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The PNC Financial Services Group Management Discusses Q3 2013 Results - Earnings Call Transcript

The PNC Financial Services Group (PNC) Q3 2013 Earnings Call October 16, 2013 10:00 AM ET


William H. Callihan - Senior Vice President and Director of Investor Relations

William S. Demchak - Chief Executive Officer, President, Director, Member of Executive Committee and Member of Risk Committee

Robert Q. Reilly - Chief Financial Officer and Executive Vice President


Erika Najarian - BofA Merrill Lynch, Research Division

John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division

Paul J. Miller - FBR Capital Markets & Co., Research Division

Matthew D. O'Connor - Deutsche Bank AG, Research Division

Keith Murray - ISI Group Inc., Research Division

Kenneth M. Usdin - Jefferies LLC, Research Division

Kevin Barker - Compass Point Research & Trading, LLC, Research Division

Stephen Scinicariello - UBS Investment Bank, Research Division

Moshe Orenbuch - Crédit Suisse AG, Research Division

Gerard S. Cassidy - RBC Capital Markets, LLC, Research Division

Dan Werner - Morningstar Inc., Research Division

Betsy Graseck - Morgan Stanley, Research Division


Good morning, everyone. My name is France, and I will be your conference operator today. At this time, I would like to welcome everyone to The PNC Financial Services Group Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded today, Wednesday, October 16, 2013. I would now like to turn the call over to the Director of Investor Relations, Mr. Bill Callihan. Please go ahead, sir.

William H. Callihan

Thank you, and good morning. Welcome to today's conference call for The PNC Financial Services Group. Participating on this call is PNC's President and Chief Executive Officer, Bill Demchak; and Rob Reilly, Executive Vice President and Chief Financial Officer.

Today's presentation contains forward-looking information. Our forward-looking statements regarding PNC's performance assume a continuation of the current economic environment and do not take into account the impact of potential legal and regulatory or federal debt ceiling contingencies. Actual results and future events could differ, possibly materially, from those anticipated in our statements and from historical performance due to a variety of factors and risks. Information about such factors, as well as GAAP reconciliation and other information on non-GAAP financial measures we discuss is included in today's conference call, earnings release, related presentation materials and our 10-K, 10-Qs and various other SEC filings and investor materials. These are all available on our corporate website, pnc.com, under the Investor Relations section. These statements speak only as of October 16, 2013, and PNC undertakes no obligation to update them.

And now I'd like to turn the call over to Bill Demchak.

William S. Demchak

Thanks, Bill, and good morning, everybody. I'm going to run through some of the highlights from the third quarter and talk about the progress we're making on our strategic priorities.

As you've seen already today, we reported net income of $1 billion or $1.79 per diluted common share with a return on average assets of 1.36%. You'd also seen that we had a few select items that impacted earnings, including a pretax gain of $85 million or $0.10 per diluted share on the sale of some Visa Class B common stock, similar to the gain that we had on Visa sales in the second quarter. In addition, the provision was lower than expected, primarily due to overall improved credit quality.

We also exceeded our own expectations regarding expense management. As you'll recall, we expected expenses to be up modestly in the quarter, but in fact, expenses declined by $11 million. And we achieved our $700 million annual continuous improvement goal in the quarter.

We also continue to build on our strong capital position. Our estimated Basel I Tier 1 common capital ratio increased to 10.4%, and our pro forma Basel III Tier 1 common capital ratio reached an estimated 8.6% in the third quarter. This stronger capital position should position us well in terms of returning capital to our shareholders in 2014, subject, of course, to the CCAR process.

And during a time when the Fed data tells us loan demand has slowed across the industry, PNC continued to grow loans in the third quarter. Importantly, we did this within our risk parameters by winning new clients, and we delivered solid fee income by deepening relationships with our existing customers.

Year-over-year, commercial and consumer lending combined are up almost $11 billion or about 6%. Now looking across the business, we continue to make important progress against our long-term strategic priorities. We're seeing very promising activity in the Southeast, outpacing our expectations. We have 51 new primary corporate banking clients in the Southeast this quarter versus 44 last quarter. And client and loan growth in the Southeast are significantly outpacing our legacy markets on a percentage basis.

Now that being said, the incremental opportunity in the Southeast is significant, as these markets are running at less than half the median productivity of our legacy markets. And across the company, especially in C&IB, we're seeing many relationships that began with lending grow deeper as the average number of products those clients are buying ticks up each year.

Now noninterest income in our Asset Management Group is up by $18 million or 11% year-over-year due to increases in the equity markets and strong sales production resulting in net positive flows. The growth was driven by an increase in new primary client acquisitions of more than 35% in the first 9 months compared to a year ago.

Now for the Residential Mortgage Banking business, refinanced volumes and gain on sale margins continue to decline as we suggested they would last quarter. Our total origination volume was down 21% in the quarter as growth and purchase volume was not enough to offset the declines on the refinance side of the business.

In response, we took steps to better align our expenses with decline in revenue, and Rob is going to talk a bit more about that in a few minutes. We continue the work we've discussed in the past to dramatically improve the home-buying process for our customers and to get them from application to closing more efficiently than our peers. Customer loyalty continues to grow stronger as a result.

In Retail, we closed or consolidated another 62 branches in the quarter, and we remain on pace to close or consolidate about 200 by year end. Still, net checking account relationships increased by 69,000, and we grew consumer loans by $1.1 billion on a spot basis in the quarter.

Additionally, we experienced record-high migration of deposit transactions, up 70% year-over-year, as evolving customer preferences continue to drive our transformation of the Retail Banking business.

Now Rob is going to review the quarterly results in a second, but I wanted to step back just for a moment to look at where we are at the end of the third quarter this year versus the same time in 2012. As we look year-to-date, net income is $3.2 billion, which is an increase of 39% from the $2.3 billion through the third quarter of 2012. Our return on average assets through the first 3 quarters of 2013 was 1.4%, and noninterest income increased by 20% compared to the same period last year. Noninterest income as a percentage of total revenue was 42% year-to-date. That's up from 37% year-to-date through the first 9 months of 2012, and that's really in keeping with our intended strategic direction.

Now we had a better-than-expected third quarter in spite of all the environmental challenges that the industry has been confronting, as well as the uncertainty created by the federal government shutdown and the threat of a potential U.S. default. Now, in my view, the shutdown here is unlikely to cause any permanent economic or financial markets damage, assuming that it doesn't continue for any extended period of time. On the other hand, a U.S. default, while still unlikely, would have a much worse outcome for the economy. Even if Congress increases the debt ceiling in a timely manner at this point, we're still likely to see an impact in the form of a slowdown in broader economic activity as we go into the fourth quarter. So things aren't going to get any easier, and we have plenty of work to do yet to fully capitalize on the opportunities that are in front of us. But our results clearly indicate that our strategy is working as designed and that we're better positioned to create long-term shareholder value because of that.

With that, let me turn it over to Rob to take you through the numbers.

Robert Q. Reilly

Great. Thanks, Bill, and good morning, everyone. Let me start with our balance sheet on Slide 4. Loan growth and solid operating performance resulted in higher retained earnings in the third quarter, which led to strengthened capital. Our total assets increased by $4 billion or 1% on a linked quarter basis as we saw growth in both consumer and commercial lending.

Total commercial lending increased by $1.2 billion compared to the second quarter of 2013, predominantly in commercial real estate and to a considerably lesser extent, our other specialty lending businesses. Consumer lending saw an increase of approximately $1.9 billion on a linked quarter basis, primarily due to accelerated growth in automobile lending across our footprint. We also saw increases from growth in our home equity and credit card portfolios.

And in addition, we purchased approximately $900 million of jumbo mortgage loans in the quarter. This growth was partially offset by paydowns in education loans.

Total deposits increased by $3.8 billion or almost 2% in the third quarter as growth in commercial deposits offset seasonal declines in consumer deposits and further CD runoff. Shareholders' equity increased by $844 million or more than 2% in the third quarter as a result of growth in retained earnings, and this drove our capital ratios higher.

Our Basel I Tier 1 common ratio at the end of the third quarter is estimated to be 10.4%. That's up 30 basis points since the end of the second quarter. And our Basel Tier 1 pro forma common capital ratio was estimated to be 8.6% as of September 30, without the benefit of phase-ins, a 40-basis-point increase from June 30, primarily due to retained earnings. This Basel III estimate is based on our current understanding of the final Basel III rules.

As you'll recall, we said our operating range for the Basel III Tier 1 common ratio was between 8% and 8.5% without the benefit of phase-ins. Our target was to achieve that by year end 2013. Through our strong year-to-date performance, we've obviously exceeded the upper end of that range. Importantly, we continue to believe we will be well positioned to return additional capital to shareholders in 2014.

Our income statement for the third quarter reflects strong overall performance. And as you can see on Slide 5, net income was up $1 billion or $1.79 per diluted common share, and our return on average assets was 1.36%. These results reflect ongoing loan balance and fee income growth, along with disciplined expense management. As Bill mentioned, this quarter's results also benefited from a gain on the sale of additional Visa stock and lower-than-expected provision for credit losses.

Let me highlight a few items in our income statement. Net interest income declined by $24 million, which was aligned with our expectations, primarily due to lower core net interest income and lower purchase accounting accretion. While fee income was strong overall in the third quarter, total noninterest income was down by $120 million or 7% on a linked quarter basis, primarily due to higher gains on asset sales and valuations we experienced in the second quarter. I'll say more about that in a moment.

As a result, total revenue for the third quarter was $3.9 billion. Third quarter expenses of $2.4 billion declined $11 million on a linked quarter basis, reflecting our focus on expense management. As a result, our pretax pre-provision earnings were $1.5 billion, down 8% compared to the second quarter, but an increase of 4% compared to the same quarter a year ago. Provision in the third quarter was $137 million, lower than the guidance we provided due to better-than-expected improvements in credit quality. Now let's discuss the key drivers of this performance in more detail.

Turning to net interest income. As you can see on Slide 6, total net interest income declined by $24 million on a linked quarter basis as loan growth largely but not entirely offset the further spread compression we saw this quarter. As expected, net interest margin decreased to 3.47% in the third quarter, primarily reflecting these lower spreads.

In our investment securities portfolio, you'll recall that we put additional money to work late in the second quarter following a substantial movement in interest rates. Those actions resulted in a slight increase in interest income in the third quarter.

Having said that, we're not taking on additional interest rate risk as we've maintained a negative duration of equity of approximately 2 years. Importantly, our balance sheet remains asset-sensitive and positioned for a rising interest rate environment.

Total purchase accounting accretion declined due to lower scheduled accretion, which was partially offset by higher-than-expected cash recoveries on purchased impaired loans. Over time, you should expect a lower level of cash recoveries as the amount of our purchased impaired loans continues to decline.

Regarding our outlook for purchase accounting accretion in the fourth quarter, we are now expecting purchase accounting to be approximately $175 million. For the full year 2013, this equates to a decline of approximately $300 million versus 2012, and that's due to the elevated cash recovery. As a result, we now expect purchase accounting to be down approximately $300 million in 2014 compared to 2013.

Bill talked about the progress we're making with our strategic priorities, and you can see that in the third quarter results for our fee income categories as shown on Slide 7. Our Asset Management Group had another good quarter with strong net positive flows and growth in asset -- I'm sorry, growth in sales and primary customers. As you know, the asset management fee category reflects the combination of fees generated by our asset managed business, along with earnings attributable to our interest in BlackRock.

Consumer service fees were up $2 million or 1% compared to the second quarter, primarily as a result of higher debit card and credit card fees. Corporate services saw increased merger and acquisition advisory fees in the third quarter, offset somewhat by reduced client activity.

The valuation gains on commercial mortgage servicing rights that we discussed with you last quarter were lower in the third quarter. And as a result, corporate service fees declined $20 million on a linked quarter basis.

Residential Mortgage was up $32 million or 19% linked quarter, and 3 factors drove these results: First, our provision for repurchase obligations was a $6 million benefit in the third quarter versus a $73 million provision in the second quarter as the third quarter benefit reflects a small reserve release; second, we did see a decline in loan sales revenue reflecting lower origination volumes and declining gain on sale margins. As you know, higher interest rates affected third quarter originations, which were $3.7 billion, down $1 billion or 21% as a result of lower refinancing activity.

Of strategic importance to us, the decline in refinancing was partially offset by home purchase transaction volume, which was up 5% on a linked quarter basis and now represents 38% of originations, up from 28% in the second quarter. At the same time, the gain on sale margin fell to 292 basis points.

