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QNBC > SEC Filings for QNBC > Form 10-K on 29-Mar-2013All Recent SEC Filings

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Form 10-K for QNB CORP


29-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Results of Operations - Overview

QNB Corp. (QNB or the Company) earns its net income primarily through its subsidiary, QNB Bank (the 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 levels approved by the Board of Directors. Due to its limited geographic area, comprised principally of Bucks, Lehigh and 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.

Tabular information, other than share and per share data, is presented in thousands of dollars.

- 17 -

Net income for the year ended December 31, 2012 was $9,175,000, or $2.86 per share on a diluted basis, and represents the third consecutive year of record earnings for the Company. Net income for 2012 also represents a 3.3% increase from 2011 net income of $8,880,000, or $2.81 per share on a diluted basis.

Two important measures of profitability in the banking industry are an institution's return on average assets and return on average shareholders' equity. Return on average assets was 1.03% and 1.06% in 2012 and 2011, respectively, and return on average shareholders' equity was 13.07% and 13.99%, respectively, during those same periods.

2012 versus 2011

The results for 2012 include the following significant components:

Net interest income decreased $1,226,000, or 4.4%, to $26,900,000 for 2012.

Average earning assets increased $49,938,000, or 6.1%, to $862,712,000 for 2012 with average loans increasing $3,751,000, or 0.8%, to $480,872,000, and average investment securities increasing $48,727,000, or 15.3%, to $367,391,000. Political, tax and fiscal uncertainty continues to hamper consumer and business loan demand.

Funding the growth in earning assets was an increase in average total deposits of $57,427,000, or 7.9%, to $785,784,000 for 2012. The growth in deposits was primarily in savings accounts, and in particular the high yielding Online eSavings product, with average savings balances increasing by $36,513,000 to $188,716,000. Also contributing to the growth in average total deposits was a $10,465,000, or 11.9%, increase in average interest-bearing demand accounts to $98,351,000 and a $15,656,000, or 27.6%, increase in average interest-bearing municipal demand deposits to $72,464,000. These increases were partially offset by a $12,276,000, or 4.2%, decline in average time deposit balances to $281,872,000.

During the second quarter of 2012, $15,000,000 of debt at a cost of 4.75% matured and was paid off.

Interest rates on Treasury securities reached historically low levels during the second quarter of 2012. This also resulted in historically low residential mortgage rates. The chart below details the highs and lows of certain Treasury rates during the year as well as a comparison of rates at year-end 2012 and 2011.

                     December 31,                  Low              High
                     2012       2011       during 2012       during 2012
3 month Treasury     0.04 %     0.02 %            0.01 %            0.11 %
2 year Treasury      0.25       0.25              0.20              0.39
5 year Treasury      0.72       0.83              0.54              1.20
10 year Treasury     1.76       1.89              1.39              2.38

The net interest margin for 2012 was 3.36%, a decrease of 36 basis points from the 3.72% reported in 2011. With the growth in earning assets occurring in the investment portfolio, the mix of earning assets changed impacting the net interest margin, as investment securities generally earn a lower yield than loans. The average rate earned on earning assets declined 60 basis points from 4.71% for 2011 to 4.11% for 2012 with the yield on loans and investment securities declining by 48 basis points and 66 basis points, respectively. In comparison, the interest rate paid on total average interest-bearing liabilities declined by 28 basis points from 1.14% for 2011 to 0.86% for 2012 with the average rate paid on interest-bearing deposits declining 22 basis points from 1.04% to 0.82% over the same time period.

QNB recorded a provision for loan losses of $900,000 for 2012, a decrease of $1,800,000 from the $2,700,000 recorded in 2011.

The lower provision for loan losses reflects a reduction in classified loans and net charge-offs compared to prior years as well as a decline in total loans outstanding.

Net charge-offs for 2012 were $369,000, or 0.08% of average total loans, as compared with $2,414,000, or 0.51% of average total loans for 2011.

Asset quality has stabilized over the past year. Total non-performing loans, which represent loans on non-accrual status, loans past due more than 90 days and still accruing interest, and restructured loans, were $21,150,000, or 4.41% of total loans at December 31, 2012, compared to $21,390,000, or 4.36% of total loans at December 31, 2011.

