SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 -------------------- FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March, 31, 2003 -------------------------------------------------- OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ----------------------- ---------------------- Commission file number 0-17706 ---------------- QNB Corp. - -------------------------------------------------------------------------------- (Exact Name of Registrant as Specified in Its Charter) Pennsylvania 23-2318082 - -------------------------------------------------------------------------------- (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 10 North Third Street, Quakertown, PA 18951-9005 - -------------------------------------------------------------------------------- (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code (215)538-5600 ----------------------------- Not Applicable - -------------------------------------------------------------------------------- Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report. Indicate by check |X| whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No ----- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).Yes No |X| ----- ----- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at May 12, 2003 Common Stock, par value $1.25 1,545,321
QNB CORP. AND SUBSIDIARY FORM 10-Q QUARTER ENDED MARCH 31, 2003 INDEX PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS (UNAUDITED) PAGE Consolidated Statements of Income for Three Months Ended March 31, 2003 and 2002.........................1 Consolidated Balance Sheets at March 31, 2003 and December 31, 2002........................................2 Consolidated Statements of Cash Flows for Three Months Ended March 31, 2003 and 2002.........................3 Notes to Consolidated Financial Statements............................4 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION...............................9 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.....................................................25 ITEM 4. CONTROLS AND PROCEDURES..............................................25 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS....................................................26 ITEM 2. CHANGES IN SECURITIES................................................26 ITEM 3. DEFAULTS UPON SENIOR SECURITIES......................................26 ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITIES HOLDERS...............26 ITEM 5. OTHER INFORMATION....................................................26 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.....................................26 SIGNATURES CERTIFICATIONS
QNB CORP. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME <TABLE> <CAPTION> (in thousands, except share data) (unaudited) - ------------------------------------------------------------------------------------------------------------------------------------ THREE MONTHS ENDED MARCH 31, 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> INTEREST INCOME Interest and fees on loans......................................................................... $ 3,622 $ 3,685 Interest and dividends on investment securities: Taxable........................................................................................ 2,191 2,607 Tax-exempt..................................................................................... 542 455 Interest on Federal funds sold..................................................................... 36 48 Interest on interest-bearing balances.............................................................. 1 1 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest income..................................................................... 6,392 6,796 - ------------------------------------------------------------------------------------------------------------------------------------ INTEREST EXPENSE Interest on deposits Interest-bearing demand accounts............................................................... 115 74 Money market accounts.......................................................................... 87 149 Savings........................................................................................ 108 118 Time .......................................................................................... 1,165 1,592 Time over $100,000............................................................................. 289 456 Interest on short-term borrowings.................................................................. 29 72 Interest on Federal Home Loan Bank advances........................................................ 712 710 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest expense.................................................................... 2,505 3,171 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income....................................................................... 3,887 3,625 Provision for loan losses.......................................................................... - - - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income after provision for loan losses....................................... 3,887 3,625 - ------------------------------------------------------------------------------------------------------------------------------------ NON-INTEREST INCOME Fees for services to customers..................................................................... 414 358 ATM and debit card income.......................................................................... 131 109 Income on cash surrender value of insurance........................................................ 77 79 Mortgage servicing (loss) income................................................................... (59) 15 Net gain (loss) on investment securities available-for-sale........................................ 155 (64) Net gain on sale of loans.......................................................................... 361 141 Other operating income............................................................................. 159 96 - ------------------------------------------------------------------------------------------------------------------------------------ Total non-interest income................................................................. 1,238 734 - ------------------------------------------------------------------------------------------------------------------------------------ NON-INTEREST EXPENSE Salaries and employee benefits..................................................................... 1,809 1,552 Net occupancy expense.............................................................................. 215 206 Furniture and equipment expense.................................................................... 270 228 Marketing expense.................................................................................. 100 144 Third party services............................................................................... 190 134 Telephone, postage and supplies expense............................................................ 137 133 State taxes........................................................................................ 83 93 Other expense...................................................................................... 334 304 - ------------------------------------------------------------------------------------------------------------------------------------ Total non-interest expense................................................................ 3,138 2,794 - ------------------------------------------------------------------------------------------------------------------------------------ Income before income taxes ................................................................... 1,987 1,565 Provision for income taxes......................................................................... 456 290 - ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME..................................................................................... $ 1,531 $ 1,275 ==================================================================================================================================== NET INCOME PER SHARE - BASIC................................................................... $ .99 $ .83 ==================================================================================================================================== NET INCOME PER SHARE - DILUTED................................................................. $ .98 $ .82 ==================================================================================================================================== CASH DIVIDENDS PER SHARE....................................................................... $ .33 $ .30 ==================================================================================================================================== </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. Page 1
QNB CORP. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS <TABLE> <CAPTION> (in thousands) (unaudited) - ------------------------------------------------------------------------------------------------------------------------------------ MARCH 31, DECEMBER 31, 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> ASSETS Cash and due from banks................................................................................. $ 21,158 $ 17,476 Federal funds sold...................................................................................... 10,421 10,001 - ------------------------------------------------------------------------------------------------------------------------------------ Total cash and cash equivalents................................................................ 31,579 27,477 Investment securities Available-for-sale (cost $214,038 and $209,217).................................................... 219,439 214,741 Held-to-maturity (market value $23,487 and $30,386)................................................ 22,936 29,736 Total loans, net of unearned income of $213 and $263 ............................................. 229,878 216,850 Allowance for loan losses.......................................................................... (2,933) (2,938) - ------------------------------------------------------------------------------------------------------------------------------------ Net loans...................................................................................... 226,945 213,912 Cash surrender value of insurance....................................................................... 7,478 7,397 Premises and equipment, net............................................................................. 5,443 5,497 Accrued interest receivable ............................................................................ 2,436 2,710 Other assets............................................................................................ 2,239 1,960 - ------------------------------------------------------------------------------------------------------------------------------------ Total assets............................................................................................ $ 518,495 $ 503,430 ==================================================================================================================================== LIABILITIES Deposits Demand, non-interest-bearing....................................................................... $ 53,004 $ 47,079 Interest-bearing demand accounts................................................................... 