And third, our net hedging gains on servicing rights were $57 million in the third quarter, an increase of $31 million on a linked quarter basis. I'll say more about the Residential Mortgage expense reductions we have taken in a moment.

Finally on this slide, deposit service charges increased by $9 million or 6% linked quarter from increased customer activity across nearly all geographies. Moving beyond the fee categories, net gains on sales of securities less net OTTI decreased in the third quarter, consistent with the levels we saw in the same quarter last year.

Other noninterest income was impacted by the sale of 2 million of our Visa Class B common shares in the third quarter resulting in a pretax gain of $85 million, consistent with the prior quarter. We continue to hold 10.4 million shares of Visa Class B common stock with an estimated fair value of approximately $833 million as of quarter end. These shares are recorded on our books at approximately $158 million, resulting in an unrecognized value of approximately $675 million pretax.

Excluding the impact of the Visa sale, other noninterest income declined by $97 million or 26%. On a linked quarter basis, the primary decline was in the lower credit valuations, and that relates to customer-initiated hedging activity, which accounted for approximately $40 million. The remainder was accumulations of small gains and recoveries on asset dispositions that we experienced in the second quarter.

Our diversified businesses resulted in noninterest income to total revenue of 43% in the third quarter. Given the progress we're making on our strategic priorities, we expect this percentage to grow over time.

We continue to expect that full year total reported revenue will increase in 2013 compared to 2012. Expenses continue to be well managed in the third quarter.

Turning to Slide 8. Total expenses decreased by $11 million on a linked quarter basis. As you'll recall, our 2013 goal is to achieve a total of $700 million in continuous improvement cost savings this year. As of September 30, we have already reached and now continue to work on surpassing that goal.

As a result of these efforts, we now expect full year 2013 expenses on a reported basis to be below 2012 by more than 5%. We recognize that controlling expenses will continue to be critical to success in this low interest rate environment. To that end, we have already started the process of identifying continuous improvement opportunities for 2014.

As a further note, we concluded our redemptions of the remaining discounted trust preferred securities in the third quarter with a noncash charge of $27 million. In total, we now -- we have now redeemed some $3.2 billion in these higher rate securities, resulting in noncash charges totaling approximately $550 million since the fourth quarter of 2011.

In regard to our Residential Mortgage business, earlier this month, we took actions to reduce operating expenses that included eliminating approximately 7% of the workforce. This will result in annual savings of approximately $24 million, which we'll begin to see in the fourth quarter with the full realization of these savings occurring in the first quarter of 2014.

As you can see on Slide 9, overall credit quality continued to improve in the third quarter. Criticized commercial loans, non-performing loans and overall delinquencies all decreased on a linked quarter basis.

Non-performing loans were down $115 million or 3% compared to the second quarter as we saw broad-based improvement in both our consumer and commercial loan portfolios. Overall delinquencies were lower by $128 million or 5% on a linked quarter basis, driven by lower 90-day past due consumer loans.

Net charge-offs increased nominally by $16 million on a linked quarter basis as recoveries were lower than previous quarters. However, as we said in the second quarter, we still believe this low level of charge-offs is not sustainable.

Finally, our provision of $137 million declined by 13% on a linked quarter basis, driven by this improved overall credit quality.

In summary, PNC posted strong financial results in the third quarter. Looking ahead to the fourth quarter, we expect our results to be consistent with our previous quarterly guidance and performance. Of course, our outlook assumes a sensible resolution to the federal government shutdown and the debt-ceiling situation.

We expect modest growth in loans and continued growth in fee income, reflecting our focus on our strategic priorities. We also expect net interest income to be down modestly, reflecting the continued decline in purchase accounting accretion. And we expect noninterest expense to be stable when compared to the third quarter.

Over the last few quarters, our provision and our guidance on provision have been coming down. While the performance of our corporate and consumer loan portfolios has been favorable, consumers, for example, are still facing a number of headwinds as a result of the sluggish economy. This causes us to believe that this reduced level of provisioning may not be sustainable. As a result, for the fourth quarter, we expect the provision for credit losses to be between $150 million and $225 million.

And with that, Bill and I are ready to take your questions.

Earnings Call Part 2: