Earnings Call Transcript
Pinnacle Financial Partners, Inc. (PNFP)
Earnings Call Transcript - PNFP Q3 2024
Operator, Operator
Good morning, everyone, and welcome to the Pinnacle Financial Partners Third Quarter 2024 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 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 open 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 the 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 have 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 a reconciliation of the non-GAAP measures to the comparable GAAP measures will be available on Pinnacle Financial's website. With that, I'm now going to turn the presentation over to Mr. Terry Turner, Pinnacle's President and CEO.
Terry Turner, CEO
Thank you, Matthew, and thanks to all of you for joining us this morning. I expect most of you know that I'm going to begin every earnings call with this shareholder value dashboard. GAAP measures first, but quickly go to the non-GAAP measures because, firstly, I find that the non-GAAP measures provide a clear picture of the job we're doing for shareholders. You can see the third quarter was a fabulous quarter. Balance sheet volumes all grew nicely with loans up 6% linked quarter annualized, earning assets up 12% linked quarter annualized, and core deposits up 9% annualized. Asset quality remains very strong. And because they've historically been the most highly correlated with long-term total shareholder returns, the three most important metrics for me are revenue growth, EPS growth, and tangible book value accretion all up nicely again this quarter. Let me point out the persistent growth in those three critical measures and the double-digit five-year CAGR for all three. Obviously, I'm proud of the long-term consistent trajectory of those three measures, but I know that even after 24 years of sustained outsized growth, there are always some that remain fearful that somehow we won't be able to propel the culture as we grow, that the law of large numbers is going to overtake us. So that somehow those results are primarily dependent upon me or on my partner, Rob McCabe, or some key man that won't always be here as opposed to a simple, consistent, repeatable model. Third quarter was another great quarter of outsized growth for our firm. But before we review those results in detail, I'm going to take a minute and make sure everybody understands exactly how that growth comes about and why we've been able to consistently deliver it over time. Obviously, the fact that we serve major markets in the Southeast is huge. Census Bureau numbers paint a vivid picture of the tailwind that exists for banks in the Southeast. It will be very hard for banks in the shrinking Northeast, West, and Midwest markets to match our growth. But more important than the size and growth dynamics is the competitive landscape. Here, we're plotting the share gains and losses for us and the other market share leaders in Tennessee's four urban markets over the last decade. We're blessed to do business in markets where we consistently take share from vulnerable competitors who dominated the market heretofore. We entered the North Carolina, South Carolina, and Virginia markets in 2017 with our acquisition of BNC. We specifically targeted the Carolina and Virginia markets to some extent because of the size and growth dynamics, but more importantly, because we wanted to compete against those same vulnerable competitors with whom we have successfully competed in Tennessee. So, you can see here that the shares concentrated among those same vulnerable banks, and for the most part, they've established a track record of consistently giving it up, which is why the competitive landscape is the most important contributor to our ongoing growth even more than such impressive size and growth dynamics. Here's what that share climb looked like in our first market, Nashville, Tennessee, according to the FDIC deposit share statistics. Now firm wide, assets are over $50 billion. And you can see that we have a lead share position in Nashville with roughly 50% more shares than our next closest competitor, an astounding position. As most of you know, we're a commercially focused bank. So, this is the commercial market share data according to Greenwich for businesses with sale from $1 billion to $500 million in Nashville. There in the middle, you can see that we have a 30% lead bank share, more than 4x our next closest competitor. We've been executing the same playbook across the state of Tennessee, first with a novo start in Knoxville back in 2007, followed by acquisitions in Chattanooga and Memphis, both in 2015. You can see the remarkably similar growth in all three markets. In 2015, following our acquisition in Memphis, we were number 13 on the FDIC chart. In the most recently released FDIC data, we climbed to number three. In Chattanooga, we were in the fourth position in terms of FDIC share following our acquisition in 2015. Today, we're number two, rapidly closing on number one. And in Knoxville, from a de novo start of 2007, we're now number four on the FDIC chart, a similar position to where we were at the same tenure in Nashville. And like Nashville, we're number one in terms of the commercial market share as measured by Greenwich. As I mentioned a minute ago, we acquired BNC in 2017. Here you can see the dramatic transition we made in the Carolinas and Virginia with a 10% loan CAGR and a 14% deposit CAGR since the acquisition. Importantly, on the right, you can see the growth in commercial deposits when we apply Pinnacle's simple, consistent, and repeatable model. Just like the urban markets in Tennessee, we're executing the same playbook across the Carolinas and Virginia. And in 2019, we began a number of de novo market extensions in the large southeastern markets like Atlanta, D.C., and Jacksonville, Florida, all with similar growth dynamics and a competitive landscape to that in Nashville. I've already demonstrated the trajectory that we had in Nashville over our 24-year history there, where we are still taking share, by the way. You can see the largest markets on the left that the deposit growth is even more rapid than it was in the start-up period in Nashville. And even some of the smaller markets on the right using this simple, consistent, repeatable model, it appears we're replicating our start-up pace in Nashville there as well. So yes, we have the added benefit of operating in some of the best markets in the U.S. Frankly, it's even more important that the share leaders in those strong Southeastern markets are vulnerable, offering us a once-in-a-generation opportunity. But the hedgehog strategy here is to attract and retain the best bankers in the market, leveraging our award-winning work environment using our differentiated recruitment model. We created a laser-like focus on revenue and EPS growth for every single non-commissioned associate in our firm using our win-together, lose-together incentive plan. And then for roughly 24 years, virtually every year, we've targeted top quartile revenue and EPS growth in order for management and associates to earn their incentive at target. Think about that, an ability to continually attract the best bankers in the market and aligning nearly all roughly 3,500 associates to produce top-quartile revenue and EPS growth with one simple annual cash incentive plan. It's simple, consistent, and repeatable, no longer happenstance. This nationally recognized culture continues to propel itself with Pinnacle just listed last quarter as Fortune's third-best place to work in America among finance and insurance firms, and it's pervasive. In most markets, we are perennially the best place to work with Memphis and Knoxville repeating again just last quarter. As investors, I know most bankers will try to convince you that their people are the best, that their people are the most valuable asset. So, I'm not going to try to convince you that. I'm going to let our clients do that. On the left, this is how business clients in our eight-state footprint rate our relationship managers and how they relate those vulnerable banks with the largest share in these southeastern markets. We literally have amassed the best talent in the southeast from a business client's perspective according to Greenwich. As you would expect, highly valued relationship managers produce better financial outcomes over the long term. On the right, you can see how our associates compare to our primary Southeastern competitors in terms of PPNR per associate, a critical test of effectiveness. Attracting the best talent has enabled us to build a national reputation for an unmatched client experience both among consumers and businesses, both in terms of people and systems, which has resulted in peer-leading long-term value creation. It's about our ability to consistently and repeatably grow earnings. You can see on the top right, TSR leadership is not a new phenomenon. It's true across 5, 10, 15, and 20-year timeframes. And if you look at the EPS growth across the bottom of that chart, our earnings growth has substantially outpaced peers for a decade, and nobody is close. And so, to put a bow on all that, in this one chart, you see our unusual ability to consistently attract and retain market-best talent and their ability over time to consolidate their clients and associated loan and deposit volumes. We have validated this modeling number of times over the years. Averages are dangerous, probably nobody's average. Everyone's above or below average. But on average, it takes relationship managers about five years to consolidate their books. It generally comes in on a roughly straight-line basis. And when consolidated, it's roughly a self-funded book in the $65 million range on both sides of the balance sheet. You can see on the left that we currently have a total of 235 relationship managers that are at various stages of consolidation within that five-year consolidation start-up period. On the right, you see the extraordinary loan and deposit volumes that we believe will land on our balance sheet just in ‘25 and ‘26 if these cohorts and relationship managers continue the consolidation of their books over the next two years at the average pace. And I've already told you it's our expectation that we'll layer in another large cohort next year and the year after that and so on, producing incrementally laddered volumes. It's a simple, consistent, repeatable model. And so as Harold walks you through our third quarter results, hopefully, you'll be able to see these factors that underlie not only our historical success, but our third quarter success and our ongoing success for that matter, that our culture continues to strengthen as we grow, not diminish, and that this persistent growth model is not dependent upon me or other key leaders; is not dependent on a change of administrations; is not even meaningfully dependent on a more vibrant economy, although a vibrant economy with strong loan demand will very likely enhance our growth. Our remarkably persistent growth even in difficult times is a result of this very simple, consistent, and repeatable model. So, Harold will walk us through the quarter in greater detail.
Harold Carpenter, CFO
Thanks, Terry. Good morning, everyone. We will start with loans, which increased by $539 million during the quarter or 6.4% linked quarter annualized. When we consider just C&I and owner-occupied commercial real estate, our loan growth in these two critical segments was approximately $706 million or 17% linked quarter annualized. We're modifying our growth expectations for 2024 to now reflect a range of 7% to 8% growth. We are obviously pleased with loan growth this year. It's been an uncertain environment all year long, and there is quite a bit of uncertainty currently. But with the election coming up and what appears to be the initiation of a downgrade cycle, both of these matters tend to point to somewhat less uncertainty in the near future, which hopefully creates confidence and brings entrepreneurs back to the borrowing table. As to our end-of-period rates, particularly SOFR-based loans, end-of-period rates are beginning to reflect the debt decrease by quarter end. More on loan and deposit betas in just a second. One of the keys to our financial plan all year long has been increasing pricing on the renewal of fixed-rate loans. As the top right slide indicates, we're expecting about $1 billion in cash flows for our fixed-rate loan portfolio during the fourth quarter of this year with an average yield of around 5.1%. We believe a yield lift of nearly 200 basis points is reasonable as these cash flows come to us during the fourth quarter. Our competitive advantage is that approximately 22% of our revenue producers have been with us less than two years. All of them are ready to continue to move market share, which bodes well for us as we begin our planning processes for 2025. We will continue to lean on our new lenders as we enter the fourth quarter and head into 2025. Deposit growth has been a real bright spot for us all year. Excluding brokered, we increased deposits by $887 million in the third quarter. We're also pleased with noninterest-bearing deposits and their performance in the third quarter, again signaling that we are finally beginning to see volume growth for DDA accounts. Given our third quarter deposit growth, we are maintaining our deposit volume forecast with somewhat more specificity around a 7% to 9% growth estimate. We continue to move deposits into the index deposit product categories. Almost 50% of our deposits are now indexed to fed funds as we prepare for a downing environment; this should be helpful. As we have said before, we continue to like our competitive position as to deposit rates and believe it gives us more flexibility so our current rate forecast materializes, which includes two additional 25-basis-point rate cuts in the fourth quarter. We've included some information on betas thus far for loans and deposits. We are very pleased with how the loan and deposit pricing has performed over the last few weeks as our relationship managers have been diligent and making sure that we're able to reprice our deposits as quickly as we can to offset the impact of a lower rate environment on our earning assets. So far, our deposit beta has outperformed our loan data, and we remain optimistic that we can continue to mitigate the impact of rate cuts by the debt to both our net interest margin and more importantly, our net interest income as we move through the next several quarters. As expected, with the investment security restructuring late last quarter, we did anticipate NIM expansion and are pleased with the 3.22% we posted this quarter. Our outlook for the fourth quarter is that we believe our NIM will be flattish after we consider the incremental rate cuts. We are modifying our outlook for net interest income growth for 2024 to 7% to 8% growth for 2024. We know everyone is thinking about 2025 net interest income, as we are. The yield curve will have a significant influence on how all that plays out next year, so we are running a lot of rate scenarios currently. We believe all banks performed better with the traditional yield curve, and I believe all of us are optimistic that the risk of the existing inverted curve continuing or impact decreasing. A traditional curve, commercial clients coming back with increased energy to borrowing, and national elections in the rearview mirror we believe to provide a better operating environment for our growth alike. We're again presenting our traditional credit metrics. We mentioned a $90 million charge-off of a C&I in the press release last night. We performed an in-depth review of that credit during the quarter, elected to charge off a portion of the credit in place the remainder on nonaccrual. Resolution, we hope will occur next year as the company seeks a permanent takeout partner. As to our outlook for charge-offs, we're narrowing our guidance to a range of 21 basis points to 23 basis points for 2024. We are also narrowing our guidance around provisioning in relation to average loans to a range of 32 basis points to 35 basis points. No real change in how we feel about credit as we head into the fourth quarter or 2025 for that matter. Our charts for past dues, classified loans, and potential problem loans indicate we are performing near historic lows, which should be a meaningful indicator as to what we believe credit is currently. We have no reason to believe this won't continue to perform well as we head into the fourth quarter as well as into 2025. More about commercial real estate and again, in the supplementals is more information on commercial real estate, primarily from multifamily, industrial, and all this. As we noted in the press release, we have now successfully dropped the lower target of 70% for construction loans to total risk-based capital at September 30, which was sooner than we thought last quarter. Our appetite has changed modestly now that we are below the 70% threshold. That said, let me stress, any new commitments to this space continue to prioritize strategic client relationships only, and that we will proceed cautiously. We anticipate that our construction concentration will fall further over the next several quarters into the 50% range, and we don't expect to see any incremental in the concentration until mid- to late-2025. Beyond all that, we are currently tracking to achieve our 25% target for total non-owner-occupied commercial real estate multifamily construction in mid-2025. Candidly, we have always admired our commercial real estate book. The last couple of years have been a roller coaster of negative media attention around CRE and the impact on regional banks. I know many of you know this for Pinnacle. Our house limits are very modest. We pride ourselves on a granular book. Our largest ticket sizes for our bank are conservative in comparison to what we hear from other franchises. Thus far for Pinnacle, our commercial real estate portfolio continues to perform very well, and we expect that to continue. Now, fees. And as always, I'll speak to BHG in a few minutes. Excluding the loss on the sale of securities in the second quarter, fee revenues were up 8.3% between 3Q and 2Q. Our wealth management units have had a strong year and fully expect the efforts of our wealth management professionals will continue into the fourth quarter and into 2021. The fees associated with deposits are also doing quite well with commercial account analysis leading the way. As to run rates in comparison to the second quarter, during 3Q, we realized an increase of about $1.5 million from the sale of fixed assets and approximately $3 million in increased fair value adjustments from several of our other equity investments. As to our outlook for 2024, we're again raising guidance for our fee revenues, excluding DSG, from 14% to 17% to a range of 23% to 26% growth over last year, which seems reasonable given the performance of several of our primary business lines this year. Expenses came in slightly more than where we thought they would as of the end of the second quarter. Importantly, we are increasing our incentive target to a 90% target payout for fiscal year 2024. Again, we're raising our target which points to our belief 2024 will be better than we thought as of the end of the last quarter. As you know, direct linkage between our financial performance and our incentive plans are correlated, and thus, we can't raise one without believing the other will move up as well. Additionally, our hiring was really strong in the third quarter with 37 new revenue producers compared to 89 for the first six months of the year. Going into the fourth quarter, our recruitment pipeline remains strong across the franchise. Lending-related expenses are up quarter-over-quarter primarily due to a $2.1 million new recurring charge related to the loss protection fee from the credit deposit swaps we executed in the second quarter. As we look to the fourth quarter, we currently estimate our total rig expense level for 4Q should approximate the third-quarter level. Now to BHG, and we will be quick. As the slide indicates, originations picked up again in the third quarter with originations approaching $1 billion. As to the fourth quarter, BHG production should be somewhat consistent with the third quarter. As to placements, total placements were less than originations, which was consistent with the second quarter. BSG continues to build inventory in order to fill larger orders in the fourth quarter and as we enter 2025. Also, there remains great demand for BSG Paper, both from the auction platform and the institutional buyers. More than 600 unique bank buyers acquired loans over the trailing 12 months and the number of banks eligible to purchase loans from BHG continues to grow. As the spreads, auction platform spreads increased to 9.2% in the third quarter. Balance sheet spreads have remained fairly consistent with the prior quarter. All in, BHG spreads are holding in what has been a higher rate environment. BSG believes as rates decrease, that will be good news for them from both a volume and a rate perspective. Off-balance sheet substitution losses amounted to 4.2% in the third quarter, up from 3.4% in the second. As a result, BSG increased reserves off-balance sheet losses to 6.2%. The good news is that past dues are trending in the right direction, which hopefully is a sign of a better credit experience in the not-so-distant future. Home balance sheet losses were up modestly to 7.4% in 3Q from 2Q. Again, even though the percentage of on-balance sheet losses increased in the third quarter, the actual dollar amount or on-house balance sheet losses decreased. A similar circumstance has occurred in the prior two quarters, as balances fell faster than actual losses, which is why a percentage loss was higher. Our BHG fees amounted to approximately $16.4 million in the third quarter, and we expect the fourth quarter to approximate that amount. Our concluding thoughts on BHG this time around are that their management is focused on building a sustainable franchise, and as such, pushing as much product as the pipe is not as important as maintaining and building a strong balance sheet. We believe BHG remains one of the most profitable and dynamic tech models in the country, and with an even stronger balance sheet, BHG should be an even stronger competitor in the future. Now to our outlook for the remainder of 2024. Again, we've raised our expectations in some cases and lowered our expectations in others. In the end, we feel more confident about our 2024 outlook given our strong performance in the third quarter. All of this should be a good sign for 2025. We've started our annual planning effort for next year. Our financial bills will be the same: top quartile revenue and top quartile earnings were the investments we've made in our new markets and our hiring success are the building blocks we will lean into as we build our 2025 plan. As I mentioned earlier, if we can get beyond an inverted yield curve and our owner-manager clients getting more confidence and start borrowing again for growth, uncovered 2025 will be another strong year for Pinnacle. We've been through a lot of information, so I don't want to spend a whole lot of time wrapping up as we move into Q&A. We are very fortunate that we operate in what we believe is the best hiking is in the United States and in markets where we believe our large-cap competitors are volatile and giving up market share as a shy away from relationship-based banking and the impact that has on delivering differentiated levels of service. We have also, over the years, become an employer of choice. Our recruiting efforts have helped tremendously by the success of our brand in all of our markets. No longer do our market leaders have to spend hours introducing our brand to prospective associates as brand awareness has already found its way into our markets in and outside of the workplace. Our best place to work and work environment results resonate among not only our associates but also potential recruits, and that translates to a very successful client experience and ultimately to our shareholders. In the end, we are focused on earnings growth, revenue growth, and tangible book value growth. The top quartile performance is gold year in and year out. We believe if we consistently hit these financial goals, as well as our strategic goals, our shareholders will be rewarded. And that, with that, we will open up for Q&A.
Operator, Operator
Your first question is from Brett Rabatin from Hovde Group. You are now live.
Brett Rabatin, Analyst
Guys, good morning. Wanted to start with Slide 23 and just talking about the flattish margin expectations for 4Q. Given the beta performance that you've seen so far with loans and deposits and the fixed-rate loans repricing in 4Q, I'm a little surprised some margin expectations aren't a little better for at least the fourth quarter. Can you just walk through again kind of your expectations for the fourth quarter betas of loans and deposits and maybe how you see some of those SOFR tied loans performing in 4Q?
Harold Carpenter, CFO
Yes, I'll address it this way. Regarding the margin itself, we believe it will remain relatively stable. As we move further into rate cuts, we anticipate better opportunities for some balance sheet hedges, but this won't happen until we exceed 100 basis points. We still have significant work to do with our clients over the next 50 to 75 basis points in rate cuts. Consequently, we will need to focus on our depositors in the coming months to reach a point where these balance sheet hedges can take effect and we can see some positive changes. In terms of net interest income, we still anticipate growth in the next quarter, so we don't foresee that being stable, but we do expect the net interest margin to remain fairly consistent for the year.
Brett Rabatin, Analyst
Thank you, Harold. One concern I often hear is that while you’ve effectively transitioned a lot of deposits to being indexed, the loan portfolio is quite variable, with over 60% being impacted by pricing changes relatively quickly. Do you believe the margin might be lower in a quarter or two, considering there are many factors to consider? I understand it may be premature to speculate before we see the yield curve in the coming months, but with respect to timing and whether the bank is liability or asset sensitive, do you think it’s reasonable to anticipate a lower margin? Or is there potential to manage through some of the longer pricing as betas adjust within the SOFR portfolio specifically?
