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

August 11, 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 and six months ended June 30, 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.

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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 June 30, 2014, National Penn Bank operated 111 retail branch offices, of which 110 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 closed 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.



Merger with TF Financial Corporation

On June 3, 2014, the Company entered into an Agreement and Plan of Merger with TF Financial Corporation ("TF Financial"), the parent company of 3rd Fed Bank, pursuant to which TF Financial will merge with and into the Company. As part of the transaction, 3rd Fed Bank will also merge with and into National Penn Bank. TF Financial operates 18 full service retail and commercial banking offices in Bucks and Philadelphia Counties in Pennsylvania, and Burlington, Mercer, and Ocean Counties in New Jersey. Subject to the terms and conditions of the Agreement and Plan of Merger, upon consummation of the merger, each outstanding share of common stock of TF Financial will be automatically converted into and exchangeable for the right to receive either: (i) $42.00 in cash, or (ii) 4.22 shares of the Company's common stock, with cash being paid in lieu of fractional shares. The Agreement and Plan of Merger provides that 60% of the outstanding shares of TF Financial common stock will be converted into stock consideration and 40% of the outstanding shares of TF Financial common stock will be converted into cash consideration. Each shareholder of TF Financial will be entitled to elect the number of shares of TF Financial common stock held by such shareholder that will be exchanged for the stock consideration or the cash consideration subject to proration in the event that a selected form of consideration is over-elected. The transaction is subject to customary closing conditions, including the receipt of regulatory approvals and approval of the merger by shareholders of TF Financial. 33 --------------------------------------------------------------------------------

Table of Contents Overview Three Months Ended Six Months Ended (dollars in thousands, except per June 30, March 31, June 30, June 30, June 30, share data) 2014 2014 2013 2014 2013 EARNINGS Total interest income $ 70,528$ 70,133$ 72,101$ 140,661$ 144,696 Total interest expense 7,577 7,844 8,847 15,421 19,818 Net interest income 62,951 62,289 63,254 125,240 124,878 Provision for loan losses - 1,251 1,500 1,251 3,000 Net interest income after provision for loan losses 62,951 61,038 61,754 123,989 121,878 Net gains from fair value changes of subordinated debentures - - - - 2,111 Net gains on investment securities - 8 22 8 47 Other non-interest income 24,396 21,470 24,946 45,866 48,387 Loss on debt extinguishment - - - - 64,888 Other non-interest expense 52,114 52,337 53,153 104,451 105,587 Income before income taxes 35,233 30,179 33,569 65,412 1,948 Income tax expense (benefit) 9,034 7,469 8,550 16,503 (5,667 ) Net income $ 26,199$ 22,710 $



25,019 $ 48,909$ 7,615

Basic earnings per share $ 0.19$ 0.16$ 0.17$ 0.35$ 0.05 Diluted earnings per share 0.19 0.16 0.17 0.35 0.05 Dividends per share 0.10 0.10 0.10 0.20 0.10 (a) Net interest margin 3.43 % 3.44 % 3.53 % 3.43 % 3.51 % Efficiency ratio (i) 57.02 % 59.60 % 57.43 % 58.28 % 58.01 % Return on average assets 1.23 % 1.09 % 1.21 % 1.16 % 0.18 % Adjusted return on average assets (i) 1.23 % 1.09 % 1.21 % 1.16 % 1.17 % Asset Quality Metrics Allowance / total loans 1.66 % 1.73 % 1.99 % Non-performing loans / total loans 0.80 % 0.89 % 1.05 % Delinquent loans / total loans 0.32 % 0.31 % 0.43 % Allowance / non-performing loans 207 % 194 % 189 % Annualized net charge-offs / average loans 0.25 % 0.33 %



0.32 % 0.29 % 0.36 %

(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. (i) Refer to the Statement Regarding Non-GAAP Financial Measures at the beginning of Part I, Item 2.



For the three months ended June 30, 2014, the Company recorded net income

of $26.2 million, or $0.19 per diluted share, compared to $25.0 million,

or $0.17 per diluted share, in the comparable prior year period. Due to

the continued improvement in credit quality, the Company did not record a

provision for loan losses in the current period, compared to $1.5 million

for the three months ended June 30, 2013. Additionally, during the second

quarter of 2014, the Company recognized a $0.9 million gain on the sale of

non-performing loans. Other non-interest expense of $52.1 million, for the

second quarter of 2014, decreased $1.0 million from the same period last

year as a result of a continued focus on expense control. The efficiency

ratio of 57.02%, for the second quarter of 2014, compared to 57.43% for the prior year period.



For the six months ended June 30, 2014, the Company recorded net income of

$48.9 million, or $0.35 per diluted share, compared to a net income of $7.6 million, or $0.05 per diluted share, in the comparable prior year



period. The prior year period's results were impacted by the $64.9 million

($42.2 million after-tax) charge from the extinguishment of $400 million

of previously restructured FHLB advances, that occurred during the first

quarter of 2013. 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. 34

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Contents

Net interest income totaled $125 million for the six months ended June 30,

2014 and June 30, 2013. The Company's net interest margin declined eight

basis points to 3.43% for the six months ended June 30, 2014, compared to

3.51% for the six months ended June 30, 2013, as the prolonged low

interest rate environment continued to impact loan and investment yields

and as average earning assets increased $160 million to $7.8 billion for the six months ended June 30, 2014.



Provision for loan losses was $1.3 million for the six months ended

June 30, 2014, compared to $3.0 million for the comparable prior year

period, as the Company continued to experience improvements in asset

quality. Classified loans declined by 25.8% since June 30, 2013 and

non-performing loans declined to 0.80% of total loans at June 30, 2014,

compared to 1.05% at June 30, 2013.

Other non-interest income totaled $45.9 million for the six months ended

June 30, 2014, a decrease of $2.5 million, when compared to the prior year

period. The decrease is primarily attributable to a decrease in mortgage

banking income of $2.3 million when compared to the six months ended

June 30, 2013 and a $0.5 million loss incurred during the first quarter of

2014 on an unconsolidated equity investment. Other non-interest expense for the six months ended June 30, 2014 continued to be well controlled at $104 million, a decrease of $1.1 million when compared to the six months ended June 30, 2013. Adjusted net income and adjusted return on average assets(i) 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(i). Three Months Ended Six Months Ended



(dollars in thousands, except per June 30, March 31, June 30, June 30, June 30, share data)

2014 2014 2013 2014 2013 Adjusted net income reconciliation Net income $ 26,199$ 22,710$ 25,019$ 48,909$ 7,615 After tax unrealized fair value gain on subordinated debentures - - - - (1,372 ) After tax loss on debt extinguishment - - - - 42,177 Adjusted net income $ 26,199$ 22,710$ 25,019$ 48,909$ 48,420 Earnings per share Net income $ 0.19$ 0.16$ 0.17$ 0.35$ 0.05 After tax unrealized fair value gain on subordinated debentures - - - - (0.01 ) After tax loss on debt extinguishment - - - - 0.29 Adjusted net income $ 0.19$ 0.16$ 0.17$ 0.35$ 0.33 Average assets $ 8,512,845$ 8,479,686$ 8,326,499$ 8,496,357$ 8,312,734 Adjusted return on average assets 1.23 % 1.09 %



1.21 % 1.16 % 1.17 %

(i) Refer to the Statement Regarding Non-GAAP Financial Measures at the beginning of Part I, Item 2.

For the six months ended June 30, 2013, adjusted net income 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). Adjusted net income of $48.9 million, or $0.35 per diluted share, for the six months ended June 30, 2014 remained relatively stable when compared to the adjusted net income of $48.4 million, or $0.33 per diluted share for the six months ended June 30, 2013, as asset quality continues to improve and expense levels remain well controlled. 35 -------------------------------------------------------------------------------- Table of



Contents


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