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NATIONAL PENN BANCSHARES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 9, 2014

The following discussion and analysis is intended to assist in understanding and evaluating the major changes in the earnings performance and financial condition of the Company as of and for the three months ended March 31, 2014, with a primary focus on an analysis of operating results. Current performance does not guarantee, and may not be indicative of similar performance in the future. The Company's consolidated financial statements included in this Report are unaudited, and as such, are subject to year-end examination.



Statement Regarding Non-GAAP Financial Measures:

This Report contains supplemental financial information determined by methods other than in accordance with Accounting Principles Generally Accepted in the United States of America ("GAAP"). National Penn's management uses these non-GAAP measures in its analysis of National Penn's performance. These measures should not be considered a substitute for GAAP basis measures nor should they be viewed as a substitute for operating results determined in accordance with GAAP. Management believes the presentation of the following non-GAAP financial measures, which exclude the impact of the specified items, provides useful supplemental information that is essential to a proper understanding of the financial results of National Penn. Tangible common equity excludes goodwill and intangible assets and preferred equity. Banking and financial institution regulators also exclude goodwill and intangible assets from shareholders' equity when assessing the capital adequacy of a financial institution.



Tangible

common equity provides a method to assess the Company's tangible capital trends.



Tangible book value expresses tangible common equity on a per-share

basis. Tangible book value provides a method to assess the level of tangible net assets on a per-share basis.



Adjusted net income and adjusted return on assets excludes the effects

of certain gains and losses, adjusted for applicable taxes.



Adjusted

net income and adjusted return on assets provides a method to



assess

earnings performance by excluding items that management believes are not comparable among the periods presented. Efficiency ratio expresses operating expenses as a percentage of fully-taxable equivalent net interest income plus non-interest



income.

Operating expenses exclude items from non-interest expense that management believes are not comparable among the periods



presented.

Non-interest income is adjusted to also exclude items that



management

believes are not comparable among the periods presented.



Efficiency

ratio is used as a method for management to assess its operating expense level and to compare to financial institutions of varying sizes.



Management believes the use of non-GAAP measures will help readers compare National Penn's current results to those of prior periods as presented in the accompanying discussion.

CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES The accounting and reporting policies of the Company conform to GAAP and predominant practice within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. The following accounting policies comprise those that management believes are the most critical to aid in fully understanding and evaluating our reported financial results:



allowance for loan losses;

goodwill and other intangible assets;

income taxes; and

other-than-temporary impairment.

There have been no material changes in the Company's critical accounting policies, judgments and estimates, including assumptions or estimation techniques utilized, as compared to the Company's most recent Annual Report on Form 10-K.

31 --------------------------------------------------------------------------------

Table of Contents FINANCIAL HIGHLIGHTS Business and Industry National Penn Bancshares, Inc. is a Pennsylvania business corporation and a registered bank holding company headquartered in Allentown, Pennsylvania. National Penn operates as an independent community banking company that offers a diversified range of financial products principally through its bank subsidiary, National Penn Bank, as well as an array of investment, insurance and employee benefit services through its non-bank subsidiaries. National Penn's financial services affiliates consist of National Penn Wealth Management, N.A., including its National Penn Investors Trust Company division; National Penn Capital Advisors, Inc.; Institutional Advisors, LLC; and National Penn Insurance Services Group, Inc., including its Higgins Insurance and Caruso Benefits divisions. The Company's primary business is accepting deposits from customers through its retail branch offices, and investing those deposits, together with funds generated from operations and borrowings, in loans, including commercial business loans, commercial real estate loans, residential mortgages, home equity loans, other consumer loans, and investment securities. The Company's strategic plan is designed to enhance shareholder value by operating a highly profitable financial services company within the markets it serves. Specifically, management is focused on increasing market penetration in selected geographic areas and achieving excellence in both retail and commercial lines of business. The Company also intends to grow revenue through appropriate and targeted acquisitions, through expanding into new geographical markets, or through further penetrating existing markets or business lines. At March 31, 2014, National Penn Bank operated 119 retail branch offices, of which 118 are located in Pennsylvania and one is located in Maryland. As part of a restructuring plan announced during the fourth quarter of 2013, the Company plans to close 8 branches during the second quarter of 2014. The Company's results of operations are affected by five major elements: (1) net interest income, or the difference between interest income earned on loans and investments and interest expense paid on deposits and borrowed funds; (2) the provision for loan losses, or the amount added to the allowance for loan losses to provide reserves for inherent losses on loans and leases; (3) non-interest income, which is made up primarily of banking fees, wealth management income, insurance income, change in fair value measurements, gains and losses from the sale of securities, and other transactions; (4) non-interest expense, which consists primarily of salaries, employee benefits and other operating expenses; and (5) income taxes. Results of operations are also significantly affected by general economic and competitive conditions, as well as changes in market interest rates, government policies and actions of regulatory authorities. 32 --------------------------------------------------------------------------------

Table of Contents Overview Three Months Ended (dollars in thousands, except per share data) March 31,



December 31, March 31,

2014 2013 2013 EARNINGS Total interest income $ 70,133 $ 72,085 $ 72,595 Total interest expense 7,844 8,013 10,971 Net interest income 62,289 64,072 61,624 Provision for loan losses 1,251 1,000 1,500 Net interest income after provision for loan losses 61,038 63,072 60,124 Net gains from fair value changes of subordinated debentures - - 2,111 Net gains on investment securities 8 - 25 Other non-interest income 21,470 22,714 23,441 Loss on debt extinguishment - - 64,888 Corporate reorganization expense - 6,000 - Other non-interest expense 52,337 51,833 52,434 Income (loss) before income taxes 30,179 27,953 (31,621 ) Income tax expense (benefit) 7,469 6,741 (14,217 ) Net income (loss) $ 22,710 $ 21,212 $ (17,404 ) Basic earnings per share $ 0.16 $ 0.15 $ (0.12 ) Diluted earnings per share 0.16 0.15 (0.12 ) Dividends per share 0.10 0.10 - (a) Net interest margin 3.44 % 3.51 % 3.49 % Efficiency ratio (n) 59.60 % 57.00 % 58.61 % Return on average assets 1.09 % 1.00 % NM Adjusted return on average assets (n) 1.09 % 1.19 % 1.14 % Asset Quality Metrics Allowance / total loans 1.73 % 1.81 % 2.04 % Non-performing loans / total loans 0.89 % 0.99 % 1.02 % Delinquent loans / total loans 0.31 % 0.55 % 0.46 % Allowance / non-performing loans 194 % 183 % 199 % Annualized net charge-offs / average loans 0.33 % 0.41 % 0.41 % (a) In lieu of a 1st quarter 2013 cash dividend, the Company paid an additional dividend of $0.10 per share in the 4th quarter of 2012. (n) Refer to the Statement Regarding Non-GAAP Financial Measures at the beginning of Part I, Item 2.



For the three months ended March 31, 2014, the Company recorded net income

of $22.7 million, or $0.16 per diluted share, compared to a net loss of $17.4 million, or $(0.12) per diluted share, in the comparable prior year



period. The net loss in the comparable prior year period was the result of

a first quarter $64.9 million ($42.2 million after-tax) charge from the

extinguishment of $400 million of previously restructured FHLB advances.

Additionally, during the first quarter of 2013, the Company redeemed $65.2

million of 7.85%, fixed-rate subordinated debentures. This transaction

produced a $2.1 million ($1.4 million after-tax) gain since these

instruments were previously accounted for at fair value and the Company

had a call at par. These strategic initiatives were undertaken for

asset/liability, interest rate risk, and capital management purposes.

Net interest income totaled $62.3 million for the three months ended

March 31, 2014 compared to $61.6 million for the three months ended

March 31, 2013. Average earning assets increased $153 million to $7.8

billion. The Company's net interest margin declined five basis points to

3.44% for the three months ended March 31, 2014, compared to 3.49% for the

three months ended March 31, 2013 as the prolonged low interest rate environment continued to impact loan and investment yields. The Company continued to experience improvements in asset quality.



Classified loans declined by 28.1% since March 31, 2013 and non-performing

loans declined to 0.89% of total loans at March 31, 2014, compared to 1.02% at March 31, 2013. 33

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Contents

Other non-interest income totaled $21.5 million for the three months ended

March 31, 2014, a decrease of $2.0 million, when compared to the prior

year period. The decrease is attributable to a $0.5 million loss on an

unconsolidated equity investment incurred during the current year period

and a decrease in mortgage banking income of $1.1 million when compared to

the three months ended March 31, 2013. Other non-interest expense for the three months ended March 31, 2014 remained stable at $52.3 million compared to $52.4 million for the three months ended March 31, 2013. Adjusted net income and adjusted return on average assets(n) are non-GAAP measures and exclude certain items which management believes affect the comparability of results between periods. The following table reconciles the non-GAAP measure of adjusted net income to the GAAP measure of net income available to common shareholders and diluted earnings per share and calculates the adjusted return on average assets(n). Three Months



Ended

(dollars in thousands, except per share March 31, December 31,

March 31, data) 2014 2013



2013

Adjusted net income reconciliation Net income (loss) $ 22,710$ 21,212$ (17,404 ) After tax unrealized fair value gain on subordinated debentures - - (1,372 ) After tax loss on debt extinguishment - - 42,177 After tax corporate reorganization expense - 3,900 - Adjusted net income $ 22,710$ 25,112$ 23,401 Earnings per share Net income (loss) $ 0.16$ 0.15$ (0.12 ) After tax unrealized fair value gain on subordinated debentures - - (0.01 ) After tax loss on debt extinguishment - - 0.29 After tax corporate reorganization expense - 0.03 - Adjusted net income $ 0.16$ 0.17 (o) $ 0.16 Average assets $ 8,479,686$ 8,385,094$ 8,298,815 Adjusted return on average assets 1.09 % 1.19 % 1.14 % (n) Refer to the Statement Regarding Non-GAAP Financial Measures at the beginning of Part I, Item 2. (o) Difference in summation of quarterly adjusted net income due to rounding. Adjusted net income in the fourth quarter of 2013 excluded the effects of the corporate reorganization expense of $6.0 million ($3.9 million after-tax). Adjusted net income in the first quarter of 2013 excluded the loss on debt extinguishment of $64.9 million ($42.2 million after-tax) and the gain on the Company's subordinated debentures accounted for at fair value of $2.1 million ($1.4 million after-tax). First quarter 2014 adjusted net income remained relatively stable when compared to the three months ended March 31, 2013, as asset quality continues to improve and expense levels remain well controlled. The $0.7 million decrease in adjusted net income for the three months ended March 31, 2014, when compared to the prior year period, is related to a $0.5 million loss on an unconsolidated equity investment. 34 -------------------------------------------------------------------------------- Table of



Contents


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