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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended: September 30, 2004
------------------------------------------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OF 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from: to
------------------------ ----------------------
Commission file number: 0-22537-01
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NATIONAL PENN BANCSHARES, INC.
------------------------------
(Exact name of registrant as specified in its charter)
Pennsylvania 23-2215075
------------ ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
Philadelphia and Reading Avenues, Boyertown, PA 19512
-----------------------------------------------------
(Address of principal executive offices) (Zip Code)
(610) 367-6001
----------------------------------------------------
(Registrant's telephone number, including area code)
N/A
----------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 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 X No .
--- ---
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.
Class Outstanding at October 27, 2004
----- -------------------------------
Common Stock (no stated par value) (No.) Shares 34,518,134
TABLE OF CONTENTS
Part I - Financial Information. Page
- ------------------------------- ----
Item 1. Financial Statements........................................................3
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operation...................................................15
Item 3. Quantitative and Qualitative Disclosures about Market Risk.................33
Item 4. Controls and Procedures....................................................33
Part II - Other Information.
- ----------------------------
Item 1. Legal Proceedings .........................................................35
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds ..............35
Item 3. Defaults Upon Senior Securities............................................36
Item 4. Submission of Matters to a Vote of Security Holders.......................36
Item 5. Other Information .........................................................36
Item 6. Exhibits
Signatures...........................................................................................38
Exhibits ............................................................................................39
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
NATIONAL PENN BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEET Sept. 30
(Dollars in thousands, except per share data) 2004 Dec. 31
(Unaudited) 2003
------------ ------------
ASSETS
Cash and due from banks $ 95,092 $ 96,164
Interest bearing deposits in banks 12,318 2,233
Federal funds sold 19,200 --
----------- -----------
Total cash and cash equivalents $ 126,610 $ 98,397
Investment securities held to maturity 50,273 --
Investment securities available for sale, at fair value 1,028,487 934,375
Loans and leases held for sale 5,101 29,344
Loans and leases, less allowance for loan and lease losses
of $57,391 and $49,265 in 2004 and 2003 respectively 2,751,439 2,192,090
Premises and equipment, net 53,352 43,653
Accrued interest receivable 16,974 14,309
Bank owned life insurance 78,770 69,937
Goodwill and other intangibles 201,965 111,210
Unconsolidated investments under the equity method 6,907 2,968
Other assets 19,378 16,291
----------- -----------
Total Assets $ 4,339,256 $ 3,512,574
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Non-interest bearing deposits $ 522,683 $ 386,620
Interest bearing deposits 2,626,975 2,048,676
----------- -----------
Total Deposits 3,149,658 2,435,296
Securities sold under repurchase agreements
and federal funds purchased 370,819 500,038
Short-term borrowings 10,000 10,000
Long-term borrowings 230,467 164,037
Subordinated debt 127,063 --
Guaranteed preferred beneficial interests in
Company's subordinated debentures -- 63,250
Accrued interest payable and other liabilities 28,208 22,140
----------- -----------
Total Liabilities 3,916,215 3,194,761
Shareholders' equity
Preferred stock, no stated par value;
authorized 1,000,000 shares, none issued -- --
Common stock, no stated par value;
authorized 62,500,000 shares; issued and outstanding
2004 - 34,522,076; 2003 - 30,356,883; net of shares
in Treasury: 2004 - 17,366; 2003 - 2,626 359,917 272,534
Retained earnings 44,765 25,770
Accumulated other comprehensive income 18,885 19,595
Treasury stock at cost (526) (86)
----------- -----------
Total Shareholders' Equity 423,041 317,813
----------- -----------
Total Liabilities and Shareholders' Equity $ 4,339,256 $ 3,512,574
=========== ===========
The accompanying notes are an integral part of these condensed financial statements.
3
NATIONAL PENN BANCSHARES, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED CONDENSED STATEMENTS OF INCOME
Three Months Ended Nine Months Ended
(Dollars in thousands, except per share data) September 30 September 30
---------------------------------------------------
2004 2003 2004 2003
--------- --------- --------- ---------
INTEREST INCOME
Loans and leases, including fees $ 41,967 $ 32,471 $ 111,976 $ 96,619
Investment securities
Taxable 7,830 5,243 21,756 16,094
Tax-exempt 3,305 3,247 9,731 9,802
Federal funds sold 13 173 37 459
Deposits in banks 18 15 32 46
--------- --------- --------- ---------
Total interest income 53,133 41,149 143,532 123,020
--------- --------- --------- ---------
INTEREST EXPENSE
Deposits 9,883 8,186 26,251 25,571
Securities sold under repurchase agreements and
federal funds purchased 1,682 931 4,821 2,818
Short-term borrowings 10 13 29 30
Long-term borrowings 4,393 3,458 11,437 10,316
--------- --------- --------- ---------
Total interest expense 15,968 12,588 42,538 38,735
--------- --------- --------- ---------
Net interest income 37,165 28,561 100,994 84,285
Provision for loan and lease losses 1,225 2,286 4,188 6,896
--------- --------- --------- ---------
Net interest income after provision
for loan and lease losses 35,940 26,275 96,806 77,389
--------- --------- --------- ---------
OTHER INCOME
Trust income 1,570 1,314 4,345 3,967
Service charges on deposit accounts 4,084 3,141 11,087 8,850
Bank owned life insurance income 1,188 716 2,950 2,448
Other service charges and fees 2,600 2,361 8,159 6,507
Net gains (loses) on sale of investment securities 100 (369) (96) (369)
Mortgage banking income 1,057 1,246 3,020 4,239
Insurance commissions and fees 917 703 2,686 1,892
Service charges cash management 665 587 1,976 1,628
Equity in undistributed net earnings of affiliates (3) 82 126 197
--------- --------- --------- ---------
Total other income 12,178 9,781 34,253 29,359
--------- --------- --------- ---------
OTHER EXPENSES
Salaries, wages and employee benefits 17,633 14,055 47,888 40,211
Net premises and equipment 4,323 3,281 11,957 10,227
Advertising and marketing expenses 813 924 3,099 2,601
FHLB prepayment fee -- 7,002 -- 7,002
Other operating expenses 7,267 5,424 18,857 15,783
--------- --------- --------- ---------
Total other expenses 30,036 30,686 81,801 75,824
--------- --------- --------- ---------
Income before income taxes 18,082 5,370 49,258 30,924
Income tax expense 4,349 951 11,977 6,690
--------- --------- --------- ---------
Net income from continuing operations 13,733 4,419 37,281 24,234
Net income from discontinued operations, net of taxes -- 6,585 -- 7,923
--------- --------- --------- ---------
Net income $ 13,733 $ 11,004 $ 37,281 $ 32,157
========= ========= ========= =========
PER SHARE OF COMMON STOCK
Net income per share - basic $ 0.40 $ 0.37 $ 1.17 $ 1.08
Net income per share - diluted $ 0.39 $ 0.36 $ 1.14 $ 1.05
Dividends paid in cash $ 0.19 $ 0.18 $ 0.57 $ 0.52
The accompanying notes are an integral part of these condensed financial statements.
4
NATIONAL PENN BANCSHARES, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 2004
(Dollars in thousands)
Accumulated
Common Stock other
-------------------------- Retained conprehensive Treasury Comprehensive
Shares Value earnings income stock Total income
------------------------------------------------------------------------------------------------
Balance at December 31, 2003 24,284,506 $ 272,534 $ 25,770 $ 19,595 $ (86) 317,813
Net income -- -- 37,281 -- -- 37,281 $ 37,281
Cash dividends declared -- -- (18,286) -- -- (18,286)
5-for-4 stock split 6,904,415
Shares issued under stock-based
plans 510,344 (1,078) -- -- 9,659 8,581
Shares issued for acquisition
of Peoples Bank of Oxford
and Pennsurance 3,130,094 88,461 88,461
Other comprehensive loss, net
of reclassification adjustment
and taxes -- -- -- (710) -- (710) (710)
------------------------------------------------------------------------------------------------
Total comprehensive income -- -- -- -- -- -- $ 36,571
------------------------------------------------------------------------------------------------
Treasury shares purchased (307,283) -- -- -- (10,099) (10,099)
------------------------------------------------------------------------------------------------
Balance at September 30, 2004 34,522,076 $ 359,917 $ 44,765 $ 18,885 $ (526) $ 423,041
September 30, 2004
----------------------------------------
Before Tax Net of
Components of Other Comprehensive Income tax (expense) tax
amount benefit amount
----------------------------------------
Unrealized gains on securities
Unrealized holding losses arising during period (1,764) 416 (1,348)
Less: Reclassification adjustment for losses
realized in net income (96) 34 (62)
Change in the fair value of cash flow hedges (576) - (576)
----------------------------------------
Other comprehensive loss, net (1,092) 382 (710)
========================================
NINE MONTHS ENDED SEPTEMBER 30, 2003
(Dollars in thousands)
Accumulated
Common Stock other
-------------------------- Retained comprehensive Treasury Comprehensive
Shares Value earnings income stock Total income
------------------------------------------------------------------------------------------------
Balance at December 31, 2002 20,699,782 $ 172,471 $ 30,593 $ 19,296 $ - 222,360
Net income - - 32,157 - - 32,157 $ 32,157
Cash dividends declared - - (10,661) - - (10,661)
5% stock dividend 1,152,796 31,702 (31,702) - - -
Shares issued under stock-based
plans 194,849 (7,044) - - 16,386 9,342
Shares issued for acquisition
of FirstService Bank 2,563,552 61,262 - - 1,924 63,186
Other comprehensive income, net
of reclassification adjustment
and taxes - - - (2,110) - (2,110) (2,110)
------------------------------------------------------------------------------------------------
Total comprehensive income - - - - - - $ 30,047
------------------------------------------------------------------------------------------------
Treasury shares purchased (388,602) - - - (19,399) (19,399)
------------------------------------------------------------------------------------------------
Balance at September 30, 2003 24,222,377 $ 258,391 $ 20,387 $ 17,186 $ (1,089) 294,875
September 30, 2003
----------------------------------------
Before Tax Net of
Components of Other Comprehensive Income tax (expense) tax
amount benefit amount
----------------------------------------
Unrealized gains on securities
Unrealized holding gains arising during period (3,752) 1,265 (2,487)
Less: Reclassification adjustment for losses
realized in net income (369) 129 (240)
Change in the fair value of cash flow hedges (137) - (137)
----------------------------------------
Other comprehensive income, net (3,246) 1,136 (2,110)
========================================
The accompanying notes are an integral part of these statements.
5
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands) Nine Months Ended September 30,
2004 2003
- -----------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
- -----------------------------------------------------------------------------------------------------
Net income 37,281 32,157
Adjustments to reconcile net income to net
cash provided by operating activities:
Provision for loan and lease losses 4,188 6,896
Depreciation and amortization 3,705 4,786
Amortization of premiums and discounts on investment
securities, net 752 (3,053)
Investment securities (gains) losses, net 96 (533)
Mortgage loans originated for resale (100,500) 369
Sale of mortgage loans originated for resale 102,540 (184,819)
Gain on sale of mortgage loans originated for resale (2,040) 188,505
Changes in assets and liabilities
(Increase) decrease in accrued interest receivable (1,118) 1,920
(Decrease) increase in accrued interest payable (1,339) (3,927)
(Increase) decrease in other assets 1,368 (5,039)
Increase (decrease) in other liabilities 5,374 10,196
- -----------------------------------------------------------------------------------------------------
Net cash provided by operating activities 50,307 47,458
- -----------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
- -----------------------------------------------------------------------------------------------------
Cash paid in excess of cash equivalents for business acquired (32,408) (221)
Cash received in excess of cash equivalents for business sold -- 12,732
Purchase of investment securities held to maturity (50,273) --
Proceeds from sales of investment securities available for sale 42,300 34,663
Proceeds from maturities of investment securities available for sale 160,475 205,675
Purchase of investment securities available for sale (248,461) (343,221)
Net increase in loans (181,901) (133,348)
Purchases of premises and equipment (4,735) (5,747)
Purchase of bank-owned life insurance -- (760)
- -----------------------------------------------------------------------------------------------------
Net cash used in investing activities (315,003) (230,227)
- -----------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
- -----------------------------------------------------------------------------------------------------
Net increase in interest and non-interest
bearing demand deposits and savings accounts 248,151 288,083
Net increase in certificates of deposit 83,531 (116,766)
Net increase (decrease) in securities sold under
agreements to repurchase and federal funds purchased (115,808) 28,097
Net (decrease) in short-term borrowings -- (569)
Proceeds from new long-term borrowings 50,000 70,000
Repayments of long-term borrowings (15,018) (81,370)
Issuance of subordinated debentures 61,857 --
Issuance of common stock under dividend
reinvestment and stock option plans 8,581 13
Purchase of Treasury stock (10,099) (10,070)
Cash dividends (18,286) (15,421)
- -----------------------------------------------------------------------------------------------------
Net cash provided by financing activities 292,909 161,997
- -----------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 28,213 (20,772)
Cash and cash equivalents at beginning of year 98,397 134,447
- -----------------------------------------------------------------------------------------------------
Cash and cash equivalents at September 30 126,610 113,675
The accompanying notes are an integral part of these statements.
6
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated condensed financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States of America for interim financial information. The financial
information included herein is unaudited; however, such information reflects all
adjustments (consisting solely of normal recurring adjustments) which are, in
the opinion of management, necessary to a fair statement of the results for the
interim periods. For further information, refer to the consolidated financial
statements and footnotes thereto included in the Company's Annual Report on Form
10-K for the year ended December 31, 2003.
The results of FirstService Bank, which was acquired on February 25,
2003, are included in the income statement for the nine months ended September
30, 2003 from February 25, 2003 through September 30, 2003. The results of
FirstService Bank, and HomeTowne Heritage Bank, which was acquired on December
12, 2003, are included in the income statement for the entire first nine months
of 2004. The results of Peoples First, Inc., which was acquired on June 10,
2004, are included in the income statement from June 10, 2004 through September
30, 2004.
All National Penn share and per share information in this Report has
been retroactively restated to reflect National Penn's five-for-four stock split
effective as of September 30, 2004. See Footnote #4.
The results of operations for the nine-month period ended September 30,
2004 are not necessarily indicative of the results to be expected for the full
year.
2. ACQUISITIONS AND DISPOSITIONS
Acquisition of Pennsurance, Inc.
--------------------------------
On July 1, 2004, National Penn Bancshares, Inc. completed the
acquisition of Pennsurance, Inc., an insurance agency located in Oley,
Pennsylvania. Pennsurance was merged into National Penn Bank's insurance agency
subsidiary, FirstService Insurance Agency, Inc., where it will retain its name
and operate as a division. The value paid for this acquisition is not material
to the Company's balance sheet or results of operations.
Acquisition of Peoples First, Inc.
----------------------------------
On June 10, 2004, National Penn Bancshares, Inc. completed the
acquisition of Peoples First, Inc. ("Peoples"), parent company of The Peoples
Bank of Oxford. The Peoples Bank of Oxford, headquartered in Oxford,
Pennsylvania, operated eight community offices in Chester and Lancaster
Counties, Pennsylvania, and one community office in Cecil County, Maryland, at
the time of acquisition.
Under the terms of the merger agreement, 2,956,288 shares of Peoples
stock were each converted into 1.88125 shares of National Penn common stock,
$49.54 in cash, or a combination of both, resulting in the issuance of 3,893,062
shares of National Penn common stock and payment of approximately $43,936,352
million in cash. The total purchase price (cash and stock) was valued at $130.8
million. In addition, outstanding stock options to purchase shares of Peoples
common stock were converted into options to purchase 134,088 shares of National
Penn common stock, with an exercise price of $11.20 per share. This transaction
was accounted for under the purchase method of accounting. Accordingly, the
results of operations of the Company include Peoples' results from and after
June 10, 2004. The acquisition resulted in the recording of approximately $83.1
million of goodwill and $8.5 million of other intangible assets. The Company
acquired assets, loans and deposits of $455.9 million, $361.6 million, and
$381.2 million, respectively. All National Penn share and per share information
in this paragraph has
7
been retroactively restated to reflect National Penn's five-for-four stock split
effective as of September 30, 2004. See Footnote #4.
Disposition of Panasia Bank, N.A.
---------------------------------
On September 11, 2003, the Company completed the cash sale of Panasia
Bank N.A., a wholly owned subsidiary, for $34.5 million, which resulted in a
gain of $6.68 million after taxes of $1.8 million. In accordance with SFAS No.
144, Accounting for the Impairment or Disposal of Long-Lived Assets, the income
of Panasia is presented as discontinued operations for all periods presented. At
the time of the sale, Panasia had total assets of $213.5 million, net loans of
$99.7 million, investments of $84.4 million, deposits of $188.2 million, and
total equity of $24.4 million. The Company has classified the results of
operations of Panasia from January 1, 2003 through September 11, 2003 as
discontinued operations in the consolidated statement of income. Net income from
discontinued operations, net of taxes of $3,404,000, for the nine months ended
September 30, 2003 was $7.9 million.
The following represents the per share amounts for continuing and
discontinued operations for the three months and nine months ended September 30,
2003:
Three Months Ended Nine Months Ended
September 30, 2003 September 30, 2003
------------------ ------------------
Net income per share - basic
Continuing operations $0.15 $0.81
Discontinued operations 0.22 0.27
Net income per share - basic $0.37 $1.08
Net income per share - diluted
Continuing operations $0.14 $0.79
Discontinued operations 0.22 0.26
Net income per share - diluted $0.36 $1.05
3. LOANS
The Company identifies a loan as impaired when it is probable that
interest and principal will not be collected according to the contractual terms
of the loan agreement. The balance of impaired loans was $13.1 million at
September 30, 2004, all of which are non-accrual loans. The allowance for loan
and lease loss associated with these impaired loans was $86,000 at September 30,
2004. The Company recognizes income on an impaired loan under the cash basis
when the loan is current and the collateral on the loan is sufficient to cover
the outstanding obligation to the Company. If these factors do not exist, the
Company will not recognize income on an impaired loan.
4. SHAREHOLDERS' EQUITY
On October 27, 2004, the Company's Board of Directors declared a cash
dividend of $.20 per share, payable on November 17, 2004, to shareholders of
record on November 6, 2004.
On August 25, 2004, the Company's Board of Directors declared a
five-for-four stock split of the Company's common stock, distributable to
shareholders of record on September 10, 2004, and which was distributed on
September 30, 2004. All weighted average share and per share information has
been retroactively restated.
8
On September 24, 2003, the Company's Board of Directors authorized the
repurchase of up to one million shares of the Company's common stock to be used
to fund the Company's dividend reinvestment plan, stock option plans,
stock-based benefit plans and employee stock purchase plan. No timetable has
been set for these repurchases. As of September 30, 2004, 580,869 shares were
repurchased at an average price of $25.816 per share.
On August 27, 2003, the Company's Board of Directors declared a 5%
stock dividend paid on September 30, 2003 to shareholders of record on September
12, 2003. All weighted average share and per share information has been
retroactively restated.
9
5. EARNINGS PER SHARE
Three Months Ended September 30, 2004 Income Shares Per Share
- ------------------------------------- (numerator) (denominator) Amount
----------- ------------- ----------
Basic earnings per share
Net income available to common stockholders $13,733 34,446 $0.40
Effect of dilutive securities
Options ---- 632 (0.01)
Diluted earnings per share
Net income available to common stockholders ------- ------- ---
Plus assumed conversions $13,733 $35,078 .39
======= ======= ===
Options to purchase 420,176 shares of common stock at $25.88 to $26.51
per share, that were outstanding for the three months ended September 30, 2004,
were not included in the computation of diluted earnings per share because the
option exercise price was greater than the average market price.
Year to Date September 30, 2004 Income Shares Per Share
- ------------------------------- (numerator) (denominator) Amount
----------- ------------- ------
Basic earnings per share
Net income available to common stockholders $37,281 31,997 $ 1.17
Effect of dilutive securities
Options ---- 701 (0.03)
Diluted earnings per share
Net income available to common stockholders ------- ------ --------
Plus assumed conversions $37,281 32,698 $ 1.14
======= ====== ========
Options to purchase 420,118 shares of common stock at $25.88 to $26.51 per
share, that were outstanding for the nine months ended September 30, 2004, were
not included in the computation of diluted earnings per share because the option
exercise price was greater than the average market price.
Three Months Ended September 30, 2003 Income Shares Per Share
- ------------------------------------- (numerator) (denominator) Amount
----------- ------------- ------
Basic earnings per share
Net income available to common stockholders $11,004 29,766 $ 0.37
Effect of dilutive securities
Options ----- 693 (0.01)
Diluted earnings per share
Net income available to common stockholders ------- ------ -------
Plus assumed conversions $11,004 30,459 $ 0.36
======= ====== =======
Year to Date September 30, 2003 Income Shares Per Share
- ------------------------------- (numerator) (denominator) Amount
----------- ------------- ------
Basic earnings per share
Net income available to common stockholders $32,157 29,766 $1.08
Effect of dilutive securities
Options ---- 721 (0.03)
Diluted earnings per share
Net income available to common stockholders ------- ------ ------
Plus assumed conversions $32,157 30,487 $1.05
======= ====== =====
10
There were no stock options outstanding for the three and nine months
ended September 30, 2004 that were not included in the computation of diluted
earnings per share because the option exercise price was greater than the
average market price.
6. SEGMENT REPORTING
SFAS No. 131, Segment Reporting, identifies operating segments as
components of an enterprise which are evaluated regularly by the chief operating
decision maker in deciding how to allocate resources and assess performance. The
Company's chief operating decision maker is the Chairman and Chief Executive
Officer. The Company has applied the aggregation criteria set forth in SFAS No.
131 for its National Penn Bank operating segment through September 30, 2004, to
create a reportable operating segment, "Community Banking." Prior to its
disposition on September 11, 2003, Panasia Bank, N.A. was consolidated as part
of the Community Banking operating segment.
The Community Banking operating segment consists of commercial and
retail banking. The Community Banking segment is managed as a single strategic
unit, which generates revenue from a variety of products and services. For
example, commercial lending is dependent upon the ability to fund it with retail
deposits and other borrowings and to manage interest rate and credit risk. This
situation is also similar for consumer and residential mortgage lending.
Nonreportable operating segments of the Company's operations which do
not have similar characteristics to the Community Banking operations and do not
meet the quantitative thresholds requiring disclosure are included in the
"Other" category. These nonreportable segments include Investors Trust Company,
Penn Securities Inc., National Penn Leasing Company, FirstService Insurance
Agency, Inc., FirstService Capital Inc., National Penn Life Insurance Company,
and the Company. The balances of NPB Capital Trust II were consolidated with
National Penn Bancshares, Inc. and are included in the "Other" category as of
and for the nine months ended September 30, 2003.
The accounting policies used in this disclosure of operating segments
are the same as those described in the summary of significant accounting
policies. The consolidating adjustments reflect certain eliminations of
intersegment revenues, cash and investment in subsidiaries.
