QNB Corp. - 10-Q quarterly report FY

(Mark One)

OR

1. REPORTING AND ACCOUNTING POLICIES

The accompanying unaudited consolidated financial statements include the accounts of QNB Corp. (QNB) and its wholly-owned subsidiary, The Quakertown National Bank (the Bank). All significant intercompany accounts and transactions are eliminated in the consolidated financial statements.

The unaudited consolidated financial statements reflect all adjustments, which in the opinion of management are necessary for a fair presentation of the results of the interim periods and are of a normal and recurring nature. Tabular information, other than share and per share data, is presented in thousands of dollars.

In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from such estimates.

As of March 31, 2006, there was approximately $173,000 of unrecognized compensation cost related to unvested share-based compensation awards granted. That cost is expected to be recognized over the next three years.

The risk-free interest rate was selected based upon yields of U.S. Treasury issues with a term equal to the expected life of the option being valued. Historical information was the primary basis for the selection of the expected dividend yield, expected volatility and expected lives of the options.

The fair market value of options granted in the first quarter of 2006 and 2005 was $3.13 and $6.46, respectively.

Stock option activity during the three months ended March 31, 2006 is as follows:

2. PER SHARE DATA

The following sets forth the computation of basic and diluted earnings per share:

There were 34,900 and 40,000 stock options that were anti-dilutive as of March 31, 2006 and 2005, respectively. These stock options were not included in the above calculation.

3. COMPREHENSIVE INCOME

Comprehensive income is defined as the change in equity of a business entity during a period from transactions and other events and circumstances, excluding those resulting from investments by and distributions to owners. For QNB, the sole component of other comprehensive income is the unrealized holding gains and losses on available-for-sale investment securities.

The following shows the components and activity of comprehensive income during the periods ended March 31, 2006 and 2005 (net of the income tax effect):

4. LOANS

The following table presents loans by category as of March 31, 2006 and December 31, 2005:

5. INTANGIBLE ASSETS

As a result of a purchase of deposits in 1997, QNB recorded a deposit premium of $511,000. This premium is being amortized, for book purposes, over ten years and is reviewed annually for impairment. The net deposit premium intangible was $81,000 and $94,000 at March 31, 2006 and December 31, 2005, respectively. Amortization expense for core deposit intangibles was $13,000 for both periods ended March 31, 2006 and 2005.

The following table reflects the components of mortgage servicing rights as of the periods indicated:

5. INTANGIBLE ASSETS (Continued):

The annual estimated amortization expense of intangible assets for each of the five succeeding fiscal years is as follows:

6. RELATED PARTY TRANSACTIONS

As of March 31, 2006, amounts due from directors, principal officers, and their related interests totaled $4,157,000. All of these transactions were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons. Also, they did not involve a more than normal risk of collectibility or present any other unfavorable features.

QNB Corp. (the Corporation) is a bank holding company headquartered in Quakertown, Pennsylvania. The Corporation, through its wholly-owned subsidiary, The Quakertown National Bank (the Bank), has been serving the residents and businesses of upper Bucks, northern Montgomery and southern Lehigh Counties in Pennsylvania since 1877. The Bank is a locally managed community bank that provides a full range of commercial and retail banking and retail brokerage services. The consolidated entity is referred to herein as “QNB”.

In addition to historical information, this document contains forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference.

Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, could affect the future financial results of the Corporation and its subsidiary and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include, but are not limited, to the following:

QNB cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which change over time, and QNB assumes no duty to update forward-looking statements. Management cautions readers not to place undue reliance on any forward-looking statements. These statements speak only as of the date made, and they advise readers that various factors, including those described above, could affect QNB’s financial performance and could cause actual results or circumstances for future periods to differ materially from those anticipated or projected. Except as required by law, QNB does not undertake, and specifically disclaims any obligation, to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

QNB believes the following critical accounting policies affect its more significant judgments and estimates used in preparation of its consolidated financial statements: allowance for loan losses, income taxes and other-than-temporary investment security impairment. Each estimate is discussed below. The financial impact of each estimate is discussed in the applicable sections of Management’s Discussion and Analysis.

QNB considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a level believed by management to be sufficient to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.

