PNC Financial Services Group, Inc. (PNC) Barclays Capital Global Financials Conference Call September 9, 2013 11:15 AM ET
William S. Demchak – President and Chief Executive Officer
Robert Q. Reilly – Chief Financial Officer
William H. Callihan – Senior Vice President, Investor Relations
Everybody in the room take your seats, we’re going to get continued. So those that have been regulars at this conference over the last decade or so, a couple of things as, one usually PNC presents kind of mid-word in the first day, it’s typically how it works out. And then secondly, for whatever reason that this conference usually falls on Monday, is the Saturday after the Michigan-Notre Dame game.
And one of the kind of things, I think six or seven people commented this morning as every year I get to rib – I used to get to rib Jim Rohr, the prior CEO who is at Notre Dame game the fact that might Michigan Wolverines beat them. This year looks like people tell me before Mich Notre Dame actually won; Jim would actually be here to grow themselves for the first time. But we’re very happy this year to have Bill Demchak, our CEO who is like me, University of Michigan grad, so a recent upgrade from that standpoint.
And additionally, Rob Reilly who’s also been voted the new Chief Financial Officer and then Bill Callihan, our Investor Relations, who is certainly not new to that role and probably one of the few IR folks that was in the business when I started in that role in 1995.
William S. Demchak
Who was in the business when you were born?
And on that, now let me turn over to Bill Demchak.
William S. Demchak
Thank you and good morning to everybody. Again we have Rob Reilly with us who is our new Chief Financial Officer and Bill Callihan, Director of Investor Relations. Just before we get going, as you can see on this slide, our presentation materials and information in the Investor Relations section of our website pnc.com include cautionary statements regarding forward-looking and adjusted information, and I urge you to read them.
So in recent years, our PNC has grown into one of the largest diversified financial companies in the United States with assets greater than $300 billion and a retail banking footprint that covers approximately half of the U.S. population. Then unlike many of our competitors, we grew the company both deliberately and dramatically through the crisis, which is significant because it positions PNC and markets, with favorable demographics to grow organically for the foreseeable future and create long-term value for our shareholders, what’s more in all of the businesses that we choose to compete, we have the scale and the prudent competency to successfully compete.
Today, I’m going to talk about how our strategic priorities are aligned to enhance shareholder value, and then I’m going to share some of the progress we are making within each of these priorities. And finally, I’ll discuss our position relative to our capital goals and what that means for shareholders going forward.
You’ve heard us talk about this before that our organization is focused on five strategic priorities. First, we want to drive growth in the newly acquired and under-penetrated markets, essentially what we are talking about is leveraging our business model then over time bringing our performance in the Midwest and importantly, the Southeast up to the levels of our Northeast markets like Pittsburgh and Philadelphia.
Second, we want to substantially increase our growth in investment platform through deeper penetration of our new and existing clients. Third, in light of the environmental conditions in the steady march of customers toward multi-channel banking behaviors, we have to redefine the retail banking model. Fourth, we are working to build a stronger residential mortgage banking businesses deeply integrated into the rest of our company. And finally, expense management may not necessarily be strategic in the true sense of the word, but it’s certainly a long-term necessity given what’s going on in the industry. But these priorities are aligned to help us create a company that’s pre-disposed to increasing fee income, making us less assessable to downturns and less dependent on chasing higher risk assets or bidding on how fast interest rates may or may not rise.
Now we can see the results of our focus on these priorities paying off in key metrics. Revenue growth was triple the peer average for the first half of 2013 versus the first half of 2012. Expenses were down 5 times the peer average from the first half of 2012 to the first half of this year, and pre-tax pre-provision earnings growth is up nearly 3 times the peer average.
Here again, we see the results of our strategic position, and as ROA and ROE have both improved dramatically since the first half of 2012. A year ago, we lagged the peer average in both metrics and through the first half of 2013, we see that was significantly outperforming even as the peer averages have continued to improve as well.
If we just turn a second, talking about how we’ve come to be where we are and why this is the right time for us to really be focusing on fee income. In early days of the crisis, corporate bond spreads, loan spreads on spike as many institutions pull back on credit. We took advantage of this phenomenon by shifting our balance sheet strategy to add credit assets when risk adjusted returns were at a premium. And it enabled us to significantly accelerate commercial client loan growth at a time and importantly at a time when you got paid to do so. As you can see on the right, we grew commercial loans at a double-digit pace most of which was organic.
