Earnings Call Transcript - PNFP Q3 2023

Operator, Operator

Good morning, everyone, and welcome to the Pinnacle Financial Partners Third Quarter 2023 Earnings Conference Call. Hosting the call today from Pinnacle Financial Partners is Mr. Terry Turner, Chief Executive Officer, and Mr. Harold Carpenter, Chief Financial Officer. Please note that Pinnacle's earnings release and this morning's presentation are available on the Investor Relations page of their website at www.pnfp.com. Today's call is being recorded and will be available for replay on Pinnacle's website for the next 90 days. During this presentation, we may make comments that include forward-looking statements. These statements are subject to risks, uncertainties, and other factors that may cause the actual results, performance, or achievements of Pinnacle Financial to differ materially from any expressed or implied results. Many of these factors are beyond Pinnacle Financial's control or ability to predict, and listeners are advised not to place undue reliance on these forward-looking statements. More detailed descriptions of these and other risks are contained in Pinnacle Financial's annual report on Form 10-K for the year ended December 31, 2022, and its subsequent quarterly reports. Pinnacle Financial disclaims any obligation to update or revise any forward-looking statements in this presentation, whether due to new information, future events, or otherwise. Additionally, these remarks may include certain non-GAAP financial measures as defined by SEC Regulation G, along with a presentation of the most directly comparable GAAP financial measures and a reconciliation of non-GAAP measures, which will be available on Pinnacle Financial's website at www.pnfp.com. With that, I will now turn the presentation over to Mr. Terry Turner, Pinnacle's President and CEO.

Terry Turner, CEO

Thank you, Paul, and thank you for joining us here this morning. Most of you have endured these calls before. And so, you know we're going to begin every one of these calls with this shareholder value dashboard because these metrics are our North Star. There are a lot of interesting things that can be talked about, but ultimately, we're here to produce shareholder value, and this is how we think you do that. Of course, we always resort to these non-GAAP measures because this is how I really manage the business. At a glance, you can see that we continue to grow revenue and EPS more rapidly and reliably than peers, that we continue to grow our balance sheet volumes more rapidly and reliably than peers, and that we relentlessly focus on tangible book value. Also, our asset quality continues to be strong with problem asset metrics continuing to outperform peers at 23 basis points. Net charge-offs are excellent, but a little lumpy. You can see that they jumped up just a little bit this quarter because of a large, much-publicized syndication we were in. But generally, our nonperformers and classified assets have been peer-leading with NPAs ranked number three among peers in Q2 and classified assets, number two among peers. So, from 30,000 feet, it's my opinion that we continue to deliver on all the key drivers of real long-term shareholder value creation. So, with that, Harold, let's take a more in-depth look at the quarter.

Harold Carpenter, CFO

Thanks, Terry. Good morning, everybody. We will again start with deposits, reporting linked quarter annualized average growth of almost 19% in the third quarter was again a real positive for us. The third quarter was yet another indication that obtaining deposits in an environment where competition can be unpredictable is very much doable for this franchise. Early in the third quarter, competitive rate pressures remained fairly intense. As we approach the middle part of the quarter, it appeared that rate pressures did subside somewhat, with a mix shift of noninterest-bearing to interest-bearing slowing during the third quarter as we were down $112 million, much less than prior quarters of this year. All-in deposit costs increased to 2.92%. I'd like to point out that we ended the quarter with a spot rate at quarter end of 2.97%, only 5 basis points higher than the average for the quarter. That is the smallest difference we've seen between the average rate in the quarter in rate and a long time signaling to us perhaps a much more modest increase in deposit rates in the near term, and we are optimistic about the pace of deposit rate increases as we head into the fourth quarter. We also believe we'll continue to be disciplined as to the relationship between pricing and growth of our deposit book. As many of you know, our goal is to be the best organic deposit grower and we feel like we are on our way. Terry will speak more to our deposit-gathering capabilities in a minute. The third quarter was another strong loan growth quarter for us as we were reporting an 8.4% linked quarter annualized average loan growth. Given that, we're maintaining our EOP loan goals for 2023 at low to mid-teens growth. As we've mentioned over the last several quarters, we're exhibiting much more discipline on fixed-rate loan pricing, which ended the quarter with average fixed-rate loan yields on new originations of 7.17%. Spread maintenance on floating and variable rate loans continues to be strong. We are pleased with yields on our originations and believe we can continue to maintain similar loan spreads as we enter the fourth quarter. As the top chart reflects, our NIM decreased 14 basis points, which is more than we anticipated at the start of the quarter. What we did anticipate was an increase in average cash as we had more cash on our balance sheet spillover at the end of the second quarter into the third quarter. During the third quarter, our cash balances did decrease modestly as our liquidity did decrease during the quarter. So, we believe that liquidity will be less impactful on our margins in the fourth quarter. That said, with a backdrop of slowing deposit pricing and with fixed-rate loan repricing at better spreads, we're growing more confident that our NIM has found the bottom or we at least are fairly close. We're anticipating our fourth quarter NIM to approximate our third quarter NIM or perhaps be slightly down. Obviously, should deposit pricing heat up in conjunction with competitors just becoming more aggressive, we might need to revisit that assertion. But as we sit here today, we feel like we are close. Our rate forecast, we believe, is consistent with most rate forecasts out there. Our planning assumption is that we're not going to see another Fed rate increase, and future Fed rate decreases are not expected until the second half of next year. Call us believers in a higher-for-longer rate environment. With that, we don't believe a near-term Fed rate increase will be that impactful to us either in the fourth quarter or as we enter 2024. As you know, the macro environment is volatile and very unpredictable right now. And given that we will have a continued bias towards elevated interest rate risk management, guarding the liquidity of our balance sheet and modest capital accretion. As for credit, we're again presenting our traditional credit metrics. Pinnacle's loan portfolio continued to perform well in the third quarter. Our belief is that credit should remain consistent for the remainder of the year. Our credit officers continue their routine periodic credit reviews of the portfolio and bring resources to bear for borrowers exhibiting potential signs of weakness. The CRE appetite chart on the bottom right is largely unchanged from the prior quarter but does reflect perhaps a slightly more conservative appetite for multifamily and industrial from what we have shown over the last few quarters. Charge-offs did increase to 23 basis points during the quarter. During the quarter, there was a lot of information out there about a single syndicated credit out of Atlanta. We were a participant in the syndication for about $10 million, not sure of any recovery opportunities at this point, but we will continue to work with the lead bank and the syndicate to recover whatever might be available. We have shown this slide before the top-left chart deals with trends in construction originations. We began dramatically reducing our appetite for construction last summer, which is consistent with the chart. A modest amount of new construction originations during the third quarter was primarily due to new home construction loans under existing officer guidance lines to our residential homebuilders. Secondly, much discussion about renewals of commercial real estate fixed-rate loans, which is the objective of the chart on the top right. Over the next several quarters, we will have approximately $100 million in fixed-rate commercial real estate renewals coming up for repricing where the average rate on these loans is currently around 4.5%. Our current yield target for these loans at renewal will be in the 7.5% to 8% range. Altogether, we have about $6 billion in fixed-rate loans maturing over the next two years with a weighted average yield of 4.4%. Thus, we see real opportunity from a repricing perspective. Now on the fees. And as always, I’ll speak to BHG in a few minutes. Excluding BHG and the impact of the gain on sale of fixed assets and the loss on the sale of investment securities, fee revenues were up slightly from the second quarter. A couple of items to point out here, which we believe are noteworthy. During the quarter, we recognized $5.9 million in revenues from a solar tax investment that we entered into in December of 2022. We received a third-party report as to the adjusted value of the investment during the third quarter, which provided us the support for the results we posted. We're excited about our solar business and what we believe it can and will accomplish. Starting last year, it's relatively new to us as we only have about $130 million in balances, where we have a staff with seasoned industry veterans from large cap franchises. So, we expect great things from this business line. Just like many of our other equity investments, valuation gains and losses are difficult to predict, and thus the ongoing contribution to our fee revenues will always be choppy. As I mentioned, we'll go into BHG more in just a second, but I wanted to emphasize that BHG continues to represent less of our pretax revenues this quarter than in previous quarters. As we noted in last night's press release, we believe BHG has decreased to a 9% contribution to this year's fully diluted EPS compared to approximately 20% last year. We anticipate that fee revenues, excluding BHG, the gain on the sale of fixed assets and investment security losses were coming in at around a mid to high single-digit growth rate for '23 over '22. Not a lot to say here this time on expenses. Total expenses came in about where we thought. We did adjust our incentive accrual downward to 65% of target this quarter based on where we believe our performance metrics will come in for all of 2023. Our outlook for expense growth for 2023 over 2022 remains in the high single, low double-digit range, same as last time. One quick comment on FDIC insurance. We are expecting a special assessment to replace the bank insurance fund before year-end. Our understanding is that the industry will likely recognize that as a charge to the P&L when that amount is known. Just so you know, we expect that charge to be in the $25 million to $30 million range, and this charge is not reflected in our outlook for 2023 expense growth. Our tangible book value per common share decreased to $48.78 at quarter end, down slightly from June 30. The decrease was primarily attributable to the rise in intermediate-term interest rates during the third quarter and the resulting impact of that on the market values of our AFS portfolio and, of course, AOCI. Our outlook for the fourth quarter is that our capital ratios will likely be flat to down next quarter. Contributing to this will be the usual fourth quarter P&L matters, fourth quarter loan growth, et cetera. Of note is that BHG will record their day one CECL adjustment in the fourth quarter, and this will serve to reduce our capital accounts by a modest amount. This day one non-cash adjustment will not impact our fourth quarter earnings. I repeat, it will not impact our fourth quarter earnings and should approximate a charge to capital of approximately $40 million. Subsequently, BHG will likely need to maintain their reserves that amounts to approximately 9% of total balance sheet loans. The impact of maintaining loss reserves at those levels going forward has been considered at our fourth quarter outlook for BHG. We believe the actions we've taken to preserve our tangible book value and our tangible capital ratio have served us well, and we have no plans currently to alter our Tier 1 capital stack being any sort of common or preferred offer. The chart on the bottom left of the slide details several pro forma capital ratios as of the end of September. Although we don't anticipate significant changes to the capital rules, we are pleased with these results and believe they will likely compare favorably to other peer banks. Now a few comments about BHG. The top right chart is consistent with our previous quarterly earnings calls and details that production has been consistent over the last several quarters, at about $1 billion to $1.2 billion per quarter. Placements to the bank network were less in the third quarter, while placements to the institutional investors were again at the highest level ever and signaled that demand for BHG paper from some of the most respected asset managers in the country continues to be really strong. As we look to the fourth quarter, BHG believes origination volumes will likely be less than Q3 as they continue to shrink their credit box, and they believe sales into the bank network could experience some decline over the next few quarters as that client base continues to wrestle with a more restricted funding environment, and we also believe BHG will likely want to build loan inventories in the fourth quarter as they head into 2024. BHG's bank network, which we think is quite distinctive and challenging for competitors to replicate, will keep expanding and providing significant liquidity to BHG. We shared insights on the substantial liquidity changes available to BHG and their loan production placement during our last update. In the third quarter, BHG successfully negotiated two private home loan sales totaling approximately $400 million, with these transactions executed without recourse to BHG. Additionally, BHG is preparing for its eighth Capital Markets transaction in the fourth quarter, expecting a securitization volume around $300 million. In summary, we believe BHG has built an impressive liquidity platform that will serve it well for many years ahead. We presented the usual data on spread trends since the first quarter of 2021, featuring a chart depicting gains from the off-balance sheet bank network and another showing a blended view of all on-balance sheet funding, which reflects historical balance buildups and expected spreads for balance sheet loan placements that have slightly decreased due to higher rates and a tighter credit box. During the third quarter, the blended spreads for all balance sheet loans was slightly higher than the bank network given the balance sheet loans reflect the buildup of balances over the last three years. As we hit the fourth quarter, BHG believes that spreads for both on and off-balance sheet loans should be consistent with the third quarter. As we've noted in previous quarters, BHG has tightened its credit box over the last several quarters, particularly with respect to lower tranches of its borrowing base. Production volumes remain strong even with tighter credit underwriting. BHG refreshes its credit scores monthly, always looking for indications of weakness in its borrowing base. Credit scores are obviously up from previous years. The finish chart on the right is helpful to understand how much underwriting has improved and does impact the loss containing the portfolio. At the top of the chart of the lines reflecting originations in 2012 and through 2015, lines begin to level out at cumulative loss rates of 10% to 12%. Vintages after 2015 began to reflect improved performance with the lines leveling out within the 5% to 10% loss ranges. BHG continues to allocate resources to the post-COVID vintages of 2021 through the first half of 2022 as those vintages BHG believes were graded higher than the borrower ultimately market and thus skewed the loss rates higher for those loans. This slide again provides more information on credit and detailed reserves and losses for both off-balance sheet and on-balance sheet loans. BHG is optimistic about credit at the end of the third quarter. Typically for BHG, approximately 70% of the loss is incurred within the first three years of origination. But with great inflation, as was mentioned about the 2021 and the first half of 2022 vintages while it should and has come to light sooner. As a result, BHG has expended significant resources to bulk up collection activities, and we'll be instituting in-person closings for new borrowers, which was suspended during COVID. Although higher than historical losses are likely for the near term, the credit performance of the portfolio does appear to be improving pointing towards cautious optimism as we enter the fourth quarter and into 2024. BHG had another strong quarter with approximately $1 billion in originations and are on track to achieve $3.8 billion to $4 billion in originations this year, which is slightly less than last year, but consistent with our outlook from the last quarter. As we mentioned last quarter, BHG had a conservative bias going into the third quarter such that as they continually tightened their credit box, production in the last half of the year was expected to be lower than the first half. The current fourth quarter loan production forecast should approximate $600 million to $800 million in order to follow within the 2023 full-year guidance, which is less than the quarterly production levels thus far this year. During the quarter, BHG record several one-time expenses related to the markdown of a building they anticipate selling as well as markdowns of some software assets and other items that were related to some business lines that BHG has elected to not support any longer. These one-time charges amounted to approximately $10 million during the third quarter. These amounts have been incorporated in BHG results and outlook for 2023. Net earnings for 2023 are forecasted at $175 million to $185 million, inclusive of the one-time adjustments just mentioned, and is basically consistent with the range from last year's forecast. Quickly, the useful slide detailing our financial outlook for 2023, we have a bias currently toward a more cautious outlook when it comes to credit, interest rates, and capital. Our job is to manage the risk that face this franchise every day, what we know is that our business model remains relationship-based, nimble, and resilient. Our management team has significant experience and has tackled economic downturns before. We have great confidence that we'll be able to manage the high-quality banking franchise that our shareholders have put it back from us and can currently handle whatever curve balls get thrown our way. And with that, I'll turn it back over to Terry.

Terry Turner, CEO

Thanks, Harold. Warren Buffett and others have famously said, manage the fundamentals and tell the story, and the stock will take care of itself. I believe that. At Pinnacle, we are managing what we believe are the fundamentals, the critical variables to creating outsized shareholder value. And so, my goal here now is to tell the story to crystallize the extraordinarily valuable deposit franchise we've built. As an industry, we've been in war the last three quarters, and in the fog of war, it's easy to get confused about what's really important. We've all witnessed three high-profile franchises go to zero, primarily because of two things. Number one, their enterprise-wide risk management. In my judgment, they all took extraordinary risks; and two, the stickiness of their deposits. The risk of the management team is willing to take matters and how they use their security book matters and how they manage interest rate sensitivity matters and how they manage concentrations matters, and then how they attract and retain their deposits matters. Personally, I wouldn't want to be long any bank our size that's stuck in the commodity trap. That means an undifferentiated franchise from a client's perspective. Because in that case, there's no ability to reliably gather deposits at a pace sufficient to sustain outsized revenue and EPS growth and no ability to retain deposits in difficult times, which again jeopardizes the reliability of their growth but a bank that can attract talent by virtue of being an employer of choice, a bank that utilizes its client experience as the primary basis by which it attracts clients and retains clients a bank that can rapidly and reliably grow net interest income, the largest component of EPS, that's available deposit franchise. Anyone who's heard me tell Pinnacle stories has heard me talk about the Pinnacle philosophy that excited associates produce engaged clients and nothing enriches shareholders like engaged clients, meaning raving fans that bring more business to you and refuse to leave you in times of uncertainty. Many times, when I discuss that philosophy, I try to list the profits, the workplace awards we've won, the service and brand awards we've won, the outsized shareholder returns we've produced over short, medium, and long-term time frames. But today, I want to show you the power of building a great workplace and being an employer of choice. Happily, most of the banks that have leading market share positions in our footprint are hemorrhaging talent. While I can't provide a metric to prove that, I do believe we're the employer of choice throughout our footprint. What bank do you know that has produced a compound annual growth rate of revenue producers of 7%, a 7% per annum increase in the number of experienced revenue producers while still producing top-quartile profitability? That's a valuable deposit franchise. By virtue of the associate engagement you're able to create, you provide clients an experience that lights them up, that engages them in such a way that they want to bring you more of their business and they want their friends and colleagues to experience the same thing. Those are what researchers refer to as promoters. At 57, according to J.D. Power, we have the second highest Net Promoter Score of all the top 50 banks in the United States based on asset size. Number two in the country. That's impressive. Of course, J.D. Power has more of a consumer's lens, so we rely a little more on Coalition Greenwich, which is more focused on businesses. According to Greenwich, our ability to create an experience that results in raving fans, promoters is literally one of the best in the nation. I know no competitor in our area is coming close to a 79 Net Promoter Score, and I'd be surprised if any bank in the country exceeds that. This helps explain our significant outperformance in deposit growth, particularly in net deposit growth and our capacity to attract and retain deposits, which is far superior to our peers, both before and after the bank failures. I would characterize this as a valuable deposit franchise. Nashville serves as the prime example. Referring to the FDIC summary of deposit market share data, you can observe the market share leaders in Nashville as of June 2000, just before we opened in October 2000. I've included the 2022 data for clarity, showing the impressive market share we gained and how we achieved it. The most recent data on the far right indicates that our model continues to rapidly increase deposit market share in Nashville in 2023, defying the law of large numbers. What I want to highlight is that while being in large, high-growth markets is incredibly advantageous, nothing is more valuable than providing a unique experience that consistently captures market share from weaker competitors in our markets. Think about that. Over 23 years in existence in Nashville, the top three banks gave up 27% share, and we took nearly 21% of the market from them. That's a valuable deposit franchise. Honestly, I'm not aware of a single bank in the country with that kind of deposit-building franchise. And while we've been at it the longest in Nashville, based on FDIC market share data for 2023, we're growing share in virtually every market that we're in. All of those listed here have positive share growth. Look at this, when you compare the deposit volumes we're now producing in markets like Atlanta and Washington, D.C. to our first three years in Nashville, where we now dominate, you have to be blown away by how that propels sustainable growth going forward. As I've alluded to several times now, to be a valuable deposit franchise, in addition to your ability to attract deposits, it’s critical that you can retain deposits in times of crisis. And we don't need to invent metrics that we hope might be predictive of how sticky banks' deposits are; we can know, right? I would say the best test of a bank's ability to retain clients was how well they did in the period of time leading up to and immediately following the Silicon Valley Bank failure. It was the worst bank crisis since the Great Depression, and it occurred in this time of frictionless transfers. It's never been easier to transfer bank balances than at this time. We've seen three relatively large bank failures occur precisely for that reason. But at Pinnacle, in that extreme crisis, not one of our 200 largest depositors left us in the month following those failures, not one. The balances of those 200 totaled $3.9 billion at the time of the SVB failure and $3.9 billion roughly a month after that failure. It's just hard to leave a bank you love and trust, and that's a valuable deposit franchise. A further proof of the power of the franchise is that, according to Greenwich, over the next six to 12 months in our footprint, Pinnacle is the most likely bank to earn more business and the least at risk of losing business. For each of the three banks that dominate our footprint in terms of existing deposit client share, between 17% and 22% of their clients indicate they're likely to lose business in the next six to 12 months. That's a huge opportunity for us to produce outsized growth, given our proven ability to take their share. Because our clients' engagement with us, nearly 40% of our clients indicate a likelihood that we'll earn more of their business. I would say that the franchise is most likely to earn new business and least likely to lose business is a very valuable deposit franchise. And of course, the ultimate goal of all that is to rapidly and reliably increase total shareholder returns. Over the last 10 years, our total shareholder returns have substantially outperformed all our peers. As we've grown in asset size, our PE multiple has contracted more than most of our peers, largely, I suspect, due to a fear of the law of large numbers. For us to produce outsized total shareholder returns as our PE contracts, we had to substantially outgrow peers in terms of EPS, which we did. Given that net interest income is by far the largest component of EPS, it'd be hard to substantially outgrow peers in terms of EPS over an extended period of time without growing them in terms of net interest income. And it'd be hard to outgrow peers over the long haul in terms of net interest income without outsized loan and deposit volume growth. So hopefully, you'll agree that a bank that can attract talent by virtue of being an employer of choice, a bank that utilizes its client experience as the primary basis by which it attracts clients and retains clients, a bank that can rapidly and reliably grow its net interest income, the largest component of EPS, that's a high-value deposit franchise. Paul, I'll stop there, and we'll take questions.

Operator, Operator

The first question today is coming from Steven Alexopoulos from JPMorgan. Steven, your line is live.