The allowance for loan losses is based on management’s continuing review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. The portion of the allowance that is allocated to internally criticized and non-accrual loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general reserves are based on the composition and risk characteristics of the loan portfolio, including the nature of the loan portfolio, credit concentration trends, historic and anticipated delinquency and loss experience, as well as other qualitative factors such as current economic trends.

Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and loan administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of uncollectibility. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent loan review group tests risk assessments and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value are not necessarily favorable, or that there is a lack of evidence to support realizable value equal to or greater than carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced, and a corresponding charge to earnings is recognized.

QNB Corp. earns its net income primarily through its subsidiary, The Quakertown National Bank. Net interest income, or the spread between the interest, dividends and fees earned on loans and investment securities and the expense incurred on deposits and other interest-bearing liabilities, is the primary source of operating income for QNB. QNB seeks to achieve sustainable and consistent earnings growth while maintaining adequate levels of capital and liquidity and limiting its exposure to credit and interest rate risk to Board of Directors approved levels. Due to its limited geographic area comprised principally of upper Bucks, southern Lehigh and northern Montgomery counties, growth is pursued through expansion of existing customer relationships and building new relationships by stressing a consistent high level of service at all points of contact.

QNB reported net income for the first quarter of 2006 of $1,678,000, or $.53 per common share on a diluted basis. This represents a 12.6 percent decrease from the $1,919,000, or $.60 per share diluted, for the same period in 2005.

Two important measures of profitability in the banking industry are an institution's return on average assets and return on average shareholders' equity. Return on average assets and return on average shareholders' equity were 1.18 percent and 14.06 percent, respectively, for the first quarter of 2006 compared with 1.34 percent and 17.04 percent, respectively, for the first quarter of 2005.

QNB’s net interest income declined in the first quarter of 2006, to $3,986,000, as compared to $4,085,000 for the same quarter of 2005 due to the continued compression of the net interest margin, as well as a slight decrease in average earning assets. Funding costs of deposits and short-term borrowings increased to a greater degree than the rates earned on loans and investments. This difference was primarily the result of three factors: a highly competitive deposit and loan pricing environment, a sustained flat Treasury yield curve and the current structure of QNB’s balance sheet. The net interest margin declined 4 basis points to 3.26 percent from the first quarter of 2005 to the first quarter of 2006. In addition, included in net interest income for the first quarter of 2005 was $40,000 of interest income recovered on non-accrual and previously charged off loans.

Non-interest income was $1,208,000 for the quarter ended March 31, 2006, a 27.6 percent decrease from the $1,669,000 recorded in 2005. The decline in non-interest income was primarily the result of non-core business activities that occurred in the first quarter of 2005. These activities included a $209,000 gain on the liquidation of the remaining assets relinquished by a borrower during the third quarter of 2004. In addition, the net gain on the sale of investment securities decreased $258,000, while the net gain on the sale of loans decreased $22,000, when comparing the first quarter of 2006 to the first quarter of 2005.

Non-interest expense remained flat at $3,236,000 for the quarter ended March 31, 2006. Salary and benefit expense declined $32,000, to $1,805,000, for the quarter ended March 31, 2006 primarily due to a decrease in the accrual for incentive compensation of $40,000 which was partially offset by the $27,000 expense related to the adoption of FASB No. 123r. Net occupancy and furniture and equipment expense declined by $53,000, when comparing the two quarters, due to declines in depreciation and amortization expense. The effective tax rate was 14.3 percent for the first quarter of 2006 compared to 23.8 percent for the first quarter of 2005. During the first quarter of 2006, QNB was able to reverse $138,000 of the tax valuation allowance, established in 2005.

The balance sheet experienced strong growth in loans, with average loans increasing $39,901,000, when comparing the three months ended March 31, 2006 to March 31, 2005. QNB’s successful loan growth was attributable to developing new relationships, as well as further cultivating existing relationships with small businesses in the communities served. Also contributing to the loan growth was the new indirect lease financing line of business. This loan growth was achieved while maintaining excellent asset quality. No provision for loan losses was necessary during the quarter. On the funding side of the balance sheet, total average deposits decreased $13,667,000, or 2.9 percent. This is primarily a result of a decision not to aggressively seek to retain the short-term money market deposits of a school district by paying high short-term rates. With the flat yield curve, these funds would not have added significant incremental net interest income and would have further eroded the net interest margin.

