The PNC Financial Services Group (PNC) Q2 2013 Earnings Call July 17, 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
Richard J. Johnson
Gerard S. Cassidy - RBC Capital Markets, LLC, Research Division
R. Scott Siefers - Sandler O'Neill + Partners, L.P., Research Division
Paul J. Miller - FBR Capital Markets & Co., Research Division
John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division
Todd L. Hagerman - Sterne Agee & Leach Inc., Research Division
Moshe Orenbuch - Crédit Suisse AG, Research Division
Erika Penala - BofA Merrill Lynch, Research Division
Kenneth M. Usdin - Jefferies & Company, Inc., Research Division
Jack Micenko - Susquehanna Financial Group, LLLP, Research Division
Matthew D. O'Connor - Deutsche Bank AG, Research Division
Stephen Scinicariello - UBS Investment Bank, Research Division
Matthew H. Burnell - Wells Fargo Securities, LLC, Research Division
Betsy Graseck - Morgan Stanley, Research Division
Nancy A. Bush - NAB Research, LLC, Research Division
Good morning. My name is France, and I will be your operator for 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 conference is being recorded. I will now turn the call over to the Director of Investor Relations, Mr. Bill Callihan. You may 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 CEO, Bill Demchak; and Rick Johnson, Executive Vice President and Chief Financial Officer.
Today's presentation contains forward-looking information. Actual results and future events could differ possibly materially from those anticipated in our statements and from our historical performance due to a variety of risks and other factors. 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 contingencies. Information about such factors, as well as GAAP reconciliations and other information on non-GAAP financial measures we discuss is included in today's conference call, earnings release, related presentation materials, and in our 10-K, 10-Q, 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 July 17, 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. Thanks for joining us today. I'm going to start by running through some of the highlights of our second quarter earnings and talking about the progress we are making on some of our strategic priorities. I will also share some views on the environment and how it's likely to affect us through the remainder of the year before I turn it over to Rick to run you through the actual results, and then we'll take your questions.
As you've all seen, we reported net income of $1.1 billion or $1.99 per diluted common share, with the return on average assets of 1.49%. Honestly, these are big numbers. And while we're pleased with the results, as we noted, we did have several select items in the quarter, and let me run through a couple of these.
First, we sold some Visa Class B common stock and we realized a gain of $83 million. As you all know, we've been monetizing our position in Visa over time and at the end of the second quarter, we still had approximately $750 million in unrealized gains. And we also sold some securities early in the quarter when rates were low, which gave rise to some security gains and increased our asset sensitivity. As rates rose later in the quarter, we reinvested those proceeds. Now the net effect was higher than normal security gains and lower than forecasted NII. All else equal, it should benefit NII in future quarters.
In addition, higher interest rates improved the valuations of our commercial mortgage servicing rights and our derivative counterparty book. Also you've seen our provision for loan losses declined this quarter and was substantially below, I tell you, our own expectations, as credit quality improves faster than our forecast, and this is particularly true on the commercial space.
Having said all of that, on the negative side, we did record increased residential mortgage repurchase provisions this quarter, primarily in response to additional information for Freddie Mac. Now this is an issue that everybody in the industry is working hard to bring to a close as quickly as possible, and that's certainly our goal as well.
Now apart from those select items, client fee income was really strong, and as you've seen, our capital ratios were strengthened. We hit our expense numbers in the second quarter and we remain focused on improving our efficiency ratio even as we make targeted investments through the remainder of the year to meet our clients' needs.
And as we look at where we are in relation to our long-term priorities, we're starting to see the tangible benefits of our long-term growth strategy, and the shift of our revenue mix towards fee income is becoming visible as a result of this. Last quarter, we talked about our efforts to cash in more of our clients' investable assets and are investing in retirement cross-sell effort continues to gain traction. AMG new primary client acquisitions, referral sales, brokerage fees were all up linked-quarter and year-over-year.
