SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2004
For the transition period from to
Commission file number: 001-15373
ENTERPRISE FINANCIAL SERVICES CORP
(Exact Name of Registrant as Specified in its Charter)
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification Number)
Registrant’s telephone number, including area code: 314-725-5500
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities and Exchange Act of 1934). Yes x No ¨
Indicate the number of shares outstanding of each of the Registrant’s classes of common stock as of October 29, 2004:
Common Stock, $.01 par value 9,736,790 shares outstanding
ENTERPRISE FINANCIAL SERVICES CORP AND SUBSIDIARIES
TABLE OF CONTENTS
PART I -FINANCIAL INFORMATION
Item 1.
Consolidated Balance Sheets
At September 30, 2004 and December 31, 2003
Consolidated Statements of Operations
Three Months and Nine Months Ended September 30, 2004 and 2003
Consolidated Statements of Comprehensive Income
Consolidated Statements of Cash Flows
Nine Months Ended September 30, 2004 and 2003
Notes to Consolidated Financial Statements
Item 2.
Item 3.
Item 4.
PART II - OTHER INFORMATION
Signatures
Certifications
PART I -Item 1
(Unaudited)
At September 30,2004
(Audited)
At December 31,2003
Cash and due from banks
Federal funds sold
Interest-bearing deposits
Investments in debt and equity securities:
Available for sale, at estimated fair value
Held to maturity, at amortized cost (estimated fair value of $8,464 at September 30, 2004 and $9,923 at December 31, 2003)
Total investments in debt and equity securities
Loans held for sale
Loans, less unearned loan fees
Less allowance for loan losses
Loans, net
Other real estate owned
Fixed assets, net
Accrued interest receivable
Goodwill
Prepaid expenses and other assets
Total assets
Deposits:
Demand
Interest-bearing transaction accounts
Money market accounts
Savings
Certificates of deposit:
$100,000 and over
Other
Total deposits
Subordinated debentures
Federal Home Loan Bank advances
Notes payable and other borrowings
Accrued interest payable
Accounts payable and accrued expenses
Total liabilities
Shareholders’ equity:
Common stock, $.01 par value; authorized 20,000,000 shares; issued and outstanding 9,731,990 shares at September 30, 2004 and 9,618,482 shares at December 31, 2003
Additional paid-in capital
Retained earnings
Accumulated other comprehensive (loss) income
Total shareholders’ equity
Total liabilities and shareholders’ equity
See accompanying notes to consolidated financial statements.
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Consolidated Statements of Operations (unaudited)
Three months ended
September 30,
Nine months ended
Interest income:
Interest and fees on loans
Interest on debt and equity securities:
Taxable
Nontaxable
Interest on federal funds sold
Interest on interest-bearing deposits
Dividends on equity securities
Total interest income
Interest expense:
Federal Home Loan Bank borrowings
Other borrowings
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Noninterest income:
Service charges on deposit accounts
Wealth Management income
Other service charges and fee income
Gain on sale of branches
Gain on sale of mortgage loans
Gain on sale of securities
Total noninterest income
Noninterest expense:
Compensation
Payroll taxes and employee benefits
Occupancy
Furniture and equipment
Data processing
Total noninterest expense
Income before income tax expense
Income tax expense
Net income
Per share amounts:
Basic earnings per share
Basic weighted average common shares outstanding
Diluted earnings per share
Diluted weighted average common shares outstanding
2
Consolidated Statements of Comprehensive Income (unaudited)
Other comprehensive income (loss):
Unrealized gain (loss) on investment securities arising during the period, net of tax
Less reclassification adjustment for realized gain on sale of securities included in net income, net of tax
Unrealized gain (loss) on cash flow type derivative instruments arising during the period, net of tax
Total other comprehensive income (loss)
Total comprehensive income
3
Consolidated Statements of Cash Flows (unaudited)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Net amortization of debt and equity securities
Mortgage loans originated
Proceeds from mortgage loans sold
Noncash compensation expense attributed to stock option grants
(Increase) decrease in accrued interest receivable
Increase (decrease) in accrued interest payable
(Decrease) increase in accrued salaries payable
Other, net
Net cash provided by operating activities
Cash flows from investing activities:
Cash paid in sale of branches
Purchases of available for sale debt and equity securities
Proceeds from sale of available for sale debt securities
Redemption (purchase) of equity securities
Proceeds from maturities and principal paydowns on available for sale debt and equity securities
Proceeds from maturities and principal paydowns on held to maturity debt securities
Net increase in loans
Recoveries of loans previously charged off
Purchases of fixed assets
Net cash used in investing activities
Cash flows from financing activities:
Net increase (decrease) in non-interest bearing deposit accounts
Net increase in interest bearing deposit accounts
Proceeds from issuance of subordinated debentures
Maturities and paydowns of Federal Home Loan Bank advances
Proceeds from borrowings of Federal Home Loan Bank advances
Decrease in short-term borrowings
Proceeds from notes payable
Paydowns of notes payable
Decrease in other borrowings
Cash dividends paid
Proceeds from the exercise of common stock options
Net cash provided by financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest
Income taxes
Noncash transactions:
Transfer to to other real estate owned in settlement of loans
Write off of goodwill associated with sale of branches
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(1) Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. They do not include all information and footnotes required by U.S. generally accepted accounting principles for complete consolidated financial statements. The accompanying consolidated financial statements of Enterprise Financial Services Corp and subsidiaries (the “Company”) are unaudited and should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. Enterprise Financial Services Corp (the “Company”) is a financial holding company that provides a full range of banking services to individual and corporate customers located in the St. Louis and Kansas City Metropolitan markets through its subsidiary, Enterprise Bank & Trust (the “Bank”). In the opinion of management, all adjustments consisting of normal recurring accruals considered necessary for a fair presentation of the results of operations for the interim periods presented herein have been included. Operating results for the three and nine month periods ended September 30, 2004 are not necessarily indicative of the results that may be expected for any other interim period or for the year ending December 31, 2004. The consolidated financial statements include all accounts of the Company. All significant intercompany accounts and transactions have been eliminated.
Certain amounts in the consolidated financial statements for the year ended December 31, 2003 have been reclassified to conform to the 2004 presentation. Such reclassifications had no effect on previously reported consolidated net income or shareholders’ equity.
(2) Earnings Per Share
Basic earnings per share data is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share gives effect to the increase in the average shares outstanding which would have resulted from the exercise of dilutive stock options and warrants. The components of basic and diluted earnings per share for the three and nine months ended September 30, 2004 and 2003 are as follows:
Basic
Net income attributable to common shareholders’ equity
Weighted average common shares outstanding
Diluted
Effect of dilutive stock options
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(3) Subordinated Debentures
On May 11, 2004, EFSC Capital Trust II (“EFSC Trust”), a newly-formed Delaware business trust and subsidiary of the Company, issued 5,000 floating rate Trust Preferred Securities (“Preferred Securities”) at $1,000 per share to a Trust Preferred Securities Pool. The floating rate is equal to the three month LIBOR rate plus 2.65%, and reprices quarterly. The Preferred Securities are fully irrevocably and unconditionally guaranteed on a subordinated basis by the Company. The proceeds of the Preferred Securities were invested in junior subordinated debentures of the Company. The net proceeds to the Company from the sale of the junior subordinated debentures, after deducting underwriting commissions and estimated offering expenses, were approximately $4.97 million. Distributions on the Preferred Securities will be payable quarterly on March 17, June 17, September 17 and December 17 of each year that the Preferred Securities are outstanding, commencing September 17, 2004. The Preferred Securities are classified as subordinated debentures and the distributions are recorded as interest expense in the Company’s consolidated financial statements.
A portion of the proceeds from the offering were used to invest $3 million in the form of additional capital in the Bank with the remaining funds available for operating expenses at the holding company level.
(4) Segment Disclosure
Management segregates the Company into three distinct businesses for evaluation purposes. The three segments are Banking, Wealth Management, and Corporate and Intercompany. The segments are evaluated separately on their individual performance, as well as, their contribution to the Company as a whole.
The majority of the Company’s assets and income result from the Banking segment. The Bank consists of three banking branches and an operations center in the St. Louis region and two banking branches in the Kansas City region. The products and services offered by the banking branches include a broad range of commercial and personal banking services, including certificates of deposit, individual retirement accounts, checking and other demand deposit accounts, interest checking accounts, savings accounts and money market accounts. Loans include commercial, financial, real estate construction and development, commercial and residential real estate, consumer and installment loans. Other financial services include mortgage banking, debit and credit cards, automatic teller machines, internet account access, safe deposit boxes, and treasury management services.
Wealth Management provides fee-based personal and corporate financial consulting and trust services. Personal financial consulting includes estate planning, investment management, and retirement planning. Corporate consulting services are focused in the areas of retirement plans, management compensation, strategic planning and management succession issues. The Wealth Management segment also provides life, annuity, disability income, and long-term care products and mutual funds.
The Corporate and Intercompany segment includes the holding company and subordinated debentures. The Company incurs general corporate expenses and owns Enterprise Bank & Trust.
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The following are the financial results and balance sheet information for the Company’s operating segments as of September 30, 2004 and December 31, 2003 and for the three and nine month periods ended September 30, 2004 and 2003 (unaudited):
Balance Sheet Information:
Corporateand
Intercompany
September 30, 2004
Deposits
Borrowings
December 31, 2003
Income statement information:
Three months ended September 30, 2004
Noninterest income
Noninterest expense
Income (loss) before income tax expense
Income tax expense (benefit)
Net income (loss)
Three months ended September 30, 2003
Nine months ended September 30, 2004
Nine months ended September 30, 2003
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(5) Derivative Instruments and Hedging Activities
The Company utilizes interest rate swap derivatives as one method to manage some of its interest rate risk from recorded financial assets and liabilities. These derivatives are utilized when they can be demonstrated to effectively hedge a designated asset or liability and such asset or liability exposes the Bank to interest rate risk.
The Bank accounts for its derivatives under Statement of Financial Accounting Standards (SFAS) No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities and SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. These Standards require recognition of all derivatives as either assets or liabilities in the balance sheet and require measurement of those instruments at fair value through adjustments to either other comprehensive income, current earnings, or both, as appropriate.
The decision to enter into an interest rate swap is made after considering the asset/liability position of the Bank, the desired asset/liability sensitivity and interest rate levels. Prior to entering into a hedge transaction, the Bank formally documents the relationship between hedging instruments and this hedged items, as well as the risk management objective for undertaking the various hedge transactions.
The following is a summary of the Company’s accounting policies for derivative instruments and its activities under SFAS No. 149 and SFAS No. 133.
Cash Flow Hedges – The Bank enters into interest rate swap agreements to convert floating-rate loan assets to fixed rates. The swap agreements provide for the Bank to pay a variable rate of interest equivalent to the prime rate and to receive a fixed rate of interest. Under the swap agreements the Bank is to pay or receive interest quarterly. Amounts to be paid or received under these swap agreements are accounted for on an accrual basis and recognized as interest income of the related loan asset. The net cash flows related to cash flow hedges increased interest income on loans by $307,000 and $979,000 for the three and nine months ended September 30, 2004, respectively. The net cash flows related to cash flow hedges increased interest income on loans by $487,000 and $1,309,000 for the three and nine months ended September 30, 2003, respectively.
Cash flow hedges are accounted for at fair value. The effective portion of the change in the cash flow hedge’s gain or loss is reported as a component of other comprehensive income net of taxes. The ineffective portion of the change in the cash flow hedge’s gain or loss is recorded in earnings on each quarterly measurement date. At September 30, 2004 and December 31, 2003, ($32,000) and $544,000, respectively, in deferred (losses)/gains, net of tax, related to cash flow hedges were recorded in accumulated other comprehensive (loss) income. Because all cash flow hedges were effective, there was no ineffectiveness recorded in earnings during the three and nine months ended September 30, 2004 and 2003.
The maximum term over which the Bank is hedging its exposure to the variability of future cash flows is less than 2 years.
Fair Value Hedges - The Bank enters into interest rate swap agreements with the objective of converting the fixed interest rate on brokered CDs to a variable interest rate. The swap agreements require the Bank to pay a variable rate of interest based on a spread to the three-month London Interbank Offered Rate (LIBOR) and to receive a fixed rate of interest equal to that of the brokered CD (hedged instrument.) Under the swap agreements the Bank is to pay or receive interest semiannually. Amounts to be paid or received under these swap agreements are accounted for on an accrual basis and recognized as interest expense of the related liability. The net cash flows related to fair value hedges decreased interest expense on certificates of deposit by $44,000 and $361,000 for the three and nine months ended September 30, 2004, respectively. The net cash flows related to fair value hedges decreased interest expense on certificates of deposit by $145,000 and $376,000 for the three and nine months ended September 30, 2003, respectively.
Fair value hedges are accounted for at fair value. The swaps qualify for the “shortcut method” under SFAS No. 133. Based on this shortcut method, no ineffectiveness is assumed. As a result, changes in the fair value of the swaps directly offset changes in the fair value of the underlying hedged item (i.e., brokered CDs). All changes in fair value are measured on a quarterly basis.
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The maturity dates, notional amounts, interest rates paid and received and fair value of our interest rate swap agreements as of September 30, 2004 were as follows:
Hedge
Cash Flow
Fair Value
(6) New Accounting Standards
In December 2003, the FASB issued FASB Interpretation No. 46R,Consolidation of Variable Interest Entities, an interpretation of ARB No. 51, a revision to FASB Interpretation No. 46, Consolidation of Variable Interest Entities issued in January 2003. This Interpretation is intended to achieve more consistent application of consolidation policies to variable interest entities and, thus to improve comparability between enterprises engaged in similar activities even if some of those activities are conducted through variable interest entities. The provisions of this Interpretation are effective for financial statements issued for fiscal years ending after December 15, 2003. The Company has three statutory and business trusts that were formed for the sole purpose of issuing trust preferred securities. The Company implemented FASB Interpretation No. 46R, as amended, which resulted in the deconsolidation of our two statutory and business trusts owned at that time The implementation of this Interpretation had no material effect on the Company’s consolidated financial position or results of operations.
FASB Statement No. 150, Accounting for Certain Financial Instruments with Character of both Liabilities and Equity, was issued in May 2003. This Statement establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. The Statement also includes required disclosures for financial instruments within its scope. For the Company, the Statement was effective for instruments entered into or modified after May 31, 2003 and otherwise will be effective as of January 1, 2004, except for mandatorily redeemable financial instruments. For certain mandatorily redeemable financial instruments, the Statement will be effective for the Company on January 1, 2005. The effective date has been deferred indefinitely for certain other types of mandatorily redeemable financial instruments. The Company currently does not have any financial instruments that are within the scope of this Statement.
In July 2004, the Derivatives Implementation Group of the FASB issued guidance on FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, Implementation Issue No. G25 (DIG Issue G25). DIG Issue G25 clarifies the FASB’s position on the ability of entities to hedge the variability in interest receipts or overall changes in cash flows on a group of prime-rate based loans. Under the new guidance these hedge relationships are allowed the use of the first payments received technique if all other conditions of FASB Statement No. 133 are met. The effective date of DIG Issue G25 is October 1, 2004 and should be applied to all hedging relationships as of the effective date. If a pre-existing cash flow hedging relationship has identified the hedged transactions in a manner inconsistent with the guidance in DIG Issue G25, the hedging relationship must be de-designated at the effective date. Any derivative gains or losses in other comprehensive income related to the de-designated hedging relationships should be accounted for under paragraphs 31 and 32 of Statement 133. The Company had pre-existing cash flow hedging relationships in a manner inconsistent with the guidance in DIG Issue G25 which had a $32,000 loss, net of tax, in other comprehensive income as of September 30, 2004. The Company implemented DIG Issue G25 on October 1, 2004 and de-designated its cash flow hedges which were inconsistent with the guidance. The $32,000 loss in other comprehensive income will be accreted to interest income over the remaining lives of the hedging relationships which range from 4 months to 18 months. These cash flow hedges were re-designated as new cash flow hedging relationships under the new guidance of DIG Issue G25. The implementation of DIG Issue G25 is not expected to have a material effect on the Company’s consolidated financial position or results of operations.
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In March 2004, the SEC issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments, or SAB 105, which addresses the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments. SAB 105 is effective for all mortgage loan commitments that are accounted for as derivative instruments that are entered into after March 31, 2004. The implementation of SAB 105 had no material effect on the Company’s consolidated financial position or results of operations.
(7) Stock Option Plans
The Company applies the intrinsic-value-based method of accounting proscribed by Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, issued in March 2000, to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an Amendment of FASB Statement No. 123.The following table illustrates the effect on net income if the fair-value-based method had been applied to all outstanding and unvested awards in each period.
