SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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, 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.
---------------------------------------------
(Exact Name of Registrant as Specified in Its Charter)
Pennsylvania 23-2318082
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(State or Other Jurisdiction (I.R.S. Employer
of 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
---------------
Not Applicable
------------------------------------
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 August 13, 1999
Common Stock, par value $1.25 1,436,348
<PAGE>
QNB CORP. AND SUBSIDIARY
FORM 10-Q
QUARTER ENDED JUNE 30, 1999
INDEX
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS PAGE
Consolidated Statements of Income for Three and
Six Months Ended June 30, 1999 and 1998.....................1
Consolidated Balance Sheets at June 30, 1999
and December 31, 1998 ......................................2
Consolidated Statements of Cash Flows for Six
Months Ended June 30, 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 ............................................21
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS .........................................22
(See Regulation S-K Item 305)
ITEM 2. CHANGES IN SECURITIES .......................................22
ITEM 3. DEFAULTS UPON SENIOR SECURITIES .............................22
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITIES HOLDERS ......22
ITEM 5. OTHER INFORMATION ...........................................22
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ............................23
<PAGE>
QNB Corp. and Subsidiary
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
(in thousands, except share data)
(unaudited)
- ------------------------------------------------------------------------------------------------------------
THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
1999 1998 1999 1998
- ------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
INTEREST INCOME
Interest and fees on loans ................................. $ 3,572 $ 3,777 $ 7,167 $ 7,402
Interest and dividends on investment securities:
Taxable ................................................ 1,896 1,632 3,575 3,257
Tax-exempt ............................................. 242 160 434 300
Interest on Federal funds sold ............................. 72 119 119 184
Interest on interest-bearing balances ...................... 1 -- 1 --
- ------------------------------------------------------------------------------------------------------------
Total interest income ............................. 5,783 5,688 11,296 11,143
- ------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Interest on deposits
Interest-bearing demand accounts ....................... 105 150 198 293
Money market accounts .................................. 199 239 390 474
Savings ................................................ 176 206 345 404
Time ................................................... 1,432 1,444 2,869 2,836
Time over $100,000 ..................................... 304 287 597 564
Interest on short-term borrowings .......................... 92 86 188 161
Interest on Federal Home Loan Bank advances ................ 231 -- 231 --
- ------------------------------------------------------------------------------------------------------------
Total interest expense ............................ 2,539 2,412 4,818 4,732
- ------------------------------------------------------------------------------------------------------------
Net interest income ............................... 3,244 3,276 6,478 6,411
Provision for loan losses .................................. 60 100 120 200
- ------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 3,184 3,176 6,358 6,211
- ------------------------------------------------------------------------------------------------------------
NON-INTEREST INCOME
Fees for services to customers ............................. 298 225 564 456
Mortgage servicing fees .................................... 29 44 63 86
Net gain on investment securities available-for-sale ....... 77 -- 163 68
Net gain on sale of loans .................................. 40 110 144 164
Other operating income ..................................... 273 119 457 318
- ------------------------------------------------------------------------------------------------------------
Total non-interest income ......................... 717 498 1,391 1,092
- ------------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSE
Salaries and employee benefits ............................. 1,431 1,363 2,869 2,724
Net occupancy expense ...................................... 164 160 326 316
Furniture and equipment expense ............................ 218 162 425 319
Marketing expense .......................................... 114 124 205 188
Other real estate owned expense ............................ 48 35 67 81
Other expense .............................................. 531 543 1,032 1,008
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Total non-interest expense ........................ 2,506 2,387 4,924 4,636
- ------------------------------------------------------------------------------------------------------------
Income before income taxes ............................. 1,395 1,287 2,825 2,667
Provision for income taxes ................................. 341 346 727 749
- ------------------------------------------------------------------------------------------------------------
NET INCOME ............................................. $ 1,054 $ 941 $ 2,098 $ 1,918
============================================================================================================
NET INCOME PER SHARE - BASIC ........................... $ .73 $ .66 $ 1.46 $ 1.34
============================================================================================================
NET INCOME PER SHARE - DILUTED ......................... $ .73 $ .65 $ 1.45 $ 1.33
============================================================================================================
CASH DIVIDENDS PER SHARE ............................... $ .21 $ .18 $ .42 $ .36
============================================================================================================
</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)
- ------------------------------------------------------------------------------------
JUNE 30, DECEMBER 31,
1999 1998
- ------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
Cash and due from banks ............................... $ 13,546 $ 14,020
Federal funds sold .................................... 8,300 4,869
Investment securities available-for-sale .............. 100,292 70,088
held-to-maturity (market value $50,693 and
$50,473) .......................................... 51,567 50,065
Total loans, net of unearned income of $271 and $412 .. 174,808 176,443
Allowance for loan losses ......................... (3,077) (2,951)
- ------------------------------------------------------------------------------------
Net loans .................................... 171,731 173,492
Premises and equipment, net ........................... 4,526 4,520
Other real estate owned ............................... 531 696
Accrued interest receivable ........................... 2,064 1,900
Other assets .......................................... 6,525 5,022
- ------------------------------------------------------------------------------------
Total assets .......................................... $ 359,082 $ 324,672
====================================================================================
LIABILITIES
Deposits
Demand, non-interest-bearing ...................... $ 39,804 $ 39,083
Interest bearing demand accounts .................. 46,282 46,411
Money market accounts ............................. 30,526 29,918
Savings ........................................... 38,598 36,770
Time .............................................. 111,309 109,464
Time over $100,000 ................................ 26,018 17,577
- ------------------------------------------------------------------------------------
Total deposits ............................... 292,537 279,223
Short-term borrowings ................................. 10,660 14,491
Federal Home Loan Bank advances ....................... 25,000 --
Accrued interest payable .............................. 1,539 1,185
Other liabilities ..................................... 1,539 1,435
- ------------------------------------------------------------------------------------
Total liabilities ..................................... 331,275 296,334
- ------------------------------------------------------------------------------------
Commitments and contingencies
SHAREHOLDERS' EQUITY
Common stock, par value $1.25 per share;
authorized 5,000,000 shares; issued 1,436,348
shares and 1,433,066 shares ....................... 1,795 1,791
Surplus ............................................... 4,435 4,413
Retained earnings ..................................... 22,714 21,218
Accumulated other comprehensive income ................ (1,137) 916
- ------------------------------------------------------------------------------------
Total shareholders' equity ............................ 27,807 28,338
- ------------------------------------------------------------------------------------
Total liabilities and shareholders' equity ............ $ 359,082 $ 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)
- ------------------------------------------------------------------------------------------
SIX MONTHS ENDED JUNE 30, 1999 1998
- ------------------------------------------------------------------------------------------
<S> <C> <C>
OPERATING ACTIVITIES
Net income .................................................. $ 2,098 $ 1,918
Adjustments to reconcile net income to net cash
provided by operating activities
Provision for loan losses ................................. 120 200
Net recovery of charged off loans ......................... 6 --
Depreciation and amortization ............................. 304 215
Securities gains .......................................... (163) (68)
Net gain on sale of loans ................................. (144) (164)
Proceeds from sales of residential mortgages .............. 9,270 7,199
Originations of residential mortgages held-for-sale ....... (6,009) (5,159)
Proceeds from sales of student loans ...................... 1,670 1,467
Net gains on sales or writedowns of other real estate owned (48) (16)
Deferred income tax provision ............................. (12) (63)
Change in income taxes payable ............................ 134 106
Net increase in interest and dividends receivable ......... (164) --
Net amortization of premiums and discounts ................ (1) 5
Net increase in interest payable .......................... 354 68
Increase in other assets .................................. (472) (124)
Increase (decrease) in other liabilities .................. 10 (16)
- ------------------------------------------------------------------------------------------
Net cash provided by operating activities ................. 6,953 5,568
- ------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Proceeds from maturities and calls of investment securities
available-for-sale ........................................ 14,319 10,924
held-to-maturity .......................................... 8,437 8,599
Proceeds from sales of investment securities
available-for-sale ........................................ 7,453 5,114
Purchase of investment securities
available-for-sale ........................................ (54,855) (16,701)
held-to-maturity .......................................... (10,006) (13,007)
Net increase in Federal funds sold .......................... (3,431) (6,188)
Net increase in loans ....................................... (3,152) (4,280)
Net purchases of premises and equipment ..................... (311) (331)
Proceeds from the sale of other real estate owned ........... 213 856
- ------------------------------------------------------------------------------------------
Net cash used by investing activities ..................... (41,333) (15,014)
- ------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Net increase (decrease) in non-interest-bearing deposits .... 721 (842)
Net increase in interest-bearing deposits ................... 12,593 10,002
Net (decrease) increase in short-term borrowings ............ (3,831) 1,168
Proceeds from Federal Home Loan Bank advances ............... 25,000 --
Cash dividends paid ......................................... (602) (515)
Proceeds from issuance of common stock ...................... 25 20
- ------------------------------------------------------------------------------------------
Net cash provided by financing activities ................. 33,906 9,833
- ------------------------------------------------------------------------------------------
(Decrease) increase in cash and cash equivalents .......... (474) 387
Cash and cash equivalents at beginning of year ............ 14,020 12,574
- ------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period ................ $ 13,546 $ 12,961
==========================================================================================
SUPPLEMENTAL CASH FLOW DISCLOSURES
Interest paid ............................................... $ 4,464 $ 4,664
Income taxes paid ........................................... 590 700
Non-Cash Transactions
Change in net unrealized holding gains (losses),
net of taxes, on investment securities ................. (2,053) 43
Transfer of loans to other real estate owned .............. -- 49
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
3
<PAGE>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 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 June 30, 1999, as well as the respective
statements of income and cash flows for the three and the six month periods
ended June 30, 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):
<TABLE>
<CAPTION>
For the Three Months For the Six Months
Ended June 30, Ended June 30,
------------------------ ------------------------
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
Numerator for basic and diluted earnings $ 1,054 $ 941 $ 2,098 $ 1,918
per share-net income
Denominator for basic earnings per share- 1,435,928 1,431,483 1,435,198 1,431,362
weighted average shares outstanding
Effect of dilutive securities-employee 6,635 10,560 8,261 9,262
stock options
Denominator for diluted earnings per 1,442,563 1,442,043 1,443,459 1,440,624
share-adjusted weighted average
shares outstanding
Earnings per share-basic $ .73 $ .66 $ 1.46 $ 1.34
Earnings per share-diluted $ .73 $ .65 $ 1.45 $ 1.33
</TABLE>
4
<PAGE>
QNB CORP. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999 AND 1998, AND DECEMBER 31, 1998
(Unaudited)
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, 1999 and 1998 (net of the income tax effect):
Unrealized holding losses arising during the period
on securities held at June 30, 1999 $(1,945)
Reclassification adjustment equal to beginning
unrealized for all sold securities (108)
-------
Net change in unrealized during the period (2,053)
Unrealized, beginning of period 916
-------
Unrealized, end of period $(1,137)
Net income $ 2,098
Other comprehensive income, net of tax:
Unrealized holding losses arising during the period (2,053)
-------
Comprehensive Income $ 45
=======
Unrealized holding gains arising during the period
on securities held at June 30, 1998 $ 88
Reclassification adjustment equal to beginning
unrealized for all sold securities (45)
-------
Net change in unrealized during the period 43
Unrealized, beginning of period 873
-------
Unrealized, end of period $ 916
Net income $ 1,918
Other comprehensive income, net of tax:
Unrealized holding gains arising during the period 43
-------
Comprehensive Income $ 1,962
=======
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 122 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 10Q
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 $1,054,000 or $.73 per share on a diluted basis
for the three month period ending June 30, 1999. This represents a 12.0 percent
increase from net income of $941,000 or $.65 per share-diluted reported for the
second quarter of 1998. For the six month periods ending June 30, 1999 and 1998,
net income was $2,098,000 and $1,918,000, respectively, an increase of 9.4
percent. Net income per share diluted was $1.45 and $1.33 for the corresponding
six-month periods.
An increase in non-interest income and a reduction in the provision for loan
losses offset a slight decline in net interest income and an increase in
non-interest expense when comparing the two quarters. Non-interest income
increased from $498,000 to $717,000, an increase of 44.0 percent. Contributing
to the increase was higher fee income on deposit accounts, which increased 41.5
percent or $98,000. Increases in merchant processing income, check card income
and mutual fund commission income also contributed to the positive variance.
During the second quarter of 1999, QNB recorded a gain on the sale of two
properties classified as other real estate owned. The gain on the sales was
$47,000. During the second quarter of 1998 a loss of approximately $25,000 was
recorded on other real estate owned. Gains on the sale of investment securities
and loans were $117,000 and $110,000 for the quarters ending June 30, 1999 and
1998, respectively. Total non-interest income represents approximately 11.0
percent of total revenue during the second quarter of 1999 compared to 8.1
percent during the same period in 1998.
Net interest income which represents interest income, dividends, and fees on
earning assets, less interest expense incurred on funding sources, decreased 1.0
percent to $3,244,000 for the quarter ending June 30, 1999 as compared to
$3,276,000 for the quarter ending June 30, 1998. Net interest income declined
despite 10 percent growth in average earning assets. Average loans increased 3.4
percent, while average investment securities
6
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
RESULTS OF OPERATIONS (Continued)
increased 23.0 percent when comparing the two quarters. Some of the growth in
average earning assets was funded through wholesale funding. This has the impact
of increasing net interest income, but lowering the net interest margin. The net
interest margin declined from 4.66 percent during the second quarter of 1998 to
4.25 percent for the second quarter of 1999. Excluding the impact of the
wholesale funding transaction, the net interest margin for the second quarter of
1999 would have been 4.42 percent. Included in the net interest margin in 1998
was the recovery of approximately $86,000 in interest on a nonaccrual loan.
Excluding this recovery the net interest margin for the second quarter of 1998
would have been 4.54 percent.
Non-interest expense increased $119,000 or 5.0 percent when comparing the two
periods. Salary and benefits expense increased 5.0 percent or $68,000 to
$1,431,000 for the second quarter of 1999. Approximately half the increase in
salary expense relates to the accrual for incentive based pay. Merit increases
as well as an increase in hours worked resulting from the installation of a new
item processing system and Year 2000 testing, also contributed to the increase
in salary expense. Increased investment in technology, which began during 1998,
was also a major contributor to the increase in non-interest expense.
Depreciation expense resulting from this investment increased $46,000 when
comparing the two quarters.
Return on average assets was 1.23 percent and 1.21 percent while the return on
average equity was 14.75 percent and 14.49 percent for the three months ending
June 30, 1998 and 1997, respectively. For the six-month periods ending June 30,
1998 and 1997, return on average assets was 1.27 percent and 1.26 percent and
the return on average equity was 14.96 percent and 15.05 percent, respectively.
NET INTEREST INCOME
Net interest income is the primary source of operating income for NCNB. 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 June 30, 1999 was $3,244,000
compared to $3,276,000 for the period ending June 30, 1998. On a tax-equivalent
basis net interest income was $3,426,000 and $3,418,000 for the respective
quarters. A 10.0 percent increase in average earning assets was offset by a 41
basis point decrease in the net interest margin. The yield on earning assets on
a fully taxable equivalent basis was 7.39 percent for the second quarter of 1999
versus 7.95 percent for the second quarter of 1998, while the rate paid on
interest-bearing liabilities was 3.69 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 June 30, 1999 was 4.25 percent compared to 4.66 percent
for the same period in 1998. Some of the growth in average earning assets was
funded through a wholesale funding transaction, whereby QNB borrowed $25,000,000
from the Federal Home Loan Bank (FHLB) and reinvested the proceeds in a 30 year
mortgage-backed security and 15 year tax-exempt municipal securities. This
transaction has the impact of increasing net interest income, but lowering the
net interest margin. Excluding the impact of the wholesale funding transaction,
the net interest margin for the second quarter of 1999 would have been 4.42
percent. Positively impacting the yield on earning assets and the net interest
margin during the second quarter of 1998 was the recognition of approximately
$88,000 in interest income on a non-accrual loan. The loan had been in
non-accrual status since September of 1995 and was paid off during the second
7
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (Continued)
quarter of 1998. Excluding the recognition of this interest, the yield on
earning assets would have been 7.83 percent, while the net interest margin would
have been 4.54 percent.
The lower yield on earning assets and rate paid on interest-bearing liabilities
was a result of a general decline in market interest rates during 1998, 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. In
response, interest rates began to increase rapidly and at the end of June, the
Federal Reserve Bank raised the Federal funds target rate 25 basis points. The
prime rate also increased by .25 percent. As an example of the higher market
rates, the interest rate on a 10-year Treasury note has increased approximately
115 basis points from the end of 1998 to the end of the second quarter of 1999.
This rate has increased approximately another 25 basis points since the end of
June in anticipation of further Fed tightening at its August meeting. These
higher rates should lead to higher yields on both loans and investment
securities in the third quarter of 1999.
When comparing the second quarter of 1999 to the second quarter of 1998, the
yield on investment securities decreased to 6.47 percent from 6.60 percent while
the yield on loans decreased to 8.21 percent from 8.77 percent (excluding the
recognition of the non-accrual interest). QNB was able to reduce the impact on
the yield of its investment portfolio by purchasing mortgage-backed securities,
whose yields did not decline to the same degree as Treasury securities and by
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 56 basis point decline in the yield on loans was a result of the
decline 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.
Despite dramatically falling market interest rates during 1998 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 .95 percent for the second quarter of 1999 compared
to 1.42 percent for the second 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, 29 basis points and 35 basis
points, respectively. The rate on deposits is likely to increase over the next
quarter, as the increase in Treasury rates is passed on to the consumer in the
form of higher deposit rates, particularly time deposits. The yield on
short-term borrowings declined to 3.38 percent for the period ended June 30,
1999 from 3.68 percent for the period ended June 30, 1998. This was primarily
the result of a decline in rates paid on the cash management accounts.
For the six-month period ending June 30, 1999, net interest income increased
$67,000 to $6,478,000. On a tax-equivalent basis net interest income increased
$129,000 or 1.9 percent. The 7.8 percent growth in average earning assets was
partially offset by a 25 basis point decline in the net interest margin. Total
interest income
8
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NET INTEREST INCOME (Continued)
increased $153,000 from $11,143,000 to $11,296,000 when comparing the six-month
periods ending June 30, 1998 to June 30, 1999. The yield on earning assets,
excluding the impact of the interest on the non-accrual loan in 1998 decreased
from 7.90 percent to 7.52 percent, with the yield on loans declining from 8.81
percent to 8.29 percent. During the six-month period the yield on investment
securities decreased from 6.66 percent to 6.57 percent. Average investment
securities increased 15.6 percent to $129,920,000 while average loans increased
4.1 percent to $177,012,000. Total interest expense increased $86,000 from
$4,732,000 to $4,818,000 for the six-month periods. The yield on
interest-bearing liabilities decreased from 3.89 percent to 3.66 percent.
Average interest-bearing deposits increased 3.8 percent to $245,212,000, while
total average interest-bearing liabilities increased 8.3 percent to
$265,329,000. The primary difference in the percent change is the impact of the
borrowings from the FHLB, entered into at the end of April 1999.
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 implementation of SFAS No. 118, as
discussed below, also impacts the determination of the allowance for loan
losses.
The provision for loan losses was $60,000 for the quarter ending June 30, 1999
compared to $100,000 for the second quarter of 1998. For the six-month periods
the provision for loan losses was $120,000 and $200,000, respectively. 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 $1,000 and net charge-offs of $1,000 for the second
quarter of 1999 and 1998. For the six-month periods QNB had net recoveries of
$6,000 and $16,000, 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 half of 1999 and amounted to .31 percent of total assets at June 30, 1999.
This compares to .55 percent at June 30, 1998 and .37 percent at December 31,
1998. Non-accrual loans were $300,000 and $937,000 at June 30, 1999 and 1998.
Non-accrual loans at December 31, 1998 were $506,000. Other real estate owned
was $531,000 and $696,000 at June 30, 1999 and December 31, 1998, respectively,
and $773,000 at June 30, 1998.
There were no restructured loans as of June 30, 1999, December 31, 1998 or June
30, 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.
9
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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 $3,077,000 and $2,951,000 at June 30, 1999
and December 31, 1998, respectively. The ratio of the allowance to total loans
was 1.76 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 June 30, 1999 and 1998, the recorded investment in loans for which impairment
has been recognized in accordance with SFAS No. 114 totaled $207,000 and
$866,000, respectively, of which $199,000 and $816,000 related to loans with no
valuation allowance. At June 30, 1999 and 1998 there were $8,000 and $50,000 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 increased $219,000 or 44.0
percent to $717,000 for the quarter ending June 30, 1999 when compared to June
30, 1998. For the six-month period total non-interest income increased $299,000
or 27.4 percent to $1,092,000.
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 32.4 percent, to $298,000 from $225,000, when comparing the two
quarters and 23.7 percent to $564,000 when comparing the six-month periods. An
increase in overdraft fee income accounts for approximately $55,000 of the
increase for the three-month period and $74,000 for the six-month period. 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 $5,000
and $13,000 to the overall increase for the respective three and six month
periods.
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 June 30,
1999 were $29,000 which represents a $15,000 decline from the same period in
1998. For the six month period mortgage servicing fees decreased $23,000 to
$63,000. The decrease in mortgage servicing fees for the quarter and the
six-month period 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 second quarter of
1999, QNB amortized approximately $14,000 of the mortgage servicing asset
compared to $5,000 during the second quarter of 1998. For the respective
six-month periods the amortization was $24,000 and $8,000. The average balance
of mortgages
10
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST INCOME (Continued)
serviced for others was $68,720,000 for the second quarter of 1999 compared to
$67,036,000 for the second quarter of 1998. The average balance of mortgages
serviced was approximately $68,127,000 for the six-month period ending June 30,
1999 compared to $67,681,000 for the first six months of 1998. The timing of
mortgage payments and delinquencies also impacts the amount of servicing fees
recorded.
Gains on the sale of investment securities were $77,000 for the second quarter
of 1999 and $163,000 for the first six months of 1999. This compares to no gains
in the second quarter of 1998 and $68,000 for the six-month period ending June
30, 1998. QNB owns a small portfolio of marketable equity securities, bank
stocks. The gains recorded during 1999 relate to the sale of securities out of
this portfolio. Also during the second quarter of 1999, QNB sold approximately
$7,000,000 of callable agency securities that were likely to be called during
the quarter at breakeven. These securities were sold for liquidity reasons. Of
the gain in 1998 $62,000 relates to the sale of equity securities. In addition,
during the first quarter of 1998, QNB sold approximately $5,000,000 in lower
yielding agency securities at a gain of $6,000. These securities had a weighted
average yield of 5.81 percent and were sold for both liquidity purposes and to
reposition the portfolio.
QNB recorded a gain of $40,000 on the sale of loans during the second quarter of
1999. This compares to a $110,000 gain for the same period in 1998. For the
six-month periods ending June 30, 1999 and 1998 net gains on the sale of loans
were $144,000 and $164,000, respectively. The sale of student loans accounts for
$30,000 and $33,000 of the gains during the second quarter of 1999 and 1998. QNB
sold approximately $1,497,000 and $1,223,000 in student loans during the second
quarter of 1998 and 1997. Gains on the sale of student loans accounted for
$33,000 and $36,000 of the total gains during the six-month periods ending June
30, 1999 and 1998, respectively.
The net gain on the sale of residential mortgages loans was $10,000 and $77,000
for the three month periods ending June 30, 1999 and 1998 and $111,000 and
$128,000 for the respective six month periods. 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
during the second quarter of 1998 is a function of both factors. Proceeds from
the sale of residential mortgages were approximately $1,844,000 and $5,148,000
during the second quarters of 1999 and 1998, respectively. Rising interest rates
during the second quarter of 1999 slowed the refinancing activity and reduced
the origination of mortgage loans. The rising rates also had the impact of
reducing the net gains on the sales. Proceeds from the sale of residential
mortgages was approximately $9,270,000 and $7,199,000 during the first six
months of 1999 and 1998. The increase in interest rates reduced the gains on the
loan sold during 1999. As of June 30, 1999 QNB had approximately $377,000 in
mortgage loans classified as held for sale. These loans are accounted for at
lower of cost or market.
Other operating income increased $154,000 to $273,000 when comparing the
three-month periods ending June 30, 1999 and 1998 and $139,000 to $457,000 when
comparing the six-month periods. The results for the second quarter of 1999
include the gain on the sale of other real estate owned of $47,000 while the
results for the second quarter of 1998 include a loss on the sale of other real
estate owned of $25,000. During the second quarter of 1999, QNB recognized
$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, merchant
processing and mutual fund income offset a decline in ATM card income and rental
income on other real estate owned. 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. A refund of sales tax also contributed to the
increase in other
11
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST INCOME (Continued)
operating income during the second quarter of 1999.
The recognition of earnings on the single premium life insurance contributed
$75,000 to the increase in other operating income for the six months ended June
30, 1999. Checkcard income increased $23,000 and net gains on the sale of other
real estate owned increased $31,000 when comparing the two periods. These
increases offset a decline in rental income on other real estate owned of
$39,000. The rental income decreased as a result of the sale of some revenue
generating properties.
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 $2,506,000 for the quarter ending June 30, 1999 represents an increase of
$119,000 or 5.0 percent from levels reported in the second quarter of 1998.
Total non-interest expense for the six months ending June 30, 1999 was
$4,924,000, an increase of $288,000 or 6.2 percent over 1998 levels.
Salaries and benefits, the largest component of non-interest expense, increased
$68,000 or 5.0 percent to $1,431,000 for the quarter ending June 30, 1999
compared to the same quarter in 1998. Salary expense increased $75,000 or 6.9
percent during the period to $1,167,000 while benefits expense decreased $7,000
or 2.6 percent to $264,000. For the six-month period ending June 30, 1999
salaries and benefits expense increased $145,000 or 5.3 percent compared to
1998. Salary expense increased $159,000 or 7.4 percent while benefits expense
decreased $14,000 or 2.5 percent. Excluding the accrual for bonuses in both
years, salary expense increased 4.0 percent for the quarter and 3.9 percent for
the six-month period. 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 $4,000 or 2.5 percent for the three-month
periods and $10,000 or 3.2 percent when comparing the six-month periods ending
June 30, 1999 and 1998. Higher building repairs and maintenance expense was the
reason for the increase during both time frames.
Furniture and equipment expense increased $56,000 or 34.6 percent when comparing
the three-month periods ending June 30, 1999 and 1998, respectively and $106,000
or 33.2 percent when comparing the six-month periods. Increased investment in
technology, which began during 1998, was a major contributor to the increase in
furniture and equipment expense during the second quarter and first half of
1999. Depreciation expense resulting from this investment increased $46,000 when
comparing the two quarters and 91,000 when comparing the six-month periods. The
implementation of the check imaging system was completed at the end of the first
quarter of 1999. Higher equipment maintenance costs of $8,000 for the quarter
and $15,000 for the six-month period 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 decreased $10,000 or 8.1 percent to $114,000 for the quarter
ending June 30, 1999 but increased $17,000 or 9.0 percent when comparing the
six-month periods. The timing of donations contributed
12
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST EXPENSE (Continued)
to the variance in the quarter. A pledge to the Main Street Program in June
1998, a program designed for the revitalization of downtown Quakertown,
contributed to the higher expense during the second quarter of 1998. For both
six-month periods donation expense was approximately $50,000. Advertising costs
and annual report costs increased when comparing both the quarter and six month
periods.
Other real estate owned expense decreased $14,000 or 17.3 percent to $67,000 for
the six months ending June 30, 1999. 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. The majority of the expense
during the second quarter of 1999 relates to the environmental clean up of one
property which is expected to sell during the third quarter of 1999.
INCOME TAXES
Applicable income taxes and effective tax rates were $341,000 or 24.4 percent
for the three-month period ending June 30, 1999, and $346,000 or 26.9 percent
for the same period in 1998. For the six-month period applicable income taxes
and effective rates were $727,000 or 25.7 percent and $749,000 or 28.1 percent,
respectively. 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.
QNB utilizes an asset and liability approach for financial accounting and
reporting of income taxes. As of June 30, 1999, QNB's net deferred tax asset was
$1,578,000. Included in the deferred tax asset was $802,000 relating to the
allowance for loan losses and $586,000 resulting from the SFAS No.115 adjustment
for available-for-sale investment securities. As of December 31, 1998, QNB's net
deferred tax asset was $506,000. A deferred tax asset of $762,000 related to the
allowance for loan losses was partially offset by a deferred tax liability of
$472,000 resulting from the SFAS No. 115 adjustment.
BALANCE SHEET ANALYSIS
The Balance Sheet Analysis reviews average balance sheet data for the six months
ended June 30, 1999 and 1998, as well as the period ending balances as of June
30, 1999 and December 31, 1998.
Average earning assets for the six-month period ended June 30, 1999 increased
$22,487,000 or 7.8 percent to $311,669,000 from $289,182,000 for the six months
ending June 30, 1998. Average investments and average loans increased
$17,566,000 and $7,010,000, respectively while average Federal funds sold
decreased $2,133,000. The large increase in the investment portfolio is a result
of the growth in funding sources, both retail and wholesale, outpacing the
growth in loans. The advance from the Federal Home Loan Bank had the impact of
increasing average investments by approximately $9,000,000 during the six-month
period. The increase in average loans is a result of the business development
program developed over the past several 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 $4,259,000
and average commercial loans increased $2,329,000. The increase in home equity
loans is a result of aggressive pricing and promotion.
13
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QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
BALANCE SHEET ANALYSIS (Continued)
In addition to borrowing from the Federal Home Loan Bank, the growth in average
earning assets was 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 $3,003,000, while average
time deposits increased $9,766,000. Attractive rates on time deposits relative
to rates on other interest-bearing accounts along with the introduction of the
"Flex 12" 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 $2,260,000 when comparing the
six-month periods. Average interest-bearing transaction accounts, which include
interest-bearing demand deposits, money market accounts and savings accounts,
decreased $847,000 between the periods. Average total deposits increased 4.4
percent when comparing the six-month periods, while average shareholders' equity
increased $2,588,000 or 10.1 percent to $28,286,000.
Total assets at June 30, 1999 were $359,082,000, compared with $324,672,000 at
December 31, 1998, an increase of 10.6 percent for the six months. The advance
from the Federal Home Loan Bank contributed $25,000,000 to the increase. Without
the advance total assets would have increased by approximately 2.9 percent.
Total deposits increased from $279,223,000 at December 31, 1998 to $292,537,000
at June 30, 1999, an increase of 4.8 percent. 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 June 30, 1999 is primarily
centered in investment securities and Federal funds sold, which increased
$31,706,000 and $3,431,000, respectively, during the period. The higher balance
of Federal funds sold at June 30, 1999 is in response to the increase in
short-term $100,000 time deposits. Total time deposits increased $10,286,000,
with time deposits over $100,000 increasing $8,441,000. The $1,503,000 increase
in other assets is primarily related to increases in the net deferred tax asset
caused by the increase in the unrealized loss on available-for-sale securities
and a deposit to a third party vendor for the processing of cashier checks.
At June 30, 1999 the fair value of investment securities available-for-sale was
$100,292,000 or $1,723,000 below the amortized cost of $102,015,000. 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 loss, net of taxes,
of $1,137,000 was recorded as a decrease to shareholders' equity at June 30,
1999 and an unrealized holding gain of $916,000 was recorded as an increase to
shareholder's equity at December 31, 1998. Rising interest rates during the
first half of 1999 as well as the lengthening of the average life of the
investment portfolio contributed to the unrealized loss in the portfolio at June
30, 1999.
The available-for-sale portfolio had a weighted average maturity of
approximately 6 years, 11 months and 4 years, 10 months at June 30, 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 5 years, 7 months
at June 30, 1999 and I year, 2 months at December 31, 1998, based on these
assumptions. The extension of the expected average life of the portfolio is a
result of a number of factors including: the purchase of $20,000,000 of a 30
year mortgage-backed security, with an average life of 9.3 years, and $5,000,000
in 15 year tax exempt municipal bonds with the proceeds from the advances from
the Federal Home Loan Bank; the replacement of bonds that had been called during
the first quarter of 1999 with bonds with longer maturities and the increase in
interest rates which has lengthened the
14
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
BALANCE SHEET ANALYSIS (Continued)
average life on mortgage related securities and callable agency bonds. The
portfolio as of December 31, 1998 had shortened dramatically as a result of the
decline in interest rates during 1998. The decline in rates caused prepayments
on mortgage-backed securities to increase and the likelihood of callable agency
bonds to be called to increase. The structure of the portfolio at the end of
1998 created reinvestment risk, as approximately 70 percent of the portfolio was
likely to be reinvested at lower interest rates during 1999 and 2000. The
current composition of the portfolio reduces this risk.
