ENTERPRISE FINANCIAL SERVICES CORP annual report, FY2017

Business context and reporting period

Enterprise Financial Services Corp is a financial holding company operating Enterprise Bank & Trust, a commercial bank and wealth manager serving primarily the St. Louis, Kansas City, and Phoenix markets. This Form 10-K covers the fiscal year ended December 31, 2017; quarterly figures below are unaudited. The financial statements received an unqualified audit opinion, and the auditor also reported effective internal control over financial reporting.

Financial performance and condition

• Growth and earnings: Net interest income rose 31%, principally from the JCB acquisition, organic loan growth, and higher loan yields. Noninterest income increased 18%, led by deposit service charges, card services, and wealth management. GAAP net income edged down despite growth, largely because of a $12.1 million deferred-tax-asset revaluation charge following U.S. tax reform. Management’s non-GAAP core net income was $59.9 million, or $2.58 diluted EPS, versus $41.2 million, or $2.03, in 2016; these measures exclude specified items and should not replace GAAP results.
• Costs and margins: Noninterest expense rose 34% to $115.1 million, reflecting JCB operating costs, merger expenses, and growth investment. Core net interest margin expanded 21 basis points to 3.72%, while reported margin increased four basis points. Management noted that funding-cost pressure could offset future margin benefits.
• Balance sheet and funding: Total assets were $5.29 billion, up 30%; portfolio loans were $4.07 billion, up 30%; and deposits were $4.16 billion, up 29%. Cash and cash equivalents were $153.3 million. Debt included $172.7 million of FHLB advances, $253.7 million of other borrowings, and $118.1 million of subordinated debentures and notes. The Bank was well capitalized; year-end consolidated ratios included 12.21% total risk-based capital, 8.88% common equity tier 1, and a 9.72% leverage ratio.
• Credit quality: Nonperforming assets were $16.2 million, or 0.31% of assets, versus $15.9 million, or 0.39%, a year earlier. Net charge-offs rose to $10.2 million from $1.4 million; the portfolio-loan provision increased to $10.8 million from $5.6 million. The allowance was 0.95% of portfolio loans, down from 1.20%. Potential problem loans declined to $59.4 million from $77.6 million.
• Cash flows and liquidity: Operating cash flow was $45.8 million; investing activities used $312.4 million and financing activities provided $221.2 million. The Bank reported additional borrowing availability of $484.7 million from the FHLB and $898.1 million from the Federal Reserve, plus $75 million in correspondent-bank lines. The parent company held $10.0 million cash and management said it expected this to cover projected needs for at least a year. Unused loan commitments were $1.30 billion and letters of credit were $73.8 million; these commitments are not equivalent to expected immediate cash outflows.

Material changes and unusual items

• On February 10, 2017, the Company completed its acquisition of Jefferson County Bancshares for approximately $171.0 million, including 3.3 million EFSC shares and $29.3 million cash. JCB added about $923.5 million in acquired assets and $765.2 million in deposits; the transaction generated $87.0 million goodwill. Results include JCB from the acquisition date, so year-over-year comparisons are affected by the partial-year consolidation.
• The Company repurchased approximately 430,000 shares for $16.6 million during 2017 and paid $10.2 million in common dividends. Shares issued for the acquisition and repurchases affected per-share comparisons.
• The fourth-quarter deferred tax revaluation reduced 2017 earnings by $12.1 million, or $0.52 per diluted share. The full-year effective tax rate was 44.3%; the filing estimates a 2018 rate of approximately 17%–19%.
• Unaudited fourth-quarter 2017 net income was $7.5 million, or $0.32 diluted EPS, versus $13.6 million, or $0.67, in fourth-quarter 2016. Fourth-quarter 2017 tax expense was $19.8 million and included the tax-law-related revaluation.

Outlook, commentary, and risks

• Management expected 2018 portfolio-loan growth of approximately 7%–9% and fee-income growth of 5%–7%. It anticipated expense growth equal to 35%–45% of projected revenue growth, with modest efficiency-ratio improvement, and expected to maintain core net interest margin while recognizing possible funding-cost pressure.
• Interest-rate sensitivity modeling indicated estimated next-12-month net interest income increases of 1.4%, 2.7%, and 3.9% under parallel rate increases of 100, 200, and 300 basis points, respectively, and a 5.9% decrease under a 100-basis-point decline. Actual results may differ from these modeled scenarios.
• Key risks include commercial and real-estate credit exposure; higher charge-offs and allowance-estimation uncertainty; geographic concentration; deposit competition and funding costs; rate changes; integration and execution of acquisitions; and operational, cybersecurity, vendor, regulatory, and litigation risks. The filing also describes potential indemnification obligations tied to New Markets Tax Credit transactions. Management stated that no pending or threatened legal proceeding was expected to have a material adverse effect.

Important facts for investors to verify

• How much of loan, deposit, revenue, and expense growth reflects JCB versus organic growth, and whether expected integration benefits are being realized.
• Whether higher 2017 charge-offs, the lower allowance-to-loan ratio, and concentrated or potential-problem credits signal a change in underlying credit risk.
• Whether deposit costs rise faster than loan yields and affect net interest margin, liquidity, or reliance on wholesale funding.
• The final tax effects of the Tax Act and the realization of the projected 2018 effective tax rate.
• Capital and liquidity headroom after considering large unfunded commitments, debt obligations, acquisition integration, and regulatory restrictions on subsidiary dividends.