Earnings Call Transcript - PNFP Q2 2024

Operator, Operator

Good morning, everyone, and welcome to the Pinnacle Financial Partners Second Quarter 2024 Earnings 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 Pinnacle's earnings release and this morning's presentation are available on the Investor Relations page of their website. Today's call is being recorded and will be available for replay on Pinnacle Financial's website for the next 90 days. At this time, all participants have been placed on a listen-only mode. The floor will be opened for your questions following the presentation. During this presentation, we may make comments, which may constitute forward-looking statements. All forward-looking statements are subject to risks, uncertainties, and other facts that may cause actual results, performance, or achievements of Pinnacle Financial to differ materially from any results expressed or implied by such forward-looking statements. Many of such factors are beyond Pinnacle Financial's ability to control or predict. And listeners are cautioned not to put undue reliance on such forward-looking statements. A more detailed description of these and other risks is contained in Pinnacle Financial's annual report on Form 10-K for the year ended December 31, 2023, and its subsequently filed quarterly reports. Pinnacle Financial disclaims any obligation to update or revise any forward-looking statements contained in this presentation, whether as a result of new information, future events, or otherwise. In addition, these remarks may include certain non-GAAP financial measures as defined by SEC Regulation G; a presentation of the most directly comparable GAAP financial measures and the reconciliation of the non-GAAP measures to the comparable GAAP measures will be available on Pinnacle Financial's website. With that, I am now going to turn the presentation over to Mr. Terry Turner, Pinnacle’s President and CEO.

Terry Turner, CEO

Thank you, Matt. Hopefully, everybody knows we're going to start with this snapshot. Our primary objective here is total shareholder return, and we believe these are the best metrics to ensure we get that done. As always, we begin with the GAAP measures, but for me in quarters like this where there's a lot of noise, the non-GAAP measures are perhaps more revealing. This quarter, our treasury management team here did some extraordinary work, in my opinion, to reposition our securities book, which of course creates a loss on the sale of securities in this period but provides a meaningful lift to our ongoing revenue and earnings run rates with what we expect to be a slightly better than three-year payback. It increases both tangible book value and risk-based capital at the same time, a really elegant and value-creating strategy. So looking at the non-GAAP metrics in general, the objective is to have all the balance sheet and P&L metrics moving steadily up and to the right. That's been the case for the better part of our 24-year existence. Unfortunately, as everyone knows, over the last couple of years, earnings for banks have had to recalibrate given the extraordinary impacts of rapidly rising interest rates and an inverted yield curve. Harold tells a story about two campers awakened in the night by a big bear. One of the campers stopped to put his tennis shoes on and tie them up. The other camper asked him, 'Do you really think you can outrun that bear?' He said, 'Well, I don't know if I can outrun that bear; I just have to outrun you.' And so I hate that this calibration has been required, but I believe that we're outrunning most of our peers. As you look across the top row this quarter, you see an inflection point for revenue, EPS, and adjusted PPNR. And you see those lists even as we're attracting record numbers of revenue producers and supporting them with incremental facilities, the truth is our opportunities to invest in the ongoing growth of our revenue, EPS, and PPNR have been even better than we would have projected. Turning to balance sheet growth, I'm very encouraged by the underlying growth going on there. Harold will review the numbers in greater detail, but quickly in a market with prolonged contractions in money supply, many are unable to grow client deposits. But as a result of building important specialty deposit products, we're able to grow client deposits and grow them fast enough to allow us to remix the deposit book away from higher-cost broker deposits. In the case of loans, our current growth rate is outsized, albeit less than we had originally hoped. Most are aware that we began a strategic reduction of our CRE as a function of risk-based capital 18 to 24 months ago. These targets are currently 70% or less of risk-based capital allocated to construction and 225% or less allocated to total CRE. We've been traveling pretty fast in the construction bucket. It's now down to 72.5%. So we're rapidly approaching our target there. In dollars, our various categories of CRE loans contracted $76 million during the quarter, which highlights the underlying success we're having among our commercial and industrial clients. So the quarter's numbers have a lot of noise, but the strength in the underlying growth is remarkable. I'd comment across the bottom row, you get a snapshot of asset quality. While net charge-offs ticked up to 27 basis points in the quarter, we continue to guide to 25 basis points on the year with virtually no problem formation at this point. So Harold, let me turn it over to you to let you review the numbers in detail.

