10-Q 1 june2004q.txt U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 [ ] 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 0-22208 QCR HOLDINGS, INC. (Exact name of Registrant as specified in its charter) Delaware 42-1397595 (State or other jurisdiction of (I.R.S. EmployerID Number) incorporation or organization) 3551 7th Street, Suite 204, Moline, Illinois 61265 (Address of principal executive offices) (309) 736-3580 (Registrant's telephone number, including area code) Check whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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: As of August 1, 2004, the Registrant had outstanding 4,229,453 shares of common stock, $1.00 par value per share. 1 QCR HOLDINGS, INC. AND SUBSIDIARIES INDEX Page Number Part I FINANCIAL INFORMATION Item 1 Consolidated Financial Statements (Unaudited) Consolidated Balance Sheets, June 30, 2004 and December 31, 2003 3 Consolidated Statements of Income, For the Three Months Ended June 30, 2004 and 2003 4 Consolidated Statements of Income, For the Six Months Ended June 30, 2004 and 2003 5 Consolidated Statements of Cash Flows, For the Six Months Ended June 30, 2004 and 2003 6 Notes to Consolidated Financial Statements 7-10 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 11-26 Item 3 Quantitative and Qualitative Disclosures 26-27 About Market Risk Item 4 Controls and Procedures 27-28 Part II OTHER INFORMATION Item 1 Legal Proceedings 29 Item 2 Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities 29 Item 3 Defaults Upon Senior Securities 29 Item 4 Submission of Matters to a Vote of Security Holders 29 Item 5 Other Information 29 Item 6 Exhibits and Reports on Form 8-K 29-30 Signatures 31 2 Part I Item 1 QCR HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED) June 30, 2004 and December 31, 2003 June 30, December 31, 2004 2003 -------------- --------------- ASSETS Cash and due from banks $ 32,058,828 $ 24,427,573 Federal funds sold 9,275,000 4,030,000 Interest-bearing deposits at financial institutions 9,695,860 10,426,092 Securities held to maturity, at amortized cost 400,008 400,116 Securities available for sale, at fair value 130,796,692 128,442,926 -------------- --------------- 131,196,700 128,843,042 -------------- --------------- Loans receivable held for sale 4,363,774 3,790,031 Loans receivable held for investment 587,820,591 518,681,380 Less: Allowance for estimated losses on loans (9,745,968) (8,643,012) -------------- -------------- 582,438,397 513,828,399 -------------- -------------- Premises and equipment, net 14,011,606 12,028,532 Accrued interest receivable 3,652,206 3,646,108 Bank-owned life insurance 15,358,194 3,085,797 Other assets 13,853,895 9,724,012 ------------- -------------- Total assets $ 811,540,686 $ 710,039,555 ============== =============== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES Deposits: Noninterest-bearing $ 106,271,687 $ 130,962,916 Interest-bearing 403,010,012 380,688,947 -------------- --------------- Total deposits 509,281,699 511,651,863 -------------- --------------- Short-term borrowings 126,881,723 51,609,801 Federal Home Loan Bank advances 96,628,400 76,232,348 Other borrowings 7,000,000 10,000,000 Junior subordinated debentures 20,620,000 12,000,000 Other liabilities 8,209,212 6,722,808 -------------- -------------- Total liabilities 768,621,034 668,216,820 -------------- -------------- STOCKHOLDERS' EQUITY Common stock, $1 par value; shares authorized, June 2004 - 10,000,000 and December 2003 - 5,000,000; June 2004 - 4,224,462 shares issued and outstanding, December 2003 - 4,295,985* shares issued and 4,205,766* outstanding 4,224,462 2,863,990 Additional paid-in capital 15,543,326 17,143,868 Retained earnings 22,748,989 20,866,749 Accumulated other comprehensive income 402,875 1,802,664 ------------ -------------- 42,919,652 42,677,271 Less: Cost of common shares acquired for the treasury; June 2004 - none; December 2003 - 90,219 - (854,536) ------------ -------------- Total stockholders' equity 42,919,652 41,822,735 ------------ ------------- Total liabilities and stockholders' equity $ 811,540,686 $ 710,039,555 ============== =============== * Share and per share data has been retroactively adjusted to effect a 3:2 common stock split, which occurred on May 28, 2004, as if it had occurred on January 1, 2003. See Notes to Consolidated Financial Statements 3 QCR HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) Three Months Ended June 30 2004 2003 ------------------------------- Interest and dividend income: Loans, including fees 8,024,411 7,302,264 Securities: Taxable 987,279 757,712 Nontaxable 144,289 119,985 Interest-bearing deposits at financial institutions 66,757 111,856 Federal funds sold 2,989 54,407 ---------- ----------- Total interest and dividend income 9,225,725 8,346,224 ---------- ----------- Interest expense: Deposits 1,519,714 1,826,459 Short-term borrowings 237,687 101,556 Federal Home Loan Bank advances 860,472 957,189 Other borrowings 10,172 58,555 Junior subordinated debentures 578,868 283,377 --------- ----------- Total interest expense 3,206,913 3,227,136 --------- ----------- Net interest income 6,018,812 5,119,088 Provision for loan losses 467,659 358,000 --------- ----------- Net interest income after provision for loan loss 5,551,153 4,761,088 Noninterest income: Merchant credit card fees, net of processing costs 302,085 657,754 Trust department fees 608,031 580,579 Deposit service fees 407,764 362,923 Gains on sales of loans, net 406,435 1,214,011 Securities gains, net 26,188 (591) Other 628,909 434,062 --------- ---------- Total noninterest income 2,379,412 3,248,738 --------- ---------- Noninterest expenses: Salaries and employee benefits 3,119,302 3,200,921 Professional and data processing fees 530,826 530,436 Advertising and marketing 287,198 204,770 Occupancy and equipment expense 790,760 656,741 Stationery and supplies 132,247 114,443 Postage and telephone 162,779 164,557 Bank service charges 147,401 111,581 Insurance 125,073 102,403 Other 141,994 313,728 --------- ---------- Total noninterest expenses 5,437,580 5,399,579 --------- ---------- Income before income taxes 2,492,985 2,610,247 Federal and state income taxes 821,773 883,347 --------- ---------- Net income $ 1,671,212 $ 1,726,900 ========= ========== Earnings per common share: * Basic $ 0.40 $ 0.41 Diluted $ 0.39 $ 0.41 Weighted average common shares outstanding 4,212,795 4,165,878 Weighted average common and common equivalent 4,322,443 4,265,559 shares outstanding Cash dividends declared per common share* $ 0.00 $ 0.00 ========= ========== Comprehensive income $ 84,736 $ 2,069,385 ========= ========== *Share and per share data has been retroactively adjusted to effect a 3:2 common stock split, which occurred on May 28, 2004, as if it had occurred on January 1, 2003. See Notes to Consolidated Financial Statements 4 QCR HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) Six Months Ended June 30 2004 2003 ----------------------------- Interest and dividend income: Loans, including fees $ 15,492,896 $ 14,111,493 Securities: Taxable 1,978,684 1,563,881 Nontaxable 287,101 240,242 Interest-bearing deposits at financial institutions 138,272 234,918 Federal funds sold 7,579 101,757 ------------- ------------- Total interest and dividend income 17,904,532 16,252,291 ------------- ------------- Interest expense: Deposits 3,022,895 3,695,524 Short-term borrowings 379,937 188,864 Federal Home Loan Bank advances 1,660,607 1,723,436 Other borrowings 46,050 110,515 Junior subordinated debentures 1,000,293 566,753 ------------- ------------ Total interest expense 6,109,782 6,285,092 ------------- ------------ Net interest income 11,794,750 9,967,199 Provision for loan losses 1,324,500 1,688,427 ------------- ------------ Net interest income after provision for loan losses 10,470,250 8,278,772 Noninterest income: Merchant credit card fees, net of processing costs 841,283 995,247 Trust department fees 1,288,835 1,141,721 Deposit service fees 817,108 693,771 Gains on sales of loans, net 667,853 2,169,420 Securities gains (losses), net 26,188 (591) Other 1,096,881 737,993 ------------- ----------- Total noninterest income 4,738,148 5,737,561 ------------- ----------- Noninterest expenses: Salaries and employee benefits 6,271,103 6,085,713 Professional and data processing fees 996,102 959,506 Advertising and marketing 500,990 353,526 Occupancy and equipment expense 1,521,750 1,308,438 Stationery and supplies 269,192 224,720 Postage and telephone 329,059 318,122 Bank service charges 285,243 223,263 Insurance 225,567 209,209 Loss on redemption of junior subordinated debentures 747,490 - Other 380,172 500,926 ------------- ----------- Total noninterest expenses 11,526,668 10,183,422 ------------- ----------- Income before income taxes 3,681,730 3,832,911 Federal and state income taxes 1,174,601 1,279,063 ------------- ----------- Net income $ 2,507,129 $ 2,553,848 ============= =========== Earnings per common share:* Basic $ 0.60 $ 0.61 Diluted $ 0.58 $ 0.60 Weighted average common shares outstanding 4,213,635 4,158,200 Weighted average common and common equivalent 4,330,533 4,253,576 Cash dividends declared per common share* 0.04 0.03 ============= =========== Comprehensive income $ 1,107,340 $ 2,971,765 ============= =========== * Share and per share data has been retroactively adjusted to effect a 3:2 common stock split, which occurred on May 28, 2004, as if it had occurred on January 1, 2003. See Notes to Consolidated Financial Statements 5 QCR HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) Six Months Ended June 30 2004 2003 -------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 2,507,129 $ 2,553,848 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 685,551 527,914 Provision for loan losses 1,324,500 1,688,427 Amortization of offering costs on subordinated debentures 10,775 14,753 Loss on redemption of junior subordinated debentures 747,490 - Amortization of premiums on securities, net 578,330 287,770 Investment securities (gains) losses, net (26,188) 591 Loans originated for sale (45,896,508) (140,594,814) Proceeds on sales of loans 45,990,618 143,917,116 Net gains on sales of loans (667,853) (2,169,420) Net losses on sales of premises and equipment - 40,299 Tax benefit of nonqualified stock options exercised 113,437 113,489 (Increase) decrease in accrued interest receivable (6,098) 13,908 (Increase) decrease in other assets (4,049,784) 12,538,885 Increase (decrease) in other liabilities 1,485,264 (619,978) ------------ ----------- Net cash provided by operating activities $ 2,796,663 18,312,788 ------------ ----------- CASH FLOWS FROM INVESTING ACTIVITIES Net increase in federal funds sold (5,245,000) (17,355,000) Net decrease in interest-bearing deposits at financial institutions 730,232 2,481,216 Activity in securities portfolio: Purchases (31,993,964) (25,280,886) Calls and maturities 25,848,001 10,750,000 Paydowns 1,002,010 2,530,330 Activity in bank-owned life insurance: Purchases (11,950,717) (66,312) Increase in cash value (321,680) (73,738) Net loans originated and held for investment (69,360,755) (41,829,346) Purchase of premises and equipment (2,676,872) (484,675) Proceeds from sales of premises and equipment 8,247 222,479 ------------ ----------- Net cash used in investing activities $ (93,960,498) (69,105,932) CASH FLOWS FROM FINANCING ACTIVITIES Net (decrease) increase in deposit accounts (2,370,164) 48,303,419 Net increase in short-term borrowings 75,271,922 3,395,132 Activity in Federal Home Loan Bank advances: Advances 28,500,000 10,350,000 Payments (8,103,948) (6,043,425) Net (decrease) increase in other borrowings (3,000,000) 2,000,000 Proceeds from issuance of junior subordinated debentures 20,620,000 - Redemption of junior subordinated debentures (12,000,000) - Payment of cash dividends (167,838) (138,146) Payment of fractional shares on 3:2 stock split (2,549) - Proceeds from issuance of common stock, net 47,667 10,133 ------------ ----------- Net cash provided by financing activities $ 98,795,090 57,877,113 ------------ ----------- Net increase in cash and due from banks 7,631,255 7,083,969 Cash and due from banks, beginning 24,427,573 24,906,003 ------------ ----------- Cash and due from banks, ending $ 32,058,828 $31,989,972 ============ =========== Supplemental disclosure of cash flow information, cash payments for: Interest $ 6,200,693 $ 6,713,509 ============ =========== Income/franchise taxes $ 536,535 $ 2,312,153 ============ =========== Supplemental schedule of noncash investing activities: Change in accumulated other comprehensive income, unrealized (losses)/gains on securities available for sale, net $ (1,399,789) $ 417,917 ============= ============ 6 QCR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) JUNE 30, 2004 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of presentation: The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include information or footnotes necessary for a fair presentation of financial position, results of operations and changes in financial condition in conformity with accounting principles generally accepted in the United States of America. However, all adjustments that are, in the opinion of management, necessary for a fair presentation have been included. Any differences appearing between numbers presented in financial statements and management's discussion and analysis are due to rounding. Results for the periods ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. Certain amounts in the prior period financial statements have been reclassified, with no effect on net income or stockholders' equity, to conform with the current period presentation. Principles of consolidation: The accompanying consolidated financial statements include the accounts of QCR Holdings, Inc. (the "Company"), a Delaware corporation, and its wholly owned subsidiaries, Quad City Bank and Trust Company ("Quad City Bank & Trust"), Cedar Rapids Bank and Trust Company ("Cedar Rapids Bank & Trust"), Quad City Bancard, Inc. ("Bancard"), and Quad City Liquidation Corporation ("QCLC"). All significant intercompany accounts and transactions have been eliminated in consolidation. The Company also wholly owns QCR Holdings Statutory Trust II ("Trust II"), and QCR Holdings Statutory Trust III ("Trust III"). These two entities were both established by the Company for the sole purpose of issuing trust preferred securities. As required by a ruling of the Securities and Exchange Commission in December 2003, the Company's equity investments in these entities are not consolidated, but are included in other assets on the consolidated balance sheet for $620 thousand in aggregate. In addition to these six wholly owned subsidiaries, the Company has an aggregate investment of $330 thousand in three associated companies, Nobel Electronic Transfer, LLC, Nobel Real Estate Investors, LLC, and Velie Plantation Holding Company. The Company owns 20% equity positions in each of these associated companies. Stock-based compensation plans: The Company accounts for its stock-based employee compensation 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 following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. Three Months Three Months Six Months Six Months Ended Ended Ended Ended June 30, June 30, June 30, June 30, 2004 2003 2004 2003 ----------------------------------------------- Net income, as reported $1,671,212 $1,726,900 $2,507,129 $2,553,848 Deduct total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (30,864) (25,416) (64,563) (51,613) ----------------------------------------------- Net income $1,640,348 $1,701,484 $2,442,566 $ 2,502,235 =============================================== Earnings per share:* Basic As reported $0.40 $0.41 $0.60 $0.61 Pro forma 0.39 0.41 0.58 0.60 Diluted: As reported $0.39 $0.41 $0.58 $0.60 Pro forma 0.38 0.40 0.57 0.59 * Share and per share data has been retroactively adjusted to effect a 3:2 common stock split, which occurred on May 28, 2004, as if it had occurred on January 1, 2003. 7 In determining compensation cost using the fair value method prescribed in Statement No. 123, the value of each grant is estimated at the grant date with the following weighted-average assumptions for grants during the six months ended June 30, 2004 and 2003: dividend rate of 0.38% to 0.43% for the six months ended June 30, 2004 and 0.59% for the six months ended June 30, 2003; expected price volatility of 23.54% to 24.88%; risk-free interest rate based upon current rates at the date of grants (3.68% to 4.72% for stock options and 0.82% to 1.29% for the employee stock purchase plan); and expected lives of 10 years for stock options and 3 months to 6 months for the employee stock purchase plan. NOTE 2 - EARNINGS PER SHARE The following information was used in the computation of earnings per share on a basic and diluted basis. Share and per share data has been retroactively adjusted to effect a 3:2 common stock split, which occurred on May 28, 2004, as if it had occurred on January 1, 2003. Three months ended Six months ended June30, June 30, ------- -------- 2004 2003 2004 2003 ---- ---- ---- ---- Net income, basic and diluted Earnings $1,671,212 $1,726,900 $2,507,129 $2,553,848 ========== ========== ========== ========== Weighted avereage common shares Outstanding 4,212,795 4,165,878 4,213,635 4,158,200 Weighted average common shares issuable upon exercise of stock options and under the employee stock purchase plan 109,648 99,681 116,898 95,376 ------- ------ ------- ------ Weighted average common and common equivalent shares outstanding 4,322,443 4,265,559 4,330,533 4,253,576 ========= ========= ========= ========= NOTE 3 - BUSINESS SEGMENT INFORMATION Selected financial information on the Company's business segments is presented as follows for both the three-month and six-month periods ended June 30, 2004 and 2003, respectively. Three months ended Six months ended June 30, June 30, 2004 2003 2004 2003 ---- ---- ---- ---- Revenue: Commercial banking $10,505,587 $10,250,725 $20,149,586 $19,605,673 Credit card processing 348,056 698,852 932,735 1,080,362 Trust management 608,032 580,578 1,288,836 1,141,721 All other 143,462 64,807 271,523 162,096 ----------- ----------- ----------- ----------- Total revenue $11,605,137 $11,594,962 $22,642,680 $21,989,852 =========== =========== =========== =========== Net income (loss): Commercial banking $ 1,897,154 $ 1,660,457 $ 3,166,773 $ 2,540,163 Credit card processing 100,535 334,005 345,399 491,712 Trust management 135,426 129,027 334,901 257,679 All other (461,903) (396,589) (1,339,944) (735,706) ----------- ----------- ----------- ------------ Total net income $ 1,671,212 $ 1,726,900 $ 2,507,129 $ 2,553,848 =========== =========== =========== ============ 8 NOTE 4 - COMMITMENTS AND CONTINGENCIES In the normal course of business, the Company's subsidiary banks make various commitments and incur certain contingent liabilities that are not presented in the accompanying consolidated financial statements. The commitments and contingent liabilities include various guarantees, commitments to extend credit, and standby letters of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The subsidiary banks evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the banks upon extension of credit, is based upon management's credit evaluation of the counter-party. Collateral held varies but may include accounts receivable, marketable securities, inventory, property, plant and equipment, and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the banks to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements and, generally, have terms of one year, or less. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The subsidiary banks hold collateral, as described above, supporting those commitments if deemed necessary. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the banks would be required to fund the commitments. The maximum potential amount of future payments the banks could be required to make is represented by the contractual amount. If the commitment is funded, the banks would be entitled to seek recovery from the customer. At June 30, 2004 and December 31, 2003, no amounts were recorded as liabilities for the banks' potential obligations under these guarantees. As of June 30, 2004 and December 31, 2003, commitments to extend credit aggregated $233.5 million and $194.9 million, respectively. As of June 30, 2004 and December 31, 2003, standby letters of credit aggregated $11.4 million and $6.0 million, respectively. Management does not expect that all of these commitments will be funded. The Company has also executed contracts for the sale of mortgage loans in the secondary market in the amount of $4.4 million and $3.8 million, at June 30, 2004 and December 31, 2003, respectively. These amounts are included in loans held for sale at the respective balance sheet dates. Bancard is subject to the risk of cardholder chargebacks and its merchants being incapable of refunding the amount charged back. Management attempts to mitigate such risk by regular monitoring of merchant activity and in appropriate cases, holding cash reserves deposited by the merchant. The Company also has a guarantee to MasterCard International, Incorporated, which is backed by a performance bond in the amount of $1.0 million. As of June 30, 2004 and December 31, 2003, there were no significant pending liabilities. A significant portion of residential mortgage loans sold to investors in the secondary market are sold with recourse. Specifically, certain loan sales agreements provide that if the borrower becomes delinquent a number of payments or a number of days, within six months to one year of the sale, the banks must repurchase the loan from the subject investor. The banks did not repurchase any loans from secondary market investors under the terms of these loan sales agreements during the six months ended June 30, 2004 and the year ended December 31, 2003, respectively. In the opinion of management, the risk of recourse to the banks is not significant and, accordingly, no liability has been established related to such. 9 NOTE 5 - JUNIOR SUBORDINATED DEBENTURES In June 1999, the Company issued 1,200,000 shares of 9.2% cumulative trust preferred securities through a newly formed subsidiary, Trust I, which used the proceeds from the sale of the trust preferred securities to purchase junior subordinated debentures of the Company. These securities were $12.0 million at December 31, 2003. In February 2004, the Company issued, in a private transaction, $8.0 million of floating rate trust preferred securities and $12.0 million of fixed rate trust preferred securities through two newly formed subsidiaries, Trust II and Trust III, respectively. Trust II and Trust III used the proceeds from the sale of the trust preferred securities, along with the funds from their equity, to purchase junior subordinated debentures of the Company in the amounts of $8.2 million and $12.4 million, respectively. In February 2004, the Federal Reserve provided confirmation to the Company for their treatment of these new issuances as Tier 1 capital for regulatory capital purposes, subject to current established limitations. These securities were $20.0 million in aggregate at June 30, 2004. On June 30, 2004, the Company redeemed the $12.0 million of 9.2% cumulative trust preferred securities issued by Trust I in 1999. During the six months ended June 30, 2004, the Company recognized a loss of $747 thousand on the redemption of these trust preferred securities at their earliest call date, which resulted from the one-time write-off of unamortized costs related to the original issuance of the securities in 1999. NOTE 6 - RECENT ACCOUNTING DEVELOPMENTS SEC Staff Accounting Bulletin ("SAB") No. 105 "Application of Accounting Principles to Loan Commitments" was released in March 2004. This release summarizes the SEC staff position regarding the application of GAAP to loan commitments accounted for as derivative instruments. The Company accounts for interest rate lock commitments issued on mortgage loans that will be held for sale as derivative instruments. Consistent with SAB No. 105, the Company considers the fair value of these commitments to be zero at the commitment date, with subsequent changes in fair value determined solely on changes in market interest rates. The Company's adoption of this bulletin had no impact on the consolidated financial statements. At the March 17-18, 2004 Emerging Issues Task Force ("EITF") meeting, the Task Force reached a consensus on Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments". EITF 03-1 provides guidance for determining the meaning of "other-than-temporarily impaired" and its application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115") and investments accounted for under the cost method. The guidance set forth in the Statement is effective for the Company in the September 30, 2004 consolidated financial statements. Issue 03-1 is not expected to have a material impact on the consolidated financial statements. 