ENTERPRISE FINANCIAL SERVICES CORP quarterly report, Q2 FY2014

Business context and reporting period

Enterprise Financial Services Corp is a financial holding company providing banking and wealth-management services in the St. Louis, Kansas City and Phoenix markets. This summary covers the unaudited quarter and six months ended June 30, 2014; balance-sheet comparisons are to December 31, 2013.

Financial performance and position

Q2 pretax income was $10.8 million and income tax expense was $3.7 million. Noninterest income was $3.4 million, including a $2.7 million reduction in the FDIC loss-share receivable; noninterest expense was $20.4 million. The efficiency ratio was 63.6% for the quarter and 62.5% year to date. The filing also reports a 4.04% Q2 net interest margin on its financial highlights, while its fully tax-equivalent table reports 4.03%.

At June 30, total assets were $3.18 billion, portfolio loans $2.25 billion, PCI loans $118.5 million, deposits $2.47 billion and shareholders’ equity $301.6 million. Compared with year-end, portfolio loans grew 5.3%, total loans grew 4.0%, deposits declined 2.7%, and equity increased 7.8%. Cash and cash equivalents fell 41.9% to $122.4 million. Subordinated debentures were $56.8 million; FHLB advances rose to $153.6 million from $50.0 million, while other borrowings declined.

For the first six months, operating cash flow was $5.0 million, investing cash flow was negative $82.6 million and financing cash flow was negative $10.6 million. Cash and cash equivalents decreased $88.1 million from the start of the year.

Material changes versus comparable periods

• Q2 net income fell about 35% year over year; six-month net income fell about 38%. Management attributed the decline principally to weaker net interest income and the absence of the prior-year portfolio-loan provision benefits, as well as lower PCI-loan revenue and fewer investment-security gains year to date.
• Net interest income declined about 14% in Q2 and 16% for the first six months. Management cited lower balances and accelerated cash flows from PCI loans, lower prepayment fees, and lower rates on new loans. Portfolio loan growth and lower funding costs partly offset these pressures.
• Core net interest margin, a non-GAAP measure excluding incremental PCI-loan accretion, was 3.39% in Q2 versus 3.56% a year earlier, and 3.42% for six months versus 3.55%.
• Portfolio loans increased $113.8 million from year-end, led by commercial and industrial lending; PCI loans decreased $22.0 million, primarily from paydowns and accelerated payoffs.
• Portfolio nonperforming loans were $19.3 million, or 0.86% of portfolio loans, versus $15.5 million and 0.71% at March 31, but below $25.9 million and 1.25% a year earlier. The portfolio-loan allowance was $28.4 million, or 1.26% of portfolio loans, equal to 147% of nonperforming loans. Net charge-offs were $0.8 million in Q2.
• Available-for-sale securities increased to $448.0 million. Other comprehensive income of $5.0 million in the first half moved accumulated other comprehensive income to positive $0.6 million from a $4.4 million loss at year-end.

Outlook, commentary, risks and unusual items

• Management expected noninterest expense to remain between $20 million and $22 million per quarter in 2014. It projected average PCI loans of $101 million for 2014 and $69 million for 2015, and warned that loan-yield pressure could further reduce core net interest margin through the remainder of 2014.
• Interest-rate simulation indicated a positive net-interest-income effect in a rising-rate environment: +2.5% for a 100-basis-point shock, +6.0% for +200 basis points and +9.4% for +300 basis points; a 100-basis-point decline indicated -0.9%.
• Management reported that the company and bank met regulatory capital requirements and the bank remained well capitalized. June 30 ratios included Tier 1 capital to risk-weighted assets of 12.38%, total capital of 13.63%, Tier 1 leverage of 10.38%, and tangible common equity to tangible assets of 8.49% (non-GAAP).
• Available liquidity included $180 million of additional FHLB borrowing capacity, $667 million from the Federal Reserve under pledged-loan arrangements, and $45 million of correspondent-bank federal-funds lines. The parent company held approximately $7.7 million of cash, which management believed sufficient for at least one year.
• The company recorded a $1.6 million liability for expected payments to the FDIC under two loss-share agreements, based on favorable projected cash flows; this estimate remains subject to quarterly remeasurement. Commitments to extend credit were $836.1 million and standby letters of credit were $47.3 million; these contractual amounts are not necessarily expected cash outflows.
• In March, the remaining $5.0 million of 9% trust preferred securities were converted into 287,852 common shares. The company also reported a $3.6 million term-loan prepayment to reduce its rate. State tax credits included $15.0 million carried at fair value using Level 3 inputs; unrealized securities losses were attributed primarily to interest-rate changes, and management found no securities other-than-temporarily impaired.
• Management identified credit and collateral valuation, local economic and real-estate conditions, interest-rate changes, competition, regulatory requirements and key-personnel retention as risks. It reported no material changes to the prior annual report’s risk factors and no pending or threatened legal proceedings expected to have a material adverse effect. The company was evaluating newly issued revenue-recognition guidance and had not determined its impact.

Important facts for investors to verify

• Whether portfolio-loan growth and credit performance can offset continuing pressure on loan yields, margins and PCI-loan income.
• Whether the Q2 increase in nonperforming loans from the linked quarter persists, particularly in commercial real estate and construction, and whether allowance coverage remains adequate.
• How deposit trends and increased FHLB advances affect funding costs, liquidity and the balance-sheet funding mix.
• The assumptions underlying PCI-loan cash-flow estimates, FDIC loss-share and clawback balances, and Level 3 state-tax-credit valuations.
• Whether quarterly expenses remain within management’s $20 million–$22 million range and whether the stated PCI-loan and margin outlook is achieved.