Now that growth coupled with reductions and funding costs enabled us to keep an eye relatively stable over the past several years and even to grow it in 2012. But like others in the industry, we are facing pressure on our NIIs, the headwinds of declining purchase accounting accretion, and narrowing loan spreads will be difficult to overcome in this environment.
Assuming no significant changes in interest rates, we expect core NII that is NII other than purchase accounting accretion, will be difficult to grow. As a result, we focused on execution in our fee income businesses. Now this focus on execution aligned with the strategic priorities I mentioned a few minutes ago is starting to pay off. In the first half of the year, we’ve seen an increase in our fee income to total revenue ratio to 42%. We are leveraging our business model to grow fee income. Over the last few years, we planted seeds and you’ve heard us talk about this repeatedly, but we planted seeds by adding customers and growing loans. And as you’ll see on the next side, we are now beginning to harvest those seeds in order to drive new fee income.
Over the last 4.5 years since our acquisition of National City, growth in the Midwest has significantly outpaced growth in our legacy Northeast markets. But that growth though it’s levered off recently due to the effects of tighter loan spreads and more intense competition, as well as our unwillingness to modify our risk appetite to a place it causes it us to make irrational pricing or structuring in our credit decisions. But still our success in the Midwest markets gives us confidence in our ability to enter new markets and leverage our model for growth. It’s going to be a key factor for our success in the Southeast in the coming years.
Now the chart on the right here, illustrates our product penetration. You can think about this as a share wallet measurement for corporate banking primary clients, which kind of gets the point I was just making. Now we added more than 3,000 new corporate banking clients from 2009 to 2012. Many of whom not surprisingly came to us for financing a lot of banks who are lending. So basically, you start out as a loan client and lend money. That’s the way the relationship typically starts and then you cross-sell through time as those relationships become deeper. And you can see on this chart that we are making progress on that metric.
Now the opportunity to move these new clients toward the depth of product penetration means all of their longer term clients represent significant potential to generate new fee income. We are also beginning to see difference in the Southeast expansion. In every line of business from the second quarter of 2012 through the second quarter of 2013, we’ve seen significant growth in the Southeast. In retail, we added 40,000 households in more than $0.5 billion in average loans. In CNIB, we grew average loans by nearly $1 billion. In AMG, we almost doubled our client base, admittedly offer small base with referrals from other lines of business accounted for a lot of that progress.
And mortgage originations were up significantly with the majority of our growth in new purchases, which has been our strategic focus. Clearly it’s very early in what is going to be our long-term gain, but the response from the region has been encouraging, a relative scenario where we have significant opportunity to drive new fee income as well.
For a lot of years, our wealth and investment businesses were not priorities for the firm as a whole. The silo business that focused on high networks and ultra-high network clients, but a candidate is still on isolation and it didn’t really try to attract the investments of the rest of our client base.
Last year, though we launched a new initiative to go after all of PNC’s clients for the wealth and investments needs, and we did so with the full relationship, however with the firm behind the effort. We’ve given every client facing employees in the company, clear goals related to capturing more of our clients’ investable assets. And as a result, AMG’s assets under administration are up, the retail banks brokerage managed account assets are growing rapidly, and we’ve seen year-over-year gains in this space in terms of AMG new primary client acquisitions referral sales and retail brokerage fees. Over time, we believe that we can double our investment in retirement business.
We jump to retail, on the retail side, what’s clear is that the model on which the industry is operated for decades; just it’s not sustainable today. In the old days, the bank would give away our core product checking accounts and we make our money on the interest on deposits, overdraft and other fees, I mean the interest that we collected on loans.
It’s really not true anymore. Industry revenue has been negatively impacted by billions of dollars due to the historically low interest rates, the higher cost of regulatory compliance and the significant reduction of overdraft and other fees due to regulatory change. This is more of the situation doesn’t get much better even if we have rates return to normalized level. This isn’t going to be solved by simply higher interest rates and it’s not going to be solved by taking costs out of the system.
Given this new reality, you couldn’t really start a bank today under the old model and survive and in fact, that we’ve seen this. If you go back and look at new bank starts over the last couple of years, there has maybe been a couple since 2009 of new banks started and the old model is basically broken.
In the PNC, we have diversity within our retail bank with products like cards and investments that help to offset some of the challenges the industry is facing. But we like every bank in the country to have this core retail operation inside of our model that needs fixed, and we’re taking on these issues with our eyes wide open.
In June, you will have seen that we announced the phase out of free checking; it’s a start, but our new approach rather than simply hitting our customers with a bunch of new fees on old products, almost to design a relationship continuum that enables them to have service fees waived, provided they made certain relationship criteria.
It’s an important step towards redefining the fair value of exchange with our customers. If you think about what’s happened to you through time for 30 years, we’ve basically conditioned customers believed that banking is a free product it’s in the bill of rights. You get banking for free that’s just what you’ve grown to be used to. And we didn’t just give away the free checking accounts, right we then created really cool technology products, online banking and mobile bill pay and mobile deposit then we gave that stuff away free as well, defending the free product that didn’t make any money.
Given the changes in the operating environment, banking in the future has got to be very different from banking in the past, there’s clearly offered choices from the line-up of the company’s product and services and transparency in pricing, so that customers know what they’re going to pay for services that they select. It’s not an idea that’s very dissimilar from a number of other industries. You think about cable and cellphone companies, but it’s a new and necessary direction for retail banking that is customer focused and sustainable.
The part of this strategy is going to ensure, continuing to improve our multi-channel offerings such as popular Virtual Wallet and mobile deposit products. As you can see here, more customers are moving towards self-service mobile, ATM and online banking options, which operate at a much lower cost to serve than the expense we incur for transactions to take place at teller numbers.
Now we’re adjusting staffing accordingly, you’ll see that over the last six months, we reduced a number of traditional tellers by about 600. and importantly, we’ve redeployed a lot of that talent and positions that are sales oriented, as well as a more cost efficient call center operations to service the multi-channel customers.
Innovation also means a completely thinking of our branch network and our expansion into the Southeast offers a lot of opportunity to experiment, in order to figure out what works best for our customers. On the markets we’ve entered in the Southeast and we get criticized for this, we will never have the physical presents that we traditionally had in the Northeast, the Midwest markets. But we don’t actually think that, that would fit the banking model in the future, and it doesn’t mean that we’re not going to occasionally open new branches, and we’ll do so when we think branches remain important, and then we’ll do so where it’s strategically important to do that. But the branches of the future may not function the same way as the branches of the past. In the traditional branches, we do operate, we’ll be complemented by what we refer to as a digital thin network featuring hub and spoke model of all purpose universal branches supported by sales focused cashless branches and fully functioning in ATMs, all of which complement our mobile and online platforms to enable our customers to bank when, where and how they want.
So when we talk about meeting the needs of our customers, we can’t ignore the need for quality service from a residential mortgage loan and notwithstanding the current volume declines and I’ll talk about that in the second in mortgage. Line of home is going to continue to be the single most financial – single most important financial transaction that the vast majority of our retail clients are rather being entertained in the course of the life. We can’t offer anything above the best client service in this business, but we expect to become an integrated and important part of our client experience relationship.
We believe that the mortgage business has the potential to be a brand enhancer that certainly hasn’t been that for the last couple of years for the majority of the industry. But we believe that has a potential to be a brand advancer, a service of that cements relationships between the bank and customers for decades. If we get this rise – if we get this right, customers are far more likely to want their check-in accounts and investment accounts with us.
The residential mortgage banking business, we’re making an important progress on a critical metric, time for an application to close, which is a key driver of customer loyalty. Now through the last couple of years, we’ve performed slightly better than the industry average on time to close. But recently, we’ve been rolling out our seamless delivery program across our network of mortgage originators and we brought our average time to close for the loans going through the new process, down even further to 42 days as of July.
So almost two four weeks better than the industry average. But importantly, customer loyalty ratings have improved by nearly 20% as a result. And as you can see on the chart here, we’ve been growing application volume for new purchase loans if more than twice the pace of the industry as a whole. The result is that we’re growing purchase volumes both in terms of absolute dollars and as a percentage of older mortgages that we originate.
Now in addition to seamless delivery, we’ve done considerable work to better understand the customer experience. We have a lot more to say on this for the future, but we’re leveraging what we’ve learned and investing to dramatically redesign and improve the entire home buying experience for our customers.
Now just a comment on volumes. Clearly, the recent rise in rates has caused the industry origination volumes and gain – volumes and gain on sale margins to decline. And as I mentioned on our second quarter call, we’re not immune from this trend, but our retail on the origination business, the historical focus on purchase volume and the enhanced client service levels should help mitigate some of this impact of the volume decline and at least relative to our peers.
So if you have seen, our strategic priorities are all focused clearly on growth, but we don’t have any doubt that the environment will continue to challenge us for the foreseeable future. Growing revenues is not going to come easily. so it’s absolutely critical that we remain committed to disciplined expense management and improving operational efficiency into 2014 and beyond.