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.

For purposes of this discussion, interest income and the average yield earned on loans and investment securities are adjusted to a tax-equivalent basis as detailed in the table that appears on page 16. This adjustment to interest income is made for analysis purposes only. Interest income is increased by the amount of savings of Federal income taxes, which QNB realizes by investing in certain tax-exempt state and municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more easily compared.

As mentioned previously, the Federal Reserve Board continued to increase short-term rates by increasing the Federal funds rate twice by 25 basis points each time during the first quarter of 2006. Despite the significant increase in short-term interest rates over the past year, the long period of historically low interest rates has had an impact on the yield on earning assets and the rates paid on interest-bearing liabilities. While the yield on earning assets on a tax-equivalent basis has increased from 5.28 percent for the first quarter of 2005 to 5.82 percent for the first quarter of 2006, the rate of increase was slowed because of the fixed-rate nature of the investment and loan portfolio as well as the price competition for loans.

Interest income on investment securities decreased $312,000 when comparing the two quarters, as the decline in balances offset the increase in the yield on the portfolio. The average yield increased from 4.61 percent for the first quarter of 2005 to 4.90 percent for the first quarter of 2006.

The yield on loans increased 50 basis points to 6.49 percent when comparing the first quarter of 2006 to the first quarter of 2005. The average prime rate when comparing these same periods increased 199 basis points, from 5.44 percent to 7.43 percent. While QNB was positively impacted by the increases in the prime rate, the overall yield on the loan portfolio did not increase proportionately, since only a portion of the loan portfolio reprices immediately with changes in the prime rate. Also, the benefits from an increase in the prime rate were partially offset by the long period of historically low interest rates which resulted in the refinancing of residential mortgage, home equity and commercial loans into lower yielding fixed-rate loans.

While total interest income on a tax-equivalent basis increased $682,000 when comparing the first quarter of 2006 to the first quarter of 2005, total interest expense increased $767,000. The increase in interest expense was a result of an increase in interest rates paid on both deposits and short-term borrowings. The rate paid on interest-bearing liabilities increased from 2.26 percent for the first quarter of 2005 to 2.94 percent for the first quarter of 2006, with the rate paid on interest-bearing deposits increasing from 1.86 percent to 2.58 percent during this same period. Interest expense and the rate paid on interest-bearing demand and time deposit accounts increased the most as these accounts were more reactive to the increase in market interest rates. Interest expense on interest-bearing demand accounts increased $242,000, and the rate paid increased from .87 percent to 1.85 percent when comparing the two quarters. Interest expense on money market accounts increased by only $5,000 as the 80 basis point increase in the average rate paid was offset by lower average balances. Average money market balances decreased $20,176,000 when comparing the two quarters, a direct result of not retaining the school district deposits. The increase in the average rate on money market accounts is primarily the result of the majority of the remaining balances being indexed to a percentage of the 91-day Treasury bill. This rate has increased as short-term interest rates have increased over the past year.

Interest expense on time deposits increased $400,000, while the average rate paid on time deposits increased from 2.78 percent to 3.48 percent when comparing the two periods. Like fixed-rate loans and investment securities, time deposits reprice over time and, therefore, have less of an immediate impact on costs in either a rising or falling rate environment. Unlike loans and investment securities, the maturity and repricing characteristics tend to be shorter. This feature, combined with the strong rate competition for these deposits, has resulted in the increase in the yield on time deposits in 2006. Average time deposits increased $5,799,000, or 2.8 percent, when comparing the first quarter of 2006 to the first quarter of 2005.

Interest expense on short-term borrowings increased $101,000 both as a result of an increase in balances and rates. The average rate paid increased from 1.61 percent for the first quarter of 2005 to 3.01 percent for the first quarter of 2006, while average balances increased $8,661,000 to $19,300,000.

Management expects the remainder of 2006 to be challenging with respect to net interest income and the net interest margin. It is anticipated that the Federal Reserve Board will increase short-term rates by at least another 25 basis points and that the yield curve will remain flat. Other economists are predicting the yield curve to steepen as inflation possibly becomes an issue. The extremely competitive environment for deposits is expected to continue, which could also have a negative impact on the net interest margin. The ability to continue to successfully increase loan balances should have a positive impact on the net interest margin and interest income, as loans tend to earn a higher yield than investment securities.

The provision for loan losses represents management's determination of the amount necessary to be charged to operations to bring the allowance for loan losses to a level that represents management’s best estimate of the known and inherent losses in the existing loan portfolio. Actual loan losses, net of recoveries, serve to reduce the allowance.

The determination of an appropriate level of the allowance for loan losses is based upon an analysis of the risk inherent in QNB's loan portfolio. Management uses various tools to assess the adequacy of the allowance for loan losses. One tool is a model recommended by the Office of the Comptroller of the Currency. This model considers a number of relevant factors including: historical loan loss experience, the assigned risk rating of the credit, current and projected credit worthiness of the borrower, current value of the underlying collateral, levels of and trends in delinquencies and non-accrual loans, trends in volume and terms of loans, concentrations of credit, and national and local economic trends and conditions. This model is supplemented with another analysis that also incorporates QNB’s portfolio exposure to borrowers with large dollar concentration. Other tools include ratio analysis and peer group analysis.

QNB’s management determined no provision for loan losses was necessary for either of the three-month periods ended March 31, 2006 or 2005 as the results of the analyses described above indicated an allowance for loan losses that was adequate in relation to the estimate of known and inherent losses in the portfolio. In addition, charge-offs and non-performing assets remain at low levels. QNB had net charge-offs of $20,000 and $6,000 during the first quarter of 2006 and 2005, respectively.

The allowance for loan losses was $2,506,000 and $2,526,000 at March 31, 2006 and December 31, 2005, respectively. The ratio of the allowance to total loans was .79 percent and .84 percent at March 31, 2006 and December 31, 2005, respectively. While QNB believes that its allowance is adequate to cover losses in the loan portfolio, there remain inherent uncertainties regarding future economic events and their potential impact on asset quality.

Management, 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.

QNB, through its core banking business, generates various fees and service charges. Total non-interest income is composed of service charges on deposit accounts, ATM and check card income, income on bank-owned life insurance, mortgage servicing fees, gains or losses on the sale of investment securities, gains on the sale of residential mortgage loans, and other miscellaneous fee income.

Total non-interest income decreased $461,000, or 27.6 percent, to $1,208,000 for the quarter ended March 31, 2006 when compared to March 31, 2005. Excluding gains on the sale of securities and loans, non-interest income decreased $181,000, or 17.7 percent. As mentioned previously, included in non-interest income in the first quarter of 2005 was a gain of $209,000 on the liquidation of assets relinquished by a borrower. This item accounted for the decline in other operating income when comparing the two periods.

ATM and debit card income is primarily comprised of income on debit cards and ATM surcharge income for the use of QNB’s ATM machines by non-QNB customers. ATM and debit card income was $184,000 for the first quarter of 2006, an increase of $25,000, or 15.7 percent, from the amount recorded during the first quarter of 2005. Debit card income increased $21,000, or 18.9 percent, for the three-month period. The increase in debit card income was a result of the increased reliance on the card as a means of paying for goods and services by both consumer and business cardholders. In addition, an increase in pin-based transactions, as well as the fee received from VISA, resulted in additional interchange income of $7,000 when comparing the two quarters. Partially offsetting these positive variances was a reduction in ATM surcharge income of $2,000 between the two quarters. This decrease was a result of fewer transactions by non-QNB customers at QNB’s ATM machines.

Income on bank-owned life insurance represents the earnings on life insurance policies of which the Bank is the beneficiary. The earnings on these policies were $61,000 and $63,000 for the three months ended March 31, 2006 and 2005, respectively. The insurance carriers reset the rates on these policies annually. The decline in income is a result of a lower earnings rate resulting from the lower interest rate environment at the last reset date.

Financial service organizations, including QNB, are challenged to demonstrate that they can generate an increased contribution to revenue from non-interest sources. QNB will continue to analyze other opportunities and products that could enhance its fee-based businesses.

Non-interest expense 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 for both quarters ended March 31, 2006 and 2005 was $3,236,000.

Furniture and equipment expense decreased $51,000, to $231,000, when comparing the two quarters. Decreases in depreciation and amortization expense were the primary contributors to the decrease in furniture and equipment expense. Items associated with the bank’s core computer system acquired in 2000 became fully depreciated in 2005. Some hardware associated with the system will be replaced during the second quarter of 2006.