11
Reportable segment-specific information and reconciliation to
consolidated financial information is as follows:
Community Banking Other Consolidated
----------------- ----- ------------
(in thousands)
As of, and for the Nine Months Ended, September 30, 2004
- --------------------------------------------------------
Total assets $3,755,335 $583,921 $4,339,256
Total deposits 3,149,658 ---- 3,149,658
Net interest income (loss) 104,544 (3,550) 100,994
Total noninterest income 24,891 9,362 34,253
Total noninterest expense 72,769 9,032 81,801
Net income (loss) 39,976 (2,695) 37,281
As of, and for the Nine Months Ended, September 30, 2003
- --------------------------------------------------------
Total assets $2,898,650 370,570 $3,269,220
Total deposits 2,384,538 ----- 2,384,538
Net interest income (loss) 87,493 (3,208) 84,285
Total noninterest income 20,908 8,451 29,359
Total noninterest expense 68,410 7,414 75,824
Net income from continuing 26,394 (2,160) 24,234
Operations
Discontinued operations 1,935 5,988 7,923
Net income (loss) 28,329 3,828 32,157
7. STOCK BASED COMPENSATION
The Company accounts for stock options under SFAS No. 123, Accounting
for Stock-Based Compensation, as amended by SFAS No. 148, which contains a fair
value-based method of valuing stock-based compensation that entities may use,
which measures compensation cost at the grant date based on the fair value of
the award. Compensation is then recognized over the service period, which is
usually the vesting period. Alternatively, SFAS No. 123 permits entities to
continue accounting for employee stock options and similar equity instruments
under Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued
to Employees. Entities that continue to account for stock options using APB
Opinion 25 are required to make pro forma disclosures of net income and earnings
per share, as if the fair value-based method of accounting defined in SFAS No.
123 had been applied.
At September 30, 2004, the Company had two stock-based employee
compensation plans. The Company accounts for these plans under recognition and
measurement principles of APB No. 25, Accounting for Stock Issued to Employees,
and related interpretations. Stock-based employee compensation costs are not
reflected in net income, as all options granted under the 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
SFAS No. 123 to stock-based employee compensation (in thousands, except per
share amounts). These results are not indicative of results for the year ended
December 31, 2004.
Three Months Ended September 30,
--------------------------------
2004 2003
---- ----
Net income, as reported $13,733 $11,004
Less: stock-based compensation costs determined
under fair value-based method for all awards (256) (170)
------- -------
Net income, pro forma $13,477 $10,834
======= =======
12
Earnings per share of common stock - basic As reported $.40 $.37
Pro forma .39 .36
Earnings per share of common stock - diluted As reported $.39 $.36
Pro forma .38 .36
Year to Date Ended September 30,
--------------------------------
2004 2003
---- ----
Net income, as reported $37,281 $32,157
Less: stock-based compensation costs determined
under fair value-based method for all awards (794) (582)
------- -------
Net income, pro forma $36,487 $31,575
======= =======
Earnings per share of common stock - basic As reported $1.17 $1.08
Pro forma 1.14 1.06
Earnings per share of common stock - diluted As reported $1.14 $1.05
Pro forma 1.11 1.04
The Company granted options for 15,796 and 12,924 shares in the first
nine months of 2004 and 2003, respectively. The fair value of each option grant
is estimated on the date of grant using the Black-Scholes options-pricing model
with the following weighted average assumptions used for grants in 2004 and
2003, respectively: dividend yield of 3.02% and 3.28%; expected volatility of
27.7% and 35.1%; risk-free interest rates for each plan of 4.04% for 2004 and
3.93% for 2003; and expected lives of 6.00 years in 2004 and 6.83 years in 2003.
On March 31, 2004, the Financial Accounting Standards Board (FASB)
issued a proposed Statement, Share-Based Payment - an Amendment of FASB
Statements No. 123 and APB No. 95, that addresses the accounting for share-based
payment transactions in which an enterprise receives employee services in
exchange for (a) equity instruments of the enterprise or (b) liabilities that
are based on the fair value of the enterprise's equity instruments or that may
be settled by the issuance of such equity instruments. Under the FASB's
proposal, all forms of share-based payments to employees, including employee
stock options, would be treated the same as other forms of compensation by
recognizing the related cost in the income statement. The expense of the award
would generally be measured at fair value at the grant date. Current accounting
guidance requires that the expense relating to so-called fixed plan employee
stock options only be disclosed in the footnotes to the financial statements.
The proposed Statement would eliminate the ability to account for share-based
compensation transactions using APB Opinion No. 25, Accounting for Stock Issued
to Employees. On October 13, 2004, FASB voted to delay the adoption of this
proposed standard by public companies until their first fiscal quarter beginning
after June 15, 2005. The Company continues to evaluate this proposed statement
and its effects on its results of operations.
8. SUBORDINATED DEBT
As of September 30, 2004, the Company has established four statutory
business trusts, NPB Capital Trust II, NPB Capital Trust III, NPB Capital Trust
IV and NPB Capital Trust V. In each case, the Company owns all the common
capital securities of the trust. These trusts issued preferred capital
securities to investors and invested the proceeds in the Company through the
purchase of junior subordinated debentures issued by the Company. These
debentures are the sole assets of the trusts.
o The $65.206 million of debentures issued to NPB Capital Trust II
on August 20, 2002 mature on September 30, 2032, and bear interest
at the annual fixed rate of 7.85%.
13
o The $20.619 million of debentures issued to NPB Capital Trust III
on February 20, 2004 mature on April 23, 2034, and bear interest
at a floating rate (three month LIBOR plus a margin of 2.75%).
o The $20.619 million of debentures issued to NPB Capital Trust IV
on March 25, 2004 mature on April 7, 2034, and bear interest at a
floating rate (three month LIBOR plus a margin of 2.75%).
o The $20.619 million of debentures issued to NPB Capital Trust V on
April 7, 2004 mature on April 7, 2034, and bear interest at a
floating rate (three month LIBOR plus a margin of 2.75%).
Based on current interpretations of the banking regulators, all the
foregoing junior subordinated debentures qualify under the risk-based capital
guidelines of the Federal Reserve as Tier 1 capital, subject to certain
limitations. In each case, the debentures are callable by National Penn, subject
to any required regulatory approvals, at par, in whole or in part, at any time
after five years. In each case, the Company's obligations under the junior
subordinated debentures and related documents, taken together, constitute a
full, irrevocable and unconditional guarantee on a subordinated basis by the
Company of the obligations of the trusts under the preferred securities.
In first quarter 2004, management determined that NPB Capital Trust II
qualified as a variable interest entity under FIN 46, as revised. NPB Capital
Trust II had previously issued mandatorily redeemable preferred capital
securities to investors and loaned the proceeds to the Company through the
purchase of debentures as discussed above. NPB Capital Trust II is included in
the Company's consolidated balance sheet and statements of income as of and for
the year ended December 31, 2003. Subsequent to the issuance of FIN 46 in
January 2003, the FASB issued a revised interpretation, FIN 46(R) Consolidation
of Variable Interest Entities, the provisions of which had to be applied to
certain variable interest entities by March 31, 2004. The Company adopted the
provisions under the revised interpretation in the first quarter of 2004.
Accordingly, the Company de-consolidated NPB Capital Trust II as of March 31,
2004. FIN 46(R) precludes consideration of the call option embedded in the
preferred capital securities when determining if the Company has the right to a
majority of NPB Capital Trust II's expected residual returns. The
de-consolidation resulted in the investment in the common capital securities of
NPB Capital Trust II being included in unconsolidated investments under the
equity method as of March 31, 2004 with a corresponding increase in outstanding
debt of $1.956 million. In addition, the income received on the Company's common
capital securities investment is included in equity in earnings of
unconsolidated subsidiaries. The adoption of FIN 46(R) did not have a material
impact on the financial position or results of operations.
The Federal Reserve has issued proposed guidance on the regulatory
capital treatment for the trust-preferred securities issued by the various
business trusts identified above as a result of the adoption of FIN 46(R). The
proposed rule would retain the current maximum percentage of total capital
permitted for trust preferred securities at 25%, but would enact other changes
to the rules governing trust preferred securities that affect their use as part
of the collection of entities known as "restricted core capital elements". The
rule would take effect March 31, 2007; however, a three year transition period
leading up to that date would allow bank holding companies to continue to count
trust preferred securities as Tier 1 Capital after applying FIN-46(R).
Management has evaluated the effects of the proposed rule and does not
anticipate a material impact on its capital ratios when the proposed rule is
finalized.
9. EMPLOYEE BENEFIT PLANS
Net periodic defined benefit pension expense for the nine months ended
September 30, 2004 and 2003 included the following components:
September 30, 2004 September 30, 2003
------------------ ------------------
Service cost $392,944 $315,960
Interest cost 316,460 267,178
Expected return on plan assets (388,391) (320,547)
Amortization of prior service cost (6,382) (10,471)
Amortization of unrecognized net actual loss 27,131 12,107
------ ------
Net periodic benefit expense $343,106 $291,334
======== ========
14
We contributed $1,328,876 to our pension plan in September 2004. We are
currently evaluating the impact of the Pension Funding Equity Act enacted in
April 2004 on our projected funding.
10. NEW ACCOUNTING PRONOUNCEMENTS
Staff Accounting Bulletin 105
-----------------------------
The Securities and Exchange Commission staff released Staff Accounting
Bulletin (SAB) 105, "Loan Commitments Accounted for as Derivative Instruments."
SAB 105 requires that a lender should not consider the expected future cash
flows related to loan servicing or include internally developed intangible
assets, such as customer-related intangible assets, in determining the fair
value of loan commitments accounted for as derivatives.
The Company adopted SAB 105 at the beginning of second quarter 2004. It
is effective for commitments entered into after March 31, 2004. The requirements
of SAB 105 apply to the Company's mortgage loan interest rate lock commitments
related to loans held for sale. At September 30, 2004, such commitments with a
notional amount of approximately $19.7 million were outstanding. The Company's
prior accounting policy was to not record the fair value of these commitments
because they were immaterial. The Company anticipates that application of SAB
105 will not have a material impact on the Company's results of operations.
EITF Issue No. 03-1
-------------------
In November 2003, the Emerging Issues Task Force (EITF) of the FASB
issued EITF Abstract 03-1, The Meaning of Other-Than-Temporary Impairment and
its Application to Certain Investments (EITF 03-1). The quantitative and
qualitative disclosure provisions of EITF 03-1 were effective for years ending
after December 15, 2003 and were included in the Company's 2003 Form 10-K . In
March 2004, the EITF issued a Consensus on Issue 03-1 requiring that the
provisions of EITF 03-1 be applied for reporting periods beginning after June
15, 2004 to investments accounted for under SFAS No. 115 and 124. EITF 03-1
establishes a three-step approach for determining whether an investment is
considered impaired, whether that impairment is other-than-temporary, and the
measurement of an impairment loss. In September 2004, the FASB issued a proposed
Staff Position, EITF Issue 03-1-a, Implementation Guidance for the Application
of Paragraph 16 of EITF 03-1 (EITF 03-1-a). EITF 03-1-a would provide
implementation guidance with respect to debt securities that are impaired solely
due to interest rates and/or sector spreads and analyzed for
other-than-temporary impairment under paragraph 16 of EITF 03-1. In September
2004, the FASB issued a Staff Position, EITF Issue 03-1-1, Effective Date of
Paragraphs 10-20 of EITF Issue No. 03-1 (EITF 03-1-1). FSP EITF Issue No.
03-1-1, Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, 'The Meaning
of Other-Than-Temporary Impairment and Its Application to Certain Investments
delays the effective date of certain provisions of EITF Issue 03-1, including
steps two and three of the Issue's three-step approach for determining whether
an investment is other-than-temporarily impaired. However, step one of that
approach must still be initially applied for impairment evaluations in reporting
periods beginning after June 15, 2004. The delay of the effective date for
paragraphs 10-20 of EITF Issue 03-1 will be superseded with the final issuance
of proposed FSP EITF Issue 03-1-a, Implementation Guidance for the Application
of Paragraph 16 of EITF Issue No. 03-1, ''The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments. The Company is in the
process of determining the impact that this EITF will have on its financial
statements.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
- -------------------------------------------------------------------------------
of Operations
- -------------
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 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. These are unaudited financial
statements and, as such, are subject to year end examination. In addition to
historical information, this Form 10-Q contains forward-looking statements.