10 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL QCR Holdings, Inc. is the parent company of Quad City Bank & Trust, Cedar Rapids Bank & Trust, and Quad City Bancard, Inc. Quad City Bank & Trust and Cedar Rapids Bank & Trust are Iowa-chartered commercial banks that are members of the Federal Reserve System with depository accounts insured to the maximum amount permitted by law by the Federal Deposit Insurance Corporation. Quad City Bank & Trust commenced operations in 1994 and provides full-service commercial and consumer banking, and trust and asset management services to the Quad City area and adjacent communities through its four offices that are located in Bettendorf and Davenport, Iowa and Moline, Illinois. Cedar Rapids Bank & Trust commenced operations in 2001 and provides full-service commercial and consumer banking service to Cedar Rapids and adjacent communities through its office located in the GreatAmerica Building in downtown Cedar Rapids, Iowa. Bancard provides merchant and cardholder credit card processing services. In October 2002, the Company sold Bancard's independent sales organization (ISO) related merchant credit card operations to iPayment, Inc. Until September 24, 2003, Bancard continued to temporarily process transactions for iPayment, Inc., and approximately 32,500 merchants. Since iPayment, Inc. discontinued processing with Bancard, processing volumes have decreased significantly. Bancard does, however, continue to provide credit card processing for its local merchants and agent banks and for cardholders of the Company's subsidiary banks. OVERVIEW Net income for the first six months of 2004 was $2.5 million as compared to net income of $2.6 million for the same period in 2003, a decrease of $47 thousand, or 2%. Basic earnings per share for the first six months of 2004 were $0.60 and for the first six months of 2003 were $0.61. As a result of the common stock split, which occurred on May 28, 2004, all share and per share data has been retroactively adjusted to effect a three-for-two common stock split as if it had occurred on January 1, 2003. For the six months ended June 30, 2004, net interest income improved by $1.8 million, or 18%, while, as a result of the dramatic drop in residential mortgage refinancing and the proportionate decrease in gain on sales of loans, noninterest income declined by $999 thousand, or 17%, to combine for a net improvement of $828 thousand when compared to the same period in 2003. Enhancing this 5% improvement in revenue for the Company was a decline in the provision for loan losses of $364 thousand, or 22%. The first six months of 2004 reflected an increase in noninterest expense of 13%, when compared to the same period in 2003. The increase in noninterest expense was predominately due to the one-time write-off of unamortized costs relating to the issuance of trust preferred securities ("TPS"), in combination with $213 thousand of growth in occupancy and equipment expense. After-tax income at Cedar Rapids Bank & Trust was $329 thousand for the six months ended June 30, 2004, as compared to $15 thousand for the same period in 2003. While profitability at the second bank charter has improved at a pace anticipated by management, Cedar Rapids Bank & Trust's asset growth has been more rapid than expected, as total assets were $187.9 million at June 30, 2004. In March 2004, as a result of the Company's intention to redeem $12.0 million of trust preferred securities issued in 1999 at their June 30, 2004 call date, the Company realized significant non-recurring expense in the form of a write-off of unamortized TPS issuance costs. This refinancing strategy, expected to provide long-term benefits for the Company, resulted in an increase to noninterest expense of $747 thousand, and combined with the additional interest costs of the new trust preferred securities, reduced after-tax net income for the first six months of 2004 by $712 thousand, or $0.16 in diluted earnings per share. Excluding this one-time write-off of unamortized TPS issuance costs and the additional interest costs, net income for the six months ended June 30, 2004 would have been $3.2 million, or diluted earnings per share of $0.74. Although excluding the impact of this event is a non-GAAP measure, management believes that it is important to provide such information due to the non-recurring nature of this expense and to more accurately compare the results of the periods presented. 11 In June 2004, the Company announced its expansion into the Rockford, Illinois market through the proposed creation of a third de novo bank charter. Consistent with the strategies of both Quad City Bank & Trust and Cedar Rapids Bank & Trust, the new bank, Rockford Bank and Trust Company ("Rockford Bank & Trust") will focus on the local community and on the creation of personalized banking relationships with a team of outstanding local bankers. It is expected that this new bank will operate initially as a bank of Quad City Bank & Trust, until the new charter can be approved by regulators. During the first six months of 2004, the Company experienced a $50 thousand reduction in after-tax net income as a result of start-up costs associated with the creation of Rockford Bank & Trust. The Company's operating results are derived largely from net interest income. Net interest income is the difference between interest income, principally from loans and investment securities, and interest expense, principally on borrowings and customer deposits. Changes in net interest income result from changes in volume, net interest spread and net interest margin. Volume refers to the average dollar levels of interest-earning assets and interest-bearing liabilities. Net interest spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Net interest margin refers to the net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities. The Company realized a 0.04% decrease in its net interest spread, declining from 3.16% for the three months ended June 30, 2003 to 3.12% for the three months ended June 30, 2004. The average yield on interest-earning assets decreased 0.61% for the three months ended June 30, 2004 when compared to the same period ended June 30, 2003. At the same time, the average cost of interest-bearing liabilities decreased 0.57%. The narrowing of the net interest spread resulted in a 0.17% reduction in the Company's net interest margin percentage. For the three months ended June 30, 2004, the net interest margin was 3.40% compared to 3.57% for the same period in 2003. Without the June 2004 redemption of $12.0 million of capital securities issued in 1999, the related issuance of $20.6 million in new trust preferred securities, and the subsequent pay-off of the Company's $10.0 million line of credit during the first quarter of 2004, the Company's net interest margin would have been 3.50% for the three months ended June 30, 2004. Although excluding the impact of these events is a non-GAAP measure, management believes that it is important to provide such information due to the non-recurring nature of the related expense and to more accurately compare the results of the periods presented. For both the six months ended June 30, 2004 and the six months ended June 30, 2003, the Company demonstrated stability in the net interest spread at 3.11%. The average yield on interest-earning assets decreased 0.54% for the six months ended June 30, 2004 when compared to the same period ended June 30, 2003. At the same time, the average cost of interest-bearing liabilities also decreased 0.54%. While the net interest spread remained stable, a decline in the ratio of earning assets to paying liabilities, combined with the lower rate environment, resulted in a 0.10% reduction in the Company's net interest margin percentage. For the six months ended June 30, 2004, the net interest margin was 3.42% compared to 3.52% for the same period in 2003. Without the June, 2004 redemption of $12.0 million of capital securities issued in 1999, the related issuance of $20.6 million in new trust preferred securities, and the subsequent pay-off of the Company's $10.0 million line of credit during the first quarter of 2004, the Company's net interest margin would have been 3.51% for the three six ended June 30, 2004. 12 Consolidated Average Balance Sheets and Analysis of Net Interest Earnings For the three months ended June 30, 2004 2003 --------------------------- ----------------------------- Interest Average Interest Average Average Earned Yield or Average Earned Yield or Balance or Paid Cost Balance or Paid Cost --------------------------- ------------------------------ ASSETS Interest earnings assets: Federal funds sold $ 5,581 3 0.22% $ 17,317 54 1.25% Interest-bearing deposits at financial institutions 11,781 67 2.27% 14,382 112 3.12% Investment securities (1) 126,506 1,206 3.81% 83,314 940 4.51% Gross loans receivable (2). 573,781 8,024 5.59% 465,679 7,302 6.27% ---------------- ------------------ Total interest earning assets 717,649 9,300 5.18% 580,692 8,408 5.79% Noninterest-earning assets: Cash and due from banks $ 31,678 $ 27,774 Premises and equipment 13,473 8,974 Less allowance for estimated losses on loans (9,677) (7,583) Other 33,773 31,650 --------- ---------- Total assets $786,896 $ 641,507 ========= ========== LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities: Interest-bearing demand deposits $170,021 319 0.75% $ 148,280 404 1.09% Savings deposits 15,061 12 0.32% 12,263 18 0.59% Time deposits 211,632 1,189 2.25% 194,770 1,406 2.89% Short-term borrowings 101,225 238 0.94% 37,855 101 1.07% Federal Home Loan Bank advances 92,346 860 3.73% 78,023 957 4.91% Junior subordinated debentures 29,620 579 7.82% 12,000 283 9.43% Other borrowings 1,750 10 2.29% 7,000 58 3.31% ----------------- ------------------- Total interest-bearing liabilities 621,655 3,207 2.06% 490,191 3,227 2.63% Noninterest-bearing demand 109,900 92,453 Other noninterest-bearing liabilities 12,567 20,315 Total liabilities 744,122 602,959 Stockholders' equity 42,774 38,548 -------- ---------- Total liabilities and stockholders' equity $786,896 $ 641,507 ======== ========= Net interest income $ 6,093 $ 5,181 ======= ======== Net interest spread 3.12% 3.16% ======= ======= Net interest margin 3.40% 3.57% ======= ======= Ratio of average interest earning assets to average interest- bearing liabilities 115.44% 118.46% ========= =========
(1) Interest earned and yields on nontaxable investment securities are determined on a tax equivalent basis using a 34% tax rate in each year presented. (2) Loan fees are not material and are included in interest income from loans receivable. 13 Analysis of Changes of Interest Income/Interest Expense For the three months ended June 30, 2004 Components Inc./(Dec.) of Change (1) from --------------------------- Prior Period Rate Volume ---------------------------------------- 2004 vs. 2003 ---------------------------------------- (Dollars in Thousands) INTEREST INCOME Federal funds sold $ (51) $ (28) $ (23) Interest-bearing deposits at financial institutions (45) (27) (18) Investment securities (2) 266 (836) 1,102 Gross loans receivable (3) 722 (4,080) 4,802 ---------------------------------------- Total change in interest income $ 892 $ (4,971) $ 5,863 ---------------------------------------- INTEREST EXPENSE Interest-bearing demand deposits $ (85) $ (380) $ 295 Savings deposits (6) (26) 20 Time deposits (217) (857) 640 Short-term borrowings 137 (81) 218 Federal Home Loan Bank advances (97) (853) 756 Junior subordinated debentures 296 (317) 613 Other borrowings (48) (14) (34) ---------------------------------------- Total change in interest expense $ (20) $ (2,528) $ 2,508 ---------------------------------------- Total change in net interest income 912 $ (2443) 3,355 ======================================== (1) The column "increase/decrease from prior period" is segmented into the changes attributable to variations in volume and the changes attributable to changes in interest rates. The variations attributable to simultaneous volume and rate changes have been proportionately allocated to rate and volume. (2) Interest earned and yields on nontaxable investment securities are determined on a tax equivalent basis using a 34% tax rate for each period presented. (3) Loan fees are not material and are included in interest income from loans receivable. 14 Consolidated Average Balance Sheets and Analysis of Net Interest Earnings For the six months ended June 30, 2004 2003 --------------------------- ----------------------------- Interest Average Interest Average Average Earned Yield or Average Earned Yield or Balance or Paid Cost Balance or Paid Cost --------------------------- ------------------------------ ASSETS Interest earnings assets: Federal funds sold $ 4,975 8 0.32% $ 18,218 102 1.12% Interest-bearing deposits at financial institutions 11,369 138 2.43% 14,101 235 3.33% Investment securities (1) 126,163 2,414 3.83% 82,394 1,928 4.68% Gross loans receivable (2). 555,272 15,493 5.58% 458,465 14,111 6.16% ---------------- ------------------ Total interest earning assets 697,778 18,053 5.17% 573,177 16,376 5.71% Noninterest-earning assets: Cash and due from banks $ 30,652 $ 26,919 Premises and equipment 12,975 9,012 Less allowance for estimated losses on loans (9,325) (7,385) Other 29,967 22,955 --------- ---------- Total assets $762,047 $ 624,678 ========= ========== LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities: Interest-bearing demand deposits $171,058 641 0.75% $ 144,657 769 1.06% Savings deposits 14,816 24 0.32% 12,120 35 0.58% Time deposits 206,965 2,358 2.28% 194,041 2,894 2.98% Short-term borrowings 82,554 380 0.92% 37,987 188 0.99% Federal Home Loan Bank advances 87,950 1,660 3.77% 77,064 1,723 4.47% Junior subordinated debentures 25,965 1,000 7.70% 12,000 566 9.43% Other borrowings 3,375 46 2.73% 6,500 110 3.38% ----------------- ------------------- Total interest-bearing liabilities 592,682 6,109 2.06% 484,369 6,285 2.60% Noninterest-bearing demand 115,379 89,283 Other noninterest-bearing liabilities 11,778 13,203 Total liabilities 719,839 586,854 Stockholders' equity 42,208 37,824 -------- ---------- Total liabilities and stockholders' equity $762,047 $ 624,678 ======== ========= Net interest income $11,944 $ 10,091 ======= ======== Net interest spread 3.11% 3.11% ======= ======= Net interest margin 3.42% 3.52% ======= ======= Ratio of average interest earning assets to average interest- bearing liabilities 117.73% 118.33% ========= =========