Marketing expense increased $3,000, to $153,000, for the quarter ended March 31, 2006. Advertising expense increased $18,000 when comparing the two quarters as QNB increased its use of billboards and television for product advertising. Donations decreased $30,000 when comparing the three-month periods, as the first quarter of 2005 included several one-time contributions for special projects. QNB contributes to not-for-profit organizations, clubs and community events in the local communities it serves.

Third party services are comprised of professional services including legal, accounting and auditing and consulting services as well as fees paid to outside vendors for support services of day-to-day operations. These support services include correspondent banking services, statement printing and mailing, investment security safekeeping and supply management services. Third party services expense was $169,000 for the first quarter of 2006 compared to $141,000 for the first quarter of 2005. The increase in expense is primarily related to the use of consultants for special projects and increases in legal and internal and external auditing fees.

Telephone, postage and supplies expense increased $17,000 to $140,000 for the quarter ended March 31, 2006. Postage expense increased $7,000 as a result of an increase in both the volume of mailings as well as the cost per mailing as the U.S. Postal service raised rates effective January 2006. Supplies expense increased $14,000 when comparing the two quarters. Contributing to this increase were costs for ATM cards and costs related to supplies for the new lending center scheduled to open during the second quarter of 2006.

State tax expense represents the payment of the Pennsylvania Shares Tax, which is based on the equity of the Bank, Pennsylvania sales and use tax and the Pennsylvania capital stock tax. State tax expense was $113,000 for the first quarter of 2006, an increase of $10,000 compared to the same period in 2005. This increase was a result of a higher Shares Tax resulting from an increase in the Bank’s equity.

QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of March 31, 2006, QNB's net deferred tax asset was $1,917,000. The primary components of deferred taxes were a deferred tax asset of $770,000 relating to the allowance for loan losses and a deferred tax asset of $1,243,000 resulting from the FASB No.115 adjustment for available-for-sale investment securities. As of March 31, 2005, QNB's net deferred tax asset was $1,119,000. A deferred tax asset of $715,000 related to the allowance for loan losses and a deferred tax asset of $560,000 resulting from the FASB No. 115 adjustment for available-for-sale investment securities.

The realizability of deferred tax assets is dependent upon a variety of factors including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. A valuation allowance of $209,000 was established as of December 31, 2005 to offset a portion of the tax benefits associated with certain impaired securities that management believed may not be realizable. Approximately $138,000 of this valuation allowance was reversed during the first quarter of 2006 as a result of the ability to realize tax benefits associated with certain impaired securities. Management believes it is more likely than not that QNB will realize the benefits of these remaining deferred tax assets. The net deferred tax asset is included in other assets on the consolidated balance sheet.

Applicable income taxes and effective tax rates were $280,000, or 14.3 percent, for the three-month period ended March 31, 2006 and $599,000, or 23.8 percent, for the same period in 2005. The lower effective tax rate in the first quarter of 2006 is primarily a result of the reversal of a portion of the tax valuation allowance discussed above. Excluding the reversal of the tax valuation allowance, the effective tax rate would have been 21.3 percent for the three-month period ended March 31, 2006. A higher proportion of tax free income to pretax income in the first quarter of 2006 as compared to the first quarter of 2005 also contributed to the lower effective tax rate.

The balance sheet analysis compares average balance sheet data for the three months ended March 31, 2006 and 2005, as well as the period ended balances as of March 31, 2006 and December 31, 2005.

QNB’s primary functions and responsibilities are to accept deposits and to make loans to meet the credit needs of the communities it serves. Loans are the most significant component of earning assets and growth in loans to small businesses and residents of these communities has been a primary focus of QNB. Once again, QNB has been successful in achieving strong growth in total loans, while at the same time maintaining excellent asset quality.

Average earning assets for the three-month period ended March 31, 2006 decreased $2,968,000, or .5 percent, to $543,865,000 from $546,833,000 for the three months ended March 31, 2005. Average loans increased $39,901,000, or 14.9 percent, while average investments decreased $41,845,000, or 15.4 percent. Average Federal funds sold decreased $773,000 when comparing these same periods. The growth in average loans during the past year was funded primarily through the reduction of the investment portfolio.

Total loans have increased 17.2 percent between March 31, 2006 and March 31, 2005 and 5.0 percent since December 31, 2005. This loan growth was achieved despite the extremely competitive environment for both commercial and consumer loans. Continued loan growth remains one of the primary goals of QNB in 2006.

Average total commercial loans and average indirect lease financing loans increased $26,144,000 and $7,239,000, respectively, when comparing the first three months of 2006 to the first three months of 2005, while average home equity loans and residential mortgage loans increased $4,474,000 and $2,299,000, respectively. During this same time frame, average consumer loans decreased $255,000. Most of the growth in average commercial loans is in loans secured by real estate, either commercial or residential properties, which increased $12,702,000. Of this increase $10,347,000, or 81.5 percent, are adjustable rate loans. These loans could have a fixed rate for a period of time, such as three or five years, before the rate adjusts. Most of the growth in the commercial and industrial category represents loans with fixed interest rates. Given the significant increase in the prime rate over the past year and a half and the possibility of further rate increases combined with the flat shape of the yield curve, customers are requesting to lock in a fixed rate versus a rate floating with prime. Also contributing to the growth in total commercial loans was an increase in tax-exempt loans. QNB continues to be successful in competing to loans for schools and municipalities. Average tax-exempt loans increased $5,843,000 when comparing the two quarters.

The 7.5 percent increase in average home equity loans reflects their continued popularity with consumers, especially those refinancing existing residential mortgage loans, because they have lower origination costs than residential mortgage loans. When comparing average balances, most of the growth in home equity loans in the past year has been in the fixed-rate home equity term loan. This product became more attractive to consumers as the prime rate rose during 2005 and led many to refinance their floating-rate lines into fixed-rate home equity loans.

Total average deposits decreased $13,667,000, or 2.9 percent, to $453,400,000 for the first quarter of 2006 compared to the first quarter of 2005. Money market account balances decreased $20,176,000 on average. The decrease in money market balances reflects the decision not to aggressively seek to retain the short-term deposits of a school district by paying high short-term rates. With the flat yield curve, these funds would not have added significant incremental net interest income and would have further eroded the net interest margin. The decline in money market accounts was partially offset by growth in average interest-bearing demand and time deposits, which increased $4,873,000 and $5,799,000, respectively, when comparing the two quarters.

Increasing time deposit balances continues to be a challenge because of the extreme rate competition for such deposits, particularly with maturities between eight months through two years. Matching or beating competitors’ rates could have a negative impact on the net interest margin.

Average savings accounts decreased $5,242,000, or 9.4 percent. The decline in savings deposits can be attributed to consumers starting to move these funds into higher yielding money market accounts and time deposits, as well as to the equity markets.

QNB used short-term borrowings including overnight borrowings and repurchase agreements to help fund the loan growth and decline in deposits. Total average short-term borrowings increased $8,661,000 when comparing the two quarters with repurchase agreements, a sweep product for commercial accounts, increasing $5,957,000.

Total assets at March 31, 2005 were $579,191,000, compared with $582,205,000 at December 31, 2005, a decrease of .5 percent. The composition of the asset side of the balance sheet shifted from year-end with total loans and Federal funds sold increasing $15,057,000 and $7,434,000, respectively, between December 31, 2005 and March 31, 2006. In contrast, total investment securities declined by $24,746,000 between these dates. On the liability side, total deposits increased by $1,410,000 or .3 percent, since year-end. The composition of the deposits changed slightly as declines in non-interest bearing and interest-bearing demand accounts and time deposits was offset by growth in money market accounts. Treasury Select Money Market balances increased $12,375,000 between December 31, 2005 and March 31, 2006. This account is a variable-rate product indexed to a percentage of the 91-day Treasury bill. With the increase in short-term interest rates this product offers an attractive rate relative to savings and interest checking products.

Short-term borrowings decreased $4,903,000 between December 31, 2005 and March 31, 2006, as repurchase agreement balances declined and QNB paid off its overnight borrowings.

At March 31, 2005, the fair value of investment securities available-for-sale was $208,531,000, or $3,654,000 below the amortized cost of $212,185,000. This compares to a fair value of $233,275,000, or $1,912,000 below the amortized cost of $235,187,000, at December 31, 2005. An unrealized holding loss, net of taxes, of $2,412,000 was recorded as a decrease to shareholders’ equity at March 31, 2006, while an unrealized holding loss of $1,262,000 was recorded as a decrease to shareholders' equity at December 31, 2005. The increase in interest rates since December 31, 2005 has contributed to the further decline in the market value of the investment portfolio.

The available-for-sale portfolio had a weighted average maturity of approximately 4 years, 6 months at March 31, 2006 and 4 years, 5 months at December 31, 2005. The weighted average tax-equivalent yield was 4.95 percent and 4.87 percent at March 31, 2006 and December 31, 2005. The weighted average maturity is based on the stated contractual maturity or likely call date of all securities except for mortgage-backed securities and collateralized mortgage obligations (CMOs), which are based on estimated average life. The maturity of the portfolio could be shorter if interest rates would decline and prepayments on mortgage-backed securities and CMOs increased or if more securities are called. However, the estimated average life could be longer if rates were to increase and principal payments on mortgage-backed securities and CMOs would slow or bonds anticipated to be called are not called. The interest rate sensitivity analysis reflects the repricing term of the securities portfolio based upon estimated call dates and anticipated cash flows assuming an unchanged as well as a shocked interest rate environment.

Investment securities held-to-maturity are reported at amortized cost. The held-to-maturity portfolio is comprised solely of tax-exempt municipal securities. As of March 31, 2006 and December 31, 2005, QNB had securities classified as held-to-maturity with an amortized cost of $5,895,000 and $5,897,000 and a market value of $6,044,000 and $6,082,000, respectively. The held-to-maturity portfolio had a weighted average maturity of approximately 4 years, 1 month at March 31, 2006 and 3 years, 10 months at December 31, 2005. The weighted average tax-equivalent yield was 6.80 percent at March 31, 2006 and 6.78 percent at December 31, 2005.

Approximately $69,933,000 and $68,917,000 of available-for-sale securities at March 31, 2006 and December 31, 2005, respectively, were pledged as collateral for repurchase agreements and deposits of public funds. In addition, under terms of its agreement with the FHLB, QNB maintains otherwise unencumbered qualifying assets (principally 1-4 family residential mortgage loans and U.S. Government and agency notes, bonds, and mortgage-backed securities) in the amount of at least as much as its advances from the FHLB.

Shareholders' equity averaged $48,409,000 for the first three months of 2006 and $46,580,000 during all of 2005, an increase of 3.9 percent. The ratio of average total equity to average total assets increased to 8.36 percent for the first quarter of 2006, compared to 7.98 percent for all of 2005.

QNB is subject to various regulatory capital requirements as issued by Federal regulatory authorities. Regulatory capital is defined in terms of Tier I capital (shareholders’ equity excluding unrealized gains or losses on available-for-sale securities and intangible assets), Tier II capital which includes the allowance for loan losses and a portion of the unrealized gains on equity securities, and total capital (Tier I plus Tier II). Risk-based capital ratios are expressed as a percentage of risk-weighted assets. Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet arrangements, such as letters of credit and loan commitments, based on associated risk. Regulators have also adopted minimum Tier I leverage ratio standards, which measure the ratio of Tier I capital to total average assets.

The minimum regulatory capital ratios are 4.00 percent for Tier I, 8.00 percent for the total risk-based capital and 4.00 percent for leverage. Based on the requirements, QNB had a Tier I capital ratio of 13.33 percent and 13.04 percent, a total risk-based ratio of 14.05 percent and 13.77 percent and a leverage ratio of 8.50 percent and 8.15 percent at March 31, 2006 and December 31, 2005, respectively.

The Federal Deposit Insurance Corporation Improvement Act of 1991 established five capital level designations ranging from "well capitalized" to "critically undercapitalized." At March 31, 2006 and December 31, 2005, QNB met the "well capitalized" criteria which requires minimum Tier I and total risk-based capital ratios of 6.00 percent and 10.00 percent, respectively, and a leverage ratio of 5.00 percent.

Since the assets and liabilities of QNB have diverse repricing characteristics that influence net interest income, management analyzes interest sensitivity through the use of gap analysis and simulation models. Interest rate sensitivity management seeks to minimize the effect of interest rate changes on net interest margins and interest rate spreads and to provide growth in net interest income through periods of changing interest rates. The Asset/Liability Management Committee (ALCO) is responsible for managing interest rate risk and for evaluating the impact of changing interest rate conditions on net interest income.

Gap analysis measures the difference between volumes of rate-sensitive assets and liabilities and quantifies these repricing differences for various time intervals. Static gap analysis describes interest rate sensitivity at a point in time. However, it alone does not accurately measure the magnitude of changes in net interest income because changes in interest rates do not impact all categories of assets and liabilities equally or simultaneously. Interest rate sensitivity analysis also involves assumptions on certain categories of assets and deposits. For purposes of interest rate sensitivity analysis, assets and liabilities are stated at their contractual maturity, estimated likely call date, or earliest repricing opportunity. Mortgage-backed securities, CMOs and amortizing loans are scheduled based on their anticipated cash flow. Savings accounts, including passbook, statement savings, money market, and interest-bearing demand accounts, do not have stated maturities or repricing terms and can be withdrawn or repriced at any time. This may impact QNB’s margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff. Management projects the repricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity. The Treasury Select Indexed Money Market account reprices monthly, based on a percentage of the average of the 91-day Treasury bill.

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, 2006, interest-earning assets scheduled to mature or likely to be called, repriced or repaid in one year were $181,163,000. Interest-sensitive liabilities scheduled to mature or reprice within one year were $263,706,000. The one-year cumulative gap, which reflects QNB’s interest sensitivity over a period of time, was a negative $82,543,000 at March 31, 2006. The cumulative one-year gap equals -14.9 percent of total rate sensitive assets. This compares to a negative gap position of $39,123,000, or -7.04 percent, of total rate sensitive assets, at December 31, 2005. The increase in the negative gap position in the one-year time frame is a result of the increase in the amount of time deposits maturing or repricing in less than one year. At March 31, 2006 $137,006,000, or 66.0 percent, of total time deposits was scheduled to reprice or mature in the next twelve months. This compares to $95,840,000, or 45.4 percent, of total time deposits at December 31, 2005. In addition, balances in the Treasury Select Money Market account increased by $12,375,000 during the first quarter. Both of these events reflect consumers desire to invest in shorter term investments whose rate could increase if market rates continue to increase.

QNB also uses a simulation model to assess the impact of changes in interest rates on net interest income. The model reflects management’s assumptions related to asset yields and rates paid on liabilities, deposit sensitivity, and the size, composition and maturity or repricing characteristics of the balance sheet. The assumptions are based on what management believes, at that time, to be the most likely interest rate environment. Management also evaluates the impact of higher and lower interest rates by simulating the impact on net interest income of changing rates. While management performs rate shocks of 100, 200 and 300 basis points, it believes, given the level of interest rates at March 31, 2006, it is unlikely that interest rates would decline by 300 basis points. The simulation results can be found in the chart on page 30.

The decline in net interest income in a rising rate environment is consistent with the gap analysis and reflects the fixed-rate nature of the investment and loan portfolio and the increased expense associated with higher cost funding sources. The decline in net interest income, if rates decline, reflects the interest rate floors on interest-bearing transaction accounts, regular money market accounts and savings accounts. Interest rates on these products do not have the ability to decline to the degree that rates on earning assets can. These results are inconsistent with the gap analysis and identify some of the weaknesses of gap analysis which does not take into consideration the magnitude of the rate change on different instruments or the timing of the rate change.

Actual results may differ from simulated results due to various factors including time, magnitude and frequency of interest rate changes, the relationship or spread between various rates, loan pricing and deposit sensitivity, and asset/liability strategies.

Management believes the assumptions utilized in evaluating the vulnerability of QNB’s net interest income to changes in interest rates approximate actual experience. However, the interest rate sensitivity of QNB’s assets and liabilities as well as the estimated effect of changes in interest rates on net interest income could vary substantially if different assumptions are used or actual experience differs from the experience on which the assumptions were based.

The nature of QNB’s current operation is such that it is not subject to foreign currency exchange or commodity price risk. Additionally, neither the Corporation nor the Bank owns trading assets. At March 31, 2006, 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.

The information required herein is set forth in Item 2, above.

We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the consolidated financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report. No changes were made to our internal controls over financial reporting or other factors that have materially affected, or are reasonably likely to materially affect, these controls during the prior fiscal quarter covered by this report.

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.