We’re on pace to exceed the $700 million of continuous improvement goal that we announced earlier in the year and our efficiency ratio was down to 60% in the second quarter of this year from 73%, the second quarter of 2012. This how it start and I can’t say enough about how pleased I am with the way our management team at every level that company really and who has gotten behind this and taken ownership with their responsibility in their opportunities to control expenses. And then as we’ve said before, though expenses are likely to be higher in the second half of the year than they were in the first half, most of that was seasonal.
And for the full-year, we expect to see a material decline of at least 5% compared to 2012, and we believe we can continue to do better. As we look ahead, in order to have a more meaningful impact on expenses, we’re taking a big picture look at some of the redundancies that we know exist throughout our company. Many of which are the natural byproduct with the large integrations associated with our growth in recent years. We also need to revamp some complex processes where we have the opportunity through innovation and automation and better standardization to bring down operating cost.
We know they’re controlling everyday expenses like travel and entertainment helps to hold the line, and it’s largely what we’ve done thus far. But in order to move the needle in a dramatic way and take us over time from the middle of the path through an industry leader in terms of our expense ratio, we’ve got to take core process redundancy, inefficiency and bureaucracy of the operational functions of the company.
We’ve also seen that we continue to build on our strong capital position. Our pro forma Basel III Tier one common capital ratio reached 8.2% in the second quarter without the benefit of phasing. The pending completion of our evaluation of the Basel III final rules that we adopted this July, these estimates of 8.2% are based on our understanding to prior year Basel III rule proposals issued in 2012.
Having said that, we don’t think that any of the changes in the final rules are going to have an – negative impact on this number, we just need to continue to work through our interpretation of the finals. We also note that regulators have proposed significantly raising the Basel III supplementary leverage ratio from 3% to 6% at the bank level.
Totally important only for globally, systemically important facts. So why that does not apply to PNC and if it did, we would be in K shape with the 6% at the bank level. Earlier this year, we saw the increase in our dividend, 10% to $0.44 a share and a strong capital position and earnings should allow us to return a higher percentage of capital to our shareholders in 2014. On the other side of the slide, you can see that we’ve grown tangible book value faster than anyone on our peer group, which reflects that we are profitable due to the crisis and good starts of your capital.
So key takeaways, as you’ve seen today, we’re making real progress against each of our priorities, and that since, we’re building the bank of the future. But certainly through in a retail bank where we’re transforming our entire model to meet the new realities of the environment and our customers evolving preferences, it’s true in residential mortgage where we’re working to train this important product and the true brand enhancer.
It’s true in AMG and brokerage where we’re leveraging the resources through the entire front offer investment retirement services that every customer with whom we do business, then it started CNIB where we’re leveraging our traditional strengths to build deeper, longer lasting more profitable relationships with thousands of clients who turn to us at a time of economic uncertainty. All of that work is geared to increase fee income. Everything that we’re doing from the execution of our strategic priorities to expensing some capital management is aligned to continue to create shareholder value.
As we look out into our third quarter forecast, we know that at the margin, higher interest rates will benefit us but I would caution you that probably not at the same level that we saw in the third quarter where we said had some outsized fee gains and largely related to rates. I mentioned earlier that mortgage is likely to be down as a function of volumes and gain on sale. Credit cost looks to be well controlled, expenses look to be good. but we still got a month to go, so I’ll leave it there in terms of gains.
With that, thank you for joining us today. and Rob and Bill and I would be happy to take some questions.
Before I let the audience for questions, maybe I’ll hit down some of the less questions. If you currently get on the shares of PNC run rate, will it cause you to change your minds, one, greater comfort in terms of margin outlook; two, greater comfort on our acquisitions; three, more capital return; four, more expense reductions; five, at a loan growth and then six, in our more consistent results.
And we’ll go with better loan growth, and then number five, as it is the first choice filed by about results, which was filed by greater comfort in the margin outlook, interesting last year when we asked this question, I would say margin was first; loan growth, the second and more capital return was third. I guess, please could you talk – you touched loan growth, maybe just talk about on the second reason, which is more consistent results and I think some quarters we’ve seen results, it’s above expectations, some quarters below driven by a lot of kind of chunkier “one-time items”. At what point, do you think you kind of get these guys some more smoother or cleaner, I mean for lack of better word.
William S. Demchak
Good work. Accounting results are accounting results, so we don’t do anything other than to report the outcomes. Cleary, we’ve gone through some environmental factors as it relates to mortgage and some other things that two times anticipate, but managing the company, we look at long-term growth potential and kind of outlook to the quarterly number notwithstanding that we obviously get the same fees that from investors over and over again. So the one interesting one here is that jumps out of me that’s faster loan growth number of 28%. We have been in the top one or two banks in loan growth and certainly, through the crisis and continuing through last year. And probably even still today as it falls off somewhat due to environmental factors. And one of the big themes in this presentation and our focus here is that loan – competition for loan growth intensifies when structures and spreads get worse. Chasing loan growth for the sake of growth becomes a dangerous thing and its one of the reasons we are very focused on cross-selling growing our fee line.
William H. Callihan
Which do you think is the best capital strategy for PNC: one, continuing to build; two, acquisitions; three, increased dividend; four, buyback?
William S. Demchak
And the answer is, the one was buyback followed by, I guess basically to nothing.
I guess this one last year, how should we do not. Although, I guess you’ve talked about that in terms of greater capital probably next year. I guess how you think that, that the rating between dividend versus buyback?
William S. Demchak
Well I think, practically in the near-term, the amount that you can do in the form a dividend is governed by a CCAR and their sort of guidance on the amount of that ignores whether that will be potential for special dividends, which nobody has explored as yet. So I think given the amount of capital, we will have to deploy that we’ve already hit it till today, which was kind of supported in our operating guidelines. We will have much more than just dividend to be able to do next year. So I think we’ll get dividend within the range that CCAR guidance would allow us to do subject to our Board approval and then could put you I think at the share buyback.
William H. Callihan
Great, and then next question?
Should PNC divested BlackRock stakes one yes, but only if it could be tax efficient, two yes, we borrowed the tax statement and three, no.
And then interestingly, so it’s two thirds one third, yes, sell it, don’t sell, which is exactly the same split we had this time a year ago. But I think BlackRock stocks will be higher. Can you maybe just talk about, if you keep it, not keep it, if you only keep it if you can actually, or you not keep it, only if you could do them at sufficient manners, how you think about this overall BlackRock position in the current environment?
Unidentified Company Representative
Well, sure, I mean just facts, right we have a $10 billion plus or minus investment in a very successful company with the tax basis is basically zero. So we too sell it out right, you’re paying a hefty tax bill. And even if you could redeploy capital straight backward out, slippage, which you couldn’t, it would be dilutive to shareholders pretty substantially. we recognized that what was a great partnership in part of our company through time has become an investment as they use their own currency to buy Merrill Lynch and BGI and grow.
So now we have a terrific investment that’s performing fantastically well for us. but we’ve recognized that it’s a lot of capital we have tied up. We recognized that because of that, we need to be good students of your capital, practically what that means is make intelligent choices about whether you would sell and pay a tax bill, look for a different structure, try to redeploy it some other way through time. There’s nothing currently going, ongoing with it, but the one thing that I’d say to everybody, this is not most of our decision about at all part of our company. This is a fantastic company, great investment, we’ll make a rationale choice when the time comes that there’s something to do with it.
William H. Callihan
Okay. That’s the last question I think is.
There is one more. Do you expect the recent change in both CEO and CFO of PNC result in wonderful changes, yes for the better; two, yes for the worse; three, expect nothing material, I expect changes that are nothing material for no change, and these are unanimous, so if you see still raindrop anywhere, okay.
William S. Demchak
So in between yes for the better, and changes have been nothing material. I guess on that Bill or Rob, you want to chime in…
Robert Q. Reilly
Looks like, we get to keep our jobs for now …
William S. Demchak
Rob, you are in an earnings call yet.
Which maybe talks right is, well you, guys both have been in the company a long time, but you are new to your roles and obviously have more power than what you did previously, as investors look at PNC is going to determine, what – there will be changes on the margin point of time, what should we maybe expect?
Robert Q. Reilly
I don’t know if it’s a change, because of management as much of it’s a change, because of the environment that we’re in. But the growth that we’ve gone through for the last seven or eight years through acquisition and we effectively grew the company five-fold, so it’s the charge on us to figure out how to execute on what we have and make it more efficient in more of the machines, right. So there’s operational efficiency build, real focus on costs, building the infrastructure to support the larger company is what our job is, our job is the longer – once upon a time we had the strategic need to be larger to be able to compete with technology and other things. We no longer have that, we have to scale, to compete and everything that we choose to compete with, so now its about running the business and getting very crisp in operational efficient and go-to-market strategies. So I don’t know, I think that’s a natural evolution of our growth process as much as it is a change in management.
Great. We have about 10 minutes left, so why don’t we open it – open up the floor for Q&A.
Earnings Call Part 2: