Enterprise Financial Services Corp (NASDAQ:EFSC) Q3 2023 Earnings Call Transcript

Enterprise Financial Services Corp (NASDAQ:EFSC) Q3 2023 Earnings Call Transcript October 24, 2023

Operator: Thank you for standing by. At this time, I would like to welcome everyone to the Enterprise Financial Services Corp Third Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Jim Lally, President and CEO, Enterprise Financial Corp. You may begin your conference.

James Lally: Thank you, and thank you all very much for joining us this morning and welcome to our 2023 third quarter earnings call. Joining me this morning is Keene Turner, EFSC’s Chief Financial Officer and Chief Operating Officer; and Scott Goodman, President of Enterprise Bank & Trust. Before we begin, I would like to remind everybody on the call that a copy of the release and accompanying presentation can be found on our website. The presentation and earnings release were furnished on SEC Form 8-K yesterday. So please refer to Slide 2 of the presentation titled Forward-Looking Statements and our most recent 10-K and 10-Q for reasons why actual results may vary from any forward-looking statements that we make today. The third quarter represents a strong performance during a series of rapid changes affecting the economic and therefore banking landscape.

Our business model, associate base and management team has been constructed to perform during times of challenge. Our teams are adept at navigating difficult circumstances and using them to differentiate our strength as a banking partner. Over the last several years, we have worked diligently to diversify our business model such that we do not have to depend on any one business, market or asset class to produce high quality and predictable earnings. Our third quarter financial results and momentum that we’ve displayed on both sides of the balance sheet during all of 2023 are the results of this corporate strategy. The business model delivered well again in the third quarter of 2023. Our financial scorecard begins on Slide 3. Our strong financial performance continued during the third quarter.

We earned net income of $44.7 million or $1.17 per diluted share, and we produced an ROAA of 1.26% and a PPNR ROAA of 1.84%. These results reflect a robust earnings profile that easily allowed us to absorb some deterioration in credit during the third quarter. Combined with our already strong reserves and balance sheet, we remain positioned to operate from a position of strength. This means both delivering returns to shareholders while also supporting the needs of existing and new clients. The ability to continue to fulfill the loan needs of these clients and prospects have opened up channels of deposit growth as well. Our net interest income increased over $900,000 in the quarter, a trend that has continued each quarter since the beginning of 2022.

This result despite challenging competitive and interest rate conditions, reflects the strength of the franchise we have built. We remain positioned to produce high-quality earnings stream that consistently improve shareholder value through deep-rooted client relationships. Growth of net interest income was aided by the defense and resilience of our net interest margin at 4.33%. This is a direct result of our appropriately priced stable deposit base and our ability to originate commensurate to the needs of our clients, but priced well amid the current interest rate environment. As we thought would happen, loans moderated in the quarter largely through lower line utilization and a focus in higher valued segments. This resulted in loan growth during the quarter of $104 million and total outstanding loans at the end of the quarter of $10.6 billion.

We also committed to funding our second half growth with client deposits, an area where we made significant progress in the current period. For the quarter, we grew net deposits $290 million netting out the reduction in brokerage CDs, client deposits grew by $488 million in the quarter. Equally impressive is the fact that the DDA as a percentage of total deposits remain strong at 32% and our loan-to-deposit ratio at quarter end was 89%. Scott will give much more color on the markets and businesses where we saw continued success, but we are encouraged that we have a significant amount of runway to continue growing throughout the remainder of 2023 and into 2024. Our balance sheet remains strong and positioned for continued growth. Capital levels at quarter end remain stable and strong with our TCE to TA ratio of 8.51%.

Tangible book value per common share was $31.06, an increase of over 8% this year due to our strong earnings that has more than offset the impact of securities portfolio in AOCI. During the quarter, we did see credit begin to normalize. However, the results I noted both on the income statement and the balance sheet reflect that we both anticipated and are positioned well to deal with these changes. I did want to provide a little color around one commercial office loan that moved into OREO during the quarter. This was a St. Louis based borrower that had a single tenant midtown office building where the tenant defaulted on its lease. After pay downs related to the personal guarantees and lease termination penalties, we charged off approximately $4.7 million of an approximately $16 million loan balance.

This loan represented our only single tenant office CRE loan in our portfolio. Additionally, we saw non-performing loans edge up in the quarter. It’s important to reiterate that the strength of our earnings profile generates pre-provision earnings that have averaged nearly $70 million a quarter this year. This provides a significant buffer to absorb credit issues before ever touching our loan loss reserves or capital. There are also very strong levels, particularly when considering the short duration of our loan portfolio. Slide 5 shows where we are focused for the foreseeable future. Just like we’ve done so far this year and the second half of 2023 will continue to be focused on funding future loan growth with client deposits. Additionally, I’m confident that we can continue to improve shareholder value through the execution of our strategy.

Our focus combined with modest improvement in certain business lines and markets, along with continued steadfast expense management should consistently produce strong earnings amid the current economic and rate environment that we are in. My optimism for our prospect stems from both my confidence in our existing performance, but also my conversations I’m having with our clients. Our manufacturing distribution clients continue to have good backlogs and consistent sales volumes. Margins are compressing slightly due to increased labor and interest expense causing overall profitability to decline, but not to a point where debt service has been compromised. Advising and helping clients navigate through times like these is a specialty of our teams.

Past turbulent times have shown that these conversations will solidify the relationships that we currently have and invite several more companies to come our way. Our CRE clients predict a much slower 2024. Current projects will be completed, but new opportunities will be challenged with higher costs, particularly interest expense. I believe that higher demand asset classes such as industrial and housing will find return equilibrium such that we’ll see projects and corresponding loan demand come to life late in 2024. I do believe that this bit of optimism will manifest itself in our higher growth markets like Phoenix, Dallas, and Southern California. With all that said, I feel strongly that our multiple business lines and geographies will be robust enough to produce loan volumes in the mid single-digit range over the next several quarters funded by our continued success in generating well-priced relationship-oriented client deposits.

Before turning the call over to Scott, another piece of good news that I would like to share is that we were recently awarded a $60 million new markets tax credit allocation by the Community Development Financial Institutions fund or the CDFI, a bureau within the United States Department of the Treasury. This will serve us well over the next 12 to 18 months to attract new clients and projects that qualify for these credits. With that, I would like to turn the call over to Scott Goodman. Scott?

Scott Goodman: Thank you, Jim and good morning, everyone. As you heard from Jim and as we show on Slide number 6, loans grew by $104 million in the quarter and results and year-over-year growth of 13.5%. Components of the growth for the last 12 months are broken out on Slide number 7 and reflect the prior comments regarding balance and diversification with increases across all major categories and proportionate between our metro markets and the specialized lines of business. For the quarter, shown on Slide number 8, we saw the most lift in the owner-occupied commercial real estate, tax credit and construction categories. It’s also worth noting that revolving line of credit usage declined in the quarter as operating companies manage their working capital more efficiently in response to higher rates and a more risk off approach to their businesses.

Outstanding balances on lines declined by $100 million in the quarter. So while the C&I loan portfolio was down by $9 million net of line reductions, this book actually grew $91 million. This C&I lift as well as the owner-occupied commercial real estate growth reflects continued success in attracting new operating company relationships and expanding business with our existing clients. The construction category rose in conjunction with improved momentum of projects following the COVID and supply chain induced construction lags that we saw last year and earlier this year. And while we were certainly seeing new development loan requests slow significantly, the existing projects closed over the past 12 to 18 months are continuing to move forward.

This portfolio overall is well diversified with the majority of the book fairly well balanced within the multi-family, residential, industrial and mixed use projects. Investor-owned CRE office represents less than 5% of this total construction book. Within the specialized business units, tax credit lending had a strong quarter, reflecting continued momentum in the funding of existing affordable housing projects on the books. Jim also mentioned our recent award of $60 million in new market tax credit allocation by the U.S. Treasury Department. As we have with prior awards, these credits will serve as a catalyst to facilitate much needed projects within under invested areas in our metro markets. But these credits will also allow our bankers to bring a differentiated solution to the table to attract new banking relationships and can provide a source of fee income, which is typically 7% to 8% of the allocation earned over seven years.

Life insurance premium finance grew modestly this quarter with some seasonally slower premium fundings on existing policies, but has grown nearly 19% year-over-year and continues to build a solid pipeline of new opportunities. Sponsor Finance also had a modest growth quarter, reflecting some seasonal softness on origination volume, but also an uptick in pay downs related to the sale of portfolio companies by our private equity sponsored companies. The SBA portfolio declined by $19 million in Q3 mainly due to the sale of $33 million in 7(a) loans. Payoffs continue to be somewhat of a headwind from certain borrowers that are now bank qualified while origination volumes were stable and in line with expectations. We also remain focused on improving returns opportunistically within specialties or in loan categories where the supply demand dynamics have shifted.

Generally in these cases, and depending upon the loan type, we are targeting some combination of higher loan spreads or requiring associated compensating deposit balances. Our regional breakdown of the loan trends are shown on Slide number 9. Growth of the specialized businesses continues on a solid and steady pace, up 15% annualized for the quarter and 19% year-over-year. In addition to my prior comments on the specialized businesses, our Practice Finance unit also performed well in 2023 growing by roughly $70 million year-to-date, including $23 million of growth in Q3. This team, which has a long history and deep expertise in this niche, focuses mainly on banking, dental and veterinary practices, which are generally viewed as stable and high credit quality business types.

Within the Midwest region, reduction in revolving lines were a primary headwind to growth this quarter, offsetting some of the otherwise solid origination activity. New relationships were opened in Kansas City and St. Louis for reputable, longstanding companies in these markets with businesses such as electrical contracting, hospitality, entertainment and medical services. The Southwest region of Arizona, New Mexico, Las Vegas and Texas grew by $50 million in the quarter posting year-over-year loan growth of 26% and reflecting our team’s successes in leveraging the above average economic growth profile in these markets. Significant wins in Q3 included several new owner operator and C&I deals with a large local, not-for-profit and automotive services business, a regional storage operator and a commercial design company.

In addition, these markets benefited from the elevated fundings under existing construction lines. In Southern California, which is our west region, we continue to show positive momentum posting another quarter of growth. Year-over-year, this portfolio is up 9.3% following an intentional shift during 2022 to move away from higher risk, large fix-and-flip resi real estate lending and focus the legacy platform on a more balanced relationship based CRE and C&I strategy, which is consistent with our other markets. New loans during Q3 included moderate to mid-sized seven figure relationships with an apparel manufacturer, a hospitality business, transportation company and specialty printing business. We’ve also continued to expand our talent base in this region, adding a new market leader in San Diego as well as two experienced relationship managers and a Treasury Management Officer in the LA Orange County market during the quarter.

Moving now to deposits, which are broken out on slides number 10 and 11. Total balances grew by $290 million in the quarter after a reduction in higher cost broker deposits of $198 million, so net of brokered funds client deposit balances are up $488 million or 18% annualized in the quarter. The regional market client deposits rose $185 million, reflecting success in our sales plan to recapture excess funds from existing relationships that had moved to non-bank alternatives earlier in the year, as well as our ongoing focus on deposit heavy new relationships. Specialized deposits rose by $303 million. This breakdown is highlighted on Slide number 12. Within the geographies, we grew client deposits net of brokered balances in each of our major markets with the exception of New Mexico.

This growth generally mirrors the concentration of our C&I client base and was most evident in the Midwest where client balances were up $125 million. In California, representing our west region, client deposits rose by roughly $46 million in the quarter. I think this is a particularly positive sign just given the sensitivity to stress banks in that market and also another indicating of our success in landing balance new relationships there. The specialized deposit portfolio, which is broken out on Slide 13, also continued its growth trajectory in Q3 now representing 27% of total deposits. There’s good balance amongst the lines of business within this book with property management and third-party escrow driving most of the growth this quarter.

Property management continues to be a consolidating industry which provides opportunity to expand the account base as our clients are generally the larger acquirers. Slide number 14 shows some additional detail on our core funding mix and account activity for the quarter. Deposits are generally balanced among our four main channels and anchored to client relationships that have an assigned team or a key point of contact within our company. These deposits are also well diversified by industry, by household and by geographic market. The underlying account activity also continues to trend favorably with new accounts open exceeding closed accounts and average balances stable to increasing across all channels. Now I’d like to turn the call over to Keene Turner for his comments.

Keene?

Keene Turner: Thanks, Scott and good morning, everyone. My comments being on Slide 15, where we reported earnings per share of $1.17 in the third quarter on net income of $45 million. Net interest income expanded from the linked quarter as we have continued to focus on growing and defended net interest income. Our disciplined pricing on loans and deposits combined with improved customer funding benefited our results. A decline in fee income offset the growth in net interest income during the quarter and we had a few moving parts in this area that I’ll touch on in a few minutes. The provision for credit loss has increased for the quarter, driven by net charge-offs, an increase in non-performing loans and loan growth. Finally, non-interest expense was higher in the current quarter with continued growth and deposit costs to support our expanding specialized deposit business.

Overall, pre-provision net revenue of $65 million for the quarter shows the strength of our earnings profile and our ability to generate capital to support balance sheet growth. Turning to Slide 16. Net interest income for the third quarter of 2023 was $141.6 million, an increase of nearly $1 million compared to the linked quarter. We are pleased with the growth of net interest income in the quarter as it reflects balance sheet growth amid improving the proportion of the balance sheet that has been customer funded since the last quarter. Interest income increased $13 million during the third quarter of 2023, driven equally by continued loan growth and higher rates on the loan portfolio. Additionally, our success in generating customer funding improved cash levels due to the timing of maturing brokered CDs and added roughly $2 million to interest income.

With that said, our lending pricing and the structure of the loan portfolio continues to shine. Loan yields increased 16 basis points while average balances were up over $230 million. The average interest rate of new loan originations in the third quarter of 2023 was 7.89% and the most recent month yield is just under 7% overall. More details on this are on Slide 17. Interest income in the quarter was more than sufficient to absorb the $12 million increase we experienced in interest expense. We were able to grow customer deposits nearly $500 million during the quarter, which allowed for the previously mentioned decrease in brokered funding. The balance growth was coupled with a 38 basis point increase in the cost of deposits principally driven by commercial balances.

With that said, total cost of deposits was 1.84% in the third quarter and is approximately 2% in the most recent month. The deposit pricing performance is aided overall by DDA percentage at 33%, while our asset yield and balance sheet growth more than paid for the increase in the cost of our liabilities in the third quarter. The resulting net interest margin was 4.33% in the third quarter of 2023, decreasing 16 basis points sequentially. Most notably, we believe that we are seeing stabilization in net interest margin. At least that’s been accurate for the last couple of months. When I say that, I mean notably that deposit pricing is becoming more predictable. We are expecting continued net interest margin drift rather than contraction in the fourth quarter of 2023 and early quarters of 2024.

We are encouraged by both deposit generation and the overall performance of net interest income and margin, and we are growing optimistic that with modest growth in net interest income and some slowing in net interest margin compression, that will have the opportunity to further expand net interest income growth in the upcoming quarters. It’s worth noting that excluding PPP, we’ve grown net interest income dollars for the last 12 quarters and expanded it by roughly 2.5x during that period. Slide 18 reflects our credit trends. Annualized net charge-offs were 26 basis points of average loans in the period. On a year-to-date basis, net charge-offs were 13 basis points, which continues to be below our historical average. The credit relationship Jim mentioned moving into ORE made up the majority of net charge-off balance for the quarter.

It’s worth reiterating that this loan represented the only material loan in the investor-owned office portfolio that was supported by a single tenant. Non-performing assets were 40 basis points of total assets compared to 12 basis points at the end of June. The increase primarily relates to the single credit totaling $6 million in foreclosed assets from the investor-owned office property that we charged down in the quarter and an approximately $30 million increase in commercial real estate loans made up of three relationships. While we did experience some deterioration in our credit metrics this quarter, we continue to have relatively low levels of problem loans. The provision for credit losses was $8 million during the third quarter and largely reflects the impact of the net charge-offs, non-performing loans and loan growth.

Slide 19 represents the allowance for credit losses. The allowance for credit losses increased $1 million in the quarter and is 1.34% of total loans or 1.47% when adjusting for guarantees. On Slide 20, third quarter fee income of $12 million was a decrease of $2 million from the second quarter. Income from community development investments decreased as was anticipated, which was mostly offset by recognized gains from the sale of roughly $33 million of SBA loans, which occurred in the third quarter. Tax credit income was the largest driver of the sequential decline in fee income as a 70 basis point increase in the 10-year SOFR rate in the quarter negatively impacted the credits that are carried at fair value and masked the strong transaction volumes in the period.

As a reminder, tax credit income has some seasonal volatility and is typically stronger to the end of it each year and thus we expect fourth quarter fee income to be roughly $15 million to $17 million. Turning to Slide 21. Third quarter non-interest expense was $89 million, an increase of $3 million compared to the second quarter. Deposit service expenses were higher, which was partially mitigated by a sequential decline in employee compensation and benefits as well as other expenses. Deposit servicing expenses grew roughly $4 million in the quarter due to both rate and volume on certain specialized deposits. We expect this line item to continue to expand with both continued growth and balances as well as higher rates, but at a decreasing rate, at least as it relates to increased pricing.

We do expect specialized deposits to continue to outpace overall deposit growth, which we will continue to drive this expense line item. Comp and benefits was lower quarter-over-quarter due to favorable medical plan performance combined with hiring discipline. Other expenses were lower sequentially primarily from the non-recurrence of the operational event in the second quarter, as well as certain other expenses. Overall, we expect non-interest expense to increase to roughly $90 million to $92 million in the fourth quarter, reflecting an increase in deposit service expense. The third quarter’s core efficiency was 56.2%, an increase of 220 basis points compared to the second quarter and was driven primarily by the rise in both interest and non-interest expenses, while the decrease in fee income impacted revenues.

With some moderation of our net interest margin and net interest income expectations, we do expect core efficiency to move up slightly in the coming quarters. However, this is a function of our expectation for expanding our market share in the specialized deposit business. For all other expense categories, we expect to prudently maintain cross controls which are part of our daily disciplines. Our capital metrics are demonstrated on Slide 22, our tangible common equity ratio was 8.5% at the end of the third quarter, down from 8.6% in the linked quarter. Decline is due to the increase in longer term interest rates and the related impact on the fair value of securities and derivatives that are reflected in comprehensive income. Our regulatory capital ratios continue to be above well capitalized minimums when including the impact of unrealized losses on available for sale and health and maturities securities.

Our strong earnings and manageable dividend level allowed us to quickly build capital that we can use to support our growth. And overall, this was a strong quarter and we’ve been pleased with the performance so far this year, return on assets has been 1.47% and return on tangible common equity is nearly 17%. With that, I’ll conclude my remarks and open the line for analyst questions.

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Q&A Session

Operator: [Operator Instructions] Your first question is from Jeff Rulis of D.A. Davidson. Please go ahead. Your line is open.

Jeffrey Rulis: Thanks. Good morning.

James Lally: Good morning.

Jeffrey Rulis: Just a couple of follow-up questions on the deposit base that’s impacted by the variable deposit costs. I just want to try to get a sense for, is that the entire specialty loan or specialty deposit balance, or is it a portion of that?

Keene Turner: Hey, Jeff. This is Keene. If you look at Slide 13, it’s really going to be community property and third-party. So it’s roughly $2.5 billion that the $21 million in the quarter is attributable to.

Jeffrey Rulis: Got it. Okay.

Keene Turner: The other is really more part of what’s assigned based on specialized lending verticals. So that’s how that’s delineated.

Jeffrey Rulis: Okay. So just want to kind of walk down the strategy again. These are maybe accretive to net interest margin. But on the expense side, certainly there’s been a source of cost increase. Could you just sort of lay out the strategy of that? Overall, it’s a more efficient deposit, franchise is stickier. Just want to kind of get a sense for the cost and the value of that relative to traditional deposits?

James Lally: Yes, Jeff. This is Jim. Let me tackle that and then Scott and Keene can certainly join in. So I look at it this way, it blends well with our overall deposit base. If you think about how we built the business and the franchise carefully with commercial and business banking and consumer and the specialized blends in nicely. It’s very stable deposit base. Largely an insured deposit base, and it does come in with some nice chunks and we’ve done some great work relative to the areas, especially in the property management in the last year to pick up great clients that were somewhat orphaned by those who are no longer around. And so we feel as we go forward, it blends well with everything, and certainly too much of a good thing is too much of a good thing. But as we see it, it’s allowed us to reduce reliance on brokered CDs and yet maintain a very healthy return profile.

Jeffrey Rulis: Got it. Is there a limit that you – too much of a good thing? Do you say, hey, we want to cap this at a certain percent right now with an elevated brokered and running it off, and it seems appropriate?

James Lally: Yes. So we look at it this way. So we look at – carefully, we look at our growth for 2024 and beyond. And you know us too. We’re not a spigot on, spigot off business, right? We’re going to support a particular segment well, but we’re not going to do it to a point that it’s harmful to the company. And so I look at it this way that if they’re – behind that deposit is an entity that is a long-lived client in any great environment, we’re going to support that. And we’re just going to have to figure out ways with respect to that blended into our overall deposit base to make a great return. And so we look at the overall growth for 2024 and 2025. And to the extent that we could fund all of that confidently without leaning into specialized deposits, likely we would, but we’re not going to be able to – so it’s going to be an important part of our overall growth going forward. But at this point in time, I’m not willing to put a cap on what that’s going to be.

Jeffrey Rulis: Got it. And Keene, kind of baked into that expense guidance you’re alluding to, continue to expand deposit costs there, but it maybe at a diminishing level. And you can give us overall deposit – excuse me, overall non-interest expense? Anything to guide us on how to model that ahead? Is there a percent of those deposits? Or I guess that’s variable, but any thoughts on how to model it?

Keene Turner: Yes. Let me give you a couple of pieces of information that I sort of think about high level and maybe this is helpful and you can either follow-up or tell me it’s not helpful. So in the second quarter, the $17 million on roughly $2.2 billion of deposits was like a 3% relative cost. In the current quarter, you’re at like [$3.35 billion] with $21 million on $2.5 billion. So when you look at $4 million sequentially, we estimate that roughly half was due to rate and pricing and competitive pressures and us really trying to drive down the brokered, and then the other half was really due to growth in the underlying balances of a few hundred million. So I think, obviously, you’ve got some blending in there in the quarter, but if you took [$3.50 billion] and said that’s your kind of current earnings credit.

And we’re I think viewing it as absent more activity by the Fed that the competition in that space should come down with some of what we’re seeing in the industry. We’ve been very fair to those customers, and we really think that moving forward, that the majority of the expense is going to be driven by volumes. So I think from my perspective that will be a way to kind of think about how we’re at least thinking about the fourth quarter and maybe the first quarter. And then I think you made some comments earlier to Jim and in terms of the efficiency of the business. And we look at this, if you stack it up versus peers, our margins near the top of the stack and efficiency sort of in the top third, as it’s reported today. But if you re-class these deposit costs, margin would maybe be in the sort of top 10% or 15%, but efficiency would go right to the top of the chart at roughly 50% in the quarter and lower than that, and then the 40% year-to-date.

So to Jim’s point on returns, I mean, I think if we look at it that way and you just sort of do some with and without, it helps you really characterize how efficient we are truly being in the business and where we stack up. Obviously, we wouldn’t – we don’t necessarily publish those results because it belongs in non-interest expense, but just a way for us to gauge what it would be if that was just truly a commercial deposit and we were paying an interest rate on it.

Jeffrey Rulis: Got it. Yes, second guessing, just trying to get a better handle on it. So I appreciate the detail. Maybe just one other topic. Just on the loan front, and Jim, I think you mentioned it’s kind of mid-single digit. I just wanted to make sure that’s sort of net of – well, one, I don’t – to be embedded in that as. Do you anticipate more SBA loan sales? And would that mid-single-digit include – is that net of expected sales or…

James Lally: Yes, that would be net of that. That’s what we’re predicting. And part of it is not having a whole lot of faith that the CRE market is going to be significant in the first half of 2024. That’s why we moderate back to that. So we feel good about that number and being able to do it in a very responsible manner with some high yield there, too.

Jeffrey Rulis: Okay. I appreciate it. I’ll step back. Thanks.

Operator: Your next question is from Andrew Liesch of Piper Sandler. Please go ahead. Your line is open.

Andrew Liesch: Some clarification on the non-performers here. I guess how long have they been on your radar screen and then look out into the future? And what are you seeing with trends in 30 to 89-day past dues?