ENTERPRISE FINANCIAL SERVICES CORP quarterly report, Q2 FY2012

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Enterprise Financial Services Corp — Q2 2012 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2012. Enterprise is a financial holding company providing banking and wealth-management services in the St. Louis, Kansas City and Phoenix markets. Figures below are in U.S. dollars; “million” and “billion” are used for readability.

Financial performance and condition

  • Q2 earnings: Net income was $8.8 million, versus $8.3 million a year earlier. Net income available to common shareholders was $8.1 million; diluted EPS was $0.44, versus $0.43.
  • First-half earnings: Net income was $15.0 million, versus $12.4 million. Diluted EPS was $0.75, versus $0.70.
  • Net interest income and margin: Q2 net interest income was $34.1 million, up from $31.0 million. Tax-equivalent net interest margin was 4.81%, versus 4.75% in Q2 2011 and 4.33% in Q1 2012. First-half tax-equivalent net interest income was $65.4 million, up 20%; margin was 4.57%, versus 4.17%.
  • Noninterest income and expenses: Q2 noninterest income was $0.8 million, down from $4.2 million, chiefly reflecting a $5.7 million negative change in the FDIC loss-share receivable. Q2 noninterest expense rose 19% to $21.4 million. The efficiency ratio increased to 61.2% from 51.2%.
  • Credit costs and asset quality: Q2 provision was $0.3 million in total, including $75,000 for non-covered loans; first-half provision was $4.3 million. Non-covered net charge-offs were $1.4 million in Q2 versus $5.0 million a year earlier. Nonperforming non-covered loans were $40.6 million, or 2.08% of loans, versus $43.1 million and 2.36% a year earlier. The non-covered allowance was $36.3 million, equal to 1.86% of loans and 90% of nonperforming loans.
  • Balance sheet: Total assets were $3.18 billion, down from $3.38 billion at December 31, 2011. Net portfolio loans were $2.15 billion; non-covered loans grew 3% from year-end, while FDIC-covered loans declined to $242.5 million from $300.6 million. Deposits were $2.60 billion, down 7% from year-end. Shareholders’ equity increased to $255.9 million from $239.6 million.
  • Debt and liquidity: Subordinated debentures were $85.1 million, FHLB advances $90.5 million, and other borrowings $132.5 million. Cash and cash equivalents fell to $76.0 million from $188.1 million at year-end. First-half operating cash flow was $26.4 million, investing cash flow was positive $84.4 million, and financing cash flow was negative $222.9 million. Management cited additional FHLB, Federal Reserve and correspondent-bank borrowing capacity.
  • Capital: The company reported a 12.51% Tier 1 risk-based capital ratio, 13.88% total risk-based ratio, and 9.17% leverage ratio. Tangible common equity to tangible assets was 5.84%, versus 4.99% at year-end.

Material changes versus comparable periods

  • First-half net income and net interest income increased year over year, supported by loan growth, the FNB acquisition’s contribution and lower funding costs.
  • Q2 noninterest income declined sharply because lower expected losses on FDIC-covered assets required a reduction in the FDIC loss-share receivable. Management expected a further $5 million–$7 million of negative accretion for the remainder of 2012, absent other remeasurement changes.
  • Noninterest expense increased, particularly compensation and other operating costs, including acquisition-related costs and long-term incentive expense.
  • Problem assets improved overall: nonperforming loans and other real estate declined from year-end, and Q2 non-covered loan charge-offs were lower than in Q2 2011. However, covered loans past due 90 days or more totaled $39.9 million at quarter-end.
  • Deposits declined from year-end as the company reduced certificate-of-deposit balances through lower-cost pricing; core deposits remained 96% of total deposits.

Outlook, risks and unusual items

  • Management outlook: Expects 6%–8% full-year growth in non-covered portfolio loans; net interest margin of at least 4% for 2012; non-covered loan-loss provision of approximately $8 million–$10 million; and quarterly noninterest expense of $20 million–$22 million. Management expected nonperforming assets to decline by year-end and estimated full-year non-covered net charge-offs of $10 million–$15 million.
  • Capital plan: Targets tangible common equity to tangible assets of at least 7% by the end of 2014. Management planned to seek regulatory approval in August 2012 to redeem all or part of the approximately $35 million of Treasury-held preferred stock by year-end. Proposed federal capital rules could require additional capital, constrain dividends or share repurchases, and phase out trust-preferred securities’ Tier 1 capital treatment.
  • Legal contingencies: The company is defending two lawsuits related to Distinctive Notes; plaintiffs seek more than $25 million in one case and approximately $800,000 plus other damages in the other. A separate securities class action alleges improper accounting for FDIC-covered loans and seeks unspecified damages. The company says it cannot reasonably estimate possible losses for these proceedings and intends to defend them.
  • Financial reporting controls: Management reported that disclosure controls were effective and believed it had remediated a previously identified material weakness involving accounting for acquired, credit-impaired loans. Management cautioned that remediation does not guarantee similar weaknesses will not recur.
  • Other risks and unusual items: Results are sensitive to local economic and real-estate conditions, credit quality, interest-rate movements, FDIC loss-share estimates, and litigation outcomes. Q2 covered-loan yield was unusually high at 20.15%, primarily because cash flows from loan payoffs exceeded expectations; management expected covered-loan yields to remain volatile.

Important facts for investors to verify

  1. Whether the expected FDIC loss-share receivable reductions and covered-loan cash-flow remeasurements materially affect future earnings.
  2. Whether loan growth, problem-asset resolution, charge-offs and the allowance remain consistent with management’s outlook.
  3. Whether deposit outflows and the sharp reduction in cash are offset by stable core funding and available borrowing capacity.
  4. Whether the planned Treasury preferred-stock redemption receives regulatory approval and how proposed capital rules affect capital targets, dividends and trust-preferred securities.
  5. Developments in the Distinctive Notes and securities litigation, including any change in the company’s ability to estimate potential losses.
  6. Whether the acquired-loan accounting control remediation proves effective in subsequent periods.