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EFSC > SEC Filings for EFSC > Form 10-K on 15-Mar-2013All Recent SEC Filings

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Form 10-K for ENTERPRISE FINANCIAL SERVICES CORP


15-Mar-2013

Annual Report


ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction
The objective of this section is to provide an overview of the results of operations and financial condition of the Company for the three years ended December 31, 2012. It should be read in conjunction with the Consolidated Financial Statements, Notes and other financial data presented elsewhere in this report, particularly the information regarding the Company's business operations described in Item 1.

Executive Summary
This overview of management's discussion and analysis highlights selected information in this document and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting estimates, you should carefully read this entire document.

2012 Operating Results
For 2012, we reported net income of $28.3 million compared to net income of $25.4 million in 2011. After deducting preferred stock dividends, net income available to common shareholders was $25.1 million, or $1.37 per diluted share, compared to net income available to common shareholders of $22.9 million, or $1.34 per diluted share in 2011.

Below are highlights of our Banking and Wealth Management segments. For more information on our segments, see Item 8, Note 21 - Segment Reporting.

Banking Segment
Loans - Portfolio loans totaled $2.3 billion at December 31, 2012, including $201.1 million of loans covered under FDIC shared loss agreements ("Covered loans"). Portfolio loans excluding Covered loans ("Noncovered loans") increased $209.0 million , or 11%, from December 31, 2011. Commercial & industrial loans increased $199.7 million, or 26% , Consumer loans increased $5.9 million or 53%, Construction and Residential real estate decreased $13.3 million or 5%, and Commercial Real Estate decreased $17.8 million or 2%.

Covered loans decreased $99.5 million, or 33%, in 2012, due to loans that paid off and principal paydowns. Based on the most recent remeasurement of expected cash flows, the Company expects the average balance of Covered loans to be approximately $163 million, $118 million, and $60 million in 2013, 2014, and 2015, respectively.
See Note 6 - Portfolio Loans not covered by loss share and Note 7 - Portfolio Loans covered by loss share for more information.

                                                           December 31,
(in thousands)                                       2012                 2011
Commercial and industrial                       962,884     42 %     763,202     35 %
Commercial real estate - Investor Owned         486,467     21 %     477,154     22 %
Commercial real estate - Owner Occupied         333,242     14 %     334,416     15 %
Construction and land development               160,911      7 %     140,147      6 %
Residential real estate                         145,558      6 %     171,034      8 %
Consumer & other                                 16,977      1 %      11,121      1 %
Portfolio loans covered under FDIC loss share   201,118      9 %     300,610     13 %
Total loan portfolio                          2,307,157    100 %   2,197,684    100 %

Deposits - Total deposits at December 31, 2012 were $2.7 billion, a decrease of $132.5 million, or 5%, from December 31, 2011 as the Company is forcing a decline in certificates of deposit through lower cost pricing.


Core deposits, which exclude brokered certificates of deposit and include reciprocal CDARS deposits, decreased $100.4 million, or 4%, for 2012 as compared to 2011. Interest bearing transaction accounts decreased $3.4 million, or less than 1%, non CDARS certificates of deposit decreased $196.0 million , or 29%, while noninterest bearing demand deposit accounts increased $101.3 million or 17%. Core deposits represented 96% of total deposits at December 31, 2012, compared to 95% at December 31, 2011.
Reciprocal CDARS certificates were $5.4 million at December 31, 2012 compared to $14.5 million at December 31, 2011. Brokered certificates of deposit were $94.5 million at December 31, 2012 compared to $126.6 million at December 31, 2011.
Asset quality - Nonperforming loans, including troubled debt restructurings were $38.7 million at December 31, 2012, compared to $41.6 million at December 31, 2011. Nonperforming loans represented 1.84% of total loans excluding Covered loans at December 31, 2012 versus 2.19% at December 31, 2011. Excluding non-accrual loans and Covered loans, portfolio loans that were 30-89 days delinquent at December 31, 2012 remained at very low levels, representing 0.10% of the portfolio compared to 0.36% at December 31, 2011.

Provision for loan losses not covered under FDIC loss share was $8.8 million in 2012, compared to $13.3 million in 2011. The decrease in the provision for loan losses in 2012 was due to lower levels of loan risk rating downgrades, and less movement of loans to non-performing assets in 2012 as compared to 2011. See Note
6 - Portfolio Loans Not Covered by Loss Share and Provision for Loan Losses and Allowance for Loan Losses in this section for more information.
Interest rate margin - The net interest rate margin (fully tax equivalent) was 4.94% for 2012, compared to 4.12% for 2011. See Net Interest Income in this section for more information.

Covered loans and other assets covered under FDIC shared loss agreements - The following table illustrates the net revenue contribution of covered assets for the most recent 3 fiscal years. This presentation excludes the cost of funding the related assets and the operating expenses to service the assets.

                                                            For the Years ended
(in thousands)                        December 31, 2012     December 31, 2011      December 31, 2010
Accretion income                     $          29,673     $          18,494     $             6,597
Accelerated cash flows                          25,230                14,294                   4,097
Other                                              758                   138                     230
Total interest income                           55,661                32,926                  10,924
Provision for loan losses                      (14,033 )              (2,803 )                     -
Gain on sale of other real estate                2,081                   992                     184
Change in FDIC loss share receivable           (14,869 )              (3,494 )                    99
Change in FDIC clawback liability                 (575 )                   -                       -
Pre-tax net revenue                  $          28,265     $          27,621     $            11,207

Wealth Management Segment

Fee income from the Wealth Management segment includes Wealth Management revenue and income from state tax credit brokerage activities. Wealth Management revenue was $7.3 million in 2012, an increase of $459,000, or 7% over 2011. See Noninterest Income in this section for more information.


RESULTS OF CONTINUING OPERATIONS ANALYSIS

Net Interest Income
Comparison of 2012 and 2011
Net interest income is the primary source of the Company's revenue. Net interest income is the difference between interest income on earning assets, such as loans and securities, and the interest expense on interest-bearing deposits and other borrowings used to fund interest earning and other assets. The amount of net interest income is affected by changes in interest rates and by the amount and composition of interest-earning assets and interest-bearing liabilities, such as the mix of fixed vs. variable rate loans. When and how often loans and deposits mature and re-price also impacts net interest income.

Net interest spread and net interest rate margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest-earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest rate margin is expressed as the percentage of net interest income to average interest-earning assets. The net interest rate margin exceeds the interest rate spread because noninterest-bearing sources of funds (net free funds), principally demand deposits and shareholders' equity, also support earning assets.

Net interest income (on a tax equivalent basis) was $143.8 million for 2012 compared to $114.0 million for 2011, an increase of $29.8 million, or 26%. Total interest income increased $22.8 million and total interest expense decreased $7.0 million.

Average interest-earning assets increased $143.3 million, or 5%, to $2.9 billion for the year ended December 31, 2012 from $2.8 billion for the year ended December 31, 2011. Average loans increased $144.9 million, or 7%, to $2.2 billion for the year ended December 31, 2012 from $2.1 billion for the year ended December 31, 2011. Average securities and short-term investments remained relatively flat decreasing only $1.6 million, to $712.7 million from 2011 as core deposit growth was consistent with loan demand. Interest income on earning assets increased $10.9 million due to higher volumes and $11.9 million due primarily to higher yields on covered loans during 2012 for a total increase of $22.8 million in interest income from 2011.

For the year ended December 31, 2012, average interest-bearing liabilities decreased $36.4 million, or 2%, to $2.3 billion compared to $2.4 billion for the year ended December 31, 2011. The decrease in average interest-bearing liabilities resulted from a $54.5 million decrease in average interest-bearing deposits. This decrease resulted from a decrease of $171.8 million in certificates of deposits, which was partially offset by a $72.4 million increase in average money market accounts and savings accounts, and an increase of $44.9 million in interest-bearing transaction accounts. The significant decrease in certificates of deposits was due to an initiative by the Company to lower its cost of funds. For the year ended December 31, 2012, interest expense on interest-bearing liabilities decreased $5.4 million due to declining rates and $1.6 million due to the impact of lower volumes, for a total decrease of $7.0 million versus the same period in 2011.

For the year ended December 31, 2012, the tax-equivalent net interest rate margin was 4.94%, compared to 4.12% in the same period of 2011. The increase in the margin was primarily due to better earning asset mix and lower funding costs.

Comparison of 2011 and 2010
Net interest income (on a tax-equivalent basis) increased $29.0 million, or 34%, from $85.0 million for 2010 to $114.0 million for 2011. Total interest income increased $26.7 million while total interest expense decreased $2.3 million.

Average interest-earning assets were $2.8 billion in 2011, an increase of $505.4 million, or 22%, from 2010. Loans increased by $198.7 million, or 11%, to $2.1 billion. Securities and short-term investments increased $306.7 million, or 75% to $714.3 million from 2010. Interest income increased $30.9 million due to volume and decreased by $4.2 million due to the impact of rates, for a net increase of $26.7 million versus 2010.


Average interest-bearing liabilities increased $419.7 million, or 21%, to $2.4 billion compared to $2.0 billion for 2010. The increase in interest-bearing liabilities primarily resulted from a $397.8 million increase in interest-bearing deposits. For 2011, interest expense on interest-bearing liabilities increased $4.3 million due to volume while the impact of declining rates decreased interest expense on interest-bearing liabilities by $6.5 million, for a net decrease of $2.3 million versus 2010. See Liquidity and Capital Resources in this section for more information.

For the year ended December 31, 2011, the tax-equivalent net interest rate margin was 4.12% compared to 3.76% for 2010. The net interest margin was favorably impacted by lower deposit costs and the net interest income generated by the loans acquired in the Legacy and FNBO acquisitions. For 2011, the net interest rate margin, less the FDIC loss share loans, related nonearning assets and acquired deposits, was 3.42% compared to 3.53% for 2010.


Average Balance Sheet
The following table presents, for the periods indicated, certain information
related to our average interest-earning assets and interest-bearing liabilities,
as well as, the corresponding interest rates earned and paid, all on a tax
equivalent basis.

                                                                                                For the years ended December 31,
                                                        2012                                                  2011                                                  2010
                                                                            Average                                               Average                                              Average
                                                           Interest         Yield/                               Interest         Yield/                              Interest         Yield/
(in thousands)                    Average Balance       Income/Expense       Rate       Average Balance       Income/Expense       Rate       Average Balance      Income/Expense       Rate
Assets
Interest-earning assets:
Taxable loans (1)                $      1,918,567     $         96,694        5.04 %   $      1,786,601     $         95,520        5.35 %   $      1,751,459     $        95,798        5.47 %
Tax-exempt loans (2)                       34,860                2,580        7.40               32,935                2,542        7.72               30,564               2,621        8.58
Covered loans (3)                         243,359               55,661       22.87              232,363               32,926       14.17               71,152              10,924       15.35
                     Total loans        2,196,786              154,935        7.05            2,051,899              130,988        6.38            1,853,175             109,343        5.90
Taxable investments in debt and
equity securities                         568,264               10,192        1.79              473,620               11,510        2.43              276,493               7,458        2.70
Non-taxable investments in debt
and equity securities (2)                  34,432                1,577        4.58               22,434                1,086        4.84                5,132                 245        4.77
Short-term investments                    110,050                  257        0.23              218,287                  562        0.26              126,058                 380        0.30
 Total securities and short-term
                     investments          712,746               12,026        1.69              714,341               13,158        1.84              407,683               8,083        1.98
   Total interest-earning assets        2,909,532              166,961        5.74            2,766,240              144,146        5.21            2,260,858             117,426        5.19
Noninterest-earning assets:
Cash and due from banks                    16,311                                                15,801                                                11,800
Other assets                              345,325                                               357,993                                               227,038
Allowance for loan losses                 (40,240 )                                             (43,887 )                                             (45,673 )
                    Total assets $      3,230,928                                      $      3,096,147                                      $      2,454,023

Liabilities and Shareholders'
Equity
Interest-bearing liabilities:
Interest-bearing transaction
accounts                         $        257,193     $            721        0.28 %   $        212,257     $            811        0.38 %   $        190,275     $           847        0.45 %
Money market accounts                   1,026,444                4,679        0.46              997,415                7,987        0.80              701,360               6,245        0.89
Savings                                    70,470                  275        0.39               27,106                  112        0.41               10,022                  35        0.35
Certificates of deposit                   675,224                9,731        1.44              847,057               12,748        1.50              784,369              15,740        2.01
 Total interest-bearing deposits        2,029,331               15,406        0.76            2,083,835               21,658        1.04            1,686,026              22,867        1.36
Subordinated debentures                    85,081                4,082        4.80               85,081                4,515        5.31               85,081               4,954        5.82
Borrowed funds                            226,200                3,679        1.63              208,128                3,982        1.91              186,283               4,590        2.46
          Total interest-bearing
                     liabilities        2,340,612               23,167        0.99            2,377,044               30,155        1.27            1,957,390              32,411        1.66
Noninterest bearing liabilities:
Demand deposits                           627,197                                               494,609                                               305,887
Other liabilities                          10,655                                                10,844                                                12,115
               Total liabilities        2,978,464                                             2,882,497                                             2,275,392
Shareholders' equity                      252,464                                               213,650                                               178,631
             Total liabilities &
            shareholders' equity $      3,230,928                                      $      3,096,147                                      $      2,454,023
             Net interest income                      $        143,794                                      $        113,991                                      $        85,015
             Net interest spread                                              4.75 %                                                3.94 %                                               3.53 %
    Net interest rate margin (4)                                              4.94                                                  4.12                                                 3.76

(1) Average balances include non-accrual loans. The income on such loans is included in interest but is recognized only upon receipt. Loan fees, net of amortization of deferred loan origination fees and costs, included in interest income are approximately $1.5 million, $1.0 million, and $1.4 million for the years ended December 31, 2012, 2011, and 2010 respectively.


(2) Non-taxable income is presented on a fully tax-equivalent basis using a 36% tax rate. The tax-equivalent adjustments were $1.5 million, $1.3 million, and $1.0 million for the years ended December 31, 2012, 2011, and 2010 respectively.

(3) Covered loans are loans covered under FDIC shared-loss agreements.

(4) Net interest income divided by average total interest-earning assets.

Rate/Volume
The following table sets forth, on a tax-equivalent basis for the periods
indicated, a summary of the changes in interest income and interest expense
resulting from changes in yield/rates and volume.

                                     2012 compared to 2011                    2011 compared to 2010
                                  Increase (decrease) due to                Increase (decrease) due to
(in thousands)                Volume(1)     Rate(2)        Net         Volume(1)       Rate(2)        Net
Interest earned on:
Taxable loans                $   6,828     $ (5,654 )   $  1,174     $      1,902     $ (2,180 )   $   (278 )
Tax-exempt loans (3)               145         (107 )         38              194         (273 )        (79 )
Covered loans                    1,626       21,109       22,735           22,907         (905 )     22,002
Taxable investments in debt
and equity securities            2,039       (3,357 )     (1,318 )          4,855         (803 )      4,052
Non-taxable investments in
debt and equity securities
(3)                                553          (62 )        491              838            3          841
Short-term investments            (257 )        (48 )       (305 )            244          (62 )        182
Total interest-earning
assets                       $  10,934     $ 11,881     $ 22,815     $     30,940     $ (4,220 )   $ 26,720

Interest paid on:
Interest-bearing transaction
accounts                     $     152     $   (242 )   $    (90 )   $         92     $   (128 )   $    (36 )
Money market accounts              226       (3,534 )     (3,308 )          2,422         (680 )      1,742
Savings                            169           (6 )        163               70            7           77
Certificates of deposit         (2,495 )       (522 )     (3,017 )          1,182       (4,174 )     (2,992 )
Subordinated debentures              -         (433 )       (433 )              -         (439 )       (439 )
Borrowed funds                     327         (630 )       (303 )            497       (1,105 )       (608 )
Total interest-bearing
liabilities                     (1,621 )     (5,367 )     (6,988 )          4,263       (6,519 )     (2,256 )
Net interest income          $  12,555     $ 17,248     $ 29,803     $     26,677     $  2,299     $ 28,976

(1) Change in volume multiplied by yield/rate of prior period.

(2) Change in yield/rate multiplied by volume of prior period.

(3) Nontaxable income is presented on a fully-tax equivalent basis using a 36% tax rate.

NOTE: The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the absolute dollar amounts of the change in each.

Provision for loan losses.
The provision for loan losses not covered under FDIC loss share was $8.8 million for 2012 compared to $13.3 million for 2011 and $33.7 million for 2010. The lower loan loss provision for 2012 compared to 2011 and 2011 as compared to 2010 was due to lower levels of loan risk rating downgrades, and lower additions to non-performing loans during the year.


For Covered loans, the Company remeasures contractual and expected cash flows on a quarterly basis. When the remeasurement process results in an increase in expected losses, impairment is recorded through provision for loan losses. As a result of this impairment, the FDIC loss share receivable is increased to reflect anticipated future cash to be received from the FDIC. The amount of the increase is determined based on the specific loss share agreement, but is generally 80% of the losses. Changes in the FDIC loss share receivable are recorded in noninterest income. The provision for loan losses on Covered loans was $14.0 million for 2012 compared to $2.8 million in 2011.

See the sections below captioned Loans and Allowance for Loan Losses for more information on our loan portfolio and asset quality.

Noninterest Income
The following table presents a comparative summary of the major components of
noninterest income.

                                  Years ended December 31,
                                                                       Change 2012 over
(in thousands)               2012            2011           2010             2011           Change 2011 over 2010
 Wealth Management
revenue                  $     7,300     $    6,841     $    6,414     $        459       $               427
 Service charges on
deposit accounts               5,664          5,091          4,739              573                       352
 Other service charges
and fee income                 2,504          1,679          1,128              825                       551
 Sale of other real
estate                         2,225            862             79            1,363                       783
 State tax credit
activity, net                  2,207          3,645          2,250           (1,438 )                   1,395
 Sale of securities            1,156          1,450          1,987             (294 )                    (537 )
Change in FDIC loss
share receivable             (14,869 )       (3,494 )           99          (11,375 )                  (3,593 )
 Miscellaneous income          2,897          2,434          1,664              463                       770
Total noninterest income $     9,084     $   18,508     $   18,360     $     (9,424 )     $               148

Comparison of 2012 and 2011
Noninterest income decreased $9.4 million, or 51%, in 2012 compared to 2011. The decrease is primarily due to decreases in income related to changes in the FDIC loss share receivable partially offset by increased amounts across most other noninterest income accounts.
Wealth Management revenue - For the year ended December 31, 2012, Wealth Management revenue from the Trust division increased $459,000, or 7%, compared to 2011. The increase in Wealth Management revenue was primarily due to increased investment advisory revenue. Assets under administration were $1.8 billion at December 31, 2012, a 13% increase from December 31, 2011 due to market value increases and additional accounts from new and existing clients.

Service charges and other fee income - For the year ended December 31, 2012, service charges and other fee income increased $1.4 million compared to 2011 due to an increase in service charges on business accounts, debit card and credit card income, and overdraft fees, primarily due to the acquisition of FNBO.

Sale of other real estate - For the year ended December 31, 2012, we sold $48.8 million of other real estate for a gain of $2.2 million which included a gain of $144,000 from other real estate not covered by loss share agreements and a gain of $2.1 million from other real estate covered by loss share agreements. In 2011, we sold $13.1 million of other real estate for a net gain of $862,000.

State tax credit activity, net - For the year ended December 31, 2012, the Company recorded a gain of $2.2 million compared to a gain of $3.6 million in 2011. The decrease is due to the timing of client purchases of the state tax credits in 2012 as compared to 2011, as well as a reduction in the gain on the fair value of tax credits. For more information on the fair value treatment of the state tax credits, see Note 20 - Fair Value Measurements.


Sale of securities - During 2012, the Company realized approximately $110.9 million of proceeds on the sale of investment securities, generating a net gain of $1.2 million. This compared to 2011 amounts of approximately $84.5 million of proceeds, and a net gain of $1.5 million.

Change in FDIC loss share receivable - Income related to changes in the FDIC loss share receivable reduced noninterest income by $14.9 million in 2012 compared to $3.5 million in 2011. The decrease in income related to the FDIC . . .

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