time deposits over
$100,000 increasing $7,902,000. The $620,000 increase in other assets is
primarily related to increases in the net deferred tax asset caused by the
decline in the unrealized gain on available-for-sale securities, the prepayment
of the Pennsylvania Bank shares tax expense
12
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
BALANCE SHEET ANALYSIS (Continued)
and an increase in mortgage servicing assets. Savings accounts increased
$793,000 while interest-bearing demand deposits declined by $3,654,000 from
December 31, 1998 to March 31, 1999. Other liabilities increased $1,848,000 to
$3,283,000 at March 31, 1999. $1,000,000 of the increase relates to a security
purchased by QNB that was not delivered by a broker. QNB booked the investment
as an asset and setup a liability for the payment that would be due upon
delivery of the security. Approximately $480,000 of the increase relates to a
liability of principal and interest on a participated loan.
At March 31, 1999 the fair value of investment securities available-for-sale was
$73,090,000 or $458,000 above the amortized cost of $72,632,000. This compares
to a fair value of $70,088,000 or $1,387,000 above the amortized cost of
$68,701,000 at December 31, 1998. An unrealized holding gain, net of taxes, of
$302,000 and $916,000 was recorded as an increase to shareholders' equity at
March 31, 1999 and December 31, 1998. Rising interest rates during the first
quarter of 1999 contributed to the decrease in the fair value of the investment
portfolio.
The available-for-sale portfolio had a weighted average maturity of
approximately 5 years and 4 years, 10 months at March 31, 1999 and December 31,
1999, respectively. The weighted average maturity is based on the stated
contractual maturity of all securities except for mortgage-backed securities
which are based on estimated average life. The maturity of the portfolio may be
shorter because of call features in many debt securities and because of
prepayments on mortgage-backed securities. The interest rate sensitivity
analysis reflects the expected maturity distribution of the securities portfolio
based upon estimated call dates and anticipated cash flows assuming management's
most likely interest rate environment. The expected weighted average life of the
available-for-sale portfolio was 2 years, 1 month at March 31, 1999 and 1 year,
2 months at December 31, 1998, based on these assumptions. The slight extension
of the expected average life of the portfolio is a result of the replacement of
some bonds that had been called with bonds with longer maturities.
Investment securities held-to-maturity are reported at amortized cost. As of
March 31, 1999 and December 31, 1998, QNB had securities classified as
held-to-maturity with an amortized cost of $49,696,000 and $50,065,000 and a
market value of $49,913,000 and $50,473,000, respectively. The held-to-maturity
portfolio had a weighted average maturity of approximately 4 years and 3 years,
10 months at March 31, 1999 and December 31, 1998. The increase in the average
maturity is a result of the increase in the percentage of the portfolio in 10
year tax-exempt municipal securities.
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. Th portfolio of investment
securities available-for-sale and QNB's policy of selling certain residential
mortgage originations and student loans in the secondary market also provide
sources of liquidity.
13
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
LIQUIDITY (Continued)
Cash and due from banks, Federal funds sold, available-for-sale securities and
loans held-for-sale were $96,035,000 and $93,860,000 at March 31, 1999 and
December 31, 1998. These sources were adequate to meet seasonal deposit
withdrawals during the first quarter of 1999 and should be adequate to meet
normal fluctuations in loan demand and or deposit withdrawals. Approximately
$38,619,000 and $44,715,000 of available-for-sale securities at March 31, 1999
and December 31, 1998 were pledged as collateral for repurchase agreements,
public deposits and other deposits as provided by law. Additional sources of
liquidity are provided by the Bank's membership in the Federal Home Loan Bank
and a $5,000,000 unsecured Federal funds line granted by the Bank's
correspondent.
The consolidated statements of cash flows present the changes in cash and cash
equivalents from operating, investing and financing activities. QNB's cash and
cash equivalents decreased $2,256,000 to $11,764,000 at March 31, 1999. This
compares to an $834,000 decrease during the first three months of 1998. After
adjusting net income for non-cash transactions, operating activities provided
$5,590,000 in cash flow in the first three months of 1999, compared to
$1,752,000 in the same period of 1998. An increase in residential mortgage loan
activity as well as an increase in other liabilities accounted for most of the
difference between the periods.
