Pinnacle Financial Partners, Inc. (NASDAQ:PNFP) Q2 2023 Earnings Call Transcript
Pinnacle Financial Partners, Inc. (NASDAQ:PNFP) Q2 2023 Earnings Call Transcript July 19, 2023
Operator: Good morning, everyone, and welcome to the Pinnacle Financial Partners' Second Quarter 2023 Earnings Conference Call. Hosting the call today from Pinnacle Financial Partners is Mr. Terry Turner, Chief Executive Officer; and Mr. Harold Carpenter, Chief Financial Officer. Please note, Pinnacle's earnings release and this morning's presentation are available on the Investor Relations page of their website at www.pnfp.com. Today's call is being recorded and will be available for replay on Pinnacle's website for the next 90 days. At this time, all participants have been placed on a listen-only mode. The floor will be opened for your questions following the presentation. [Operator Instructions] 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, 2022, 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 a reconciliation of non-GAAP measures to comparable GAAP measures will be available on Pinnacle Financial's website at www.pnfp.com. With that, I'm now going to turn the presentation over to Mr. Terry Turner, Pinnacle's President and CEO.
Terry Turner: Thank you, Paul. Those of you that have followed us for a while, know and expect I am going to begin every quarterly earnings call with this dashboard of what we believe are the primary things that matter over time in terms of bank performance, GAAP measures first, followed by the non-GAAP measures, which provide the best insight into what I focus on and consequently what we focus on at Pinnacle. My guess is that as 2Q earnings continue to roll out, we'll see some pretty wide variability in performance among the banks; but for us, 2Q was a really good quarter. On an adjusted basis, we grew revenues 11.7% linked-quarter annualized, EPS 10.8% linked quarter annualized, and pre-tax pre-provision net income 24.8% linked quarter annualized.
We continued the dramatic growth in loans and deposits at 11.3% and 9.1% linked quarter annualized respectively, which are generally the best predictors of our ability to continue growing revenue and earnings going forward. Tangible book value per share grew meaningfully during the quarter, aided by a sale leaseback transaction that Harold will review in greater detail shortly. And the key asset quality metrics like NPAs, classified assets, and net charge-offs continue to hold up extremely well. So, in summary, second quarter was a great quarter for us. Now I'm going to let Harold review the quarter in greater detail and I'll come back and give some thoughts on the shares later.
Harold Carpenter: Thanks, Terry. Good morning, everybody. We will again start with deposits. Reporting linked quarter AUR's average growth of 12% in the second quarter was again a real positive for us. As we've mentioned previously, growing deposits in 2023 is a key focus, and the second quarter was another indication that obtaining deposits in an environment where competitors can be fairly unpredictable is very much doable for this franchise. Several factors contributed to increased deposit rates in the second quarter. Competitive pressures were heightened during the quarter, primarily from large regional banks offering rate specials at some fairly incredible rates and an apparent effort to achieve funding goals. We also have an important public funds client base with much of these balances being tied to Fed funds.
Lastly, the mix shift of reduced noninterest-bearing to interest-bearing continued in the second quarter, albeit at a lesser pace. All of these factors contributed to average deposit cost increasing to 2.52% with a spot rate at quarter end of 2.77%. We're optimistic about the pace of deposit rate increases as we head into the third quarter. Several factors to consider. Over the last few weeks, our costs do not appear to be moving up at the same pace as we experienced through the end of the first quarter and most of the second quarter, a contributor to the slower pace is the slowing of the mix shift of deposits from noninterest-bearing to interest bearing. Also, we intend to reduce the absolute size of our more expensive wholesale funding base in the third quarter by absorbing some of the added liquidity, which has been acquired over the last few months.
In other words, we do not believe we need to be nearly as aggressive on gathering funding as we have been over the last few months. Deposit rates will continue to increase in the second half of this year as we hopefully approach a terminal value for Fed funds. We just believe with all the liquidity noise in the first half of the year, a more deliberate stance for gathering deposits is available to us as we move into the third quarter. Lastly, in the supplemental slides, there's more information on uninsured deposits, which are down to 28% of total deposits at quarter end. We won't go into this on the call, but just making sure everyone knows the information is there. The second quarter was another strong loan growth quarter for us. That said, our line leadership successfully managed our loan growth down to the 11% linked quarter annualized rate.
We are maintaining our loan guidance for 2023 at low to mid-teens growth. As we mentioned over the last several quarters, we've tightened the credit box for construction and deployed more discipline on loan pricing, which should serve to reduce our normally outsized growth. Spreads on floating and variable rate loans have continued to be very respectful. We also are seeing spreads on fixed rate lending improve given emphasis by our line leadership. Our loan line thus far is essentially the same as the deposit beta, which we believe reflects a great deal of effort on the part of our relationship managers. Our aim with respect to loan pricing is to maintain our spreads on floating and variable rate loans and achieve 7% to 8% plus yields on both new and renewed fixed rate paper.
As the top chart reflects, our GAAP NIM decreased 20 basis points, which is more than we anticipated at the start of the quarter. As we noted last quarter, out of an abundance of caution, our average liquidity increased by approximately $1.2 billion in cash during the second quarter, and our quarter end liquidity is slightly higher. So we have a lot of cash going into the third quarter, which should help us eliminate some wholesale funding as well as provide for loan growth in the second half of the year. Contributing to the cash build this quarter was the impact of the sale leaseback transaction we mentioned in the press release last night. We received approximately $199 million from the sale of nonearning fixed assets. We also sold $174 million from the sale of investment securities.
These two transactions allowed us to reposition under-earning assets into interest-bearing cash in order to eliminate the negative near-term impact from increased lease costs. Our rate forecast is consistent with most rate forecasts out there. We are optimistic that a July raise by the Fed is the terminal point for Fed funds, but we may be slightly more pessimistic in that we don't see rate decreases occurring until mid to late 2024. With that, our forecast for the rest of 2023 is that quarterly net interest income will likely be flat to slightly up from the second quarter results. As for credit, we again are presenting our traditional credit metrics. Pinnacle's loan portfolio continued to perform very well in the second quarter. Our belief is that credit should remain fairly consistent for the remainder of this year.
We did increase the ratio of our allowance for credit losses to total loans during the quarter to 1.08%. We reworked several of our CECL models during the quarter and are implementing these changes this quarter. We don't anticipate seller increases during the second half of 2023. Any increases from this point should be fairly modest dependent, we believe, primarily on macro trends. As noted for the last few quarters, we continue to have a very limited, if any, appetite for new construction. Also, the CRE appetite chart on the bottom right is basically unchanged from the prior quarter, but does give you a real perspective on how we have reduced our appetite in commercial real estate over the last year or more. In summary, our outlook for our loan portfolio from a credit perspective remains strong.
So if negative macro trends begin to develop, we believe we are advantaged as we enter any potential recession from a position of strength. Again, and consistent with last time, more information around credit, the top left chart deals with trends in construction originations. We began reducing, eliminating our appetite for new construction originations last summer, which is consistent with the chart. The chart would indicate that our limited appetite is largely concentrated in warehouse, multifamily and residential. A quick note about new residential commitments. The gold bars on the chart are new lines for new homes under old guidance lines for a limited set of long-time residential builders. We continue to support our resi builders under guidance lines that have been in place, in some cases, for years.
As you likely know, residential builders are very busy right now given the state of the housing market and the lack of existing home inventories, which is especially relevant in our markets, which have a lot of in-migration from around the country. Secondly, the chart on the top left -- top right, we are providing updates and information about the status of maturities for CRE and construction fixed rate loans. Our yield target for these loans has increased into the 7% to 8% range. Two comments regarding this chart: the absolute size of the fixed rate volumes coming up for renewal remains manageable; and that with rental increases over the last three to five years and occupancy levels remain strong, we believe that our borrowers will continue to be able to afford the incremental interest costs.
Additionally, our underwriting for several years has required that any new commercial real estate or construction commitment be underwritten at higher rates than the contract rate, which in most cases, is 200 to 300 basis points higher. Again, we believe our borrowers have the resources to afford these increased rates, both due to increased revenues on their part and based on our previous conclusions from our underwriting practices. Now on the fees. And as always, I'll speak to BHG in a few minutes. Excluding BHG, the impact of the gain on sale of fixed assets and the loss on the sale of investment securities fee revenues were up slightly from the first quarter. That said, we're pleased with the effort of our fee-generating units turn what is proving to be a challenging banking environment.
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We continue to anticipate that fee revenues, excluding BHG and all these other items, will come in at around a high single-digit growth rate for 2023 over 2022. Linked quarter expenses were essentially flat as personnel costs were down and other expenses were up by similar amounts. Seasonal decreases in payroll taxes and other benefit categories from the first quarter were the cause for the reduced personnel cost, while the sale leaseback lease expense offset in part by reduced depreciation costs was the primary contributor to the increased occupancy costs. Additionally, we reduced our anticipated annual cash incentive payout from 70% to approximately 67% of target awards at the end of the second quarter. So not much change quarter-over-quarter with respect to our outlook for incentive costs for either cash or equity incentives.
Again, the reduced incentive accruals speaks to the variable cost nature of our incentives, which are all substantially performance-based. Additionally, along with deferring projects are slowing our hiring, we feel like we have enough leverage to throttle back on expenses should we need to. We have again lowered our expense growth forecast for this year and have incorporated that into our updated outlook. As it stands, our expense guidance was previously low to mid-teens growth for 2023, we have lowered to high single digits to low teens growth for 2023 over 2022. Our tangible book value per common share increased to $48.85 at quarter end, up 16%. Influence of this increase was the sale leaseback transaction, which provided almost $86 million in pretax gains, offset in part by $10 million in securities losses.
In view of the macro environment, we anticipate retaining this incremental capital at least through the end of this year. We believe the actions we've taken to preserve tangible book value and our tangible capital ratio have served us well and have no plans currently to alter our Tier 1 capital stack via any sort of common or preferred offering. The chart on the bottom left of the slide compares several capital ratios as of the end of March to our peers. Although we don't anticipate significant changes to the capital rules, we are pleased with these results and our ability to withstand any changes to the capital rules that potentially could come our way. Now a few comments about BHG before we look at the outlook for the rest of the year. The top right chart is consistent with various calls and details that production has been consistent over the last several quarters at $1 billion to $1.2 billion per quarter.
Placements to the bank network were less in the second quarter while placements to institutional investors were at the highest level ever and signaled that demand for BHG paper by some of the most respected asset managers in the country is really strong. BHG has been able to penetrate a very liquid channel over the last few years, which during some of these times, has proven to be somewhat fickle for some of the BHG's competitors. Over the last several years, BHG has made periodic calls to pivot between on-balance sheet investor paper and off-balance sheet bank placements. Historically, as institutional investors come to the table, their orders may receive a level of priority as to funding, which BHG has to manage. That said, BHG's unique bank network, which we believe can't be replicated by any other BHG competitor continues to grow and provide the necessary liquidity to BHG.
This is a new slide where we're trying to provide additional clarity with regard to the significant funding channels available to BHG in replacement of their loan production. What's new to the funding channel list is that in the second quarter, BHG successfully negotiated two private whole loan sales with $550 million of capacity. These are slightly different in that in both cases these were large purchases structured similar to the bank network. Gain on sale treatment has afforded these sales as the investors acquired the loan with no recourse. BHG has negotiated three warehouse lines with three well-known and respective asset managers private equity firms. Performance of BHG's loans sold to the capital markets have been such that many of the firms that have participated in the past are in constant contact to acquire more loans in the future.