Forward-looking statements in this document are subject to risks and
uncertainty. Forward-looking statements include information concerning possible
or assumed future results of operations by the Company. When we use words such
as "believe", "expect", "anticipate", or similar expressions, we are making
forward-looking statements. Additional information concerning forward-looking
statements is contained later on within this discussion.
The Company recorded a 24.8% increase in third quarter 2004 net income
and a 15.9% increase in net income for the first nine months of 2004, compared
to the same periods in 2003. Diluted earnings per share for the three and nine
month periods of $.39 and $1.14 increased 8.3% and 8.6%, respectively, compared
to the same periods in 2003. The percentage increase in net income is higher
than the percentage increase in earnings per share due to the larger number of
weighted average common shares outstanding, principally resulting from various
15
acquisitions since January 2003. Per share results have been restated for the
five-for-four stock split which was effected on September 30, 2004.
For the nine months ended September 30, 2004, the annualized return on
average shareholders' equity and annualized return on average assets were 14.6%
and 1.29%, compared to 15.9% and 1.33% for the same period in 2003. This
decrease is due primarily to the higher levels of average equity and average
assets outstanding resulting from various acquisitions since January 2003. The
return on average tangible equity for the first nine months of 2004 was 25.5%,
compared to 21.1% for the same period in 2003.
Return on average tangible equity is supplemental financial information
determined by a method other than in accordance with accounting principles
generally accepted in the United States of America ("GAAP"). National Penn's
management uses this non-GAAP measure in its analysis of the Company's
performance. Annualized net income return on average tangible equity excludes
the average balance of acquisition-related goodwill and intangibles in
determining average tangible shareholders' equity. Banking and financial
institution regulators also exclude goodwill and intangibles from shareholders'
equity when assessing the capital adequacy of a financial institution.
Management believes the presentation of this financial measure excluding the
impact of these items provides useful supplemental information that is essential
to a proper understanding of the financial results of National Penn, as it
provides a method to assess management's success in utilizing the company's
tangible capital. This disclosure should not be viewed as a substitute for
results determined in accordance with GAAP, nor is it necessarily comparable to
non-GAAP performance measures that may be presented by other companies.
The following table reconciles this non-GAAP performance measure to the
GAAP performance measure, return on average shareholders' equity.
Reconciliation Table for Non-GAAP Financial Measure
September 30, 2004 September 30, 2003
------------------ ------------------
Return on average shareholders' equity 14.6% 15.9%
Effect of goodwill and intangibles 10.9% 5.2%
Return on average tangible equity 25.5% 21.1%
Average tangible equity excludes acquisition related average goodwill and
intangibles:
Average shareholders' equity $341,348 $269,189
Average goodwill and intangibles (146,262) (66,451)
-------- -------
Average tangible equity $195,086 $202,738
======== ========
The Company's strategic plan provides for a highly profitable financial
services company within the markets it serves. Specifically, management is
focused on increased market penetration in selected geographic areas, and
excellence in both retail and commercial lines of business. The acquisition of
Peoples First, Inc. and its subsidiary, The Peoples Bank of Oxford, in second
quarter 2004 represents a strategic initiative by the Company in furtherance of
its focused goals.
CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES
-----------------------------------------------------
The accounting and reporting policies of the Company conform with
accounting principles generally accepted in the United States of America
("GAAP") and general practices 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.
16
The Company considers the determination of the allowance for loan and
lease losses to involve a higher degree of judgment and complexity than its
other significant accounting policies. The allowance for loan losses is
calculated with the objective of maintaining a reserve level believed by
management to be sufficient to absorb estimated probable credit losses.
Management's determination of the adequacy of the allowance is based on periodic
evaluations of the loan portfolio and other relevant factors. However, this
evaluation is inherently subjective as it requires material estimates,
including, among others, expected default probabilities, loss given default,
expected commitment usage, the amounts and timing of expected future cash flows
on impaired loans, value of collateral, estimated losses on consumer loans and
residential mortgages, and general amounts for historical loss experience. The
process also considers economic conditions, uncertainties in estimating losses
and inherent risks in the loan portfolio. All of these factors may be
susceptible to significant change. To the extent actual outcomes differ from
management's estimates, additional provisions for loan losses may be required
that would adversely impact earnings in future periods.
Goodwill is subject to impairment testing at least annually to
determine whether write-downs of the recorded balances are necessary. In this
testing, the Company employs general industry practices in accordance with GAAP.
A fair value is determined for each reporting unit using various market
valuation methodologies. If the fair values of the reporting units exceed their
book values, no write-down of recorded goodwill is necessary. If the fair value
of a reporting unit is less than its book value, an expense may be required on
the Company's books to write down the related goodwill to the proper carrying
value. The Company tests for impairment of goodwill as of June 30 each year, and
again at quarter-end if any material events occur during the quarter that may
affect goodwill. Through its annual analysis as of June 30, 2004, the Company
has not identified any impairment of its goodwill. No events occurred during
third quarter 2004 necessitating a re-test of goodwill impairment. No assurance
can be given that future goodwill impairment tests will not result in a charge
to earnings.
The Company recognizes deferred tax assets and liabilities for the
future tax effects of temporary differences, net operating loss carryforwards
and tax credits. Deferred tax assets are subject to management's judgment based
upon available evidence that future realization is more likely than not. If
management determines that the Company may be unable to realize all or part of
net deferred tax assets in the future, a direct charge to income tax expense may
be required to reduce the recorded value of the net deferred tax asset to the
expected realizable amount.
The Company has not substantively changed any aspect of its overall
approach in the application of the foregoing policies. There have been no
material changes in assumptions or estimation techniques utilized as compared to
prior periods.
RESULTS OF OPERATIONS
---------------------
Net income for the quarter ended September 30, 2004 was $13.7 million,
24.8% more than for the third quarter of 2003. For the first nine months of
2004, net income was $37.3 million or 15.9% more than the $32.2 million reported
in the first nine months of 2003.
The Company's performance has been and will continue to be influenced
in part by the strength of the economy and conditions in the real estate market.
The results of third quarter 2004 include Peoples First, Inc., acquired on June
10, 2004, and HomeTowne Heritage Bank, acquired on December 12, 2003, for the
full quarter. The results of third quarter 2004 and third quarter 2003 include
FirstService Bank, acquired on February 25, 2003, for the full quarters.
Net interest income is the difference between interest income earned on
assets and interest expense paid on liabilities. Net interest income for the
third quarter of 2004 was $37.2 million, which increased $8.6 million or 30%
over $28.6 million for the third quarter of 2003. Net interest income for the
nine months ended September 30, 2004 was $101.0 million, a 19.8% increase over
net interest income of $84.3 million in the comparable period in 2003.
Interest income for the third quarter of 2004 increased $12.0 million
due to an increase in loan interest income of $9.5 million and an increase in
investment securities income of $2.7 million, offset by a decrease in
17
interest on federal funds sold and deposits in bank of $157,000. Interest
expense for third quarter 2004 increased $3.4 million due to an increase in
interest on deposits of $1.7 million, an increase in interest on long-term
borrowings of $935,000, and increase in expense for securities sold under
repurchase agreements and federal funds sold of $751,000. The increase in
interest expense on deposits is due primarily to the acquisition of Peoples
First, Inc., whose interest bearing deposits totaled $288.6 million at
acquisition. The increase in interest expense on the borrowings is a result of
increased balances due in part to the issuance of $60.0 million of trust
preferred securities, as well as the Peoples First, Inc. acquired securities
sold under repurchase agreements and long-term borrowings of $36.4 million.
The following table presents the dollar amount of changes in interest
income and interest expense for major components of interest-earning assets and
interest-bearing liabilities. It distinguishes between the increase related to
higher outstanding balances and that due to the levels and volatility of
interest rates. For each category of interest-earning assets and
interest-bearing liabilities, information is provided on changes attributable
to:
o changes in volume (i.e., changes in volume multiplied by old rate); and
o changes in rate (i.e., changes in rate multiplied by old volume).
For purposes of this table, changes attributable to both rate and
volume, which cannot be segregated, have been allocated proportionately to the
change due to volume and the change due to rate. The information is presented on
a taxable equivalent basis, using an effective rate of 35% (in thousands). Net
interest income, on a taxable equivalent basis, increased $16.7 million in the
first nine months of 2004, as compared to the same period in 2003. This increase
is due to a $23.4 million increase due to volume, attributable mainly to the
FirstService Bank, HomeTowne Heritage Bank and Peoples First, Inc. acquisitions,
offset by a $6.7 million net interest margin compression.
Nine Months Ended September 30, 2004 over 2003
----------------------------------------------
Volume Rate Total
------ ---- -----
Increase (decrease) in:
Interest income:
Interest bearing deposits in banks $ 10 $ (24) $ (14)
Federal funds sold (404) (18) (422)
Investment securities 7,991 (2,400) 5,591
Total loans 25,894 (10,537) 15,357
------ ------- ------
Total interest income $ 33,491 $(12,979) $ 20,512
======== ======== ========
Interest expense:
Interest bearing deposits $ 4,980 $ (4,300) $ 680
Short-term borrowings 2,184 (182) 2,002
Long-term borrowings 2,912 (1,791) 1,121
Total interest expense 10,076 (6,273) 3,803
-------- -------- --------
Increase (decrease) in net interest income $ 23,415 $ (6,706) $ 16,709
======== ======== ========
Net interest margin is net interest income divided by total interest
earning assets. During third quarter 2004, net interest margin was 4.07%,
compared to 4.17% during the third quarter of 2003 and 4.01% during the second
quarter of 2004. A portion of the decline in the net interest margin from the
third quarter 2003 margin is attributable to the issuance of $60.0 million of
trust preferred securities bearing an interest rate of 2.75% over the
three-month London InterBank Offered Rate ("LIBOR"), or 4.77% at September 30,
2004, for capital and liquidity purposes in conjunction with the acquisition of
Peoples First, Inc., and to the exchange of $50.0 million of overnight
borrowings from the Federal Home Loan Bank of Pittsburgh for long-term advances
for purposes of managing interest rate risk. Both of these actions resulted in
significantly higher funding costs. The remainder of the margin decline is due
to continued competitive pressures and general overall margin compression.
18
Despite the current interest rate environment, the cost of attracting
and holding deposited funds is an ever-increasing expense in the banking
industry. These increases are the real costs of deposit accumulation and
retention, including FDIC insurance costs and branch overhead expenses. Such
costs are necessary for continued growth and to maintain and increase market
share of available deposits.
Management conducts a quarterly analysis of the loan portfolio and
adjusts the allowance for loan and lease losses accordingly. During our
quarterly analysis of the loan and lease loss allowance, we considered a variety
of factors, some of which included:
o General economic conditions.
o Trends in charge-offs.
o The level of non-performing assets, including loans over 90 days
delinquent. o Levels of allowance for specific classified assets.
o A review of portfolio concentration of any type, either customer,
industry loan type, collateral or risk grade.
Based on the analysis for third quarter 2004, the Company provided $1.2
million to its allowance for loan and lease losses, a decrease of $1.1 million
compared to the three months ended September 30, 2003. The Company maintains the
allowance for loan and lease losses at a level believed adequate to absorb
probable losses on existing loans. The Company's net charge-offs of $1.2 million
for the three months ended September 30, 2004 decreased by $600,000, compared to
the $1.8 million in net charge-offs for the same period in 2003. The Company
provided $4.2 million to its allowance for loan and leases losses for the nine
months ended September 30, 2004, a $2.7 million decrease compared to the $6.9
million provided in the same period ended September 30, 2003. Net charge-offs
decreased $3.2 million in the nine months ended September 30, 2004 from $5.4
million in the first nine months of 2003, to $2.2 million as of September 30,
2004.
The Company's allowance for loan and lease losses increased $8.1
million, from $49.3 million as of December 31, 2003 to $57.4 million as of
September 30, 2004. The following table details the components of the change in
the balance of the allowance for loan and lease losses as of September 30, 2004:
(In thousands)
Balance at 12/31/2003 $49,265
Acquisition of Peoples First, Inc. 6,164
Charge-Offs (4,422)
Recoveries 2,196
Provision for loan and lease losses 4,188
-------
Balance at 9/30/2004 $57,391
Non-interest income increased $2.4 million or 24.5% during the third
quarter of 2004 compared to the same period in 2003. Approximately $1.1 million
of the increase in non-interest income is attributable to the acquisition of
Peoples First, which was completed on June 10, 2004. Principal components of the
third quarter increase were increased service charges on deposit accounts, other
service charges and cash management service charges of $943,000, $239,000 and
$78,000, respectively, increased bank-owned life insurance income of $472,000,
increased trust income of $256,000 and increased insurance commissions and fees
of $214,000. There was an increase in net gains on sale of investment securities
of $469,000; a gain of $100,000 in the third quarter 2004 compared to a loss on
sale of $369,000 for the same period in 2004. These increases totaling $2.4
million were partially offset by a decrease in mortgage banking income of
$189,000 and an $85,000 change in net earnings affiliates as compared to third
quarter 2003. The mortgage income decrease is a result of slower refinancing
volume in the third quarter, reflecting the rise in interest rates that began in
mid-June 2003. Mortgage banking income is vulnerable as interest rates rise and
mortgage refinance volume contracts. Management continues working to identify
alternative strategies to replace the refinance volume. Mortgage banking income
increased in third quarter 2004 over the second quarter 2004 level due, in part,
to National Penn's new initiatives in the purchase mortgage market. Increased
service charge income is due primarily to an increase in the collection of fees
on a larger deposit base and price increases. A life insurance benefit is the
source of the increase in bank owned life insurance income.
19
Increased trust income is due in part to the acquisition of Peoples First, which
contributed $135,000 in trust income in the quarter. Increased insurance
commissions and fees are due to the growth in the customer base.
Non-interest income increased $4.9 million, or 16.7%, in the nine
months ended September 30, 2004. The inclusion of a full nine months of income
in 2004 from FirstService Bank and HomeTowne Heritage Bank contributed to the
increase, as well as the inclusion of non-interest income from Peoples First
from the June 10, 2004 acquisition date. Increases in service charges on deposit
accounts of $2.2 million, other service charges and fees of $1.7 million and
service charges on cash management of $348,000 are attributable to an increase
in the collection of fees on a larger base and price increases. The increase in
bank-owned life insurance of $502,000 is primarily attributable to a benefit
received. The increase in insurance commissions and fees of $794,000 is due to
the growth in the customer base of First Service Insurance. Trust income
increased $1.2 million primarily as a result of the improving performance in the
equity markets. Mortgage banking income decreased $1.2 million in the nine
months ended September 30, 2004 compared to the same period in 2003. The
mortgage income decrease is a result of slower refinancing volume in the
quarter, reflecting the rise in interest rates beginning in mid-June 2003.
Non-interest expenses decreased $650,000, or 2.1%, to $30.0 million
during the third quarter of 2004, compared to third quarter 2003, principally
due to the one-time of Federal Home Loan Bank pre-payment fees of $7.0 million
in the 2003 third quarter. Non-interest expense would have increased $6.3
million in the third quarter 2004 compared to the same period in 2003, excluding
the Federal Home Loan Bank pre-payment fees of $7.0 million Salaries, wages and
benefits increased $3.6 million, net premises and equipment expense increased
$1.0 million, and other operating expenses increased of $1.8 million in the
third quarter 2004. Advertising and marketing expenses decreased $111,000.
Salaries, wages and benefits increased due to normal salary increases and an
increase in staff resulting from various acquisitions beginning January 2003.
The FirstService acquisition resulted in the addition of 137 employees; the
acquisition of HomeTowne Heritage Bank added 30 employees; and the acquisition
of Peoples First, Inc. on June 10, 2004 added 160 employees. Net premises and
equipment expense increase is due primarily to the acquisition of Peoples First
and its network of nine community offices. Other operating expenses increased
$1.8 million through September 30, 2004, compared to the same period last year.
The inclusion of a full quarter of expenses from HomeTowne Heritage Bank and
Peoples First, Inc. contributed to the third quarter 2004 increase. The decrease
in advertising and marketing expense is attributable to less mass media
advertising campaigns conducted in the third quarter of 2004.
Non-interest expenses increased $6.0 million or 7.8% for the nine
months ended September 30, 2004 compared to the same period in 2003.
Non-interest expense would have increased $13.0 million for the nine months
ended September 30, 2004 compared to the same period in 2003, excluding the
Federal Home Loan Bank pre-payment fees of $7.0 million Salaries, wages and
employee benefits increased $7.7 million, due to the inclusion of a full nine
months of expense from FirstService Bank and HomeTowne Bank and 112 days of
Peoples First expenses, as well normal salary increases. The increase in net
premises and equipment expense of $1.7 is also partially associated with the
acquisitions of FirstService Bank, HomeTowne Heritage Bank and Peoples First,
which included community office networks of seven offices, three offices, and
nine offices, respectively. The increase in marketing expense of $498,000 is
attributable to additional advertising campaigns conducted in the first nine
months of 2004. Other operating expenses increased $3.1 million through
September 30, 2004, compared to the same period last year. The inclusion of a
full nine months of expenses from FirstService Bank and HomeTowne Heritage Bank
and 112 days of expenses from Peoples First contributed to the increase.
Income taxes increased $3.4 million or 457.3% for the quarter ended
September 30, 2004 compared to the same period in 2003, due to the $12.7 million
increase in net income before taxes, continuing operations. The Company's
effective tax rate increased for the three months ended September 30, 2004
compared to the same period in 2003, to 24.1% from 17.7%. Net income after tax
from continuing operations increased $9.3 million, or 210.0% in third quarter
2004 compared to third quarter 2003.
Income taxes increased $5.3 million or 79.0% for the nine months ended
September 30, 2004 due to the $18.3 million increase in net income before taxes,
continuing operations. The Company's effective tax rate increased for the nine
months ended September 30, 2004, compared to the same period in 2003, to 24.3%
from
20
21.6%. Part of the increase in the effective tax rate both for the quarter and
year to date in 2004 is due to the decrease in tax-free income relative to total
income. Our average tax-free assets for the nine months ended September 30, 2004
total $322.1 million, or 9.4% of average earning assets of $3.437 billion.
Average tax-free assets in 2004 consisted of $259.2 million in marketable
securities and $62.9 million in loans. For the nine months ended September 30,
2003, average tax-free assets were $302.3 million, or 11.1% of average earning
assets of $2.733 billion. Average tax-free assets for 2003 consisted of $261.3
million in marketable securities and $41.0 million in loans.
FINANCIAL CONDITION
-------------------
At September 30, 2004, total assets were $4.339 billion, an increase of
$826.7 million or 23.5% from the $3.513 billion at December 31, 2003. Of this
increase, $455.9 million was attributable to the acquisition of Peoples First,
Inc. on June 10, 2004.
Total cash and cash equivalents increased $28.2 million or 28.7% at
September 30, 2004 when compared to December 31, 2003. This increase resulted
from an increase in federal funds sold of $19.2 million, a decrease in cash and
due from banks of $1.1 million, of which $10.3 million resulted from the June
10, 2004 acquisition of Peoples First, Inc., and an increase in interest bearing
deposits in banks of $10.1 million.
Net loans and leases, including loans held for sale, which totaled
$2.757 billion at September 30, 2004, increased $593.0 million, or 26.8%
compared to the $2.221 billion in loans at December 31, 2003. Of this increase,
$355.4 million was attributable to the June 10, 2004 Peoples First, Inc.
acquisition. Loans also continued to increase as a result of the improving
economy and an increase in capital goods spending by the Company's business
customers. Loans originated for immediate resale during the nine-month period
ended September 30, 2004 amounted to $100.5 million.
For the three months ended September 30, 2004, approximately 64.3% of
the Company's gross revenue (total interest income plus total other income or
$65.3 million through September 30, 2004) was derived from interest income on
loans it makes to individuals and business owners throughout its marketplace,
which totaled $42.0 million. The Company's total loan portfolio, including loans
held for sale, as of September 30, 2004, was $2.814 billion and consisted of
three broad categories of loans:
o Loans to individuals to finance the purchase of personal assets or
activities was $305.0 million or 10.9% of total loans.
o Residential mortgage loans for the purchase or financing of an
individual's private residence was $283.5 million or 10.1% of total
loans.
o Commercial loans were $2.226 billion or 79.0% of the total loan
portfolio. This includes commercial real estate, commercial
construction, commercial and industrial loans, and agricultural loans.
Loans to individuals consisted primarily of loans with fixed terms and
lines of credit secured by liens on the individual's residence. The principal
risk associated with these credits is the overall creditworthiness of the
individual borrower. Changes in an individual's employment or life circumstances
can have an effect on the repayment of these assets.
Residential mortgage loans are extended to individuals for the purchase
or financing of their residence. These loans are secured by a first lien
title-insured mortgage on their home. Again, the primary risk in these credits
is the financial soundness of the individual borrower.
Commercial loans consist of lines of credit, term loans, mortgages, and
leases extended to business owners or to individuals for business purposes. The
types of business borrowers represented in the portfolio consist of
manufacturing companies, wholesalers, distributors and warehouses, professional
service providers, retailers,
21
farmers and agricultural related industries, commercial real estate investors,
and land developers. The commercial portfolio has a concentration in loans to
commercial real estate investors and developers with loans outstanding to this
group of $518.3 million. These loans outstanding are 23.3% of the commercial
loan portfolio and 18.4% of the total loan portfolio.
There are numerous risks associated with commercial loans that could
impact the borrower's ability to repay on a timely basis. They include but are
not limited to: the owner's business expertise, changes in local, national, and
in some cases international economies, competition, governmental regulation, and
the general financial stability of the borrowing entity.
The Company attempts to mitigate these risks by making an analysis of
the borrower's business and industry history, its financial position, as well as
that of the business owner. The Company will also require the borrower to
provide financial information on the operation of the business periodically over
the life of the loan. In addition, most commercial loans are secured by assets
of the business or those of the business owner, which can be liquidated if the
borrower defaults, along with the personal surety of the business owner.
All of the aforementioned loan types can be made on a floating or fixed
rate basis, either of which can pose an interest rate risk to the Company as
financial markets change. Interest rate risk is discussed in detail in the
Liquidity and Interest Rate Sensitivity subsection of this Management's
Discussion and Analysis section.
The following table shows detailed information and ratios pertaining to
the Company's loans and asset quality (dollars in thousands):
22
September 30, 2004 December 31, 2003
------------------ -----------------
Nonaccrual loans $13,102 $13,673
Loans past due 90 or more days
As to interest or principal 320 318
------- -------
Total nonperforming loans 13,422 13,991
Other real estate owned 793 735
------- -------
Total nonperforming assets $14,215 $14,726
======= =======
Total loans and leases, including loans
held for sale 2,813,931 2,270,699
Average total loans and leases 2,516,991 2,036,847
Allowance for loan and lease losses 57,391 49,265
Allowance for loan and lease losses to:
Nonperforming assets 403.7% 344.3%
Total loans and leases (1) 2.04% 2.17%
Average total loans and leases 2.28% 2.42%
Nine months ended Nine months ended
----------------- -----------------
September 30, 2004 September 30, 2003
------------------ ------------------
Net charge-offs to: (annualized) $2,226 $5,407
Total loans and leases 0.11% .34%
Average total loans and leases 0.12% .36%
Allowance for loan and lease losses 5.17% 15.68%
_______________________________
(1) Ratio includes loans held for sale of $5.1 million as of September 30, 2004
and $29.3 million as of December 31, 2003. This ratio is 2.04% as of
September 30, 2004 and 2.20% as of December 31, 2003, excluding loans held
for sale.
The $511,000 decrease in nonperforming assets is due primarily to a
$571,000 decrease in nonaccrual loans, from $13.7 million at December 31, 2003
to $13.1 million at September 30, 2004. The decrease in nonaccrual loans is due
to the improving condition of the Company's commercial and industrial borrowers,
the payoff of some nonaccruals, and the charge-off of some other loans that were
deemed no longer collectable. Management expects nonaccrual loans to remain
stable for the balance of 2004. Management reviews the loan portfolio quarterly
to identify nonperforming credits. As of September 30, 2004, loans secured by
non-farm, non-residential real estate and commercial and industrial loans
account for 72.7% of total nonaccrual loans; residential real estate-secured
loans account for 23.6% of total nonaccrual loans.
The investment portfolio is primarily a secondary source of liquidity,
but it also serves as a source of income. As such, the investment portfolio
consists of shorter-term investments that provide current liquidity and
longer-term investments that provide higher income. Over the past three years,
the Company has worked to shorten the duration of the investment portfolio in
response to lower interest rates and to help improve liquidity. Regardless of
classification as to shorter-term or longer-term, the majority of the Company's
investments are readily marketable securities held as available for sale, and
the majority of the Company's investments qualify as collateral for deposit
pledging needs.
23
Certain investment securities purchased during the third quarter of
2004 were classified as held to maturity. These securities consisted of shorter
average life securities that, due to our pledging requirements, would most
likely be held to maturity regardless of classification.
Investments of both held to maturity and available for sale securities
increased $144.4 million or 15.4% to $1.08 billion at September 30, 2004
compared to December 31, 2003. Of this increase, $54.8 million was attributable
to the June 10, 2004 acquisition of Peoples First, Inc. Investment purchases
during the nine months ended September 30, 2004 were $298.7 million, primarily
U.S. Government Agency securities. This increase was partially offset by
investment calls and maturities and the amortization of mortgage-backed
securities totaling $160.2 million. Also, during the nine months of 2004, the
Company sold approximately $42.3 million in investment securities available for
sale resulting in a $96,000 loss. The sale proceeds were re-deployed into higher
yielding investments.
Other assets on the balance sheet increased to $377.3 million, an
increase of $118.9 million from the $258.4 million at December 31, 2003. These
assets include net premises and equipment, accrued interest receivable, bank
owned life insurance, goodwill and other intangibles, unconsolidated
investments, and other assets. This increase is due primarily to increased
goodwill and other intangibles of $90.8 million (net of amortization of
intangibles) resulting from the Peoples First, Inc. acquisition. The Company
tests goodwill for impairment periodically. See "Critical Accounting Policies,
Judgments and Estimates" part of this Management's Discussion and Analysis. The
increases in premises and equipment, accrued interest receivable and bank-owned
life insurance are also due primarily to the acquisition of Peoples First, Inc.
Also, there was an increase in unconsolidated investments of $3.9 million,
attributable to the $60.0 million in additional trust preferred securities
issued in the first half of 2004 and the adoption of FIN46(R). The Company
adopted FIN46(R) in the first quarter 2004 and de-consolidated NPB Capital Trust
II as of March 31, 2004 on its financial statements. Other assets increased $3.1
million, primarily due to an increase in the deferred tax asset, related to the
decrease of the market valuation of investment securities.
In 1998 and 1999, the Company invested in bank owned life insurance
(BOLI) policies that provide earnings to help cover the cost of employee benefit
plans. BOLI involves the purchasing of life insurance by the Company on a chosen
group of employees. The Company is the owner and beneficiary of the policies.
The Company has additional BOLI policies that have been received through several
of its bank acquisitions. Cashflow from these policies will occur over an
extended period of time. The Company periodically reviews the creditworthiness
of the insurance companies that have underwritten the policies. The insurance
companies are all highly rated by A.M. Best, and the earnings accruing to the
Company are derived from the general account investments of the insurance
companies. The policies appear on the Company's balance sheet and are subject to
full regulatory capital requirements.
As the primary source of funds, aggregate deposits of $3.150 billion at
September 30, 2004 increased $714.4 million or 29.3%, as compared to December
31, 2003. The increase is comprised of a $136.1 million increase in non-interest
bearing deposits, and a $578.3 million increase in interest bearing deposits.
The acquisition of Peoples First, Inc. was a significant source of the total
deposit increase from December 31, 2003. Peoples' $387.7 million in deposits
consisted of non-interest bearing deposits of $100.0 million, interest-bearing
non-time deposits of $198.4 million, and time deposits of $89.3 million. Another
major source of the increase in non-interest bearing deposits is our growth in
the government banking area, which contributed approximately $397.0 million.
In addition to deposits, earning assets are funded to some extent
through purchased funds and borrowings. These include securities sold under
repurchase agreements, federal funds purchased, short-term borrowings, long-term
debt obligations, and subordinated debt. In the aggregate, these funds totaled
$738.3 million at September 30, 2004, and $737.3 million at December 31, 2003.
The increase of $1.0 million in purchased funds and borrowings is comprised of a
$129.2 million decrease in securities sold under repurchase agreements and
federal funds purchased, as a result of paydowns of overnight borrowings.
Subordinated debt increased $63.8 million as the result of the issuance of
various trust preferred securities in the first two quarters of 2004. Long-term
borrowings increased to $66.4 million, of which $30.5 million resulted from the
June 10, 2004 Peoples First, Inc. acquisition. Long-term borrowings also
increased as a result of the Company's decision to term out short term
adjustable rate borrowings to
24
longer-term fixed rate borrowings. Subordinated debt was classified as
"guaranteed preferred beneficial interest in Company's subordinated debentures"
prior to the Company's adoption of FIN-46(R) as of March 31, 2004. See Footnote
#8 to the financial statements included in this Report at Part I, Item 1.
Shareholders' equity increased $105.2 million from December 31, 2003
through September 30, 2004. This was primarily due to the issuance of shares of
National Penn common stock in the June 10, 2004 acquisition of Peoples First,
Inc. Retained earnings increased $19.0 million due to the retention of net
income, partially offset by cash dividends declared, in the first nine months of
2004. Accumulated other comprehensive income decreased $710,000 due to a
decrease in market values of available for sale investment securities and
adjustments to the fair value of interest rate swaps. Cash dividends paid during
the first nine months of 2004 increased $2.9 million or 18.3% to $18.3 million
compared to the cash dividends paid during the first nine months of 2003.
Earnings retained during the first nine months of 2004 were 51.0% compared to
52.0% during the first nine months of 2003. The Company split its common stock
five-for-four effective September 30, 2004. The split did not affect the
Company's equity accounts on its balance sheet.
REGULATORY/COMPLIANCE AND INTERNAL CONTROL
------------------------------------------
During 2004, management undertook an extensive effort to enhance the
Company's documentation of systems of internal controls. Management is currently
testing the Company's systems of internal controls in preparation for the
Company's Sarbanes-Oxley Act Section 404 certification of internal controls as
of December 31, 2004. Management has an effective process for monitoring
existing and new regulatory developments, such as the Sarbanes-Oxley Act. This
process includes ongoing evaluations of policies, procedures, and personnel. The
Company recognizes the need for maintaining systems of internal controls and
regulatory compliance and contributes substantial amounts of operating income,
management focus, time and effort to this end.
LIQUIDITY AND INTEREST RATE SENSITIVITY
---------------------------------------
The primary functions of asset/liability management are to assure
adequate liquidity and maintain an appropriate balance between interest-earning
assets and interest-bearing liabilities.
Liquidity management involves the ability to meet the cash flow
requirements of customers who may be either depositors wanting to withdraw funds
or borrowers needing assurance that sufficient funds will be available to meet
their credit needs. During the past year, liquidity has tightened as loan demand
has improved and competition for deposits has intensified. Wholesale funding is
funding from sources outside our core deposit base, such as the national jumbo
CD market, or correspondent bank borrowings. At the present time, we have ample
availability of wholesale funding because our use of these sources of funds is
reduced from prior levels, and we have increased our availability of wholesale
funding in the past year. Regardless of our comfort with our liquidity position
at the present time, we actively monitor our position and any increased use of
wholesale funding increases our attention in this area.
The Company's main liquidity concern is that as the economy and
consequently the equity markets strengthen, the Company may suffer
disintermediation back to the equity market. The Company has sought to prepare
for this potential disintermediation by working to build its share of customers'
banking business (on the theory that even if some funds move back to the equity
market, the Company will still retain a larger share than it had three years
ago), growing its government banking unit, reviewing its deposit product
offerings, establishing additional non-core sources of funding, maintaining a
more liquid investment portfolio, and continuing to develop its capability to
securitize assets.
The Company's acquisition of HomeTowne Heritage Bank during the fourth
quarter of 2003 did not have a material impact on the Company's current
liquidity position. HomeTowne Heritage Bank, as a division of National Penn
Bank, has retained its name and management. Accordingly, the Company expects no
material run-off in
25
deposits over the long term, and as a result, does not anticipate a negative
material impact on the Company's overall long-term liquidity position.
The Company's acquisition on June 10, 2004 of Peoples First, Inc.,
parent company of The Peoples Bank of Oxford, did not have a material impact on
the Company's current liquidity position. As a division of National Penn Bank,
The Peoples Bank of Oxford has retained its name and management. Accordingly,
the Company expects no material run-off in deposits over the long term, and as a
result, does not anticipate a negative material impact on the Company's overall
long-term liquidity position.
The goal of interest rate sensitivity management is to avoid
fluctuating net interest margins, and to enhance consistent growth of net
interest income through periods of changing interest rates. Such sensitivity is
measured as the difference in the volume of assets and liabilities in the
existing portfolio that are subject to repricing in a future time period.
The following table shows separately the interest rate sensitivity of
each category of interest-earning assets and interest-bearing liabilities at
September 30, 2004.
Repricing Periods(1)
----------------------------------------------------------------------------------
Within Three Months One Year Over
Three Months Through One Year Through Five Years Five Years
------------ ---------------- ------------------ ----------
Assets
Interest bearing deposits
at banks $ 12,318 $ ---- $ ---- $ ----
Federal funds sold 19,200 0 0 ----
Investment securities 125,889 125,997 550,526 276,348
Loans(1) 1,181,172 349,955 936,142 289,271
Other assets ---- ---- ---- 472,438
Liabilities and equity
Non-interest bearing deposits 5,472 11,414 133,863 371,934
Interest bearing deposits(2) 1,077,929 342,719 331,090 875,237
Borrowed funds 195,409 18,200 137,446 260,231
Subordinated debt 61,857 ---- ---- 65,206
Other liabilities ---- ---- ---- 28,208
Shareholders' equity ---- ---- ---- 423,041
Interest sensitivity gap (2,088) 103,619 884,269 (985,800)
------------ -------- -------- ------------
Cumulative interest rate
Sensitivity gap $ (2,088) $101,531 $985,800 $ (0)
============ ======== ======== ============
(1) Adjustable rate loans are included in the period in which interest rates are
next scheduled to adjust rather than in the period in which they are due. Fixed
rate loans are included in the period in which they are scheduled to be repaid
and are adjusted to take into account estimated prepayments based upon
assumptions estimating prepayments in the interest rate environment prevailing
during the third calendar quarter of 2004. The table assumes prepayments and
scheduled principal amortization of fixed-rate loans and mortgage-backed
securities and assumes that adjustable rate mortgages will reprice at
contractual repricing intervals. There has been no adjustment for the impact of
future commitments and loans in process.
(2) Savings and NOW deposits are scheduled for repricing based on historical
deposit decay rate analyses, as well as historical moving averages of run-off
for the Company's deposits in these categories. While generally subject to
immediate withdrawal, management considers a portion of these accounts to be
core deposits having significantly longer effective maturities based upon the
Company's historical retention of such deposits in changing
26
interest rate environments. Specifically, 50.0% of these deposits are considered
repriceable within three months and 50.0% are considered repriceable in the over
five years category.
- ---------------------------------
Interest rate sensitivity is a function of the repricing
characteristics of the Company's assets and liabilities. These characteristics
include the volume of assets and liabilities repricing, the timing of the
repricing, and the relative levels of repricing. Attempting to minimize the
interest rate sensitivity gaps is a continual challenge in a changing rate
environment. Based on the Company's gap position as reflected in the above
table, current accepted theory would indicate that net interest income would
decrease in a falling rate environment and would increase in a rising rate
environment. An interest rate gap table does not, however, present a complete
picture of the impact of interest rate changes on net interest income. First,
changes in the general level of interest rates do not affect all categories of
assets and liabilities equally or simultaneously. Second, assets and liabilities
which can contractually reprice within the same period may not, in fact, reprice
at the same time or to the same extent. Third, the table represents a one-day
position; variations occur daily as the Company adjusts its interest sensitivity
throughout the year. Fourth, assumptions must be made to construct such a table.
For example, non-interest bearing deposits are assigned a repricing interval
within three months, although history indicates a significant amount of these
deposits will not move into interest bearing categories regardless of the
general level of interest rates. Finally, the repricing distribution of interest
sensitive assets may not be indicative of the liquidity of those assets.
The Company uses financial simulation models to measure interest rate
exposure. These tools provide management with extensive information on the
potential impact of net income caused by changes in interest rates. Interest
rate related risks such as pricing spreads, the lag time in pricing administered
rate accounts, prepayments and other option risks are considered. Off-balance
sheet items are used in hedging the values of selected assets and liabilities
from changes in interest rates. The effect of these hedges is included in the
simulations of net income.
Gap analysis is a useful measurement of asset and liability management;
however, it is difficult to predict the effect of changing interest rates based
solely on this measure. Therefore, the Company supplements gap analysis with the
calculation of the Economic Value of Equity. This report forecasts changes in
the company's market value of portfolio equity ("MVPE") under alternative
interest rate environments. The MVPE is defined as the net present value of the
Company's existing assets, liabilities, and off-balance sheet instruments. The
calculated estimates of change in MVPE at September 30, 2004 are as follows:
MVPE
Change in Interest Rate Amount % Change
- ----------------------- ------ --------
( In Thousands)
+300 Basis Points 543,693 (7.90)%
+200 Basis Points 555.699 (5.87)%
+100 Basis Points 557,270 (5.60)%
Flat Rate 590,355 -0- %
- -100 Basis Points 578,534 (2.00)%
- -200 Basis Points 587,570 (0.47)%
- -300 Basis Points 562,580 (4.70)%
Management also estimates the potential effect of shifts in interest
rates on net income. The following table demonstrates the expected effect that a
parallel interest rate shift would have on the Company's net income.
September 30, 2004 September 30, 2003
----------------------------------------- --------------------------------------------
Change in $ Change in % Change in $ Change in % Change in
Interest Rates Net Income Net Income Net Income Net Income
- ------------------------------------------------------------------------------------------------------------------
(In basis points) (Dollars in Thousands)
+300 (1604) (2.75)% (2699) (6.0)%
+200 (830) (1.42)% (1657) (3.7)%
+100 (179) (0.31)% (833) (1.9)%
27
-100 (1190) (2.04)% (1944) (4.3)%
-200 (5456) (9.36)% (4386) (9.8)%
-300 (9028) (15.49)% (4671) (10.5)%
The Company uses financial derivative instruments for management of
interest rate sensitivity. The Company's Asset/Liability Management Committee
("ALCO") approves the use of derivatives in balance sheet hedging. The
derivatives employed by the Company include interest rate swaps and forward
sales of mortgage commitments. The Company does not use any of these instruments
for trading purposes.
At the current level of interest rates, the Company has some exposure
to a movement in rates in either direction due to the optionality of financial
instruments on both sides of the balance sheet. Optionality exists because
customers have choices regarding their deposit accounts or loans. For example,
if a customer has a fixed rate mortgage, he/she may choose to refinance the
mortgage if interest rates decline. One way to reduce this option risk is to
sell the Company's long-term fixed rate mortgages in the secondary market. The
impact of a rising or falling interest rate environment on net interest income
is not expected to be significant to the Company's results of operations.
Nonetheless, ALCO's priority is to manage this optionality and therefore limit
the level of interest rate risk.
OFF-BALANCE SHEET ARRANGEMENTS AND OTHER CONTRACTUAL OBLIGATIONS AND COMMITMENTS
- --------------------------------------------------------------------------------
The Company consolidates all of its majority-owned subsidiaries. Other
entities, in which there is greater than 20% ownership, but upon which the
Company does not possess, nor cannot exert, significant influence or control,
are accounted for by the equity method of accounting and are not consolidated;
those in which there is less than 20% ownership are generally carried at cost.
The Company no longer consolidates NPB Capital Trust II on the balance
sheet as of March 31, 2004. For additional information, see Footnote #8 to the
financial statements at Part I, Item 1 of this Report.
The following table sets forth the contractual obligations and other
commitments representing required and potential cash outflows as of September
30, 2004:
Less than One to Four to After
Total One Year Three Years Five Years Five Years
(Dollars in thousands) ----- -------- ----------- ---------- ----------
Minimum annual rentals or
noncancellable operating leases $23,348 $3,057 $4,997 $3,536 $11,758
Remaining contractual maturities of
time deposits 830,818 495,998 307,585 23,506 3,729
Loan commitments 937,958 634,820 50,578 27,833 224,727
Long-term borrowed funds 230,467 13,200 99,643 37,804 79,820
Subordinated debt 127,063 61,857 ---- ---- 65,206
Standby letters of credit 82,691 48,811 22,897 10,850 133
---------- ---------- -------- -------- --------
Total $2,232,345 $1,257,743 $485,700 $103,529 $385,373
========== ========== ======== ======== ========
The Company currently does not have any off-balance sheet special
purpose entities. The Company had no capital leases at September 30, 2004.
28
CAPITAL LEVELS
--------------
The following table sets forth the Company's capital ratios:
Tier 1 Capital to
Tier 1 Capital to Risk-Weighted Assets Total Capital to
Average Assets Ratio Ratio Risk-Weighted Assets Ratio
---------------------------- --------------------------- ------------------------------
Sept. 30, Dec. 31, Sept. 30, Dec. 31, Sept. 30, Dec. 31,
2004 2004 2003 2004 2003 2003
---- ---- ---- ---- ---- ----
The Company 8.04% 7.84% 10.17% 9.74% 11.43% 11.00%
National Penn Bank 7.16% 7.06% 9.08% 8.88% 10.34% 10.14%
"Well Capitalized" 5.00% 5.00% 6.00% 6.00% 10.00% 10.00%
institution (under
banking regulation)
The Company's capital ratios above compare favorably to the minimum
required amounts of Tier 1 and total capital to "risk-weighted" assets and the
minimum Tier 1 leverage ratio, as defined by banking regulators. At September
30, 2004, the Company was required to have minimum Tier 1 and total capital
ratios of 4.0% and 8.0%, respectively, and a minimum Tier 1 leverage ratio of
4.0%. In order for the Company to be considered "well capitalized", as defined
by banking regulators, the Company must have Tier 1 and total capital ratios of
6.0% and 10.0%, respectively, and a minimum Tier 1 leverage ratio of 5.0%. The
Company currently meets the criteria for a well capitalized institution, and
management believes that, under current regulations, the Company will continue
to meet its minimum capital requirements in the foreseeable future.
The issuance of trust preferred securities in the first half of 2004
improved the Company's capital ratios. The Company has various trust preferred
securities outstanding. See Footnote #8 to the financial statements at Part I,
Item 1 of this Report. During second quarter 2004, the Board of Governors of the
Federal Reserve System issued a proposed rule that would retain trust preferred
securities in the Tier 1 capital of bank holding companies, but with stricter
quantitative and clearer qualitative standards. Under the proposal, after a
three-year transition period, the aggregate amount of trust preferred securities
and certain other capital elements would be limited to 25 percent of Tier 1
capital elements, net of goodwill. The amount of trust preferred securities and
certain other elements in excess of the limit could be included in Tier 2
capital, subject to certain restrictions. As of the date of this report, the
Board of Governors has not taken any action on this proposed rule change.
Management has evaluated the effects of the proposed rule and does not
anticipate a material impact on its capital ratios when the proposed rule is
finalized.
The acquisition of Peoples First, Inc. also contributed to the
Company's increased capital ratios, as Peoples First had a higher capitalization
level than National Penn.
At present, the Company's commitments for significant capital
expenditures are within its historical norms.
Historically, the Company's dividend payout ratio has been in the range
of 45% to 50%. We do not anticipate a material change to this ratio due to the
Peoples First acquisition. The level of dividend payout remains at the
discretion of the Company's Board of Directors.
The Company is not under any agreement with regulatory authorities nor
is the Company aware of any current recommendations by the regulatory
authorities, which, if such recommendations were implemented, would have a
material effect on liquidity, capital resources or operations of the Company.
29
RELATED PARTY TRANSACTIONS
The Company has no material transactions with related parties as
defined in SFAS No. 57, Related Party Disclosures, or with any other persons
who, because of a prior relationship with the Company, i.e., former members of
senior management or individuals with former management relationships with the
Company, had the ability to negotiate transactions with the Company on more
favorable terms to themselves than had they not had such prior relationships
with the Company.
ACQUISITION OF PEOPLES FIRST, INC.
----------------------------------
On June 10, 2004, National Penn Bancshares, Inc. acquired Peoples
First, Inc., parent company of The Peoples Bank of Oxford in a stock and cash
transaction. The Peoples Bank of Oxford, headquartered in Oxford, Pennsylvania,
operated eight community offices in Chester and Lancaster Counties,
Pennsylvania, and one community office in Cecil County, Maryland, at the time of
acquisition.
Under the terms of the merger agreement, Peoples shareholders were
entitled to select to receive either 1.88125 shares of National Penn common
stock (as adjusted for National Penn's five-for-four stock split effective
September 30, 2004), $49.54 in cash, or a combination of both, for each share of
Peoples common stock. As a result of applicable allocation procedures, 30
percent of the Peoples shares were exchanged for cash, and 70 percent of the
Peoples shares were exchanged for shares of National Penn common stock. Options
to purchase shares of Peoples common stock were converted into options to
purchase shares of National Penn common stock. Closing of this acquisition
occurred before the record date for the five-for-four stock split effected on
September 30, 2004. Accordingly, all shares issued, and all substitute stock
options issued, received the benefit of the subsequent stock split.
The foregoing description does not purport to be complete and is
qualified in its entirety by reference to the Merger Agreement. Additional
information is provided in the Company's Report on Form 8-K dated December 17,
2003, filed with the Securities and Exchange Commission. This report includes a
copy of the Merger Agreement. Additional information is also provided in the
Company's registration statement on Form S-4, filed with the SEC on April 9,
2004, and amended on April 26, 2004, and in the Company's Report on Form 8-K
dated June 10, 2004, filed with the SEC.
Additional information is also included in Footnote #2 to the financial
statements included in Part I, Item 1 of this Report.
FUTURE OUTLOOK
--------------
The Company's market area, while diverse, is subject to many of the
same economic forces being experienced regionally and nationally:
o The recovery in the general economy, although slow, will likely
generate loan growth in 2004, possibly in the range of eight to twelve
percent.
o The principal challenge faced by the Company today is to grow our
earnings in light of the compression of our net interest margin due to
current and anticipated interest rate levels. In this environment, we
seek to increase our net interest income principally through increased
volume, including volume from mergers and acquisitions, and to increase
our non-interest income, especially revenues from insurance and wealth
management activities. We anticipate continued pressure on net interest
margin through the end of 2004.
The Company, like many of its peers, continues to be concerned about
current and near term uncertain economic conditions and their effect on its loan
volume as well as its overall credit quality.
30
FORWARD-LOOKING STATEMENTS
--------------------------
From time to time, National Penn or its representatives make written or
oral statements that may include "forward-looking statements" with respect to
its:
* Financial condition.
* Results of operations.
* Asset quality.
* Product, geographic and other business expansion plans and
activities.
* Investments in new subsidiaries and other companies.
* Capital expenditures, including investments in technology.
* Pending or completed mergers with or acquisitions of financial
or non-financial companies or their assets, loans, deposits
and branches, and the revenue enhancements, cost savings and
other benefits anticipated in those transactions.
* Pending or completed sales of businesses or assets, and the
benefits anticipated in those transactions.
* Other matters.
Many of these statements can be identified by looking for words such as
"believes," "expects," "anticipates," "estimates", "projects" or similar words
or expressions.
These forward-looking statements involve substantial risks and
uncertainties. There are many factors that may cause actual results to differ
materially from those contemplated by such forward-looking statements. These
factors include, among other things, the following possibilities:
* National Penn's unified branding campaign and other marketing
initiatives may be less effective than expected in building
name recognition and greater customer awareness of National
Penn's products and services. Use of non-National Penn brands
may be counter-productive.
* National Penn may be unable to differentiate itself from its
competitors by a higher level of customer service, as intended
by its business strategy.
* Expansion of National Penn's products and services offerings
may take longer, and may meet with more effective competitive
resistance from others already offering such products and
services, than expected.
* New product development by new and existing competitors may be
more effective, and take place more quickly, than expected.
* Competitors with substantially greater resources may enter
product market, geographic or other niches currently served by
National Penn.
* Geographic expansion may be more difficult, take longer, and
present more operational and management risks and challenges,
than expected.
31
* Business development in newly entered geographic areas,
including those entered by mergers and acquisitions, may be
more difficult, and take longer, than expected.
* Competitive pressures may increase significantly and have an
adverse effect on National Penn's pricing, spending,
third-party relationships and revenues.
* Customers may substitute competitors' products and services
for National Penn's products and services, due to price
advantage, technological advantages, or otherwise.
* National Penn may be less effective in cross-selling its
various products and services, and in utilizing alternative
delivery systems such as the Internet, than expected.
* Projected business increases following new product
development, geographic expansion, and productivity and
investment initiatives, may be lower than expected, and
recovery of associated costs may take longer than expected.
* Internal organization realignments may be unsuccessful in
accomplishing their objectives.
* National Penn may be unable to retain key executives and other
key persons, such as customer service/contact personnel, due
to intense competition for such persons or otherwise.
* Increasing interest rates may increase funding costs and
reduce interest margins more than expected, and may adversely
affect business volumes, including mortgage origination
levels.
* Growth and profitability of National Penn's non-interest
income or fee income may be less than expected, including
income from mortgage banking activities.
* General economic or business conditions, either nationally or
in the regions in which National Penn will be doing business,
may be less favorable than expected, resulting in, among other
things, a deterioration in credit quality or a reduced demand
for credit, including the resultant effect on National Penn's
loan portfolio and allowance for loan losses.
* Expected synergies and cost savings from mergers and
acquisitions may not be fully realized or realized as quickly
as expected.
* Revenues and loan growth following mergers and acquisitions
may be lower than expected.
* Loan losses, deposit attrition, operating costs, customer and
key employee losses, and business disruption following mergers
and acquisitions may be greater than expected.
* Business opportunities and strategies potentially available to
National Penn after mergers and acquisitions may not be
successfully or fully acted upon.
* Costs, difficulties or delays related to the integration of
businesses of acquired companies with National Penn's business
may be greater or take longer than expected.
* Technological changes may be harder to make or more expensive
than expected or present unanticipated operational issues.
32
* Recent and proposed legislative or regulatory changes,
including changes in accounting rules and practices, new
internal controls documentation and testing requirements of
the Sarbanes-Oxley Act, and customer privacy and data
protection requirements, and intensified regulatory scrutiny
of the financial services industry in general, may adversely
affect National Penn's costs and business.
Goodwill recorded under GAAP as the result of mergers and
acquisitions could be impaired as the result of subsequent
developments, resulting in a charge to the Company's earnings.
* Market volatility may continue in the securities markets, with
an adverse effect on National Penn's securities and asset
management activities.
* There may be unanticipated regulatory rulings or developments.
* Changes in consumer spending and savings habits could
adversely affect National Penn's business.
* Negative publicity with respect to any National Penn product
or service, whether legally justified or not, could adversely
affect National Penn's reputation and business.
* Various domestic or international military or terrorist
activities or conflicts may have a negative impact on National
Penn's business as well as the foregoing and other risks.
* National Penn may be unable to successfully manage the
foregoing and other risks and to achieve its current
short-term and long-term business plans and objectives.
Because such statements are subject to risks and uncertainties, actual
results may differ materially from those expressed or implied by such
statements. National Penn cautions shareholders not to place undue reliance on
such statements.
All written or oral forward-looking statements attributable to National
Penn or any person acting on its behalf made after the date of this Report are
expressly qualified in their entirety by the cautionary statements contained in
this Report. National Penn does not undertake any obligation to release publicly
any revisions to such forward-looking statements to reflect events or
circumstances after the date of this Report or to reflect the occurrence of
unanticipated events.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
- -------------------------------------------------------------------
The information presented in the Liquidity and Interest Rate Risk
subsection of Part I, Item 2 of this Report, Management's Discussion and
Analysis of Financial Condition and Results of Operations, is incorporated by
reference into this Item 3.
Item 4. Controls and Procedures.
- --------------------------------
National Penn's chief executive officer and chief financial officer
evaluated National Penn's "disclosure controls and procedures" as of September
30, 2004. Disclosure controls and procedures are defined in SEC Rule 13a-15(e)
as controls and other procedures of an issuer that are designed to ensure that
information required to be disclosed by the issuer in the reports that it files
or submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the SEC's rules and
forms. For National Penn, these reports are its annual reports on Form 10-K, its
quarterly reports on Form 10-Q (including this report), and its reports on Form
8-K. These officers concluded that such controls and procedures are adequate and
effective.
33
There were no changes in the registrant's internal control over
financial reporting during the fiscal quarter ended September 30, 2004 that
materially affected, or are reasonably likely to materially affect, National
Penn's internal control over financial reporting.
During 2004, management undertook an extensive effort to enhance the
Company's documentation of systems of internal controls. Management is currently
testing the Company's systems of internal controls in preparation for the
Company's Sarbanes-Oxley Act Section 404 certification of internal controls as
of December 31, 2004. Management has an effective process for monitoring
existing and new regulatory developments, such as the Sarbanes-Oxley Act. This
process includes ongoing evaluations of policies, procedures, and personnel. The
Company recognizes the need for maintaining systems of internal controls and
regulatory compliance and contributes substantial amounts of operating income,
management focus, time and effort to this end.
34
PART II - OTHER INFORMATION
---------------------------
Item 1. Legal Proceedings.
- --------------------------
None.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
- --------------------------------------------------------------------
Sales of Unregistered Securities
--------------------------------
On July 1, 2004, the Company acquired Pennsurance, Inc., an insurance
agency headquartered in Oley, Pennsylvania. In a transaction in which
Pennsurance was merged into National Penn Bank's insurance agency subsidiary,
FirstService Insurance Agency, Inc., the Company exchanged 20,056 shares of the
Company's common stock (as adjusted for the Company's September 30, 2004
five-for-four stock split) for all of the outstanding shares of stock of
Pennsurance. The shares were offered and sold soley to the two shareholders of
Pennsurance in exchange for the transfer of their entire ownership interests in
Pennsurance. The shares were offered and sold without registration under the
Securities Act of 1933, as amended (the "Securities Act"), in reliance on the
exemption afforded by Section 4(2) of the Securities Act and/or Rule 506 of
Regulation D promulgated under the Securities Act. In relying upon these
exemptions, the Company took into account the limited number of only two
Pennsurance shareholders; the limitation of the Company's offering to these
shareholders; the information regarding the Company and the merger furnished to
the Pennsurance shareholders; the representation of Pennsurance and the two
Pennsurance shareholders by legal counsel in connection with the transaction;
and the representations and warranties made by Pennsurance and the two
shareholders to the Company in connection with the transaction.
Quarterly Stock Repurchases
---------------------------
The following table provides information on repurchases by National
Penn of its common stock in each month of the quarter ended September 30, 2004:
Total Number of Maximum Number
Shares Purchased as Of Shares that may
Part of Publicly yet be Purchased
Total Number of Average Price Paid Announced Plan Under the Plans
Period Shares Purchased Per Share or Programs or Programs
- ------ ---------------- --------- ----------- -----------
July 1, 2004
Through
July 31, 2004 4,063 $22.42 4,063 692,694
August 1, 2004
Through
August 31, 2004 13,000 $22.95 13,000 679,694
September 1, 2004
Through
September 30. 2004 10,563 $24.93 10,563 669,131
35
1. Transactions are reported as of settlement dates.
2. National Penn's current stock repurchase program was approved
by its Board of Directors and announced on September 24, 2003.
3. The number of shares approved for repurchase under National
Penn's current stock repurchase program is 1,250,000 (as
adjusted for the five-for-four stock split on September 30,
2004)
4. National Penn's current stock repurchase program does not have
an expiration date.
5. No National Penn stock repurchase plan or program expired
during the period covered by the table.
6. National Penn has no stock repurchase plan or program that it
has determined to terminate prior to expiration or under which
it does not intend to make further purchases.
Item 3. Defaults Upon Senior Securities.
- ------- --------------------------------
None.
Item 4. Submission of Matters to a Vote of Security Holders.
- ------- ----------------------------------------------------
Not applicable.
Item 5. Other Information.
- ------- ------------------
Stock Split
-----------
On August 25, 2004, the Company's Board of Directors declared a
five-for-four stock split of the Company's common stock distributable to
shareholders of record on September 10, 2004, and which was distributed on
September 30, 2004.
Cash Dividend
-------------
On October 27, 2004, the Board of Directors of National Penn declared a
cash dividend of $.20 per share payable on November 17, 2004 to shareholders of
record as of November 5, 2004.
Wealth Management Reorganization
--------------------------------
National Penn is in the process of consolidating its various wealth
management subsidiaries, Investors Trust Company, FirstService Capital, Inc. and
Penn Securities, Inc., into a single entity focused on the wealth management
business. It is anticipated that this will be completed in first quarter 2005.
Item 6. Exhibits.
- ------- ---------
10.1 Amendment No. 3 to National Penn Bancshares, Inc. Pension Plan
(Amended and Restated Effective January 1, 2001).
10.2 Amendment No. 4 to National Penn Bancshares, Inc. Pension Plan
(Amended and Restated Effective January 1, 2001).
10.3 Consulting Agreement dated as of December 17, 2003 among
National Penn Bancshares, Inc., National Penn Bank and George
C. Mason.
31.1 Certification of Chairman and Chief Executive Officer of
National Penn Bancshares, Inc., pursuant to Commission Rule
13a-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002.
36
31.2 Certification of Treasurer and Chief Financial Officer of
National Penn Bancshares, Inc., pursuant to Commission Rule
13a-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chairman and Chief Executive Officer of
National Penn Bancshares, Inc., pursuant to Commission Rule
13a-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002. (Furnished, not
filed.)
32.2 Certification of Treasurer and Chief Financial Officer of
National Penn Bancshares, Inc., pursuant to Commission Rule
13a-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002. (Furnished, not
filed.)
37
SIGNATURES
----------
Pursuant to the requirements of Section 13 of the Securities Exchange
Act of 1934, the Registrant has caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
NATIONAL PENN BANCSHARES, INC.
Dated: November 4, 2004 By /s/ Wayne R. Weidner
----------------------------------------
Name: Wayne R. Weidner
Title: Chairman and Chief Executive Officer
Dated: November 4, 2004 By /s/ Gary L. Rhoads
----------------------------------------
Name: Gary L. Rhoads
Title: Treasurer and Chief Financial Officer
38