Harold Carpenter, CFO
Well, we do believe we've got the opportunity to kind of keep the margin where it is. There's obviously going to be some risk that the margin does go down, but it won't be a lot. It might be a basis point or two. But again, what we're going to have to do is rely on our relationship managers to continue to communicate with their clients to be able to reduce these lower into these lower rate categories. And that's what we're going to do. By pushing a lot of deposits into the 50% index, that's obviously a tailwind for that. So, I guess I'll stop there.
Brett Rabatin, Analyst
Okay. And then if I could sneak in one last one, just around DDA. Impressive in your period growth versus average. Any seasonality in the DDA this quarter and just maybe any comments around your efforts to grow that bucket, which the whole industry is focused on?
Harold Carpenter, CFO
Yes. We think there is seasonality. We don't think that's all the story for the third quarter, and we don't think it will be all a story for the fourth quarter. In order to attract those deposit accounts of noninterest-bearing, you've got to get the entire client relationship. And we've been successful in a lot of our newer markets in attracting that and pulling that critical product across the street. And so that's why we think we're going to get some lift as we move forward and not only Atlanta, but also D.C. and Jackson.
Terry Turner, CEO
Brett, I want to add that our lead bank penetration is very high according to Greenwich data. Compared to our competitors, our business clients see us as their lead bank, which indicates that we hold their operating accounts. We're adding clients at a significant rate and capturing market share. Overall, that's the main factor behind our growth in deposit accounts.
Operator, Operator
Your next question is coming from Russell Gunther from Stephens. Your line is live.
Russell Gunther, Analyst
You spent some time in the prepared remarks and the slides discussing how successful you've been in terms of M&A and then organically taking share from there into the Carolinas and into Memphis. Is that a strategy today that still makes sense or is of interest to you? Could you just touch on your thoughts there?
Terry Turner, CEO
Let me clarify the question. You're asking, do we have an appetite for M&A?
Russell Gunther, Analyst
Yes, that's right. I mean, we spent some time on the deck going through the success you've had there. And then the next leg taking organic share from there? Is that part of the strategy going forward?
Terry Turner, CEO
I think what I would say is unlikely; I never say never, but I think it is very unlikely that we'll be acquiring banks. And I think you've heard me say all of the reasons for that is our ability to hire so many people, our ability to do these market extensions to grow so rapidly with a significantly lower risk profile than doing an acquisition because of that; I don't think it's likely we will make acquisitions Russell. I think one of the points I'd hope to make is, okay, we entered some of these markets by way of acquisition, but the organic growth that we put on, the pace of that organic growth was substantially beyond what those companies were doing when we acquired them. So, we're really just trying to illustrate the power of this simple model of hiring the best bankers in the market, having them consolidate their books of business from where they were to here is a really reliable growth mechanism. So, because of all that, I don't think you're going to have much expectation we'll be acquiring banks.
Russell Gunther, Analyst
Understood. Okay. I appreciate your thoughts there, guys. And then just one more for me, switching gears, if we could, to BHG. I appreciate the thoughts on the 4Q trend. But as we think about to comment that lower rates should be better from a volume and rate perspective and past dues trending in the right direction. Is it reasonable to think that that revenue could grow in '25? Or are there big picture takes you could share in terms of the revenue trajectory going forward?
Harold Carpenter, CFO
Yes, Russell, I'll try to work my way on in that question. We really don't want to give out too much 2025 numbers. But we've had conversations with BHG to their expectations for next year. I would imagine that it's probably going to be a mid-single to high single-digit kind of number when we finally get to it. But we've got more work to do there. We've got a lot of kind of work to do around what their expense base is going to look like, so on and so forth for next year.
Operator, Operator
Your next question is coming from Jared Shaw from Barclays. Your line is live.
Unidentified Analyst, Analyst
This is John Rau on for Jared. John, I guess just sticking to BHG for a second. The reserve for on-balance sheet losses has been coming down, I guess, the last few quarters, but the liability for substitution and prepayments looks like that's still trending up. I guess why wouldn't those be moving in the same direction? And I guess, is there any color on where that liability for substitution and prepayment could be headed at a good level here?
Harold Carpenter, CFO
Yes, here are a couple of points to consider. First, the loans sold for the Community Bank network are the responsibility of the Community Bank. Therefore, there is a delay in how those losses affect them compared to loans on their own balance sheet. Additionally, those loans typically have a longer duration. Consequently, the losses related to the on-balance sheet loans are more recent, and I usually observe most loss activity within the first 30 months. The ongoing situation with off-balance sheet loans is tied to older losses and the timeliness of community banks submitting those losses.
Unidentified Analyst, Analyst
Okay. That's really helpful. So, I guess maybe we could think of the on-balance sheet credit trends as more of a leading indicator of the off-balance sheet credit trends?
Harold Carpenter, CFO
Yes, we believe so. We believe eventually, the off-balance sheet will replicate with the on-balance sheet. Now the reserves associated with them are calculated in two different ways. One is a CECL-based reserve, and the other is a trailing loss content with so on the trailing 12.
Unidentified Analyst, Analyst
Okay. Great. That's really good color. And then I guess just one other one for me. Moving over to the hiring. It sounds like 2025 are going to be a pretty big year for bringing on new hires. As you kind of deepen your presence in some of the expansion markets, can we still expect the new hires to ramp up in terms of bringing on loans and deposits at the same pace as some of the initial hires? Or is there sort of a diminishing return that we should expect as you kind of add to the total number of RMs in the market?
Terry Turner, CEO
Yes, I believe the assumptions we used in that illustration are solid for the future. We've tested this model numerous times, and it consistently aligns with the numbers we are presenting, illustrating the growth from when employees have been with us for one year, two years, three years, four years, and so on. The 234 associates or relationship managers we currently have are at various stages of consolidation. Therefore, we think it's reasonable to assume they will progress at the average run rate. Did I address your question?
Operator, Operator
Your next question is coming from Stephen Scouten from Paper Sandler. Your line is live.
Stephen Scouten, Analyst
Good morning. Just a clarifying question around the move in index deposits. I know, Harold, you touched on this a little bit last quarter as well. But how exactly are you getting those customers to move from negotiated to index? And do you think that this creates any sort of pressure on potential outflows as rates presumably move lower in the future?
Harold Carpenter, CFO
I believe that we are working with individual clients to transition them from a negotiated rate to the index rate. I don’t foresee any increased pressure for clients to leave us due to rates, and we will reduce the rate in that unchanged category as well. Therefore, we should focus on the strong relationships our team has with these clients, and I am confident that we won't experience significant outflows in this area.
Terry Turner, CEO
Stephen, one of the things, if you remember some of the conversations that we had back when it seemed apparent we were headed into a downrate cycle. I think we gave indications that we had already begun prep and both our associates, particularly our associates and also our clients for how we would respond in the down rate environment. And so, inside the company, there's a great understanding by our relationship managers, which as you know, is the whole key to both how we get business and how we keep businesses; that's the relationship they have with those clients. And so, as Harold said, those are one-off negotiations. We're not sneaking up on somebody any of those kinds of things. So, it would not seem to me that there is much risk of attrition.
Stephen Scouten, Analyst
Fantastic. That's helpful. And Terry, I mean, you guys added in a lot of great slides in the deck this quarter. And clearly, like you showed, you crossed 10, and nothing changed across 50, nothing changed. The growth profile is still what it is. But as you continue to look more and more like one of the large regional banks that you've kind of taken a lot of the personnel from through the years. How do you continue to outperform them so significantly? Or how do you keep yourself from starting to look like a large regional bank? Is it really just the incentives and the culture? Or is there anything in particular that keeps you from, I don't know, centralizing in the ways that they have that becomes an impediment?
Terry Turner, CEO
Yes, that's an excellent question. To begin with, the culture here is strong and has been in place long before I arrived. Many have said that as we grow, it becomes challenging to maintain that culture. However, we conduct an internal work environment survey where 93% of our associates participate. It's rare to find such high engagement from employees willing to provide feedback. The responses consistently show over 70% agreement in positive ratings, and those numbers have remained stable rather than declining. Specifically, we're improving our standings as a Best Place to Work among millennials, women, and in the financial services sector, ranking third behind American Express and Synchrony. These trends are positive, not negative. I believe I and others influence our culture, though it's largely self-sustaining once established. Our geographic focus plays a crucial role as well. I understand how many larger companies operate, and while their goal may be to become big by adopting a line of business structure, our aim is to be the best. We're committed to providing a unique client experience, which necessitates maintaining our geographic structure. I see opportunities for market expansion and capturing additional market share. There's skepticism about whether we can sustain our growth, but we continue to attract bankers from larger banks who bring their clients with them. We don't rely on sophisticated technology or complicated strategies. We simply offer a great work environment that draws talent away from larger firms. Our hiring pace is rapid and even increasing. To summarize, I believe the law of large numbers won't hinder us, at least not in the foreseeable future. The culture seems unlikely to fade, and I don't anticipate the challenges sometimes associated with growth will impact us negatively.
Stephen Scouten, Analyst
Perfect. Congrats on all the continued success.
Operator, Operator
Your next question is coming from Ben Gerlinger from Citi. Your line is live.
Ben Gerlinger, Analyst
I appreciate it. I also really liked Slide 21. You discussed it quite a bit, and I believe it effectively illustrates the essence of your team. When you see that about one-sixth of the bank isn't fully established yet, it indicates that while you have the personnel, you haven't fully capitalized on loans. This suggests that even if you stopped hiring, there would still be significant growth potential. My next question relates to your management of the balance sheet, especially with respect to interest rates. Given your substantial growth opportunities, what are you considering regarding rates and deposits? I'm particularly curious about the profile of the people you've hired. I assume it leans towards commercial and industrial, but what kind of mix of deposits and relationships should we expect as they join, particularly in terms of loans and deposits? I know they're likely to enhance your franchise, but that's a crucial element for your margin outlook moving forward.
Harold Carpenter, CFO
Yes, Ben, that's a great question. I think we do emphasize C&I and private bankers. I think we have a general belief that commercial real estate lenders, we've got those. We're well healed there with our capacity there. So, we are interested in private bankers and C&I lenders. And I think they bring just a general mix depending on what market they're in, if you're in a market like Huntsville or Bowling Green or Louisville, so on and so forth, you're going to have a broader client base than say, if you're a C&I lender in Atlanta or Jacksonville or D.C. side. So, I think it just all depends. But the calculus that we use is pretty much consistent that we're looking for that person to bring a significant amount of their book from their former employer over to our bank and to do that within a reasonable time period. So, we keep up with that. We try to make sure if somebody needs help. We give them the help to do that. Otherwise, we're saying, go get them.
Terry Turner, CEO
Ben, I would like to add to that. As I mentioned before, averages can be misleading because not everyone is average; some are above or below it. Overall, it appears to be a self-funded book with around $65 million on both sides of the balance sheet over a five-year period. This includes various bankers such as private, commercial, large business, and small business bankers. Generally, it's a self-funded book, but there needs to be a focus on deposits. The key challenge for a company like ours is how to fund the balance sheet while we can produce assets at such a high pace. For example, in D.C., which is a significant high-growth market where we're expanding rapidly, the funding ratio is more than 2:1. In summary, many clients are consolidating their entire relationship, which impacts both sides of the balance sheet.
Ben Gerlinger, Analyst
Got you. No, that's helpful. also, kind of just dovetailing off of that, like with the additional hires? And then you gave guidance, but this flywheel isn't stopping. If anything, it's speeding up. Is it fair to kind of assume double-digit higher equal to double-digit expense growth next year? Or is there any sort of initiatives behind the scene or synergies, obviously, some synergies just by scale. But anything kind of lever pulling on you guys' side of the table where we could kind of mitigate some of the expense growth?
Harold Carpenter, CFO
Yes, we can always do things to slow down the hiring. I don't think we'll do that. The biggest impact that we will have to our expense growth next year will be where we end up in the incentive pool this year and how much more will take us to get back to target next year because we will load the expense target for next year, the expense growth number at target. And that will be the biggest influencer of how much growth we'll have next year or at least at the first part of the year.
Terry Turner, CEO
Ben, if I could say this, and obviously, somebody is going to take this comment the wrong way, but I'll just say this, we generally take great pride. And if you look at our noninterest expense growth over a decade, over two decades, over the last five years, whatever, it's a double-digit expense growth rate. We just grow the revenues faster. And so again, to the point you hit it, which is really important to me is like you look at all those 234 people that have yet to consolidate their whole book here, I've got 100% of that expense run rate with the revenue coming. And so again, as long as we believe we're going to continue to hire people, and they're going to continue to move those books of business, which I do, then you don't fear an elevated noninterest expense growth rate. We're more concerned about revenue growth and EPS growth.
Operator, Operator
Your next question is coming from Anthony Elian from JPMorgan. Your line is live.
Anthony Elian, Analyst
Good morning. In the prepared remarks, you commented that if the yield curve slopes more favorably in the coming quarters, that could lead to a better 2025 revenue outlook? But if the yield curve doesn't become more positively sloped than it currently is, for example, if long rates continue to decline, to what degree would that impact the optimism you have for next year's revenue outlook?
Harold Carpenter, CFO
Tony, thanks for the question. I think you're getting at why we want to try to pursue as neutral a balance sheet as we can, and you know this as well as there's a blue million assumptions that go into that. But life just gets harder with an inverted curve and has been hard over the last couple of years in dealing with that and trying to manage a spread target over the last couple of years. We think we're advantaged because of the neutrality of our balance sheet. We think we can manage through it if the inverted curve continues to just kind of lag along during 2025. But we can always be hopeful. And it looks like that we've got some reason to be hopeful that at some point in 2025. And when we talk about an inverted curve, just to be candid, we're talking about from the overnight rate to probably around 5 years. So, if we can get a traditional slope curve there, we think that's good news for us and probably a lot of bankers as well.
Anthony Elian, Analyst
Thank you. For my follow-up on Slide 21, regarding the cumulative growth capacity you mentioned for deposits and loans in 2025 and 2026, do the figures of 5.9% and 5.6% for loans indicate the best-case scenario you anticipate for the balance sheet over the next two years? Or are they just average expectations for what might be recognized on the balance sheet?
Harold Carpenter, CFO
I think it's more indicative of an average. We're not prepared yet to kind of give you any sort of outlook on 2025 other than what we've talked about in the prepared remarks.
Operator, Operator
Your next question is coming from Catherine Mealor from KBW. Your line is live.
Catherine Mealor, Analyst
Good morning. I have a follow-up regarding the outlook for net interest income. If you are able to grow the balance sheet at a double-digit rate into next year, is there any reason to think we can't achieve double-digit growth in net interest income as we move into next year? Or should we aim for a safer high single-digit growth similar to what we experienced in 2024?
Harold Carpenter, CFO
Yes, Catherine. For us, there's a strong correlation to loan growth percentage growth as well as in a high percentage growth, probably because of the way our margin performs and how tight it is. But I think if you look out over the last several years, they would be closely correlated. So, we're not ready to put out kind of a loan growth target for next year, but we are optimistic that we should do better than what we're doing this year.
Catherine Mealor, Analyst
Okay. That's great. About the fees, we had a really strong performance this quarter and we're providing a higher guidance for 2024. Can you discuss the increase in service charges? I assume this is primarily due to account growth, but any additional insights would be helpful. Additionally, what is your outlook for growth in service charges for this quarter, and perhaps the latter half of 2024? Is there anything that might be noticeably high that we should consider adjusting for when modeling 2025?
