Earnings Call Transcript - PNFP Q2 2021

Operator, Moderator

Good morning, everyone, and welcome to the Pinnacle Financial Partners Second Quarter 2021 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. At this time, all participants have been placed in a listen-only mode. The floor will be open for your questions following the presentation. During this presentation, we may make comments that could be considered forward-looking statements. All forward-looking statements are subject to risks, uncertainties, and other factors that may cause the actual results, performance, or achievements of Pinnacle Financial to differ significantly from any results expressed or implied by those statements. Many of those factors are beyond Pinnacle Financial’s control or prediction, and listeners are advised not to place undue reliance on such statements. A more detailed description of these and other risks can be found in Pinnacle Financial’s Annual Report on Form 10-K for the year ended December 31, 2020, and in the quarterly reports filed thereafter. Pinnacle Financial disclaims any obligation to update or revise any forward-looking statements made during 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. A presentation of the most comparable GAAP financial measures and a reconciliation of the non-GAAP measures to the applicable GAAP measures will be available on Pinnacle Financial’s website at www.pnfp.com. With that, I’m now turning the call over to Mr. Terry Turner, Pinnacle’s President and CEO.

Terry Turner, CEO

Thank you, operator, and thank you for joining us this morning. Q2 was an outstanding quarter, in my view. As most of you know that have been following us for some time, we took a number of actions in the early stages of the pandemic, like modifying our incentive, focusing on PPNR growth during 2020, to ensure that we'd be in a position to quickly return to our pre-pandemic growth trajectory as the pandemic waned. I think the first two quarters of 2021 suggest that we've been largely successful in that. We begin every quarterly call with this dashboard reflecting our key performance metrics on a GAAP basis, but as we most always do, because there are so many adjustments required in order to focus on the variables that we're truly managing here at Pinnacle, I'll move quickly to the chart reflecting the adjusted non-GAAP measures. As you can see, the second quarter was another fabulous quarter for us. Linked-quarter annualized loan growth ex-PPP was 12.6%. Linked-quarter annualized core deposit growth was 14.2%. Linked-quarter annualized revenue growth was 20.1%, and already strong asset quality got even better. On a lot of these earnings calls, I try to provide more color on all or several of the key metrics that are on this chart, but today I want to focus more on the big picture. And that's really the speed and the reliability of the growth over an extended period of time. Look at the CAGR for virtually every important growth metric. And I think that demonstrates the speed and reliability of our growth, even in the face of the various headwinds we've encountered over time. Take EPS as an example. The 17% CAGR, you got a dip in 1Q, 2Q 2020 associated with the COVID-triggered reserve bill. But other than that, the growth is extremely reliable. Look at the revenue CAGR, the loan CAGR, the deposit CAGR, all very fast, all very reliable. Most of you know we conducted a three-day orientation program for every single new associate of this firm, conducted by me and other key leaders here. We invested time to help associates understand this culture, why it is what it is, and what makes the difference. It's intended to inspire a high level of associate excitement and engagement. One of the topics that we covered in great detail is how we produce shareholder value. The hour-long sessions conducted by Harold are intended to help every single associate personalize specifically what they do individually that increases shareholder value and the kinds of things they might do that destroy shareholder value. But the principal takeaway we expect every single associate to get is that two things are required for us to produce outsized shareholder returns. Number one, speed of growth. And number two, reliability of growth. So how is it that we produce such fast and reliable growth and how is it that we expect to continue reliable growth going forward – excuse me – even as many of our peers are being overwhelmed by the current headwinds like slack loan demand and heavy payouts. First of all, we've positioned ourselves in fabulous markets with extraordinary size and growth dynamics. Most of you heard me talk about our outlook in markets like Nashville, Charlotte and Raleigh, North Carolina, Greenville and Charleston, South Carolina, and Atlanta, one of the biggest and best markets in the country. And, of course, those size and growth dynamics are critical to growth. It's just hard to have a large, high-growth bank without large, high-growth markets. On last quarter's call, I talked about the fact that I expected to continue hiring revenue producers in our existing footprint at a rapid pace and that we'd likely have opportunities to expand into other southeastern markets due to the high level of M&A activity and all the associated vulnerabilities that that creates. And so, as you can see here, primarily as a result of integration turmoil, we were the most desirable alternative for a good number of high-profile revenue producers in Birmingham, the Southeast's 13th largest market, and Huntsville, the Southeast's 13th fastest-growing market in terms of GDP. I want you to know that our reputation as a highly successful challenger brand with those large regional and national franchises has called frustrated teams to seek us out. And I'm not trying to foreshadow anything in particular here, but I'd be shocked if we don't have more of those hiring opportunities going forward as M&A appears to be picking up and the bureaucratic grind at many of our larger competitors continues to weigh on their associates. So the markets we currently serve and the markets that are likely available to us over time would suggest an ability to grow rapidly on an organic basis, even at a time when many are going to struggle to grow revenue and earnings organically. Now, in my judgment, more important even than the size and growth dynamics of our market is the fact that this firm has been built to create raving fans. I'm confident virtually every bank you hear talk will talk about service. I know not one of them has ever said we are trying to give poor service and bad advice. But trust me, many do. So let me spend a minute on just how differentiated our service and advice is from every other bank in our footprint. What you're looking at here is data from Greenwich Associates, the foremost provider of commercial market research to large banks in the United States. This data is based on client responses across our entire footprint. That means businesses with annual sales from $1 million to $500 million in Tennessee, North Carolina, South Carolina, Atlanta and Roanoke. So let's focus on the Pinnacle line at the bottom of the chart. You see the navy-blue portion bar that 80% of the Pinnacle client survey rated us a nine or a ten on the question, how likely are you to recommend your lead provider to a friend or colleague, using a scale of zero to ten, where zero means not at all likely and ten means extremely likely. So in other words, 80% of our clients are highly engaged active promoters. Trust me, that's an extremely unusual level of engagement. Another 19% rated us a seven or eight; that's not bad. Combining the two, 99% of our clients rated as a seven or better on a 10-point scale. But that 19%, that gold portion of the bar, scored us a seven or eight. They're referred to as passive because while they generally rate you well, they're not so fired up just to being vocal advocates for you in the market. And then that last 1%, the red portion of the bar, are detractors, meaning they rated you somewhere between zero and six. Out beside that blue bar, out beside our bar there, you can see a 79. That's the Net Promoter Score. The number of promoters less the number of detractors. As you can see, that score is widely differentiated from all our major competitors in our footprint. And not only is that a fabulous Net Promoter Score in the Southeast, according to Greenwich, it's the second-best Net Promoter Score in the country. Now, if you bear with me just another minute here on this slide, it's not just that our Net Promoter Score is high. It's also that the banks with the most clients to lose have very low Net Promoter Scores with the loss of detractors. When you look at the gold boxes at the top of the slide, you see that the top five banks in terms of market share have an average Net Promoter Score of 40.2%. And the top 10 banks in terms of market share have an average Net Promoter Score of 51. One of the top five banks in our footprint from a market share perspective has a Net Promoter Score of six and 36% of their clients are actively detracting from their reputation. So the banks that have the most share are extraordinarily vulnerable. The differential between their client perception of their service versus ours, where we have a Net Promoter Score of 79, is really wide or differentiated, as they say. I've already talked about the size and growth dynamics of our market and how that barrels growth, but more importantly, in our attractive footprint, the banks who currently have the share lead are extraordinarily vulnerable. So as you think about the speed and reliability of growth, which is largely dependent on taking share as opposed to economic loan demand, this explains why we've been so successful taking share over the last 20 years, while we grew loans ex-PPP 12.6% on an annualized basis this quarter and why I believe we will continue to produce outsized growth for the foreseeable future.

Harold Carpenter, CFO

Thanks, Terry. Good morning, everybody. We're obviously pleased with our second quarter loan growth results. Excluding PPP, average loans were up 9% between the first and second quarters. Excluding PPP, end of period loans at June 30 compared to March 31 were up 12.6% annualized. As to loan yields, the yield curve remained volatile during the second quarter, and we have mentioned for at least the last two conference calls, loan yields will be a fight in 2021. We will lean into our relationships even harder to maintain our yields. Overall loan rates were basically flat with the first quarter, but that was assisted by a big quarter and likely a high watermark for PPP forgiveness. PPP forgiveness boosted the second quarter yield on PPP loans to 5.47% from 4.51% in the first quarter. It will continue to be difficult to model loan yields for the next few quarters, given the impact of PPP. Excluding PPP loans, our average loan yield approximated 3.98% compared to approximately 4.07% in the first quarter. So where to from here? Our market leaders continue to believe that a loan growth forecast excluding PPP in the high single digits for 2021 is a reasonable growth target for our firm. As always, we will lean on our new recruits to give us an advantage on loan growth coupled with our markets, which we believe to be some of the best banking markets with many of the best bankers in the Southeast, we're optimistic about our loan growth goals this year. We also recently announced our expansion in Huntsville and Birmingham with seven relationship managers in total. We and they are both very excited about our opportunities in these two markets. The loan volumes were modeled around $150 million in loan growth this year from those two markets, and I'm expecting P&L breakeven from our new associates in late 2022. As to yields, we have some reason to be optimistic that our core yields are stabilizing, so additional dilution of our loan yields excluding PPP will likely occur, but should slow. Obviously, the yield curve does impact all of this, so hopefully we get some stabilization to help curtail the decrease in loan yields. As to PPP yield, it's anybody's guess. And even though we will continue to work our borrowers proactively, we don't believe we will see quite the pace of forgiveness in 3Q that we experienced in 2Q. That said, since the start of PPP, we recorded $125 million in fees associated with the program, of which we've recognized 60% of those fees thus far. So we still have $48 million in unrecognized fees, which we believe will help bolster loan yields at least over the near term.

Terry Turner, CEO

Now on deposits, we had another big deposit quarter but not quite as large as several of our previous quarters. Core deposits were up almost $900 million in the second quarter. We had experienced significant growth in non-interest bearing deposits ending up at $8.9 billion at quarter end, up 29.5% since the end of last year. Our average loans to average deposit ratio was up slightly in the second quarter at 82.7%. So we consider that a small victory, and this is the first increase in our loan to deposit ratio since the first quarter of last year. Our average deposit rates were 20 basis points, while end-of-period deposit rates were at 18 basis points, so we continue to see downward momentum for 2021 and look to be around 10 to 15 basis points by the fourth quarter of 2021, assuming our short-term rate forecast plays out for the remainder of this year. Helping us get there will be about $1 billion or so in maturing CDs over the next few quarters that have an average rate of approximately 70 basis points. Liquidity continues to gain attention from all banks. The yield curve remains on everyone's mind. We did put some excess liquidity to work this quarter, approximately $650 million in additional investment securities. We don't currently anticipate any more big security purchases this year. As to the interest rate risk management, we do have a balance sheet bias today of rates being neutral to up slightly over the next year or two. So before all the bond experts beat me up for deploying money into fixed-rate bonds in the second quarter, we executed an interest rate swap on the front-end cash flows of about 50% of those bonds we acquired, swapping the cash flows from fixed to variable, so our interest – so our asset sensitivity position is essentially the same before and after the bond transaction, but we did pick up, say, 100 basis points in yields over what we received on the cash purchases.

Harold Carpenter, CFO

Our securities to assets ratio increased by 15% in 2Q, and we expect that to hold for the foreseeable future. Our estimate is that peers, say the banks with assets of $20 billion to $60 billion are running a good bit more than that, say, in the 25% range. We continue to look at ways to create increased momentum through deployment of excess liquidity in higher yielding assets or elimination of wholesale funding sources. All those lines, and in addition to the bond purchases we made in the second quarter, we increased our repo instrument we acquired in the first quarter from $450 million to $500 million in the second quarter. As I mentioned last time, this repo instrument is secured by the counterparty's investment securities portfolio at yields around 40 basis points. We're looking at another somewhat similar repo product, but it will likely be somewhat less in balances than the repo we have on our balance sheet. We also reduced our wholesale funding book in the second quarter by almost $1 billion. Many of you might recall that we bolstered our liquidity during the historic pandemic with additional broker and other funds by more than $2.4 billion. At this time, a significant amount of that has been redeemed. We have about $250 million left for redeeming this year and $400 million in 2022 and 2023. Additionally, we have about $900 million in Federal Home Loan Bank borrowings that cost us an annual rate of 2%. We continue to explore prepayment of those FHLB borrowings, but the prepayment penalty remains too rich for us right now. Lastly, we do fully anticipate redeeming $130 million in bank-level subordinated debt in a few weeks using available cash. The subordinated debt instrument held was initiated during the pandemic last year, but we elected to hold the capital at that time and now feel the current environment provides us enough confidence to eliminate this funding, which is costing us about 3.3% annually and may lose some of its favorable capital treatment. In the supplemental information, we've updated our interest rate sensitivity, which with all these initiatives accomplished in the second quarter points toward an increased asset sensitivity in the up-100 scenario. As it stands currently, we like where our balance sheet is positioned with no big moves planned on our current agenda. As the chart at the top left of the slide illustrates, our net interest margin after PPP and liquidity was approximately 3.25% in the second quarter, which compares to a similar calculation last quarter at 3.29%. Thus our adjusted NIM after being up for four quarters in a row retreated slightly, but has held steady over the last year or so. As to credit, obviously Tim is not here, but rest easy; he's on the job, doing what he does best, working both our relationship managers and clients and making sure we continue to focus on being a well-run and very sound financial institution. Using the big four traditional credit metrics, the net charge-offs, classified assets, NPAs, and past-due accruing loans, Pinnacle's loan portfolio continues to perform very well and in many cases, these are the best credit metrics we've experienced in quite some time. In the second quarter, as was the case in prior quarters during COVID, our bankers and credit teams continued their diligence around conducting thorough credit reviews with particular emphasis placed on non-pass credits, our hotel portfolio and credits in the COVID-specific low pass risk grade categories. Our second-quarter credit metrics remain very encouraging. As noted on the slide, net charge-offs are running at a respectable 17 basis points, our classified asset ratio declines with a very strong 6.8%. NPAs also decreased this quarter down to 27 basis points and pass risk were down to just 7 basis points, which collectively points to the great effort of our relationship managers and credit officers across our firm keeping a strong focus on soundness. Many of us appreciate that in order to obtain these sorts of credit trends, it takes discipline and active management.

Terry Turner, CEO

During the second quarter, our relationship managers and credit officers not only experienced an uptick in credit requests and loan growth, they also worked to see all four of the major credit metrics improve as well. Great work, everybody. Our credit team continues to bounce back and forth between offense and defense, as they worked diligently to assist our relationship managers and structuring new loans appropriately as well as maintaining an alertness toward the existing portfolio and looking for any trends pointing toward incremental deterioration. Tactically, during the second quarter, the credit team essentially accomplished the detailed credit reviews like hotels and non-pass exposures. For the second half of the year, our attention will remain on the COVID segments, particularly hotels. Again, it's a good report on hotel occupancy, revenue per room, average daily rate, all trending in the right direction. As to occupancy, we continue to run about 5% higher than national rates with our hotel portfolio saying 65% occupancy through the first two months of the same quarter. We expect June occupancy to be even higher as the national occupancy rates trended up in June as well. If you recall, we downgraded all our hotels to criticized last spring at the onset of the pandemic; it's now time to review what has transpired and begin to look to establish upgrade targets over the next few quarters. Our credit officers have initiated a hotel upgrade plan for our criticized hotel loans, so the credit officers will be looking at year-ago support, operating trends over the last 12 months, and the ability to meet PNFP debt service coverage ratios. Hopefully, we will have another report for you on hotels at our next call in October. As noted on the slide, we expect continued reductions in our allowance to total loss ratio over the next several quarters, as the overall economic outlook continues to improve and our COVID impact loan segments continue to trend positive. All in all, Pinnacle’s credit metrics have held up really well, and even though we have shifted back to a more offensive stance, we will continue our thorough defensive work, particularly in the COVID impact, etc. Now to fee income. While there's lots of good news here, for the quarter, fee revenues were up more than 34% over the same quarter number of last year. Wealth management, which includes investment services, trust and insurance had a great year in comparison to last year, up more than 35%. We continue to be very active on the hiring front across our franchise, particularly as we continue to build wealth management in the Carolinas and Atlanta and eventually Birmingham and Huntsville. You might think that we were disappointed in our mortgage results for the second quarter; quite contrary, mortgage has had a phenomenal last four or so quarters at $6.7 million for the second quarter. We are pleased and believe they have an excellent chance in holding that run rate for the rest of the year, assuming the rate environment holds.

Harold Carpenter, CFO

SBA loan sales had a great quarter and we're optimistic that this business should hold for the remaining two quarters of this year. We also had a great quarter with respect to our equity investments, excluding BHG; one of our investments completed a follow-on equity raise during the quarter, the results of which provided a significant insight into an updated valuation of that investment and thus we booked a $2.4 million increase for this one investment. I'll talk more about BHG in just a second. As expenses specifically incentives, I think everyone is familiar with the impact of incentive costs on our expense base. If our earnings hit our targets, costs go up; if not, costs go down. Last year, we did not hit our targets, thus incentives were significantly below expectations with our eventual payout equating to 65% of our targets. We fully anticipate that based on the current operating environment, 2021 will come back strong, and hopefully our associates will recoup some of the lost incentive from 2020. Along those lines, we provided an opportunity in 2021 for our associates to earn outside of incentive as much as 160% of target. However, and as we've said repeatedly, there is no free lunch; increased incentives only occur if our earnings growth supports the incentive. Additionally, we anticipate max payout retreating back to the traditional 125% of target in 2022. All-in incentive costs are higher than anticipated this quarter, as we began accruing at the maximum award for 2021, thus we experienced a catch up from the first quarter. We believe the incentive costs for the third and fourth quarters will be slightly less than the second quarter. As to our overall total expense run rate, we now believe that expenses for the third and fourth quarters should be flat to down from the amounts we booked in the second quarter.

Terry Turner, CEO

Quickly some comments on capital. I mentioned the subordinated debt retention earlier; we also intend to redeem another $120 million in subordinated debt issues later this year. We'll work with our regulators on that matter over the next few months. And as I mentioned last time, and I want to just reinforce the point, we've intensified our focus on tangible book value growth by adding a peer-relative component to our leadership's equity compensation plan. We're currently calculating an annualized increase for 13.5% in our tangible book value per share thus far this year. Our plan is designed so that we will compare our tangible book value per share growth with figures alongside relative return on tangible common equity and relative total shareholder return and determine the best results for our leadership. As our outlook for the rest of 2021, I won't go into this slide in depth as we've covered much previously. So this, again, is really a summary for the model builders of what we currently believe. Obviously, we realize that we appear more optimistic than most; that said, we have great confidence in our people, our markets, and our class, and renewed optimism about where Pinnacle is headed.

Harold Carpenter, CFO

Now BHG. This is a slide that we've shown for several quarters. The blue bars on the chart are originations with record demand sets for the past four quarters. In fact, they've almost doubled loan originations over that time period. BHG would also tell you that their market share is less than 1%, so we believe there's much room for growth. As their research indicates, the personal, small, and mid-size business lending, home improvement and patient finance businesses are collectively a $925 billion annual loan origination business, and BHG intends to be competitive in all. The green bar represents loans on which gain-on-sale has been recorded as these loans are sold to downstream banks. This is the traditional BHG model, which generates revenues associated with our gain-on-sale model. As to the bottom left chart, borrower coupons have fluctuated only slightly over the last few years ending at 13.4% for the second quarter. Bank borrowings failed to new records at just under 4% in the second quarter, so the net spread remained in the mid-9%, which over time is up from previous years. As noted on the slide, BHG executed on their securitization in the second quarter last year, the first securitization was approximately $177 million; this year, securitization approximated $375 million. They also are looking to conduct another similar style securitization before the end of 2021. Doing this allows them to take advantage of some of the very attractive funding rates, as well as diversify both the revenue strength and funding sources. We consider the diversification strategy a good idea, even though the gang wholesale model results in more near-term earnings for BHG. Of note is that BHG is rapidly approaching a 50-50 revenue split between the gang wholesale and all balance sheet models and believe by 2023, they could be there, much sooner than we anticipated.

Terry Turner, CEO

As credit, we've updated BHG’s recourse obligation chart; the chart on the left shows the green bars detail loans that BHG has sold and their network of other banks, which currently amounts to just over $4 billion in credits sold through their network. The blue line on the chart details the recourse growth as a percentage of outstanding loans with these other banks. As noted, the recourse obligation is a reserve for future loss absorption. As noted on the chart during 2020, BHG increased their reserves in anticipation of potential losses from the pandemic, with the reserve standing at 7.65% of outstanding loans at year-end 2020. During the second quarter of 2021, as a result of a better outlook, BHG decreased the pandemic-related reserves. In the second quarter, as a percentage of loans, it was down approximately 100 basis points. As noted on the chart at the bottom right, the trailing 12-month loss has landed at 4.5%, basically consistent with the last few years and during the year where we had no idea how COVID would impact loss rates. This chart has also been updated from our previous presentations to better split the actual credit loss from losses BHG absorbed from reimbursing banks for the unamortized premium the acquiring bank paid to get the loan. As the chart indicates, the prepayment portion has gotten somewhat larger over the last few years. Keep in mind, prepayment losses are for good loans; they're just paid off prior to maturity. This can occur for several reasons, but primarily the actual premium type for BHG credit has gotten somewhat lower. Consumer credit, which is occupying more of BHG’s business, tends to have a higher prepayment track record, and loans are being paid off earlier as rates have decreased. We have again updated these two charts; the quality of BHG’s borrowers has improved steadily in the past and over the last few years. BHG continues to refine their scorecard, which has increased the quality of its borrowing base. Again the right chart and as I've said before, may be the most powerful chart I have to offer related to BHG steadily improving credit quality. Looking at losses by vintage, losses continue to level out in earlier months from originations, thus pointing toward a lower loss percentage over the life of the underlying loan. The quality of the borrowing base, in our opinion, is very impressive and much better than just a few years ago. Lastly, BHG had another great operating quarter in the same quarter and exceeded everyone's expectations yet again. We've upped our expectations for 2021, now expecting 2021 to produce outsized growth in relation to 2020 of approximately 40%, compared to our prior estimate of 20% to 25% or more. We are also adding a growth factor for 2022 of approximately 30%, thus no rest for BHG, as they continue to build a strong and more revenue-diverse franchise. As the slide indicates, they've got more ideas or in some phase of development, which should foster continued growth over the next several years. All this, and we believe PNFP had a fabulous quarter and one that continues to give us much confidence that our franchise and our people are poised for outsized growth for the foreseeable future. With that operator, we'll open it up for any questions.

Operator, Moderator

Thank you, sir. The floor is now open for questions. Our first question is from Steven Alexopoulos from JPMorgan. Your line is open.