The bank auction platform remains very liquid and able to meet the necessary funding that BHG requires of it. All in, these funding channels to collectively provide several billion dollars in capacity and the flexibility to manage liquidity risk effectively between the various channels. This is the usual information we've shown in the past detailing spread trends just in a slightly different format. The top chart represents the gain on sale of the off-balance sheet bank network and the bottom chart is a blended chart of all balance sheet funding strategies, which incorporates the historical buildup of balances. As anticipated, spreads have come in with higher rates with the bank auction rates being consistent with pre-COVID spreads. During the second quarter, the blended spreads for on balance sheet was slightly higher than the bank network given the balance sheet loans reflecting buildup of balances over the last three years.
And as it stands today, BHG expects spreads to be fairly consistent going into the second half of 2023. As we've noted in previous quarters, BHG has tightened its credit box over the last several quarters, particularly with respect to the lower tranches of its borrowing base. This will have an impact on both production and spreads. Average FICO scores in 2023 have increased to 743. As we've stated in prior quarters, BHG has been modifying their credit models towards originated less risky assets. Production volumes remained strong even with tighter credit underwriting. BHG refreshes its credit score monthly, always looking for indications of weakness in its borrowing base. Credit scores are up from previous years. Additionally, approximately 22% of BHG's production is with repeat borrowers adding to the quality of their loan base.
This slide details reserves and losses for both off-balance sheet and on balance sheet loans. As we mentioned in previous quarters, BHG determined that loss rates in several lower tranches of their production was exceeding internal tolerances and elected to stop lending into these lower tranches. Their conclusion was that for loans written in 2021 and for most of 2022, several contained an element of reinflation which require remediation. As a result, we believe outsized losses could occur over the next couple of quarters at a similar pace as the last two quarters. Typically for BHG, approximately 70% of the lost content is incurred within the first three years of origination. But with great inflation, losses should come in -- come to light sooner.
As a result, BHG has expended significant resources to bulk up collection activities, including hiring more loggers and will be instituting in-person closings for new borrowers, which was suspended during COVID. BHG had another strong quarter with approximately $1.1 billion in originations and are on track to achieve $3.8 billion to $4 billion originations this year, which is slightly less than last year. Thus far, through two quarters production is slightly more than the prior year even with efforts to tighten the credit box. BHG has a conservative bias that production in the last half of the year will likely be lower than the first half, but should be close to what they had last year. Net earnings are being forecasted at $175 million to $190 million, which is a tighter forecast from last year -- last quarter's production of a 30% to 40% reduction from prior year's results.
The numbers now work out to be of 35% to 40% reduction. Quickly, again, the usual slide detailing on our current financial outlook for 2023. We continue to plan for a recession, but how severe it will be neither we nor anyone else really knows. Our job is to manage the risk that face this franchise every day. What we know is that our business model is relationship-based, nimble and resiliant. Our management team has significant experience and have tackled the economic downturn before. We have great confidence that we'll be able to manage the high-quality binding franchise that our shareholders have come to expect from us and can currently handle whatever curve balls get thrown at us. And with that, I'll turn it back over to Terry.
Terry Turner: Thanks, Harold. I mentioned that -- I said that I've come back to offer my thoughts on the shares. Obviously, the primary goal of the call is to have an in-depth review of quarterly performance, which we've now completed. But beyond that, we work hard to make sure that investors have an opportunity to understand more than just what went up and what went down during the quarter. But to get to a better understanding of our approach for producing long-term shareholder value, aka, total shareholder returns or TSR. So perhaps the best place to begin is just examine what kind of total shareholder return we've produced historically. As you can see here over the last decade, PNFP has produced the single best total shareholder return among peers.
And I'd invite you, if you get a chance, to go back and look at it since our inception in 2000, look at it over our first decade, look at it over our second decade, over the last 15 years, over the last 20 years, I think you'd find us at or near the top in all those time segments. Absolutely consistent performance irrespective of the various economic rate cycles over the last 23 years. And so what I won't to examine now is how that happened. The analyses of a number of bank stock experts, and I suspect that of yours, would show that there are three primary metrics that are highly correlated to TSR over time, and they're revenue growth, reported EPS growth and tangible book value accretion. I suppose that there are an infinite number of metrics that bear little or no correlation with TSR over time.