Net cash used by investing activities was $12,236,000 during the first quarter
of 1999. An increase in Federal funds sold of $3,617,000 and loans of $5,180,000
were a use of cash. The purchase of investment securities exceeded the maturity,
call and sale of securities by $3,470,000 during the first quarter of 1999. Net
cash used by investing activities was $9,540,000 during the first three months
of 1998. The $8,225,000 increase in Federal funds sold was the largest factor. A
net increase in loans of $4,516,000 was also an investing activity that used
cash. Proceeds from the sale, maturity and call of securities of $17,418,000
exceeded the cost of the purchase of securities of $15,073,000 and was a net
provider of cash. Proceeds from the sale of other real estate owned was also a
provider of cash.
Net cash provided by financing activities was $4,390,000 during the first
quarter of 1999 and $6,954,000 during the first quarter of 1998. The increase in
both periods is the result of an increase in interest-bearing deposits,
primarily time deposits. A reduction in non-interest bearing deposits of
$2,984,000 was a use of cash during the first quarter of 1998, while a decline
in short-term borrowings of $1,607,000 was a use of cash in 1999.
CAPITAL ADEQUACY
A strong capital position is fundamental to support continued growth and
profitability, to serve the needs of depositors, and to yield an attractive
return for shareholders. QNB's shareholders' equity at March 31, 1999 was
$28,470,000 or 8.59 percent of total assets compared to shareholders' equity of
$28,338,000 or 8.73 percent at December 31, 1998. Shareholders' equity at March
31, 1999 includes a positive adjustment of $302,000 related to unrealized
holding gains, net of taxes, on investment securities available-for-sale, while
shareholders' equity at December 31, 1998 includes a positive adjustment of
$916,000. Without these adjustments shareholders' equity to total assets would
have been 8.50 percent and 8.45 percent at March 31, 1999 and December 31, 1998.
Shareholders' equity averaged $27,899,000 for the first three months of 1999 and
$26,323,000 during all of 1998, an increase of 6.0 percent. The ratio of average
total equity to average total assets improved to 8.71 percent for 1999, compared
to 8.48 percent for 1998. The increase in the equity to asset ratio is a
function of
14
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
CAPITAL ADEQUACY (Continued)
significantly higher net income, an increase in capital retention despite
increasing the cash dividend in both 1999 and 1998 and modest growth in average
assets.
QNB Corp. and the Quakertown National Bank are subject to various regulatory
capital requirements as issued by Federal regulatory authorities. Regulatory
capital is defined in terms of Tier I capital (shareholders' equity excluding
unrealized gains or losses on available-for-sale securities), Tier II capital
which includes a portion of the allowance for loan losses, and total capital
(Tier I plus II). Risk-based capital ratios are expressed as a percentage of
risk-weighted assets. Risk-weighted assets are determined by assigning various
weights to all assets and off-balance sheet arrangements, such as letters of
credit and loan commitments, based on associated risk. Regulators have also
adopted minimum Tier I leverage ratio standards, which measure the ratio of Tier
I capital to total assets.
The minimum regulatory capital ratios are 4.00 percent for Tier I, 8.00 percent
for the total risk-based and 4.00 percent for leverage. Under the requirements,
QNB has a Tier I capital ratio of 14.03 percent and 14.02 percent, a total
risk-based ratio of 15.29 percent and 15.28 percent and a leverage ratio of 8.66
percent and 8.58 percent at March 31, 1999 and December 31, 1998, respectively.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established
five capital level designations ranging from "well capitalized" to "critically
undercapitalized." At March 31, 1999 and December 31, 1998 QNB met the "well
capitalized" criteria which requires minimum Tier I and total risk-based capital
ratios of 6.00 percent and 10.00 percent, respectively, and a Tier I leverage
ratio of 5.00 percent.
INTEREST RATE SENSITIVITY
Since the assets and liabilities of QNB have diverse repricing characteristics
that influence net interest income, management analyzes interest sensitivity
through the use of gap analysis and simulation models. Interest rate sensitivity
management seeks to minimize the effect of interest rate changes on net interest
margins and interest rate spreads, and to provide growth in net interest income
through periods of changing interest rates. The Asset/Liability Management
Committee (ALCO) is responsible for managing interest rate risk and for
evaluating the impact of changing interest rate conditions on net interest
income.
Gap analysis measures the difference between volumes of rate-sensitive assets
and liabilities and quantifies these repricing differences for various time
intervals. Static gap analysis describes interest rate sensitivity at a point in
time. However, it alone does not accurately measure the magnitude of changes in
net interest income since changes in interest rates do not impact all categories
of assets and liabilities equally or simultaneously. Interest rate sensitivity
analysis also involves assumptions on certain categories of assets and deposits.
For purposes of interest rate sensitivity analysis, assets and liabilities are
stated at their contractual maturity, estimated likely call date, or earliest
repricing opportunity. Mortgage-backed securities and amortizing loans are
scheduled based on their anticipated cash flow. Savings accounts, including
passbook, statement savings, money market, and interest-bearing demand accounts,
do not have a stated maturity or repricing term and can be withdrawn or repriced
at any time. This may impact QNB's margin if more expensive alternative sources
of deposits are required to fund loans or deposit runoff. Management projects
the repricing characteristics of these accounts based on historical performance
and assumptions that it believes reflect their rate sensitivity.
15
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INTEREST RATE SENSITIVITY (Continued)
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 March 31, 1999, interest-earning assets scheduled to mature
or likely to be called, repriced or repaid in one year were $113,160,000.
Interest-sensitive liabilities scheduled to mature or reprice within one year
were $136,720,000. The one year cumulative gap, which reflects QNB's interest
sensitivity over a period of time, was a negative $23,560,000 at March 31, 1999
and a negative $1,156,000 at December 31, 1998. The cumulative one-year gap
equals 7.61 percent and .39 percent of total earning assets at these respective
dates. The increase in the negative gap position is a result of a combination of
extending the maturity of the investment portfolio and the shortening of the
maturity of time deposits. This negative or liability sensitive gap will
generally benefit QNB in a falling interest rate environment, while rising
interest rates could negatively impact QNB.
QNB also uses a simulation model to assess the impact of changes in interest
rates on net interest income. The model reflects management's assumptions
related to asset yields and rates paid on liabilities, deposit sensitivity, and
the size, composition and maturity or repricing characteristics of the balance
sheet. The assumptions are based on what management believes at that time to be
the most likely interest rate environment. Management also evaluates the impact
of higher and lower interest rates.
Actual results may differ from simulated results due to various factors
including time, magnitude and frequency of interest rate changes, the
relationship or spread between various rates, loan pricing and deposit
sensitivity, and asset/liability strategies. Based on management's estimate of
balance sheet growth and composition and interest rates for the next year, net
interest income for the next twelve months is expected to increase compared to
the prior twelve months. The projected increase in net interest income is
primarily the result of forecasted growth in total assets. These factors will be
partially offset by an anticipated decrease in the net interest margin.
If interest rates are 100 basis points lower than management's most likely
interest rate environment, the simulation model projects net interest income for
the next twelve months to slightly exceed the most likely scenario. Conversely,
if interest rates were 100 basis points higher, net interest income for the most
likely scenario would decline slightly. These results are consistent with the
results of the gap analysis described above.
Management believes that the assumptions utilized in evaluating the
vulnerability of QNB's net interest income to changes in interest rates
approximate actual experience; however, the interest rate sensitivity of QNB's
assets and liabilities as well as the estimated effect of changes in interest
rates on net interest income could vary substantially if different assumptions
are used or actual experience differs from the experience on which the
assumptions were based.
In the event QNB should experience a mismatch in its desired gap ranges or an
excessive decline in its net interest income subsequent to an immediate and
sustained change in interest rates, it has a number of options which it could
utilize to remedy such a mismatch. QNB could restructure its investment
portfolio through 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.
16
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INTEREST RATE SENSITIVITY (Continued)
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 March 31, 1999, 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.
<TABLE>
<CAPTION>
Change in Interest Rates Net Interest Income Dollar Change Percent Change
- ------------------------ ------------------- ------------- --------------
<S> <C> <C> <C>
+300 Basis Points................. $12,249 $(884) (6.73)%
+200 Basis Points................. 12,561 (572) (4.35)
+100 Basis Points................. 12,878 (255) (1.94)
FLAT RATE ........................ 13,133 -- --
- -100 Basis Points................. 13,260 127 .97
- -200 Basis Points................. 13,122 (11) (.08)
- -300 Basis Points................. 12,753 (380) (2.89)
</TABLE>
IMPACT OF YEAR 2000
During the first quarter of 1999, QNB continued to very actively address all
issues surrounding the Year 2000. The Year 2000 challenge faces all users of
automated systems, including information systems. Many computer systems process
data using only two digits to represent the year of a transaction, rather than
storing the full four-digit year. If renovations are not done to these systems,
they may not operate properly when the last two digits become "00," as will
occur on January 1, 2000. The problem could affect a wide variety of automated
systems, including mainframe systems, personal computers, application processing
systems, resource allocation systems, communications systems, environmental
systems, and other information systems.
In 1997, QNB developed a five phase plan to address the Year 2000. The five
phases include Awareness, Assessment, Renovation, Validation and Implementation.
The Awareness phase included the establishment of a team of employees, including
Executive Management. The focus of this team was development and sharing of
information to insure that our employees, systems providers, and customers were
aware of the Bank's Year 2000 strategies. This team provides updates to the
Bank's Board of Directors on a quarterly basis. While the initial Awareness
effort was completed in 1997, the Bank continues to promote awareness by
maintaining close contact with systems providers, key customers, vendors, and
other stakeholders.
The Assessment phase included the identification of all systems on which QNB
relies to provide the services our stakeholders rely upon. These systems were
risk ranked according to their importance to providing uninterrupted services;
they were further ranked to identify those systems that are mission critical for
delivery of products and services. This phase also included the inventory of all
hardware, software, and systems, as well as customer and vendor
interdependencies. The Assessment phase has been completed.
17
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QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
IMPACT OF YEAR 2000 (Continued)
The Renovation phase includes code enhancement, vendor validation, and hardware
and software upgrades as needed. Largely, the systems used by QNB are purchased
from outside vendors. The vendors are responsible for maintenance and upgrades
to the systems as part of systems maintenance agreements; these upgrades include
the modifications necessary to enable uninterrupted usage after December 31,
1999. In a few instances, vendors did not provide the Bank with assurance that
their systems would be Y2K-ready o available for the testing we required in a
timely manner; in those cases, the Bank elected to replace those systems with
others that were already Y2K certified. At the end of the first quarter 1999,
internal systems upgrades were 100% completed. Overall renovations, including
the utility companies and external vendor upgrades, were about 88% complete and
on target for completion during 1999.
The Validation phase includes testing of all impacted applications, both
internally developed and third-party provided. Testing of systems began in 1998.
A test system was purchased to replicate the mainframe hardware used to
facilitate our mission critical core account processing systems. A test plan
detailing plans to 'validate' all inventoried systems was developed, reviewed by
Senior Management and internal audit, adopted by the Board of Directors, and
reviewed by the Office of the Comptroller of Currency for completeness,
thoroughness, and value in validating the Y2K compliant nature of tested
products.
Validation involves not only extensive in-house testing, but also interpretation
and evaluation of vendor proxy tests and/or vendor certifications. Where
appropriate, validation expands to testing systems that must integrate with
other systems to effectively process. The Y2K team, including Senior Management
in each division of the Bank, reviews the various components of each validation
to measure its reliability and completeness. Only after passing this thorough
review is a product deemed `compliant' wit QNB's definition of Y2K-ready.
Mission critical systems are given the greatest scrutiny in this validation
process.
Testing was substantially completed at the end of the first quarter of 1999.
Internal integration testing of two mission critical applications is scheduled
to be completed by the end of the second quarter. Both of these applications,
however, have vendor certification and completed proxy testing. The Bank
continues to review progress with utility companies providing services to the
Bank to measure their progress for Y2K readiness.
Contingency plans for systems that are not expected to be Y2K ready by December
31, 1999 will be developed as necessary. As of the end of the first quarter
1999, there were no systems for which contingency plans were necessary. In
addition, business resumption plans are being developed to handle any unexpected
situations that may arise in the millennium change.
The Implementation phase includes incorporating all changes, achieving
certification of Year 2000 compliance, and implementing contingency plans, if
necessary. QNB's plan also includes reviewing any potential risks associated
with the loan, deposit, and investment portfolios due to Year 2000 issues. Based
on currently available information, management does not anticipate that the cost
to address Year 2000 issues will have a significant impact on QNB's financial
condition, results of operations, liquidity or capital resources. The total
anticipated cost for Year 2000 compliance is under $100,000. A significant
portion of the anticipated costs are not incremental, but rather represent the
re-deployment of existing information technology and management resources. The
only major investment in technology made partially as a result of the Year 2000,
was the purchase of an imaging system to do item processing. QNB's previous item
processing system was deemed not to be Year 2000 compliant after QNB had
previously adopted a long range
18
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
IMPACT OF YEAR 2000 (Continued)
technology plan which included migrating to imaging during 1999. The new system
was installed during the first quarter of 1999. The cost of the imaging system
was approximately $325,000. Through QNB's Year 2000 team efforts, three areas of
Year 2000 exposure have been identified: 1) customer uncertainty; 2) utility and
communications companies; and 3) indirect debit and ATM gateways. QNB is
addressing these areas through its business resumption contingency plans. A Y2K
business resumption program is being prepared and scheduled to be completed by
June 30, 1999.
OTHER ITEMS
Management is not aware of any current specific recommendations by regulatory
authorities or proposed legislation, which if they were implemented, would have
a material adverse effect upon the liquidity, capital resources, or results of
operations, although the general cost of compliance with numerous and multiple
federal and state laws and regulations does have, and in the future may have, a
negative impact on QNB's results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The information required herein is set forth in Item 2, above.
19
<PAGE>
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
MARCH 31, 1999
Item 1. Legal Proceedings
None.
Item 2. Changes in Securities
None.
Item 3. Default Upon Senior Securities
None.
Item 4. Submission of Matters to Vote of Securities Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
The following Exhibits are included in this Report:
Exhibit 3.1 Articles of Incorporation of Registrant, as amended.
(Incorporated by reference to Exhibit 3.1 of Registrants
Form 10-Q filed with the Commission on August 13, 1998).
Exhibit 3.2 Bylaws of Registrant, as amended. (Incorporated by
reference to Exhibit 3.1 of Registrants Form 10-Q filed
with the Commission on August 13, 1998).
Exhibit 10.1 Employment Agreement between the Registrant and
Thomas J. Bisko. (Incorporated by reference to Exhibit 10.1
of Registrants Form 10-K filed with the Commission on
March 31, 1999).
Exhibit 10.2 Salary Continuation Agreement between the Registrant and
Thomas J. Bisko. (Incorporated by reference to Exhibit 10.2
of Registrants Form 10-K filed with the Commission on
March 31, 1999).
20
<PAGE>
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
MARCH 31, 1999
Item 6. Exhibits and Reports on Form 8-K (Continued)
Exhibit 10.4 QNB Corp. Stock Incentive Plan. (Incorporated by reference
to Exhibit 4A to Registration Statement No. 333-16627 on
Form S-8, filed with the Commission on November 22, 1996).
Exhibit 10.5 QNB Corp. Employee Stock Purchase Plan. (Incorporated by
reference to Exhibit 4B to Registration Statement No.
333-16627 on Form S-8, filed with the Commission on
November 22, 1996).
Exhibit 10.6 The Quakertown National Bank Profit Sharing and Section
401(k) Salary Deferral Plan. (Incorporated by reference to
Exhibit 4C to Registration Statement No. 333-16627 on Form
S-8, filed with the Commission on November 22, 1996).
Exhibit 11 Statement Re: Computation of Earnings Per Share.
(Included in Part I, Item I, hereof.)
Exhibit 27 Financial Data Schedule
(b) Reports on Form 8-K
None
21
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized.
QNB Corp.
Date: May 14, 1999 By: /s/ Thomas J. Bisko
-----------------------------------
Thomas J. Bisko
President/CEO
Date: May 14, 1999 By: /s/ Robert C. Werner
-----------------------------------
Robert C. Werner
Vice President
Date: May 14, 1999 By: /s/ Bret H. Krevolin
-----------------------------------
Bret H. Krevolin
Chief Accounting Officer
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