(1) Interest earned and yields on nontaxable investment securities are determined on a tax equivalent basis using a 34% tax rate for each period presented. (2) Loan fees are not material and are included in interest income from loans receivable. 15 Analysis of Changes of Interest Income/Interest Expense For the six months ended June 30, 2004 Components Inc./(Dec.) of Change (1) from --------------------------- Prior Period Rate Volume ---------------------------------------- 2004 vs. 2003 ---------------------------------------- (Dollars in Thousands) INTEREST INCOME Federal funds sold $ (94) $ (47) $ (47) Interest-bearing deposits at financial institutions (97) (57) (40) Investment securities (2) 486 (923) 1,409 Gross loans receivable (3) 1,381 (3,235) 4,616 ---------------------------------------- Total change in interest income $ 1,676 $ (4,262) $ 5,938 ---------------------------------------- INTEREST EXPENSE Interest-bearing demand deposits $ (128) $ (426) $ 298 Savings deposits (11) (28) 17 Time deposits (536) (1,019) 483 Short-term borrowings 192 (38) 230 Federal Home Loan Bank advances (63) (544) 481 Junior subordinated debentures 435 (299) 734 Other borrowings (64) (18) (46) ---------------------------------------- Total change in interest expense $ (175) $ (2,372) $ 2,197 ---------------------------------------- Total change in net interest income 1,851 $ (1,890) 3,741 ======================================== (1) The column "increase/decrease from prior period" is segmented into the changes attributable to variations in volume and the changes attributable to changes in interest rates. The variations attributable to simultaneous volume and rate changes have been proportionately allocated to rate and volume. (2) Interest earned and yields on nontaxable investment securities are determined on a tax equivalent basis using a 34% tax rate for each period presented. (3) Loan fees are not material and are included in interest income from loans receivable. CRITICAL ACCOUNTING POLICY The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policy to be that related to the allowance for loan losses. The Company's allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan loss that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including economic conditions throughout the Midwest and in particular, the state of certain industries. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. Management may report a materially different amount for the provision for loan losses in the statement of operations to change the allowance for loan losses if its assessment of the above factors were different. This discussion and analysis should be read in conjunction with the Company's financial statements and the accompanying notes presented elsewhere herein, as well as the portion of this Management's Discussion and Analysis, which discusses the allowance for loan losses in the section entitled "Financial Condition." Although management believes the levels of the allowance as of both June 30, 2004 and December 31, 2003 were adequate to absorb losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time. 16 RESULTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2004 AND 2003 Interest income increased by $880 thousand to $9.2 million for the three-month period ended June 30, 2004 when compared to $8.3 million for the quarter ended June 30, 2003. The increase of 11% in interest income was attributable to greater average, outstanding balances in interest earning assets, principally with respect to loans receivable, partially offset by significant reductions in interest rates. The Company's average yield on interest-earning assets decreased 0.61% for the three months ended June 30, 2004 when compared to the three months ended June 30, 2003. Interest expense decreased by $20 thousand to remain stable at $3.2 million for the three-month period ended June 30, 2004, as it had been for the three-month period ended June 30, 2003. The less than 1% decrease in interest expense was the result of a combination of significant reductions in interest rates, principally with respect to customers' deposits in subsidiary banks, almost entirely offset by greater average, outstanding balances in interest-bearing liabilities, principally with respect to Federal Home Loan Bank advances and customers' deposits in subsidiary banks. The Company's average cost of interest-bearing liabilities was 2.06% for the three months ended June 30, 2004, which was down 0.57% when compared to the three months ended June 30, 2003. Without the June, 2004 redemption of $12.0 million of trust preferred securities issued in 1999, the related issuance of new trust preferred securities, and the subsequent pay-off of the Company's line of credit, the Company's average cost of interest-bearing liabilities would have instead decreased from 2.56% for the comparable period one year ago to 1.94% for the three months ended June 30, 2004. Although excluding the impact of these events is a non-GAAP measure, management believes that it is important to provide such information due to the non-recurring nature of the related expense and to more accurately compare the results of the periods presented. At June 30, 2004 and March 31, 2004, the Company had an allowance for estimated losses on loans of 1.65% and 1.69%, respectively. The provision for loan losses increased by $110 thousand from $358 thousand for the three-month period ended June 30, 2003 to $468 thousand for the three-month period ended June 30, 2004. During the second quarter of 2004, management made monthly provisions for loan losses based upon a number of factors, including the increase in loans and a detailed analysis of the loan portfolio. During the second quarter of 2004, the $468 thousand provision to the allowance for loan losses was attributed entirely to net growth in the loan portfolio and was offset slightly by a recovery received by Quad City Bank & Trust in June. For the three months ended June 30, 2004, there was a single commercial loan charge-off of $221 thousand, and there were commercial recoveries of $77 thousand. Consumer loan charge-offs and recoveries totaled $60 thousand and $6 thousand, respectively, during the quarter. Credit card loans accounted for 38% of the second quarter consumer charge-offs. Residential real estate loans had no charge-offs or recoveries for the three months ended June 30, 2004. Noninterest income of $2.4 million for the three-month period ended June 30, 2004 was an $869 thousand, or 27%, decrease from $3.2 million for the three-month period ended June 30, 2003. Noninterest income during each of the quarters in comparison consisted primarily of income from the merchant credit card operation, fees from the trust department, depository service fees, gains on the sale of residential real estate mortgage loans, and other miscellaneous income. The quarter ended June 30, 2004, when compared to the same quarter in 2003, posted a $356 thousand decrease in fees earned by the merchant credit card operations of Bancard. Gains on the sale of residential real estate mortgage loans, net, decreased $808 thousand from the quarter ended June 30, 2003 to the same quarter in 2004, as a result of the significant decline in the refinancing of residential home mortgages. Additional variations in noninterest income consisted of a $27 thousand increase in trust department fees, a $45 thousand increase in deposit service fees, and a $195 thousand increase in other noninterest income. Other noninterest income in each quarter consisted primarily of investment advisory and management fees, earnings on the cash surrender value of life insurance, and income from associated companies. Merchant credit card fees, net of processing costs for the three months ended June 30, 2004 decreased by 54% to $302 thousand from $658 thousand for the second quarter of 2003. In October 2002, the Company sold Bancard's ISO related merchant credit card operations to iPayment, Inc., and Bancard's core business focus was shifted to processing for its agent banks, cardholders, and local merchants. Through September 2003, Bancard continued to process ISO related transactions for iPayment, Inc. for a fixed monthly service fee, which increased as the temporary processing period was extended. For the second quarter of 2003, net fixed monthly service fees collected from iPayment totaled $321 thousand, and Bancard's core merchant credit card fees, net of processing costs were $337 thousand. In September 2003, the transfer of the ISO related Visa/Mastercard processing activity to iPayment, Inc. was completed and significantly reduced Bancard's exposure to risk of credit card loss that the ISO activity carried with it. Bancard had established and carried ISO reserves, which provided coverage for this exposure. In March 2004, the Company recognized a recovery of $144 thousand from a reduction in these ISO reserves. For the second quarter of 2004, Bancard's core merchant credit card fees, net of processing costs were $302 thousand, or a decline of 10% when compared to the second quarter of the previous year. 17 For the quarter ended June 30, 2004, trust department fees increased $27 thousand, or 5%, to $608 thousand from $581 thousand for the same quarter in 2003. There was continued development of existing trust relationships and the addition of new trust customers throughout the past twelve months, as well as an improvement in market values of securities held in trust accounts, when compared to one year ago. Each of these factors had a resulting impact in the calculation and realization of trust fees. Deposit service fees increased $45 thousand, or 12%, to $408 thousand from $363 thousand for the three-month periods ended June 30, 2004 and June 30, 2003, respectively. This increase was primarily a result of the growth in noninterest bearing demand deposit accounts of $7.1 million, or 7%, since June 30, 2003. Service charges and NSF (non-sufficient funds) charges related to demand deposit accounts were the main components of deposit service fees. Gains on sales of loans, net, were $406 thousand for the three months ended June 30, 2004, which reflected a decrease of 67%, or $808 thousand, from $1.2 million for the three months ended June 30, 2003. The decrease resulted from the steep decline in mortgage refinances, which has been experienced in recent months, and its effect on the subsequent sale of the majority of residential mortgages into the secondary market. Management anticipates that the level of gains on sales of loans, net, will continue to be depressed significantly from those experienced throughout much of 2003. For the quarter ended June 30, 2004, other noninterest income increased $195 thousand, or 45%, to $629 thousand from $434 thousand for the same quarter in 2003. The increase was primarily due to a combination of the improved generation of investment advisory and management fees from the subsidiary banks' investment center operations, increased earnings on the cash surrender value of life insurance, and the increase in income from associated companies. Noninterest expenses for both the three months ended June 30, 2004, and the three months ended June 30, 2003, were $5.4 million. The significant components of noninterest expenses were salaries and benefits, occupancy and equipment expenses, and professional and data processing fees, for both quarters. The following table sets forth the various categories of noninterest expenses for the three months ended June 30, 2004 and 2003. Noninterest Expenses Three months ended June 30, -------- 2004 2003 % change ---------- ---------- -------- Salaries and employee benefits $3,119,302 $3,200,921 (2.6)% Professional and data processing fees 530,826 530,436 0.1% Advertising and marketing 287,198 204,770 40.3% Occupancy and equipment expense 790,760 656,741 20.4% Stationery and supplies 132,247 114,443 15.6% Postage and telephone 162,779 164,557 (1.1)% Bank service charges 147,401 111,581 32.1% Insurance 125,073 102,403 22.1% Other 141,994 313,728 (54.7)% ---------- --------- Total noninterest expenses $5,437,580 $5,399,579 0.7% ========== ========== For the quarter ended June 30, 2004, total salaries and benefits decreased to $3.1 million, which was down $82 thousand from the previous year's quarter total of $3.2 million. The decrease of 3% was primarily due to the Company's decreased expenses related to both tax benefit rights and stock appreciation rights and decreased real estate commissions which were proportionate to the decline in gains on sales of loans, net. Offsetting a large portion of these reductions was an increase in compensation and benefits related to an increase in employees from 203 full time equivalents to 229 from year-to-year. Occupancy and equipment expense increased $134 thousand, or 20%, from quarter to quarter. The increase was a proportionate reflection of the additional furniture, fixtures and equipment and leasehold improvements at the subsidiary banks. Advertising and marketing fees increased 40% from $205 thousand for the three months ended June 30, 2003 to $287 thousand for the same three-month period in 2004. Bank service charges increased 32% from $112 thousand for the second quarter of 2003 to $147 thousand for the comparable quarter in 2004. The $36 thousand increase was a reflection of the increase in activity between the subsidiary banks and their upstream banks. Insurance expense experienced a 32% increase from $102 thousand for the second quarter of 2003 to $125 thousand for the like quarter in 2004. This $23 thousand increase was a reflection of the facilities expansions taking place at the subsidiary banks, along with the general growth of the Company. Stationary and supplies experienced an $18 thousand increase for the second quarter of 2004, when compared to the like period in 2003. Increases in the volume of bank forms and copier/fax supplies used at the subsidiary banks were the primary contributors to the 16% increase. Other noninterest expense decreased $172 thousand, or 55%, for the three months ended June 30, 2004 when compared to the like period in 2003. The decrease was primarily due to loan expense incurred during the second quarter of 2003, which was related to other real estate owned. 18 The provision for income taxes was $822 thousand for the three-month period ended June 30, 2004 compared to $883 thousand for the three-month period ended June 30, 2003 for a decrease of $62 thousand, or 7%. The decrease was the result of a decrease in income before income taxes of $117 thousand, or 4%, for the 2004 quarter when compared to the 2003 quarter, in combination with a decrease in the effective tax rate from 33.8 % in 2003 to 33.0% in 2004. SIX MONTHS ENDED JUNE 30, 2004 AND 2003 Interest income increased by $1.7 million to $17.9 million for the six-month period ended June 30, 2004 when compared to $16.3 million for the six months ended June 30, 2003. The increase of 10% in interest income was attributable to greater average, outstanding balances in interest earning assets, principally with respect to loans receivable, partially offset by significant reductions in interest rates. The Company's average yield on interest-earning assets decreased 0.54% for the six months ended June 30, 2004 when compared to the six months ended June 30, 2003. Interest expense decreased by $175 thousand from $6.3 million for the six-month period ended June 30, 2003 to $6.1 million for the six-month period ended June 30, 2004. The 3% decrease in interest expense was the result of a combination of significant reductions in interest rates, principally with respect to customers' deposits in subsidiary banks, almost entirely offset by greater average, outstanding balances in interest-bearing liabilities, principally with respect to junior subordinated debentures and customers' deposits in subsidiary banks. The Company's average cost of interest-bearing liabilities was 2.06% for the six months ended June 30, 2004, which was down 0.54% when compared to the six months ended June 30, 2003. Without the redemption in June 2004 of $12.0 million of trust preferred securities issued in 1999, the related issuance of new trust preferred securities, and the subsequent pay-off of the Company's line of credit, the Company's average cost of interest-bearing liabilities would have instead decreased from 2.60% for the comparable period one year ago to 1.97% for the six months ended June 30, 2004. Although excluding the impact of these events is a non-GAAP measure, management believes that it is important to provide such information due to the non-recurring nature of the related expense and to more accurately compare the results of the periods presented. At both June 30, 2004 and December 31, 2003, the Company had an allowance for estimated losses on loans of 1.65%. The provision for loan losses decreased by $364 thousand from $1.7 million for the six-month period ended June 30, 2003 to $1.3 million for the six-month period ended June 30, 2004. During the first six months of 2004, management made monthly provisions for loan losses based upon a number of factors, including the increase in loans and a detailed analysis of the loan portfolio. During the first six months of 2004, the $1.3 million provision to the allowance for loan losses was attributed 87%, or $1.1 million, to net growth in the loan portfolio, and 13%, or $177 thousand, to downgrades within the portfolio. For the six months ended June 30, 2004, there were $221 thousand commercial loan charge-offs, and there were commercial recoveries of $86 thousand. Consumer loan charge-offs and recoveries totaled $119 thousand and $32 thousand, respectively, during the period. Credit card loans accounted for 39% of the first six months of consumer charge-offs. Residential real estate loans had no charge-offs or recoveries for the six months ended June 30, 2004. Noninterest income of $4.7 million for the six-month period ended June 30, 2004 was a $999 thousand, or 17%, decrease from $5.7 million for the six-month period ended June 30, 2003. Noninterest income during each of the periods in comparison consisted primarily of income from the merchant credit card operation, fees from the trust department, depository service fees, gains on the sale of residential real estate mortgage loans, and other miscellaneous income. The six months ended June 30, 2004, when compared to the same period in 2003, posted a $154 thousand decrease in fees earned by the merchant credit card operations of Bancard. Gains on the sale of residential real estate mortgage loans, net, decreased $1.5 million from the six months ended June 30, 2003 to the same period in 2004, as a result of the significant decline in the refinancing of residential home mortgages. Additional variations in noninterest income consisted of a $147 thousand increase in trust department fees, a $123 thousand increase in deposit service fees, and a $359 thousand increase in other noninterest income. Other noninterest income in each period consisted primarily of investment advisory and management fees, earnings on the cash surrender value of life insurance, and income from associated companies. Merchant credit card fees, net of processing costs for the six months ended June 30, 2004 decreased by 15% to $841 thousand from $995 thousand for the first six months of 2003. In October 2002, the Company sold Bancard's ISO related merchant credit card operations to iPayment, Inc., and Bancard's core business focus was shifted to processing for its agent banks, cardholders, and local merchants. Through September 2003, Bancard continued to process ISO related transactions for iPayment, Inc. for a fixed monthly service fee, which increased as the temporary processing period was extended. For the first six months of 2003, net fixed monthly service fees collected from iPayment totaled $481 thousand, and Bancard's core merchant credit card fees, net of processing costs were $514 thousand. In September 2003, the transfer of the ISO related Visa/Mastercard processing activity to iPayment, Inc. was completed and significantly reduced Bancard's exposure to risk of credit card loss that the ISO activity carried with it. Bancard had established and carried ISO reserves, which provided coverage for this exposure. 19 In March 2004, the Company recognized a recovery of $144 thousand from a reduction in these ISO reserves. Less this recovery and an additional $50 thousand of service fees collected from iPayment, Bancard's core merchant credit card fees, net of processing costs were $647 thousand for the first six months of 2004, or an improvement of 26% over the first six months of the previous year. For the six months ended June 30, 2004, trust department fees increased $147 thousand, or 13%, to $1.3 million from $1.1 million for the same period in 2003. There was continued development of existing trust relationships and the addition of new trust customers throughout the past twelve months, as well as an improvement in market values of securities held in trust accounts, when compared to one year ago. Each of these factors had a resulting impact in the calculation and realization of trust fees. Deposit service fees increased $123 thousand, or 18%, to $817 thousand from $694 thousand for the six-month periods ended June 30, 2004 and June 30, 2003, respectively. This increase was primarily the result of the growth in noninterest bearing demand deposit accounts of $7.1 million, or 7%, since June 30, 2003. Service charges and NSF (non-sufficient funds) charges related to demand deposit accounts were the main components of deposit service fees. Gains on sales of loans, net, were $668 thousand for the six months ended June 30, 2004, which reflected a decrease of 69%, or $1.5 million, from $2.2 million for the six months ended June 30, 2003. The decrease resulted from the steep decline in mortgage refinances, which has been experienced in recent months, and its effect on the subsequent sale of the majority of residential mortgages into the secondary market. Management anticipates that the level of gains on sales of loans, net, will continue to be depressed significantly from those experienced throughout much of 2003. For the six months ended June 30, 2004, other noninterest income increased $359 thousand, or 49%, to $1.1 million from $738 thousand for the same period in 2003. The increase was primarily due to a combination of the improved generation of investment advisory and management fees from the subsidiary banks' investment center operations, increased earnings on the cash surrender value of life insurance, and the increase in income from associated companies. Noninterest expenses for the six months ended June 30, 2004 were $11.5 million, as compared to $10.2 million for the same period in 2003, for an increase of $1.3 million, or 13%. The primary contributor to this significant increase was the $747 thousand loss on redemption of junior subordinated debentures, which reflected the write-off of unamortized TPS issuance costs related to the redemption, on June 30, 2004, of $12.0 million of capital securities issued in June 1999. Other significant components of noninterest expenses were salaries and benefits, occupancy and equipment expenses, and professional and data processing fees, for both periods. The following table sets forth the various categories of noninterest expenses for the six months ended June 30, 2004 and 2003. Noninterest Expenses Six months ended June 30, -------- 2004 2003 % change ----------- ----------- -------- Salaries and employee benefits $ 6,271,103 $ 6,085,713 3.1% Professional and data processing fees 996,102 959,506 3.8% Advertising and marketing 500,990 353,526 41.7% Occupancy and equipment expense 1,521,750 1,308,438 16.3% Stationery and supplies 269,192 224,720 19.8% Postage and telephone 329,059 318,122 3.4% Bank service charges 285,243 223,263 27.8% Insurance 225,567 209,209 7.8% Loss on redemption of junior subordinated debentures 747,490 - NA Other 380,172 500,926 (24.1)% ----------- ----------- Total noninterest expenses $11,526,668 $10,183,422 13.2% =========== =========== 20 The six months ended June 30, 2004 reflected a $747 thousand loss on the redemption of trust preferred securities at their earliest call date of June 30, 2004. For the six months ended June 30, 2004, total salaries and benefits increased to $6.3 million or $185 thousand over the previous year's six-month total of $6.1 million. The increase of $185 thousand was primarily due to the Company's increase in employees from 203 full time equivalents to 229 from year-to-year, in combination with decreased expenses for both real estate commissions and for tax benefit rights and stock appreciation rights. Occupancy and equipment expense increased $213 thousand, or 16%, from period to period. The increase was a proportionate reflection of the additional furniture, fixtures and equipment and leasehold improvements at the subsidiary banks. Advertising and marketing fees increased 42% from $354 thousand for the six months ended June 30, 2003 to $501 thousand for the same six-month period in 2004. Bank service charges increased 28% from $223 thousand for the first six months of 2003 to $285 thousand for the comparable period in 2004. The $62 thousand increase was a reflection of the increase in activity between the subsidiary banks and their upstream banks. Stationary and supplies experienced a $44 thousand increase for the first six months of 2004, when compared to the like period in 2003. Increases in the volume of bank forms and copier/fax supplies used at the subsidiary banks were the primary contributors to the 20% increase. Other noninterest expense decreased $121 thousand, or 24%, for the six months ended June 30, 2004 when compared to the like period in 2003. The decrease was primarily due to loan expense incurred during the second quarter of 2003, which was related to other real estate owned. The provision for income taxes was $1.2 million for the six-month period ended June 30, 2004 compared to $1.3 million for the six-month period ended June 30, 2003 for a decrease of $104 thousand, or 8%. The decrease was the result of a decrease in income before income taxes of $151 thousand, or 4%, for the 2004 period when compared to the 2003 period, in combination with a decrease in the effective tax rate from 33.4 % in 2003 to 31.9% in 2004. FINANCIAL CONDITION Total assets of the Company increased by $101.5 million, or 14%, to $811.5 million at June 30, 2004 from $710.0 million at December 31, 2003. The growth resulted primarily from increases in the loan portfolio and in bank-owned life insurance, funded by short-term borrowings and Federal Home Loan Bank advances. Cash and due from banks increased by $7.7 million, or 31%, to $32.1 million at June 30, 2004 from $24.4 million at December 31, 2003. Cash and due from banks represented both cash maintained at its subsidiary banks, as well as funds that the Company and its banks had deposited in other banks in the form of non-interest bearing demand deposits. Federal funds sold are inter-bank funds with daily liquidity. At June 30, 2004, the subsidiary banks had $9.3 million invested in such funds. This amount increased by $5.3 million, or 130%, from $4.0 million at December 31, 2003. The increase was primarily a result of the demands for Federal funds by Quad City Bank & Trust's downstream correspondent banks. Interest-bearing deposits at financial institutions decreased by $730 thousand, or 7%, to $9.7 million at June 30, 2004 from $10.4 million at December 31, 2003. Included in interest-bearing deposits at financial institutions are demand accounts, money market accounts, and certificates of deposit. The decrease was the result of increases in money market accounts of $734 thousand and maturities of certificates of deposit totaling $1.5 million. Securities increased by $2.4 million, or 2%, to $131.2 million at June 30, 2004 from $128.8 million at December 31, 2003. The increase was the result of a number of transactions in the securities portfolio. Paydowns of $1.0 million were received on mortgage-backed securities, and the amortization of premiums, net of the accretion of discounts, was $578 thousand. Maturities and calls of securities occurred in the amount of $25.8 million, and the portfolio experienced a decrease in the fair value of securities, classified as available for sale, of $2.2 million. These portfolio decreases were offset by the purchase of an additional $32.0 million of securities, classified as available for sale. 21 Total gross loans receivable increased by $69.7 million, or 13%, to $592.2 million at June 30, 2004 from $522.5 million at December 31, 2003. The increase was the result of the origination or purchase of $270.3 million of commercial business, consumer and real estate loans, less loan charge-offs, net of recoveries, of $222 thousand, and loan repayments or sales of loans of $200.4 million. During the six months ended June 30, 2004, Quad City Bank & Trust contributed $158.0 million, or 58%, and Cedar Rapids Bank & Trust contributed $112.3 million, or 42%, of the Company's loan originations or purchases. Cedar Rapids Bank & Trust participated $25.8 million, or 23%, of their originations during the period to Quad City Bank & Trust. The mix of loan types within the Company's portfolio at June 30, 2004 reflected 82% commercial, 9% real estate and 9% consumer loans. The majority of residential real estate loans originated by the Company were sold on the secondary market to avoid the interest rate risk associated with long term fixed rate loans. Loans originated for this purpose were classified as held for sale. The allowance for estimated losses on loans was $9.7 million at June 30, 2004 compared to $8.7 million at December 31, 2003, an increase of $1.0 million, or 13%. The allowance for estimated losses on loans was determined based on factors that included the overall composition of the loan portfolio, types of loans, past loss experience, loan delinquencies, potential substandard and doubtful credits, economic conditions, and other factors that, in management's judgement, deserved evaluation. To ensure that an adequate allowance was maintained, provisions were made based on a number of factors, including the increase in loans and a detailed analysis of the loan portfolio. The loan portfolio was reviewed and analyzed monthly utilizing the percentage allocation method. In addition, specific reviews were completed on all credits risk-rated less than "fair quality" and carrying aggregate exposure in excess of $250 thousand. The adequacy of the allowance for estimated losses on loans was monitored by the loan review staff, and reported to management and the board of directors. Although management believes that the allowance for estimated losses on loans at June 30, 2004 was at a level adequate to absorb losses on existing loans, there can be no assurance that such losses will not exceed the estimated amounts or that the Company will not be required to make additional provisions for loan losses in the future. Asset quality is a priority for the Company and its subsidiaries. The ability to grow profitably is in part dependent upon the ability to maintain that quality. The Company is focusing efforts at its subsidiary banks in an attempt to improve the overall quality of the Company's loan portfolio. A slowdown in economic activity beginning in 2001 severely impacted several major industries as well as the economy as a whole. Even though there are numerous indications of emerging strength, it is not certain that this strength is sustainable. Future events could still adversely affect cash flows for both commercial and individual borrowers, as a result of which, the Company could experience increases in problem assets, delinquencies and losses on loans, and require further increases in the provision. Net charge-offs for the six months ended June 30 were $222 thousand in 2004 and $659 thousand in 2003. One measure of the adequacy of the allowance for estimated losses on loans is the ratio of the allowance to the gross loan portfolio. The allowance for estimated losses on loans as a percentage of gross loans was 1.65% at both June 30, 2004 and December 31, 2003. At June 30, 2004, total nonperforming assets were $6.7 million compared to $5.0 million at December 31, 2003. The $1.7 million increase was the result of a $1.5 million increase in nonaccrual loans in combination with an increase of $250 thousand in accruing loans past due 90 days or more. All of the nonperforming assets were located in the loan portfolio at Quad City Bank & Trust. The loans in the Cedar Rapids Bank & Trust loan portfolio have been originated since the bank's inception in 2001, and none of the loans have been categorized as nonperforming assets. As the loan portfolio at Cedar Rapids Bank & Trust matures, it is likely that there will be nonperforming loans or charge-offs associated with the portfolio. 22 Nonaccrual loans were $5.7 million at June 30, 2004 compared to $4.2 million at December 31, 2003, an increase of $1.5 million. The increase in nonaccrual loans was comprised of increases in commercial loans of $830 thousand, real estate loans of $414 thousand and consumer loans of $241 thousand. The $830 thousand increase in nonaccrual commercial loans for the period was primarily due to the addition of two commercial lending relationships totaling $1.1 million at Quad City Bank & Trust. Six large commercial lending relationships at Quad City Bank & Trust, with an aggregate outstanding balance of $3.9 million, comprised 69% of the nonaccrual loans at June 30, 2004. Management maintained the Company's percentage of allowance for estimated loan losses to total loans at 1.65% at June 30, 2004, as it had been at December 31, 2003. Management is closely monitoring the Company's loan portfolio and the level of allowance for loan losses. Management continues to focus efforts to improve the overall quality of the loan portfolio. Nonaccrual loans represented approximately one percent of the Company's held for investment loan portfolio at June 30, 2004. From December 31, 2003 to June 30, 2004, accruing loans past due 90 days or more increased from $756 thousand to $1.0 million. Seven lending relationships at Quad City Bank & Trust comprised $847 thousand, or 84%, of this balance at June 30, 2004. Premises and equipment showed an increase of $2.0 million, or 16%, to climb to $14.0 million at June 30, 2004 from $12.0 million at December 31, 2003. During the six-month period there were purchases of additional land, furniture, fixtures and equipment and leasehold improvements of $2.7 million, which were partially offset by depreciation expense of $686 thousand. In August 2003, Quad City Bank & Trust purchased the northern segment of its Brady Street facility in Davenport, which had previously been owned by the developer of the property. Project costs incurred during the first six months of 2004 totaled $583 thousand. In September 2003, the Company announced plans for a fifth Quad City Bank & Trust banking facility, to be located in west Davenport. During October 2003, the Company purchased a site for this location, and during the first six months of 2004, the Company experienced costs of $250 thousand for demolition and site preparation. Total costs for this project are anticipated to be approximately $1.7 million, which will likely be completed in late 2004 or early 2005. In the fall of 2003, Quad City Bank & Trust initiated the purchase of check and document imaging hardware and software. During the first six months of 2004, purchases related to this project totaled $485 thousand. In February 2004, Cedar Rapids Bank & Trust announced plans to build a facility in downtown Cedar Rapids. The Bank's main office will be relocated to this site in early 2005, when completion is anticipated. Costs for this facility during the first six months of 2004 were $834 thousand, and total costs are projected to be $5.0 million at completion. Cedar Rapids Bank & Trust also intends to construct a branch office during 2004. The Company has incurred costs for this project of $51 thousand during the first six months of 2004. Accrued interest receivable on loans, securities and interest-bearing deposits with financial institutions increased by $6 thousand, or less than 1%, to remain at $3.6 million at June 30, 2004 as at December 31, 2003. Bank-owned life insurance increased by $12.3 million from $3.1 million at December 31, 2003 to $15.4 million at June 30, 2004. The subsidiary banks purchased life insurance of $8.0 million in connection with the establishment of benefit plans for the executive officers of the Company. These plans prescribe the payment of supplemental retirement benefits to the executive officers at retirement. In addition, the Company purchased life insurance totaling $3.9 million on the lives of a number of senior management personnel in connection with the execution of employment agreements and the establishment of deferred compensation arrangements with these officers. These new purchases during the first quarter, combined with the existing bank-owned life insurance, resulted in each subsidiary bank holding investments in bank-owned life insurance contracts near the regulatory maximum allowable. These purchases were made due to the significant tax-equivalent yields available on bank-owned life insurance, and the possibility of legislative action that could restrict or eliminate the tax advantaged status of future purchases of bank-owned life insurance. Earnings on bank-owned life insurance totaled $322 thousand for the six months ended June 30, 2004, and benefit expense associated with the supplemental retirement benefits and deferred compensation arrangements was $72 thousand and $54 thousand, respectively, for the same period. 23 Other assets increased by $4.2 million, or 43%, to $13.9 million at June 30, 2004 from $9.7 million at December 31, 2003. Other assets included $6.1 million of equity in Federal Reserve Bank and Federal Home Loan Bank stock, $2.4 million of deferred tax assets, $950 thousand in investments in unconsolidated companies, $547 thousand of accrued trust department fees, $424 thousand of unamortized prepaid TPS offering expenses, $488 thousand of prepaid Visa/Mastercard processing charges, other miscellaneous receivables, and various prepaid expenses. Deposits decreased by $2.3 million, or less than 1%, to $509.3 million at June 30, 2004 from $511.6 million at December 31, 2003. The decrease resulted from a $29.0 million net decrease in non-interest bearing, NOW, money market and savings accounts offset by a $26.7 million net increase in interest-bearing certificates of deposit. As anticipated for several quarters, the merchant credit card processing for the independent sales organization ("ISO") portfolio, which was sold to iPayment, Inc. in October 2001, was transferred to another processor on February 1, 2004. Funds related to this transfer accounted for $16.3 million of the decrease in non-interest bearing deposits from December 31, 2003 to June 30, 2004. Short-term borrowings increased $75.3 million, or 146%, from $51.6 million at December 31, 2003 to $126.9 million at June 30, 2004. The subsidiary banks offer short-term repurchase agreements to some of their major customers. Also, on occasion, the subsidiary banks purchase Federal funds for short-term funding needs from the Federal Reserve Bank, or from their correspondent banks. As a result of the significant growth in assets during the first six months of 2004, primarily the loan portfolio and bank-owned life insurance, and the concurrent decline in deposits, the subsidiary banks utilized short-term borrowings for their funding needs. Short-term borrowings were comprised of customer repurchase agreements of $45.0 million and $34.7 million at June 30, 2004 and December 31, 2003, respectively, as well as federal funds purchased of $81.9 million at June 30, 2004 and $16.9 million at December 31, 2003. Federal Home Loan Bank advances increased by $20.4 million, or 27%, to $96.6 million at June 30, 2004 from $76.2 million at December 31, 2003. As a result of their memberships in the FHLB of Des Moines, the subsidiary banks have the ability to borrow funds for short or long-term purposes under a variety of programs. FHLB advances are utilized for loan matching as a hedge against the possibility of rising interest rates, and when these advances provide a less costly or more readily available source of funds than customer deposits. Other borrowings were $7.0 million at June 30, 2004 for a decrease of $3.0 million from December 31, 2003. In September 2001, the Company had drawn a $5.0 million advance on a line of credit at an upstream correspondent bank as partial funding for the initial capitalization of Cedar Rapids Bank & Trust. In February and July 2003, the Company drew additional advances of $2.0 million and $3.0 million, respectively, as funding to maintain the required level of regulatory capital at Cedar Rapids Bank & Trust in light of the bank's growth. In February 2004, the Company formed two trusts, which, in a private transaction, issued $8.0 million of floating rate trust preferred securities and $12.0 million of fixed rate trust preferred securities. Partial proceeds from this transaction were used to pay off the $10.0 million secured credit note balance existing on that date. In June 2004, the Company drew an advance of $7.0 million as partial funding for the redemption of the $12.0 million in trust preferred securities, which had been issued in 1999. Junior subordinated debentures increased $8.6 million, or 72%, from $12.0 million at December 31, 2003 to $20.6 million at June 30, 2004. In June 1999, the Company issued 1,200,000 shares of trust preferred securities through a newly formed subsidiary, Trust I. These securities were $12.0 million at December 31, 2003. The Company redeemed these securities on June 30, 2004. In February 2004, the Company formed two new subsidiaries and issued, in a private transaction, the $8.0 million of floating rate trust preferred securities and $12.0 million of fixed rate trust preferred securities of Trust II and Trust III, respectively. Trust II and Trust III used the proceeds from the sale of the trust preferred securities, along with the funds from their equity, to purchase junior subordinated debentures of the Company in the amounts of $8.2 million and $12.4 million, respectively. Other liabilities were $8.2 million at June 30, 2004, up $1.5 million, or 22%, from $6.7 million at December 31, 2003. Other liabilities were comprised of unpaid amounts for various products and services, and accrued but unpaid interest on deposits. At June 30, 2004, the most significant components of other liabilities were $1.8 million of accounts payable, $4.3 million of accrued expenses, and $1.1 million of interest payable. Common stock at June 30, 2004 was $4.2 million, which was up 48% from $2.9 million at December 31, 2003. The increase of $1.4 million was the net result of a three-for-two common stock split, which was paid in the form of a stock dividend on May 28, 2004, stock issued from the net exercise of stock options, stock purchased under the employee stock purchase plan, and the retirement of treasury shares. 24 Additional paid-in capital totaled $15.5 million at June 30, 2004, down $1.6 million, or 9%, from $17.1 million at December 31, 2003. The decrease resulted primarily from a three-for-two common stock split, which was paid in the form of a stock dividend on May 28, 2004 and the retirement of treasury shares, partially offset by the proceeds received in excess of the $1.00 per share par value for the 18,832 shares of common stock issued as the result of the net exercise of stock options and stock purchased under the employee stock purchase plan. Retained earnings increased by $1.8 million, or 9%, to $22.7 million at June 30, 2004 from $20.9 million at December 31, 2003. The increase reflected net income for the six-month period, partially offset by the retirement of treasury shares, the payout for fractional shares resulting from the common stock split, and for the declaration of a cash dividend of $0.04 per share, which was paid on July 2, 2004. Unrealized gains on securities available for sale, net of related income taxes, totaled $403 thousand at June 30, 2004 as compared to $1.8 million at December 31, 2003. The decrease in gains of $1.4 million was attributable to decreases during the period in fair value of the securities identified as available for sale. At December 31, 2003, the Company held 90,219 treasury shares at a total cost of $855 thousand. The weighted average cost of the shares was $9.47. On April 30, 2004, these treasury shares were retired by the Company. LIQUIDITY Liquidity measures the ability of the Company to meet maturing obligations and its existing commitments, to withstand fluctuations in deposit levels, to fund its operations, and to provide for customers' credit needs. The liquidity of the Company primarily depends upon cash flows from operating, investing, and financing activities. Net cash provided by operating activities, consisting primarily of proceeds on sales of loans, was $2.8 million for the six months ended June 30, 2004 compared to $18.3 million net cash provided in the same period in 2003. Net cash used in investing activities, consisting principally of loan originations to be held for investment and purchases of available for sale securities, was $94.0 million for the six months ended June 30, 2004 and $69.1 million for the six months ended June 30, 2003. Net cash provided by financing activities, consisting primarily of proceeds from short-term borrowings and from Federal Home Loan Bank advances, for the six months ended June 30, 2004 was $98.8 million, and for the same period in 2003 was $57.9 million. The Company has a variety of sources of short-term liquidity available to it, including federal funds purchased from correspondent banks, sales of securities available for sale, FHLB advances, lines of credit and loan participations or sales. At June 30, 2004, the subsidiary banks had ten lines of credit totaling $78.0 million, of which $8.0 million was secured and $70.0 million was unsecured. At December 31, 2003, the subsidiary banks had seven lines of credit totaling $41.0 million, of which $4.0 million was secured and $37.0 million was unsecured. At both June 30, 2004 and December 31, 2003, the Company also had an unsecured revolving credit note, which was renewed in July 2004, at an upstream correspondent bank for $15.0 million. At June 30, 2004, there was an outstanding balance of $7.0 million on this note. At December 31, 2003, the note had an outstanding balance of $10.0 million. On February 18, 2004, the Company issued $8.0 million of floating rate trust preferred securities and $12.0 million of fixed rate trust preferred securities. The securities represent undivided beneficial interests in Trust II and Trust III, which were established by the Company for the purpose of issuing the trust preferred securities. The securities issued by Trust II and Trust III mature in 30 years. The floating rate trust preferred securities are callable at par after five years and the fixed rate trust preferred securities are callable at par after seven years. The floating rate trust preferred securities have a variable rate based on the three-month LIBOR, reset quarterly, with the current rate set at 4.44%, and the fixed rate trust preferred securities have a fixed rate of 6.93%, payable quarterly, for seven years, at which time they will convert to a variable rate based on the three-month LIBOR, reset quarterly. Trust II and Trust III used the proceeds from the sale of the trust preferred securities, along with the funds from their equity, to purchase junior subordinated debentures of the Company in the amounts of $8.2 million and $12.4 million, respectively. The Company incurred issuance costs of $429 thousand, which are being amortized over the lives of the securities. The Company used the net proceeds for general corporate purposes, which included a net paydown of $3.0 million on the balance of the Company's unsecured revolving credit note, an infusion of $3.0 million to Cedar Rapids Bank & Trust for capital maintenance purposes, and an infusion of $1.0 million to Quad City Bank & Trust for capital maintenance purposes. Management's primary use for the balance of the proceeds was the redemption, in June 2004, of the $12.0 million of 9.2% cumulative trust preferred securities issued by Trust I in 1999. Based on this intended redemption, $747 thousand of unamortized issuance costs related to the trust preferred securities of Trust I were expensed in March 2004. 