QNB CORP - Quarter Report: 2006 September (Form 10-Q)
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
WASHINGTON,
DC 20549
FORM
10-Q
(Mark
One)
|
ý
|
QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF
1934
|
For
the
quarterly period ended: September
30, 2006
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
QNB
CORP.
(Exact
Name of Registrant as Specified in Its Charter)
|
Pennsylvania
|
23-2318082
|
|
(State
or Other Jurisdiction of Incorporation or Organization)
|
(I.R.S.
Employer Identification No.)
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15
North Third Street, Quakertown, PA
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18951-9005
|
|
(Address
of Principal Executive Offices)
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(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 mark 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 ü No____
Indicate
by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large
accelerated filer ____ Accelerated
filer ü Non-accelerated
filer ____
Indicate
by check mark whether the Registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).
Yes
____
No ü
Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date.
|
Class
|
Outstanding
at November 6, 2006
|
|
|
Common
Stock, par value $.625
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3,126,985
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QNB
CORP. AND SUBSIDIARY
FORM
10-Q
QUARTER
ENDED SEPTEMBER 30, 2006
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ITEM
1.
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2.
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3.
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ITEM
4.
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37
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ITEM
1.
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38
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ITEM
1A.
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38
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ITEM
2.
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38
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ITEM
3.
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38
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ITEM
4.
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ITEM
5.
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ITEM
6.
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QNB
CORP. AND SUBSIDIARY
SEPTEMBER
30, 2006 AND 2005, AND DECEMBER 31, 2005
(Unaudited)
1.
REPORTING AND ACCOUNTING POLICIES
The
accompanying unaudited consolidated financial statements include the accounts
of
QNB Corp. (QNB) and its wholly-owned subsidiary, The Quakertown National Bank
(the Bank). All significant intercompany accounts and transactions are
eliminated in the consolidated financial statements.
These
consolidated financial statements should be read in conjunction with the audited
consolidated financial statements and notes thereto included in QNB's 2005
Annual Report incorporated in the Form 10-K. Operating results for the three-
and nine-month periods ended September 30, 2006 are not necessarily indicative
of the results that may be expected for the year ending December 31, 2006.
The
unaudited consolidated financial statements reflect all adjustments, which
in
the opinion of management are necessary for a fair presentation of the results
of the interim periods and are of a normal and recurring nature. Tabular
information, other than share and per share data, is presented in thousands
of
dollars.
In
preparing the consolidated financial statements, management is required to
make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the dates of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting periods. Actual
results could differ from such estimates.
STOCK-BASED
COMPENSATION
QNB
sponsors stock-based compensation plans, administered by a committee, under
which both qualified and non-qualified stock options may be granted periodically
to certain employees. QNB accounted for all awards granted after January 1,
2002
under the “fair value” approach under Financial
Accounting Standards Board (FASB) Statement No. 123, Accounting
for Stock-Based Compensation.
Effective January 1, 2006, QNB adopted FASB Statement No. 123 (revised 2004),
Share-Based
Payment (FASB
No.
123r), using the modified prospective application method. The modified
prospective application method applies to new awards, to any outstanding
liability awards, and to awards modified, repurchased, or cancelled after
January 1, 2006. For all awards granted prior to January 1, 2006, unrecognized
compensation cost, on the date of adoption, will be recognized as an expense
in
future periods. The results for prior periods have not been
restated.
The
adoption of FASB No. 123r reduced net income by approximately $27,000 and
$86,000 for the three- and nine-months ended September 30, 2006, respectively.
The
following table illustrates the effect on net income and earnings per share
if
QNB had applied the fair value recognition provisions to stock-based employee
compensation during the period presented. For purposes of this pro forma
disclosure, the value of the options is estimated using the Black-Scholes
option-pricing model and amortized to expense over the options’ vesting
period.
QNB
CORP. AND SUBSIDIARY
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER
30, 2006 AND 2005, AND DECEMBER 31, 2005
(Unaudited)
|
Three
Months Ended
September
30, 2005
|
Nine
Months
Ended
September
30, 2005
|
||||||
| Net income, as reported | $ | 1,431 | $ | 3,833 | |||
|
Deduct:
Total stock-based employee compensation expense
determined under fair value based method
for all awards, net of related tax effects
|
25
|
76
|
|||||
|
Pro
forma net income
|
$
|
1,406
|
$
|
3,757
|
|||
|
Earnings
per share
Basic
- as reported
|
$
|
.46
|
$
|
1.24
|
|||
|
Basic
- pro forma
|
$
|
.45
|
$
|
1.21
|
|||
|
Diluted
- as reported
|
$
|
.45
|
$
|
1.21
|
|||
|
Diluted
- pro forma
|
$
|
.44
|
$
|
1.18
|
|||
As
of
September 30, 2006, there was approximately $119,000 of unrecognized
compensation cost related to unvested share-based compensation awards granted.
That cost is expected to be recognized over the next two and a quarter
years.
Options
are granted to certain employees at prices equal to the market value of the
stock on the date the options are granted. The 1998 Plan authorizes the issuance
of 220,500 options. The time period during which any option is exercisable
under
the Plan is determined by the committee but shall not commence before the
expiration of six months after the date of grant or continue beyond the
expiration of ten years after the date the option is awarded. The granted
options vest ratably over a three-year period. As of September 30, 2006, there
were 180,458 options outstanding under this Plan. The 2005 Plan authorizes
the
issuance of 200,000 options. The terms of the 2005 Plan are identical to the
1998 Plan, except options expire five years after the grant date. As of
September 30, 2006, there were 8,900 options outstanding under this
Plan.
The
fair
value of each option is amortized into compensation expense on a straight-line
basis between the grant date for the option and each vesting date. QNB estimated
the fair value of stock options on the date of the grant using the Black-Scholes
option pricing model. The model requires the use of numerous assumptions, many
of which are subjective in nature. The following assumptions were used in the
option pricing model in determining the fair value of options granted during
the
three- and nine-months ended September 30:
|
Options
granted
|
2006
|
2005
|
2004
|
|||||||
|
Risk-free
interest rate
|
4.27
|
%
|
4.18
|
%
|
4.39
|
%
|
||||
|
Dividend
yield
|
3.23
|
2.40
|
2.20
|
|||||||
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Volatility
|
13.28
|
14.05
|
13.61
|
|||||||
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Expected
life
|
5
yrs.
|
10
yrs.
|
10
yrs.
|
|||||||
The
risk-free interest rate was selected based upon yields of U.S. Treasury issues
with a term equal to the expected life of the option being valued. Historical
information was the primary basis for the selection of the expected dividend
yield, expected volatility and expected lives of the options.
QNB
CORP. AND SUBSIDIARY
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER
30, 2006 AND 2005, AND DECEMBER 31, 2005
(Unaudited)
The
fair
market value of options granted in the first nine months of 2006 and 2005 was
$3.13 and $6.46, respectively.
Stock
option activity during the nine-months ended September 30, 2006 is as
follows:
|
Weighted
|
|||||||||||||
|
Average
|
Aggregate
|
||||||||||||
|
Weighted
|
Remaining
|
Intrinsic
|
|||||||||||
|
Number
of
|
Average
|
Contractual
|
Value
|
||||||||||
|
Options
|
Exercise
Price
|
Term
(in yrs.)
|
(in
thousands)
|
||||||||||
|
Outstanding
at January 1, 2006
|
193,374
|
$
|
19.18
|
5.93
|
|||||||||
|
Exercised
|
(21,416
|
)
|
16.27
|
||||||||||
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Granted
|
17,400
|
26.00
|
|||||||||||
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Outstanding
at September 30, 2006
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189,358
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20.13
|
5.17
|
$
|
1,177
|
||||||||
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Exercisable
at September 30, 2006
|
137,058
|
16.16
|
4.58
|
$
|
1,177
|
||||||||
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
September 30,
|
For
the Nine Months
Ended
September 30,
|
||||||||||||
|
2006
|
2005
|
2006
|
2005
|
||||||||||
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Numerator
for basic and diluted earnings per
share-net income
|
$
|
1,517
|
$
|
1,431
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$
|
4,497
|
$
|
3,833
|
|||||
|
Denominator
for basic earnings per share-weighted
average shares outstanding
|
3,126,985
|
3,102,628
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3,123,800
|
3,101,300
|
|||||||||
|
Effect
of dilutive securities-employee stock
options
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51,086
|
71,420
|
52,300
|
74,898
|
|||||||||
|
Denominator
for diluted earnings per share-
adjusted weighted average shares
outstanding
|
3,178,071
|
3,174,048
|
3,176,100
|
3,176,198
|
|||||||||
|
Earnings
per share-basic
|
$
|
.48
|
$
|
.46
|
$
|
1.44
|
$
|
1.24
|
|||||
|
Earnings
per share-diluted
|
$
|
.48
|
$
|
.45
|
$
|
1.42
|
$
|
1.21
|
|||||
QNB
CORP. AND SUBSIDIARY
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER
30, 2006 AND 2005, AND DECEMBER 31, 2005
(Unaudited)
2.
PER
SHARE DATA (Continued):
There
were 52,300 and 34,900 stock options that were anti-dilutive for the three-
and
nine-month periods ended September 30, 2006, respectively. There were 40,000
stock options that were anti-dilutive for the three- and nine-month periods
ended September 30, 2005. These stock options were not included in the above
calculation.
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 table shows the components and activity of comprehensive income during
the periods ended September 30, 2006 and 2005:
|
For
the Three Months
Ended
September 30,
|
For
the Nine Months
Ended
September 30,
|
||||||||||||
|
2006
|
2005
|
2006
|
2005
|
||||||||||
|
Unrealized
holding gains (losses) arising during the period on securities held
(net
of taxes of $(1,222), $718, $(215) and $1,052, respectively)
|
$
|
2,373
|
$
|
(1,283
|
)
|
$
|
418
|
$
|
(1,811
|
)
|
|||
|
Reclassification
adjustment for (gains) losses included in net income (net of taxes
of $67,
$(1), $208 and $(7), respectively)
|
(129
|
)
|
3
|
(403
|
)
|
573
|
|||||||
|
Net
change in unrealized gains (losses) during the period
|
2,244
|
(1,280
|
)
|
15
|
(1,238
|
)
|
|||||||
|
Unrealized
holding (losses) gains, beginning of period
|
(3,491
|
)
|
733
|
(1,262
|
)
|
691
|
|||||||
|
Unrealized
holding losses, end of period
|
$
|
(1,247
|
)
|
$
|
(547
|
)
|
$
|
(1,247
|
)
|
$
|
(547
|
)
|
|
|
Net
income
|
$
|
1,517
|
$
|
1,431
|
$
|
4,497
|
$
|
3,833
|
|||||
|
Other
comprehensive income, net of tax:
Unrealized
holding gains (losses) arising during the period (net of taxes of
$(1,155), $717, $(7) and $1,045, respectively)
|
2,244
|
(1,280
|
)
|
15
|
(1,238
|
)
|
|||||||
|
Comprehensive
income
|
$
|
3,761
|
$
|
151
|
$
|
4,512
|
$
|
2,595
|
|||||
QNB
CORP. AND SUBSIDIARY
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER
30, 2006 AND 2005, AND DECEMBER 31, 2005
(Unaudited)
4.
LOANS
The
following table presents loans by category as of September 30, 2006 and December
31, 2005:
|
September
30,
2006
|
December
31,
2005
|
||||||
|
Commercial
and industrial
|
$
|
64,477
|
$
|
64,812
|
|||
|
Construction
|
11,084
|
7,229
|
|||||
|
Real
estate-commercial
|
114,386
|
104,793
|
|||||
|
Real
estate-residential
|
123,754
|
112,920
|
|||||
|
Consumer
|
5,288
|
5,080
|
|||||
|
Indirect
lease financing
|
12,665
|
6,451
|
|||||
|
Total
loans
|
331,654
|
301,285
|
|||||
|
Unearned
costs
|
146
|
64
|
|||||
|
Total
loans net of unearned costs
|
$
|
331,800
|
$
|
301,349
|
|||
5.
INTANGIBLE ASSETS
As
a
result of a purchase of deposits in 1997, QNB recorded a deposit premium of
$511,000. This premium is being amortized, for book purposes, over ten years
and
is reviewed annually for impairment. The net deposit premium intangible was
$56,000 and $94,000 at September 30, 2006 and December 31, 2005, respectively.
Amortization expense for core deposit intangibles was $12,000 for both
three-month periods ended September 30, 2006 and 2005 and $38,000 for both
nine-month periods ended September 30, 2006 and 2005.
The
following table reflects the components of mortgage servicing rights as of
the
periods indicated:
|
September
30,
|
December
31,
|
||||||
|
2006
|
2005
|
||||||
|
Mortgage
servicing rights beginning balance
|
$
|
528
|
$
|
552
|
|||
|
Mortgage
servicing rights capitalized
|
23
|
80
|
|||||
|
Mortgage
servicing rights amortized
|
(65
|
)
|
(109
|
)
|
|||
|
Fair
market value adjustments
|
—
|
5
|
|||||
|
Mortgage
servicing rights ending balance
|
$
|
486
|
$
|
528
|
|||
|
Mortgage
loans serviced for others
|
$
|
76,369
|
$
|
77,196
|
|||
|
Amortization
expense of intangibles
|
103
|
160
|
|||||
QNB
CORP. AND SUBSIDIARY
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER
30, 2006 AND 2005, AND DECEMBER 31, 2005
(Unaudited)
5.
INTANGIBLE ASSETS (Continued):
The
annual estimated amortization expense of intangible assets for each of the
five
succeeding fiscal years is as follows:
Estimated
Amortization Expense
|
For
the Year Ended 12/31/06
|
$
|
138
|
||
|
For
the Year Ended 12/31/07
|
130
|
|||
|
For
the Year Ended 12/31/08
|
75
|
|||
|
For
the Year Ended 12/31/09
|
62
|
|||
|
For
the Year Ended 12/31/10
|
51
|
6.
RELATED PARTY TRANSACTIONS
As
of
September 30, 2006, amounts due from directors, principal officers, and their
related interests totaled $4,281,000. All of these transactions were made in
the
ordinary course of business on substantially the same terms, including interest
rates and collateral, as those prevailing at the time for comparable
transactions with other persons. The Bank believes that these loans did not
involve a more than normal risk of collectibility or present any other
unfavorable features.
On
September 22, 2005, the Bank approved and entered into an agreement with Eugene
T. Parzych, Inc. to act as the general contractor for the renovation of its
property at 322 W. Broad Street, Quakertown, Pennsylvania to be used as
additional office space. The bids for this project were submitted through a
formal bidding process and reviewed by the Board of Directors. Mr. Gary S.
Parzych is the president of Eugene T. Parzych, Inc. and is also a director
of
QNB Corp. Management and the Board of Directors of QNB Corp. and the Bank
believe this is an arms-length transaction. The
total
paid to Eugene T. Parzych Inc. for this project was $1,243,000 with $1,029,000
being paid during 2006.
7.
RECENT
ACCOUNTING PRONOUNCEMENTS
In
February 2006, the FASB issued FASB No. 155, Accounting
for Certain Hybrid Instruments, as an amendment of FASB Statements No. 133
and
140.
FASB
No. 155 allows financial instruments that have embedded derivatives to be
accounted for as a whole (eliminating the need to bifurcate the derivative
from
its host) if the holder elects to account for the whole instrument on a fair
value basis. This statement is effective for all financial instruments acquired
or issued after the beginning of an entity’s first fiscal year that begins after
September 15, 2006. The adoption of this standard is not expected to have a
material effect on the QNB’s results of operations or financial
position.
In
March
2006, the FASB issued FASB No. 156, Accounting
for Servicing of Financial Assets.
This
Statement, which is an amendment to FASB No. 140, will simplify the accounting
for servicing assets and liabilities, such as those common with mortgage
securitization activities. Specifically, FASB No. 156 addresses the recognition
and measurement of separately recognized servicing assets and liabilities and
provides an approach to simplify efforts to obtain hedge-like (offset)
accounting. FASB No. 156 also clarifies when an obligation to service financial
assets should be separately recognized as a servicing asset or a servicing
liability, requires that a separately recognized servicing asset or servicing
liability be initially measured at fair value, if practicable, and permits
an
entity with a separately recognized
QNB
CORP. AND SUBSIDIARY
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER
30, 2006 AND 2005, AND DECEMBER 31, 2005
(Unaudited)
servicing
asset or servicing liability to choose either of the amortization or fair value
methods for subsequent measurement. The provisions of FASB No. 156 are effective
as of the beginning of the first fiscal year that begins after September 15,
2006. The adoption of this standard is not expected to have a material effect
on
QNB’s results of operations or financial position.
In
September 2006, the FASB issued FASB No. 157, Fair
Value Measurements,
which
provides enhanced guidance for using fair value to measure assets and
liabilities. The standard applies whenever other standards require or permit
assets or liabilities to be measured at fair value. The Standard does not expand
the use of fair value in any new circumstances. FASB No. 157 is effective
for financial statements issued for fiscal years beginning after
November 15, 2007 and interim periods within those fiscal years. Early
adoption is permitted. The adoption of this standard is not expected to have
a
material effect on QNB’s results of operations or financial position.
In
June
2006, the FASB issued FASB Interpretation No. 48 (FIN 48), Accounting
for Uncertainty in Income Taxes.
FIN 48
is an interpretation of FASB No. 109, Accounting
for Income Taxes,
and it
seeks to reduce the diversity in practice associated with certain aspects of
measurement and recognition in accounting for income taxes. In addition, FIN
48
requires expanded disclosure with respect to the uncertainty in income taxes
and
is effective for fiscal years beginning after December 15, 2006. The adoption
of
this standard is not expected to have a material effect on QNB’s results of
operations
In
September 2006, the SEC issued Staff Accounting Bulletin No. 108
(SAB 108), Considering
the Effects of Prior Year Misstatements When Quantifying Misstatements in
Current Year Financial Statements,
providing guidance on quantifying financial statement misstatement and
implementation when first applying this guidance. Under SAB 108, companies
should evaluate a misstatement based on its impact on the current year income
statement, as well as the cumulative effect of correcting such misstatements
that existed in prior years existing in the current year's ending balance sheet.
SAB 108 is effective for fiscal years ending after November 15, 2006. The
adoption of this standard is not expected to have a material effect on QNB’s
results of operations.
In
September 2006, the FASB reached consensus on the guidance provided by Emerging
Issues Task Force Issue 06-4 (EITF 06-4), Accounting
for Deferred Compensation and Postretirement Benefit Aspects of Endorsement
Split-Dollar Life Insurance Arrangements.
The
guidance is applicable to endorsement split-dollar life insurance arrangements,
whereby the employer owns and controls the insurance policy, that are associated
with a postretirement benefit. EITF 06-4 requires that for a split-dollar life
insurance arrangement within the scope of the Issue, an employer should
recognize a liability for future benefits in accordance with FAS No. 106 (if,
in
substance, a postretirement benefit plan exists) or Accounting Principles Board
Opinion No. 12 (if the arrangement is, in substance, an individual deferred
compensation contract) based on the substantive agreement with the employee.
EITF 06-4 is effective for fiscal years beginning after December 15, 2007.
QNB
is currently evaluating the impact the adoption of the standard will have on
its
results of operations and financial position.
In
September 2006, the FASB reached consensus on the guidance provided by Emerging
Issues Task Force Issue 06-5 (EITF 06-5), Accounting
for Purchases of Life Insurance—Determining the Amount That Could Be Realized in
Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases
of
Life Insurance.
EITF
06-5 states that a policyholder should consider any additional amounts included
in the contractual terms of the insurance policy other than the cash surrender
value in determining the amount that could be realized under the insurance
contract. EITF 06-5 also states that a
QNB
CORP. AND SUBSIDIARY
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER
30, 2006 AND 2005, AND DECEMBER 31, 2005
(Unaudited)
policyholder
should determine the amount that could be realized under the life insurance
contract assuming the surrender of an individual-life by individual-life policy
(or certificate by certificate in a group policy). EITF 06-5 is effective for
fiscal years beginning after December 15, 2006. QNB is currently evaluating
the
impact the adoption of the standard will have on its results of operations
and
financial position.
QNB
Corp.
(the Corporation) is a bank holding company headquartered in Quakertown,
Pennsylvania. The Corporation, through its wholly-owned subsidiary, The
Quakertown National Bank (the Bank), has been serving the residents and
businesses of upper Bucks, northern Montgomery and southern Lehigh Counties
in
Pennsylvania since 1877. The Bank is a locally managed community bank that
provides a full range of commercial and retail banking and retail brokerage
services. The consolidated entity is referred to herein as “QNB”.
Forward-Looking
Statements
In
addition to historical information, this document contains forward-looking
statements. Forward-looking statements are typically identified by words or
phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,”
“project” and variations of such words and similar expressions, or future or
conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar
expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides
safe harbor in regard to the inclusion of forward-looking statements in this
document and documents incorporated by reference.
Shareholders
should note that many factors, some of which are discussed elsewhere in this
document and in the documents that are incorporated by reference, could affect
the future financial results of the Corporation and its subsidiary and could
cause those results to differ materially from those expressed in the
forward-looking statements contained or incorporated by reference in this
document. These factors include, but are not limited, to the
following:
|
·
|
Operating,
legal and regulatory risks
|
|
·
|
Economic,
political and competitive forces affecting the Corporation’s line of
business
|
|
·
|
The
risk that the analysis of these risks and forces could be incorrect,
and/or that the strategies developed to address them could be
unsuccessful
|
|
·
|
Volatility
in interest rates and shape of the yield
curve
|
|
·
|
Increased
credit risk
|
QNB
cautions that these forward-looking statements are subject to numerous
assumptions, risks and uncertainties, all of which change over time, and QNB
assumes no duty to update forward-looking statements. Management cautions
readers not to place undue reliance on any forward-looking statements. These
statements speak only as of the date made, and they advise readers that various
factors, including those described above, could affect QNB’s financial
performance and could cause actual results or circumstances for future periods
to differ materially from those anticipated or projected. Except as required
by
law, QNB does not undertake, and specifically disclaims any obligation, to
publicly release any revisions to any forward-looking statements to reflect
the
occurrence of anticipated or unanticipated events or circumstances after the
date of such statements.
Critical
Accounting Policies and Estimates
Discussion
and analysis of the financial condition and results of operations are based
on
the consolidated financial statements of QNB, which are prepared in accordance
with U.S. generally accepted accounting principles (GAAP). The preparation
of
these consolidated financial statements requires QNB to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues
and
expenses, and related
disclosures of contingent assets and liabilities. QNB evaluates estimates on
an
on-going basis, including those
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
Critical
Accounting Policies and Estimates (Continued):
related
to the allowance for loan losses, non-accrual loans, other real estate owned,
other-than-temporary investment impairments, intangible assets, stock option
plans and income taxes. QNB bases its estimates on historical experience and
various other factors and assumptions that are believed to be reasonable under
the circumstances, the results of which form the basis for making judgments
about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from these estimates
under different assumptions or conditions.
QNB
believes the following critical accounting policies affect its more significant
judgments and estimates used in preparation of its consolidated financial
statements: allowance for loan losses, income taxes and other-than-temporary
investment security impairment. Each estimate is discussed below. The financial
impact of each estimate is discussed in the applicable sections of Management’s
Discussion and Analysis.
Allowance
for Loan Losses
QNB
considers that the determination of the allowance for loan losses involves
a
higher degree of judgment and complexity than its other significant accounting
policies. The allowance for loan losses is calculated with the objective of
maintaining a level believed by management to be sufficient to absorb probable
known and inherent losses in the outstanding loan portfolio. The allowance
is
reduced by actual credit losses and is increased by the provision for loan
losses and recoveries of previous losses. The provisions for loan losses are
charged to earnings to bring the total allowance for loan losses to a level
considered necessary by management.
The
allowance for loan losses is based on management’s continuing review and
evaluation of the loan portfolio. The level of the allowance is determined
by
assigning specific reserves to individually identified problem credits and
general reserves to all other loans. The portion of the allowance that is
allocated to internally criticized and non-accrual loans is determined by
estimating the inherent loss on each credit after giving consideration to the
value of underlying collateral. The general reserves are based on the
composition and risk characteristics of the loan portfolio, including the nature
of the loan portfolio, credit concentration trends, historic and anticipated
delinquency and loss experience, as well as other qualitative factors such
as
current economic trends.
Management
emphasizes loan quality and close monitoring of potential problem credits.
Credit risk identification and review processes are utilized in order to assess
and monitor the degree of risk in the loan portfolio. QNB’s lending and loan
administration staff are charged with reviewing the loan portfolio and
identifying changes in the economy or in a borrower’s circumstances which may
affect the ability to repay debt or the value of pledged collateral. A loan
classification and review system exists that identifies those loans with a
higher than normal risk of uncollectibility. Each commercial loan is assigned
a
grade based upon an assessment of the borrower’s financial capacity to service
the debt and the presence and value of collateral for the loan. An independent
loan review group tests risk assessments and evaluates the adequacy of the
allowance for loan losses. Management meets monthly to review the credit quality
of the loan portfolio and quarterly to review the allowance for loan losses.
In
addition, various regulatory agencies, as an integral part of their examination
process, periodically review QNB’s allowance for loan losses. Such agencies may
require QNB to recognize additions to the allowance based on their judgments
about information available to them at the time of their
examination.
Management
believes that it uses the best information available to make determinations
about the adequacy of the allowance and that it has established its existing
allowance for loan losses in accordance with GAAP. If circumstances differ
substantially from the assumptions used in making determinations, future
adjustments to the
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
Critical
Accounting Policies and Estimates (Continued):
allowance
for loan losses may be necessary and results of operations could be affected.
Because future events affecting borrowers and collateral cannot be predicted
with certainty, increases to the allowance may be necessary should the quality
of any loans deteriorate as a result of the factors discussed
above.
Income
Taxes.
QNB
accounts for income taxes under the asset/liability method. Deferred tax assets
and liabilities are recognized for the future tax consequences attributable
to
differences between the financial statement carrying amounts of existing assets
and liabilities and their respective tax bases, as well as operating loss and
tax credit carryforwards. Deferred tax assets and liabilities are measured
using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized
in
income in the period that includes the enactment date. A valuation allowance
is
established against deferred tax assets, when in the judgment of management,
it
is more likely than not that such deferred tax assets will not become available.
A valuation allowance of $46,000 existed as of September 30, 2006 to offset
a
portion of the tax benefits associated with certain impaired securities that
management believes may not be realizable. Because the judgment about the level
of future taxable income is dependent to a great extent on matters that may,
at
least in part, be beyond QNB’s control, it is at least reasonably possible that
management’s judgment about the need for a valuation allowance for deferred
taxes could change in the near term.
Other-than-Temporary
Impairment of Investment Securities
Securities
are evaluated periodically to determine whether a decline in their value is
other-than-temporary. Management utilizes criteria such as the magnitude and
duration of the decline, in addition to the reasons underlying the decline,
to
determine whether the loss in value is other-than-temporary. The term
“other-than-temporary” is not intended to indicate that the decline is
permanent, but indicates that the prospects for a near-term recovery of value
are not necessarily favorable, or that there is a lack of evidence to support
realizable value equal to or greater than carrying value of the investment.
Once
a decline in value is determined to be other-than-temporary, the value of the
security is reduced, and a corresponding charge to earnings is
recognized.
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
RESULTS
OF OPERATIONS - OVERVIEW
QNB
Corp.
earns its net income primarily through its subsidiary, The Quakertown National
Bank. Net interest income, or the spread between the interest, dividends and
fees earned on loans and investment securities and the expense incurred on
deposits and other interest-bearing liabilities, is the primary source of
operating income for QNB. QNB seeks to achieve sustainable and consistent
earnings growth while maintaining adequate levels of capital and liquidity
and
limiting its exposure to credit and interest rate risk to Board of Directors
approved levels. Due to its limited geographic area, comprised principally
of
upper Bucks, southern Lehigh and northern Montgomery counties, growth is pursued
through expansion of existing customer relationships and building new
relationships by stressing a consistently
high
level of service at all points of contact.
QNB
reported net income for the third quarter of 2006 of $1,517,000, or $.48 per
common share on a diluted basis. The results for the 2006 period compare to
net
income of $1,431,000, or $.45 per share on a diluted basis, for the same period
in 2005. Net income for the first nine months of 2006 was $4,497,000, or $1.42
per diluted share, an increase from the $3,833,000, or $1.21 per diluted share,
for the comparable period in 2005.
The
results for the nine-month period ended September 30, 2005 were significantly
impacted by a $1,253,000 unrealized loss as an other-than-temporary impairment
related to certain Fannie Mae (FNMA) and Freddie Mac (FHLMC) preferred stock
issues recorded in accordance with U.S. generally accepted accounting principles
(GAAP). On an after-tax basis, the charge was approximately $1,017,000, or
$.32
per share diluted. QNB established a $190,000 valuation allowance to offset
a
portion of the tax benefits associated with the write-down of these securities
because such tax benefits may not be realizable. During the first quarter of
2006, QNB sold its preferred stock holdings and recorded a gain of $451,000
on
the carrying value of those issues that had previously been impaired and a
$300,000 loss on one issue that was not impaired in 2005. In addition, during
the first nine months of 2006, QNB realized capital gains which allowed a
reversal of $164,000 of the tax valuation allowance provided in
2005.
Two
important measures of profitability in the banking industry are an institution's
return on average assets and return on average shareholders' equity. Return
on
average assets was 1.00 percent and .97 percent, while the return on average
equity was 11.99 percent and 12.19 percent, for the three-months ended September
30, 2006 and 2005, respectively. For the nine-month periods ended September
30,
2006 and 2005, return on average assets was 1.02 percent and .88 percent, and
the return on average equity was 12.18 percent and 11.07 percent, respectively.
Excluding the impact of the impairment charge, the return on average assets
for
the nine-month period ended September 30, 2005 would have been 1.11 percent
and
the return on average equity would have been 14.00 percent.
QNB’s
net
interest income increased in the third quarter of 2006, to $4,040,000, as
compared to $4,018,000 for the same quarter of 2005. Growth in average earning
assets and the continued shift of the balance sheet from investment securities
to loans helped offset the decline in the net interest margin. For the
nine-month periods, net interest income declined by 1.3 percent, to $12,056,000,
as the decrease in the net interest margin was only partially offset by growth
in average earning assets and the change in the balance sheet composition.
Like
most financial institutions, QNB’s funding costs of deposits and borrowed money
continued to increase at a faster pace than the rates earned on loans and
investment securities. This trends is primarily the result of three factors:
a
highly competitive deposit and loan pricing environment, a sustained flat to
inverted Treasury yield curve and the current structure of QNB’s balance sheet.
The net interest margin declined 12 basis points, to 3.06 percent, from the
third quarter of 2005 to the third quarter of 2006 and declined 9 basis points
for the nine-month period, to 3.16 percent. Included in net interest income
for
the nine-month period of 2005 was $40,000 of interest income recovered on
non-accrual and previously charged-off loans.
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
RESULTS
OF OPERATIONS - OVERVIEW (Continued)
Total
non-interest income was $1,147,000 for the third quarter of 2006, compared
to
$938,000 for the same period in 2005. Excluding gains and losses on securities
and loans, non-interest income was $931,000 for the quarter-ended September
30,
2006 compared to $911,000 for the same period in 2005. An increase in ATM and
debit card income accounted for the $20,000 difference in non-interest income.
For
the
nine-month period, total non-interest income increased $871,000, to $3,306,000.
Excluding gains and losses on securities and loans, non-interest income for
the
nine-month period decreased $237,000. Included in
non-interest
income, under the category other income, during 2005 were several non-operating
items; life insurance proceeds of $61,000, a sales tax refund of $45,000 and
a
$209,000 gain on the liquidation of assets relinquished by a
borrower.
QNB
has
been successful in operating efficiently and controlling the growth in
non-interest expense. Total non-interest expense increased $114,000, or 3.6
percent, for the three-month period with salary and benefit expense contributing
$92,000 to the increase. Of the $92,000 increase in salaries and benefits
expense, $27,000 related to the adoption of FASB No. 123r in 2006 and $40,000
was a result of a reversal during the third quarter of 2005 of an accrual for
incentive compensation that was recorded during the first quarter of 2005.
For
the
nine-month period, total non-interest expense increased $80,000, or .8 percent,
to $9,772,000. Salary and benefit expense accounted for $11,000 of this increase
when comparing the nine-month periods. Salary expense, excluding the impact
of
the stock option expense, actually decreased when comparing the nine-month
periods, as the adoption of FASB No. 123r in 2006 had the impact of increasing
salary expense $86,000 for the nine-month period. The remaining increase in
non-interest expense was spread across various categories.
Loan
growth, which has been extremely strong since the second quarter of 2005, slowed
during the third quarter of 2006. Total loans decreased from $332,650,000 at
June 30, 2006 to $331,800,000 at September 30, 2006. Some of this decline
related to seasonal usage of commercial credit lines. However, when comparing
total loans at September 30, 2005 and 2006, loans increased $44,312,000, or
15.4
percent. QNB’s successful loan growth is attributable to developing new
relationships, as well as further developing existing relationships with small
businesses in the communities served. Also contributing to loan growth was
QNB’s
entrance into indirect lease financing during the second quarter of 2005. This
loan growth was achieved while maintaining excellent asset quality.
Non-performing assets increased from .00 percent of total average assets at
September 30, 2005 to .03 percent at September 30, 2006. While asset quality
remained high, the strong growth in loans prompted the need for a provision
for
loan losses of $60,000 during the third quarter of 2006 and $105,000 for the
first nine months of 2006. These provisions represented the first charges to
loan loss expense since 1999. On the funding side of the balance sheet, total
deposits increased $3,637,000, or .8 percent, from September 30, 2005 to
September 30, 2006. The competition for deposits remains
aggressive.
QNB
operates in an attractive market for financial services, but also in a market
with intense competition from other local community banks and regional and
national financial institutions. QNB has been able to compete effectively with
other financial institutions by emphasizing technology, including
internet-banking and electronic bill pay, and customer service, including local
decision-making on loans, an emphasis on long-term customer relationships and
customer loyalty, and products and services designed to address the specific
needs of our customers.
These
items, as well as others, will be explained more thoroughly in the next
sections.
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
Average
Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent
Basis)
|
Three
Months Ended
|
|||||||||||||||||||
|
September
30, 2006
|
September
30, 2005
|
||||||||||||||||||
|
Average
|
Average
|
Average
|
Average
|
||||||||||||||||
|
Balance
|
Rate
|
Interest
|
Balance
|
Rate
|
Interest
|
||||||||||||||
|
Assets
|
|||||||||||||||||||
|
Federal
funds sold
|
$
|
10,570
|
5.27
|
%
|
$
|
140
|
$
|
6,779
|
3.45
|
%
|
$
|
59
|
|||||||
|
Investment
securities:
|
|||||||||||||||||||
|
U.S.
Treasury
|
6,071
|
4.35
|
%
|
67
|
6,107
|
2.22
|
%
|
34
|
|||||||||||
|
U.S.
Government agencies
|
36,587
|
5.03
|
%
|
460
|
26,580
|
3.98
|
%
|
265
|
|||||||||||
|
State
and municipal
|
41,937
|
6.62
|
%
|
694
|
52,595
|
6.50
|
%
|
855
|
|||||||||||
|
Mortgage-backed
and CMOs
|
119,239
|
4.30
|
%
|
1,282
|
140,905
|
4.17
|
%
|
1,468
|
|||||||||||
|
Other
|
21,278
|
6.54
|
%
|
348
|
28,291
|
5.87
|
%
|
415
|
|||||||||||
|
Total
investment securities
|
225,112
|
5.07
|
%
|
2,851
|
254,478
|
4.77
|
%
|
3,037
|
|||||||||||
|
Loans:
|
|||||||||||||||||||
|
Commercial
real estate
|
148,679
|
6.66
|
%
|
2,497
|
125,132
|
6.23
|
%
|
1,965
|
|||||||||||
|
Residential
real estate
|
26,125
|
5.92
|
%
|
387
|
25,669
|
5.85
|
%
|
375
|
|||||||||||
|
Home
equity loans
|
68,377
|
6.40
|
%
|
1,103
|
61,055
|
6.00
|
%
|
923
|
|||||||||||
|
Commercial
and industrial
|
49,016
|
7.26
|
%
|
897
|
47,761
|
6.33
|
%
|
763
|
|||||||||||
|
Indirect
lease financing
|
10,642
|
9.15
|
%
|
246
|
3,674
|
8.85
|
%
|
82
|
|||||||||||
|
Consumer
loans
|
5,545
|
9.31
|
%
|
130
|
5,434
|
8.68
|
%
|
119
|
|||||||||||
|
Tax-exempt
loans
|
21,347
|
5.95
|
%
|
320
|
11,939
|
5.21
|
%
|
157
|
|||||||||||
|
Total
loans, net of unearned*
|
329,731
|
6.71
|
%
|
5,580
|
280,664
|
6.20
|
%
|
4,384
|
|||||||||||
|
Other
earning assets
|
4,706
|
4.90
|
%
|
58
|
4,716
|
2.12
|
%
|
25
|
|||||||||||
|
Total
earning assets
|
570,119
|
6.00
|
%
|
$
|
8,629
|
546,637
|
5.45
|
%
|
$
|
7,505
|
|||||||||
|
Cash
and due from banks
|
14,087
|
20,101
|
|||||||||||||||||
|
Allowance
for loan losses
|
(2,555
|
)
|
(2,582
|
)
|
|||||||||||||||
|
Other
assets
|
20,539
|
19,112
|
|||||||||||||||||
|
Total
assets
|
$
|
602,190
|
$
|
583,268
|
|||||||||||||||
|
Liabilities
and Shareholders' Equity
|
|||||||||||||||||||
|
Interest-bearing
deposits:
|
|||||||||||||||||||
|
Interest-bearing
demand
|
$
|
105,227
|
2.62
|
%
|
$
|
696
|
$
|
97,314
|
1.43
|
%
|
$
|
352
|
|||||||
|
Money
market
|
54,154
|
3.11
|
%
|
425
|
45,183
|
1.84
|
%
|
210
|
|||||||||||
|
Savings
|
47,722
|
0.39
|
%
|
47
|
52,571
|
0.39
|
%
|
52
|
|||||||||||
|
Time
|
163,987
|
3.90
|
%
|
1,612
|
161,786
|
3.11
|
%
|
1,270
|
|||||||||||
|
Time
over $100,000
|
44,775
|
4.16
|
%
|
469
|
47,676
|
3.21
|
%
|
386
|
|||||||||||
|
Total
interest-bearing deposits
|
415,865
|
3.10
|
%
|
3,249
|
404,530
|
2.23
|
%
|
2,270
|
|||||||||||
|
Short-term
borrowings
|
23,337
|
3.62
|
%
|
213
|
17,693
|
2.25
|
%
|
100
|
|||||||||||
|
Federal
Home Loan Bank advances
|
55,000
|
5.60
|
%
|
776
|
55,000
|
5.45
|
%
|
755
|
|||||||||||
|
Total
interest-bearing liabilities
|
494,202
|
3.40
|
%
|
4,238
|
477,223
|
2.60
|
%
|
3,125
|
|||||||||||
|
Non-interest-bearing
deposits
|
54,383
|
56,833
|
|||||||||||||||||
|
Other
liabilities
|
3,420
|
2,643
|
|||||||||||||||||
|
Shareholders'
equity
|
50,185
|
46,569
|
|||||||||||||||||
|
Total
liabilities and shareholders' equity
|
$
|
602,190
|
$
|
583,268
|
|||||||||||||||
|
Net
interest rate spread
|
2.60
|
%
|
2.85
|
%
|
|||||||||||||||
|
Margin/net
interest income
|
3.06
|
%
|
$
|
4,391
|
3.18
|
%
|
$
|
4,380
|
|||||||||||
|
Tax-exempt
securities and loans were adjusted to a tax-equivalent basis and
are based
on the marginal Federal corporate tax rate
|
|
of
34 percent.
|
|
Non-accrual
loans are included in earning assets.
|
|
*
Includes loans held-for-sale
|
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
Average
Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent
Basis)
|
Nine
Months Ended
|
|||||||||||||||||||
|
September
30, 2006
|
September
30, 2005
|
||||||||||||||||||
|
Average
|
Average
|
Average
|
Average
|
||||||||||||||||
|
Balance
|
Rate
|
Interest
|
Balance
|
Rate
|
Interest
|
||||||||||||||
|
Assets
|
|||||||||||||||||||
|
Federal
funds sold
|
$
|
5,309
|
5.09
|
%
|
$
|
202
|
$
|
6,312
|
3.07
|
%
|
$
|
145
|
|||||||
|
Investment
securities:
|
|||||||||||||||||||
|
U.S.
Treasury
|
6,075
|
3.77
|
%
|
171
|
6,124
|
2.10
|
%
|
96
|
|||||||||||
|
U.S.
Government agencies
|
29,129
|
4.72
|
%
|
1,032
|
37,498
|
3.74
|
%
|
1,052
|
|||||||||||
|
State
and municipal
|
44,165
|
6.61
|
%
|
2,190
|
52,660
|
6.50
|
%
|
2,569
|
|||||||||||
|
Mortgage-backed
and CMOs
|
123,623
|
4.29
|
%
|
3,975
|
136,983
|
4.18
|
%
|
4,299
|
|||||||||||
|
Other
|
22,829
|
6.30
|
%
|
1,080
|
29,431
|
5.66
|
%
|
1,249
|
|||||||||||
|
Total
investment securities
|
225,821
|
4.99
|
%
|
8,448
|
262,696
|
4.70
|
%
|
9,265
|
|||||||||||
|
Loans:
|
|||||||||||||||||||
|
Commercial
real estate
|
142,179
|
6.56
|
%
|
6,971
|
123,388
|
6.15
|
%
|
5,674
|
|||||||||||
|
Residential
real estate
|
26,017
|
5.87
|
%
|
1,146
|
24,957
|
5.87
|
%
|
1,098
|
|||||||||||
|
Home
equity loans
|
66,294
|
6.31
|
%
|
3,131
|
60,100
|
5.88
|
%
|
2,642
|
|||||||||||
|
Commercial
and industrial
|
50,342
|
7.09
|
%
|
2,671
|
45,628
|
6.15
|
%
|
2,099
|
|||||||||||
|
Indirect
lease financing
|
8,874
|
9.25
|
%
|
614
|
1,488
|
9.11
|
%
|
101
|
|||||||||||
|
Consumer
loans
|
5,197
|
9.19
|
%
|
357
|
5,298
|
8.83
|
%
|
350
|
|||||||||||
|
Tax-exempt
loans
|
20,875
|
5.82
|
%
|
909
|
12,683
|
5.25
|
%
|
499
|
|||||||||||
|
Total
loans, net of unearned*
|
319,778
|
6.61
|
%
|
15,799
|
273,542
|
6.09
|
%
|
12,463
|
|||||||||||
|
Other
earning assets
|
4,614
|
4.92
|
%
|
170
|
4,689
|
2.50
|
%
|
88
|
|||||||||||
|
Total
earning assets
|
555,522
|
5.93
|
%
|
$
|
24,619
|
547,239
|
5.37
|
%
|
$
|
21,961
|
|||||||||
|
Cash
and due from banks
|
17,225
|
19,252
|
|||||||||||||||||
|
Allowance
for loan losses
|
(2,531
|
)
|
(2,595
|
)
|
|||||||||||||||
|
Other
assets
|
19,979
|
19,006
|
|||||||||||||||||
|
Total
assets
|
$
|
590,195
|
5.58
|
%
|
$
|
582,902
|
5.04
|
%
|
|||||||||||
|
Liabilities
and Shareholders' Equity
|
|||||||||||||||||||
|
Interest-bearing
deposits:
|
|||||||||||||||||||
|
Interest-bearing
demand
|
$
|
100,204
|
2.22
|
%
|
$
|
1,666
|
$
|
93,440
|
1.12
|
%
|
$
|
782
|
|||||||
|
Money
market
|
50,050
|
2.85
|
%
|
1,068
|
55,073
|
1.69
|
%
|
698
|
|||||||||||
|
Savings
|
49,478
|
0.39
|
%
|
145
|
54,507
|
0.39
|
%
|
160
|
|||||||||||
|
Time
|
162,404
|
3.68
|
%
|
4,464
|
162,986
|
2.95
|
%
|
3,597
|
|||||||||||
|
Time
over $100,000
|
45,756
|
3.84
|
%
|
1,314
|
44,307
|
2.96
|
%
|
983
|
|||||||||||
|
Total
interest-bearing deposits
|
407,892
|
2.84
|
%
|
8,657
|
410,313
|
2.03
|
%
|
6,220
|
|||||||||||
|
Short-term
borrowings
|
20,532
|
3.40
|
%
|
522
|
13,330
|
2.00
|
%
|
199
|
|||||||||||
|
Federal
Home Loan Bank advances
|
55,000
|
5.59
|
%
|
2,298
|
55,000
|
5.41
|
%
|
2,225
|
|||||||||||
|
Total
interest-bearing liabilities
|
483,424
|
3.17
|
%
|
11,477
|
478,643
|
2.41
|
%
|
8,644
|
|||||||||||
|
Non-interest-bearing
deposits
|
54,279
|
55,192
|
|||||||||||||||||
|
Other
liabilities
|
3,144
|
2,766
|
|||||||||||||||||
|
Shareholders'
equity
|
49,348
|
46,301
|
|||||||||||||||||
|
Total
liabilities and shareholders' equity
|
$
|
590,195
|
2.60
|
%
|
$
|
582,902
|
1.98
|
%
|
|||||||||||
|
Net
interest rate spread
|
2.76
|
%
|
2.96
|
%
|
|||||||||||||||
|
Margin/net
interest income
|
3.16
|
%
|
$
|
13,142
|
3.25
|
%
|
$
|
13,317
|
|||||||||||
|
Tax-exempt
securities and loans were adjusted to a tax-equivalent basis and
are based
on the marginal Federal corporate tax rate
|
|
of
34 percent.
|
|
Non-accrual
loans are included in earning assets.
|
|
*
Includes loans held-for-sale
|
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
|
Three
Months Ended
|
Nine
Months Ended
|
||||||||||||||||||
|
September
30, 2006 compared
|
September
30, 2006 compared
|
||||||||||||||||||
|
to
September 30, 2005
|
to
September 30, 2005
|
||||||||||||||||||
|
Total
|
Due
to change in:
|
Total
|
Due
to change in:
|
||||||||||||||||
|
Change
|
Volume
|
Rate
|
Change
|
Volume
|
Rate
|
||||||||||||||
|
Interest
income:
|
|||||||||||||||||||
|
Federal
funds sold
|
$
|
81
|
$
|
33
|
$
|
48
|
$
|
57
|
$
|
(23
|
)
|
$
|
80
|
||||||
|
Investment
securities:
|
|||||||||||||||||||
|
U.S.
Treasury
|
33
|
(0
|
)
|
33
|
75
|
(1
|
)
|
76
|
|||||||||||
|
U.S.
Government agencies
|
195
|
99
|
96
|
(20
|
)
|
(235
|
)
|
215
|
|||||||||||
|
State
and municipal
|
(161
|
)
|
(173
|
)
|
12
|
(379
|
)
|
(415
|
)
|
36
|
|||||||||
|
Mortgage-backed
and CMOs
|
(186
|
)
|
(226
|
)
|
40
|
(324
|
)
|
(419
|
)
|
95
|
|||||||||
|
Other
|
(67
|
)
|
(103
|
)
|
36
|
(169
|
)
|
(280
|
)
|
111
|
|||||||||
|
Loans:
|
|||||||||||||||||||
|
Commercial
real estate
|
532
|
370
|
162
|
1,297
|
864
|
433
|
|||||||||||||
|
Residential
real estate
|
12
|
7
|
5
|
48
|
47
|
1
|
|||||||||||||
|
Home
equity loans
|
180
|
111
|
69
|
489
|
272
|
217
|
|||||||||||||
|
Commercial
and industrial
|
134
|
20
|
114
|
572
|
217
|
355
|
|||||||||||||
|
Indirect
lease financing
|
164
|
156
|
8
|
513
|
503
|
10
|
|||||||||||||
|
Consumer
loans
|
11
|
2
|
9
|
7
|
(7
|
)
|
14
|
||||||||||||
|
Tax-exempt
loans
|
163
|
124
|
39
|
410
|
322
|
88
|
|||||||||||||
|
Other
earning assets
|
33
|
(0
|
)
|
33
|
82
|
(2
|
)
|
84
|
|||||||||||
|
Total
interest income
|
$
|
1,124
|
$
|
420
|
$
|
704
|
$
|
2,658
|
$
|
843
|
$
|
1,815
|
|||||||
|
Interest
expense:
|
|||||||||||||||||||
|
Interest-bearing
demand
|
$
|
344
|
$
|
28
|
$
|
316
|
$
|
884
|
$
|
56
|
$
|
828
|
|||||||
|
Money
market
|
215
|
42
|
173
|
370
|
(63
|
)
|
433
|
||||||||||||
|
Savings
|
(5
|
)
|
(5
|
)
|
0
|
(15
|
)
|
(15
|
)
|
(0
|
)
|
||||||||
|
Time
|
342
|
17
|
325
|
867
|
(13
|
)
|
880
|
||||||||||||
|
Time
over $100,000
|
83
|
(23
|
)
|
106
|
331
|
32
|
299
|
||||||||||||
|
Short-term
borrowings
|
113
|
32
|
81
|
323
|
108
|
215
|
|||||||||||||
|
Federal
Home Loan Bank advances
|
21
|
—
|
21
|
73
|
—
|
73
|
|||||||||||||
|
Total
interest expense
|
1,113
|
91
|
1,022
|
2,833
|
105
|
2,728
|
|||||||||||||
|
Net
interest income
|
$
|
11
|
$
|
329
|
$
|
(318
|
)
|
$
|
(175
|
)
|
$
|
738
|
$
|
(913
|
)
|
||||
-19-
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
NET
INTEREST INCOME
The
following table presents the adjustment to convert net interest income to net
interest income on a fully taxable equivalent basis for the three- and
nine-month periods ended September 30, 2006 and 2005.
|
For
the Three Months
|
For
the Nine Months
|
||||||||||||
|
Ended
September 30,
|
Ended
September 30,
|
||||||||||||
|
2006
|
2005
|
2006
|
2005
|
||||||||||
|
Total
interest income
|
$
|
8,278
|
$
|
7,143
|
$
|
23,533
|
$
|
20,858
|
|||||
|
Total
interest expense
|
4,238
|
3,125
|
11,477
|
8,644
|
|||||||||
|
Net
interest income
|
4,040
|
4,018
|
12,056
|
12,214
|
|||||||||
|
Tax
equivalent adjustment
|
351
|
362
|
1,086
|
1,103
|
|||||||||
|
Net
interest income (fully taxable equivalent)
|
$
|
4,391
|
$
|
4,380
|
$
|
13,142
|
$
|
13,317
|
|||||
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 on funding sources. Earning assets primarily include loans,
investment securities and Federal funds sold. Sources used to fund these assets
include deposits, borrowed funds and shareholders’ equity. Net interest income
is affected by changes in interest rates, the volume and mix of earning assets
and interest-bearing liabilities, and the amount of earning assets funded by
non-interest bearing deposits.
For
purposes of this discussion, interest income and the average yield earned on
loans and investment securities are adjusted to a tax-equivalent basis as
detailed in the tables that appear on pages 17 and 18. This adjustment to
interest income is made for analysis purposes only. Interest income is increased
by the amount of savings of Federal income taxes, which QNB realizes by
investing in certain tax-exempt state and municipal securities and by making
loans to certain tax-exempt organizations. In this way, the ultimate economic
impact of earnings from various assets can be more easily compared.
The
net
interest rate spread is the difference between average rates received on earning
assets and average rates paid on interest-bearing liabilities, while the net
interest rate margin includes interest-free sources of funds.
Net
interest income increased .5 percent, to $4,040,000, for the quarter ended
September 30, 2006, as compared to $4,018,000 for the quarter ended September
30, 2005. On a tax-equivalent basis, net interest income increased by .3
percent, from $4,380,000, for the three-months ended September 30, 2005 to
$4,391,000 for the same period ended September 30, 2006. As mentioned
previously, the
growth
in average earning assets and the continued shift of the balance sheet from
investment securities to loans helped offset the continued decline in the net
interest margin.
When
comparing the third quarters of 2006 and 2005, the net interest margin declined
by 12 basis points. The net interest margin decreased to 3.06 percent for the
third quarter of 2006 from 3.18 percent for the third quarter of 2005. The
third
quarter net interest margin also represents a 12 basis point decline from the
3.18 percent recorded in the second quarter of 2006. Funding costs for deposits
and borrowed money continue to increase at a faster pace than the rate on
earning assets. Contributing to this difference was the interest rate
environment over the past year as short-term interest rates
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
NET
INTEREST INCOME (Continued)
have
increased at a much faster pace than mid- and long-term interest rates,
resulting in a flat to inverted yield curve. The
structure of QNB’s balance sheet, which is comprised primarily of fixed-rate
investments and loans and funding sources with relatively short-term repricing
characteristics, as well as the strong competition for loans and deposits,
has
also contributed to the decline in the net interest margin.
Also
contributing to the decline in the net interest margin, when comparing both
the
decline from the third quarter of 2005 and the second quarter of 2006, were
the
seasonal tax deposits of municipalities and school districts with whom QNB
has
built strong relationships. These deposits tend to be short-term and are priced
at thin margins. The average balance of municipal interest-bearing accounts
was
$51,827,000 for the third quarter of 2006, compared to $40,079,000 for the
third
quarter of 2005 and $43,426,000 for the second quarter of 2006.
While
average
earning assets increased 4.3 percent, from $546,637,000 for the third quarter
of
2005 to $570,119,000 for the third quarter of 2006, total interest income
increased $1,124,000, or 15.0 percent, during the same period. The increase
in
interest income was a result of the increase in market interest rates and
particularly the prime lending rate, in conjunction with the shift in the
composition of the assets from investment securities to loans, as loans, in
general, earn more than investment securities. When comparing the two quarters,
average loans increased $49,067,000, or 17.5 percent, while average investment
securities decreased $29,366,000, or 11.5 percent. Contributing to the increase
in average earning assets and interest income was QNB’s ability, at the end of
the second quarter of 2006, to reclassify some of its deposits for reserve
calculation purposes. This reclassification enabled QNB to reduce its reserve
requirements at the Federal Reserve Bank by approximately $8,500,000. These
funds went from a non-earning asset into Federal funds sold and investment
securities, thereby increasing interest income.
The
Federal Reserve Board ended its increase of short-term interest rates during
the
third quarter by leaving the Federal funds rate unchanged at 5.25 percent.
While
short-term interest rates have increased significantly since June 2004, when
the
Federal funds rate was 1.00 percent to its current rate of 5.25 percent, the
yield on earning assets on a tax-equivalent basis has only increased from 5.45
percent for the third quarter of 2005 to 6.00 percent for the third quarter
of
2006. This differential was due to a number of factors including the long period
of historically low interest rates since 2001 which enabled borrowers to lock
into low-rate longer-term fixed-rate loans, the flat to inverted shape of the
yield curve since the Federal Reserve began raising interest rates, the
fixed-rate nature of the investment and loan portfolio and the price competition
for loans.
Interest
income on investment securities decreased $186,000 when comparing the two
quarters, as the decline in balances offset the increase in the yield on the
portfolio. The average yield increased from 4.77 percent for the third quarter
of 2005 to 5.07 percent for the third quarter of 2006. Most of the increase
in
the yield was a result of the sale, maturity or payments of lower yielding
securities. QNB has purchased very few securities over the past year, a period
of increased interest rates, because of the growth in loans. Management has
performed purchase and sale transactions in an attempt to increase the yield
on
the portfolio and to reposition the cash flow from the portfolio. Management
will continue to look at trades that will enhance the structure and yield of
the
investment portfolio.
The
yield
on loans increased 51 basis points, to 6.71 percent, when comparing the third
quarter of 2006 to the third quarter of 2005. The average prime rate when
comparing these same periods increased 183 basis points, from 6.42 percent
to
8.25 percent. While QNB was positively impacted by the increases in the prime
rate, the overall yield on the loan portfolio did not increase proportionately,
since only a small portion of the loan portfolio reprices immediately with
changes in the prime rate. As short-term interest rates were increasing, mid-
and longer-term interest rates were increasing but at a slower rate, creating
a
yield curve that is flat and
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
NET
INTEREST INCOME (Continued)
even
inverted at points. This rate phenomenon, along with the competition for loans,
has created an environment where borrowers are refinancing variable-rate and
adjustable-rate loans tied to prime into lower fixed-rate borrowings, and new
originations, while at higher rates than two years ago, are still at relatively
low rates.
While
total interest income on a tax-equivalent basis increased $1,124,000,
or 15.0
percent, when comparing the third quarter of 2006 to the third quarter of 2005,
total interest expense increased $1,113,000, or 35.6 percent. Average deposits
increased $8,885,000, or 1.9 percent, when comparing the third quarters of
2006
and 2005. The increase in interest expense was a result of the increase in
interest rates paid on both deposits and short-term borrowings. The rate paid
on
interest-bearing liabilities increased from 2.60 percent for the third quarter
of 2005 to 3.40 percent for the third quarter of 2006, while the rate paid
on
interest-bearing deposits increased from 2.23 percent to 3.10 percent during
this same period. Interest expense on interest-bearing demand accounts increased
$344,000, and the rate paid increased from 1.43 percent to 2.62 percent when
comparing the two quarters. Approximately 49.3 percent of the average balances
of interest-bearing demand accounts for the third quarter of 2006 are the
municipal deposits discussed previously. This compares to 41.2 percent of the
average balance for the third quarter of 2005. The rates on these accounts
are
generally indexed to the Federal funds rate so the rate paid on these accounts
has increased as the Federal funds rate has increased over the past two years.
Interest expense on money market accounts increased by $215,000, and the rate
paid increased from 1.84 percent to 3.11 percent when comparing the two
quarters. The increase in the rate paid was primarily the result of the majority
of the balances being in the Treasury Select product which is indexed to a
percentage of the 91-day Treasury bill rate. This rate has also increased as
short-term interest rates have increased. The average balance of money market
accounts increased $8,971,000, or 19.9 percent, when comparing the two quarters
with balances of the Treasury Select product increasing $16,171,000, or 64.2
percent.
Interest
expense on time deposits increased $425,000, while the average rate paid on
time
deposits increased from 3.14 percent to 3.96 percent when comparing the two
periods. Like fixed-rate loans and investment securities, time deposits reprice
over time and, therefore, have less of an immediate impact on costs in either
a
rising or falling rate environment. Unlike loans and investment securities,
the
maturity and repricing characteristics tend to be shorter. With interest rates
increasing over the past two years, customers have opted for shorter maturity
time deposits. This result, combined with the strong rate competition for these
deposits, has led to the increase in the yield on time deposits in 2006. Average
time deposits decreased $700,000, or .3 percent, when comparing the third
quarter of 2006 to the third quarter of 2005.
Interest
expense on short-term borrowings increased $113,000, both as a result of an
increase in balances and rates. The average rate paid increased from 2.25
percent for the third quarter of 2005 to 3.62 percent for the third quarter
of
2006, while average balances increased $5,644,000, to $23,337,000. Most of
this
increase was centered in repurchase agreements, a sweep product for commercial
customers.
For
the
nine-month period ended September 30, 2006, net interest income decreased
$158,000, or 1.3 percent, to $12,056,000. On a tax-equivalent basis, net
interest income decreased $175,000, or 1.3 percent. Included in net interest
income for the first nine months of 2005 was $40,000 in interest recognized
on
the pay-off of loans that had not been accruing interest or had previously
been
charged off. Average earning assets increased $8,283,000, or 1.5 percent, while
the net interest margin declined 9 basis points. The net interest margin on
a
tax-equivalent basis was 3.16 percent for the nine-month period ended September
30, 2006 compared with 3.25 percent for the same period in 2005.
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
NET
INTEREST INCOME (Continued)
Total
interest income on a tax-equivalent basis increased $2,658,000, from $21,961,000
to $24,619,000, when comparing the nine-month periods ended September 30, 2005
to September 30, 2006. With the small growth in earning assets, the increase
in
interest income was mostly a result of rate increases and the movement of
balances from investment securities to loans. Approximately $843,000 of the
increase in interest income was related to volume, while $1,815,000 was due
to
higher interest rates. The higher volume of loans resulted in an additional
$2,218,000 in interest income, with growth in commercial loans including
tax-exempt loans contributing $1,403,000. Growth in the indirect leasing
portfolio contributed $503,000 while growth in home equity loans contributed
$272,000. The impact on interest income from the growth in loans was partially
offset by a reduction in interest income of $1,350,000 resulting from a lower
volume of investment securities. The yield on earning assets increased from
5.37
percent to 5.93 percent for the nine-month periods. The yield on loans increased
from 6.09 percent to 6.61 percent during this time, while the yield on
investments increased from 4.70 percent to 4.99 percent when comparing the
nine-month periods. The yield on commercial and industrial loans benefited
the
most from the increase in interest rates as most of these loans are indexed
to
the prime lending rate.
Total
interest expense increased $2,833,000, from $8,644,000 to $11,477,000, for
the
nine-month periods with interest on demand accounts, money market accounts,
and
time deposits accounting for $884,000, $370,000 and $1,198,000, respectively,
of
the increase. Approximately $2,728,000 of the increase in interest expense
was a
result of higher interest rates. The yield on interest-bearing demand accounts,
money market accounts and time deposits increased 110 basis points, 116 basis
points and 76 basis points, respectively, when comparing the average rate paid
for the nine-month periods ended September 30, 2006 and 2005. As was the case
for the quarter, the municipal deposits had the largest impact on interest
expense on interest-bearing demand accounts and the Treasury Select money market
account had the greatest impact on money market expense. The average balance
of
municipal interest bearing demand accounts increased $10,571,000, or 30.7
percent, when comparing the nine-month periods and the average balance in the
Treasury Select product increased $11,858,000, or 49.0 percent, during the
same
time period. Interest expense on short-term borrowings increased by $323,000
as
the average rate paid on these accounts increased from 2.00 percent to 3.40
percent. The average balance of short-term borrowings, mostly commercial sweep
accounts, increased $7,202,000, or 54.0 percent, to $20,532,000 for the
nine-months ended September 30, 2006.
Management
expects the remainder of 2006 and most of 2007 to be challenging with respect
to
net interest income and the net interest margin. The extremely competitive
environment for loans and deposits, as well as the flat yield curve, is expected
to continue. These factors combined with QNB’s current interest rate sensitivity
position, which has funding sources repricing sooner than earning assets, will
likely put more pressure on the net interest margin. However, the ability to
continue to successfully increase loan balances should have a positive impact
on
the net interest margin and interest income, as loans tend to earn a higher
yield than investment securities. Mixed signals resulting from recent data
on
the United States economy make it uncertain whether the Federal
Reserve’s
next
move will be to lower or raise short-term interest rates.
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
PROVISION
FOR LOAN LOSSES
The
provision for loan losses represents management's determination of the amount
necessary to be charged to operations to bring the allowance for loan losses
to
a level that represents management’s best estimate of the known and inherent
losses in the existing loan portfolio. Actual loan losses, net of recoveries,
serve to reduce the allowance.
The
determination of an appropriate level of the allowance for loan losses is based
upon an analysis of the risk inherent in QNB's loan portfolio. Management uses
various tools to assess the adequacy of the allowance for loan losses. One
tool
is a model recommended by the Office of the Comptroller of the Currency. This
model considers a number of relevant factors including: historical loan loss
experience, the assigned risk rating of the credit, current and projected credit
worthiness of the borrower, current value of the underlying collateral, levels
of and trends in delinquencies and non-accrual loans, trends in volume and
terms
of loans, concentrations of credit, and national and local economic trends
and
conditions. This model is supplemented with another analysis that also
incorporates QNB’s portfolio exposure to borrowers with large dollar
concentration. Other tools include ratio analysis and peer group
analysis.
QNB’s
management determined that $60,000 and $105,000 provisions for loan losses
were
necessary for the three- and nine-month periods ended September 30, 2006. There
was no provision for loan losses necessary for the same periods in 2005. The
need for a provision was determined by the analysis described above and resulted
in an allowance for loan losses that management believes is adequate in relation
to the estimate of known and inherent losses in the portfolio.
Loan
charge-offs and non-performing assets remain at low levels. QNB had net
charge-offs of $36,000 and $17,000 during the third quarters of 2006 and 2005,
respectively. For the nine-month periods ended September 30, 2006 and 2005,
QNB
had net charge-offs of $58,000 and $44,000, respectively. The net charge-offs
during both periods related primarily to loans in the consumer loan portfolio.
The asset quality of the commercial portfolio remains excellent.
Non-performing
assets (non-accruing loans, loans past due 90 days or more, other real estate
owned and other repossessed assets) amounted to .03 percent and .00 percent
of
total assets, respectively, at September 30, 2006 and 2005. These levels compare
to .002 percent at December 31, 2005. Non-accrual loans were $117,000 at
September 30, 2006. There were no non-accrual loans at December 31, 2005 or
September 30, 2005. QNB did not have any other real estate owned as of September
30, 2006, December 31, 2005 or September 30, 2005. There were no repossessed
assets at September 30, 2006, December 31, 2005 or September 30,
2005.
There
were no restructured loans as of September 30, 2006, December 31, 2005 or
September 30, 2005 as defined in FASB Statement No. 15, Accounting
by Debtors and Creditors for Troubled Debt Restructurings,
that
have not already been included in loans past due 90 days or more or non-accrual
loans.
The
allowance for loan losses was $2,573,000 and $2,526,000 at September 30, 2006
and December 31, 2005, respectively. The ratio of the allowance to total loans
was .78 percent and .84 percent at the respective period end dates. The decrease
in the ratio is a result of the strong growth in the loan portfolio. 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.
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
PROVISION
FOR LOAN LOSSES (Continued)
A
loan is
considered impaired, based on current information and events, if it is probable
that QNB will be unable to collect the scheduled payments of principal or
interest when due according to the contractual terms of the loan agreement.
The
measurement of impaired loans is generally based on the present value of
expected future cash flows discounted at the historical effective interest
rate,
except that all collateral-dependent loans are measured for impairment based
on
the fair value of the collateral. At
September 30, 2006, the recorded investment in loans for which impairment had
been recognized in accordance with FASB Statement No. 114, Accounting
by Creditors for Impairment of a Loan—an amendment of FASB Statements No. 5 and
15,
totaled
$117,000. The loans identified as impaired were collateral-dependent, with
no
valuation allowance necessary. There were no loans considered impaired at
September 30, 2005.
Management
in determining the allowance for loan losses makes significant estimates and
assumptions. Consideration is given to a variety of factors in establishing
these estimates including current economic conditions, diversification of the
loan portfolio, delinquency statistics, results of loan reviews, borrowers’
perceived financial and managerial strengths, the adequacy of underlying
collateral if collateral dependent, or the present value of future cash flows.
Since
the
allowance for loan losses is dependent, to a great extent, on conditions that
may be beyond QNB’s control, it is at least reasonably possible that
management’s estimates of the allowance for loan losses and actual results could
differ in the near term. In addition, various regulatory agencies, as an
integral part of their examination process, periodically review QNB’s allowance
for losses on loans. Such agencies may require QNB to recognize additions to
the
allowance based on their judgments about information available to them at the
time of their examination.
NON-INTEREST
INCOME
QNB,
through its core banking business, generates various fees and service charges.
Total non-interest income is composed of service charges on deposit accounts,
ATM and debit card income, income on bank-owned life insurance, mortgage
servicing fees, gains or losses on the sale of investment securities, gains
on
the sale of residential mortgage loans, and other miscellaneous fee income.
Total
non-interest income increased $209,000, to $1,147,000, for the quarter ended
September 30, 2006, when compared to September 30, 2005. For the nine-month
period, total non-interest income increased $871,000, to $3,306,000. Excluding
gains and losses on the sale of securities and loans, non-interest income for
the three-month period increased $20,000, or 2.2 percent, and for the nine-month
period decreased $237,000, or 8.2 percent. The first nine months of 2005 had
several non-operating items: gain on the liquidation of assets relinquished
by a
borrower of $209,000, life insurance proceeds of $61,000 and a sales tax refund
of $45,000. These items were included in the category other income.
Fees
for
services to customers are primarily comprised of service charges on deposit
accounts. These fees remained flat at $488,000 when comparing the two quarters
and increased $13,000, or .9 percent, to $1,392,000 when comparing the
nine-month periods. Overdraft income increased $18,000 for the three-month
period and $51,000 for the nine-month period as a result of an increase in
the
volume of overdrafts. This additional income helped offset a decline in fee
income on business checking accounts and internet bill pay. Fees on business
checking accounts declined $10,000 and $26,000 for the three- and nine-month
periods, respectively. This decline reflects the impact of a higher earnings
credit rate, resulting from the increases in short-term interest rates, applied
against balances to offset service charges incurred. QNB eliminated the fee
it
charged retail customers for the use of internet bill pay during the fourth
quarter of 2005, resulting in a
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST
INCOME (Continued)
reduction
in fee income of $7,000 and $19,000, respectively, when comparing the three-
and
nine-month periods.
ATM
and
debit card income is primarily comprised of income on debit cards and ATM
surcharge income for the use of QNB ATM machines by non-QNB customers. ATM
and
debit card income was $196,000 for the third quarter of 2006, an increase of
$20,000, or 11.4 percent, from the amount recorded during the third quarter
of
2005. Income from ATM and debit cards was $575,000 and $506,000 for the
nine-months ended September 30, 2006 and 2005, respectively. This represents
an
increase of 13.6 percent. Debit card income increased $17,000, or 13.7 percent,
and $58,000, or 16.4 percent, for the three- and nine-month periods,
respectively. The increase in debit card income was a result of the increased
reliance on the card as a means of paying for goods and services by both
consumers and business cardholders. QNB has been successfully promoting the
use
of the card by its business customers. In addition, an increase in pin-based
transactions, as well as the fee received from VISA, resulted in additional
interchange income of $6,000 and $19,000, respectively, when comparing the
respective three- and nine-month periods. Partially offsetting these positive
variances was a reduction in ATM surcharge income of $2,000 and $6,000,
respectively, for the three- and nine-month periods. This decrease was a result
of fewer transactions by non-QNB customers at QNB’s ATM machines.
Income
on
bank-owned life insurance represents the earnings on life insurance policies
in
which the Bank is the beneficiary. The earnings on these policies were $63,000
and $61,000 for the three-months ended September 30, 2006 and 2005,
respectively. For the nine-month period, earnings on these policies were
$186,000 and $187,000, respectively. The insurance carriers reset the rates
on
these policies annually.
When
QNB
sells its residential mortgages in the secondary market, it retains servicing
rights. A normal servicing fee is retained on all mortgage loans sold and
serviced. QNB
recognizes its obligation to service financial assets that are retained in
a
transfer of assets in the form of a servicing asset. The servicing asset is
amortized in proportion to and over the period of net servicing income or loss.
Servicing assets are assessed for impairment based on their fair value. Mortgage
servicing fees for the three- and nine-month periods ended September 30, 2006
were $26,000 and $74,000, respectively. For the three- and nine-month periods
ended September 30, 2005, mortgage servicing income was $27,000 and $63,000,
respectively. Included in the 2005 results is a $6,000 and $5,000 positive
adjustment to the valuation allowance for impairment resulting from the increase
in interest rates during the third quarter of 2005. Excluding the valuation
allowance adjustments in 2005, mortgage servicing income would have been $21,000
and $58,000 for the respective three- and nine-month periods. Mortgage servicing
income for both the three- and nine-month periods of 2006 was positively
impacted by the reduction in amortization expense. Amortization expense for
the
three-month periods ended September 30, 2006 and 2005 was $18,000 and $27,000,
respectively. For the respective nine-month periods, amortization expense was
$65,000 and $86,000, respectively. The higher amortization expense in 2005
was a
result of early payoffs of mortgage loans through refinancing. As mortgage
interest rates have increased, refinancing activity has slowed dramatically.
The
slowdown in mortgage activity has also had a negative impact on the average
balance of mortgages sold and serviced as well as the fee income generated
from
these loans. The average balance of mortgages serviced for others was
$72,662,000 for the third quarter of 2006 compared to $77,066,000 for the third
quarter of 2005, a decrease of 5.7 percent. The average balance of mortgages
serviced was approximately $74,294,000 for the nine-month period ended September
30, 2006, compared to $77,630,000 for the first nine months of 2005, a decrease
of 4.3 percent. The timing of mortgage payments and delinquencies also impacts
the amount of servicing fees recorded.
The
fixed-income securities portfolio represents a significant portion of QNB’s
earning assets and is also a primary tool in liquidity and asset/liability
management. QNB actively manages its fixed-income portfolio in an
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST
INCOME (Continued)
effort
to
take advantage of changes in the shape of the yield curve, changes in spread
relationships in different sectors and for liquidity purposes, as needed.
Management
continually reviews strategies that will result in an increase in the yield
or
improvement in the structure of the investment portfolio.
QNB
recorded a net gain/(loss) on investment securities of $196,000 and $(4,000)
for
the three-month periods ended September 30, 2006 and 2005, respectively. For
the
third quarter of 2006, gains on the sale of equity securities contributed
$207,000, while the sale of fixed-income securities resulted in a loss of
$11,000.
Net
security gains/(losses) were $611,000 and ($580,000) for the nine-month periods
ended September 30, 2006 and 2005, respectively. Of the gains recorded in 2006,
$465,000 was from the marketable equity securities portfolio at the Corporation
and $146,000 were from the sale of debt and equity securities at the Bank.
During the first quarter of 2006, QNB entered into several liquidity
transactions through the sale of investment securities to fund strong growth
in
loans. In addition, QNB sold its
preferred stock holdings and recorded a gain of $451,000 on the carrying value
of those issues that had previously been impaired and a $300,000 loss on one
issue that was not impaired in 2005. Excluding
the impairment charge of
$1,253,000 in the second quarter of 2005 related to perpetual preferred stock
of
FNMA and FHLMC, QNB
recorded net securities gains of $673,000 during the first nine months of 2005,
$240,000 from the sale of debt securities and $433,000 from the sale of equity
securities.
The
net
gain on the sale of residential mortgage loans was $20,000 and $31,000 for
the
quarters ended September 30, 2006 and 2005, respectively. For the nine-month
periods ended September 30, 2006 and 2005, net gains on the sale of loans were
$44,000 and $127,000, respectively. Residential mortgage loans to be sold are
identified at origination. The
net
gain on residential mortgage sales is directly related to the volume of
mortgages sold and the timing of the sales relative to the interest rate
environment. The net gain on the sale of residential mortgage loans has declined
as a result of the increase in interest rates over the past year. The increase
in interest rates has reduced both the volume of origination and sales activity
and the amount of gains recorded at the time of sale. Included in the gains
on
the sale of residential mortgages in the three-month periods ended September
30,
2006 and 2005 were $7,000 and $17,000 related to the recognition of mortgage
servicing assets.
Included
in the gains on the sale of residential mortgages in the nine-month periods
ended September 30, 2006 and 2005 were $23,000 and $56,000, respectively,
related to the recognition of mortgage servicing assets. Proceeds from the
sale
of mortgages were $908,000 and $2,277,000 for the third quarter of 2006 and
2005, respectively. For the nine-month periods, proceeds from the sale of
residential mortgage loans amounted to $3,048,000 and $7,510,000, respectively.
Other
income remained flat when comparing the third quarters of 2006 and 2005.
For
the
nine-month period, other operating income decreased $329,000, or 43.7 percent,
to $424,000. The
non-operating items mentioned earlier accounted for most
of
the
decrease.
NON-INTEREST
EXPENSE
Non-interest
expense is comprised of costs related to salaries and employee benefits, net
occupancy, furniture and equipment, marketing, third party services and various
other operating expenses. Total non-interest expense of $3,254,000 for the
quarter ended September 30, 2006 represents an increase of $114,000, or 3.6
percent, from levels reported in the third quarter of 2005. Total non-interest
expense for the nine-months ended September 30, 2006 was $9,772,000, an increase
of $80,000, or .8 percent, over 2005 levels.
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST
EXPENSE (Continued)
Salaries
and benefits is the largest component of non-interest expense. Salary and
benefit expense increased $92,000, or 5.3 percent, to $1,820,000 for the quarter
ended September 30, 2006 compared to the same quarter in 2005. Salary expense
increased $84,000, or 6.0 percent, during the period to $1,487,000, while
benefits expense increased $8,000, or 2.5 percent, to $333,000. Included in
salary expense for the third quarter of 2006 was $27,000 of stock option expense
associated with the adoption of FASB No. 123r.
Included
as a reduction to salary expense for the three-months ended September 30, 2005
was a reversal of $40,000 of anticipated incentive compensation accrued during
the first quarter of 2005. Excluding the impact of the stock option expense
in
the third quarter of 2006 and the reversal of the incentive compensation accrual
in the third quarter of 2005, salary expense increased 1.2 percent for the
three-month period. The number of full time-equivalent employees decreased
by
one when comparing the third quarters of 2006 and 2005. The increase in benefits
expense was primarily in payroll tax expense and retirement plan
expense.
For
the
nine-month period ended September 30, 2006, salary and benefit expense increased
$11,000, to $5,439,000, compared to the same period in 2005. Salary expense
increased by $12,000, or .3 percent, to $4,368,000, while benefits expense
decreased by $1,000, or .1 percent, to $1,071,000, when comparing the two
periods. Included in salary expense for the nine-month period of 2006 was
$86,000 in stock option expense associated with the adoption of FASB No. 123r.
Excluding the impact of the stock option expense, salary expense decreased
1.7
percent for the nine-month period. The number of full time-equivalent employees
decreased by five when comparing the nine-month periods.
Net
occupancy expense increased $19,000, to $287,000, when comparing the third
quarter of 2006 to the third quarter of 2005. For the nine-month period, net
occupancy expense increased $41,000, to $862,000. Contributing to the increase
in both the three- and nine-month periods was higher costs related to
depreciation, building maintenance, utilities and real estate taxes. A portion
of these increases were
a
result of the opening of a loan center in June 2006.
Furniture
and equipment expense decreased $13,000, or 4.6 percent, to $269,000, when
comparing the three-month periods ended September 30, 2006 and 2005 and
decreased $100,000, or 11.7 percent, to $755,000, when comparing the nine-month
periods. Depreciation on furniture and equipment and amortization of software
costs declined by $28,000 for the three-month period and $119,000 for the
nine-month period. Hardware and software associated with the Bank’s core
computer system acquired in 2000 became fully depreciated in 2005. The rate
of
decline in depreciation and amortization expense has slowed throughout 2006
as
some hardware associated with the computer system was replaced during the second
quarter of 2006 and due to the acquisition of assets associated with the loan
center. Partially offsetting these savings were higher costs associated with
equipment maintenance, both repairs and maintenance contracts.
Third
party services are comprised of professional services including legal,
accounting and auditing and consulting services, as well as fees paid to outside
vendors for support services of day-to-day operations. These support services
include correspondent banking services, statement printing and mailing,
investment security safekeeping and supply management services. Third party
services expense was $164,000 in the third quarter of 2006, compared to $171,000
for the third quarter of 2005. During the third quarter of 2005, QNB used
consultants to assist its entrance into the indirect leasing business and for
the development of its strategic plan, resulting in a higher expense in the
third quarter of 2005 than the same period in 2006. Partially offsetting these
savings was an increase in outsourced internal audit and external auditing
fees
and legal expense. For the nine-month period, third party services increased
$49,000, to $529,000. Legal expense increased $33,000 when comparing the
nine-month periods due to special project work. Outsourced internal
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
NON-INTEREST
EXPENSE (Continued)
audit,
external audit and accounting fees increased $26,000 due to a general increase
in fees and special project work. In addition, with the elimination of the
fee
charged to consumers for the use of internet bill pay services, QNB has
experienced rapid growth in this service. As a result, the fees paid to the
vendor who processes these payments have increased by $24,000 for the nine-month
period. QNB stopped offering trust services in 2006 resulting in a savings
of
$14,000 previously paid to a third party vendor.
Telephone,
postage and supplies expense decreased $5,000, to $120,000, when comparing
the
three-month periods, but increased $35,000, to $396,000, when comparing the
nine-month periods. Postage expense increased $14,000 when comparing the
nine-month periods, as a result of an increase in both the volume of mailings
as
well as the cost per mailing as the U.S. Postal service raised rates effective
January 2006. Supplies expense increased $18,000 when comparing the nine-month
periods. Contributing to this increase were costs for ATM cards and costs
related to supplies for the new loan center.
State
tax
expense represents the payment of the Pennsylvania shares tax, which is based
on
the equity of the Bank, Pennsylvania sales and use tax and the Pennsylvania
capital stock tax. For the three-month period ended September 30, 2006, state
tax expense increased $9,000, to $112,000, while for the nine-month period
state
taxes increased $19,000, to $339,000. The shares tax increased $9,000 for the
quarter and $27,000 for the nine-month period, a result of the increase in
the
Bank’s equity. This increase for the nine-month period was offset by a decrease
in the capital stock tax paid by the Corporation of $8,000 for the nine-month
period.
INCOME
TAXES
QNB
utilizes an asset and liability approach for financial accounting and reporting
of income taxes. As of September 30, 2006, QNB's net deferred tax asset was
$1,346,000. The primary components of deferred taxes are a deferred tax asset
of
$847,000 relating to the allowance for loan losses and a deferred tax asset
of
$642,000 resulting from the FASB No.
115
adjustment for available-for-sale investment securities. As of September 30,
2005, QNB's net deferred tax asset was $959,000. The primary components of
deferred taxes was a deferred tax asset of $743,000 relating to the allowance
for loan losses, $390,000 related to impaired equity securities and $175,000
resulting from the FASB No. 115 adjustment for available-for-sale investment
securities.
The
realizability of deferred tax assets is dependent upon a variety of factors,
including the generation of future taxable income, the existence of taxes paid
and recoverable, the reversal of deferred tax liabilities and tax planning
strategies. A valuation allowance of $190,000 was established as of June 30,
2005 to offset a portion of the tax benefits associated with certain impaired
securities that management believed may not be realizable. This valuation
allowance was increased to $209,000 at December 31, 2005. Approximately $163,000
of this valuation allowance was reversed during the first nine months of 2006
as
a result of the ability to realize tax benefits associated with certain impaired
securities. Management believes it is more likely than not that QNB will realize
the benefits of these remaining deferred tax assets. The net deferred tax asset
is included in other assets on the consolidated balance sheet.
Applicable
income taxes and effective tax rates were $356,000, or 19.0 percent, for the
three-month period ended September 30, 2006, and $385,000, or 21.2 percent,
for
the same period in 2005. For the nine-month periods, applicable income taxes
and
effective tax rates were $988,000, or 18.0 percent, in 2006 and $1,124,000,
or
22.7 percent, in 2005. The establishment of the valuation allowance in 2005
and
the partial reversal in 2006 contributed to the differences in the effective
tax
rates when comparing the periods.
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
FINANCIAL
CONDITION ANALYSIS
The
following balance sheet analysis compares average balance sheet data for the
nine-months ended September 30, 2006 and 2005, as well as the period end
balances as of September 30, 2006 and December 31, 2005.
QNB’s
primary functions and responsibilities are to accept deposits and to make loans
to meet the credit needs of the communities it serves. Loans are the most
significant component of earning assets and growth in loans to small businesses
and residents of these communities has been a primary focus of QNB. Once again,
QNB has been successful in achieving strong growth in total loans, while at
the
same time maintaining excellent asset quality.
Average
earning assets for the nine-month period ended September 30, 2006 increased
$8,283,000, or 1.5 percent, to $555,522,000, from $547,239,000 for the
nine-months ended September 30, 2005. Average loans increased $46,236,000,
or
16.9 percent, while average investments decreased $36,875,000, or 14.0 percent.
Average Federal funds sold decreased $1,003,000 when comparing these same
periods. The growth in average loans during the past year was funded primarily
through the reduction of the investment portfolio and an increase in commercial
sweep balances classified as short-term borrowings.
Total
loans increased 15.4 percent between September 30, 2006 and September 30, 2005
and 10.1 percent since December 31, 2005. This loan growth was achieved despite
the extremely competitive environment for both commercial and consumer loans.
Continued loan growth remains one of the primary goals of QNB.
Average
total commercial loans increased $31,697,000 when comparing the first nine
months of 2006 to the first nine months of 2005. Most of the 17.4 percent growth
in average commercial loans is in loans secured by real estate, either
commercial or residential properties, which increased $18,791,000. Of this
increase $15,476,000, or 82.4 percent, are adjustable-rate loans. While
adjustable, most of these loans have a fixed rate for a period of time, from
one
year to ten years, before the rate adjusts. The growth in the commercial and
industrial category represents loans with fixed interest rates. Given the
significant increase in the prime rate over the past two years and the flat
shape of the yield curve, customers are requesting to lock in a fixed-rate
versus a rate floating with prime. Also contributing to the growth in total
commercial loans was an increase in tax-exempt loans. QNB continues to be
successful in competing for loans to schools and municipalities. Average
tax-exempt loans increased $8,192,000, or 64.6 percent, when comparing the
nine-month periods.
Indirect
lease financing receivables represent loans to small businesses that are
collateralized by equipment. These loans are originated by a third party and
purchased by QNB based on criteria specified by QNB. The criteria include
minimum credit scores of the borrower, term of the lease, type and age of
equipment financed and geographic area. The geographic area primarily represents
states contiguous to Pennsylvania. QNB is not the lessor and does not service
these loans. Average indirect lease financing loans increased $7,386,000 when
comparing the nine-month periods. QNB began purchasing these loans in the second
quarter of 2005.
Average
home equity loans and residential mortgage loans increased $6,194,000 and
$1,060,000, respectively, when comparing the first nine months of 2006 to the
first nine months of 2005. The 10.3 percent increase in average home equity
loans reflects their continued popularity with consumers, especially those
refinancing existing residential mortgage loans, because they have lower
origination costs than residential mortgage loans. When comparing average
balances, all of the growth in home equity loans in the past year has been
in
fixed-rate home equity term loans. This product became more attractive to
consumers as the prime rate rose during 2005 and 2006, which resulted in many
borrowers refinancing their floating-rate lines into fixed-rate home equity
loans. QNB has been aggressive in pricing its fixed-rate home equity loans
relative to the market.
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
FINANCIAL
CONDITION ANALYSIS (Continued)
Total
average deposits decreased $3,334,000, or .7 percent, to $462,171,000 for the
nine months of 2006 compared to the first nine months of 2005. Money market
account balances decreased $5,023,000 on average. The decrease in money market
balances reflects the decision made during the third quarter of 2005 not to
aggressively seek to retain the short-term deposits of a school district by
paying high short-term rates. With the flat yield curve, these funds would
not
have added significant incremental net interest income and would have further
eroded the net interest margin. The impact of the loss of these balances was
partially offset by growth in the Treasury Select money market product. Average
balances of these accounts increased $11,858,000, or 49.0 percent, to
$36,049,000. This product is a variable-rate account, indexed to a percentage
of
the monthly average of the 91-day Treasury bill rate based on balances in the
account. This product has become a popular alternative to time deposits and
saving accounts because of its competitive rate and the ability to make deposits
and withdrawals. Average savings accounts declined $5,029,000, or 9.2 percent,
when comparing the nine-month periods as some customers sought out higher
yielding money market accounts and short-term time deposits.
The
decline in money market and savings accounts was partially offset by growth
in
average interest-bearing demand deposits, which increased $6,764,000 when
comparing the two periods. The growth in interest-bearing demand deposits is
centered in the deposits of local municipalities and school districts.
Increasing
time deposit balances continues to be a challenge because of the rate
competition for such deposits, particularly with maturities between six months
through two years. Matching or beating competitors’ rates could have a negative
impact on the net interest margin. Average time deposits increased $867,000,
or
.4 percent, to $208,160,000 for the nine months of 2006.
QNB
used
short-term borrowings, including overnight borrowings and repurchase agreements,
to help fund the loan growth and decline in deposits. Total average short-term
borrowings increased $7,202,000 when comparing the two periods with repurchase
agreements, a sweep product for commercial customers, increasing
$5,627,000.
Total
assets at September 30, 2006 were $592,874,000, compared with $582,205,000
at
December 31, 2005, an increase of 1.8 percent. The composition of the asset
side
of the balance sheet shifted from year-end with total loans increasing
$30,451,000 between December 31, 2005 and September 30, 2006. In contrast,
total
investment securities declined by $19,895,000 between these dates. Cash and
due
from banks decreased by $9,660,000, primarily as a result of deposit
reclassification which enabled QNB to reduce its required balances at the
Federal Reserve Bank. Premises and equipment increased $1,119,000 primarily
as a
result of the cost of renovations and furniture for the new loan
center.
On
the
liability side, total deposits increased by $4,831,000, or 1.1 percent, since
year-end. The composition of the deposits changed slightly as declines in
non-interest bearing demand accounts of $4,807,000 and savings accounts of
$4,471,000 was offset by growth of $12,930,000 in money market accounts.
Treasury Select money market balances increased $15,241,000 between December
31,
2005 and September 30, 2006. Time deposits increased only $169,000 between
December 31, 2005 and September 30, 2006.
Short-term
borrowings increased $2,132,000 between December 31, 2005 and September 30,
2006, as repurchase agreement balances increased $3,622,000 and Federal funds
purchased decreased $1,490,000.
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
FINANCIAL
CONDITION ANALYSIS (Continued)
At
September 30, 2006, the fair value of investment securities available-for-sale
was $213,384,000, or $1,890,000 below the amortized cost of $215,274,000. This
compares to a fair value of $233,275,000, or $1,912,000 below the amortized
cost
of $235,187,000, at December 31, 2005. An unrealized holding loss, net of taxes,
of $1,247,000 was recorded as a decrease to shareholders’ equity at September
30, 2006, while an unrealized holding loss of $1,262,000 was recorded as a
decrease to shareholders' equity at December 31, 2005.
The
available-for-sale portfolio had a weighted average maturity of approximately
3
years, 11 months at September 30, 2006 and 4 years, 5 months at December 31,
2005. The weighted average tax-equivalent yield was 5.05 percent and 4.87
percent at September 30, 2006 and December 31, 2005. The weighted average
maturity is based on the stated contractual maturity or likely call date of
all
securities except for mortgage-backed securities and collateralized mortgage
obligations (CMOs), which are based on estimated average life. The maturity
of
the portfolio could be shorter if interest rates would decline and prepayments
on mortgage-backed securities and CMOs increased or if more securities are
called. However, the estimated average life could be longer if rates were to
increase and principal payments on mortgage-backed securities and CMOs would
slow or bonds anticipated to be called are not called. The interest rate
sensitivity analysis reflects the repricing term of the securities portfolio
based upon estimated call dates and anticipated cash flows assuming an unchanged
as well as a shocked interest rate environment.
Investment
securities held-to-maturity are reported at amortized cost. The held-to-maturity
portfolio is comprised solely of tax-exempt municipal securities. As of
September 30, 2006 and December 31, 2005, QNB had securities classified as
held-to-maturity with an amortized cost of $5,893,000 and $5,897,000 and a
market value of $6,047,000 and $6,082,000, respectively. The held-to-maturity
portfolio had a weighted average maturity of approximately 3 years, 1 month
at
September 30, 2006 and 3 years, 10 months at December 31, 2005. The weighted
average tax-equivalent yield was 6.75 percent at September 30, 2006 and 6.78
percent at December 31, 2005.
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 and investment
securities 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. The
portfolio of investment securities available-for-sale and QNB's policy of
selling certain residential mortgage originations in the secondary market also
provide sources of liquidity. Additional sources of liquidity are provided
by
the Bank’s membership in the Federal Home Loan Bank of Pittsburgh (FHLB) and two
$10,000,000 unsecured Federal funds line granted by correspondent banks. In
addition, the Bank has a maximum borrowing capacity with the FHLB of
approximately $246,381,000. At September 30, 2006, QNB’s outstanding borrowings
under the FHLB credit facilities totaled $55,000,000.
Cash
and
due from banks, Federal funds sold, available-for-sale securities and loans
held-for-sale totaled $232,577,000 and $254,216,000 at September 30, 2006 and
December 31, 2005, respectively. These sources should be adequate to meet normal
fluctuations in loan demand and deposit withdrawals. During the first nine
months of 2006, QNB used both its Federal funds line and overnight borrowings
with the FHLB to help temporarily fund deposit withdrawals and loan growth.
In
addition, QNB entered into several investment sales transactions during the
first quarter of 2006 for the purpose of providing liquidity. Average Federal
funds
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
LIQUIDITY
(Continued)
purchased
and overnight borrowings were $776,000 during the third quarter of 2006 compared
to $56,000 for the same period in 2005. At September 30, 2006, QNB had no
Federal funds purchased.
Approximately
$87,707,000 and $68,917,000 of available-for-sale securities at September 30,
2006 and December 31, 2005, respectively, were pledged as collateral for
repurchase agreements and deposits of public funds. The increase in the pledged
balances at September 30, 2006 reflects the increase in the seasonal deposits
of
public funds as well as the increase in repurchase agreements since December
31,
2005. In addition, under the terms of its agreement with the FHLB, QNB maintains
otherwise unencumbered qualifying assets (principally 1-4 family residential
mortgage loans and U.S. Government and agency notes, bonds, and mortgage-backed
securities) in the amount of at least as much as its advances from the FHLB.
QNB
anticipates the rate of loan growth, which slowed during the third quarter
of
2006, to remain slow during the next couple of quarters as the economy cools.
In
addition, the deposit balances held by school districts should decrease during
the next few quarters as the taxes collected are used to fund
operations.
CAPITAL
ADEQUACY
A
strong
capital position is fundamental to support continued growth and profitability
and to serve the needs of depositors. QNB's shareholders' equity at September
30, 2006 was $49,641,000, or 8.37 percent of total assets. This level
compares to shareholders' equity of $46,564,000, or 8.00 percent of total
assets, at December 31, 2005. Shareholders’ equity at September 30, 2006
includes a negative adjustment of $1,247,000 related to unrealized holding
losses, net of taxes, on investment securities available-for-sale, while
shareholders' equity at December 31, 2005 includes a negative adjustment of
$1,262,000. Without these adjustments shareholders' equity to total assets
would
have been 8.58 percent and 8.21 percent at September 30, 2006 and December
31,
2005, respectively. The increase in the ratio was a result of the rate of
capital retention exceeding the rate of asset growth. Total assets increased
1.8
percent between December 31, 2005 and September 30, 2006, while shareholders’
equity, excluding the net unrealized holding losses, increased 6.4
percent.
Shareholders'
equity averaged $49,348,000 for the first nine months of 2006 and $46,580,000
during all of 2005, an increase of 5.9 percent. The ratio of average total
equity to average total assets increased to 8.36 percent for the first nine
months of 2006, compared to 7.98 percent for all of 2005.
QNB
is
subject to various regulatory capital requirements as issued by Federal
regulatory authorities. Regulatory capital is defined in terms of Tier I capital
(shareholders’ equity excluding unrealized gains or losses on available-for-sale
securities and disallowed intangible assets), Tier II capital, which includes
the allowance for loan losses and a portion of the unrealized gains on equity
securities, and total capital (Tier I plus Tier II). Risk-based capital ratios
are expressed as a percentage of risk-weighted assets. Risk-weighted assets
are
determined by assigning various weights to all assets and off-balance sheet
arrangements, such as letters of credit and loan commitments, based on
associated risk. Regulators have also adopted minimum Tier I leverage ratio
standards, which measure the ratio of Tier I capital to total quarterly average
assets.
The
minimum regulatory capital ratios are 4.00 percent for Tier I, 8.00 percent
for
the total risk-based and 4.00 percent for leverage. Under the requirements,
QNB
had a Tier I capital ratio of 13.21 percent and 13.04 percent, a total
risk-based ratio of 13.89 percent and 13.77 percent and a leverage ratio of
8.44
percent and 8.15 percent at September 30, 2006 and December 31, 2005,
respectively.
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 September 30, 2006 and December 31, 2005, 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 because changes in interest rates do not impact all
categories of assets and liabilities equally or simultaneously. Interest rate
sensitivity analysis also involves assumptions on certain categories of assets
and deposits. For purposes of interest rate sensitivity analysis, assets and
liabilities are stated at their contractual maturity, estimated likely call
date, or earliest repricing opportunity. Mortgage-backed securities, CMOs and
amortizing loans are scheduled based on their anticipated cash flow. Savings
accounts, including passbook, statement savings, money market, and
interest-bearing demand accounts, do not have a stated maturity or repricing
terms and can be withdrawn or repriced at any time. This may impact QNB’s margin
if more expensive alternative sources of deposits are required to fund loans
or
deposit runoff. Management projects the repricing characteristics of these
accounts based on historical performance and assumptions that it believes
reflect their rate sensitivity. The Treasury Select Indexed Money Market account
reprices monthly, based on a percentage of the average of the 91-day Treasury
bill rate.
A
positive gap results when the amount of interest rate sensitive assets exceeds
interest rate sensitive liabilities. A negative gap results when the amount
of
interest rate sensitive liabilities exceeds interest rate sensitive assets.
QNB
primarily focuses on the management of the one-year interest rate sensitivity
gap. At September 30, 2006, interest-earning assets scheduled to mature or
likely to be called, repriced or repaid in one year were $188,792,000.
Interest-sensitive liabilities scheduled to mature or reprice within one year
were $288,022,000. The one-year cumulative gap, which reflects QNB’s interest
sensitivity over a period of time, was a negative $99,230,000 at September
30,
2006. The cumulative one-year gap equals -17.27 percent of total rate sensitive
assets. This compares to a negative gap position of $39,123,000, or -7.04
percent, of total rate sensitive assets, at December 31, 2005. The increase
in
the negative gap position in the one-year time frame was primarily the result
of
changes in the repricing and maturity structure of the Bank’s interest sensitive
liabilities. The amount of time deposits maturing or repricing in less than
one
year increased significantly. At September 30, 2006, $142,923,000, or 67.6
percent, of total time deposits were scheduled to reprice or mature in the
next
twelve months. This level compares to $95,840,000, or 45.4 percent, of total
time deposits at December 31, 2005. In addition, balances in the Treasury Select
Money Market account increased by $15,241,000 between December 31, 2005 and
September 30, 2006. Both of these events reflect consumers desire to invest
in
shorter term investments whose rates have increased significantly and which
could increase further if market rates
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
INTEREST
RATE SENSITIVITY
(Continued)
continue
to increase. Also contributing to the increase in interest sensitive liabilities
was the interest bearing municipal deposit accounts which increased by
$9,045,000 between December 31, 2005 and September 30, 2006 due to the seasonal
tax deposits of the municipalities and school districts. On the asset side,
the
amount of assets maturing or repricing increased by $9,460,000 from December
31,
2005 to September 30, 2006. This increase was primarily caused by the shorter
average life of the investment portfolio and a $7,976,000 increase in Federal
funds from December. This was offset by a decline of $6,333,000 in loans
maturing or repricing in the one-year time frame. This decline was partially
a
result of customers negotiating existing variable-rate loans to longer-term
fixed rate loans. This negative gap position has contributed to the decline
in
the net interest margin as interest rates have increased on a greater amount
of
liabilities than earning assets.
QNB
also
uses a simulation model to assess the impact of changes in interest rates on
net
interest income. The model reflects management’s assumptions related to asset
yields and rates paid on liabilities, deposit sensitivity, and the size,
composition and maturity or repricing characteristics of the balance sheet.
The
assumptions are based on what management believes at that time to be the most
likely interest rate environment. Management also evaluates the impact of higher
and lower interest rates by simulating the impact on net interest income of
changing rates. While management performs rate shocks of 100, 200 and 300 basis
points, it believes, that given the level of interest rates at September 30,
2006, that it is unlikely that interest rates would decline by 300 basis points.
The simulation results can be found in the chart on page 36.
The
decline in net interest income in a rising rate environment is consistent with
the gap analysis and reflects the fixed-rate nature of the investment and loan
portfolio and the increased expense associated with higher costing deposits
and
short-term borrowings. Also, impacting net interest income in a rising rate
environment would be the conversion of some of the borrowings from the FHLB
from
fixed rate to variable rate tied to LIBOR. If converted, QNB has the option
to
return the borrowings to the FHLB without penalty. Net interest income increases
slightly if rates would to decline by 100 basis points. However, in the 200
basis point down scenario, net interest income remains relatively flat which
indicates the current interest pricing on interest-bearing transaction accounts,
regular money market accounts and savings accounts are at their hypothetical
floors. Interest rates on these products do not have the ability to decline
to
the degree that rates on earning assets can. These results are inconsistent
with
the gap analysis and identify some of the weaknesses of gap analysis which
does
not take into consideration the magnitude of the rate change on different
instruments or the timing of the rate change.
Actual
results may differ from simulated results due to various factors including
time,
magnitude and frequency of interest rate changes, the relationship or spread
between various rates, loan pricing and deposit sensitivity, and asset/liability
strategies.
Management
believes that the assumptions utilized in evaluating the vulnerability of QNB’s
net interest income to changes in interest rates approximate actual experience.
However, the interest rate sensitivity of QNB’s assets and liabilities, as well
as the estimated effect of changes in interest rates on net interest income,
could vary substantially if different assumptions are used or actual experience
differs from the experience on which the assumptions were based.
The
nature of QNB’s current operation is such that it is not subject to foreign
currency exchange or commodity price risk. Additionally, neither the Corporation
nor the Bank owns trading assets. At September 30, 2006, QNB did not have any
hedging transactions in place such as interest rate swaps, caps or
floors.
QNB
CORP. AND SUBSIDIARY
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
INTEREST
RATE SENSITIVITY
(Continued)
The
table
below summarizes estimated changes in net interest income over a twelve-month
period, under alternative interest rate scenarios.
|
Change
in Interest Rates
|
Net
Interest Income
|
Dollar
Change
|
%
Change
|
|||||||
|
+300
Basis Points
|
$
|
13,010
|
$
|
(2,815
|
)
|
(17.79
|
)%
|
|||
|
+200
Basis Points
|
14,020
|
(1,805
|
)
|
(11.41
|
)
|
|||||
|
+100
Basis Points
|
15,101
|
(724
|
)
|
(4.57
|
)
|
|||||
|
FLAT
RATE
|
15,825
|
—
|
—
|
|||||||
|
-100
Basis Points
|
16,084
|
259
|
1.64
|
|||||||
|
-200
Basis Points
|
15,822
|
(3
|
)
|
(0.02
|
)
|
|||||
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF RESULTS
OF
OPERATIONS AND FINANCIAL CONDITION
The
information required herein is set forth in Item 2, above.
We
maintain a system of controls and procedures designed to provide reasonable
assurance as to the reliability of the consolidated financial statements and
other disclosures included in this report, as well as to safeguard assets from
unauthorized use or disposition. We evaluated the effectiveness of the design
and operation of our disclosure controls and procedures under the supervision
and with the participation of management, including our Chief Executive Officer
and Chief Financial Officer. Based upon that evaluation, our Chief Executive
Officer and Chief Financial Officer concluded that our disclosure controls
and
procedures are effective as of the end of the period covered by this report.
No
changes were made to our internal controls over financial reporting or other
factors that have materially affected, or are reasonably likely to materially
affect, these controls during the prior fiscal quarter covered by this
report.
QNB
CORP. AND SUBSIDIARY
SEPTEMBER
30, 2006
| Item 1. |
Legal
Proceedings
|
None.
| Item 1A. |
Risk
Factors
|
There
were no material changes to the Risk Factors described in Item 1A in QNB’s
Annual Report
on
Form 10-K for the period ended December 31, 2005.
| Item 2. |
Unregistered
Sales of Equity Securities and Use of
Proceeds
|
None.
| Item 3. |
Default
Upon Senior Securities
|
None.
| Item 4. |
Submission
of Matters to Vote of Security
Holders
|
None.
| Item 5. |
Other
Information
|
None.
| Item 6. |
Exhibits
|
| Exhibit 3(i) |
Articles
of Incorporation of Registrant, as amended. (Incorporated by reference
to
Exhibit 3(i) of Registrants Form DEF 14-A filed with the Commission
on
April 15, 2005).
|
| Exhibit 3(ii) |
Bylaws
of Registrant, as amended. (Incorporated by reference to Exhibit
3(ii) of
Registrants Form 8-K filed with the Commission on January 23,
2006).
|
| Exhibit 10.9 |
QNB
Corp. 2006 Employee Stock Purchase Plan. (Incorporated by reference
to
Exhibit 99.1 to Registration Statement No. 333-135408 on Form S-8,
filed
with the Commission on June 28,
2006.)
|
| Exhibit 11 |
Statement
Re: Computation of Earnings Per Share. (Included in Part I, Item
I,
hereof.)
|
| Exhibit 31.1 |
Section
302 Certification of President and
CEO
|
| Exhibit 31.2 |
Section
302 Certification of Chief Financial
Officer
|
| Exhibit 32.1 |
Section
906 Certification of President and
CEO
|
| Exhibit 32.2 |
Section
906 Certification of Chief Financial
Officer
|
Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant
has
duly caused this Report to be signed on its behalf by the undersigned, thereunto
duly authorized.
QNB
Corp.
Date:
November
8, 2006
By:
/s/
Thomas J. Bisko
Thomas
J.
Bisko
President/CEO
Date:
November
8, 2006
By:
/s/
Bret
H. Krevolin
Bret
H.
Krevolin
Chief
Financial Officer
-39-