But they include metrics like net interest margin percentage, cost of funds, deposit cost beta loan yields, noninterest-bearing deposits, total deposits, operating leverage and efficiency ratios, just to name a few. In fact, you've already seen our track record for total shareholder returns over the last decade, yet I'm confident that our NIM percentage is rarely have ever been above $1 million. Our cost of funds has likely never been better than median. Our deposit beta is always high, both when rates go up and when they come down. Loan yields have generally been no better than median and our noninterest-bearing deposits to total deposits ratio has generally been less than most of our peers. There's nothing wrong with any of those metrics.
In fact, we measure and study all of them. It'd be hard to build a model without many of those inputs. But I'm just making the point that we focus much more on growing revenues, growing EPS and accreting tangible book value than we do standard model inputs like the NIM percentage or the cost beta or the percentage of noninterest-bearing deposits to total deposits because historically, revenue growth, EPS growth and tangible book value accretion have been more highly correlated with TSR, which honestly is the main thing I care about. When I say we focus much more tightly on growing revenues, growing EPS and accreting tangible book value, here's what I mean. Most of you know, 100% of our sales and associates participate in our annual cash incentive pool, 100%.
No annual cash incentive is paid virtually to any salaries associated in this firm if our classified asset ratio exceeds a certain level. But the second we had made a bunch of bad loans, the metrics that determine virtually every salaried associates payout, including mine, is the revenue growth and the EPS growth rate. Since revenue growth and EPS growth have been highly correlated with TSRs, we have literally focused every single salaried associated in this firm on those two variables. And I believe that's one of the critical reasons our firm continues to compound revenue and earnings growth like few other can. My personal incentive along with every other salaried associated with this firm depends on those two growth rates. In terms of long-term equity incentive plan, 100% of our associates are granted shares.
For most associates, those shares are time vested, but for the leadership team, the top 150 or so leaders in this firm, including me, the substantial majority of our recurring annual award vesting is performance-based, and the two primary measurements are peer-relative tangible book value accretion and peer-relative ROATCE. In other words, for the leadership of this firm to maximize the vesting of the restricted share grants from our long-term incentive plan beyond clearing an asset quality threshold, which in this case is an NPA ratio, we have to outrun 75% of the banks in our peer group in terms of the tangible book value accretion and ROATCE. Parenthetically, that may give you a little insight on why despite the extraordinary liquidity that we and virtually every other bank had on our balance sheet following the pandemic, leadership of this firm did not load the bond book with -- when yields were at near all-time lows.
So here's how that plays out. Within the last five calendar years, we've seen a COVID pandemic, quantitative easing, a mammoth influx of liquidity from all the government stimulus in response to the pandemic, inflation or CPI as high as 9%, the most percipitous increase in Fed funds rates in recent history in addition to quantitative tightening and a dramatic increase -- excuse me, a dramatic decrease in money supply and associated deposits, an inverted yield curve and a number of failures at otherwise pipeline banks. And through all that, on the upper right, you can see the dramatic outperformance of our five-year EPS growth versus peers'. On the lower left, you can see that the primary driver of that EPS growth was the dramatic growth in revenue per share regardless of all the macroeconomic volatility.
And then on the lower right, you see the very dramatic compounding and tangible book value. So I believe that continual compounding of revenue, EPS and tangible book value has been the primary contributor to producing the peer-leading total shareholder return you saw several slides back. So now when you begin to think about what the TSR chart is going to look like over the next five years or over the next 10 years or over the next 20 years, you might begin here. The Southeastern markets we serve have a dramatically different growth profile than the rest of the nation, which has the potential to turbocharge our revenue and EPS growth. I'd hate to think I had to compound earnings and revenue at the pace we intend to in some of the other regions in this country.
But even more important than the dynamic growth in the markets we serve are likely to enjoy is the competitive advantage that we've built. We're a market share taker. We've been one of the fastest-growing banks over the last 23 years and certain vibrant markets has certainly been a tailwind. But you can be sure, the substantially more important contributor to our growth has been our ability to take market share from vulnerable competitors. What you're looking at here is market data produced by Greenwich Associates, the foremost provider of research to U.S. banks on the commercial market segment. This is from their client satisfaction dashboard. Down the left side of the chart, you see critical satisfaction variables based on their research, things like ease of doing business, being trustworthy, valued long-term relationships, creative insights, the digital experience, the quality of the relationship manager, cash management capabilities and so forth.
As you can see by the scale, at the bottom, elements that are colored dark green are market-leading; elements that are colored red would be trailing or at the bottom of the market; and elements colored all the various shades from lighter green to yellow to orange are all scores in between the best and the worst. So in the three rightmost columns you see Pinnacle scores for all these important satisfaction metrics for small businesses. That's companies with sales from $1 million to $10 million. Middle market businesses that's $10 million to $500 million in sales segment. And then on the far right, the combined score for the $100 million to $500 million in sales segment throughout our multistate footprint. I've studied the chart very long to see that Pinnacle's a market leader for virtually every single one of these metrics.
And this is critically important to understand these charts cover our entire footprint and compare the five or six market share leaders in addition to Pinnacle, including Truist, Bank of America, Wells Fargo, P&C, First Citizens and First Horizon. I obviously don't know if Greenwich could identify any other banks that dominate their markets as overwhelmingly as we do. But I'd be surprised, across our footprint, we're far and away the market leader in terms of overall client satisfaction and all-important Net Promoter Score. It seems to me the most important score ball is the Net Promoter Score. Most of you know that it's a comparison to the number of clients that are so engaged with your brand that they fully intend to advocate for you with their friends and colleagues, less the clients that are so disengaged with your brand that they're detracting from your reputation in the community.
And you can see here our Net Promoter Score is a league-leading 86 among small businesses, companies from sales from $1 million to $10 million; and a league-leading 82 in the middle market, companies with sales from $10 million to $500 million. Connecting this slide with the last, regardless of all the money spent by our largest regional and national competitors on technology and on the digital experience, our clients rate our digital experience more highly than their clients rate their's throughout our footprint. So much has been said about a potential migration of regional bank clients to the national providers. When you look at these scores, it should be apparent while we lost virtually no large clients following the Silicon Valley failure.
And while we continue to grow deposits at a dramatic pace in the aftermath. Look at the dramatic difference in Net Promoter Scores between us at the top and our large national competitors at the bottom. It'd be very hard to leave a bank you absolutely love. And honestly, it's not hard to leave the bank you hate. Some banks compete on price. Some just wait for a yield curve that sets your balance sheet. But for us, it's this relentless pursuit of creating raving fans that explains our ability to grow revenue and EPS almost regardless of the economic ups and downs. So not surprisingly, when Greenwich [technical difficulty] businesses in our footprint about which banks are likely to earn a share of their business over the next 12 months, Pinnacle is far and away the most frequent response.
As you can see, at year-end, 42% of small business respondents named Pinnacle and 50% of middle market business respondents named Pinnacle as the bank most likely to receive a share of their business. That's an incredibly strong momentum. And when Greenwich probed clients regarding which banks are most at risk for losing the share of their business, Pinnacle was far and away the least frequently mentioned response. Consequently, our net momentum among businesses in our markets is market-leading at 38 in 42 in the two segments, is further substantiation of the point I've been making about our relative lack of vulnerability versus the large national banks in our markets, a thesis that regional banks are more vulnerable to the large national banks might be true for undifferentiated banks.
But business clients in these segments within our footprint might suggest otherwise, given our net business momentum score. So really to sum it up, what I've tried to say is it's our belief that revenue growth, EPS growth and tangible book value accretion have historically been most highly correlated TSR. That's why we focus our entire firm on it through our short-term and long-term incentives. We believe our relationship-based model has historically produced strong TSR with more manageable risk than many, the proof's in the pudding. When you think about the fact that the markets that we serve are likely to outperform the nation and the fact that we've got a demonstrically differentiated, high-touch and tech model that generally attracts more [technical difficulty] less clients.
That's the key to compounding earnings over time, irrespective of economic volatility. We'll stop there, operator, and take questions.
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