Loans on nonaccrual status were $18,572,000 at December 31, 2012 compared with $18,597,000 at December 31, 2011. Of the total amount of non-accrual loans at December 31, 2012, $12,836,000, or 69.1%, are current or past due less than 30 days at year end.

Total delinquent loans, which includes loans past due more than 30 days, decreased to 1.50% of total loans at December 31, 2012 from 1.81% of total loans at December 31, 2011.

At December 31, 2012 commercial classified loans, those rated substandard or doubtful loans totaled $45,514,000, a reduction of $9,755,000 from the $55,269,000 reported as of December 31, 2011.

The allowance for loan losses of $9,772,000 represents 2.04% of total loans at December 31, 2012 compared to $9,241,000, or 1.89% of total loans at December 31, 2011.

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Non-interest income increased $1,183,000 to $5,409,000 for 2012.

Net gain on investment securities of $577,000 in 2012 compared with net losses of $51,000 in 2011.

Gains on the sale of residential mortgages increased $533,000 to $885,000 for 2012. Historically low mortgage rates in 2012 contributed to a significant increase in refinancing activity as well as an increase in the amount of gains recorded per sale.

Fees for services to customers increased $88,000, or 6.3%, to $1,476,000 in 2012 with overdraft income, checking account activity income, fees charged to transfer from savings to checking accounts to protect against overdrafts and wire fees contributing to the increase.

ATM and debit card income increased $58,000, or 4.1%, to $1,467,000 for 2012. The Dodd-Frank Act and Durbin amendment had an impact on overall income as well as the distribution between debit and ATM interchange.

Merchant income increased $52,000, or 16.2%, to $373,000 as a result of an increase in the number of merchants QNB services and an increase in the volume of transactions.

Bank-owned life insurance (BOLI) income decreased $39,000 to $333,000 in 2012. Included in total BOLI income in 2011 was the recognition of a death benefit payment of $31,000.

Mortgage servicing income declined by $100,000 reflecting a reduction in the value of mortgage servicing assets as well as an increase in the amortization of the asset resulting from the higher levels of refinancing activity.

Non-interest expense increased $1,329,000, or 7.3%, to $19,625,000 for 2012.

Salaries and benefits expense increased $543,000, or 5.5%, when comparing 2012 and 2011. Promotion and merit increases coupled with an average of three additional full-time equivalent employees, including the hiring of a Chief Information Technology Officer in the third quarter of 2011, contributed to the increase in salary expense. Payroll related tax expense increased $30,000 and retirement plan expense increased $36,000, both principally a function of higher salary expense, while medical and dental premiums and reimbursement claims increased $97,000 compared to 2011, an increase of 15.7%.

Furniture and equipment expense increased $195,000, or 14.9%, to $1,503,000, when comparing 2012 to 2011. The majority of the increase in this category related to an increase in depreciation expense on new furniture and equipment as well as amortization expense on computer software. Also contributing to the higher costs in 2012 was equipment maintenance expense.

Third-party services expense increased $241,000, or 19.0%, to $1,508,000 in 2012. The largest portion of the increase relates to costs associated with the conversion to a new online and mobile banking system introduced in the third quarter of 2011 and the outsourcing of email services to a third party provider during the second quarter of 2011. Also contributing to the increase was higher costs related to customer bill payment services and implementation and ongoing costs associated with a new overdraft protection program that was instituted late in the second quarter of 2012.

Other non-interest expense increased $205,000, or 12.9%, to $1,796,000 comparing 2012 to 2011. Expenses related to foreclosure and repossessions, other real estate owned, including real estate taxes and maintenance costs accounted for a large portion of the increase in other non-interest expense. Also contributing were higher costs related to checkcards, membership and licensing fees, seminar and meeting expenses, charged-off checks, and Director fees, partially offset by declines in the cost of producing checks and coupon books, appraisal costs and training costs.

These items, as well as others, will be explained more thoroughly in the next sections.

Net Interest Income

The following table presents the adjustment to convert net interest income to
net interest income on a fully taxable equivalent basis for the years ended
December 31, 2012 and 2011.



Year ended December 31,                          2012         2011
Total interest income                        $ 33,348     $ 36,217
Total interest expense                          6,448        8,091
Net interest income                            26,900       28,126
Tax equivalent adjustment                       2,116        2,091
Net interest income (tax-equivalent basis)   $ 29,016     $ 30,217

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, interest bearing balances at the Federal Reserve Bank (Fed) and Federal funds sold. Sources used to fund these assets include deposits and borrowed funds. 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 above. 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.

- 19 -

The net interest rate spread is the difference between average rates received on earning assets and average rates paid on interest-bearing liabilities, while the net interest margin, which includes interest-free sources of funds, is net interest income expressed as a percentage of average interest-earning assets. The Asset/Liability and Investment Management Committee works to manage and maximize the net interest margin for the Company.

Net interest income decreased $1,226,000, or 4.4%, to $26,900,000 for 2012. On a tax-equivalent basis, net interest income for 2012 decreased $1,201,000, or 4.0%, to $29,016,000.

Net interest income continues to be negatively impacted by declining yields on earning assets resulting from a prolonged low interest rate environment and the low level of loan demand by both businesses and consumers. Partially offsetting the impact of declining yields on net interest income was the significant growth in earning assets, primarily investment securities, funded by continued strong growth in deposits. Average earning assets grew by $49,938,000, or 6.1%, to $862,712,000 for 2012, with average investment securities increasing $48,727,000, or 15.3%, to $367,391,000, and average loans increasing $3,751,000, or 0.8%, to $480,872,000. On the funding side, average total deposits increased $57,427,000, or 7.9%, to $785,784,000, with average transaction accounts increasing $69,703,000, or 16.1%, to $503,912,000. The growth in transaction accounts was broad based across all product lines and all customer types with the largest increases centered in QNB's Online eSavings product and the deposits of several local school districts and municipalities. Offsetting a portion of this growth was a decline in average time deposits of $12,276,000, or 4.2%, when comparing 2012 with 2011.

With the growth in earning assets occurring in the investment portfolio, the mix of earning assets changed which also contributed to a decline in the net interest margin, as investment securities generally earn a lower yield than loans. In addition, while the economy has shown signs of improvement, issues in the residential and commercial real estate markets persist as do high levels of unemployment. During the third quarter of 2011, the Federal Reserve Open Market Committee announced that they were likely to leave the Federal funds rate at exceptionally low levels through mid-2013 (subsequently extended to mid-2015) and that they would purchase longer-term Treasury securities in an effort to further reduce longer-term interest rates. These actions combined with events in Europe had the impact of lowering Treasury interest rates and flattening the yield curve as longer-term rates declined more than short-term rates. Interest rates on Treasury securities hit historically low levels during the second quarter of 2012. This also resulted in historically low residential mortgage rates. A low level of interest rates has been in place since 2008 and has resulted in lower yields earned on both loans and investment securities as well as lower rates paid on deposits and short-term borrowed funds. During the beginning of this interest rate cycle, funding costs declined at a faster pace and to a greater degree than rates on earning assets resulting in an increasing net interest margin. However, since the second quarter of 2011 this trend has reversed as funding costs have approached bottom while yields on earning assets continue to reprice lower resulting in a lower net interest margin.

The net interest margin for 2012 was 3.36% compared to 3.72% for 2011. As a result of the historically low interest rates, over the past two years, a significant amount of higher yielding bonds with call features were called and prepayments on mortgage-related securities increased, with these proceeds being reinvested in lower yielding investment securities. The significant growth in municipal deposits between the second and third quarters of 2012 and the investment of these deposits into short-term agency securities during the third quarter of 2012 also impacted the margin, as these transactions while increasing incremental net interest income do so at a significantly tighter interest rate spread. In addition, new loans are being originated at significantly lower rates, variable rate loans are repricing lower and many customers with fixed rates are requesting that their rates be modified lower. Competition for loans has also increased as larger banks have pursued smaller commercial customers to improve their loan-to-deposit ratios.

The Rate-Volume Analysis tables, as presented on a tax-equivalent basis, highlight the impact of changing rates and volumes on interest income and interest expense. Total interest income on a tax-equivalent basis decreased $2,844,000, or 7.4%, to $35,464,000 for 2012, while total interest expense decreased $1,643,000, or 20.3%, to $6,448,000. Volume growth in earning assets contributed an additional $1,683,000 of interest income but was offset by a decline in interest income of $4,527,000 resulting from lower interest rates. With regard to interest expense, lower funding costs resulted in a decline in interest expense of $1,391,000. The maturity and payoff of long-term debt in April 2012 contributed to a decline in interest expense of $511,000 while volume growth in interest-bearing deposits contributed an additional $266,000 in interest expense when comparing the two years.

The yield on earning assets on a tax-equivalent basis decreased 60 basis points from 4.71% for 2011 to 4.11% for 2012. In comparison, the rate paid on interest-bearing liabilities decreased 28 basis points from 1.14% for 2011 to 0.86% for 2012.

Interest income on investment securities decreased $715,000 when comparing the two years as the $48,727,000, or 15.3%, increase in average balances could not offset the 66 basis point decline in the average yield of the portfolio. The average yield on the investment portfolio was 2.86% for 2012 compared with 3.52% for 2011. As noted above, the decline in the yield on the investment portfolio is primarily the result of the reinvestment of the cash flow resulting from the low rate environment into lower yield securities than those they replaced. The growth in the investment portfolio was primarily in high-quality U.S. Government agency and agency issued mortgage-backed and CMO securities as well as in tax-exempt state and municipal bonds.

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Average Balances, Rates, and Interest Income and Expense Summary (Tax-Equivalent
Basis)



                                                2012                                     2011                                     2010
                                 Average      Average                     Average      Average                     Average      Average
                                 Balance        Rate       Interest       Balance        Rate       Interest       Balance        Rate       Interest
Assets
Federal funds sold                      -            -             -             -            -             -             -            -             -
Investment securities:
U.S. Treasury                           -            -             -             -            -             -     $   3,924         0.56 %   $      22
U.S. Government agencies        $  80,470         1.42 %   $   1,144     $  63,838         2.12 %   $   1,356        58,050         2.88         1,671
State and municipal                79,612         5.36         4,267        71,541         5.82         4,164        59,141         6.22         3,676
Mortgage-backed and CMOs          197,666         2.44         4,813       175,489         3.14         5,503       134,859         3.85         5,192
Pooled trust preferred              3,573         0.36            13         3,640         0.21             7         3,865         0.34            13
Corporate debt                      2,457         4.07           100           878         6.26            55           448         9.03            41
Equities                            3,613         4.25           153         3,278         3.67           120         3,020         3.66           111
Total investment securities       367,391         2.86        10,490       318,664         3.52        11,205       263,307         4.07        10,726
Loans:
Commercial real estate            253,029         5.30        13,398       261,584         5.82        15,216       252,604         5.95        15,041
Residential real estate            27,708         4.99         1,383        24,414         5.36         1,307        24,468         5.74         1,405
Home equity loans                  51,158         4.40         2,253        55,086         4.72         2,598        60,192         5.02         3,023
Commercial and industrial         101,421         4.67         4,733        88,428         5.06         4,474        82,074         5.27         4,327
Indirect lease financing           11,282         9.88         1,115        13,067         9.32         1,218        13,910         8.97         1,248
Consumer loans                      2,175        10.08           219         2,491        14.21           354         3,163        13.78           436
Tax-exempt loans                   34,099         5.38         1,834        32,051         5.91         1,895        30,652         6.02         1,844
Total loans, net of unearned
income*                           480,872         5.19        24,935       477,121         5.67        27,062       467,063         5.85        27,324
Other earning assets               14,449         0.27            39        16,989         0.24            41        17,083         0.23            40
Total earning assets              862,712         4.11        35,464       812,774         4.71        38,308       747,453         5.10        38,090
Cash and due from banks            11,151                                   10,460                                   10,157
Allowance for loan losses          (9,582 )                                 (9,080 )                                 (7,129 )
Other assets                       29,195                                   26,749                                   26,118
Total assets                    $ 893,476                                $ 840,903                                $ 776,599