Net income, as reported
Deduct total stock-based employee compensation expense determined under fair-value-based method for all awards, net of tax
Pro forma net income
Earnings per share:
Basic:
As reported
Pro forma
Diluted:
(8) Disclosures about Financial Instruments
The Bank issues financial instruments with off balance sheet risk in the normal course of the business of meeting the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments may involve, to varying degrees, elements of credit and interest-rate risk in excess of the amounts recognized in the consolidated balance sheets.
The Bank’s extent of involvement and maximum potential exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At September 30, 2004 and December 31, 2003, no amounts have been accrued for any estimated losses for these financial instruments.
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The contractual amount of off-balance-sheet financial instruments as of September 30, 2004 and December 31, 2003 is as follows:
Commitments to extend credit
Standby letters of credit
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. Since certain of these commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies, but may include accounts receivable, inventory, premises and equipment, and real estate.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support contractual obligations of the Bank’s customers. The credit risk involved in issuing letters of credit is essentially the same as the risk involved in extending loans to customers. The approximate remaining terms of standby letters of credit range from 1 month to 4 years at September 30, 2004.
Item 2: Management’s Discussion and Analysis of
Financial Condition and Results of Operations
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995
Readers should note that in addition to the historical information contained herein, some of the information in this report contains forward-looking statements within the meaning of the federal securities laws. Forward-looking statements typically are identified with use of terms such as “may,” “will,” “expect,” “anticipate,” “estimate” and similar words, although some forward-looking statements are expressed differently. You should be aware that the Company’s actual results could differ materially from those contained in the forward-looking statements due to a number of factors, including burdens imposed by federal and state regulation of banks, credit risk, exposure to local economic conditions, risks associated with rapid increase or decrease in prevailing interest rates and competition from banks and other financial institutions, all of which could cause the Company’s actual results to differ from those set forth in the forward-looking statements.
Introduction
This discussion summarizes the significant factors affecting the consolidated financial condition, results of operations, liquidity and cash flows of the Company for the three and nine month periods ended September 30, 2004 compared to the three and nine month periods ended September 30, 2003 and the year ended December 31, 2003. This discussion should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.
Financial Condition
Total assets at September 30, 2004 were $1.05 billion, an increase of $138 million, or 15%, over total assets of $908 million at December 31, 2003. Loans less unearned loan fees, were $874 million, an increase of $90 million, or 11%, over total loans of $784 million at December 31, 2003. The increase in loans is attributed to the success of the efforts of
11
the Company’s relationship officers. Federal funds sold, interest-bearing deposits and investment securities were $132 million at September 30, 2004 and $84 million at December 31, 2003. This increase was the result of the strong deposit growth discussed below.
Total deposits at September 30, 2004 were $937 million, an increase of $141 million, or 18%, over total deposits of $796 million at December 31, 2003. This deposit growth occurred in demand deposits, interest-bearing transaction deposits, money market deposits and certificates of deposit $100,000 and over as a result of new client relationships, increased sales penetration of existing clients, and additional brokered certificates of deposit. Money market deposits were $435 million, an increase of $63 million, or 17%, over money market deposits at December 31, 2003. Certificates of deposits were $236 million, an increase of $39 million, or 20%, over certificates of deposits at December 31, 2003. Consistent with the Bank’s overall funding strategy for 2004, the Bank executed $34 million of brokered certificates of deposit and had $20 million mature for a net of $14 million issued in the first nine months of 2004. These wholesale or non-client deposits supplement the Bank’s deposit gathering activities with its client base.
Total shareholders’ equity at September 30, 2004 was $71 million, an increase of $6 million, or 9%, over total shareholders’ equity of $65 million at December 31, 2003. The increase in equity is due to net income of $6.4 million for the nine months ended September 30, 2004 and the exercise of incentive stock options by employees, less dividends paid to shareholders, and a decrease in accumulated other comprehensive income.
Results of Operations
Net income was $2.9 million for the three month period ended September 30, 2004, an increase of 62% compared to net income of $1.8 million for the same period in 2003. Net income was $6.4 million for the nine month period ended September 30, 2004, an increase of 16% compared to net income of $5.5 million for the same period in 2003. The increase in net income for the three and nine months ended September 30, 2004 is attributable to an increase in net interest income and a decrease in provision for loan losses being somewhat offset by a reduction in noninterest income and a slight increase in noninterest expense. Included in noninterest income for the nine month period ended September 30, 2003 was a $2.9 million gain on the sale of branches. Basic earnings per share for the three month period ended September 30, 2004 and 2003 were $0.29 and $0.18, respectively. Fully diluted earnings per share for the three month periods ended September 30, 2004 and 2003 were $0.28 and $0.18, respectively. Basic earnings per share for the nine month periods ended September 30, 2004 and 2003 were $0.66 and $0.57, respectively. Fully diluted earnings per share for the nine month periods ended September 30, 2004 and 2003 were $0.63 and $0.56, respectively.
Net Interest Income
Net interest income (on a tax equivalent basis) was $9.5 million, or 3.85%, of average interest-earning assets, for the three months ended September 30, 2004, compared to $8.4 million, or 4.05%, of average interest-earning assets, for the same period in 2003. The $1.1 million increase in net interest income for the three months ended September 30, 2004 as compared to the same period in 2003 was the result of an increase in average interest-earning assets partially offset by an increase in the interest rates on average interest-bearing liabilities and a decrease in interest rates of average interest-earning assets and an increase in average interest-bearing liabilities.
Average interest-earning assets for the three months ended September 30, 2004 were $983 million, a $163 million, or 20% increase over $820 million, during the same period in 2003. The increase in average interest-earning assets is attributable to successful business development efforts of the Company’s relationship officers and additional investments in debt securities.
The yield on average interest-earning assets decreased to 5.12% for the three month period ended September 30, 2004 compared to 5.24% for the three month period ended September 30, 2003. The decrease in asset yield was primarily due to a change in asset mix. Loans were 84% of interest-earning assets for the three month period ended September 30, 2004 compared to 87% for the same period in 2003. Total securities and short-term investments were 12% and 9% for the same periods.
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Average interest-bearing liabilities increased to $762 million for the three months ended September 30, 2004 from $634 million for the same period in 2003. The cost of interest-bearing liabilities increased to 1.65% for the three months ended September 30, 2004 compared to 1.54% for the same period in 2003. This decrease is attributed mainly to an increase in market rates in 2004, primarily interest-bearing transaction accounts and money market accounts. Average demand deposits increased $33 million, or 22%, to $185 million for the three months ended September 30, 2004 from $152 million for the same period in 2003. The increase in demand deposit accounts, money market accounts and savings accounts is attributed to the Company’s relationship officers and new product marketing programs implemented at the beginning of the year.
Average certificates of deposits increased to $234 million for the quarter ended September 30, 2004 from $186 million for the quarter ended September 30, 2003. This increase is due to a special CD retention marketing program and the issuance of brokered certificates of deposit. Growth in our customer certificates of deposit has been difficult given the product’s relative unattractiveness compared to money market and other more liquid products in the current interest rate environment.
The Company issued $5 million in floating rate Trust Preferred Securities in May 2004 as a result of asset growth and the desire for additional regulatory capital.
The Company issued $11 million of Trust Preferred Securities in December 1999 that are callable on December 15, 2004 and carry a fixed rate of 9.40%. It is the Company’s intention to redeem those securities on the call date and issue $11 million in floating rate Trust Preferred Securities that mature in thirty years, are callable in five years and carry a floating rate of three month LIBOR plus 197 basis points. The securities to be called have remaining deferred issuance costs of $563,000 which will be charged to non-interest expense in the fourth quarter of 2004.
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The following table sets forth, on a tax-equivalent basis, certain information relating to the Company’s average balance sheet and reflects the average yield earned on interest-earning assets, the average cost of interest-bearing liabilities and the resulting net interest spread and net interest rate margin for the three month periods ended September 30, 2004 and 2003.
(Dollars in Thousands)
Assets
Interest-earning assets:
Taxable loans (1)
Tax-exempt loans(2)
Total loans
Taxable investments in debt and equity securities
Non-taxable investments in debt and equity securities(2)
Short-term investments
Total securities and short-term investments
Total interest-earning assets
Non-interest-earning assets:
Other assets
Allowance for loan losses
Liabilities and Shareholders’ Equity
Interest-bearing liabilities:
Certificates of deposit
Total interest-bearing deposits
Borrowed funds
Total interest-bearing liabilities
Noninterest-bearing liabilities:
Demand deposits
Other liabilities
Shareholders’ equity
Total liabilities & shareholders’ equity
Net interest spread
Net interest rate margin(3)
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Net interest income (on a tax equivalent basis) was $27.0 million, or 3.84%, of average interest-earning assets, for the nine months ended September 30, 2004, compared to $24.7 million, or 4.06%, of average interest-earning assets, for the same period in 2003. The $2.3 million increase in net interest income for the nine months ended September 30, 2004 as compared to the same period in 2003 was the result of an increase in average interest-earning assets and a decrease in the interest rates on average interest-bearing liabilities partially offset by a decrease in interest rates of average interest-earning assets and an increase in average interest-bearing liabilities.
Average interest-earning assets for the nine months ended September 30, 2004 were $941 million, a $127 million, or 16% increase over $814 million, during the same period in 2003. The increase in average interest-earning assets is attributable to continued calling efforts of the Company’s relationship officers and additional investments in debt securities.
The yield on average interest-earning assets decreased to 5.04% for the nine month period ended September 30, 2004 compared to 5.37% for the nine month period ended September 30, 2003. The decrease in asset yield was primarily due to a general decrease in the average yield on new fixed rate loans.
Average interest-bearing liabilities increased to $729 million for the nine months ended September 30, 2004 from $641 million for the same period in 2003. The cost of interest-bearing liabilities decreased to 1.56% for the nine months ended September 30, 2004 compared to 1.67% for the same period in 2003. This decrease is attributed mainly to declines in market interest rates for all sources of funding other than interest-bearing transaction accounts and money market accounts. Average demand deposits increased $30 million, or 20%, to $177 million for the nine months ended September 30, 2004 from $147 million for the same period in 2003. The increase in demand deposit accounts and money market accounts is attributed to the continued calling efforts of the Company’s relationship officers.
Average certificates of deposits increased to $226 million for the nine months ended September 30, 2004 from $182 million for the same period ended June 30, 2003. This increase in certificate of deposit accounts is a result of a special CD retention marketing program and the issuance of brokered certificates of deposit.
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The following table sets forth, on a tax-equivalent basis, certain information relating to the Company’s average balance sheet and reflects the average yield earned on interest-earning assets, the average cost of interest-bearing liabilities and the resulting net interest spread and net interest rate margin for the nine month periods ended September 30, 2004 and 2003.
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During the three months ended September 30, 2004, an increase in the average volume of interest-earning assets resulted in an increase in interest income of $1.8 million. Interest income increased $71,000 due to an increase in rates on average interest-earning assets. Increases in the average volume of interest-bearing liabilities contributed to an increase in interest expense of $491,000. Changes in interest rates on the average volume of interest-bearing liabilities resulted in an increase in interest expense of $203,000. The net effect of the volume and rate changes associated with all categories of interest-earning assets during the three months ended September 30, 2004 as compared to the same period in 2003 was an increase in interest income of $1.8 million, while the net effect of the volume and rate changes associated with all categories of interest-bearing liabilities was a increase in interest expense of $694,000.
During the nine months ended September 30, 2004, an increase in the average volume of interest-earning assets resulted in an increase in interest income of $4.6 million. Interest income decreased $1.8 million due to a decrease in rates on average interest-earning assets. Increases in the average volume of interest-bearing liabilities offset by declines in borrowed funds resulted in an increase in interest expense of $1.1 million. Changes in interest rates on the average volume of interest-bearing liabilities resulted in a decrease in interest expense of $606,000. The net effect of the volume and rate changes associated with all categories of interest-earning assets during the nine months ended September 30, 2004 as compared to the same period in 2003 was an increase in interest income of $2.8 million, while the net effect of the volume and rate changes associated with all categories of interest-bearing liabilities was an increase in interest expense of $499,000.
The following table sets forth on a tax equivalent basis, for the three and nine months ended September 30, 2004 compared to the same period ended September 30, 2003, a summary of the changes in interest income and interest expense resulting from changes in yield/rates and volume:
3 month
Increase (decrease) Due to
9 month
Interest earned on:
Loans
Nontaxable loans (3)
Nontaxable investments in debt and equity securities (3)
Interest paid on:
Net interest income (loss)
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.
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Provision for Loan Losses
The provision for loan losses was $100,000 and $1.4 million for the three and nine month periods ended September 30, 2004, respectively, compared to $635,000 and $2.7 million for the same periods in 2003. The decrease in the provision for loan losses during the first nine months of 2004 as compared to the same period in 2003 is due to favorable delinquency trends, low non-performing loans as a percentage of total loans and strengthening local economies. The Company experienced $586,000 in net charge-offs for the nine months ended September 30, 2004 compared to net charge-offs of $1.3 million during the same period ended September 30, 2003.
The following table summarizes changes in the allowance for loan losses arising from loans charged off and recoveries on loans previously charged off, by loan category, and additions to the allowance that have been charged to the provision:
Allowance at beginning of period
Loans charged off:
Commercial and industrial
Real estate:
Commercial
Construction
Residential
Consumer and other
Total loans charged off
Recoveries of loans previously charged off:
Total recoveries of loans previously charged off:
Net loans charged off
Provisions for loan losses
Allowance at end of period
Average loans
Non-performing loans
Net charge-offs to average loans
Allowance for loan losses to loans
Allowance for loan losses to non-performing loans
The Company’s credit management policies and procedures focus on identifying, measuring, and controlling credit exposure. These procedures employ a lender-initiated system of rating credits, which is validated in the loan approval process and subsequently tested in internal loan reviews and regulatory bank examinations. The system requires rating all loans at the time they are made.
Adversely rated credits, including loans requiring close monitoring, which would normally not be considered criticized credits by regulators, are included on a monthly loan watch list. Other loans are added whenever any adverse circumstances are detected which might affect the borrower’s ability to meet the terms of the loan. This could be initiated by any of the following:
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Loans on the watch list require detailed loan status reports, including recommended corrective actions, prepared by the responsible loan officer every three months. These reports are then discussed in formal meetings with the Chief Credit Officer of the Company and the Executive Loan Committee.
Downgrades of loan risk ratings may be initiated by the responsible loan officer, internal loan review, or the credit analyst department at any time. Upgrades of risk ratings may only be made with the concurrence of the Chief Credit Officer and Loan Review.
In determining the allowance and the related provision for loan losses, four principal elements are considered:
The first element reflects the Company’s estimate of probable losses based upon a systematic review of specific loans. These estimates are based upon discounted collateral exposure, but other objective factors such as payment history and financial condition of the borrower may be used as well.
The second element reflects the application of the Company’s loan rating system. This rating system is similar to those employed by state and federal banking regulators. Loans are rated and assigned a loss allocation factor for each category that is consistent with our historical losses, adjusted for environmental factors. The lower the rating assigned to a loan, the greater the allocation percentage that is applied.
The third element relates to specific industry risk due to the current economic, environmental, or regulatory conditions of that industry. In addition to risk rating every loan in our portfolio, the Company assigns a Standard Industry Code (SIC) to each loan so that outstanding credit exposure to different industries can be effectively monitored. For those industries that appear to be stressed based on review of credit spreads and available data in publications, the Company assigns some additional loss exposure to the balances that we have in the applicable SIC.
The fourth element is based on factors that cannot necessarily be associated with a specific credit or loan category and represents management’s attempt to ensure that the overall allowance for loan losses appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected credit losses. The Company considers a number of subjective factors when determining the unallocated portion, including local and general economic business factors and trends, portfolio concentrations, and changes in the size, mix and general terms of the loan portfolio. A specific subjective factor that has become more apparent in the past year is competitive pressures in the Company’s local markets. The pressures to maintain and grow the loan portfolio in a slow growth economic environment has to some degree affected the credit structure and pricing on a portion of the Company’s loans.
Based on this quantitative and qualitative analysis, the allowance for loan losses is adjusted. Such adjustments are reflected as “Provision for loan losses” in the Company’s consolidated statements of operations.
The Company does not engage in foreign lending. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans, which are not otherwise disclosed in the loan portfolio composition table provided in the Company’s most recent Annual Report on Form 10-K. The Company does not have a material amount of interest-bearing assets, which would have been included in non-accrual, past due or restructured loans if such assets were loans.
The Company believes the allowance for loan losses is adequate to absorb probable losses in the loan portfolio. While the Company uses available information to recognize loan losses, future additions to the allowance for loan losses may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require the Company to increase the allowance for loan losses based on their judgments and interpretations of information available to them at the time of their examinations.
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The Bank had no loans 90 days past due still accruing interest at September 30, 2004 or December 31, 2003. The following table sets forth information concerning the Company’s non-performing assets as of the dates indicated:
Non-accrual loans
Restructured loans
Total non-performing loans
Foreclosed real estate
Total non-performing assets
Total loans plus foreclosed property
Non-performing loans to loans
Non-performing assets to loans plus foreclosed property
Non-performing assets to total assets
Approximately 38% of the non-performing loans at September 30, 2004 relate to a motel property and the remainder consists of six different borrowers.
Noninterest Income
Noninterest income was $1.9 million for the three months ended September 30, 2004, compared to $2.1 million for the same period in 2003. Service charges increased $77,000 to $532,000 in the third quarter of 2004, compared to $455,000 for the same period in 2003. Service charges on commercial deposit accounts accounted for $59,000 of this increase due to an increase in the number of accounts and balances outstanding. Wealth management income decreased slightly to $1.1 million in the third quarter of 2004, compared to $1.2 million for the same period in 2003 due to a $547,000 decrease in one-time insurance fees. Excluding these one-time fees wealth management income increased $452,000 or 70%. This increase was the result of increased assets under administration, a more favorable mix of managed versus custodial assets, and the introduction of our new Wealth Products Group in March of 2004 which had $110,000 of revenue in the third quarter of 2004. Gains on the sale of mortgage loans were $9,000 for the three months ended September 30, 2004, compared to $302,000 for the same period in 2003. The decrease in mortgage gains in 2004 was due to strong demand for refinancing activities in 2003. Gains on the sale of securities were $125,000 and $0 for the three months ended September 30, 2004 and 2003, respectively. The securities were sold in order to slightly adjust the interest rate risk profile of the Company’s balance sheet in anticipation of higher rates.
Noninterest income was $5.2 million for the nine months ended September 30, 2004, compared to $7.9 million for the same period in 2003. Service charges increased $181,000 to $1.5 million for the nine month period ended September 30, 2004, compared to $1.3 million for the same period in 2003. This $181,000 increase was primarily the result of a $243,000 increase in service charges on commercial deposit accounts in 2004 which was partially offset by $117,000 of services charges earned in 2003 on the three branches which were sold in April 2003. Wealth management income increased $549,000 to $3.0 million for the nine month period ended September 30, 2004, compared to $2.5 million for the same period in 2003 as a result of the reasons stated above. Gains on the sale of mortgage loans were $219,000 for the nine months ended September 30, 2004, compared to $831,000 for the same period in 2003. See reasons above for the decline in gains on the sale of mortgage loans. Gains on the sale of securities were $126,000 and $78,000 for the nine months ended September 30, 2004 and 2003, respectively. During the second quarter of 2003 the Company recorded a $2.9 million gain on the sale of three branches.
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Noninterest Expense
Total noninterest expense was $7.1 million for the three months ended September 30, 2004, representing a $136,000, or 2% increase over the same period in 2003. Compensation expense increased $49,000 to $4.0 million in the third quarter of 2004, compared to $3.9 million for the same period in 2003. Increases attributable to annual merit increases and higher compensation associated with new middle and senior management hired in 2003 and 2004 were partially offset by a $286,000 decrease in commissions relating to the one-time insurance fees received in the third quarter of 2003. Employee benefits expense increased $15,000 to $612,000 in the third quarter of 2004, compared to $596,000 for the same period in 2003. Increased medical expenses of $29,000 accounted for most of this change. Occupancy expense increased $26,000 in the third quarter of 2004. Furniture and equipment expense and data processing expense decreased $14,000 and $10,000, respectively, in the third quarter of 2004. The majority of these decreases related to lower depreciation expense as some assets have become fully depreciated. Other expense increased $68,000 to $1.6 million in the third quarter of 2004, compared to $1.5 million for the same period in 2003.
Total noninterest expense was $21.1 million for the nine months ended September 30, 2004, representing a $109,000, or 1% increase over the same period in 2003. Increases in compensation and benefits expenses and occupancy expenses were partially offset by decreases in furniture and equipment, data processing and other expenses. Other expenses decreased $477,000 to $4.5 million for the nine months ended September 30, 2004. Lower non-compete and legal and professional expenses were partially offset by an increase in marketing expense. The Company recognized $220,000 in expense related to a non-compete agreement with a former key employee in 2003. Legal and professional expenses decreased $324,000 in 2004 due to the Company having fewer non-performing loan issues and lower legal expenses in 2004 when compared to the first nine months of 2003. Marketing expense increased $267,000 due to a targeted marketing campaign in the first half of 2004.
Income Taxes
The provision for income taxes was $1.3 million and $3.0 million for the three and nine months ended September 30, 2004 compared to $1.0 million and $3.2 million for the three and nine months ended September 30, 2003. The effective tax rates for the three and nine month periods ended September 30, 2004 were 30.6% and 32.2%, respectively. The effective tax rates for the three and nine month periods ended September 30, 2003 were 36.4% and 36.8%, respectively. During the third quarter of 2004, the Company had a $241,000 reversal of the remaining deferred tax valuation allowance related to Merchant Banking losses in 2001. The nature and deductibility of these losses were finally determined when the Company filed its 2003 income tax returns during the third quarter. During the second quarter of 2004, the Company recognized state income tax refunds of $163,000 related to amendments of prior state income tax returns.
Liquidity
The objective of liquidity management is to ensure the Company has the ability to generate sufficient cash or cash equivalents in a timely and cost-effective manner to meet its commitments as they become due. Funds are available from a number of sources, such as from the core deposit base and from loans and securities repayments and maturities. Additionally, liquidity is provided from sales of the securities portfolio, lines of credit with major financial institutions, the Federal Reserve Bank and the Federal Home Loan Bank, the ability to acquire large and brokered deposits and the ability to sell loan participations to other banks.
The Company’s liquidity management framework includes measurement of several key elements, such as the loan to deposit ratio, wholesale deposits as a percentage of total deposits, and various dependency ratios used by banking regulators. The Company’s liquidity framework also incorporates contingency planning to assess the nature and volatility of funding sources and to determine alternatives to these sources.
Strong capital ratios, credit quality and core earnings are essential to retaining cost-effective access to the wholesale
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funding markets. Deterioration in any of these factors could have an impact on the Company’s ability to access these funding sources and, as a result, these factors are monitored on an ongoing basis as part of the liquidity management process.
While core deposits and loan and investment repayment are principal sources of liquidity, funding diversification is another key element of liquidity management. Diversity is achieved by strategically varying depositor types, terms, funding markets, and instruments.
Investment securities are an important part of the Company’s liquidity objective. As of September 30, 2004, nearly all of the investment portfolio was available for sale. Of the $93 million available for sale investment portfolio, $32 million was pledged as collateral for public deposits, treasury, tax and loan notes, and other requirements. The remaining securities could be pledged or sold to enhance liquidity if necessary.
The Bank has a variety of funding sources (in addition to key liquidity sources, such as core deposits, loan repayments, loan participations sold, and investment portfolio sales) available to increase financial flexibility. At September 30, 2004, the Bank had $139 million of credit available from the Federal Home Loan Bank of Des Moines under a blanket loan pledge, absent the Bank being in default of its credit agreement, and $29 million of credit available from the Federal Reserve Bank under a pledged loan agreement. The Bank also has access to over $70 million in overnight federal funds purchased lines from various banking institutions. Finally, since the Bank is a “well-capitalized” institution, it has the ability to sell certificates of deposit through various national or regional brokerage firms, if needed.
Over the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company’s liquidity. The Company has $285 million in unused loan commitments as of September 30, 2004. While this commitment level would be very difficult to fund given the Company’s current liquidity resources, the Company believes that the nature of these commitments are such that the likelihood of such a funding demand is very low.
Capital Adequacy
The Company and Bank are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulations to ensure capital adequacy require the Company and Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets. The Company believes, as of September 30, 2004 and December 31, 2003, that the Company and Bank met all capital adequacy requirements to which they are subject.
As of September 30, 2004 and December 31, 2003, the Bank was categorized as “well capitalized” under the applicable regulatory framework. To be categorized as “well capitalized” the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following table.
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The Company’s and Bank’s actual capital amounts and ratios are also presented in the table.
For Capital
Adequacy Purposes
To Be Well
Capitalized UnderApplicable
Action Provisions
As of September 30, 2004:
Total Capital (to Risk Weighted Assets)
Enterprise Financial Services Corp
Enterprise Bank & Trust
Tier I Capital (to Risk Weighted Assets)
Tier I Capital (to Average Assets)
As of December 31, 2003:
Effects of Inflation
Persistent high rates of inflation can have a significant effect on the reported financial condition and results of operations of all industries. However, the asset and liability structure of commercial banks is substantially different from that of an industrial company in that virtually all assets and liabilities of commercial banks are monetary in nature. Accordingly, changes in interest rates may have a significant impact on a commercial bank’s performance. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase equity capital at higher than normal rates to maintain an appropriate equity-to-assets ratio.
Item 3: Quantitative and Qualitative Disclosures About Market Risk
Market risk arises from exposure to changes in interest rates and other relevant market rate or price risk. The Company faces market risk in the form of interest rate risk through other than trading activities. Market risk from other than trading activities in the form of interest rate risk is measured and managed through a number of methods. The Company uses financial modeling techniques that measure the sensitivity of future earnings due to changing rate environments to measure interest rate risk. Policies established by the Company’s Asset/Liability Committee and approved by the Company’s Board of Directors limit exposure of earnings at risk. General interest rate movements are used to develop sensitivity as the Company feels it has no primary exposure to a specific point on the yield curve. These limits are based on the Company’s exposure to a 100 bp and 200 bp immediate and sustained parallel rate move, either upward or downward.
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The following table presents the scheduled repricing of market risk sensitive instruments at September 30, 2004:
Beyond
5 years
or no stated
maturity
ASSETS
Investments in debt and equity securities
Loans (1)
Total
LIABILITIES
Savings, Now, and Money market deposits
Certificates of deposit (1)
Item 4: Disclosure Control and Procedures
As of September 30, 2004, under the supervision and with the participation of the Company’s Chief Executive Officer (CEO) and the Chief Financial Officer (CFO), management has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined under Rules 13a-15(e) and 15d-15(b) of the Securities Exchange Act of 1934. Based on that evaluation, the CEO and CFO, concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2004, to ensure that information required to be disclosed in the Company’s periodic SEC filings is processed, recorded, summarized and reported when required. There were no significant changes in the Company’s internal controls or in the other factors that could significantly affect those controls subsequent to the date of the evaluation.
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Item 6: Exhibits and Reports on Form 8-K
Description
The Company filed a report on Form 8-K on July 23, 2004 containing the text of a press release issued by the Company concerning the announcement of second quarter 2004 results.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Clayton, State of Missouri on the day of November 8, 2004.
/s/ Kevin C. Eichner
/s/ Frank H. Sanfilippo
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