25 On April 23, 2004, the Company declared a cash dividend of $0.04 per share, or $169 thousand, which was paid on July 2, 2004. It is the Company's intention to consider the payment of dividends on a semi-annual basis. The Company anticipates an ongoing need to retain much of its operating income to help provide the capital for continued growth, however it believes that operating results have reached a level that can sustain dividends to stockholders as well. RECENT REGULATORY DEVELOPMENTS Trust Preferred Securities. On May 6, 2004, the Board of Governors of the Federal Reserve System (the "Board") issued a Notice of Proposed Rulemaking in which it proposed to allow the continued inclusion of trust preferred securities in the tier 1 capital of bank holding companies, subject to stricter standards. The Board is proposing to limit the aggregate amount of a bank holding company's cumulative perpetual preferred stock, trust preferred securities and other minority interests to 25% of the company's core capital elements, net of goodwill. Current regulations do not require the deduction of goodwill. The proposal also provides that amounts of qualifying trust preferred securities and certain minority interests in excess of the 25% limit may be included in tier 2 capital but would be limited, together with subordinated debt and limited-life preferred stock, to 50% of tier 1 capital. The proposal provides a three-year transition period for bank holding companies to meet these quantitative limitations. Implementation of the proposal, in its present form, is not expected to have a material impact on the consolidated financial statements. Bank Sales of Securities. On June 17, 2004, the Securities and Exchange Commission (the "SEC") issued a Proposed Rule in which it described the parameters under which banks may sell securities to their customers without having to register as broker-dealers with the SEC in accordance with Title II of the Gramm-Leach-Bliley Act of 1999. The proposal, which is designated as Regulation B, clarifies, among other things: (i) the limitations on the amount that unregistered bank employees may be compensated for making referrals in connection with a third-party brokerage arrangement; (ii) the manner by which banks may be compensated for effecting securities transactions for its customers in a fiduciary capacity; and (iii) the extent to which banks may engage in certain securities transactions as a custodian. At this time, it is not possible to predict the impact that this proposal would have on the Company and its subsidiaries. Expanded Branching Authority. Until 2001, an Iowa-chartered bank could only establish a branch office within the boundaries of the counties contiguous to, or cornering upon, the county in which the principal place of business of the bank was located. In 2001, the Iowa Banking Act was amended to allow Iowa-chartered banks to establish up to three branches at any location in Iowa, subject to regulatory approval, in addition to any branches established under the branching rules described above. Beginning July 1, 2004, Iowa-chartered banks are permitted to establish any number of branches at any location in Iowa, subject to regulatory approval. Part I Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company realizes income principally from the spread between the interest earned on loans, investments and other interest-earning assets and the interest paid on deposits and borrowings. Loan volumes and yields, as well as the volume of and rates on investments, deposits and borrowings, are affected by market interest rates. Additionally, because of the terms and conditions on many of the investments and the loan and deposit accounts, a change in interest rates could also affect the projected maturities in the securities and loan portfolios and/or the deposit base, which could alter the Company's sensitivity to future changes in interest rates. Accordingly, management considers interest rate risk to be a significant market risk. Interest rate risk management focuses on maintaining consistent growth in net interest income within policy limits approved by the board of directors, while taking into consideration, among other factors, the Company's overall credit, operating income, operating cost, and capital profile. The subsidiary banks' ALM/Investment Committees, which includes senior management representatives and members of the board of directors, monitor and manage interest rate risk to maintain an acceptable level of change to net interest income as a result of changes in interest rates. 26 One method used to quantify interest rate risk is a short-term earnings at risk summary, which is a detailed and dynamic simulation model used to quantify the estimated exposure of net interest income to sustained interest rate changes. This simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all interest sensitive assets and liabilities reflected on the Company's consolidated balance sheet. This sensitivity analysis demonstrates net interest income exposure over a one year horizon, assuming no balance sheet growth and a 200 basis point upward and a 100 basis point downward shift in interest rates, where interest-bearing assets and liabilities reprice at their earliest possible repricing date. The model assumes a parallel and pro rata shift in interest rates over a twelve-month period. Application of the simulation model analysis at March 31, 2004 demonstrated a 1.15% decrease in interest income with a 200 basis point increase in interest rates, and a 1.23% decrease in interest income with a 100 basis point decrease in interest rates. Both simulations are within the board-established policy limits of a 10% decline in value. Part I Item 4 CONTROLS AND PROCEDURES An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended) as of June 30, 2004. Based on that evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls. SPECIAL NOTE CONCERNING FORWARD-LOOKING STATEMENTS Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995. This document contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, are generally identifiable by the use of words such as "believe," "expect," "anticipate," "bode," "predict," "suggest," "appear," "plan," "intend," "estimate," "may," "will," "would," "could," "should" or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Company and its subsidiaries include, but are not limited to, the following: o The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company's assets. o The economic impact of past and any future terrorist attacks, acts of war or threats thereof, and the response of the United States to any such threats and attacks. o The effects of, and changes in, federal, state and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters. 27 o The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company's assets) and the policies of the Board of Governors of the Federal Reserve System. o The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector. o The inability of the Company to obtain new customers and to retain existing customers. o The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet. o Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers. o The ability of the Company to develop and maintain secure and reliable electronic systems. o The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner. o Consumer spending and saving habits which may change in a manner that affects the Company's business adversely. o Business combinations and the integration of acquired businesses which may be more difficult or expensive than expected. o The costs, effects and outcomes of existing or future litigation. o Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board. o The ability of the Company to manage the risks associated with the foregoing as well as anticipated. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company's financial results, is included in the Company's filings with the Securities and Exchange Commission. 28 Part II QCR HOLDINGS, INC. AND SUBSIDIARIES PART II - OTHER INFORMATION Item 1 Legal Proceedings There are no material pending legal proceedings to which the Company or its subsidiaries is a party other than ordinary routine litigation incidental to their respective businesses. Item 2 Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities - None Item 3 Defaults Upon Senior Securities - None Item 4 Submission of Matters to a Vote of Security Holders - The annual meeting of stockholders was held at The Lodge located at 900 Spruce Hills Drive, Bettendorf, Iowa on Wednesday, May 5, 2004 at 10:00 a.m. At the meeting, Mark C. Kilmer was elected to serve as a Class II director, with a term expiring in 2007, and Larry J. Helling and Douglas M. Hultquist were re-elected to serve as Class II directors, with terms expiring in 2007. Continuing as Class III directors, with terms expiring in 2005, are Patrick S. Baird, John K. Lawson, and Ronald G. Peterson. Continuing as Class I directors, with terms expiring in 2006, are Michael A. Bauer, James J. Brownson, and Henry Royer. Also, at the meeting an amendment was approved to the Certificate of Incorporation increasing the number of authorized shares of common stock from 5,000,000 shares, par value of $1.00 per share, to 10,000,000 shares, par value of $1.00 per share, and there was approval of the QCR Holdings 2004 Stock Incentive Plan. There were 2,873,561 issued shares and 2,813,415 outstanding shares of common stock entitled to vote at the annual meeting. Either in person or by proxy, there were 2,439,380 common shares represented at the meeting, constituting approximately 86.7% of the outstanding shares. The voting was as follows: Votes Votes For Withheld --------------------------------------- Larry J. Helling 2,430,743 8,637 Douglas M. Hultquist 2,396,894 42,486 Mark C. Kilmer 2,431,841 7,539 Votes Votes Votes For Against Abstained --------------------------------------- Amendment to Certificate 2,366,004 66,335 7,041 of Incorporation Votes Votes Votes For Against Abstained --------------------------------------- 2004 Stock Incentive Plan 1,342,205 219,555 19,095 Item 5 Other Information - None Item 6 Exhibits and Reports on Form 8-K (a) Exhibits 10.1 Employment Agreement between QCR Holdings, Inc. and Thomas Budd dated June 2004. 10.2 Employment Agreement between QCR Holdings, Inc. and Shawn Way dated June 2004. 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a) 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a) 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 29 b) Reports on Form 8-K A report on Form 8-K was filed on April 23, 2004, which reported the Company's financial information, including earnings for the quarter ended March 31, 2004, pursuant to Item 12, as well as the Company's declaration of a 3:2 common stock split effected in the form of a dividend and also a cash dividend of $0.04 per share, pursuant to Item 5. A report on Form 8-K was filed on May 13, 2004 under Item 12, which reported the Company's financial information, including earnings for the quarter ended March 31, 2004, in the form of a shareholder letter dated May 2004. A report on Form 8-K was filed on May 17, 2004 under Item 5, which announced in the form of a press release, that the Company's subsidiary, QCR Holdings Capital Trust I, would redeem on June 30, 2004 all of its 9.20% Trust Preferred Securities and its 9.20% common securities. A report on Form 8-K was filed on June 24, 2004 under Item 5, which announced, in the form of a press release, that the Company will establish a new financial institution in Rockford, Illinois. A report on Form 8-K was filed on July 1, 2004 under Item 5, which announced, in the form of a press release, that the Company's subsidiary, QCR Holdings Capital Trust I, redeemed on June 30, 2004 all of its 9.20% Trust Preferred Securities and its 9.20% common securities. A report on Form 8-K was filed on July 23, 2003, pursuant to Item 12, which reported in the form of a press release, the Company's financial information, including earnings for the quarter ended June 30, 2004. 30 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. QCR HOLDINGS, INC. (Registrant) Date August 11, 2004 /s/ Michael A. Bauer ---------------------------------------- Michael A. Bauer, Chairman Date August 11, 2004 /s/ Douglas M. Hultquist ---------------------------------------- Douglas M. Hultquist, Chief Executive Officer Date August 11, 2004 /s/ Todd A. Gipple ---------------------------------------- Todd A. Gipple, Executive Vice President Chief Financial Officer 31