In the Residential Mortgage Banking business, volume trends were actually quite good in the second quarter, with loan originations of $4.7 billion, up 11% linked-quarter and 30% over the second quarter in '12, consistent with our strategic objectives. We've expanded our seamless delivery program across our entire network of mortgage originators and brought our average time to close for loans going through the new process down to 38 days in May. That's about 20 days better than our peer average of 58. And we believe we think we can do even better. And importantly, we're seeing -- we're already seeing customer satisfaction scores rise significantly from the past.
Now clearly, higher rates here are going to slow application volume and, in turn, decrease gain on sale margins. Notwithstanding this, it appears that our model of retail-only originations focus on purchase transactions, increased capacity and the rollout of seamless delivery have all combined to mitigate the potential decline relative to our peers.
In the Retail Bank, we've had lot of activity inside of our delivery channels as we work to build the bank of the future. We consolidated 78 branches this quarter on top of the 30 we consolidated in the first quarter, and we're still targeting a total of about 200 for the year. You will see and we also announced that we're phasing out traditional free checking. And despite this activity, attrition of our existing customers has been less than expected. We actually added 55,000 new DDA households and grew in average loans by about $300 million in the second quarter.
In C&IB, as we've been expecting for some time, the market has become more competitive, and it's more difficult to win new primary clients and grow loans while maintaining our risk and return thresholds. So while we continue to prospect for high-quality new clients and grow loans and we did add more than 200 clients in the second quarter in the corporate bank, our focus is shifting towards developing deeper and more valuable relationships with many of the 3,000-plus new clients that we added over the last few years.
We continue to make good progress in growing our share in the new Southeast markets, as well as the under-penetrated legacy markets like Chicago. As we look at what the Southeast is contributing in terms of new clients and the positive effect of our Southeast operations on fee income, we can start to see the benefits of the RBC Bank acquisition coming into focus.
In the second quarter in the Southeast, we added 11,000 DDA households in Retail, 95 new primary clients in Wealth and we've also seen a dramatic increase in new client wins in Corporate Banking in the Southeast. Year-to-date, over 20% of our new primary client wins in the Corporate Bank are coming from the Southeast markets.
Now much like our ongoing efforts to bring our Midwest markets in line with the performance of legacy PNC markets, our play in the Southeast is part of a long-term strategy that's going to take time and patience. But the market's receptivity to PNC continues to be enthusiastic, and we're quite encouraged from it.
We talked in the past about how we're positioned to grow relative to some other institutions because we've a lot of leverage to pull depending on market conditions, and this quarter is an example of our ability to make money even as the environment changes. It was an excellent -- we think it was an excellent quarter even without counting some of the select items. And while we're optimistic about the opportunities in the remainder of the year, and Rich's going to buy to an update on some of the guidance in a second, clearly, this remains a challenging and competitive environment. And that's probably a good place for me to turn it over to Rick to go through the quarterly results.
Richard J. Johnson
Well, thanks, Bill. Good morning, everyone. Let me begin with our balance sheet on Slide 4. Total assets increased by $3.6 billion on a linked-quarter basis, as the growth in commercial and consumer lending was partially offset by a reduction in investment securities. Investment securities were down $1.9 billion or 3% compared to the first quarter, as we replaced a portion of the prepayments, maturities and sales activities during the quarter with forward-settling positions. I'll talk more about this later.
We saw a continued loan growth in the second quarter. Total loans increased by $3.3 billion or 1.8% on a spot basis compared to the first quarter. Commercial loan growth was the primary driver of our increase in loans. Total commercial lending increased by $3 billion compared to the first quarter of 2013, as a result of increases in asset-based lending, health care, real estate and public finance. Consumer lending saw a modest increase of approximately $300 million on a linked-quarter basis, primarily due to home equity loans and automobile lending, partially offset by paydowns in education lending and residential real estate.
