Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 for the fiscal year ended DECEMBER 31, 2004
[ ] For the transition period from __________________________ to TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
Commission file number 0-17706
[LOGO OMITTED]
(Exact name of registrant as specified in its charter)
PENNSYLVANIA 23-2318082
- ------------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
15 NORTH THIRD STREET, QUAKERTOWN, PA 18951-9005
- ---------------------------------------------- -------------------------------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (215) 538-5600
Securities registered pursuant to Section 12(b) of the Act: None.
Securities registered pursuant to Section 12(g) of the Act:
Title of each class Name of each exchange on which registered
------------------- -----------------------------------------
COMMON STOCK, $.625 PAR VALUE N/A
- ------------------------------
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 X NO ____
-------
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [ ]
Indicate by check mark whether the Registrant is an accelerated filer
(as defined in Exchange Act Rule 12b-2).
YES X NO ____
-------
As of March 1, 2005, 3,098,098 shares of Common Stock of the Registrant were
outstanding. As of June 30, 2004, the aggregate market value of the Common Stock
of the Registrant, held by nonaffiliates was approximately $84,025,540 based
upon the average bid and ask price of the common stock as reported on the OTC
BB.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Registrant's Proxy Statement dated for the annual meeting of its
shareholders to be held May 17, 2005 are incorporated by reference in Part III
and IV of this report.
FORM 10-K INDEX
PART I PAGE
Item 1 Business.....................................................................................3
Item 2 Properties...................................................................................8
Item 3 Legal Proceedings............................................................................8
Item 4 Submission of Matters to a Vote of Security Holders..........................................8
PART II
Item 5 Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities..............................................9
Item 6 Selected Financial Data.....................................................................10
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations.............................................................10
Item 7A Quantitative and Qualitative Disclosures about Market Risk..................................32
Item 8 Financial Statements and Supplementary Data.................................................34
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure..............................................................59
Item 9A Controls and Procedures.....................................................................59
Item 9B Other Information ..........................................................................59
PART III
Item 10 Directors and Executive Officers of the Registrant..........................................60
Item 11 Executive Compensation......................................................................60
Item 12 Security Ownership of Certain Beneficial Owners and Management .............................60
Item 13 Certain Relationships and Related Transactions..............................................60
Item 14 Principal Accounting Fees and Services......................................................60
PART IV
Item 15 Exhibits, Financial Statement Schedules.....................................................61
2
PART I
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 we incorporate 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 our forward-looking statements contained or incorporated by
reference in this document. These factors include, but are not limited, to the
following:
o Operating, legal and regulatory risks
o Economic, political and competitive forces affecting our line of
business
o The risk that our analysis of these risks and forces could be
incorrect, and/or that the strategies developed to address them
could be unsuccessful
o Volatility in interest rates
o Increased credit risk
QNB Corp. (herein referred to as 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 our actual results or
circumstances for future periods to differ materially from those anticipated or
projected. Except as required by law, we do not undertake, and specifically
disclaim any obligation, to publicly release any revisions to any
forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
ITEM 1. BUSINESS
OVERVIEW
QNB Corp. was incorporated under the laws of the Commonwealth of Pennsylvania on
June 4, 1984. QNB Corp. is registered with the Federal Reserve Board as a bank
holding company under the Bank Holding Company Act of 1956 and conducts its
business through its wholly-owned subsidiary, The Quakertown National Bank.
The Quakertown National Bank is a national banking association organized in
1877. The Quakertown National Bank is chartered under the National Banking Act
and is subject to Federal and state laws applicable to commercial banks.
The Quakertown National Bank is engaged in the general commercial banking
business and provides a full range of banking services and trust services to its
customers. These banking services consist of, among other things, attracting
deposits and using these funds in making commercial loans, residential mortgage
loans, consumer loans, and purchasing investment securities. These deposits are
in the form of time, demand and savings accounts. Such time deposits include
certificates of deposit and individual retirement accounts. The Bank's savings
accounts include money market accounts, club accounts, interest-bearing demand
accounts and traditional statement savings accounts.
o The Quakertown National Bank's principal office is located in
Quakertown, Bucks County, Pennsylvania. The Quakertown National Bank
also operates seven other full service community banking offices in
Bucks, Montgomery and Lehigh counties in southeastern Pennsylvania.
o At December 31, 2004, QNB had total assets of approximately
$583,644,000, total loans of approximately $268,048,000, total deposits
of approximately $466,488,000 and total shareholders' equity of
approximately $45,775,000.
o For the year ended December 31, 2004, QNB reported record net income of
$6,203,000 compared to net income for the year ended December 31, 2003
of $5,648,000, an increase of 9.8 percent.
o At the end of 2004, QNB experienced its ninth consecutive year of
increased earnings and increased dividends.
3
At February 14, 2005, The Quakertown National Bank had 141 full time employees
and 36 part-time employees. These employees have a customer-oriented philosophy,
a strong commitment to service and a "sincere interest" in their customers'
success. They maintain close contact with both the residents and local business
communities in which they serve, responding to customer requests timely.
COMPETITION AND MARKET AREA
The banking business is highly competitive, and the profitability of QNB Corp.
depends principally upon The Quakertown National Bank's ability to compete in
its market area. We face intense competition within our market both in making
loans and attracting deposits. The upper Bucks, southern Lehigh, and northern
Montgomery areas have a high concentration of financial institutions including
large national and regional banks, community banks, savings institutions and
credit unions. Some of our competitors offer products and services that we
currently do not offer, such as private banking. However, we have 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, the establishment of long-term
customer relationships and customer loyalty, and products and services designed
to address the specific needs of our customers.
Our competition for loans and deposits comes principally from commercial banks,
savings institutions, credit unions and non-bank financial service providers.
Factors in successfully competing for deposits include providing attractive
rates, low fees, convenient locations and hours of operation and alternative
delivery systems. Successful loan origination tends to depend on size, rate and
terms of the loan. Many competitors within the Bank's primary market have
substantially higher legal lending limits.
Our success is dependent to a significant degree on economic conditions in
eastern Pennsylvania, especially upper Bucks, southern Lehigh and northern
Montgomery counties, which we define as our primary market. The banking industry
is affected by general economic conditions including the effects of inflation,
recession, unemployment, real estate values, trends in the national and global
economies, and other factors beyond our control.
SUPERVISION AND REGULATION
Bank holding companies and banks operate in a highly regulated environment and
are regularly examined by Federal and state regulatory authorities. Federal
statutes that apply to QNB and its subsidiaries include the Gramm-Leach-Bliley
Act (GLBA), the Bank Holding Company Act of 1956 (BHCA), the Federal Reserve Act
and the Federal Deposit Insurance Act. In general, these statutes establish the
corporate governance and eligible business activities of QNB, certain
acquisition and merger restrictions, limitations on inter-company transactions,
such as loans and dividends, and capital adequacy requirements, among other
regulations.
To the extent that the following information describes statutory or regulatory
provisions, it is qualified in its entirety by references to the particular
statutory or regulatory provisions themselves. Proposals to change banking laws
and regulations are frequently introduced in Congress, the state legislatures,
and before the various bank regulatory agencies. QNB cannot determine the
likelihood of passage or timing of any such proposals or legislation or the
impact they may have on QNB and its subsidiary. A change in law, regulations or
regulatory policy may have a material effect on QNB and its subsidiary.
BANK HOLDING COMPANY REGULATION
QNB is registered as a bank holding company and is subject to the regulations of
the Board of Governors of the Federal Reserve System (the Federal Reserve) under
the BHCA. In addition, QNB Corp., as a Pennsylvania business corporation, is
also subject to the provisions of Section 115 of the Pennsylvania Banking Code
of 1965.
Bank holding companies are required to file periodic reports with, and are
subject to examination by, the Federal Reserve. The Federal Reserve's
regulations require a bank holding company to serve as a source of financial and
managerial strength to its subsidiary banks. As a result, the Federal Reserve,
pursuant to its "source of strength" regulations, may require QNB Corp. to
commit its resources to provide adequate capital funds to The Quakertown
National Bank during periods of financial distress or adversity. The support may
be required at times when QNB Corp. is unable to provide such support.
Depending on the circumstances, Federal Reserve approval may be required before
QNB Corp. may begin to engage in any non-banking activity and before any
non-banking business may be acquired by QNB.
DIVIDEND RESTRICTIONS
Federal and state laws regulate the payment of dividends by QNB Corp's
subsidiary. Under the National Bank Act, The Quakertown National Bank is
required to obtain the prior approval of the OCC for the payment of dividends if
4
the total of all dividends declared by it in one year would exceed its net
profits for the current year plus its retained net profits for the two preceding
years, less any required transfers to surplus. In addition, the bank may only
pay dividends to the extent that its retained net profits (including the portion
transferred to surplus) exceed statutory bad debts. Under the FDIA, the bank is
prohibited from paying any dividends, making other distributions or paying any
management fees if, after such payment, it would fail to satisfy its minimum
capital requirements. See also "Supervision and Regulation - Bank Regulation".
Further, it is the policy of the Federal Reserve that bank holding companies
should pay dividends only out of current earnings. Federal banking regulators
also have the authority to prohibit banks and bank holding companies from paying
a dividend if they should deem such payment to be an unsafe or unsound practice.
CAPITAL ADEQUACY
Bank holding companies are required to comply with the Federal Reserve's
risk-based capital guidelines. The required minimum ratio of total capital to
risk-weighted assets (including certain off-balance sheet activities, such as
standby letters of credit) is 8 percent. At least half of total capital must be
"Tier 1 capital". Tier 1 capital consists principally of common shareholders'
equity, plus retained earnings, less certain intangible assets. The remainder of
total capital may consist of the allowance for loan loss (Tier 2 capital). At
December 31, 2004, QNB Corp.'s Tier 1 capital and total (Tier 1 and Tier 2
combined) capital ratios were 12.25 percent and 12.98 percent, respectively.
In addition to the risk-based capital guidelines, the Federal Reserve requires a
bank holding company to maintain a minimum "leverage ratio". This requires a
minimum level of Tier 1 capital (as determined under the risk-based capital
rules) to average total consolidated assets of 4 percent for those bank holding
companies that have the highest regulatory examination ratings and are not
contemplating or experiencing significant growth or expansion. The Federal
Reserve expects all other bank holding companies to maintain a ratio of at least
1 percent to 2 percent above the stated minimum. At December 31, 2004, QNB
Corp.'s leverage ratio was 7.44 percent.
Pursuant to the "prompt corrective action" provisions of the FDIA, the federal
banking agencies have specified, by regulation, the levels at which an insured
institution is considered "well capitalized", "adequately capitalized",
"undercapitalized", "significantly undercapitalized", or "critically
undercapitalized." Under these regulations, an institution is considered "well
capitalized" if it satisfies each of the following requirements:
o Total risk-based capital ratio of 10 percent or more,
o Tier 1 risk-based capital ratio of 6 percent or more,
o Leverage ratio of 5 percent or more, and
o Not subject to any order or written directive to meet and maintain a
specific capital level
At December 31, 2004, QNB Corp. qualified as "well capitalized" under these
regulatory standards. See Note 20 of the Notes to Consolidated Financial
Statements included at Item 8 of this Report.
BANK REGULATION
The operations of The Quakertown National Bank are subject to Federal and state
statutes applicable to banks chartered under the banking laws of the United
States, to members of the Federal Reserve System, and to banks whose deposits
are insured by the FDIC. These operations are also subject to regulations of the
Office of the Comptroller of the Currency (OCC), the Federal Reserve, and the
FDIC.
The OCC, which has primary supervisory authority over The Quakertown National
Bank, regularly examines banks in such areas as reserves, loans, investments,
management practices and other aspects of operations. These examinations are
designed for the protection of depositors rather than QNB Corp.'s shareholders.
The bank must furnish annual and quarterly reports to the OCC, which has the
authority under the Financial Institutions Supervisory Act and the Federal
Deposit Insurance Act, to prevent a national bank from engaging in an unsafe or
unsound practice in conducting its business or from otherwise conducting
activities in violation of the law.
Federal and state banking laws and regulations govern, among other things, the
scope of a bank's business, the investments a bank may make, the reserves
against deposits a bank must maintain, the types and terms of loans a bank may
make and the collateral it may take, the activities of a bank with respect to
mergers and consolidations, and the establishment of branches. Pennsylvania law
permits statewide branching.
As a subsidiary bank of a bank holding company, The Quakertown National Bank is
subject to certain restrictions imposed by the Federal Reserve Act on extensions
of credit to QNB Corp. or its subsidiaries, on investments in the stock or other
securities of QNB Corp. or its subsidiaries, and on taking such stock or
securities as collateral for loans.
5
The Bank is a member of the Federal Reserve System and therefore, the policies
and regulations of the Federal Reserve Board have a significant impact on many
elements of the Bank's operations including the ability to grow deposits, loan
growth, the rate of interest earned and paid, levels of liquidity and levels of
required capital. Management cannot predict the effects of such policies and
regulations upon the Bank's business model and the corresponding impact they may
have on future earnings.
FDIC INSURANCE ASSESSMENTS
The Quakertown National Bank is subject to deposit insurance assessments by the
Federal Deposit Insurance Corporation (FDIC) based on the risk classification of
the Bank. The Quakertown National Bank was not subject to any regular insurance
assessments by the FDIC in 2004. Under current FDIC practices, The Quakertown
National Bank does not expect to be required to pay regular insurance
assessments to the FDIC in 2005.
Insured deposits are assessed to fund debt service on certain related Federal
government bonds. The current annualized rate established by the FDIC is $.017
per $100 of deposits. These assessment rates are set quarterly. The total
assessment paid by the Bank in 2004 was $64,000.
COMMUNITY REINVESTMENT ACT (CRA)
Under the Community Reinvestment Act, as amended, the OCC is required to assess
all financial institutions that it regulates to determine whether these
institutions are meeting the credit needs of the community that they serve. The
act focuses specifically on low and moderate-income neighborhoods. The OCC takes
an institution's record into account in its evaluation of any application made
by any of such institutions for, among other things:
o Approval of a branch or other deposit facility
o An office relocation or a merger
o Any acquisition of bank shares
The CRA, as amended, also requires that the OCC make publicly available the
evaluation of the bank's record of meeting the credit needs of its entire
community, including low and moderate-income neighborhoods. This evaluation
includes a descriptive rating of either outstanding, satisfactory, needs to
improve, or substantial noncompliance, and a statement describing the basis for
the rating. These ratings are publicly disclosed. The Bank's most recent CRA
rating was satisfactory.
MONETARY AND FISCAL POLICIES
The financial services industry, including QNB Corp. and The Quakertown
National Bank, is affected by the monetary and fiscal policies of government
agencies, including the Federal Reserve. Through open market securities
transactions and changes in its discount rate and reserve requirements, the
Federal Reserve exerts considerable influence over the cost and availability of
funds for lending and investment.
USA PATRIOT ACT
In October 2001, the President signed into the law the USA Patriot Act, which
strengthens anti-money laundering provisions of the Bank Secrecy Act. The Act
requires financial institutions to establish certain procedures to be able to
identify and verify the identity of its customers. Specifically, the new rules,
developed by the Secretary of the Treasury, require that the Bank have
procedures in place to:
o Verify the identity of persons applying to open an account,
o Ensure adequate maintenance of the records used to verify a person's
identity, and
o Determine whether a person is on any U.S. governmental agency list of
known or suspected terrorists or a terrorist organization
The Bank has implemented the required internal controls to ensure proper
compliance with the Patriot Act.
6
SARBANES-OXLEY ACT OF 2002
The Sarbanes-Oxley Act, signed into law July 30, 2002, was intended to bolster
public confidence in our nation's capital markets by imposing new duties and
penalties for non-compliance on public companies and their executives,
directors, auditors, attorneys and securities analysts. Some of the more
significant aspects of the act include:
o Corporate Responsibility for Financial Reports - requires Chief
Executive Officers (CEOs) and Chief Financial Officers (CFOs) to
personally certify and be accountable for their Corporations' financial
records and accounting and internal controls.
o Management Assessment of Internal Controls - requires auditors to
certify the Corporations' underlying controls and processes that are
used to compile the financial results.
o Real-time Issuer Disclosures - requires that companies provide real-time
disclosures of any events that may affect a firm's stock price or
financial performance within a 48-hour period.
o Criminal Penalties for Altering Documents - provides severe penalties
for "whoever knowingly alters, destroys, mutilates" any record or
document with intent to impede an investigation. Penalties include
monetary fines and prison time.
The act also imposes requirements for corporate governance, auditor independence
and accounting standards, executive compensation, insider loans and
whistleblower protection. As a result of Sarbanes-Oxley, QNB Corp. adopted a
Code of Business Conduct and Ethics applicable to its CEO, CFO and Controller,
which meets the requirements of Sarbanes-Oxley, to supplement its long-standing
Code of Ethics, which applies to all employees.
QNB Corp.'s Code of Business Conduct and Ethics can be found on the Company's
website at www.qnb.com.
ADDITIONAL INFORMATION
QNB Corp.'s principal executive offices are located at 15 North Third Street,
Quakertown, Pennsylvania 18951. Its telephone number is (215) 538-5600.
This annual report, including the exhibits and schedules filed as part of the
annual report on Form 10-K, may be inspected at the public reference facility
maintained by the Securities and Exchange Commission (SEC) at its public
reference room at 450 Fifth Street, NW, Washington, DC 20549 and copies of all
or any part thereof may be obtained from that office upon payment of the
prescribed fees. You may call the SEC at 1-800-SEC-0330 for further information
on the operation of the public reference room and you can request copies of the
documents upon payment of a duplicating fee, by writing to the SEC. In addition,
the SEC maintains a website that contains reports, proxy and information
statements and other information regarding registrants, including QNB Corp.,
that file electronically with the SEC which can be accessed at www.sec.gov.
QNB Corp. also makes its periodic and current reports available, free of charge,
on its website, www.qnb.com., as soon as reasonably practicable after such
material is electronically filed with the SEC. Information available on our
website is not a part of, and should not be incorporated into, this annual
report on Form 10-K.
7
ITEM 2. PROPERTIES
The Quakertown National Bank and QNB Corp.'s main office is located at 15 North
Third Street, Quakertown, Pennsylvania. The Quakertown National Bank conducts
business from its main office and seven other retail offices located in upper
Bucks, southern Lehigh, and northern Montgomery counties. The Quakertown
National Bank owns its main office, two retail locations, its operations
facility and an adjacent property for expansion, and a computer facility. The
Quakertown National Bank leases its remaining five retail properties. The leases
on the properties generally contain renewal options. Management considers that
its facilities are adequate for its business.
The following table details The Quakertown National Bank's properties:
Location
Quakertown, Pa. - Main Office Owned
15 North Third Street
Quakertown, Pa. - Towne Bank Center Owned
320-322 West Broad Street
Quakertown, Pa. - Computer Center Owned
121 West Broad Street
Quakertown, Pa. - Country Square Office Leased
240 South West End Boulevard
Quakertown, Pa. - Quakertown Commons Branch Leased
901 South West End Boulevard
Dublin, Pa. - Dublin Branch Leased
161 North Main Street
Pennsburg, Pa. - Pennsburg Square Branch Leased
410-420 Pottstown Ave
Coopersburg, Pa. - Coopersburg Branch Owned
51 South Third Street
Perkasie, Pa. - Perkasie Branch Owned
607 Chestnut Street
Souderton, Pa. - Souderton Branch Leased
750 Route 113
In management's opinion, these properties are in good condition and are adequate
for QNB Corp.'s purposes.
ITEM 3. LEGAL PROCEEDINGS
Management, after consulting with legal counsel, is not aware of any litigation
that would have a material adverse effect on the consolidated financial position
of QNB Corp. There are no proceedings pending other than ordinary routine
litigation incidental to the business of QNB Corp. and its subsidiary, The
Quakertown National Bank. In addition, no material proceedings are known to be
contemplated by governmental authorities against QNB Corp. or The Quakertown
National Bank or any of their properties.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
8
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
STOCK INFORMATION
QNB Corp. common stock is traded in the over-the-counter (OTC) market.
Quotations for QNB Corp. common stock appear in the pink sheets published by the
National Quotations Bureau, Inc. QNB Corp. had 720 shareholders of record as of
March 1, 2005.
The following table sets forth representative high and low bid and ask stock
prices for QNB Corp. common stock on a quarterly basis during 2004 and 2003. All
periods presented have been restated to reflect the two-for-one stock split
distributed October 14, 2003.
- --------------------------------------------------------------------------------
CASH
HIGH LOW DIVIDEND
BID ASK BID ASK PER SHARE
- --------------------------------------------------------------------------------
2004
First Quarter $ 34.800 $ 34.750 $ 33.100 $ 33.800 $ .185
Second Quarter 34.000 40.000 30.250 30.950 .185
Third Quarter 31.750 32.500 31.100 31.500 .185
Fourth Quarter 32.500 34.000 31.300 31.500 .185
- --------------------------------------------------------------------------------
2003
First Quarter $ 20.500 $ 24.500 $ 20.000 $ 20.625 $ .165
Second Quarter 22.750 24.500 20.300 21.500 .165
Third Quarter 31.375 35.000 22.750 23.375 .165
Fourth Quarter 34.750 39.000 31.000 32.000 .165
- --------------------------------------------------------------------------------
QNB Corp. has traditionally paid quarterly cash dividends on the last Friday of
each quarter. The Corporation expects to continue the practice of paying
quarterly cash dividends to its shareholders; however, future dividends are
dependent upon future earnings. Certain laws restrict the amount of dividends
that may be paid to shareholders in any given year. See "Supervision and
Regulation - Bank Regulation," found on page 5 of this Form 10-K filing, and
Note 20 of the Notes to Consolidated Financial Statements, found on page 57 of
this Form 10-K filing, for the information that discusses and quantifies this
regulatory restriction.
EQUITY COMPENSATION PLAN INFORMATION
The following table summarizes our equity compensation plan information as of
December 31, 2004. Information is included for both equity compensation plans
approved by QNB shareholders and equity compensation plans not approved by QNB
shareholders.
- ------------------------------------------------------------------------------------------------------------------------------------
NUMBER OF SHARES
NUMBER OF SHARES WEIGHTED-AVERAGE AVAILABLE FOR FUTURE
TO BE ISSUED UPON EXERCISE PRICE OF ISSUANCE UNDER EQUITY
EXERCISE OF OUTSTANDING COMPENSATION PLANS
OUTSTANDING OPTIONS, OPTIONS, WARRANTS [EXCLUDING SECURITIES
PLAN CATEGORY WARRANTS AND RIGHTS AND RIGHTS REFLECTED IN COLUMN (A)]
- ------------------------------------------------------------------------------------------------------------------------------------
(a) (b) (c)
- ------------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans approved by QNB Corp. shareholders
1998 Stock Option Plan 182,392 $18.03 28,836
2001 Employee Stock Purchase Plan - - 30,888
- ------------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans not approved by QNB Corp. shareholders
None - - --
- ------------------------------------------------------------------------------------------------------------------------------------
TOTALS 182,392 $18.03 59,724
====================================================================================================================================
9
ITEM 6. SELECTED FINANCIAL AND OTHER DATA
- ------------------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
INCOME AND EXPENSE
Interest income............................................. $ 25,571 $ 25,139 $ 27,191 $ 26,928 $ 24,698
Interest expense............................................ 9,506 9,754 12,076 13,404 12,007
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest income........................................ 16,065 15,385 15,115 13,524 12,691
Provision for loan losses................................... - - - - -
Non-interest income......................................... 4,687 4,200 2,989 3,070 2,791
Non-interest expense........................................ 12,845 12,683 11,945 11,080 10,232
- ------------------------------------------------------------------------------------------------------------------------------------
Income before income taxes ................................ 7,907 6,902 6,159 5,514 5,250
Provision for income taxes.................................. 1,704 1,254 1,204 1,078 1,144
- ------------------------------------------------------------------------------------------------------------------------------------
Net income.................................................. $ 6,203 $ 5,648 $ 4,955 $ 4,436 $ 4,106
====================================================================================================================================
PER SHARE DATA
Net income - basic.......................................... $ 2.00 $ 1.83 $ 1.61 $ 1.44 $ 1.30
Net income - diluted........................................ 1.95 1.79 1.59 1.43 1.30
Book value.................................................. 14.78 14.03 13.28 11.46 10.21
Cash dividends.............................................. .74 .66 .60 .54 .46
Average common shares outstanding - basic................... 3,096,360 3,091,640 3,078,550 3,088,020 3,146,642
Average common shares outstanding - diluted................. 3,178,152 3,153,305 3,109,353 3,094,735 3,147,239
BALANCE SHEET AT YEAR-END
Investment securities available-for-sale.................... $ 267,561 $ 260,631 $ 211,156 $ 165,362 $ 111,093
Investment securities held-to-maturity...................... 6,203 12,012 29,736 42,798 42,982
Non-marketable equity securities............................ 3,947 3,810 3,585 2,740 3,152
Loans held-for-sale......................................... 312 1,439 4,159 2,122 1,642
Loans, net of unearned income............................... 268,048 232,127 212,691 200,089 183,592
Other earning assets........................................ 4,140 5,381 10,310 5,888 3,226
Total assets................................................ 583,644 550,831 503,430 451,274 371,671
Deposits.................................................... 466,488 438,639 388,913 344,731 293,822
Borrowed funds.............................................. 68,374 65,416 69,485 66,541 42,819
Shareholders' equity........................................ 45,775 43,440 40,914 35,219 31,794
SELECTED FINANCIAL RATIOS
Net interest margin......................................... 3.32% 3.40% 3.68% 3.81% 4.02%
Net income as a percentage of:
Average total assets..................................... 1.10 1.07 1.03 1.07 1.13
Average shareholders' equity................................ 14.43 14.38 13.88 13.54 13.25
Average shareholders' equity to average total assets ....... 7.64 7.46 7.45 7.93 8.53
Dividend payout ratio....................................... 36.95 36.15 37.29 37.32 34.75
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
OVERVIEW
QNB had its ninth consecutive year of record earnings in 2004. QNB's net income
for 2004 were $6,203,000, a 9.8 percent increase from the $5,648,000 reported in
2003. This represents basic net income per share of $2.00 and $1.83 for 2004 and
2003, respectively. On a diluted basis, net income per share was $1.95 and $1.79
for 2004 and 2003, respectively. Net income for 2002 was $4,955,000, or $1.61
and $1.59 per share on a basic and diluted basis, respectively.
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 and return on average shareholders' equity were
1.10 percent and 14.43 percent, respectively, in 2004 compared with 1.07 percent
and 14.38 percent in 2003 and 1.03 percent and 13.88 percent in 2002.
10
2004 VERSUS 2003
The 2004 results compared to 2003 included the following significant components:
o Net interest income increased $680,000, or 4.4 percent, to $16,065,000.
o Contributing to the increase in net interest income was a 6.8 percent
increase in average earning assets. The average balance of loans
increased by 8.6 percent, while the year-end 2003 to year-end 2004
balances increased 15.5 percent. Average deposits increased 7.3 percent
during 2004.
o The net interest margin declined 8 basis points to 3.32 percent.
Included in net interest income for 2004 is the recognition of $111,000
in interest on non-accrual loans.
o The Federal Reserve Bank Board raised the Federal funds rate from 1.00
percent to 2.25 percent during the last six months of 2004. The yield
curve flattened as short-term rates increased more than mid- and
long-term interest rates.
Non-interest income increased $487,000, or 11.6 percent, to $4,687,000.
o The net gain on the sale of investment securities increased $983,000,
while the net gain on the sale of loans decreased $769,000. The gain on
the sale of investment securities is primarily from the sales of equity
securities. The decline in the gain on the sale of loans is a result of
the decline in mortgage activity resulting from higher interest rates.
o A $141,000 gain on the liquidation of assets relinquished by a borrower
partially offsets the $350,000 charge-off recorded through the allowance
for loan losses during the third quarter of 2004, related to this loan.
o Service charges on deposit accounts increased $151,000, primarily a
result of an increase in overdraft income.
o Non-interest income in 2003 included tax-exempt life insurance proceeds
of $109,000 and dividends from QNB's interest in a title insurance
company of $70,000.
Non-interest expense increased $162,000, or 1.3 percent, to $12,845,000.
o Salary and benefit expense decreased by $32,000. Contributing to the
lower salary expense was a reduction in incentive compensation of
$247,000.
o The opening of QNB's first supermarket branch in 2004 contributed to the
increase in net occupancy, furniture and fixtures and marketing expense.
o The effective tax rate was 21.6 percent for 2004 compared to 18.2
percent for 2003. Contributing to the lower effective tax rate in 2003
was the reversal of a $95,000 tax valuation recorded in 2002. The
receipt of $109,000 in tax-exempt life insurance proceeds also had a
beneficial impact on the effective tax rate in 2003.
2003 VERSUS 2002
The 2003 results compared to 2002 included the following significant components:
Net interest income increased $270,000, or 1.8 percent, to $15,385,000.
o Contributing to the increase in net interest income was a 9.9 percent
increase in average earning assets. This offset a 28 basis point
reduction in the net interest margin to 3.40 percent.
o Average deposits increased by 12.7 percent, while average loans and
investment securities increased by 10.4 percent and 8.4 percent,
respectively.
Non-interest income increased $1,211,000, or 40.5 percent, to $4,200,000.
o A record low interest rate environment resulted in significant mortgage
refinancing activity. The increased activity resulted in an increase in
the gain on the sale of loans of $247,000.
o The loss on investment securities was $134,000 in 2003 compared to a
loss of $779,000 in 2002.
o Tax-exempt proceeds from life insurance was $109,000
Non-interest expense increased $738,000, or 6.2 percent, to $12,683,000.
o Personnel expense increased $664,000 with a new incentive compensation
plan contributing $257,000 to the increase. Medical insurance premiums
increased $68,000.
o The effective tax rate was 18.2 percent for 2003 compared to 19.5
percent for 2002. The lower effective tax rate in 2003 was a result of
the items discussed above, relating to the tax valuation and life
insurance proceeds.
These items as well as others will be explained more thoroughly in the next
sections.
11
AVERAGE BALANCES, RATES, AND INTEREST INCOME AND EXPENSE SUMMARY (TAX-EQUIVALENT BASIS)
2004 2003 2002
AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE RATE INTEREST BALANCE RATE INTEREST BALANCE RATE INTEREST
- ------------------------------------------------------------------------------------------------------------------------------------
ASSETS
- ------------------------------------------------------------------------------------------------------------------------------------
Federal funds sold................... $ 6,834 1.37% $ 93 $ 11,236 1.12% $ 126 $ 9,363 1.63% $ 152
- ------------------------------------------------------------------------------------------------------------------------------------
Investment securities:
U.S. Treasury..................... 6,536 1.97 129 6,697 2.65 177 6,530 4.45 291
U.S. Government agencies.......... 35,239 3.65 1,286 37,392 4.27 1,595 29,844 5.47 1,632
State and municipal............... 51,548 6.54 3,369 46,631 6.86 3,199 42,235 7.10 2,998
Mortgage-backed and CMOs.......... 141,464 4.25 6,012 124,002 4.19 5,195 118,135 5.40 6,382
Other............................. 29,890 5.33 1,594 31,870 5.39 1,719 30,840 6.11 1,885
- ------------------------------------------------------------------------------------------------------------------------------------
Total investment securities..... 264,677 4.68 12,390 246,592 4.82 11,885 227,584 5.79 13,188
- ------------------------------------------------------------------------------------------------------------------------------------
Loans:
Commercial real estate............... 114,804 5.88 6,748 105,670 6.19 6,545 90,346 7.58 6,852
Residential real estate.............. 20,820 6.22 1,296 24,630 6.78 1,669 27,628 7.16 1,979
Home equity loans.................... 54,910 5.71 3,134 47,741 6.43 3,070 41,286 7.11 2,934
Commercial and industrial............ 41,511 5.02 2,084 35,927 5.25 1,885 31,553 6.38 2,014
Consumer loans....................... 5,673 9.32 529 6,299 9.87 622 6,779 8.90 603
Tax-exempt loans..................... 12,627 5.23 661 10,261 6.17 633 11,190 6.91 773
- ------------------------------------------------------------------------------------------------------------------------------------
Total loans, net of unearned
income* ..................... 250,345 5.77 14,452 230,528 6.26 14,424 208,782 7.26 15,155
- ------------------------------------------------------------------------------------------------------------------------------------
Other earning assets................. 4,866 1.63 80 4,882 1.84 90 3,188 3.40 108
- ------------------------------------------------------------------------------------------------------------------------------------
Total earning assets............ 526,722 5.13 27,015 493,238 5.38 26,525 448,917 6.37 28,603
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and due from banks.............. 20,074 18,207 15,495
Allowance for loan losses............ (2,843) (2,937) (2,887)
Other assets......................... 18,629 18,266 17,969
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets.................... $ 562,582 4.80% $ 526,774 5.04% $479,494 5.97%
====================================================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------------------------------------------------------------------------------------------------------
Interest-bearing deposits
Interest-bearing demand accounts.... $ 100,684 .68% 681 $ 87,570 .63% 554 $ 61,006 .64% 393
Money market accounts................ 44,364 .99 441 36,138 .83 298 37,171 1.51 559
Savings ............................. 54,613 .39 215 50,616 .64 324 41,764 1.19 497
Time ................................ 156,511 2.65 4,153 152,321 2.96 4,511 141,854 4.12 5,843
Time over $100,000 .................. 40,880 2.42 990 43,289 2.49 1,080 46,354 3.48 1,614
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits. 397,052 1.63 6,480 369,934 1.83 6,767 328,149 2.71 8,906
- ------------------------------------------------------------------------------------------------------------------------------------
Short-term borrowings................ 11,938 1.03 124 10,226 1.04 106 13,880 1.90 264
Federal Home Loan Bank advances...... 55,000 5.28 2,902 55,000 5.24 2,881 54,540 5.33 2,906
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing
liabilities .................. 463,990 2.05 9,506 435,160 2.24 9,754 396,569 3.05 12,076
- ------------------------------------------------------------------------------------------------------------------------------------
Non-interest-bearing deposits........ 52,691 49,164 43,569
Other liabilities.................... 2,926 3,164 3,649
Shareholders' equity................. 42,975 39,286 35,707
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities and
shareholders' equity......... $ 562,582 1.69% $ 526,774 1.85% $479,494 2.52%
====================================================================================================================================
Net interest rate spread............. 3.08% 3.14% 3.32%
====================================================================================================================================
Margin/net interest income........... 3.32% $17,509 3.40% $ 16,771 3.68% $16,527
====================================================================================================================================
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.
12
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 years ended
December 2004, 2003 and 2002.
NET INTEREST INCOME
- ------------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest income..................................................................... $ 25,571 $ 25,139 $ 27,191
Total interest expense.................................................................... 9,506 9,754 12,076
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest income....................................................................... 16,065 15,385 15,115
Tax equivalent adjustment................................................................. 1,444 1,386 1,412
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest income (fully taxable equivalent)............................................ $ 17,509 $ 16,771 $ 16,527
====================================================================================================================================
Net interest income is the primary source of operating income for QNB. Net
interest income is interest income, dividends, and fees on earning assets, less
interest expense incurred for funding sources. Earning assets primarily include
loans, investment securities and Federal funds sold. Sources used to fund these
assets include deposits, borrowed funds and earnings. 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 table that appears on page 12. 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 margin includes interest-free sources of funds.
On a fully tax-equivalent basis, net interest income for 2004 increased
$738,000, or 4.4 percent, to $17,509,000. As has been the trend, the ability to
increase net interest income is a result of the growth in deposits and the
investment of these deposits into profitable loans and investment securities.
This growth in earning assets has been able to offset the continued decline in
the net interest margin resulting from the low interest rate environment of the
past few years. While core deposits continued to increase, a significant
contributor to the growth in deposits in 2004 was additional deposits of local
municipalities and school districts. The majority of the growth in these
deposits is seasonal and will likely be withdrawn during the first and second
quarters of 2005. These deposits were primarily invested in securities whose
cash flow will closely match the anticipated run-off of the deposits.
Average earning assets increased 6.8 percent in 2004 while the net interest
margin and net interest rate spread declined by 8 basis points and 6 basis
points, respectively. The net interest margin decreased to 3.32 percent in 2004
from 3.40 percent in 2003, while the net interest rate spread decreased to 3.08
percent in 2004 from 3.14 percent in 2003. Included in net interest income for
2004 is the recognition of $111,000 in interest on non-accrual loans that have
been paid in full. Excluding the impact of the recognition of interest on
non-accrual loans, the net interest margin would have been 3.30 percent for
2004.
The interest rate graph on this page shows the trend in market interest rates
for the period 2002-2004.
The year 2003 began with expectations of a slowly improving economy and rising
interest rates. While the economy did show signs of growth, the uncertainty
created by the war in Iraq as well as concerns over the lack of job growth and
deflation kept interest rates at historically low levels. Interest rates were
extremely volatile over the course of 2003. The two-year, 10-year and 30-year
Treasury bonds all reached historic lows on June 13, 2003 of 1.10 percent, 3.13
percent and 4.17 percent, respectively. At the end of June, the Federal Reserve
Board dropped the Federal funds rate by 25 basis points to 1.00 percent. One
result of these record low rates was a sharp increase in residential mortgage
loan activity, both purchase mortgages and refinances. Interest rates rebounded
quickly with the 10-year hitting its high for the year of 4.61 percent in early
September and the 30-year hitting its high of 5.45 percent in August. The
shorter end of the yield curve was slower to react as a result of indications by
the Federal Reserve Board that it would be patient in raising the Federal funds
rate. The two-year Treasury bond reached its high for the year of 2.12 percent
in early December before finishing the year at 1.82 percent. The 10-year and
30-year bonds ended the year at 4.25 percent and 5.07 percent, respectively.
13
RATE-VOLUME ANALYSIS OF CHANGES IN NET INTEREST INCOME (TAX-EQUIVALENT BASIS)
- ------------------------------------------------------------------------------------------------------------------------------------
2004 VS. 2003 2003 VS. 2002
- ------------------------------------------------------------------------------------------------------------------------------------
CHANGE DUE TO TOTAL CHANGE DUE TO TOTAL
VOLUME RATE CHANGE VOLUME RATE CHANGE
- ------------------------------------------------------------------------------------------------------------------------------------
Interest income:
Federal funds sold.......................................... $ (49) $ 16 $ (33) $ 31 $ (57) $ (26)
Investment securities available-for-sale:
U.S. Treasury.......................................... (4) (44) (48) 7 (121) (114)
U.S. Government agencies............................... (92) (217) (309) 412 (449) (37)
State and municipal.................................... 337 (167) 170 312 (111) 201
Mortgage-backed and CMOs............................... 731 86 817 317 (1,504) (1,187)
Other.................................................. (107) (18) (125) 63 (229) (166)
Loans:
Commercial real estate................................. 566 (363) 203 1,162 (1,469) (307)
Residential real estate................................ (258) (115) (373) (215) (95) (310)
Home equity loans...................................... 461 (397) 64 459 (323) 136
Commercial and industrial.............................. 293 (94) 199 279 (408) (129)
Consumer loans......................................... (62) (31) (93) (43) 62 19
Tax-exempt loans....................................... 146 (118) 28 (64) (76) (140)
Other earning assets........................................ - (10) (10) 58 (76) (18)
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest income.............................. 1,962 (1,472) 490 2,778 (4,856) (2,078)
- ------------------------------------------------------------------------------------------------------------------------------------
Interest expense:
Interest-bearing demand accounts............................ 83 44 127 171 (10) 161
Money market accounts....................................... 68 75 143 (15) (246) (261)
Savings..................................................... 25 (134) (109) 106 (279) (173)
Time ....................................................... 125 (483) (358) 431 (1,763) (1,332)
Time over $100,000.......................................... (60) (30) (90) (107) (427) (534)
Short-term borrowings....................................... 18 - 18 (70) (88) (158)
Federal Home Loan Bank advances............................. - 21 21 24 (49) (25)
- ------------------------------------------------------------------------------------------------------------------------------------
Total interest expense............................. 259 (507) (248) 540 (2,862) (2,322)
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest income......................................... $ 1,703 $ (965) $ 738 $ 2,238 $(1,994) $ 244
====================================================================================================================================
The year 2004 may be viewed as a turning point. It marks the year when the
Federal Reserve Board began tightening monetary policy after taking rates down
to 40 year lows. Using a "measured pace" strategy of tightening, the Board,
beginning in June, raised the Federal funds rate five times by 25 basis points
each time, bringing the overnight rate to 2.25 percent at the end of the year.
The 125 basis point increase in the Federal funds rate was matched by a similar
increase in the two-year Treasury bond between December 31, 2003 and December
31, 2004, while the 10-year bond fell by one basis point. This flattening of the
yield curve is generally not a positive for financial institutions, as deposits
tend to be priced off the shorter end of the yield curve while loans and
investment securities tend to be priced off the middle part of the yield curve.
This could result in deposit rates increasing at a faster pace than rates on
earning assets, further compressing the net interest margin.
The Rate-Volume Analysis table, as presented on a tax-equivalent basis above,
highlights the impact of changing rates and volumes on total interest income and
interest expense. Total interest income increased $490,000, or 1.8 percent, in
2004 to $27,015,000. The increase in interest income was a result of an increase
in earning assets offsetting the continued impact of declining yields. The
increase in interest income attributable to volume was $1,962,000, while the
decrease related to declining yields was $1,472,000. Despite the increase in
market interest rates off their historic lows, the long period of historically
low interest rates has had the impact of lowering the yield on earning assets as
loans and investment securities either repriced or were originated at lower
interest rates. The yield on earning assets on a tax-equivalent basis was 5.13
percent for 2004 compared to 5.38 percent for 2003.
Interest income on investment securities increased $505,000 for 2004 as average
balances increased 7.3 percent. This offset a decline of 14 basis points in
average yield to 4.68 percent. QNB increased its holdings of amortizing
securities including mortgage-backed securities and collateralized mortgage
obligations (CMOs) in an effort to increase both the yield and cash flow from
the portfolio, in anticipation of rising interest rates.
Interest income on loans increased by only $28,000 in 2004 as the 8.6 percent
increase in average balances was almost completely offset by the impact of
declining rates in the portfolio. The volume increase in loans was centered
primarily in commercial purpose loans and home equity loans, many of which are
indexed to the prime rate. The yield on loans decreased 49 basis points to 5.77
percent when comparing 2004 to 2003. The rate of increase in loan yields in 2005
will be impacted by how quickly and to what degree the Federal Reserve Board
continues to increase interest rates and how much the competitive nature of the
business will keep loan rates down.
14
Total interest expense decreased $248,000, or 2.5 percent, in 2004 to
$9,506,000. The impact of lower interest rates on interest expense, particularly
with regard to time deposits, offset the impact of the growth in deposits.
Volume growth resulted in interest expense increasing by $259,000 while lower
interest rates reduced interest expense by $507,000. A 7.3 percent increase in
average interest-bearing deposits resulted in an increase in interest expense of
$241,000. A $13,114,000, or 15.0 percent, increase in average interest-bearing
demand accounts contributed $83,000 to the increase in interest expense while an
$8,226,000, or 22.8 percent, increase in average money market accounts
contributed $68,000 in additional expense. As discussed previously, the majority
of the growth in interest bearing demand deposits and money market accounts can
be attributed to the successful development of relationships with several
municipal organizations and school districts.
The rate paid on total interest-bearing liabilities decreased to 2.05 percent in
2004 from 2.24 percent in 2003. The rate paid on interest-bearing deposit
accounts decreased to 1.63 percent in 2004 from 1.83 percent in 2003. Lower
rates paid on savings accounts and time deposits decreased interest expense by
$134,000 and $513,000, respectively, in 2004. The average rate paid on savings
accounts decreased 25 basis points to .39 percent while the average rate paid on
time deposits decreased 25 basis points to 2.61 percent. The rate on money
market accounts increased from .83 percent for 2003 to .99 percent for 2004.
This is primarily the result of two events. First, QNB had to pay a higher rate
to attract the municipal deposits, second, the rising short-term interest rates
in the second half of 2004 impacted the Treasury Select Money Market Account.
This product is a variable rate account, indexed to the monthly average of the
91-day Treasury bill based on balances in the account. Management expects
interest expense and the rate paid on interest-bearing liabilities to increase
throughout 2005 as higher short-term market rates of interest result in higher
rates paid initially on money market accounts and time deposits. This will be
followed by higher rates paid on interest-bearing demand accounts and savings
accounts, accounts that tend to lag as rates increase.
When comparing 2003 to 2002, net interest income on a fully tax-equivalent basis
increased $244,000, or 1.5 percent, to $16,771,000. The increase in net interest
income was the result of the growth in deposits and the investment of these
deposits into profitable loans and investment securities. Average earning assets
increased 9.9 percent in 2003. This growth helped offset the impact on net
interest income resulting from a decline in the net interest margin. The net
interest margin declined by 28 basis points, while the net interest rate spread
declined by 18 basis points. The net interest rate margin decreased to 3.40
percent in 2003 from 3.68 percent in 2002, while the net interest rate spread
decreased to 3.14 percent in 2003 from 3.32 percent in 2002.
Total interest income decreased $2,078,000, or 7.3 percent, in 2003 to
$26,525,000. The significant decline in interest rates and the extended period
of these historically low interest rates resulted in interest income decreasing
by $4,856,000 in 2003 and the yield on earning assets decreasing by 99 basis
points to 5.38 percent for 2003. The growth in earning assets resulted in an
increase in interest income of $2,778,000, helping to partially offset the
impact of lower rates.
Interest income on investment securities decreased $1,303,000, with the yield on
investment securities decreasing 97 basis points to 4.82 percent. The impact of
lower interest rates on interest income on investment securities was $2,414,000.
The decline in interest rates resulted in heavy cash flow from callable agency
bonds and municipal securities, mortgage-backed securities and CMOs. These funds
as well as new funds from deposit growth were reinvested in lower-yielding
securities. Another result of the increase in prepayments on mortgage-backed
securities and CMOs purchases at a premium was an increase in the amortization
of the premium on these securities. The net amortization on investment
securities was $1,204,000 in 2003 compared to $793,000 in 2002. The increase in
premium amortization has the impact of reducing interest income and the yield on
the portfolio. An 8.4 percent increase in the average balance of investment
securities resulted in additional interest income of approximately $1,111,000,
partially negating the impact of declining rates.
Interest income on loans declined by $731,000, with the yield on loans
decreasing 100 basis points to 6.26 percent. Lower interest rates produced a
reduction in interest on loans of $2,309,000, while a 10.4 percent increase in
average balances resulted in an increase in interest income of $1,578,000. Most
of the rate impact was in commercial purpose loans and home equity loans. Many
of these loans are indexed to the prime rate, which declined on average 55 basis
points between 2003 and 2002. Another contributor to the decline in interest
income from rates on loans was the impact of the refinancing of residential
mortgage, home equity and commercial loans into lower yielding loans.
Total interest expense decreased $2,322,000, or 19.2 percent, in 2003 to
$9,754,000. The impact of falling interest rates on interest expense offset the
impact of the growth in deposits. Volume growth resulted in interest expense
increasing by $540,000 while lower interest rates on deposits and borrowings
reduced interest expense by $2,862,000. A 12.7 percent increase in average
interest-bearing deposits resulted in an increase in interest expense of
$586,000. A $26,564,000, or 43.5 percent, increase in average interest-bearing
demand accounts contributed $171,000 to the increase in interest expense while
an $8,852,000, or 21.2 percent, increase in average savings accounts contributed
$106,000 in additional expense. As discussed previously, the majority of the
growth in interest-bearing demand deposits can be attributed to the successful
development of relationships with several municipal organizations. The continued
growth in savings deposits can be attributed to consumers looking for the
relative safety of bank deposits despite the low interest rate environment.
Average balances on time deposits increased by 3.9 percent, contributing
$324,000 to the increase in interest expense. A $10,467,000 increase in average
time deposits with balances less than $100,000 offset a $3,065,000 decrease in
average time deposits with balances of $100,000 or more.
15
The average rates paid on deposit accounts, short-term borrowings and Federal
Home Loan Bank (FHLB) advances decreased in 2003. The rate paid on total
interest-bearing liabilities, including the borrowings from the FHLB, decreased
to 2.24 percent in 2003 from 3.05 percent in 2002. The rate paid on
interest-bearing deposit accounts decreased to 1.83 percent in 2003 from 2.71
percent in 2002. Lower rates paid on money market accounts and savings accounts
decreased interest expense by $246,000 and $279,000, respectively, in 2003.
Among these transaction accounts, the average rate paid on money market accounts
was impacted the most by the decline in interest rates. The yield on money
market accounts declined 68 basis points from 1.51 percent in 2002 to .83
percent in 2003. Contributing to the decline in the yield on money market
accounts was the sharp decline in the yield on the Treasury Select Money Market
Account. The continued decline in the 91-day Treasury rate in 2003 resulted in
significantly lower rates on this product as compared to 2002. The average rate
paid on savings accounts decreased from 1.19 percent in 2002 to .64 percent in
2003.
The continuing low interest rate environment had a greater impact on time
deposits in 2003 as many time deposits with longer original maturities repriced
lower during the year. Interest expense on time deposits was $2,190,000 lower in
2003 as a result of lower interest rates. The average rate paid on time deposits
decreased from 3.96 percent in 2002 to 2.86 percent in 2003.
Management expects net interest income to increase slightly in 2005 as a result
of the growth in earning assets offsetting a net interest margin that will
likely be stable or decline slightly. The yield curve is expected to flatten
further in 2005, as the Federal Reserve Board continues to increase short-term
interest rates. A flat yield curve will continue to put pressure on the net
interest margin.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to be charged to operations to bring the allowance for loan
losses to a level that represents management's best estimate of the known and
inherent losses in the loan portfolio. Actual loan losses, net of recoveries,
serve to reduce the allowance. Despite a $350,000 charge-off during the third
quarter of 2004, management's analysis of the allowance for loan losses
determined no provision for loan losses was necessary in 2004 as non-performing
assets and delinquent loans declined and remained at reasonable levels relative
to the allowance for loan losses. Additionally, there was no provision for loan
losses recorded in 2003 or 2002. While QNB has not recorded a provision for loan
losses in the past five years, strong growth in the loan portfolio as well as
deterioration in credit quality could impact the need for a provision for loan
losses in the future.
NON-INTEREST INCOME
QNB, through its core banking business, generates various fees and service
charges. Total non-interest income is composed of service charges on deposit
accounts, ATM and check card income, income on bank-owned life insurance,
mortgage servicing fees, gains or losses on the sale of investment securities,
gains on the sale of residential mortgage loans, and other miscellaneous fee
income.
Total non-interest income was $4,687,000 in 2004 compared to $4,200,000 in 2003,
an increase of 11.6 percent. Excluding gains and losses on the sale of
investment securities and loans in both years, non-interest income increased
$273,000 or 8.0 percent. Included in the results for 2004 was a gain on the sale
of repossessed assets of $141,000. Included in the results for 2003 was the
recognition of $109,000 from life insurance proceeds.
When comparing 2003 to 2002, non-interest income increased 40.5 percent from
$2,989,000 to $4,200,000. Excluding gains and losses on the sale of securities
and loans, non-interest income increased 10.3 percent between 2002 and 2003.
Fees for services to customers, the largest component of non-interest income,
are primarily comprised of service charges on deposit accounts. These fees
increased $151,000, or 8.2 percent, during 2004 to $2,000,000. Overdraft income
increased 15.7 percent and accounted for $241,000 of the total increase in
service charge income. The increase in overdraft income is a result of an
increase in the fee effective March 1, 2004. Partially offsetting the increase
when comparing 2003 to 2004 was a $33,000 reduction in service charge income on
non-interest bearing business checking accounts. The decline in the service
charges on business accounts reflects the impact of a higher earnings credit
rate, resulting from the increases in short-term interest rates, applied against
balances to offset service charges incurred.
When comparing 2003 to 2002, fees for services to customers increased $215,000,
or 13.2 percent, during 2003 to $1,849,000. Overdraft income increased $213,000,
or 16.1 percent, during 2003, reflecting an increase in both the volume of
overdrafts as well as the fee charged. The overdraft fee was increased 7.1
percent during the fourth quarter of 2002.
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 $598,000 for 2004, an increase of $57,000 or 10.5
percent from the amount recorded in 2003. This followed an increase of $32,000
or 6.3 percent between 2002 and 2003. Debit card income increased $41,000, or
10.5 percent, to $432,000 in 2004. Debit card income was $391,000 in 2003 and
$355,000 in 2002. The increase in debit card income is a result of increased
acceptance by consumers of the card as a means of paying for goods and services.
Debit card income was negatively impacted in the second half of 2003 as a result
of the legal settlement between the card companies and the retailers. This
settlement resulted in a reduction in the amount earned per transaction.
16
CHANGE FROM PRIOR YEAR
---------------------------
NON-INTEREST INCOME COMPARISON 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002 AMOUNT PERCENT AMOUNT PERCENT
- ------------------------------------------------------------------------------------------------------------------------------------
Fees for services to customers........... $2,000 $1,849 $1,634 $ 151 8.2% $ 215 13.2%
ATM and debit card income................ 598 541 509 57 10.5 32 6.3
Income on bank-owned life insurance...... 300 330 372 (30) (9.1) (42) (11.3)
Mortgage servicing fees.................. 112 12 97 100 833.3 (85) (87.6)
Net gain (loss) on investment securities. 849 (134) (779) 983 733.6 645 82.8
Net gain on sale of loans................ 154 923 676 (769) (83.3) 247 36.5
Other operating income................... 674 679 480 (5) (.7) 199 41.5
- ------------------------------------------------------------------------------------------------------------------------------------
Total.................................... $4,687 $4,200 $2,989 $ 487 11.6% $ 1,211 40.5%
====================================================================================================================================
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 $300,000, $330,000 and $372,000 for 2004, 2003 and 2002, respectively. The
insurance carriers reset the rates on these policies annually. The decline in
income over the three-year period is a result of a lower earnings rate resulting
from the lower interest rate environment.
When QNB sells its residential mortgages in the secondary market, it retains
servicing rights. A normal servicing fee is retained on all 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 were $112,000 in 2004 compared to $12,000 in 2003 and
$97,000 in 2002. The increase in mortgage servicing fees in 2004 is a result of
both a reduction in the amount of mortgage servicing fees amortized as well as a
positive change in the fair market value adjustment. Both of these are a result
of a slowdown in mortgage refinancing activity in 2004. Amortization expense was
$122,000 in 2004 and $174,000 in 2003. QNB recorded a positive market valuation
adjustment of $26,000 in 2004, compared with a valuation allowance of $18,000 in
2003. QNB recorded amortization expense of $91,000 and a positive market
valuation adjustment of $34,000 in 2002. For additional information on
intangible assets see Note 8 of the Notes to Consolidated Financial Statements
included as Item 8 of this Report.
QNB recorded a net gain on investment securities of $849,000 in 2004. Included
in this amount are net gains of $613,000 on the sale of equity securities from
the Corporation's portfolio. In addition, QNB recorded net gains of $236,000
from the fixed income security portfolio in 2004. 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 and entered into several transactions during 2004 in
an effort to take advantage of changes in the shape of the yield curve, changes
in spread relationships in different sectors and for liquidity purposes as
needed.
QNB recorded a net loss on investment securities of $134,000 in 2003. Included
in this loss was a $105,000 write-down of marketable equity securities whose
decline in market value below cost was deemed to be other-than-temporary. These
securities were determined to be impaired. During 2003, QNB realized net gains
of $128,000 on the sale of equity securities. In the fixed income portfolio, QNB
recorded losses of $157,000 during 2003. Over the course of the year, several
transactions were entered into in an effort to reposition the portfolio. The
goals of these transactions were to reduce the amount of current cash flow from
the portfolio, reduce the impact of premium amortization and to increase the
overall yield in the portfolio. QNB recorded a net loss on investment securities
of $779,000 in 2002. Included in this loss was a $702,000 write-down of
marketable equity securities whose decline in market value below cost was deemed
to be other-than-temporary.
The net gain on the sale of loans was $154,000, $923,000 and $676,000 in 2004,
2003 and 2002, respectively. Included within the gains on sale recorded in 2003
and 2002 are gains on the sale of student loans of $35,000 and $49,000,
respectively. Effective June 30, 2002, QNB terminated its agreement with the
Student Loan Marketing Association. QNB no longer originates student loans for
sale, but originates on a referral basis. The balance in the portfolio was sold
during the second quarter of 2003. Residential mortgage loans to be sold are
identified at origination. The net gain on the sale of residential mortgage
loans was $154,000, $888,000 and $627,000 for the years 2004, 2003 and 2002,
respectively. The net gain on residential mortgage sales is directly related to
the volume of mortgages sold and the timing of the sales relative to the
interest rate environment. The larger gains recorded in 2003 and 2002 reflect
the impact of the residential refinancing wave that took place in those years as
interest rates were declining to record lows. Included in the gains on the sale
of residential mortgages in these years were $66,000, $345,000 and $246,000
related to the recognition of mortgage servicing assets.
Other operating income was $674,000, $679,000 and $480,000 in 2004, 2003 and
2002, respectively. Included in the results for 2003 was the recognition of
$109,000 from life insurance proceeds and dividends from the title insurance
company of $70,000. No dividends from the title insurance company were received
in 2004. When comparing 2004 to 2003, trust and retail brokerage income
increased $35,000 while net gains on sales of repossessed assets increased
$143,000.
17
When comparing 2003 to 2002, retail brokerage income increased $38,000,
dividends from the title insurance company increased $41,000 and merchant
processing income increased $43,000. The increase in merchant processing income
is a result of an increase in both the number of merchants and the number of
transactions processed. Included in other operating income in 2002 was a $21,000
recovery of a check card transaction that had been charged off in 2001.
Financial service organizations, including QNB, are challenged to demonstrate
that they can generate an increased contribution to revenue from non-interest
sources. QNB will continue to analyze other opportunities and products that
could enhance its fee-based businesses.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee
benefits, net occupancy, furniture and equipment, marketing, third party
services and various other operating expenses. Total non-interest expense in
2004 increased $162,000, or 1.3 percent, to $12,845,000. This followed an
increase in non-interest expense of $738,000, or 6.2 percent, between 2002 and
2003. Despite the increase in non-interest expense, QNB's overhead efficiency
ratio, which represents non-interest expense divided by net operating revenue on
a tax-equivalent basis, declined from approximately 61.2 percent in 2002 to 57.9
percent in 2004.
Salaries and benefits expense is the largest component of non-interest expense.
Salary and benefits expense for 2004 was $7,163,000, a decrease of $32,000, or
..4 percent, over 2003. Salary expense decreased $53,000, or .9 percent, in 2004
to $5,747,000. A portion of salary expense relates to the bank's incentive
compensation plan, which provides for the sharing with all employees (excluding
senior management) of incremental income above a Board determined level. This
plan resulted in a payout of $119,000, or 2.7 percent, of eligible salary in
2004. This compares to a payout of $457,000, or 10.5 percent, of eligible salary
in 2003. Salary expense, without the incentive compensation payout, increased
$285,000, or 5.3 percent, in 2004. QNB monitors, through the use of various
surveys, the competitive salary information in its markets and makes adjustments
where appropriate.
[BAR CHART OMITTED, PLOT POINTS FOLLOWS]
2000 62.06%
2001 62.11%
2002 61.21%
2003 60.48%
2004 57.87%
Benefits expense increased by $21,000, or 1.5 percent, to $1,416,000 in 2004.
The largest increase was in medical and dental premiums, which increased
$55,000, or 7.6 percent. This is a result of the general increase in medical
insurance costs. This increase was partially offset by an increase in employee
withholdings for these benefits of $26,000 and decreases in payroll taxes and
workers' compensation premiums of $9,000 and $7,000, respectively.
Salary and benefits expense for 2003 was $7,195,000, an increase of $664,000, or
10.2 percent, over 2002. Salary expense for 2003 increased $458,000, or 8.6
percent, to $5,800,000. The increase in salary expense when comparing 2003 to
2002 was related to the $257,000 increase in incentive compensation, merit
increases and an increase in the number of employees. The number of full time
equivalent employees increased by five when comparing 2003 to 2002.
Benefits expense increased by $206,000, or 17.3 percent, to $1,395,000 in 2003.
Payroll taxes increased $56,000, or 13.9 percent, primarily as a result of the
increase in salary expense. Medical and dental premiums increased $68,000, or
17.9 percent. This is a result of the general increase in medical insurance
costs as well as an increase in the number of employees covered by the plan.
Retirement plan expense increased $63,000, or 18.9 percent, between 2002 and
2003. This expense was impacted by an extra pay period in 2003. There were 27
pay periods in 2003 compared to 26 pay periods in a normal year. This accounts
for approximately $15,000 of the increase. Also impacting retirement plan
expense was the increase in eligible salary. When comparing 2003 to 2002,
workers compensation insurance premiums increased $12,000, or 47.2 percent.
CHANGE FROM PRIOR YEAR
---------------------------
NON-INTEREST EXPENSE COMPARISON 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002 AMOUNT PERCENT AMOUNT PERCENT
- ------------------------------------------------------------------------------------------------------------------------------------
Salaries and employee benefits............ $ 7,163 $ 7,195 $ 6,531 $(32) (.4)% $ 664 10.2 %
Net occupancy expense..................... 1,013 859 861 154 17.9 (2) (.2)
Furniture and equipment expense........... 1,148 1,111 1,060 37 3.3 51 4.8
Marketing expense......................... 557 536 598 21 3.9 (62) (10.4)
Third party services...................... 680 741 640 (61) (8.2) 101 15.8
Telephone, postage and supplies........... 521 556 545 (35) (6.3) 11 2.0
State taxes............................... 375 331 335 44 13.3 (4) (1.2)
Other expense............................. 1,388 1,354 1,375 34 2.5 (21) (1.5)
- ------------------------------------------------------------------------------------------------------------------------------------
Total................................ $ 12,845 $12,683 $11,945 $162 1.3 % $ 738 6.2 %
====================================================================================================================================
18
Net occupancy expense for 2004 was $1,013,000, an increase of $154,000 from the
amount reported in 2003. Contributing to the increase was higher costs related
to building maintenance, utilities and rent. The addition of the new supermarket
branch as well as some repairs to existing branch locations contributed to the
increase in net occupancy expense.
Marketing expense increased $21,000, or 3.9 percent, in 2004 to $557,000. In
2004, the largest increases were in public relations and sales promotions of
$19,000 and $13,000, respectively. These increases were primarily related to the
costs associated with opening the new branch. When comparing 2003 to 2002,
marketing expense decreased $62,000, or 10.4 percent, to $536,000. During 2002,
QNB made several large long-term charitable pledges to not-for-profit
organizations, clubs and community events in the local communities we serve.
These contributions were $90,000 less in 2003 than 2002.
Third party services are comprised of professional services including legal,
accounting and auditing, and consulting services, as well as fees paid to
outside vendors for support services of day-to-day operations. These support
services include trust services, retail non-deposit services, correspondent
banking services, statement printing and mailing, investment security
safekeeping and supply management services. Third party services expense was
$680,000 in 2004 compared to $741,000 in 2003 and $640,000 in 2002. The higher
costs in 2003 compared to both 2004 and 2002, primarily relate to the use of
consultants for technology projects as well as for human resource purposes.
Partially offsetting the decrease in consulting costs in 2004 were higher
internal and external auditing costs resulting from the increase in corporate
governance as required under the Sarbanes-Oxley Act. Also contributing to the
higher third party service expense in 2003 as compared to 2002, was the
outsourcing of the printing and mailing of statements which began in the second
quarter of 2003.
INCOME TAXES
Applicable income taxes and effective tax rates were $1,704,000, or 21.6
percent, for 2004 compared to $1,254,000, or 18.2 percent, for 2003, and
$1,204,000, or 19.5 percent, for 2002. The higher effective tax rate in 2004 was
a result of a decrease in the proportion of tax-exempt income from investment
securities, loans and bank-owned life insurance to pretax income. Also
contributing to the lower effective tax rate in 2003 was the reversal of a
$95,000 tax valuation recorded in previous periods. The reversal of the
valuation allowance was a result of the ability to realize tax benefits
associated with certain impaired securities due to the increase in unrealized
gains of certain equity securities held by QNB Corp. The receipt of $109,000 in
tax-exempt life insurance proceeds also had a positive impact on the effective
tax rate in 2003. For a more comprehensive analysis of income tax expense and
deferred taxes, refer to Note 12 in the Notes to Consolidated Financial
Statements.
FINANCIAL CONDITION
Financial service organizations today are challenged to demonstrate they can
generate sustainable and consistent earnings growth in an increasingly
competitive environment. Managing the balance sheet in a low interest rate
environment has been a major challenge during the past three years. The
flattening of the yield curve that occurred in 2004 will likely continue into
2005 as the short-term part of the yield curve increases, in response to the
action of the Federal Reserve Bank, more than the longer end of the curve.
QNB's primary competition in the banking segment of the financial services
industry ranges from a mutual thrift institution, to several large community
banks, to a few super-regional banks. The landscape in which QNB operates
continues to change as several community banks in the area have merged with
larger locally or regionally headquartered community banks. In addition, other
strong competitors continue to move into QNB's market area. The slower economy,
which has reduced the demand for loans, and the increased availability of loans
from a variety of financial service providers has led to increased price
competition for loans. Deposit growth, which for years was a concern of the
banking industry, remained strong. A challenge in 2005 will be to retain and
grow these deposits, particularly if the stock market continues to improve. The
pricing of deposits has also become very competitive, with many institutions
offering higher promotional rates. QNB will continue to price its deposits
competitively, but attempt to do so in a manner that will minimize the negative
impact on the net interest margin.
Total assets at year-end 2004 were $583,644,000, compared with $550,831,000 at
December 31, 2003, an increase of $32,813,000 or 6.0 percent. This followed
growth during 2003 of 9.4 percent. Average total assets increased 6.8 percent,
or $35,808,000, in 2004 to $562,582,000 and 9.9 percent, or $47,280,000, in
2003. This growth in assets was a result of continued growth in funding sources.
Funding sources, which include deposits and borrowed money, increased 6.1
percent from year-end 2003 to year-end 2004 and 11.5 percent from year-end 2002
to year-end 2003. Average funding sources increased 6.7 percent in 2004 and 10.0
percent in 2003.
Total loans, excluding loans held-for-sale, at December 31, 2004 were
$268,048,000, an increase of 15.5 percent from December 31, 2003. This followed
a 9.1 percent increase from December 31, 2002 to December 31, 2003. Average
total loans increased 8.6 percent in 2004 and 10.4 percent in 2003. This loan
growth was achieved despite the slow growing economy and the extreme competitive
environment for both commercial and consumer loans. Loan growth remains one of
the primary goals of QNB.
The following discussion will further detail QNB's financial condition during
2004 and 2003.
19
INVESTMENT PORTFOLIO HISTORY
- ------------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES AVAILABLE-FOR-SALE
U.S. Treasuries........................................................................... $ 6,114 $ 6,792 $ 6,641
U.S. Government agencies.................................................................. 46,478 43,279 29,480
State and municipal securities............................................................ 45,992 41,076 26,783
Mortgage-backed securities................................................................ 67,510 66,476 70,748
Collateralized mortgage obligations (CMO)................................................. 70,789 68,761 44,409
Other debt securities..................................................................... 21,972 25,214 24,530
Equity securities......................................................................... 8,706 9,033 8,565
- ------------------------------------------------------------------------------------------------------------------------------------
Total investment securities available-for-sale......................................... $267,561 $ 260,631 $211,156
- ------------------------------------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES HELD-TO-MATURITY
State and municipal securities............................................................ $ 6,203 $ 11,180 $ 19,745
Collateralized mortgage obligations (CMO)................................................. -- 832 9,991
- ------------------------------------------------------------------------------------------------------------------------------------
Total investment securities held-to-maturity........................................... $ 6,203 $ 12,012 $ 29,736
- ------------------------------------------------------------------------------------------------------------------------------------
Total investment securities............................................................ $273,764 $ 272,643 $240,892
====================================================================================================================================
INVESTMENT SECURITIES AND OTHER SHORT-TERM INVESTMENTS
Total investment securities at December 31, 2004 and 2003 were $273,764,000 and
$272,643,000, respectively. For the same periods, approximately 68.4 percent and
65.9 percent, respectively, of QNB's investment securities were either U.S.
Government or U.S. Government agency debt securities, or U.S. Government agency
issued mortgage-backed securities or collateralized mortgage obligation
securities (CMO). As of December 31, 2004, QNB held no securities of any one
issue or any one issuer (excluding the U.S. Government and its agencies) that
were in excess of 10 percent of shareholders' equity.
Average investment securities increased $18,085,000, or 7.3 percent, to
$264,677,000 in 2004 compared with a $19,008,000, or an 8.4 percent, increase in
2003. Average Federal funds sold decreased 39.2 percent in 2004 to $6,834,000.
This followed a 20.0 percent increase during 2003 to $11,236,000. The higher
level of Federal funds sold in 2003 was a result of the desire to have more
liquidity to support the significant increase in deposits, particularly
short-term time deposits and transaction accounts during 2003. In 2004,
management made the decision to reduce Federal funds sold balances by purchasing
short-term investment securities. This was done for the purpose of improving net
interest income. In addition, Federal funds sold, which would be affected by the
economic status of the banking industry, and are short-term in nature, were only
sold to banks with a minimum Sheshunoff rating of "B", an independent rating
service, at the date of the sale.
In light of the fact that QNB's investment portfolio represents a significant
portion of earning assets and interest income, QNB actively manages the
portfolio in an attempt to maximize earnings, while still considering liquidity
needs and interest rate risk. There was a significant amount of activity in the
portfolio during 2004. In response to both significant swings in interest rates
and the shape of the yield curve, QNB performed several purchase and sales
transactions. Proceeds from the sale of investments were $66,715,000 in 2004. In
addition, proceeds from maturities, calls and prepayments of securities were
$61,145,000. These proceeds were used to purchase $130,878,000 in securities
during 2004. Despite the amount of activity in the portfolio, the composition of
the portfolio remained relatively unchanged between 2003 and 2004.
Management anticipates the investment portfolio activity will be minimal during
2005 as prepayment activity slows and interest rates increase. It is also
anticipated that loan growth will outpace deposit growth, resulting in less
funds to invest. Based on prepayment projections, QNB estimates that
approximately $56,000,000, at a book yield of 3.85 percent, in cash flow from
the portfolio will be available for reinvestment. Of this amount, it is
anticipated that $20,000,000 will be used to fund withdrawals of municipal
deposits.
20
INVESTMENT PORTFOLIO WEIGHTED AVERAGE YIELDS
- ------------------------------------------------------------------------------------------------------------------------------------
UNDER 1-5 5-10 OVER 10
DECEMBER 31, 2004 1 YEAR YEARS YEARS YEARS TOTAL
- ------------------------------------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES AVAILABLE-FOR-SALE
U.S. Treasuries:
Fair value..................................................... $ 3,042 $ 3,072 -- -- $ 6,114
Weighted average yield......................................... 1.95% 2.11% -- -- 2.03%
U.S. Government agencies:
Fair value..................................................... -- $ 34,325 $ 12,153 -- $ 46,478
Weighted average yield......................................... -- 3.49% 3.60% -- 3.52%
State and municipal securities:
Fair value..................................................... -- $ 939 $ 14,304 $ 30,749 $ 45,992
Weighted average yield......................................... -- 3.37% 5.72% 6.53% 6.21%
Mortgage-backed securities:
Fair value..................................................... -- $ 67,510 -- -- $ 67,510
Weighted average yield......................................... -- 4.59% -- -- 4.59%
Collateralized mortgage obligations (CMO):
Fair value..................................................... -- $ 69,904 $ 885 -- $ 70,789
Weighted average yield......................................... -- 4.11% 4.10% -- 4.11%
Other debt securities:
Fair value..................................................... -- $ 5,408 $ 11,537 $ 5,027 $ 21,972
Weighted average yield......................................... -- 7.17% 7.48% 4.29% 6.61%
Equity securities:
Fair value..................................................... -- -- -- $ 8,706 $ 8,706
Weighted average yield......................................... -- -- -- 3.13% 3.13%
- ------------------------------------------------------------------------------------------------------------------------------------
Total fair value.................................................. $ 3,042 $181,158 $ 38,879 $ 44,482 $ 267,561
Weighted average yield ........................................... 1.95% 4.22% 5.46% 5.54% 4.59%
- ------------------------------------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES HELD-TO-MATURITY
State and municipal securities:
Amortized cost................................................. $ 300 $ 1,113 -- $ 4,790 $ 6,203
Weighted average yield......................................... 7.05% 6.00% -- 6.96% 6.79%
- ------------------------------------------------------------------------------------------------------------------------------------
Total amortized cost.............................................. $ 300 $ 1,113 -- $ 4,790 $ 6,203
Weighted average yield ........................................... 7.05% 6.00% -- 6.96% 6.79%
- ------------------------------------------------------------------------------------------------------------------------------------
Securities are assigned to categories based on stated contractual maturity
except for mortgage-backed securities and CMOs which are based on anticipated
payment periods. See interest rate sensitivity section for practical payment and
repricing characteristics. Tax-exempt securities were adjusted to a
tax-equivalent basis and are based on the marginal Federal corporate tax rate of
34 percent and a Tax Equity and Financial Responsibility Act (TEFRA) adjustment
of .15 percent. Weighted average yields on investment securities
available-for-sale are based on historical cost.
At December 31, 2004 and 2003, investment securities totaling $103,305,000 and
$84,425,000 were pledged as collateral for repurchase agreements and public
deposits. The increase is a result of the continuing success of acquiring
deposit relationships from municipalities and school districts.
QNB accounts for its investments by classifying its securities into three
categories. Securities that QNB has the positive intent and ability to hold to
maturity are classified as held-to-maturity securities and reported at amortized
cost. Debt and equity securities that are bought and held principally for the
purpose of selling them in the near term are classified as trading securities
and reported at fair value, with unrealized gains and losses included in
earnings. Debt and equity securities not classified as either held-to-maturity
securities or trading securities are classified as available-for-sale securities
and reported at fair value, with unrealized gains and losses, net of tax,
excluded from earnings and reported as a separate component of shareholders'
equity. Management determines the appropriate classification of securities at
the time of purchase. QNB held no trading securities at December 31, 2004 and
2003.
INVESTMENTS AVAILABLE-FOR-SALE
Available-for-sale investment securities include securities that management
intends to use as part of its asset/liability management strategy. These
securities may be sold in response to changes in market interest rates, related
changes in the securities prepayment risk or in response to the need for
liquidity. At December 31, 2004, the fair value of investment securities
available-for-sale was $267,561,000, or $1,561,000, above the amortized cost of
$266,000,000. This compares to a fair value of $260,631,000, or $3,547,000,
above the amortized cost of $257,084,000 at December 31, 2003. An unrealized
holding gain of $691,000 was recorded as an increase to shareholders' equity as
of December 31, 2004, while an unrealized holding gain of $2,341,000 was
recorded as an increase to shareholders' equity as of December 31, 2003. The
available-for-sale portfolio had a weighted average maturity of approximately 3
years, 7 months at December 31, 2004, and 4 years, 1 month at December 31, 2003.
The weighted average tax-equivalent yield was 4.59 percent and 4.61 percent at
December 31, 2004 and 2003.
21
The weighted average maturity is based on the stated contractual maturity or
likely call date of all securities except for mortgage-backed securities and
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 increase 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 on page 32 reflects the repricing term of the securities portfolio
based upon estimated call dates and anticipated cash flows assuming management's
most likely interest rate environment.
INVESTMENTS HELD-TO-MATURITY
Investment securities held-to-maturity are recorded at amortized cost. Included
in this portfolio are state and municipal securities. At December 31, 2004 and
2003, the amortized cost of investment securities held-to-maturity was
$6,203,000 and $12,012,000, and the fair value was $6,432,000 and $12,334,000,
respectively. The held-to-maturity portfolio had a weighted average maturity of
approximately 4 years, 5 months at December 31, 2004, and 2 years, 11 months at
December 31, 2003. The weighted average tax-equivalent yield was 6.79 percent
and 6.59 percent at December 31, 2004 and 2003. The increase in the weighted
average maturity is the result of the maturity or call of municipal bonds that
had a short average maturity at December 31, 2003.
LOANS
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 a
significant component of earning assets. Inherent within the lending function is
the evaluation and acceptance of credit risk and interest rate risk along with
the opportunity cost of alternative deployment of funds. QNB manages credit risk
associated with its lending activities through portfolio diversification,
underwriting policies and procedures, and loan monitoring practices.
QNB has comprehensive policies and procedures that define and govern both
commercial and retail loan origination and management of risk. All loans are
underwritten in a manner that emphasizes the borrowers' capacity to pay. The
measurement of capacity to pay delineates the potential risk of non-payment or
default. The higher potential for default determines the need for and amount of
collateral required. QNB makes unsecured loans when the capacity to pay is
considered substantial. As capacity lessens, collateral is required to provide a
secondary source of repayment and to mitigate the risk of loss. Various policies
and procedures provide guidance to the lenders on such factors as amount, terms,
price, maturity and appropriate collateral levels. Each risk factor is
considered critical to ensuring that QNB receives an adequate return for the
risk undertaken, and that the risk of loss is minimized.
[BAR CHART OMITTED, PLOT POINTS FOLLOWS]
2000 $183,592
2001 $200,089
2002 $212,691
2003 $232,127
2004 $268,048
QNB manages the risk associated with commercial loans, which generally have
balances larger than retail loans, by having lenders work in tandem with credit
underwriting personnel. In addition, a bank loan committee and a committee of
the Board of Directors review certain loan requests on a weekly basis.
QNB's commercial lending activity is focused on small businesses within the
local community. Commercial and industrial loans represent commercial purpose
loans that are either secured by collateral other than real estate or unsecured.
Real estate commercial loans include commercial purpose loans collateralized at
least in part by commercial real estate. These loans may not be for the express
purpose of conducting commercial real estate transactions. Real estate
residential loans include loans secured by one-to-four family units. These loans
include fixed rate home equity loans, floating rate home equity lines of credit,
loans to individuals for residential mortgages, and commercial purpose loans.
Substantially all originations of loans to individuals for residential mortgages
with maturities of 20 years or greater are sold in the secondary market. At
December 31, 2004 and 2003, real estate residential loans held-for-sale were
$312,000 and $1,439,000, respectively. These loans are carried at the lower of
aggregate cost or market.
22
LOAN PORTFOLIO
- ------------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Commercial and industrial......................................... $ 57,364 $ 47,196 $ 39,546 $ 39,694 $ 39,100
Agricultural...................................................... 8 14 176 2,622 3,027
Construction...................................................... 7,027 9,056 7,687 3,989 380
Real estate-commercial............................................ 98,397 86,707 74,125 71,112 65,271
Real estate-residential........................................... 99,893 83,703 84,907 77,273 70,745
Consumer.......................................................... 5,376 5,604 6,513 5,669 5,264
- ------------------------------------------------------------------------------------------------------------------------------------
Total loans.................................................... 268,065 232,280 212,954 200,359 183,787
Less unearned income.............................................. 17 153 263