Harold Carpenter, CFO
Yes, we briefly discussed some fair value adjustments for other equity investments and gains on the sale of fixed assets in the third quarter. However, we are not expecting those numbers to repeat in the fourth quarter. Looking ahead to 2025, we anticipate reasonable growth in our core business, whether in wealth management, mortgage, or other areas, including a full year of BOLI revenues next year. Thus, we are optimistic about potential fee growth for the upcoming year. Regarding deposit service charges, much of it stems from our commercial analysis accounts. For those experienced in banking, the details matter significantly, and we have been reviewing our accounts to ensure we are receiving the appropriate fees for the services provided. Throughout the year, we've engaged in negotiations with clients to ensure we are compensated fairly for our treasury management services.
Operator, Operator
Your next question is coming from Sam Varga from UBS. Your line is live.
Samuel Varga, Analyst
Good morning. I just wanted to put fees for a second and specifically the investment services line item. And I just wanted to I guess, ask for some commentary on what you think the run rate is here. It seems like based on just the AUM numbers you're getting better at monetizing that again? And so, I wanted to see if some of that is impacted by private banker hires or just talk about that business over the next couple of years even?
Harold Carpenter, CFO
Yes, it is significantly influenced by hiring and the ability of our new employees to transition their client accounts to Pinnacle. We operate a dual platform with Raymond James, which serves as the foundation for that process, but it is crucial to move them onto our platform. Specifically, we have experienced considerable success in Jacksonville with our recent hires. Therefore, we fully expect to see that line item continue to grow. Is that what you were looking for, Sam?
Operator, Operator
Sam, your line is live.
Samuel Varga, Analyst
Sorry, I might have been muted there. So, as you bring the private bankers over, I guess how quickly do the brokerage accounts come over as well?
Terry Turner, CEO
Let me clarify. We have private bankers who typically manage the relationships. We also employ brokers and trust administrators, all of whom have product specialties and are compensated based on the assets under management. We're actively expanding our team in all these areas, including private bankers, brokers, and trust administrators. Regarding our investment services, most of the income is derived from advisory fees rather than transaction commissions, with about 90% of that total coming from advisory services. We've been very successful with the brokers we've brought on, particularly the Series Seven licensed brokers who are consolidating their client books. For example, in Jacksonville, where we’ve been operating for less than a year, they have brought in approximately $600 million in assets. This illustrates our ability to quickly increase revenue through these strategic hires, and we are implementing this approach across our entire footprint.
Samuel Varga, Analyst
Got it. Just one more quick question about the bond book. Harold, could you comment on whether you now have more variable rate? Are you planning to keep that bond book shorter, or are you looking to extend it a bit to take advantage of the back end of the yield curve?
Harold Carpenter, CFO
We are satisfied with the current state of the bond book and do not anticipate any growth or extension in its duration. We are obtaining a good yield from it as it stands. When we evaluated variable versus fixed rates, we took measures to shift more towards variable rates through our hedges. There is still ample opportunity ahead, particularly regarding interest rate movements. If rates continue to decline, we can still gain a considerable yield before they drop to a point where a fixed rate would have been a better option. Overall, we are benefiting significantly from the yield on our variable rate bond portfolio and will maintain that advantage until rates decline substantially.
Operator, Operator
Your next question is coming from Brian Martin from Janney Montgomery. Your line is live.
Brian Martin, Analyst
Good morning, guys. A couple of quick ones for me. Just, Harold, on the margin, just on the loans that reprice immediately with rates. Can you remind us what that is?
Harold Carpenter, CFO
The levels that the loans that reprice immediately?
Brian Martin, Analyst
With rate cuts, what will move immediately as rates cut on the loan side? I know you talked about the fixed rates that are going to continue to move higher. But just in terms of rates declining on the variable rate loans kind of the variable rate loan percentage.
Harold Carpenter, CFO
Yes, all the prime rate credit will reprice immediately, and that's about are you looking at that variable beta?
Brian Martin, Analyst
Yes.
Harold Carpenter, CFO
So, that would be probably about 30% of the variable rate loans. It's about 14% of total loans. They were priced daily.
Brian Martin, Analyst
Daily. Got you. Okay. Perfect. And then just one question. I know you're not commenting a lot about the loan growth outlook. But just in terms of '25, just in terms of the mix, like this year, we've seen that the focus on reducing the CRE exposure. As we look to next year, does the mix of loan growth look similar? Or should I guess, seems like it would include a bit more from your comments earlier, Harold, that CRE, maybe the back half of next year of '25? Or just how we should be thinking about that in terms of your comments also about maybe looking for a little bit better loan growth next year than this year.
Harold Carpenter, CFO
Yes, I think so. We don't expect to see any kind of big uptick in construction or commercial real estate investment property likely until, call it, the last half of the year, as you say.
Brian Martin, Analyst
Got you. Okay. The deposit growth was very strong this quarter. Can you clarify if any part of that was driven by the deposit verticals you have been focusing on? Or was there anything significant that contributed to that growth this quarter?
Harold Carpenter, CFO
No, I think it's largely in those verticals and the business model that we put forth with those verticals where we've got experts in those industries that are across the footprint, helping relationship managers garner those deposits.
Operator, Operator
Thank you. That completes our Q&A session. Everyone, this concludes today's event. You may disconnect at this time, and have a wonderful day. Thank you for your participation.