78,913 70,478 Money market accounts.............................................................................. 34,224 39,341 Savings............................................................................................ 49,755 45,338 Time............................................................................................... 151,653 145,849 Time over $100,000................................................................................. 42,781 40,828 - ------------------------------------------------------------------------------------------------------------------------------------ Total deposits................................................................................. 410,330 388,913 Short-term borrowings................................................................................... 6,635 14,485 Federal Home Loan Bank advances......................................................................... 55,000 55,000 Accrued interest payable................................................................................ 1,576 1,555 Other liabilities....................................................................................... 3,002 2,563 - ------------------------------------------------------------------------------------------------------------------------------------ Total liabilities....................................................................................... 476,543 462,516 - ------------------------------------------------------------------------------------------------------------------------------------ Commitments and contingencies SHAREHOLDERS' EQUITY Common stock, par value $1.25 per share; authorized 5,000,000 shares; 1,598,664 shares and 1,594,140 shares issued; 1,545,321 and 1,540,797 shares outstanding......................................................... 1,998 1,993 Surplus ............................................................................................... 8,810 8,759 Retained earnings....................................................................................... 29,074 28,053 Accumulated other comprehensive gain, net............................................................... 3,564 3,603 Treasury stock, at cost; 53,343 shares at March 31, 2003 and December 31, 2002.......................... (1,494) (1,494) - ------------------------------------------------------------------------------------------------------------------------------------ Total shareholders' equity.............................................................................. 41,952 40,914 - ------------------------------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity.............................................................. $ 518,495 $ 503,430 ==================================================================================================================================== </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. Page 2
QNB CORP. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS <TABLE> <CAPTION> (in thousands) (unaudited) - ------------------------------------------------------------------------------------------------------------------------------------ THREE MONTHS ENDED MARCH 31, 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> OPERATING ACTIVITIES Net income......................................................................................... $ 1,531 $ 1,275 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization.................................................................... 207 181 Securities (gains) losses ...................................................................... (155) 64 Net gain on sale of loans........................................................................ (361) (141) Proceeds from sales of residential mortgages..................................................... 9,908 7,637 Originations of residential mortgages held-for-sale.............................................. (8,064) (6,811) Proceeds from sales of student loans............................................................. 262 903 Recovery of charged-off loans.................................................................... - 31 Income on cash surrender value of insurance...................................................... (77) (79) Deferred income tax provision.................................................................... 23 64 Change in income taxes payable................................................................... 421 207 Net decrease (increase) in interest receivable................................................... 274 (164) Net amortization of premiums and discounts....................................................... 432 124 Net increase in interest payable................................................................. 21 156 Increase in other assets ........................................................................ (439) (310) Increase in other liabilities.................................................................... 105 540 - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided by operating activities........................................................ 4,088 3,677 - ------------------------------------------------------------------------------------------------------------------------------------ INVESTING ACTIVITIES Proceeds from maturities and calls of investment securities available-for-sale............................................................................... 25,342 13,135 held-to-maturity................................................................................. 6,791 4,016 Proceeds from sales of investment securities available-for-sale............................................................................... 18,643 565 Purchase of investment securities available-for-sale............................................................................... (48,944) (31,877) held-to-maturity................................................................................. - (5,955) Net increase in loans.............................................................................. (14,778) (3,567) Net purchases of premises and equipment............................................................ (153) (119) - ------------------------------------------------------------------------------------------------------------------------------------ Net cash used by investing activities............................................................ (13,099) (23,802) - ------------------------------------------------------------------------------------------------------------------------------------ FINANCING ACTIVITIES Net increase in non-interest-bearing deposits...................................................... 5,925 173 Net increase in interest-bearing deposits.......................................................... 15,492 19,882 Net (decrease) increase in short-term borrowings................................................... (7,850) 2,582 Proceeds from Federal Home Loan Bank advances...................................................... - 2,000 Cash dividends paid................................................................................ (510) (462) Proceeds from issuance of common stock............................................................. 56 32 - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided by financing activites......................................................... 13,113 24,207 - ------------------------------------------------------------------------------------------------------------------------------------ Increase in cash and cash equivalents............................................................. 4,102 4,082 Cash and cash equivalents at beginning of year.................................................... 27,477 23,881 - ------------------------------------------------------------------------------------------------------------------------------------ Cash and cash equivalents at end of period........................................................ $ 31,579 $27,963 ==================================================================================================================================== SUPPLEMENTAL CASH FLOW DISCLOSURES Interest paid...................................................................................... $ 2,484 $ 3,015 Income taxes paid.................................................................................. - 5 Non-Cash Transactions Change in net unrealized holding gains, net of taxes, on investment securities................... (39) (806) </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. Page 3
QNB CORP. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2003 AND 2002, AND DECEMBER 31, 2002 (UNAUDITED) 1. REPORTING AND ACCOUNTING POLICIES The accompanying consolidated financial statements include the accounts of QNB Corp. and its wholly owned subsidiary, The Quakertown National Bank, (QNB). All significant intercompany accounts and transactions are eliminated in the consolidated statements. The consolidated balance sheet as of March 31, 2003, as well as the respective statements of income and cash flows for the three-month period ended March 31, 2003 and 2002, are unaudited. These financial statements should be read in conjunction with the audited financial statements and notes thereto included in QNB's 2002 Annual Report incorporated in the Form 10-K. The financial statements reflect all adjustments, which in the opinion of management are necessary for a fair presentation of the results of the interim periods and are of a normal and recurring nature. The results for the periods presented are not necessarily indicative of the full year. Tabular information other than share date is presented in thousands of dollars. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from such estimates. STOCK BASED COMPENSATION At March 31, 2003, QNB has two stock-based employee compensation plans. QNB accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The "fair value" approach under SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, takes into account the time value of the option and will generally result in compensation expense being recorded. Each year since the inception of SFAS No. 123, QNB has disclosed, in the notes to the financial statements contained in its annual report to shareholders, what the earnings impact would have been had QNB elected the "fair value" approach under SFAS No. 123. Such disclosure is now required on a quarterly basis in accordance with SFAS No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION - TRANSITION AND DISCLOSURE - AN AMENDMENT OF FASB STATEMENT NO. 123. Form 10-Q Page 4
QNB CORP. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2003 AND 2002, AND DECEMBER 31, 2002 (UNAUDITED) The following table illustrates the effect of net income and earnings per share if the company had applied the fair value recognition provisions of FASB Statement No. 123 to stock-based employee compensation. For the Three Months Ended March 31, 2003 2002 ------ ------ Net income, as reported $1,531 $1,275 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 26 22 Pro forma net income $1,505 $1,253 Earnings per share Basic - as reported $.99 $.83 Basic - pro forma $.97 $.81 Diluted - as reported $.98 $.82 Diluted - pro forma $.96 $.81 2. PER SHARE DATA The following sets forth the computation of basic and diluted earnings per share (share and per share data are not in thousands): For the Three Months Ended March 31, 2003 2002 ---- ---- Numerator for basic and diluted earnings $1,531 $1,275 per share-net income Denominator for basic earnings per share- 1,543,431 1,538,217 weighted average shares outstanding Effect of dilutive securities-employee 18,547 9,399 stock options Denominator for diluted earnings per 1,561,978 1,547,616 share- adjusted weighted average shares outstanding Earnings per share-basic $.99 $.83 Earnings per share-diluted $.98 $.82 There were no stock options that were anti-dilutive for either three-month period ended March 31, 2003 or 2002. Form 10-Q Page 5
QNB CORP. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2003 AND 2002, AND DECEMBER 31, 2002 (UNAUDITED) 3. COMPREHENSIVE INCOME Comprehensive income is defined as the change in equity of a business entity during a period from transactions and other events and circumstances, excluding those resulting from investments by and distributions to owners. For QNB, the sole component of other comprehensive income is the unrealized holding gains and losses on available-for-sale investment securities. The following shows the components and activity of comprehensive income during the periods ended March 31, 2003 and 2002 (net of the income tax effect): For the Three Months Ended March 31, 2003 2002 ---- ---- Unrealized holding gains (losses) arising during the period on securities held $63 $(848) Reclassification adjustment for sold securities (102) 42 ----- -- Net change in unrealized gains during the period (39) (806) Unrealized holding gains, beginning of period 3,603 1,099 ----- ----- Unrealized holding gains, end of period $3,564 $293 ====== ==== Net income $1,531 $1,275 Other comprehensive income, net of tax: Unrealized holding losses arising during the period (39) (806) ---- ----- Comprehensive Income $1,492 $469 ====== ==== 4. STOCK REPURCHASE PLAN In March of 2000, the Board of Directors of QNB Corp. authorized the repurchase of up to 4.99 percent or 79,180 shares of QNB Corp's outstanding common stock. Such repurchases may be made in open market or privately negotiated transactions. The repurchased shares will be held in treasury and will be available for general corporate purposes. As of March 31, 2003 QNB Corp. repurchased 53,343 shares at an average cost of $28.01 per share. No shares were repurchased during the first quarter of 2003 or 2002. Form 10-Q Page 6
QNB CORP. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2003 AND 2002, AND DECEMBER 31, 2002 (UNAUDITED) 5. INTANGIBLE ASSETS The following table presents Intangible Asset information as of March 31, 2003: <TABLE> <CAPTION> - ------------------------------------ ----------------------- ------------------------- ---------------------- Amortized Intangible Assets Gross Carrying Accumulated Net Carrying Amount Amortization Amount - ------------------------------------ ----------------------- ------------------------- ---------------------- <S> <C> <C> <C> Purchased deposit premium $511 $277 $234 - ------------------------------------ ----------------------- ------------------------- ---------------------- Mortgage servicing asset 651 230 421 - ------------------------------------ ----------------------- ------------------------- ---------------------- Total $1,162 $507 $655 - ------------------------------------ ----------------------- ------------------------- ---------------------- The following table presents Intangible Asset information as of December 31, 2002: - ------------------------------------ ----------------------- ------------------------- ---------------------- Amortized Intangible Assets Gross Carrying Accumulated Net Carrying Amount Amortization Amount - ------------------------------------ ----------------------- ------------------------- ---------------------- Purchased deposit premium $511 $264 $247 - ------------------------------------ ----------------------- ------------------------- ---------------------- Mortgage servicing asset 679 250 429 - ------------------------------------ ----------------------- ------------------------- ---------------------- Total $1,190 $514 $676 - ------------------------------------ ----------------------- ------------------------- ---------------------- </TABLE> AGGREGATE AMORTIZATION EXPENSE For the Three Months ended March 31, 2003 $118 ESTIMATED AMORTIZATION EXPENSE For the Year Ended 12/31/03 $252 For the Year Ended 12/31/04 157 For the Year Ended 12/31/05 126 For the Year Ended 12/31/06 101 For the Year Ended 12/31/07 84 6. RECENT ACCOUNTING PRONOUNCEMENTS STOCK-BASED COMPENSATION In December, 2002, the FASB issued SFAS No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION- TRANSITION AND DISCLOSURE. This Statement amends SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based compensation. It also amends the disclosure provisions of that Statement to require prominent disclosure about the effects on reported net income of an entity's accounting policy decisions with respect to stock-based employee compensation. Finally, this statement amends APB Opinion No. 28, INTERIM FINANCIAL REPORTING, to require disclosure about those effects in interim financial information. The requirements for SFAS No. 148 are effective for financial statements for fiscal years ended and interim periods beginning after December 15, 2002. QNB uses the Form 10-Q Page 7
QNB CORP. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2003 AND 2002, AND DECEMBER 31, 2002 (UNAUDITED) "intrinsic value" approach to accounting for stock-based compensation to account for stock-based compensation as permitted under APB Opinion No. 25. QNB has adopted the disclosure provisions of SFAS No. 148. The disclosure provisions had no impact on QNB's consolidated earnings, financial condition, or equity. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES In April 2003, the FASB issued SFAS No. 149, AMENDMENTS OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING Activities, which establishes accounting and reporting standards for derivative instruments, including derivatives embedded in other contracts and hedging activities. The statement amends Statement No. 133 for decisions made by the Board as part of the Derivatives Implementation Group (DIG) process. The statement also amends Statement No. 133 to incorporate clarifications of the definition of a derivative. The statement is effective for contracts entered into or modified and hedging relationships designated after June 30, 2003. The provisions of this statement are not expected to have a material impact on QNB's consolidated earnings, financial condition, or equity. GUARANTOR'S ACCOUNTING AND DISCLOSURE REQUIREMENTS FOR GUARANTEES In November 2002, the FASB issued Interpretation No. (FIN) 45, GUARANTOR'S ACCOUNTING AND DISCLOSURE REQUIREMENTS FOR GUARANTEES, INCLUDING INDIRECT GUARANTEES OF INDEBTEDNESS OF OTHERS. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. This Interpretation does not prescribe a specific approach for subsequently measuring the guarantor's recognized liability over the term of the related guarantee. This Interpretation also incorporates, without change, the guidance in FASB Interpretation No. 34, DISCLOSURE OF INDIRECT GUARANTEES OF INDEBTEDNESS OF OTHERS, which is being superseded. The initial recognition and initial measurement provisions of this Interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. There was no impact on earnings, financial condition or equity upon adoption of FIN 45. The disclosure requirements in this Interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of the disclosure requirements of FIN 45 did not have an impact on the financial statements or notes to the financial statements. CONSOLIDATION OF VARIABLE INTEREST ENTITIES In January 2003, the FASB issued Interpretation No. (FIN) 46, CONSOLIDATION OF VARIABLE INTEREST ENTITIES, AN INTERPRETATION OF ARB NO. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created or obtained after January 31, 2003. For public enterprises with a variable interest in a variable interest entity created before February 1, 2003, the Interpretation applies to that enterprise no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003. There was no impact on earnings, financial condition, or equity upon adoption of FASB Interpretation No. 46. Form 10-Q Page 8
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION QNB Corp. (the "Corporation") is a bank holding company headquartered in Quakertown, Pennsylvania. The Corporation through its wholly owned subsidiary, The Quakertown National Bank (the "Bank"), has been serving the residents and businesses of Upper Bucks, Northern Montgomery and Southern Lehigh Counties in Pennsylvania since 1877. The Bank is a locally managed community bank that provides a full range of commercial, retail banking and trust and investment management services. The consolidated entity is referred to herein as "QNB". THIS REPORT INCLUDES FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT WITH RESPECT TO FINANCIAL PERFORMANCE AND OTHER FINANCIAL AND BUSINESS MATTERS. FORWARD-LOOKING STATEMENTS ARE TYPICALLY IDENTIFIED BY WORDS OR PHRASES SUCH AS "BELIEVE," "EXPECT," "ANTICIPATE," "INTEND," "ESTIMATE," "POSITION" AND VARIATIONS OF SUCH WORDS AND SIMILAR EXPRESSIONS, OR FUTURE OR CONDITIONAL VERBS SUCH AS "WILL," "WOULD," "SHOULD," "COULD," "MAY" OR SIMILAR EXPRESSIONS. THE CORPORATION CAUTIONS THAT THESE FORWARD-LOOKING STATEMENTS ARE SUBJECT TO NUMEROUS ASSUMPTIONS, RISKS AND UNCERTAINTIES, ALL OF WHICH CHANGE OVER TIME, AND THE CORPORATION ASSUMES NO DUTY TO UPDATE FORWARD LOOKING STATEMENTS. ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS. IN ADDITION TO FACTORS PREVIOUSLY DISCLOSED BY THE CORPORATION AND THOSE IDENTIFIED ELSEWHERE HEREIN, THE FOLLOWING FACTORS, AMONG OTHERS, COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM FORWARD LOOKING STATEMENTS: INCREASED CREDIT RISK; THE INTRODUCTION, WITHDRAWAL, SUCCESS AND TIMING OF BUSINESS INITIATIVES AND STRATEGIES; CHANGES IN COMPETITIVE CONDITIONS; THE INABILITY TO SUSTAIN REVENUE AND EARNINGS GROWTH; CHANGES IN ECONOMIC CONDITIONS, INTEREST RATES AND FINANCIAL AND CAPITAL MARKETS; INFLATION; CHANGES IN INVESTMENT PERFORMANCE; CUSTOMER DISINTERMEDIATION; CUSTOMER BORROWING, REPAYMENT, INVESTMENT AND DEPOSIT PRACTICES; CUSTOMER ACCEPTANCE OF QNB PRODUCTS AND SERVICES; AND THE IMPACT, EXTENT AND TIMING OF TECHNOLOGICAL CHANGES, CAPITAL MANAGEMENT ACTIVITIES, ACTIONS OF THE FEDERAL RESERVE BOARD AND LEGISLATIVE AND REGULATORY ACTIONS AND REFORMS. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of QNB, which are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of these financial statements requires QNB to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. QNB evaluates estimates on an on-going basis, including those related to the allowance for loan losses, non-accrual loans, other real estate owned, other-than-temporary investment impairments, intangible assets, stock option plan and income taxes. QNB bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. QNB believes the following critical accounting policies affect its more significant judgments and estimates used in preparation of its consolidated financial statements: allowance for loan losses, income taxes and other-than- Form 10-Q Page 9
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION CRITICAL ACCOUNTING POLICIES AND ESTIMATES (CONTINUED) temporary investment security impairment. Each estimate is discussed below. The financial impact of each estimate is discussed in the applicable sections of Management's Discussion and Analysis. ALLOWANCE FOR LOAN LOSSES QNB maintains an allowance for loan losses, which is intended to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management. The allowance for loan losses is based on management's continuing review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. The portion of the allowance that is allocated to internally criticized and non-accrual loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general reserves are based on the composition and risk characteristics of the loan portfolio, including the nature of the loan portfolio, credit concentration trends, historic and anticipated delinquency and loss experience, as well as other qualitative factors such as current economic trends. Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. QNB's lending and loan administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower's circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of uncollectibility. Each commercial loan is assigned a grade based upon an assessment of the borrower's financial capacity to service the debt and the presence and value of collateral for the loan. An independent loan review group tests risk assessments and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB's allowance for losses on loans. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. INCOME TAXES. QNB accounts for income taxes under the asset/liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates Form 10-Q Page 10
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION CRITICAL ACCOUNTING POLICIES AND ESTIMATES (CONTINUED): INCOME TAXES (CONTINUED) expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Because the judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part go beyond QNB's control, it is at least reasonably possible that management's judgment about the need for a valuation allowance for deferred taxes could change in the near term. At March 31, 2003 QNB had a $138,000 valuation allowance for deferred taxes. OTHER THAN TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES Securities are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term "other than temporary" is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support realizable value equal to or greater than carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized. RESULTS OF OPERATIONS QNB reported net income for the first quarter of 2003 of $1,531,000 or $.98 per share on a diluted basis. Results for the first quarter of 2003 represent a record quarter for QNB. This also represents a 20.1 percent increase in net income when compared to the $1,275,000 or $.82 a diluted share reported for the first quarter of 2002. Contributing to the increase in net income when comparing the two quarters is higher net interest income and non-interest income. Net interest income increased $262,000 as an 8.2 percent increase in average earning assets offset a four basis point decline in the net interest margin. Average loans and average investment securities increased 7.4 percent and 9.1 percent, respectively. The net interest margin was 3.67 percent for the first quarter of 2003 compared to 3.71 percent for the same period in 2002. Non-interest income for the three months ended March 31, 2003 was $1,238,000, a $504,000 increase from the first quarter of 2002. When comparing these two periods gains on the sale of loans increased $220,000 and net gains on the sale of investment securities increased $219,000. The record low interest rate environment has resulted in a substantial increase in mortgage refinance activity that has contributed to the increase in the gain on the sale of loans. Non-interest expense increased from $2,794,000 for the first quarter of 2002 to $3,138,000 for the first quarter of 2003. An increase in personnel expense accounts for $257,000 of the increase in non-interest expense. Return on average assets was 1.24 percent and 1.12 percent while the return on average equity was 16.38 percent and 15.04 percent for the quarters ended March 31, 2003 and 2002, respectively. Form 10-Q Page 11
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION NET INTEREST INCOME Net interest income is the primary source of operating income for QNB. Net interest income is interest income, dividends, and fees on earning assets, less interest expense incurred for funding sources. Earning assets primarily include loans, investment securities and Federal funds sold. Sources used to fund these assets include deposits, borrowed funds and shareholders' equity. Net interest income is affected by changes in interest rates, the volume and mix of earning assets and interest-bearing liabilities, and the amount of earning assets funded by non-interest-bearing deposits. Net interest income increased 7.2 percent to $3,887,000 for the quarter ended March 31, 2003 as compared to $3,625,000 for the quarter ended March 31, 2002. On a tax-equivalent basis, which allows for the comparison of tax-exempt loans and investments to taxable loans and investments, net interest income increased by 7.1 percent from $3,964,000 for the three months ended March 31, 2002 to $4,246,000 for the same period ended March 31, 2003. The growth in net interest income is a result of the tremendous growth in deposits. This is a continuation of the trend in deposit growth that began during 2001. Continued lackluster performance of the stock market, a slow growing United States economy, and geopolitical uncertainty have contributed to the inflow of funds into the banking system. Consumers are looking for the relative safely of bank deposits despite the low interest rate environment. Average deposits increased $39,022,000 or 10.9 percent when comparing the first quarters of 2003 and 2002. These deposits were used to fund the $15,211,000 or 7.4 percent increase in average loans and the $19,544,000 or 9.1 percent increase in average investment securities. The historically low interest rate environment continued during the first quarter of 2003. This had the impact of lowering the yield on earning assets and the rate paid on interest-bearing liabilities, as loans, investment securities and time deposits either repriced at lower rates or were originated at lower interest rates. The yield on earning assets on a tax-equivalent basis was 5.84 percent for the first quarter of 2003 versus 6.67 percent for the first quarter of 2002, while the rate paid on interest-bearing liabilities was 2.45 percent and 3.35 percent for the same periods. The net interest margin, on a tax-equivalent basis, declined 4 basis points to 3.67 percent for the three-month period ended March 31, 2003 compared with 3.71 percent for the same period in 2002. However, the net interest margin for the three months ended March 31, 2003 represents an increase from the 3.53 percent reported for the fourth quarter of 2002. The yield on loans decreased 64 basis points to 6.72 percent when comparing the first quarter of 2002 to the first quarter of 2003.The average prime rate when comparing the first quarter of 2002 to the first quarter of 2003 decreased 50 basis points, from 4.75 percent to 4.25 percent. While QNB was negatively impacted from the decline in prime rate, the overall yield on the loan portfolio did not decrease proportionately, since only a percentage of the loan portfolio re-prices immediately with changes in the prime rate. A greater contributor to the decline in yield on the loan portfolio was the impact of the refinancing of residential mortgage, home equity and commercial loans into lower yielding loans. The yield on the loan portfolio may continue to decline in 2003 as fixed rate loans are refinanced at lower rates, adjustable rate loans re-price down as they reach their reset date and new loans are booked at the current lower rates. In anticipation of rising rates toward the end of 2003 and during 2004, QNB, particularly with regard to commercial loans, has attempted to originate floating rate loans indexed to the prime rate. This should help increase the yield on the loan portfolio as interest rates increase. When comparing the first quarter of 2003 to the first quarter of 2002, the yield on investment securities decreased to 5.25 percent from 6.29 percent. With the continuing low interest rate environment, cash flow from callable agency and municipal securities, mortgage-backed securities and collateralized mortgage obligations (CMOs) remains high. These funds as well as new funds from deposit growth were reinvested in Form 10-Q Page 12
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION NET INTEREST INCOME (CONTINUED) lower-yielding securities. Another result of the increase in the prepayments on mortgage backed securities and CMOs purchased at a premium was an increase in the amortization of the premium on these securities. The net amortization on investment securities was $302,000 during the first quarter of 2003 compared with $54,000 in the first quarter of 2002. The increase in premium amortization has the impact of reducing interest income and the yield on the portfolio. QNB has attempted to manage the prepayment and amortization situation by selling out of certain faster paying CMOs and mortgage backed securities and purchasing lower coupon, lower premium mortgage backed securities and CMOs that will not pay as quickly should rates stay low or decline further. The yield on the investment portfolio may continue to decline during 2003, as higher yielding securities continue to be replaced at lower rates. While total interest income on a tax-equivalent basis decreased $384,000 when comparing the first quarter of 2003 to the first quarter of 2002, total interest expense decreased $666,000. The rate paid on interest bearing deposits decreased from 3.06 percent to 2.05 for the quarters ended March 31, 2002 and 2003. The impact of lower rates on time deposits was the greatest contributor to the decline in total interest expense and the rate paid on interest bearing deposits. Total interest expense on time deposits decreased $594,000 when comparing the two quarters. The average rate paid on time declined from 4.45 percent to 3.08 percent when comparing the two periods. Like fixed-rate loans, certificates of deposit reprice over time and therefore have less of an immediate impact on yield in either a rising or falling rate environment. Average time deposits increased $4,760,000 to $191,541,000 when comparing the first quarter of 2003 to the same period in 2002. A $10,769,000 increase in average time deposits with balances less than $100,000 offset a $6,009,00 decrease in average time deposits with balances of $100,000 or more. Lower rates paid on money market accounts and savings accounts contributed to the $62,000 and $10,000 decrease in interest expense for these products. The average rate paid on money market accounts declined 69 basis points when comparing the first quarter of 2003 yield of .98 percent to the first quarter of 2002 yield of 1.67 percent. Contributing to the decline in the yield on money market accounts was the decline in the rate paid on 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. The decline in the 91-day Treasury rate resulted in significantly lower rates on this product. In response to lower market rates of interest QNB lowered the rates paid on savings accounts. The average rate paid on savings accounts declined 31 basis points to .92 percent when comparing the first quarter of 2003 to the first quarter of 2002. When comparing the first quarter of 2003 to the first quarter of 2002 average money market accounts decreased $248,000 while average savings accounts increased $8,469,000. Interest expense on interest bearing demand accounts increased from $74,000 to $115,000, while the yield on these accounts increased from .55 percent to .63 percent, when comparing the three-month periods ended March 31, 2002 and 2003. The average balance on these accounts increased from $54,833,000 to $74,421,000 when comparing the same two periods. The majority of the growth in interest bearing demand deposits can be attributed to the successful development of a relationship with a municipal organization. The yield on time deposits may continue to decline in 2003 as these deposits mature and reprice at lower rates. However, the rate of decline will likely slow because many of these deposits have already repriced at lower rates. With regard to the yield on non-maturity interest-bearing deposits, which reprice immediately when their rates are changed, management does not expect the rate paid to decline significantly as they have reached a level where only a minimal reduction in rates is possible. Form 10-Q Page 13
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION NET INTEREST INCOME (CONTINUED) Interest expense on short-term borrowing decreased from $72,000 for the first quarter of 2002 to $29,000 for the first quarter of 2002. Average short-term borrowings decreased from $14,259,000 to $9,532,000 when comparing the two periods. In addition, the rate paid on short-term borrowings decreased from 2.05 percent for the first quarter of 2002 to 1.23 percent for the first quarter of 2003. Most of these borrowings are indexed with the Federal funds rate. PROVISION FOR LOAN LOSSES The provision for loan losses represents management's determination of the amount necessary to be charged to operations to bring the allowance for loan losses to a level that represents management's best estimate of the known and inherent losses in the existing loan portfolio. Actual loan losses, net of recoveries, serve to reduce the allowance. The determination of an appropriate level of the allowance for loan losses is based upon an analysis of the risk inherent in QNB's loan portfolio. Management uses various tools to assess the adequacy of the allowance for loan losses. One tool is a model recommended by the Office of the Comptroller of the Currency. This model considers a number of relevant factors including: historical loan loss experience, the assigned risk rating of the credit, current and projected credit worthiness of the borrower, current value of the underlying collateral, levels of and trends in delinquencies and non-accrual loans, trends in volume and terms of loans, concentrations of credit, and national and local economic trends and conditions. This model is supplemented with another analysis that also incorporates exceptions to QNB's loan policy and QNB's portfolio exposure to borrowers with large dollar concentration, defined as exceeding 50% of QNB's legal lending limit. Other tools include ratio analysis and peer group analysis. QNB's management determined no provision for loan losses was necessary for either three-month period ended March 31, 2003 or 2002 as charged off loans, non-performing assets and delinquent loans remained at low levels relative to the allowance for loan losses. QNB had a net charge-off of $5,000 during the first quarter of 2003 and a net recovery of $31,000 during the first quarter of 2002. Non-performing assets (non-accruing loans, loans past due 90 days or more, other real estate owned and other repossessed assets) remained low amounting to .12 percent of total assets at March 31, 2003. This compares to .09 percent at March 31, 2002 and .13 percent at December 31, 2002. Non-accrual loans were $579,000 and $402,000 at March 31, 2003 and 2002. Non-accrual loans at December 31, 2002 were $650,000. QNB did not have any other real estate owned as of March 31, 2003, December 31, 2002 or March 31, 2002. Repossessed assets were $5,000 and $11,000 at March 31, 2003 and December 31, 2002. There were no repossessed assets as of March 31, 2002. There were no restructured loans as of March 31, 2002, December 31, 2001 or March 31, 2001 as defined in Statement of Financial Accounting Standards No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings," that have not already been included in loans past due 90 days or more or non-accrual loans. The allowance for loan losses was $2,933,000 and $2,938,000 at March 31, 2003 and December 31, 2002, respectively. The ratio of the allowance to total loans was 1.28 percent and 1.35 percent at the respective Form 10-Q Page 14
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION PROVISION FOR LOAN LOSSES (CONTINUED) period end dates. The 6.0 percent growth in total loans between December 31, 2002 and March 31, 2003 was the primary factor in the decline in this ratio. While QNB believes that its allowance is adequate to cover losses in the loan portfolio, there remain inherent uncertainties regarding future economic events and their potential impact on asset quality. A loan is considered impaired, based on current information and events, if it is probable that QNB will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. At March 31, 2003 and 2002, the recorded investment in loans for which impairment has been recognized in accordance with SFAS No. 114 totaled $552,000 and $319,000, respectively. No valuation allowance was necessary on these loans. Most of the loans identified as impaired are collateral-dependent. Management in determining the allowance for loan losses makes significant estimates. Consideration is given to a variety of factors in establishing these estimates including current economic conditions, diversification of the loan portfolio, delinquency statistics, results of loan reviews, borrowers' perceived financial and managerial strengths, the adequacy of underlying collateral if collateral dependent, or the present value of future cash flows. Since the allowance for loan losses is dependent, to a great extent, on conditions that may be beyond QNB's control, it is at least reasonably possible that management's estimates of the allowance for loan losses and actual results could differ in the near term. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB's allowance for losses on loans. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. NON-INTEREST INCOME QNB, through its core banking business, generates various fees and service charges. Total non-interest income is composed of service charges on deposit accounts, ATM and debit card income, income on bank owned life insurance, mortgage servicing fees, gains or losses on the sale of investment securities, gains on the sale of residential mortgage loans and student loans, and other miscellaneous fee income. QNB reviews all service charges and fee schedules related to its products and services on an annual basis. QNB has not materially changed these fee schedules during 2002 or 2003. During the third quarter of 2002, QNB increased its overdraft fee by 7.1 percent. Total non-interest income increased $504,000 or 68.7 percent to $1,238,000 for the quarter ended March 31, 2003 when compared to March 31, 2002. Excluding gains and losses on the sale of investment securities and loans during both periods, non-interest income increased approximately $65,000 or 9.9 percent. Fees for services to customers, the largest component of total non-interest income, is primarily comprised of service charges on deposit accounts. These fees increased 15.6 percent, to $414,000 from $358,000, when comparing the two quarters. The increase in the overdraft fee during the third quarter of 2002, as well as an increase in the volume of overdrafts contributed to the $67,000 or 23.9 percent increase in overdraft income when comparing the three month periods ended March 31, 2003 and 2002. Form 10-Q Page 15
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION NON-INTEREST INCOME (CONTINUED) ATM and debit card income is primarily comprised of interchange 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 $131,000 for the first quarter of 2003, an increase of $22,000 or 20.2 percent from the amount recorded during the first quarter of 2002. Debit card income increased $16,000 or 20.4 percent to $92,000 during the first quarter of 2003. The increase in debit card income is a result of increased acceptance by consumers as a means of paying for goods and services. ATM transaction surcharge income decreased $4,000 or 13.1 percent to $25,000 when comparing the first quarter of 2003 to the first quarter of 2002. The decline in ATM transaction surcharge income is a result of a reduction in the number of transactions by non-QNB customers at QNB machines. When QNB sells its residential mortgages in the secondary market, it retains servicing rights. A normal servicing fee is retained on all mortgage loans sold and serviced. QNB recognizes its obligation to service financial assets that are retained in a transfer of assets in the form of a servicing asset. The servicing asset is amortized in proportion to and over the period of net servicing income or loss. Servicing assets are assessed for impairment based on their fair value. Mortgage servicing fees for the quarter ended March 31, 2003 were a loss of $59,000. Included in this amount is a $75,000 valuation allowance for impairment. This impairment was a result of the historically high prepayment speeds on mortgages resulting from the record level of mortgage refinancing activity created by the low interest rate environment. Excluding the valuation allowance mortgage servicing income would have been $16,000 for the first quarter of 2003 compared to $15,000 for the first quarter of 2002. Other results from the increase in mortgage refinancing activity are an increase in amortization expense and an increase in the amount of mortgages serviced. When a loan is paid off, the servicing asset related to that mortgage must be expensed. Amortization expense for the three-month periods ended March 31, 2003 and 2002 was $31,000 and $19,000, respectively. The average balance of mortgages serviced for others was $74,876,000 for the first quarter of 2003 compared to $65,891,000 for the first quarter of 2002, an increase of 13.6 percent. The timing of mortgage payments and delinquencies also impacts the amount of servicing fees recorded. Net gains on the sale of investment securities were $155,000 for the first quarter of 2003. QNB recognized a gain of $266,000 on the sale of debt securities and a net loss of $111,000 in the marketable equity securities portfolio. QNB sold $18,161,000 of mortgage-backed securities and CMO's that were prepaying at very fast speeds. The proceeds were used to purchase lower coupon 15-year mortgage backed securities. The purpose of this transaction was to reduce the amount of cash flow currently being received. Included in the loss on equity securities was a $126,000 write-down of securities whose decline in market value below cost was deemed to be other than temporary. These securities were determined to be impaired. QNB recorded a net loss of $64,000 on the sale of investment securities during the first quarter of 2002. Included in this amount was a loss of $82,000 related to the write-down of marketable equity securities that declined in market value below cost and was deemed to be other than temporary. This gain was a result of sales of marketable equity securities. There were no sales of debt securities during the first quarter of 2002. QNB recorded a gain of $361,000 on the sale of loans during the first quarter of 2003. This compares to a $141,000 gain for the same period in 2002. The sale of residential mortgages and the sale of student loans account for $356,000 and $5,000 of the gains, respectively in 2003. For the same period in 2002 the sale of residential mortgage loans accounted for $124,000 of the gain while the sale of student loans represented Form 10-Q Page 16
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION NON-INTEREST INCOME (CONTINUED) $17,000 of the gain. QNB sold approximately $257,000 and $886,000 in student loans during the first quarters of 2003 and 2002, respectively. The decrease in the gain on the sale relates to the lower volume of loans sold. Effective June 30, 2002 QNB terminated its agreement with the Student Loan Marketing Association (SLMA). QNB will no longer be originating student loans for sale but will be working on a referral basis instead. The remaining balance in portfolio should be sold during the second quarter of 2003. 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. As mentioned previously the decline in interest rates has resulted in record mortgage refinancing activity during 2002. This activity remained strong during the first quarter of 2003. QNB originated $8,064,000 and $6,811,000 in mortgages held for sale during the first quarter of 2003 and 2002. Proceeds from the sale of residential mortgages were approximately $9,908,000 and $7,637,000 during the first quarter of 2003 and 2002. As of March 31, 2003 and 2002 QNB had approximately $2,227,000 and $187,000 in mortgage loans classified as held for sale. These loans are accounted for at lower of cost or market. Other operating income increased $63,000 to $159,000 during the first quarter of 2002. Included in other operating income was a $46,000 derivative gain on residential mortgage loans held for sale that have been committed but not settled. A $14,000 increase in retail brokerage income and a $3,000 increase in trust income also contributed to the increase in other operating income when comparing the first quarter of 2003 to the first quarter of 2002. NON-INTEREST EXPENSE Non-interest expense is comprised of costs related to salaries and employee benefits, net occupancy, furniture and equipment, marketing, third party services and various other operating expenses. Total non-interest expense of $3,138,000 for the quarter ended March 31, 2003 represents an increase of $344,000 or 12.3 percent from levels reported in the first quarter of 2002. Salaries and benefits, the largest component of non-interest expense, increased $257,000 or 16.6 percent to $1,809,000 for the quarter ended March 31, 2003 compared to the same quarter in 2002. Salary expense increased $203,000 or 16.3 percent during the period to $1,441,000 while benefits expense increased $55,000 or 17.6 percent to $368,000. The increase in salary expense related to the implementation of a new incentive program amounts to $125,000 when comparing the two quarters. Merit increases and an increase in the number of employees also contributed to the increase in salary expense. The number of full time-equivalent employees increased by six when comparing the first quarters of 2003 and 2002. QNB monitors, through the use of various surveys, the competitive salary information in its markets and makes adjustments where appropriate. In addition, in 2002 with the assistance of a consultant, QNB performed a complete analysis of its compensation program. The increase in benefits expense is a result of a $13,000 increase in payroll tax expense, a $21,000 increase in net medical and dental premiums and a $14,000 increase in retirement plan expense. Net occupancy expense increased $9,000 to $215,000 while furniture and equipment expense increased $42,000 to $270,000 when comparing the three-month periods ended March 31, 2003 and 2002, respectively. Higher utility costs and building maintenance costs contributed to the increase in net occupancy expense. A $27,000 increase in depreciation and amortization expense and a $9,000 increase in equipment maintenance costs contributed to the increase in furniture and equipment expense. Form 10-Q Page 17
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION NON-INTEREST EXPENSE (CONTINUED) Marketing expense decreased $44,000 to $100,000 for the quarter ended March 31, 2003. The decrease in marketing expense is primarily a result of the timing of advertising, sales promotion and donation expenses. The advertising and sales promotion costs will likely catch up during the remainder of the year. During the fourth quarter of 2002 QNB made several large long-term charitable pledges that would likely have been made during the first quarter of 2003. 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 include Trust services, retail non-deposit services, correspondent banking services, investment security safekeeping and supply management services, to name a few. Third party services expense was $190,000 in the first quarter of 2003 compared to $134,000 for the first quarter of 2002. The use of an executive search firm to fill an open Trust officer position was the primary contributor to the increase in third party service expense. Also contributing to the increase were consulting and training costs related to the installation of an upgrade to the item processing system. INCOME TAXES Applicable income taxes and effective tax rates were $456,000 or 22.9 percent for the three-month period ended March 31, 2003, and $290,000 or 18.5 percent for the same period in 2002. The increase in the effective tax rate when comparing 2003 to 2002 is a result of pre-tax income increasing at a rate faster than tax-exempt income. Also contributing to the higher effective tax rate was the non-deductible capital losses recorded during the first quarter for the impairment of equity securities. QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of March 31, 2003 QNB's net deferred tax liability was $942,000. The primary components of deferred taxes are a deferred tax asset of $724,000 relating to the allowance for loan losses and a deferred tax liability of $1,836,000 resulting from the SFAS No.115 adjustment for available-for-sale investment securities. As of March 31, 2002 QNB's net deferred tax asset was $625,000. A deferred tax asset of $737,000 related to the allowance for loan losses was partially offset by a deferred tax liability of $152,000 resulting from the SFAS No. 115 adjustment for available-for-sale investment securities. The realizability of deferred tax assets is dependent upon a variety of factors including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. A valuation allowance of $95,000 was established during the year ended December 31, 2002, to offset a portion of the tax benefits associated with certain impaired securities that management believes may not be realizable. At March 31, 2003 the valuation allowance was increased to $138,000. Based upon these and other factors, management believes it is more likely than not that QNB will realize the benefits of these remaining deferred tax assets. Form 10-Q Page 18
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION BALANCE SHEET ANALYSIS The Balance Sheet Analysis reviews average balance sheet data for the three months ended March 31, 2003 and 2002, as well as the period ended balances as of March 31, 2003 and December 31, 2002. Average earning assets for the three-month period ended March 31, 2003 increased $35,424,000 or 8.2 percent to $469,041,000 from $433,617,000 for the quarter ended March 31, 2002. Average investments increased $19,544,000 while average loans and Federal funds sold increased $15,211,000 and $656,000, respectively. The 7.4 percent increase in average loans is a result of the use of a business development and calling program encompassing lending personnel, branch personnel and executive management. The focus of this program is to both develop new lending and deposit relationships as well as strengthen existing relationships. This program was enhanced during 2002 with the development of a bank-wide sales initiative that concentrated on sales training, particularly with regard to identifying lending opportunities. This program is being expanded in 2003 to include an incentive compensation program that will reward employees not only for loan growth, but also for asset quality and profitability. The addition of the Souderton branch location was also key to the growth in loans, especially commercial loans. The growth in loans was achieved despite the relatively weak economy during 2002 and the first quarter of 2003. Average commercial loans increased $7,560,000 while average residential mortgage loans and consumer loans increased $362,000 and $7,289,000 when comparing the first quarter of 2003 to the first quarter of 2002. Residential mortgage loans did not experience more growth despite the increase in originations because most residential mortgage loans are sold. The increase in consumer loans is primarily in the category of home equity loans, which increased $7,647,000 or 20.6 percent. Home equity loans have been popular with consumers; especially those refinancing existing residential mortgage loans, because they have lower origination costs than residential mortgage loans. The growth in average earning assets was funded by increases in non-interest-bearing and interest-bearing deposit accounts. Average non-interest bearing demand accounts increased $6,453,000 or 16.2 percent, while average interest-bearing deposit accounts increased $32,569,000 or 10.3 percent. The "Free Checking" promotion, as well as the acquisition of new business accounts were significant factors in the increase in non-interest bearing deposits. The growth in average interest-bearing deposit accounts is primarily centered in interest bearing demand deposit accounts which increased $19,588,000 or 35.7 percent. The majority of this growth can be attributed to the successful development of a relationship with a municipal organization. Average savings accounts increased $8,469,000 or 21.7 percent. Continued lackluster performance of the stock market, a slow growing United States economy, and geopolitical uncertainty have contributed to the inflow of funds into the banking system. Consumers are looking for the relative safety of bank deposits despite the low interest rate environment. Time deposit accounts continued to increase in 2003 but at a much slower rate than in previous years. Average total time deposits increased $4,760,000 or 2.5 percent to $191,541,000 when comparing the first quarter of 2003 to the first quarter of 2002. Another difference in the growth pattern in time deposits was in the maturity time frame selected by customers. In 2001, the majority of the new time deposits were opened with maturities under one year, while in 2002 and 2003 customers extended the maturities and opened Form 10-Q Page 19
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION BALANCE SHEET ANALYSIS (CONTINUED) accounts with three to five year maturities. It appears that customers are looking to achieve the highest yields possible in this low interest rate environment. Total assets at March 31, 2003 were $518,495,000, compared with $503,430,000 at December 31, 2002, an increase of 3.0 percent for the quarter. The increase in assets from December 31, 2002 to March 31, 2003 was primarily centered in loans, which increased $13,028,000. This growth in assets was funded by a $21,417,000 increase in total deposits. Total deposits increased from $388,913,000 at December 31, 2002 to $410,330,000 at March 31, 2003. The increase in deposits was spread across all product lines except for money market accounts. Non-interest bearing demand accounts and interest bearing demand accounts increased $5,925,000 and $8,435,000, respectively when comparing balances at March 31, 2003 and December 31, 2002. Savings accounts increased $4,417,000 and total time deposits increased $7,757,000 when comparing the same time periods. Money market accounts decreased $5,117,000 during this time frame. At March 31, 2003 the fair value of investment securities available-for-sale was $219,439,000 or $5,401,000 above the amortized cost of $214,038,000. This compares to a fair value of $214,741,000 or $5,524,000 above the amortized cost of $209,217,000 at December 31, 2002. An unrealized holding gain, net of taxes, of $3,564,000 and $3,603,000 was recorded as an increase to shareholders' equity at March 31, 2003 and December 31, 2002, respectively. The composition of the portfolio has not changed significantly since December 31, 2002. During the second quarter of 2002, management and the Board of Directors approved that all future purchases of investment securities will be categorized as available-for-sale. While there is the potential for increased volatility of shareholder's equity due to market value changes, management believes it will provide for more flexibility in managing the portfolio. The available-for-sale portfolio had a weighted average maturity of approximately 4 years and 7 months at both March 31, 2003 and December 31, 2002. The weighted average tax-equivalent yield was 5.09 percent and 5.35 percent at March 31, 2003 and December 31, 2002. The weighted average maturity is based on the stated contractual maturity of all securities except for mortgage-backed securities and CMOs, which are based on estimated average life. The maturity of the portfolio may be shorter because of call features in many debt securities and because of prepayments on mortgage-backed securities and CMOs. The interest rate sensitivity analysis reflects the repricing term of the securities portfolio based upon estimated call dates and anticipated cash flows assuming management's most likely interest rate environment. The expected repricing term of the available-for-sale portfolio was 3 years at March 31, 2003 and 2 years, 11 months at December 31, 2002, based on these assumptions. Investment securities held-to-maturity are reported at amortized cost. As of March 31, 2003 and December 31, 2002, QNB had securities classified as held-to-maturity with an amortized cost of $22,936,000 and $29,736,000 and a market value of $23,487,000 and $30,386,000, respectively. The held-to-maturity portfolio had an expected repricing term of approximately 2 years, 1 month at both March 31, 2003 and December 31, 2002. The weighted average tax-equivalent yield was 6.14 percent at both March 31, 2003 and December 31, 2002. Form 10-Q Page 20
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION LIQUIDITY Liquidity represents an institution's ability to generate cash or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and demands of depositors. QNB manages its mix of cash, Federal funds sold, investment securities and loans in order to match the volatility, seasonality, interest sensitivity and growth trends of its deposit funds. Liquidity is provided from asset sources through maturities and repayments of loans and investment securities, net interest income and fee income. The portfolio of investment securities available-for-sale and QNB's policy of selling certain residential mortgage originations and student loans in the secondary market also provide sources of liquidity. Additional sources of liquidity are provided by The Quakertown National Bank's membership in the Federal Home Loan Bank and a $5,000,000 unsecured Federal funds line granted by the Bank's correspondent. Cash and due from banks, Federal funds sold, available-for-sale securities and loans held-for-sale were $253,385,000 and $246,377,000 at March 31, 2003 and December 31, 2002. These sources were adequate to meet seasonal deposit withdrawals and loan growth during the first quarter of 2003 and should be adequate to meet normal fluctuations in loan demand and or deposit withdrawals. QNB has been able to fund the growth in earning assets during the first quarter of 2003 through increased deposits. QNB did not use its Federal funds line, overnight borrowings from the FHLB or the Federal Reserve Bank discount window to fund loan growth or deposit withdrawals during the first quarter of 2003. Approximately $60,412,000 and $65,871,000 of available-for-sale securities at March 31, 2003 and December 31, 2002 were pledged as collateral for repurchase agreements and deposits of public funds. In addition, under terms of its agreement with the Federal Home Loan Bank, QNB maintains otherwise unencumbered qualifying assets (principally 1-4 family residential mortgage loans and U.S. Government and Agency notes, bonds, and mortgage-backed securities) in the amount of at least as much as its advances from the Federal Home Loan Bank. The consolidated statements of cash flows present the changes in cash and cash equivalents from operating, investing and financing activities. QNB's cash and cash equivalents increased $4,102,000 to $31,579,000 at March 31, 2003. This compares to a $4,082,000 increase during the first three months of 2002. After adjusting net income for non-cash transactions, operating activities provided $4,088,000 in cash flow in the first three months of 2003, compared to $3,677,000 in the same period of 2002. Higher net income, an increase in mortgage activity, an increase in amortization of premiums on investment securities and an increase in taxes payable accounted for the increase in net cash provided by operating activities during the first quarter of 2003. An increase in net income, proceeds for the sale of residential mortgages and student loans in excess of the origination of residential mortgage loans held-for-sale as well as an increase in other liabilities account for the cash provide by operation activities during the first quarter of 2002. Net cash used by investing activities was $13,099,000 during the first quarter of 2003. The growth in loans during the quarter was the primary use of cash. Loans, excluding mortgage and student loan activity increased $14,778,000 during the first quarter of 2003. Investment securities activity was a net provider of cash of $1,832,000 during the first quarter of 2003. Net cash used by investing activities was $23,802,000 during the first three months of 2002. The purchase of investment securities exceeded the maturity, call and sales of securities by $20,116,000 during the first quarter of 2002. Most of the activity relates to the deployment of the deposit growth experienced during the first quarter of 2002. A net increase in loans of $3,567,000 was also a use of cash during the first quarter of 2002. Net cash provided by financing activities was $13,113,000 during the first quarter of 2003 and $24,207,000 during the first quarter of 2002. The increase in deposits of $21,417,000 offset the decline in short-term borrowings of $7,850,000. The decrease in short-term borrowings is primarily the reduction of balances held Form 10-Q Page 21
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION LIQUIDITY (CONTINUED) by one repurchase agreement customer. A $19,882,000 increase in interest-bearing deposits, including a $14,637,000 increase in time deposits was the main source of funding during the first quarter of 2002. A $2,582,000 increase in short-term borrowings as well as an additional $2,000,000 advance from the FHLB also provided funding during the first quarter of 2002. CAPITAL ADEQUACY A strong capital position is fundamental to support continued growth and profitability, to serve the needs of depositors, and to yield an attractive return for shareholders. QNB's shareholders' equity at March 31, 2003 was $41,952,000 or 8.09 percent of total assets compared to shareholders' equity of $40,914,000 or 8.13 percent at December 31, 2002. Shareholders' equity at March 31, 2003 includes a positive adjustment of $3,564,000 related to unrealized holding gains, net of taxes, on investment securities available-for-sale, while shareholders' equity at December 31, 2002 includes a positive adjustment of $3,603,000. Without these adjustments shareholders' equity to total assets would have been 7.40 percent and 7.41 percent at March 31,2003 and December 31, 2002. On March 30, 2000, the Board of Directors of QNB Corp. approved a plan to repurchase up to 4.99 percent or 79,180 shares of QNB Corp's outstanding common stock in open market and privately negotiated transactions. As of March 31, 2003 and December 31, 2002, 53,343 shares had been repurchased at an average cost of $28.01. These shares are recorded as Treasury stock at cost and reduce total shareholder's equity. Shareholders' equity averaged $37,916,000 for the first three months of 2003 and $35,707,000 during all of 2002, an increase of 6.2 percent. The ratio of average total equity to average total assets increased to 7.56 percent for 2003, compared to 7.45 percent for 2002. The increase in the equity to asset ratio is a function of the growth in average equity outpacing the growth in total average assets. QNB Corp. and the Quakertown National Bank are subject to various regulatory capital requirements as issued by Federal regulatory authorities. Regulatory capital is defined in terms of Tier I capital (shareholders' equity excluding unrealized gains or losses on available-for-sale securities), Tier II capital which includes a portion of the allowance for loan losses, and total capital (Tier I plus II). Risk-based capital ratios are expressed as a percentage of risk-weighted assets. Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet arrangements, such as letters of credit and loan commitments, based on associated risk. Regulators have also adopted minimum Tier I leverage ratio standards, which measure the ratio of Tier I capital to total assets. The minimum regulatory capital ratios are 4.00 percent for Tier I, 8.00 percent for the total risk-based and 4.00 percent for leverage. Under the requirements, QNB has a Tier I capital ratio of 12.24 percent and 12.40 percent, a total risk-based ratio of 13.19 percent and 13.39 percent and a leverage ratio of 7.56 percent and 7.44 percent at March 31, 2003 and December 31, 2002, respectively. The decline in the risk based capital ratios reflects the growth in total loans since December while the increase in the leverage ratio reflects the growth in Tier I capital outpacing the growth in total average assets. The Federal Deposit Insurance Corporation Improvement Act of 1991 established five capital level designations ranging from "well capitalized" to "critically undercapitalized." At March 31, 2003 and December 31, 2002 QNB met the "well capitalized" criteria which requires minimum Tier I and total risk-based capital ratios of 6.00 percent and 10.00 percent, respectively and a Tier I leverage ratio of 5.00 percent. Form 10-Q Page 22
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION INTEREST RATE SENSITIVITY Since the assets and liabilities of QNB have diverse repricing characteristics that influence net interest income, management analyzes interest sensitivity through the use of gap analysis and simulation models. Interest rate sensitivity management seeks to minimize the effect of interest rate changes on net interest margins and interest rate spreads and to provide growth in net interest income through periods of changing interest rates. The Asset/Liability Management Committee (ALCO) is responsible for managing interest rate risk and for evaluating the impact of changing interest rate conditions on net interest income. Gap analysis measures the difference between volumes of rate-sensitive assets and liabilities and quantifies these repricing differences for various time intervals. Static gap analysis describes interest rate sensitivity at a point in time. However, it alone does not accurately measure the magnitude of changes in net interest income since changes in interest rates do not impact all categories of assets and liabilities equally or simultaneously. Interest rate sensitivity analysis also involves assumptions on certain categories of assets and deposits. For purposes of interest rate sensitivity analysis, assets and liabilities are stated at their contractual maturity, estimated likely call date, or earliest repricing opportunity. Mortgage-backed securities, CMOs and amortizing loans are scheduled based on their anticipated cash flow. Savings accounts, including passbook, statement savings, money market, and interest-bearing demand accounts, do not have a stated maturity or repricing term and can be withdrawn or repriced at any time. This may impact QNB's margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff. Management projects the repricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity. The Treasury Select Indexed Money Market account reprices monthly based on a percentage of the average of the 91-day Treasury bill. A positive gap results when the amount of interest rate sensitive assets exceeds interest rate sensitive liabilities. A negative gap results when the amount of interest rate sensitive liabilities exceeds interest rate sensitive assets. QNB primarily focuses on the management of the one-year interest rate sensitivity gap. At March 31, 2003, interest-earning assets scheduled to mature or likely to be called, repriced or repaid in one year were $218,759,000. Interest-sensitive liabilities scheduled to mature or reprice within one year were $173,604,000. The one-year cumulative gap, which reflects QNB's interest sensitivity over a period of time, was a positive $45,155,000 at March 31, 2003. The cumulative one-year gap equals 9.31 percent of total rate sensitive assets. This positive or asset sensitive gap will generally benefit QNB in a rising interest rate environment, while falling interest rates could negatively impact QNB. QNB also uses a simulation model to assess the impact of changes in interest rates on net interest income. The model reflects management's assumptions related to asset yields and rates paid on liabilities, deposit sensitivity, and the size, composition and maturity or repricing characteristics of the balance sheet. The assumptions are based on what management believes at that time to be the most likely interest rate environment. Management also evaluates the impact of higher and lower interest rates. Actual results may differ from simulated results due to various factors including time, magnitude and frequency of interest rate changes, the relationship or spread between various rates, loan pricing and deposit sensitivity, and asset/liability strategies. Based on the simulation model, net interest income for the next Form 10-Q Page 23
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION INTEREST RATE SENSITIVITY (CONTINUED) twelve months is expected to increase slightly compared to the prior twelve months. The projected increase in net interest income is principally a result of an increase in earning assets. The net interest margin in the base case is anticipated to be slightly below 2002 levels. If interest rates are 100 basis points higher than management's most likely interest rate environment, the simulation model projects net interest income for the next twelve months to be higher than the most likely scenario. If interest rates are 100 basis points lower than management's most likely interest rate environment, the model projects net interest income for the next twelve months to be lower than the most likely scenario. These results are consistent with the results indicated by the gap analysis. Management believes that the assumptions utilized in evaluating the vulnerability of QNB's net interest income to changes in interest rates approximate actual experience. However, the interest rate sensitivity of QNB's assets and liabilities as well as the estimated effect of changes in interest rates on net interest income could vary substantially if different assumptions are used or actual experience differs from the experience on which the assumptions were based. In the event QNB should experience a mismatch in its desired gap ranges or an excessive decline in its net interest income subsequent to an immediate and sustained change in interest rates, it has a number of options that it could utilize to remedy such a mismatch. QNB could restructure its investment portfolio through the sale or purchase of securities with more favorable repricing attributes. It could also emphasize loan products with appropriate maturities or repricing attributes, or it could attract deposits or obtain borrowings with desired maturities. The nature of QNB's current operation is such that it is not subject to foreign currency exchange or commodity price risk. Additionally, neither the Corporation nor the Bank owns trading assets. At March 31, 2003, QNB did not have any hedging transactions in place such as interest rate swaps, caps or floors. The table below summarizes estimated changes in net interest income over a twelve-month period, under alternative interest rate scenarios. <TABLE> <CAPTION> - --------------------------- ---------------------- ----------------- ----------------- Change in Interest Rates Net Interest Income Dollar Change Percent Change - --------------------------- ---------------------- ----------------- ----------------- <S> <C> <C> <C> +300 Basis Points................. $17,055 $1,629 10.56% +200 Basis Points................. 16,775 1,349 8 .74 +100 Basis Points................. 16,293 867 5.62 FLAT RATE......................... 15,426 - - - -100 Basis Points................. 14,069 (1,357) (8.80) - -200 Basis Points................. 13,005 (2,421) (15.69) - -300 Basis Points................. 11,884 (3,542) (22.96) </TABLE> Management believes, given the current interest rate environment that it is unlikely that interest rates would decline by 200 or 300 basis points. Form 10-Q Page 24
QNB CORP. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION OTHER ITEMS Management is not aware of any current specific recommendations by regulatory authorities or proposed legislation, which if they were implemented, would have a material adverse effect upon the liquidity, capital resources, or results of operations, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on QNB's results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK. The information required herein is set forth in Item 2, above. ITEM 4. CONTROLS AND PROCEDURES We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, within 90 days prior to the filing date of this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic Securities and Exchange Commission filings. No significant changes were made to our internal controls or other factors that could significantly affect these controls subsequent to the date of their evaluation. Form 10-Q Page 25
QNB CORP. AND SUBSIDIARY PART II. OTHER INFORMATION MARCH 31, 2003 Item 1. LEGAL PROCEEDINGS None. Item 2. CHANGES IN SECURITIES None. Item 3. DEFAULT UPON SENIOR SECURITIES None. Item 4. SUBMISSION OF MATTERS TO VOTE OF SECURITIES HOLDERS None. Item 5. OTHER INFORMATION None. Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits The following Exhibits are included in this Report: Exhibit 3(i) Articles of Incorporation of Registrant, as amended. (Incorporated by reference to Exhibit 3(i) of Registrants Form 10-Q filed with the Commission on August 13,1998). Exhibit 3(ii) Bylaws of Registrant, as amended. (Incorporated by reference to Exhibit 3(ii) of Registrants Form 10-Q filed with the Commission on August 13,1998). Exhibit 10.1 Employment Agreement between the Registrant and Thomas J. Bisko. (Incorporated by reference to Exhibit 10.1 of Registrants Form 10-K filed with the Commission on March 31, 1999 and amended on April 3,2002 on Form 8-K filed with the Commission on April 11, 2002). Exhibit 10.2 Salary Continuation Agreement between the Registrant and Thomas J. Bisko. (Incorporated by reference to Exhibit 10.2 of Registrants Form 10-K filed with the Commission on March 31, 1999). Form 10-Q Page 26
QNB CORP. AND SUBSIDIARY PART II. OTHER INFORMATION MARCH 31, 2003 Item 6. Exhibits and Reports on Form 8-K (Continued) --------------------------------------------- Exhibit 10.3 QNB Corp. 1998 Stock Incentive Plan. (Incorporated by reference to Exhibit 4.3 to Registration Statement No. 333-91201 on Form S-8, filed with the Commission on November 18, 1999). Exhibit 10.4 The Quakertown National Bank Profit Sharing and Section 401(k) Salary Deferral Plan. (Incorporated by reference to Exhibit 4C to Registration Statement No. 333-16627 on Form S-8, filed with the Commission on November 22, 1996). Exhibit 10.5 Change of Control Agreement between Registrant and Robert C. Werner (Incorporated by reference to Exhibit 10.7 of Registrants Form 10-Q filed with the Commission on November 13, 2000.) Exhibit 10.6 Change of Control Agreement between Registrant and Bret H. Krevolin (Incorporated by reference to Exhibit 10.8 of Registrants Form 10-Q filed with the Commission on November 13, 2000.) Exhibit 10.7 QNB Corp. 2001 Employee Stock Purchase Plan. (Incorporated by reference to Exhibit 99.1 to Registration Statement No. 333-67588 on Form S-8, filed with the Commission on August 15, 2001.) Exhibit 11 Statement Re: Computation of Earnings Per Share. (Included in Part I, Item I, hereof.) Exhibit 99.1 Certification of Principal Executive Officer Exhibit 99.2 Certification of Principal Financial Officer (b) Reports on Form 8-K Filed April 29, 2003, Press release dated April 23, 2003 reporting first quarter 2003 net income. Form 10-Q Page 27
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. QNB Corp. Date: May 14, 2003 By: -------------------------- /s/ Thomas J. Bisko --------------------------- Thomas J. Bisko President/CEO Date: May 14, 2003 By: -------------------------- /s/ Robert C. Werner --------------------------- Robert C. Werner Vice President Date: May 14, 2003 By: -------------------------- /s/ Bret H. Krevolin --------------------------- Bret H. Krevolin Chief Financial Officer Form 10-Q Page 28
CERTIFICATION I, Thomas J. Bisko, President and CEO, certify, that: 1. I have reviewed this quarterly report on Form 10-Q of QNB Corp. 2. Based on my knowledge, the quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report. 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report. 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date. 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of the internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls. 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect the internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 By: /s/ Thomas J. Bisko ------------ Thomas J. Bisko President and CEO
CERTIFICATION I, Bret H. Krevolin, Chief Financial Officer, certify, that: 1. I have reviewed this quarterly report on Form 10-Q of QNB Corp. 2. Based on my knowledge, the quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report. 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report. 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date. 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of the internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls. 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect the internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 By: /s/ Bret H. Krevolin ------------- Bret H. Krevolin Chief Financial Officer