Shareholders' equity increased by $600 million or almost 2% in the second quarter, primarily due to the growth in retained earnings, partially offset by a decline in AOCI. As a result, we ended the second quarter with strong capital ratios. Our Basel I Tier 1 common ratio at the end of the second quarter is estimated to be 10.1%, that's up 30 basis points since the end of the first quarter. Our Basel III Tier 1 pro forma common capital ratio was estimated to be 8.2% as of June 30, 2013, without the benefit of phase-ins, a 20 basis point increase from March 31. We achieved this improvement despite a $500 million after-tax decrease in security valuations, as interest rates increased and spreads widened. The growth in retained earnings and a modest decrease in risk-weighted assets exceeded the impact of the security valuation decline.
Although we now have final Basel III rules, we have not completed our review and continue to use the proposals for our estimated Basel III common capital. However, we are confident that the changes in the final rules from the proposals will not be negative to our common capital ratio. We continue to believe we will be well positioned to return additional capital to shareholders in 2014.
Turning to our second quarter income statement on Slide 5. Our net income for the second quarter was $1.1 billion or $1.99 per diluted common share. Our return on average assets for the second quarter was 1.49%, an increase of 15 basis points compared to the first quarter, a strong performance. We produced $4.1 billion in revenue, up 3% compared to the first quarter and 12% compared to the same quarter a year ago. The increase was primarily driven by strong noninterest income performance, which increased $240 million or 15% on a linked-quarter basis.
While customer fee income was strong, this quarter also included higher gains on asset sales and valuations. I'll get more information on these gains in a moment, but you can see the details of these items on Page 16 in the consolidated financial highlights. Those increases were partially offset by a decline of $131 million or 5% in our net interest income when compared to the first quarter, which was the result of lower core net interest income and lower purchase accounting accretion. This decline is more than we expected, and I'll provide more details shortly.
Second quarter expenses of $2.4 billion were in line with expectations. As a result, our pretax pre-provision earnings were $1.6 billion, an increase of 4% compared to the first quarter and an increase of 67% compared to the same quarter a year ago. Provision in the second quarter was $157 million, lower than the guidance we've provided due to better than expected improvement in commercial credit quality.
Looking to the third quarter, we expect that the provision to be between $170 million and $250 million, as we expect the impact of improvements in commercial credit quality to ease, and we expect an overall increase in credit exposure.
Now let's review the components of net income in more detail. As you can see on Slide 6, our total net interest income declined by $131 million or 5% on a linked-quarter basis, primarily due to a 4% decline in core net interest income. Approximately $50 million of the decline in net interest income was from securities due to unexpected decline in security yields, and in part, to the portfolio management activities mentioned previously.
We sold approximately $2 billion of securities in the quarter when long-term rates were lower contributing to security gains of $61 million for the quarter. We also had approximately $3 billion of security portfolio run-off throughout the quarter due to prepayments and maturities. We did put some of that money to work later in the quarter when interest rates were higher and spreads were wider by purchasing securities for delivery in the third and fourth quarters. While decreasing net interest income in the second quarter, these activities should benefit net interest income in the future. As a result, we expect net interest income from securities to improve in the third quarter versus second quarter.
The remaining decline of $80 million resulted from a decline in net interest income from loans of $75 million. The $75 million decline included a $20 million decline on maturing swaps related to loans; a larger than expected decrease in purchase accounting accretion of $45 million primarily due to lower cash recoveries on commercial impaired loans; and a $10 million decline as loan yields were partially offset by higher loan balances.
While we do expect further pressure on loan yields, we do not expect the decline in net interest income from swap maturities and purchase accounting accretion to continue at these levels. Keep in mind that cash recoveries on partial impaired loans was only $10 million in the second quarter. It can't get much lower.
Looking to the third quarter, we expect net interest income to be modestly down, as the continuing impact of lower loan yields and a decline in scheduled purchase accounting accretion should be partially offset by loan and securities growth, including the portfolio management activities we took in the second quarter.
For the full year, we now expect purchase accounting accretion to decline by approximately $350 million versus 2012. And in 2014, we expect purchase accounting accretion to be down approximately $250 million compared to 2013.
As you can see on Slide 7, total noninterest income increased by $240 million or 15% in the second quarter compared to first quarter results. Bill spoke to you about the progress we're making on our strategic priorities. Further evidence of that can be seen in the growth we saw during the second quarter in our customer facing fee categories.
Asset management fees increased by $32 million or 10% on a linked-quarter basis. Consumer service fees were up $18 million or 6% compared to the first quarter, primarily as a result of higher debit card, merchant services, brokerage and credit card revenue. Corporate services increased by $49 million or 18% linked-quarter, which was primarily due to a $33 million increase in valuation gains from the impact of rising interest rates on commercial mortgage servicing rights valuations and a higher capital mortgage revenue.
Residential mortgage had strong loan sales revenues, originations were up 11% on a linked-quarter basis and the gain on sale margin of approximately 4% was flat compared to the first quarter. This resulted in 10% increase in loan sales revenue to $190 million. However, total residential mortgage fees were lower than first quarter, primarily due to an increase in repurchase demands as Freddie Mac requested additional files on older vintage loans, primarily 2004 and 2005, as National City was the large originator with Freddie Mac during that period. As a result, we recorded a provision of $73 million for residential mortgage repurchase obligations. This provision covers new originations in the second quarter and the additional demand for loan files. Finally, deposit service charges increased by $11 million or 8% linked-quarter.
We also sold 2 million of our Visa Class B common shares in the second quarter, resulting in a pretax gain of $83 million. We continue to hold approximately 12.4 million shares of Visa Class B common stock, with an estimated fair value of $950 million as of June 30, 2013. These shares are recorded on our books at approximately $200 million, resulting in an unrecognized value of approximately $750 million pretax. And as I mentioned earlier, the security sales resulted in a net gain of $61 million.
In addition, we saw an increase in revenue of $37 million, associated with the impact of higher market interest rates on valuations related to customer-initiated hedging activities. Effectively, the higher interest rates reduced the fair value of our credit exposure on these activities.
Our diversified businesses resulted in noninterest income to total revenue, increasing to 44% in the second quarter. That compares to 40% on the first quarter and 30% during the second quarter of last year. We continue to expect that full year total reported revenue will increase in 2013 compared to 2012.
Now turning to Slide 8. Second quarter total expenses increased by $40 million or 2% as we expected. This is primarily due to a $30 million noncash charge on the redemption of trust preferred securities, along with a $22 million increase in marketing expenses.
As you recall, our goal is to achieve a total of $700 million in continuous improvement cost savings this year. A significant portion of these dollars are being used to offset investments we're making in our businesses and infrastructure. Through the first half of the year, we have captured approximately $600 million of annualized savings. This gives us confidence that we will exceed our full year cost savings target. For the third quarter, we currently expect noninterest expenses to be up modestly compared to the second quarter, and we expect full year 2013 expenses on a reported basis to below 2012 by at least 5%.
Our credit quality continued to improve in the second quarter, as you can see on Slide 9. In the second quarter, accruing loans past due, nonperforming loans and charge-offs were all lower compared to the first quarter. Net charge-offs were $208 million, a decrease of $248 million or 54%, reflecting in part the $140 million impact of the first quarter alignment with regulatory guidance related to consumer lending. We also saw commercial net charge-offs declined by $91 million to $30 million during the second quarter, although this level of commercial net charge-offs may not be sustainable.
As you can see on the chart, we released $57 million of reserves from our commercial book during the second quarter, primarily due to improved credit quality. And we continued to maintain our reserves for consumer lending, as we monitor our performance on refinancing interest-only home equity loan maturities. As a result, our provision of $157 million declined by 33% on a linked-quarter basis. This reduced level of provisioning may not be sustainable.
Overall, PNC posted strong financial results in the second quarter due in part to certain select items that may not continue at these levels. Looking ahead to the third quarter, we do expect modest growth in loans and solid growth in fee income as defined on Slide 7. We also expect net interest income to be down modestly and noninterest expense to be up modestly when compared to the second quarter. And we expect the provision for credit losses to be between $170 million and $250 million, as we expect the pace of commercial credit improvement to ease and net credit exposure to increase.
And with that, Bill and I are ready to take your questions.
Earnings Call Part 2:
- Q&A with PNC Financial Services Group, Inc. CEO