Harold Carpenter, CFO

Thanks, Terry. Good morning, everybody. We will start with loans, which came in a little less than we anticipated. As a result, we're lowering our outlook slightly for loan growth to 79% growth. We believe our growth will still be outsized compared to our peers. We also still believe that we're doing a great job on spreads, particularly for prime and SOFR-based credit. New volumes are coming in at essentially the same spread as the existing ones, so we're pleased in this difficult at best to grow loans environment. One of the keys to our financial plan is increasing repricing on our renewal of fixed-rate loans. As the slide indicates, we're expecting about $2 billion in cash flows from our fixed-rate loan portfolio to come in over the remainder of 2024, with an average yield of around 4.7%. As the fixed-rate loans originated in the first half of 2024, our average yields were around 7.25%, so a meaningful increase over prior yields. Our second quarter yields were only 7.08% on new loans, so we have some work to do in the second half of 2024. Our loan growth targets, we believe for the second half of 2024 should show better than the first half. Interest rate cuts will help some, but in the end, we believe it's about borrowers being more confident about the economy, eliminating uncertainties and the need to borrow for growth capital. Our competitive advantage is that we have new lenders that are ready to move market share. To that point, approximately 25% of our revenue producers have been with us for less than two years. Accordingly, we have great optimism about Jacksonville, Washington, and Atlanta. By the way, Atlanta had another great quarter, both in terms of loan growth and recruiting, as Atlanta brought in some very impressive bankers in the second quarter. Based on what I hear from mainland Atlanta, they should have a great third quarter. We believe we had another strong quarter on deposit growth. Excluding the decrease in broker deposits, we increased client deposits by more than $700 million, the second quarter having essentially the same result as that of the first quarter. We're pleased with that effort as the second quarter is usually our most difficult deposit growth quarter given tax outflows in April. You will also notice that we moved quite a bit of our deposits into the index deposit product category. Almost 40% of our deposits are now indexed to Fed funds. As we prepare for a downrate environment, this should obviously be helpful. As to 2024 deposit growth, we have lowered our deposit volume forecast to within a range of mid- to high-single-digits this year. Some of that is due to our reducing the loan volume forecast, thus putting less pressure on deposit growth. We also plan to reduce reliance on the more expensive wholesale deposits this year. That said, our efforts to grow client core deposits remain as energized as ever. What the Fed does will obviously impact our rate projections for the remainder of the year, but more on that in a second. We believe our deposit beta has served us well here as we are probably in better shape than most, as we head into a downrate cycle. As we said before, we continue to like our competitive position regarding deposit rates in our markets. Since last June, our weighted average deposit rates have increased only 33 basis points, and that includes the impact of the last 25 basis point raise in July of 2023, 12 months ago. In my opinion, our relationship managers have done an amazing job in managing our deposit costs over the last year. As Terry said in the press release last night, we believe we finally experienced an inflection with a meaningful increase in margin in the second quarter to 3.14%. We expect more margin expansion to come in the second half of 2024, maintaining our growth rate at 8% to 10% for this year. We have kept our interest rate forecast at two cuts, but delayed the first until November. That said, given the volatility of the data, we can see cuts in September or that the Fed could determine that no cuts will occur this year. We still believe, absent some unusual actions by the Fed, that our 2024 margin forecast seems to come in at a fairly higher range from here. The big news from a balance sheet management perspective was the reposition of the bond book, the credit call swaps, and all the other actions we’ve discussed pretty early in the press release last night. We've been working on this for quite some time and finally got all the pieces in place to execute and achieve our objectives. We have planned this for several months, and a portion of the increased revenues we had planned to achieve from the repositioning was considered in our outlook for net interest income growth last quarter. That's why we've elected to hold our net interest income outlook of 8% to 10% growth consistent. More on this when I get to the outlook slide a little later, but to say we are pleased with how all this turned out would be a great understatement. We continue to work on other less impactful initiatives that hopefully will also bolster our revenue run rates. So at June 30, is PNFP ready for a downturn in the interest rate cycle? We think our balance sheet is in great shape and well positioned. Our deposit beta was relatively high on the way up, and we believe will be as strong on the way down. Our sales force is set up to work with clients once these rate cuts begin. As for credit, we're again presenting our traditional credit metrics. We mentioned a $110 million charge-off of an owner-occupied commercial real estate credit in the press release last night. That situation deteriorated in the second quarter; thus, we accepted the bid for the collateral, even though we met $10 million in incremental charge-offs. Our special asset group leaders felt doing so was our best play. We're still working with the non-performing credit we mentioned last quarter. Our special asset group officers are still working with that borrower to minimize loss content for that one. As to our outlook for charge-offs, we're maintaining our guidance with the range of 20 basis points to 25 basis points for 2024. We have also included additional guidance around provisioning in relation to average loans with a range of 31 basis points to 36 basis points. Since our loan growth outlook is less, this year results in reduced loan loss provision all else equal. Loan growth is one of the biggest factors impacting our provision, and as we grow loans, we have to build our CECL reserve at greater than 1% of loan growth. So, fewer loans result in less net interest income but also less provision. So after all that, where is credit? No real change in what feels like now for several quarters. Our charts for past dues and potential problem loans indicate we are operating at near historic lows, which should be a meaningful indicator of where credit experience should be headed. The outlook for reduced rates on the short end has to be a good sign, particularly for less affluent awards and small businesses that just don't have the balance sheet that perhaps larger borrowers have. More about commercial real estate: and just so you know, we begin to add in more information on credit primarily for non-owner-occupied commercial real estate and construction in the supplemental slides. Our non-owner-occupied and construction portfolio continues to perform very well. We continue to push for lower exposure for construction. Our target of 70% of total risk-based capital, we believe, will be achieved before year-end 2024. Our appetite, as noted by the almost solid rent table on the bottom right, is unchanged, and we don't anticipate meaningful change this year. That said, we continue to have some interest in high-quality warehouse and some multifamily. But again, let me stress, any new commitments to this space are limited to strategic client relationships only, and no way should anyone perceive more on any sort of offense here. All things considered, we like our commercial real estate book. I know many of you know this, our home limits are very modest. We pride ourselves on a granular book. Our largest ticket sizes for our bank are conservative compared to what we hear from other franchises. We just don't seek out the high-profile, bulky projects. Now on the fees. And as always, I'll speak to BHG in a few minutes. Excluding BHG and various other non-recurring items, fee revenues were up 6.8% linked quarter. We're pleased to report that our wealth management units had a strong first half and we fully expect the efforts of our wealth management professionals will continue through the rest of the year. The fees associated with bank blocking and tackling are also doing quite well. Service charges and interchange both joined linked quarter gains of 8%, 12%, respectively. All in, we're again raising guidance for core fee revenues this year; a range of 14% to 17% seems reasonable given the performance of several of our primary business lines in the first half of the year. Second quarter expenses came in about where we thought they would after backing out the expenses connected with our balance sheet repositioning. Importantly, we are increasing our incentive target from 80% to 85% payout for fiscal year 2024. Again, we are raising target points to reflect that we believe 2024 will be better than we thought at the end of last quarter. As you know, the direct linkage between our financial performance and our incentive plan is closely correlated, and thus, we can't raise one without believing that the other will move up as well. Additionally, our hiring was really strong in the second quarter with 52 new revenue producers recruited compared to 39 in the first quarter. Going into the third quarter, our recruiting pipelines are very strong across the franchise. Terry will speak more to this in a few minutes. With the increase in incentives, strong revenue producer hiring, and the $4 million impact of loss protection fees from the credit default swaps, we've elected to increase our expense outlook to $960 million to $990 million for the year. Lastly, we presented this slide from time to time, bringing it back this time because of the bottom book repositioning and just as a reinforcement about how important tangible book value growth is to this firm. Sure, growing earnings is critical, but as many bank investors know, keeping a keen focus on compounding tangible book value growth is just as critical. Our tangible book value fared well during the rate up cycle, as we elected to maintain a bond book that minimized our exposure to AOCI hits. Even after we executed a significant repositioning in the second quarter, our tangible book value and common equity Tier 1 ratios expanded along with most of our other capital ratios. Now to BHG: as the slide indicates, originations picked up in the second quarter, which was good news and better results than anticipated. Last quarter, we stated that a higher prolonged rate environment could impact their production assumptions for the year. As a result, BHG believes second half 2024 production will be consistent with the first half; this results in lower production targets for 2024 in the wake of higher for longer and tighter credit levels. As to placements, total placements were less than originations, which was the opposite from the prior two quarters. This was by design as BHG's total inventory was as high as it's been in approximately three years, and BHG needed to build inventory for larger future orders this year. Also, there is still great demand for BHG paper, both from the auction platform and the institutional buyers. They successfully accomplished an ABS issuance in the first quarter and are now thinking the first quarter of 2025 will likely be the next time they fund another such issuance due to competing orders that have been previously negotiated from larger institutional buyers. As to spreads, auction platforms predefined during the second quarter at 8.7%. Balance sheet loan spreads are fairly consistent with the prior quarter. All in, BHG believes spreads are holding even in this higher rate environment. BHG still believes when rate decreases do begin, that will be good news to them, not only from a volume perspective but also from a spread perspective. On reserves, BHG did increase reserves in the first quarter for off-balance sheet loans but decreased reserves for on-balance sheet loans. There was a modest uptick in the second quarter credit losses for the off-balance sheet business, which was an actual expense related to credit loss for off-balance sheet now at 3.4%. On-balance sheet losses were up also to 7.2%. So even though the percentage for on-balance sheet losses increased in the second quarter, the actual dollar amount for on-balance sheet losses decreased. A similar circumstance occurred last quarter; average balances fell faster than actual losses, which is why the percentage loss was higher. BHG believes that they are substantially through the credit issues with respect to the on-balance sheet portfolio. Loans held off-balance sheet by the bank still need some time, perhaps three to four quarters. Data reflects that 65% of the current losses are attributable to the January '22 through June 2023 vintage credit. The news does keep getting better given BHG's past dues continue to improve and hopefully head to pre-COVID levels soon. As to the forward look for origination earnings, and as we mentioned last time, achieving the same level of originations as last year would take great effort in the higher prolonged rate environment, especially given BHG is not interested in adjusting their credit models to achieve volume build. BHG's second half of 2024 production should approximate the first half. So as you look at the chart, it should look a lot like 2021 production levels. As to earnings, BHG is also anticipating that the second half will likely look like the first half. For PNFP, that represents a decrease from prior year results of 10% to 15%. BHG always has tactics they can deploy to help their bottom line and increase near-term earnings. They have exited business lines and trimmed their expense base. The second quarter of 2024 included a loss of approximately $12 million related to exiting our SBA business line. The leadership of BHG has made several strategic decisions concerning their business model aimed at creating a more sustainable business model regardless of the economic climate. The credit pain from the COVID overhang has been real, but I don't think I have ever seen the leadership more optimistic about the near term and putting all of that behind us. Our partnership with BHG remains as strong as ever. With that, I'll turn it back over to Terry.

Terry Turner, CEO

Thanks, Harold. Over the last couple of years, we've been through a liquidity crisis as the Fed began reducing the money supply, compared to a rapidly rising interest rate cycle, an inverted yield curve, and an increase in credit costs as credit began to normalize with genuine fear about where the credit costs could go in a recessionary environment and a slowing economy, which limits incremental loan demand. That's made it hard on bank stock investors, but I believe Pinnacle offers an extraordinary opportunity for folks that need to own bank stocks. Our well-documented sustainable competitive advantage, which is built on a relentless focus on the work environment in order to attract and retain the best bankers in our markets enables us to leverage our best-in-class service and advice to move our clients from vulnerable competitors. The result is outsized growth through thick and thin with outstanding asset quality. If we can consistently take share from the market share leaders in our market, we can compound earnings faster and more reliably than peers even in a difficult operating environment. It's how we produce value for shareholders during difficult times, and it's a way to realize extraordinary value for shareholders when markets turn bullish and multiples expand. One of the hardest jobs I have is to help investors separate Pinnacle from all the other banks that say they have a great culture; it's unlikely any banker is going to declare their culture is unremarkable. But maybe you can ask them where they rank on Fortune's list of the best companies in America to work for; you can see that we're number 11, and no traditional banks rank higher. Maybe you can ask how many revenue producers they attracted to their firm from their major competitors; on the top right, it looks like we'll have a record-setting year even for a long time, prolific hiring of revenue producers. But it's not just about how many they were able to hire; perhaps you can see how fast they lose them because turnover is the number one way to demolish service levels and ultimately damage financials. So what's their associate retention rate? You can see that our annual associate retention rate is roughly 95%, and it's that year in and year out. But be critical; some want to carve out various pockets of turnover, like people they fired or people whose spouse got transferred, or people who retired or died, and so forth. For us, it's a simple measurement. If you were on the roster last period and you're not on at this period for whatever reason, that's turnover. You can see here that's very minimal. And it's not just about how many people that they hire. It's not just about how many people they keep. Perhaps you can get them to tell you how their clients view the quality and effectiveness of their client-facing people. You can see, according to Greenwich Associates, the provider of market research to banks regarding the commercial marketplace in our eight-state footprint, businesses with sales from $100 million to $500 million believe our relationship managers are literally the best. For each of those measurements, Pinnacle is the white dot on the range of responses for each of the top 10 competitors in our market. They understand the industry, treasury management, and provide proactive effective advice. If they can't give you answers to things like where they rank, recruiting and retention success rates, and objective data on how clients view their relationship managers, I would assume their culture is unremarkable. Answers to questions like these can help you separate the wheat from the chaff, and more importantly, help you understand the likelihood and reliability of their growth. Of course, simply building a great workplace is not the end game. The goal of creating a world-class place to work, attracting and retaining the best associates, is to attract and retain the best clients from other banks. Without this market share-taking strategy, it will be hard to outgrow the market, and as a lot of folks are finding out, undifferentiated franchises are struggling to produce any balance sheet volume at all right now. J.D. Power says of the largest 50 banks in the country, no one, literally no one, has been able to create as differentiated a client-engaging experience as we have. I'm obviously excited to have the highest Net Promoter Score among the 50 largest banks in the country. But most important is how we match up against Wells Fargo, Truist, and Bank of America shown in red here because those three banks are number 1, 2, and 3 in our markets in terms of market share; they dominate. Because of our work environment, we routinely attract their best people, and because of the client experience, we attract their best clients. This builds like a sustainable competitive advantage for as far as I can see. J.D. Power has quantified the seven metrics that contribute to the Net Promoter Score. They are trustworthiness, the quality of the people, ease of doing business, digital channels, account offerings, saving clients' time or money, and resolving problems. We are either number 1 or 2 on all, except digital channels where we're number 3 ahead of JPMorgan. The quality of the work environment and the quality of the client experience we provide is tightly woven into our fabric in a way that would be nearly impossible to unravel. It's why our net interest income grows at a different rate than peers. It's why we produced double-digit fee income growth in our core fee businesses. It's how we afford to invest in the market's best people and support them with incremental facilities to propel our ongoing growth when most of our peers are cutting expenses, likely damaging their future growth prospects. And so, not surprisingly, over the last decade, we provided one of the leading total shareholder returns by rapidly and reliably compounding earnings. In the table below the bar chart, you can see how much the trailing 12 months' earnings increased over that decade, and how the EPS multiple expanded or contracted. High growth stocks like PNFP have come in and out of favor. That's one of the reasons why our multiple contracted over 40% in the last decade. But even with that outsized multiple contraction, our sustained ability to hire bankers and move their clients, our sustainability to reliably grow balance sheet volumes even with loan demand slack and the Fed's trading liquidity from the system, our ability to compound earnings growth through thick and thin produces market-leading shareholder value. So we've demonstrated a way to get earnings growth at slack times like we're in now. And beyond that, to be positioned for great value creation when sentiment turns, when it becomes bullish, when bank stock multiples expand, and when growth bank stocks trade at premiums. So Harold, let me stop there. I'll turn it over to you to quantify our financial outlook for the remainder of the year.

Harold Carpenter, CFO

Thanks, Terry. Now to the traditional slide on our outlook for 2024. As I mentioned earlier, we've lowered our expectations in some cases and raised our expectations in others. Just to recap, for net interest income, we're maintaining the guidance even though we lowered loan growth. We also have a meaningful increase in run rate on the balance sheet repositioning. We're maintaining our charge-off outlook. Our outlook for provision is less this quarter given we think loan production will be less. Core fee income, we believe, will expand, and we have increased our confidence levels, which will serve to offset much of the reduction from BHG. Expenses will be slightly higher, primarily due to the increase in incentives or loss protection fees, and better than we previously thought hiring success. In the end, we feel more confident about our 2024 outlook given our strong performance in the second quarter, the success of the balance sheet initiatives. Although the macro environment still has some definite uncertainties, it feels like there is some ways to believe that some positive inflection has occurred there as well. With all of that, we concluded that our overall outlook for 2024 is a bit better than last quarter. All of this has to be a good sign for 2025. We're about to start our annual planning effort for next year. Our financial goals will be the same, top quartile revenue and top quartile earnings growth. The investments we've made in our new markets and our hiring success, even with all the uncertainties over the past few years, are building blocks we will lean into as we build our 2025 plan. So with that, let's open it up for Q&A.

Operator, Operator

Your first question is coming from Brett Rabatin from Hovde Group.

Brett Rabatin, Analyst

Great quarter from you on the growth in the core loan portfolio. I wanted to ask, if I look at the slides on the legacy markets on 28 and 43, the legacy markets are not growing, and the deposit growth this quarter in legacy markets was lower than 1Q. How much of that is the repositioning of the loan portfolio? And is there some slowing of growth in legacy markets due to either pricing selectivity? Or just you kind of already penetrated those markets and further penetration is more difficult?

Harold Carpenter, CFO

We do think that over time, as lenders are with us for an extended period of time, their growth begins to contract from a percentage perspective. That said, we always believe they will at least be able to keep up with the broader economy and how that's working. So we don't lower our expectations for our legacy markets, but we do have, as you might expect, some very high expectations for the newer markets as they start from a lower base. I don't think we've got concerns about where we are with our legacy markets and the growth we've got there. As you know, we're in some pretty spectacular markets and we're still looking to hire people. But that will, as we hire in these legacy markets, help us get this growth.

Brett Rabatin, Analyst

And then the increase in the incentive target from 80% to 85%. Obviously, your outlook is a little better. Let's just say in the back half of the year, either the margin NII ends up being better than what you've adjusted the target for to 85%. Is there a relationship we can think about if the NII is $1 better? How much of that might get taken out or taken reduced by the incentive increase, if you get to 100%?

Harold Carpenter, CFO

I don't want to go into too much detail, but there will be a clear framework provided in next year's proxy that you can refer to. There's a blend of intuition and analytics involved in this process. Regarding the increase we saw this quarter, we have gained significant confidence in our projections for this year, which is why we decided to raise the incentive accrual. For the remainder of the year, if we see an additional dollar in revenue or earnings, it's likely that about $0.20 to $0.25 could be reflected in that incentive accrual. However, please allow for some flexibility as things can change as we near the end of the year. In the past, we've sometimes needed to reduce the incentives for named executive officers to ensure that we can adequately fund the rest of the team. I'm referring to the total amounts with the 85% figure in mind, but we do occasionally collaborate with the compensation committee of the Board to make adjustments.

Operator, Operator

Your next question is coming from Steven Alexopoulos from JPMorgan.