Enterprise Financial Services Corp (NASDAQ:EFSC) Q4 2023 Earnings Call Transcript
Enterprise Financial Services Corp (NASDAQ:EFSC) Q4 2023 Earnings Call Transcript January 23, 2024
Enterprise Financial Services Corp isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Thank you for standing by, and welcome to the Enterprise Financial Services Corp. Fourth Quarter 2023 Earnings Conference Call. I would now like to welcome Jim Lally, President and CEO, to begin the call. Jim, over to you.
Jim Lally : Well, thank you, Mandeep, and thank you all very much for joining us this morning, and welcome to our 2023 fourth quarter earnings call. Today is January 23, 2024. And joining me this morning is Keene Turner, EFSC's Chief Financial Officer and Chief Operating Officer; Scott Goodman, President of Enterprise Bank & Trust; and Doug Bauche, Chief Credit Officer for 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. 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 fourth quarter once again showed the strong earnings power of our company despite the manifestation of a few credit challenges that we experienced. Diluted earnings per share for the quarter was $1.16 and versus $1.17 in the third quarter and $1.58 in the fourth quarter of 2022. Before I get into some of the highlights of a very strong quarter and year, I would like to briefly address the elevated level of charge-offs that we experienced during the quarter. 2 relationships that we charged off during the quarter could be described as extraordinary and uncharacteristic. The first such credit was an agricultural loan, which we believe was an isolated incident that was not directly related to our credit underwriting. There were irregularities in the financial information provided by the borrower that masked the challenges it was facing and ultimately covered up a $13 million collateral shortfall.
In the fourth quarter, we placed a full $16 million relationship on nonperforming status and correspondingly charged off a $13 million shortfall. Additionally, we are taking the appropriate actions and utilizing all available resources to recover what we can for the remaining $3 million outstanding. We have stopped originating new credit relationships in the agricultural space, and will wind down this approximately $200 million portfolio over the next few years. We have our team engaged and we are actively conducting thorough reviews of each relationship including physical farm inspections and even more extensive collateral field audits to reinforce our confidence in the balance of the portfolio. We'll be engaging a third party to validate these findings to ensure that we do not have any other similar situations to this one.
Our initial review provides comfort with respect to the health of the remainder of the portfolio. The other major loss that we experienced in the quarter was related to a $10 million unsecured credit exposure that was part of a First Choice legacy relationship to a Southern California commercial real estate investor. After several unsuccessful attempts to find suitable collateral to shore up this credit and the borrowers' inability to keep payments current, we took this unfortunate but appropriate action to charge off this credit. $3 million of this was identified in reserve for in the third quarter, with the remaining $7 million reserved in the fourth quarter. We ultimately charged off the full $10 million unsecured portion. We will continue to pursue all remedies for any sort of recovery.
The remainder of our loan portfolio has performed as we anticipated. Overall, classified loans remained stable in the quarter and NPLs declined over 10% to $43 million while classified loans to capital held steady at 10% at year-end. Delinquencies were well controlled at year-end at only 15 basis points. Entering 2024, I'm confident in our ability to deliver asset quality results that are in line with our historically strong performance. Despite this unusual level of charge-offs, an appropriate increase to our provision expense, our company delivered very strong financial results for both the fourth quarter and the entirety of 2023. The summary of this begins on Slide 3. Keene will provide much more detail on our quarterly and full year financial performance in his comments, but ahead of these, I would like to provide a few highlights.
Our strong financial performance continued during the fourth quarter. We earned net income of $44.5 million or $1.16 per diluted share and we produced an ROAA of 1.28% and a PPNR ROA of 2.10%. ROTCE 2 improved when compared to the third quarter increasing to 14.98% compared to 14.49%. These results reflect a robust earnings profile that allowed us to absorb some deterioration in credit during the quarter. Combined with our strong reserves and balance sheet, we remain positioned to operate as we have in the past. This means both delivering returns to shareholders while also supporting the needs of existing and new clients. The ability to continue to fulfill the low needs of these clients and prospects continues to open up channels of deposit growth as well.
Like in years past, we experienced our typical fourth quarter strength in loan growth. For the quarter, loans increased $267 million or 10% annualized. As important, we, again, were able to fund this growth with our client deposits, which increased by $479 million in the quarter after netting out the reduction in brokered CDs. We finished the year with a loan-to-deposit ratio of 89.4% and our ratio of DDA to total deposits came in at 32.5%. A couple of things worth mentioning regarding these results. First, we are seeing all markets and businesses contributing to these numbers. Unlike in years past, we're not relying on any 1 or 2 markets or businesses to achieve. This diversification, both in terms of geography and revenue has been intentional and the fruits of these investments continue to manifest themselves in our financial results.