Investment securities held-to-maturity are reported at amortized cost. As of
June 30, 1999 and December 31, 1998, QNB had securities classified as
held-to-maturity with an amortized cost of $51,567,000 and $50,065,000 and a
market value of $50,693,000 and $50,473,000, respectively. The held-to-maturity
portfolio had a weighted average maturity of approximately 5 years and 3 years,
10 months at June 30, 1999 and December 31, 1998, respectively. The increase in
the average maturity is a result of the increase in the percentage of the
portfolio in 10 year taxexempt municipal securities and the increase in the
average life of the mortgage-backed portfolio caused by the increase in interest
rates.
LIQUIDITY
Liquidity represents an institution's ability to generate cash or otherwise
obtain funds at reasonable rates to satisfy commitments to borrowers and demands
of depositors. QNB manages its mix of cash, Federal funds sold, investment
securities and loans in order to match the volatility, seasonality, interest
sensitivity and growth trends of its deposit funds. Liquidity is provided from
asset sources through maturities and repayments of loans and investment
securities, net interest income and fee income. The portfolio of investment
securities available-for-sale and QNB's policy of selling certain residential
mortgage originations and student loans in the secondary market also provide
sources of liquidity.
Cash and due from banks, Federal funds sold, available-for-sale securities and
loans held-for-sale were $123,118,000 and $93,860,000 at June 30, 1999 and
December 31, 1998. These sources were adequate to meet seasonal deposit
withdrawals during the first half of 1999 and should be adequate to meet normal
fluctuations in loan demand and or deposit withdrawals. Approximately
$42,775,000 and $44,715,000 of available-for-sale securities at June 30, 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 $474,000 to $13,546,000 at June 30, 1999. This
compares to a $387,000 increase during the first six months of 1998. After
adjusting net income for non-cash transactions, operating activities provided
$6,953,000 in cash flow in the first six months of 1999, compared to $5,568,000
in the same period of 1998. An increase in residential mortgage loan activity
accounted for most of the difference between the periods.
Net cash used by investing activities was $41,333,000 during the first half of
1999. The purchase of investment securities exceeded the maturity, call and sale
of securities by $34,652,000 during the first half of 1999. The $25,000,000
wholesale funding transaction provided most of the additional cash for the
purchases. An increase in Federal funds sold of $3,431,000 and loans of
$3,152,000 were also a use of cash during 1999. Proceeds from the sale of other
real estate owned provided $213,000 of cash during the first half of 1999. Net
15
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
LIQUIDITY (Continued)
cash used by investing activities was $15,014,000 during the first half of 1998.
A $6,188,000 increase in Federal funds sold was the largest factor. The purchase
of investment securities in excess of proceeds from maturities, calls or sales
of $5,071,000 and the net increase in loans of $4,280,000 were also activities
that used cash. Proceeds from the sale of other real estate owned provided
$856,000 of cash.
Net cash provided by financing activities was $33,906,000 during the first half
of 1999 and $9,833,000 during the first half of 1998. Federal Home Loan Bank
advances provided $25,000,000 in funding during the second quarter of 1999.
Another source of funds in 1999 was time deposits, which increased $10,286,000
since December 31, 1999. Time deposits over $100,000 accounted for $8,441,000 of
the total increase. These deposits tend to be short-term in nature and pay a
higher rate of interest. During the first half of 1999 short-term borrowings,
primarily cash management accounts, decreased by $3,831,000. The increase in net
cash provided by financing activities during the six months of 1998 was
primarily the result of an increase in interest-bearing deposits, primarily time
deposits.
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 June 30, 1999 was
$27,807,000 or 7.74 percent of total assets compared to shareholders' equity of
$28,338,000 or 8.73 percent at December 31, 1998. Shareholders' equity at June
30, 1999 includes a negative adjustment of $1,137,000 related to unrealized
holding losses, 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 8.06 percent and 8.45 percent at June 30, 1999 and December 31, 1998.
The decline in the ratio is a result of the growth in total assets, primarily
achieved through the use of a $25,000,000 wholesale funding transaction during
the second quarter of 1999.
Shareholders' equity averaged $28,286,000 for the first six months of 1999 and
$26,323,000 during all of 1998, an increase of 7.5 percent. The ratio of average
total equity to average total assets improved to 8.50 percent for 1999, compared
to 8.48 percent for 1998.
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 11 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 1, 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 14.42 percent and 14.02 percent, a total
risk-based ratio of 15.67 percent and 15.28 percent and a leverage ratio of 8.28
percent and 8.58 percent at June 30, 1999 and December 31, 1998, respectively.
As discussed previously, the decline in the leverage ratio is related to the
significant growth in total assets resulting primarily from the wholesale
funding transaction.
16
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QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
CAPITAL ADEQUACY (Continued)
The Federal Deposit Insurance Corporation Improvement Act of 1991 established
five capital level designations ranging from "well capitalized" to "critically
undercapitalized." At June 30, 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.
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, 1999, interest-earning assets scheduled to mature
or likely to be called, repriced or repaid in one year were $96,763,000.
Interest-sensitive liabilities scheduled to mature or reprice within one year
were $138,792,000. The one year cumulative gap, which reflects QNB's interest
sensitivity over a period of time, was a negative $42,029,000 at June 30, 1999
and a negative $1,156,000 at December 31, 1998. The cumulative one-year gap
equals 12.48 percent and .39 percent of total earning assets at these respective
dates. The increase in the negative gap position is primarily the result of a
few factors. Rising interest rates as well as the purchase of some intermediate
term and long term callable agency and mortgage-backed securities has extended
the average life and cash flow of the investment portfolio. On the liability
side, the time deposit portfolio continues to shorten with $97,403,000 in time
deposits either maturing or re-pricing within the next twelve months. This
negative or liability sensitive gap will generally benefit QNB in a failing
interest rate environment, while rising interest rates could negatively impact
QNB. It is the intention of management to reduce the negative gap position by
promoting higher rate, longer-term time deposits.
17
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INTEREST RATE SENSITIVITY (Continued)
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 exceed the most likely scenario. Conversely, if
interest rates were 100 basis points higher, net interest income for the most
likely scenario would decline. 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.
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, 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 ................................... $11,694 $(1,803) (13.35)%
+200 Basis Points ................................... 12,296 (1,201) (8.90)
+100 Basis Points ................................... 12,894 (603) (4.47)
</TABLE>
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
INTEREST RATE SENSITIVITY (Continued)
<TABLE>
<S> <C> <C> <C>
FLAT RATE ............................................ 13,497 -- --
- -100 Basis Points .................................... 14,037 540 4.00
- -200 Basis Points .................................... 14,247 750 5.56
- -300 Basis Points .................................... 14,168 671 4.97
</TABLE>
IMPACT OF YEAR 2000
During the second 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.
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 or available for the testing we required in a
timely manner; in those cases, the Bank elected to replace those systems with
others that were already Y2K certified. At the end of the second quarter 1999,
internal systems upgrades were 100% completed. Mission Critical systems
upgrades, including utility companies, were also 100% complete. Overall
renovations, including external vendor upgrades and testing, were about 93%
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'
19
<PAGE>
QNB CORP. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
IMPACT OF YEAR 2000 (Continued)
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' with QNB's definition of Y2K-ready.
Mission critical systems are given the greatest scrutiny in this validation
process.
Testing was 97% complete at the end of the second quarter of 1999. Internal
integration of all mission critical applications was completed by the end of the
second quarter.
As of the end of the second quarter 1999, there were no systems that are not
expected to be Y2K ready by December 31, 1999. If this expectation would change,
contingency plans for those systems will be developed as necessary. During the
second quarter, significant effort was placed on continuing to expand our
existing business resumption plans with specific attention to any possible
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.
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 has specifically
addressed these areas through its business resumption contingency plans. In the
coming months, our efforts will be directed toward validation plans and
installing additional back-up systems as a part of the business resumption
contingency plan that was completed during the second quarter of 1999.
OTHER ITEMS
Management is not aware of any current specific recommendations by regulatory
authorities or proposed legislation, which if they were implemented, would have
a material adverse effect upon the liquidity, capital resources, or results of
operations, although the general cost of compliance with numerous and multiple
federal and state laws and regulations does have, and in the future may have, a
negative impact on QNB's results of operations.
20
<PAGE>
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.
21
<PAGE>
QNB CORP. AND SUBSIDIARY
PART II. OTHER INFORMATION
JUNE 30, 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
The 1999 Annual Meeting (the "Meeting") of the shareholders of QNB Corp.
(the Registrant") was held on May 4, 1999. Notice of the Meeting was
mailed to shareholders of record on or about April 2, 1999, 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 purpose:
(1) To elect three (3) Directors
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, as well as the
number of abstentions and broker non-votes for each of the nominees for
election to the Board of Directors were as follows:
Nominee For Withhold
------- --- --------
Kenneth F. Brown, Jr. 1,163,979 7,416
Henry L. Rosenberger 1,162,935 8,460
Edgar L. Stauffer 1,163,965 7,430
The continuing directors of the Registrant are:
Dennis Helf, Donald T. Knauss, Thomas J. Bisko, Gary S. Parzych, Norman
L. Baringer, Charles M. Meredith, III
Item 5. Other Information
None.
22
<PAGE>
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 Conmmission 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 June 30,
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 June
30, 1999).
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 1, Item 1, hereof.)
Exhibit 27 Financial Data Schedule
(b) Reports on Form 8-K
None
23
<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: August 13, 1999 By:
--------------------------
Thomas J. Bisko
President/CEO
Date: August 13, 1999 By:
--------------------------
Robert C. Werner
Vice President
Date: August 13, 1999 By:
--------------------------
Bret H. Krevolin
Chief Accounting Officer
<TABLE> <S> <C>
<ARTICLE> 9
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-END> JUN-30-1999
<CASH> 13,465
<INT-BEARING-DEPOSITS> 81
<FED-FUNDS-SOLD> 8,300
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 100,292
<INVESTMENTS-CARRYING> 51,567
<INVESTMENTS-MARKET> 50,693
<LOANS> 174,808
<ALLOWANCE> 3,077
<TOTAL-ASSETS> 359,082
<DEPOSITS> 292,537
<SHORT-TERM> 10,660
<LIABILITIES-OTHER> 3,078
<LONG-TERM> 25,000
0
0
<COMMON> 1,795
<OTHER-SE> 26,012
<TOTAL-LIABILITIES-AND-EQUITY> 359,082
<INTEREST-LOAN> 7,167
<INTEREST-INVEST> 4,009
<INTEREST-OTHER> 120
<INTEREST-TOTAL> 11,296
<INTEREST-DEPOSIT> 4,399
<INTEREST-EXPENSE> 4,818
<INTEREST-INCOME-NET> 6,478
<LOAN-LOSSES> 120
<SECURITIES-GAINS> 163
<EXPENSE-OTHER> 4,994
<INCOME-PRETAX> 2,825
<INCOME-PRE-EXTRAORDINARY> 2,098
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,098
<EPS-BASIC> 1.46
<EPS-DILUTED> 1.45
<YIELD-ACTUAL> 4.25
<LOANS-NON> 300
<LOANS-PAST> 293
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 1,228
<ALLOWANCE-OPEN> 2,951
<CHARGE-OFFS> 13
<RECOVERIES> 19
<ALLOWANCE-CLOSE> 3,077
<ALLOWANCE-DOMESTIC> 3,077
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 1,967
</TABLE>
