Enterprise Financial Services Corp. — Q1 2012 Form 10-Q
Business and period. Enterprise Financial Services Corp. is a financial holding company providing banking and wealth-management services primarily in the St. Louis, Kansas City and Phoenix markets. This unaudited report covers the three months ended March 31, 2012; comparisons are to Q1 2011 unless otherwise noted. Dollar amounts below are in millions unless specified.
Financial performance and position
- Profit and revenue: Net income was $6.2 million, up from $4.1 million; net income available to common shareholders was $5.5 million. Basic and diluted EPS were $0.31, versus $0.23. Net interest income was $30.6 million, up 35%; total noninterest income was $4.0 million, down 20%.
- Net interest and margins: Tax-equivalent net interest income increased to $31.0 million from $23.0 million. Tax-equivalent net interest margin was 4.33%, versus 3.58% in Q1 2011 and 4.35% in Q4 2011. Excluding covered loans and related effects, management reported a 3.45% margin.
- Expenses and earnings quality: Noninterest expense rose 19% to $21.4 million, mainly reflecting higher compensation, professional fees and intangible amortization. The efficiency ratio improved to 62% from 65%. A $3.0 million negative change in the FDIC loss-share receivable weighed on noninterest income.
- Cash flow: Operating activities provided $14.9 million; investing activities provided $124.4 million, including securities-sale proceeds; financing activities used $152.2 million. Cash and cash equivalents decreased $13.0 million to $175.2 million.
- Balance sheet and liquidity: Total assets were $3.25 billion, down from $3.38 billion at year-end 2011. Loans, net, were $2.15 billion. Deposits declined $87.2 million, or 3%, to $2.70 billion. Management cited $156.6 million of additional FHLB borrowing capacity, $430.5 million available from the Federal Reserve against pledged loans, and $35 million in correspondent-bank lines. Brokered CDs were $101.6 million, or 3.8% of deposits.
- Debt and capital: Balance-sheet borrowings comprised $85.1 million of subordinated debentures, $87.0 million of FHLB advances and $105.9 million of other borrowings. The company reported a 12.48% Tier 1 risk-based capital ratio, 13.85% total risk-based capital ratio and 8.75% leverage ratio; it said the company and bank met well-capitalized requirements. Tangible common equity to tangible assets was 5.41%, up from 4.99% at year-end.
Changes and credit quality
- Non-covered loans increased 1% from year-end to $1.92 billion; commercial and industrial loans grew 4%. Covered loans declined 10% to $269.2 million, primarily from payoffs and principal repayments.
- Nonperforming non-covered loans rose to $47.2 million from $41.6 million at year-end; they were 2.46% of non-covered loans. Nonperforming assets were $66.8 million, down from $72.5 million a year earlier. The allowance on non-covered loans was $37.6 million, or 1.96% of those loans, versus 2.00% at year-end.
- Non-covered net charge-offs were $2.1 million, an annualized 0.45% of average loans, versus $3.5 million and 0.81% in Q1 2011. Covered loans had a $2.3 million provision in the quarter; their allowance was $3.0 million.
- Other real estate totaled $45.4 million, down from $53.7 million at year-end. The company sold $13.4 million of properties and recognized a $1.2 million gain.
Outlook, risks and unusual items
- Management expected 6%–8% growth in non-covered portfolio loans in 2012, a net interest margin of 4% or more, non-covered loan-loss provision of approximately $13–$14 million, and non-covered net charge-offs of $15–$20 million. It expected noninterest expenses to average $20–$22 million per quarter and noted that FDIC-covered loan yields may remain volatile.
- Management anticipated further negative accretion on the FDIC loss-share receivable if expected losses continue to decline. In Q1, $45.4 million was reclassified from nonaccretable difference to accretable yield for purchased loans; this estimate affects future interest income.
- Controls and accounting: Management concluded disclosure controls were ineffective at March 31 because of a material weakness in internal control over financial reporting related to accounting for acquired loans. Remediation included new systems, additional reconciliations and staff, outside accounting support, and reversal of contractual interest related to acquired loans. Management warned that unremediated deficiencies could cause further material misstatements.
- Litigation: The company faces two lawsuits related to client investments in Distinctive Notes, including one seeking more than $25 million plus fees and potentially trebled damages, and a separate claim seeking approximately $0.8 million plus other damages. A securities class action filed April 10, 2012 alleges improper income recognition on FDIC loss-share loans; damages are unspecified. The company denies the allegations and said it could not reasonably estimate potential losses.
- Capital plan: The company targeted tangible common equity to tangible assets of at least 7% by the end of 2014, assuming no significant acquisitions. It intended to seek regulatory approval to redeem all or part of the $35 million of Treasury-held preferred stock by year-end 2012.
- Key risks identified include borrower and real-estate credit quality, local economic conditions, interest-rate changes, litigation outcomes, regulation, competition and the effectiveness of accounting-control remediation.
Important facts for investors to verify
- Progress and independent validation of remediation for the acquired-loan accounting material weakness, and whether any restatement or further adjustment is required.
- Developments in the securities class action and Distinctive Notes cases, including potential exposure and insurance or indemnification coverage.
- Trends in nonperforming loans, criticized credit grades, charge-offs and other real estate, particularly for construction and commercial real-estate exposures.
- Assumptions behind purchased-loan cash-flow remeasurement, the $45.4 million accretable-yield reclassification and continuing FDIC receivable adjustments.
- Deposit stability and funding costs, and whether loan growth, margin and credit-cost guidance are achieved.
- Regulatory approval and funding for the planned preferred-stock redemption, alongside progress toward the 2014 capital target.