Secondly, post the March banking crisis, we set a goal to fund our second half loan growth with client deposits. Not only did we do this, but we just about funded the entire year's loan growth with our second half success. We also set a goal to keep the percentage of DDA to total deposits north of 30%, and we accomplished this too. Finally, we believe that we have relatively stabilized NII, which means that our daily net interest income has remained stable the last several months. Scott will give much more color on the markets and the businesses where we saw continued success, but I'm encouraged that we'll be able to fund our mid-single-digit loan growth in 2024 with well-priced relationship-oriented client deposits. Moving on to capital. Our balance sheet remains strong and positioned for continued growth.
Capital levels at quarter end remained stable and strong, with our TCE to TA ratio at 8.96%. Tangible book value per common share at year-end was $33.85. This is an increase of 18% in 2023 and is due to our strong earnings and return profile. Before I move on to where we will be focused in 2024, I want to reiterate that the strength of our earnings profile generates pre-provision earnings that have averaged over $70 million per quarter this year. This provides a significant buffer to absorb credit issues before ever touching our loan loss reserves or capital that are also at 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 in the second half of 2023, we 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. We will stay focused on continually improving our performance in all our business lines and markets. This, combined with improved credit performance and continued steadfast expense management should consistently produce strong earnings amid the current economic and rate environment that we are in. My optimism for our prospects stems both from my confidence in our business model, a careful review of our loan portfolio and the optimism that I continue to hear from our clients. One final note. Throughout 2024, we'll be working on a core system conversion after 35 years on the same system, this upgrade will further improve our efficiency in many areas while also improving the quality and accessibility of our data.
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, Q4 loan and deposit growth was strong, pushing us to double-digit annual growth for both categories in 2023. These results are significant, not just based on the magnitude of the growth, but also when considering that they're fully organic and highly diversified across geographic markets and specialty business lines. . Loans, which are highlighted on Slides 8 and 9 were up $1.15 billion or 12% for the year with most major categories of the portfolio contributing materially to this growth. For the quarter, broken out on Slide 9. Loans rose $267 million, contributing 23% of our growth for the year and up 157% from the prior quarter. displaying the traditional seasonal lift, which is characteristic of our portfolio.
C&I was a standout this quarter, benefiting from several significant new client relationships and elevated usage on revolving lines of credit. Specialized loan growth was helped by strong seasonal performance in the life insurance premium finance and tax credit lines of business. In Premium Finance, we continue to originate steady closings on new policy loans from our referral network and experienced the typical Q4 uptick in premium payments due for the existing policies. Advances on affordable housing projects and process accounted for the majority of the increase in the tax credit portfolio. For Q4, SBA came in somewhat below expectations, down $27 million due mainly to slower execution of the pipeline and elevated prepayments. Prepayments continue to be stressed by the higher rate environment, and we remain committed to our high credit standards and focus on owner-occupied real estate secured loans.
Much of the lag to pipeline is expected to push into Q1 and gross production remains relatively consistent, but paydowns continue to be a headwind. The Sponsor Finance book posted a modest decline in the quarter as actively slowed in general in the space -- activity slowed in general in the space during Q4. Following robust activity in the first half of the year, private equity and slowed their pace of acquisition to digest this activity and to consider the impact and direction of the interest rate environment on their pipeline opportunities. We're also taking a disciplined approach to sponsors and to credit structures in this segment, and we would expect these factors to moderate the growth rate in the coming year. Moving to Slide 10. Loan portfolios posted growth across all major regions for the year and in the current quarter.
Specialty lending was up modestly for the quarter related to the aforementioned niche business lines as well as continued growth in the practice finance vertical, which was up $12 million in Q4 and $81 million for the full year of 2023. In the Midwest, St. Louis and Kansas City portfolios were up $78 million or nearly 10% annualized, showing balanced growth between increased line usage, fundings on construction and process and new loan originations. Notable deals this quarter include a new relationship with a middle market construction materials provider and 2 new loan facilities with long-time relationships in the hospitality and business finance industries. In the Southwest, the combined markets grew $102 million in Q4 and 26% for the full year of 2023.
Results for the quarter were bolstered by elevated new originations as well as additional fundings on existing construction projects in process. Significant new loans include new relationships with a premier middle market electric contractor, and a specialty precision parts manufacturer in Phoenix as well as large, well-established general contractor in Las Vegas. In our Western region of Southern California, loan balances were up by $58 million in Q4 to round out a year in which we grew this portfolio by 9.5%. The increase this quarter is primarily related to success by our recent talent additions onboarding a number of new relationships, including companies in the specialty food production business, financial services and manufacturing spaces.
We also continue to expand legacy relationships in this book with new loans to top-tier clients in the franchise and commercial real estate sectors. Moving now to deposits on Slides 11 and 12. Total deposit balances were up $266 million for the quarter and $1.3 billion or 12.4% year-over-year. Breaking this down, noninterest-bearing DDA accounts were down year-over-year by $684 million, with interest-bearing DDA accounts up by a similar amount due mainly to the remixing behavior of depositors precipitated by accelerated rate increases throughout 2023. In the quarter, however, noninterest-bearing DDA balances grew by $107 million relating to success of onboarding new C&I commercial banking relationships, increased property management and third-party escrow accounts as well as some seasonal cash build.
Deposit growth by region is broken out on Slide 13. We grew client balances net of specialty deposits and brokered CDs in the quarter by $394 million with growth being spread throughout the geographic footprint and across all regions. Higher growth was experienced in the Midwest, mainly relating to the larger C&I books in our Kansas City and St. Louis markets, but highlighted as well by several large new C&I deposit relationships. In the West and Southwest regions, higher balances reflect the impacts of new relationships as well as a focused effort to attract new funds through the consolidation of balances from our existing clients. Specialty deposits grew $85 million in the quarter and are broken out in more detail on Slide 14. The increases this quarter were mainly within the property management and third-party escrow segments as we continue to expand these lines of business with new accounts and new relationships.
Q4 is typically a seasonally softer growth quarter in the Community Association line as expenses are paid and new accounts begin to be opened, which will then fund up as assessments are collected during Q1. Additional detail on the core funding mix and the account activity is shown on Slide 15. A majority of our growth this quarter has been with the commercial account base, which generally represents relationship-based balances, 80% of which are treasury management clients. And while we have seen the aforementioned mix shift from DDA into interest-bearing options, the pace of this activity has slowed. 37% of our total balances still reside in noninterest-bearing accounts. The underlying account activity also continues to trend favorably and reflect our intentional and elevated efforts toward emphasizing core deposits, with new accounts open exceeding closed accounts and net balance increases when comparing new accounts to closed accounts 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 be on Slide 16, where we reported earnings per share of $1.16 in the fourth quarter on net income of $45 million. Excluding the impact of the FDIC special assessment, EPS was $1.21 per share, an increase from the third quarter. Net interest income in the quarter was relatively stable earning asset growth and disciplined pricing on loans and deposits, mostly offset the increase in interest expense in the quarter due to the deposit remixing and rate changes. . Fee income was seasonally higher, which is typical in the fourth quarter and was the primary driver of the increase in operating revenue. The provision for credit losses increased for the quarter, as Jim discussed, driven by net charge-offs and loan growth.
And noninterest expense was higher in the current quarter mostly due to the FDIC special assessment. Overall, pre-provision net revenue of $76 million for the quarter increased $11 million or 16% from the third quarter. For the full year, preprovision net revenue was $285 million, an increase of 10% from 2022. Pre-provision net revenue was up 12% in 2023 and when you consider that pre-provision net revenue in 2022 included $5 million of PPP income that did not repeat this year. This continues to reflect the strength of our earnings profile and our ability to generate capital to support balance sheet growth. Turning to Slide 17. Net interest income for the fourth quarter of 2023 was $141 million, which was a decrease of less than $1 million compared to the linked quarter.
Interest income increased $6.2 million in the fourth quarter, driven mainly by continued loan growth and higher rates on portfolio loans. Cash levels also increased modestly as a result of strong customer funding and added $1 million to interest income. Loan yields increased 7 basis points while average balances were higher by more than $160 million. The average interest rate on new loan originations in the fourth quarter of 2023 was 7.95% and the most recent month loan yield is just under 7% overall. More details follow on Slide 18. Interest expense growth slightly outpaced growth in interest income in the quarter. Customer deposit balances increased nearly $480 million in the quarter. This additional funding allowed us to reduce broker deposits by $213 million.
The balance growth was coupled with a 19 basis point increase in the cost of deposits, which was half the increase we observed in the previous quarter. With that said, the total cost of deposits was 2.03% in the fourth quarter and only slightly higher at 2.07% in the most recent month. The deposit pricing performance is aided by overall DDA percentage remaining at approximately 33%. The resulting net interest margin was 4.23% in the fourth quarter of 2023, a decrease of 10 basis points from the linked quarter and represents the 5 basis point drift from where net interest margin was in the month of September. We're encouraged by recent results that demonstrate deposit pricing has begin to further stabilize and margin pressure while still present, continues to level off.
Looking forward, while interest rates remain at current levels or higher for longer, we expect that overall funding costs will continue to move slightly higher over the next couple of quarters, and we will see margin drift of around 5 basis points per quarter on the existing balance sheet. Current asset growth at current spreads should allow us to defend net interest income dollars albeit somewhat with lower margin overall. With the prospect of rate cuts on the table, we anticipate each quarter point reduction in the Fed funds rate equates to an additional 6 to 8 basis points of margin loss initially or $2 million to $2.5 million of quarterly net interest income. Our expectation is that deposit rates will be more stable initially and in order to remain competitive, we may need to be cautious in reducing those rates.
With additional Fed cuts, we will be more methodical in moving deposit rates down, just as we were when we were increasing them. And while not a component of net interest income, reduction in interest rates would positively impact deposit-related noninterest expense trends as more than half of the underlying balances are indexed to the Fed funds rate. Each 25 basis points in Fed funds equates to approximately $4 million of annual expense on this line item. With that, we'll move on to our Credit Trends on Slide 19. Net charge-offs were $28 million for the quarter and $38 million for the year, representing 37 basis points of average loans in 2023. The majority of the charge-offs in the quarter relate to the 2 relationships that Jim discussed, the real estate developer in California and the agricultural loan that arose unexpectedly late in the fourth quarter.
These charge-offs coupled with the charge-off on the investor-owned office loan that moved into other real estate in the third quarter, make up the majority for the year. Nonperforming assets were 34 basis points of total assets compared to 40 basis points at the end of September. There were $32 million of loans that moved into nonperforming status in the fourth quarter, of which $24 million were charged off. An additional $4 million of nonperforming loans were charged off that were outstanding at the end of September. Between gross charge-offs, recoveries and pay downs, nonperforming assets decreased $6.4 million from the third quarter. We proactively worked through a number of problem credits over the last 2 quarters so that these issues were not carried forward into the current year.
The provision for credit losses of $18 million during the fourth quarter largely reflects the impact of net charge-offs and loan growth, partially offset by modest improvement in the economic forecast. Included in the provision for credit losses is $3.2 million benefit from the reduction of the reserve for unfunded commitments. This benefit primarily relates to a reduction in commitments on nonperforming loans and a general reduction in commitments due to the higher advance rate at the end of the quarter. Slide 20 represents the allowance for credit losses. The allowance for credit losses represents 1.24% of total loans or 1.35% when adjusting for government guaranteed loans. On Slide 21, fourth quarter fee income of $25 million was an increase of $13 million from the third quarter driven primarily by tax credit income, which is typically strongest in the fourth quarter.
In addition to the seasonality, an 80-basis point decrease in the 10-year SOFR rate in the quarter, positively impact credits carried at fair value, driving approximately half of the quarterly profit. Linked quarter increases related to community development, private equity distributions and BOLI helped to offset the gain on SBA loan sales from the third quarter. As a reminder, along with the seasonal tax credit income, community development and private equity distributions will fluctuate from period to period. Turning to Slide 22. Fourth quarter noninterest expense was $93 million, an increase of $4 million compared to the third quarter. Included in the current quarter was the FDIC special assessment of $2.4 million. Deposit service expenses were higher compared to the linked quarter, primarily due to growth in average balances, as Scott mentioned.
We do expect specialized deposits to continue to be a significant contributor to overall growth, which will continue to drive this expense line item higher. Other expenses increased from the linked quarter, but were partially offset by lower compensation and benefits expense related to lower performance-based incentive accruals and a reduction in accrued paid time off. The fourth quarter's core efficiency was 53.1%, a decrease of 312 basis points compared to the third quarter driven primarily by the increase in fee income. With some moderation of our net interest margin and net interest income expectations, in addition to the seasonally strong fee income, we do expect core efficiency to move up in the coming quarters. For all other expense categories, we expect to prudently maintain cost controls.
Our capital metrics are shown on Slide 23, and our tangible common equity ratio was 9% at the end of the third quarter, up from 8.5% in the linked quarter. The strength of our earnings profile and a rebound in the fair value of securities and derivatives drove the expansion in the quarter. On a per share basis, tangible book value increased to $33.85, which is a 9% increase over the third quarter. For the full year, tangible book value per share increased $5.18 or 18%. And looking back over a longer time frame, we have successfully compounded tangible book value per share by 10% annually over the last 5 years. With our capital, balance sheet and liquidity and strong positions we're operating with a strong foundation as we look into 2024. And while there was significant turmoil industry to start the year, we had great success in expanding our client base and generating returns.
We delivered a 16% return on average tangible common equity with average tangible common equity for the year at 8.7% and delivered a 1.4% return on average assets. With that, I'll conclude my comments, and I appreciate your attention. We're going to open the line for questions.
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