Liabilities and Shareholders'
Equity
Interest-bearing deposits:
Interest-bearing demand         $  98,351         0.30 %         291     $  87,886         0.47 %         412     $  83,546         0.65 %         545
Municipals                         72,464         0.50           364        56,808         0.69           392        40,242         0.91           366
Money market                       77,269         0.30           231        73,661         0.43           317        75,128         0.76           568
Savings                           188,716         0.60         1,141       152,203         0.78         1,184        93,576         0.79           739
Time                              180,293         1.33         2,391       192,231         1.55         2,977       211,867         2.09         4,420
Time of $100,000 or more          101,579         1.43         1,454       101,917         1.61         1,637       105,482         2.19         2,306
Total interest-bearing
deposits                          718,672         0.82         5,872       664,706         1.04         6,919       609,841         1.47         8,944
Short-term borrowings              24,847         0.44           109        25,806         0.75           194        27,658         0.97           269
Long-term debt                      9,678         4.75           467        20,304         4.75           978        22,077         4.72         1,057
Total interest-bearing
liabilities                       753,197         0.86         6,448       710,816         1.14         8,091       659,576         1.56        10,270
Non-interest-bearing deposits      67,112                                   63,651                                   56,072
Other liabilities                   2,971                                    2,972                                    3,362
Shareholders' equity               70,196                                   63,464                                   57,589
Total liabilities and
shareholders' equity            $ 893,476                                $ 840,903                                $ 776,599
Net interest rate spread                          3.25 %                                   3.57 %                                   3.54 %
Margin/net interest income                        3.36 %   $  29,016                       3.72 %   $  30,217                       3.72 %   $  27,820

Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 34 percent. Non-accrual loans and investment securities are included in earning assets.
* Includes loans held-for-sale

- 21 -

Rate-Volume Analysis of Changes in Net Interest Income (1) (2) (3)



                                                      2012 vs. 2011                           2011 vs. 2010
                                             Due to change in:         Total         Due to change in:         Total
                                            Volume         Rate        Change       Volume         Rate        Change
Interest income:
Federal funds sold                                 -            -            -             -            -            -
Investment securities:
U.S. Treasury                                      -            -            -     $     (22 )          -     $    (22 )
U.S. Government agencies                   $     354     $   (566 )   $   (212 )         167     $   (482 )       (315 )
State and municipal                              470         (367 )        103           771         (283 )        488
Mortgage-backed and CMOs                         694       (1,384 )       (690 )       1,565       (1,254 )        311
Pooled trust preferred                             -            6            6            (1 )         (5 )         (6 )
Corporate debt                                    99          (54 )         45            38          (24 )         14
Equities                                          12           21           33             9            -            9
Loans:
Commercial real estate                          (498 )     (1,320 )     (1,818 )         535         (360 )        175
Residential real estate                          177         (101 )         76            (4 )        (94 )        (98 )
Home equity loans                               (185 )       (160 )       (345 )        (257 )       (168 )       (425 )
Commercial and industrial                        657         (398 )        259           335         (188 )        147
Indirect lease financing                        (166 )         63         (103 )         (75 )         45          (30 )
Consumer loans                                   (45 )        (90 )       (135 )         (93 )         11          (82 )
Tax-exempt loans                                 121         (182 )        (61 )          85          (34 )         51
Other earning assets                              (7 )          5           (2 )           -            1            1
Total interest income                          1,683       (4,527 )     (2,844 )       3,053       (2,835 )        218
Interest expense:
Interest-bearing demand                           49         (170 )       (121 )          28         (161 )       (133 )
Municipals                                       108         (136 )        (28 )         151         (125 )         26
Money market                                      15         (101 )        (86 )         (11 )       (240 )       (251 )
Savings                                          284         (327 )        (43 )         463          (18 )        445
Time                                            (185 )       (401 )       (586 )        (410 )     (1,033 )     (1,443 )
Time of $100,000 or more                          (5 )       (178 )       (183 )         (78 )       (591 )       (669 )
Short-term borrowings                             (7 )        (78 )        (85 )         (18 )        (57 )        (75 )
Long-term debt                                  (511 )          -         (511 )         (85 )          6          (79 )
Total interest expense                          (252 )     (1,391 )     (1,643 )          40       (2,219 )     (2,179 )
Net interest income                        $   1,935     $ (3,136 )   $ (1,201 )   $   3,013     $   (616 )   $  2,397

(1) Loan fees have been included in the change in interest income totals . . .

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