PNC Financial Services Group Inc (PNC) — Q3 2017 Transcript

Well, thank you and good morning. And welcome to today’s conference call for The PNC Financial Services Group. Participating on this call are PNC’s Chairman, President and CEO, 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 performance assume a continuation of the current economic trends and do not take into account the impact of potential legal and regulatory 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 risks and other factors. 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, and related presentation materials and in our 10-K, 10-Qs, and other SEC filings and investor materials. These are all available on our corporate website, pnc.com, under Investor Relations. These statements speak only as of October 13, 2017 and PNC undertakes no obligation to update them. Now, I’d like to turn the call over to Bill Demchak.

Thanks, Bryan. Good morning, everybody. As you have seen this morning, PNC reported net income of $1.1 billion or $2.16 per diluted common share in the third quarter. As Rob is going to lay out in more detail in just a second, this is a good quarter for us. A couple of things stood out. I’m just going to comment on those very quickly before I turn it over to Rob. First, we continued to experience solid loan growth driven by our commercial lending business, and we saw some growth on the consumer side as well. Within the commercial business, we’re growing loans and adding clients around a diversified product offering, and we’re capitalizing on opportunities in our underpenetrated and newer markets. Importantly, we haven’t changed our credit standards here, and there is one particular lending product that stands out. But in the end, we’re effectively executing on a model that’s based on patience, consistency of coverage, and good ideas. And this loan growth together with higher interest rates and continued low betas on our deposit pricing allowed us to grow net interest income even as security balances declined slightly. Second, on the fee revenue side, we saw a drop in corporate services fees, which was largely expected given that we had a record second quarter. And notwithstanding that, this is actually the second-best quarter ever for non-interest income in C&IB. You’ll notice we also saw provision up at least in part to the impact of hurricanes Harvey and Irma along with loan growth and some seasonal consumer trends. And beyond that, it’s a pretty uneventful quarter. Rob is going to quickly take you through the results, and then we’ll take your questions. Over to you, Rob.

Okay. Good morning. Thanks, Bill, and good morning, everyone. As Bill just mentioned, our third quarter net income was $1.1 billion or $2.16 per diluted common share. Our balance sheet is on slide four and is presented on an average basis. Total loans grew by $2.9 billion or 1% linked quarter. Commercial lending was up $2.7 billion from the second quarter as we saw growth in our secured lending businesses as well as large corporate and middle markets. Consumer lending increased by approximately $200 million linked quarter, driven by growth in residential mortgage, auto, and credit card, partially offset by lower home equity and education loans, which included our run-off portfolios. Investment securities decreased by approximately $900 million or 1% linked quarter as a result of lower reinvestments due in part to a relatively less attractive market opportunity during the third quarter. Compared to the same quarter a year ago, securities were up $2.8 billion or 4%. Our interest-earning deposits with banks, mostly at the Federal Reserve, were $23.9 billion for the third quarter, up $1.3 billion from the second quarter. On the liability side, total deposits increased by $3.1 billion or 1% compared to the second quarter, driven by seasonal growth in commercial deposits. Average shareholders’ equity increased by approximately $300 million linked quarter, and we continue to return substantial capital to shareholders. During the third quarter, our capital return totaled $898 million, comprised of $535 million in share repurchases and $363 million in common dividends. This resulted in a payout ratio of approximately 86%. Period-end common shares outstanding were 476 million, down 12 million or 2% compared to the same time a year ago. As of September 30, 2017, our fully phased-in Basel III common equity Tier 1 capital ratio was estimated to be 9.8%. As you can see on slide five, net income was $1.1 billion and we continued to generate positive operating leverage on both the linked quarter and year-to-date basis. Revenue was up $65 million or 2% from the second quarter, driven by growth in net interest income. Non-interest expense remained well-managed and decreased by $23 million or 1% compared to the second quarter. Provision for credit losses in the third quarter was $130 million and included $10 million related to hurricanes Harvey and Irma. In addition, loan growth and some seasonality in the performance of certain consumer categories contributed to the increase. Our effective tax rate in the third quarter was 26.8%. For the full year 2017, we continue to expect the effective tax rate to be between 25% and 26%. Turning to slide six. Our third quarter performance is reflected in these metrics, which have all improved over the past year. Our return on average assets for the third quarter was 1.2%, our return on average common equity was 9.89%, our return on tangible common equity was 12.66%, and our tangible book value increased to $69.72 per common share as of September 30th. We believe our well-positioned balance sheet, diversified revenue mix, and focus on expense management provide momentum for us to continue to deliver strong results. Now, let’s discuss the key drivers of this performance in more detail. Turning to slide seven. Revenue increased by $296 million or 8% year-over-year, driven by higher net interest income of $250 million or 12% and non-interest income growth of $46 million or 3%. It’s worth noting that our fee income on a year-to-date basis was a record-setting $4.3 billion, reflecting efforts to grow our fee-based businesses with increases in every category except for residential mortgage. On a linked quarter basis, net interest income increased by $87 million or 4%. The increase was driven by higher loan yields and balances, partially offset by higher funding costs. Additionally, the third quarter of this year benefited from one additional day compared to the second quarter. Our net interest margin expanded by 7 basis points linked quarter to 2.91%, driven by higher interest rates. And our third quarter non-interest income decreased slightly linked quarter. Looking at the various fee categories, asset management revenue, which includes earnings from our equity investment in BlackRock, was up $23 million or 6% linked quarter; year-over-year, asset management revenue increased by $17 million or 4%. Both comparisons benefited from higher equity markets and client activity. Consumer services fees were down slightly linked quarter, as credit card fee growth was offset by lower merchant services and debit card. Compared to the same quarter a year ago, consumer services fees were up $9 million or 3% due to growth in credit card, debit card, and brokerage fees. Within that, higher credit card fees were partially offset by increased year-over-year rewards activity. Corporate services fees decreased by $63 million or 15%, following a record second quarter, which was driven by elevated loan syndication and Harris Williams revenue. Compared to the same quarter a year ago, corporate services fees were down $18 million or 5%, primarily due to lower merger and acquisition advisory fees. Third quarter residential mortgage non-interest income remained flat linked quarter, as increased production revenue was offset by lower net hedging gains on mortgage servicing rights. The year-over-year comparison decreased by $56 million or 35% due to both lower loan sales revenue and lower net hedging gains on mortgage servicing rights. Service charges on deposits increased by $11 million or 6% linked quarter and $7 million or 4% compared to the third quarter of last year. Growth in both periods correlated with increased customer activity. Other non-interest income increased $10 million linked quarter or 3% and included higher gains on asset sales, partially offset by lower net securities gains. Compared to the same quarter a year ago, other non-interest income increased by $87 million or 34% and included higher revenue from private equity investments. We expect other non-interest in the fourth quarter to be in the range of $250 million to $300 million. Turning to slide eight. Expenses continue to be well-managed due in large part to our continuous improvement program. Through the first three quarters of the year, we are on track and confident we will achieve our annual target of $350 million in expense savings, which as you know, have helped fund our technology and business investments. Importantly, our efficiency ratio declined to 60% in the third quarter. On a linked quarter basis, our expenses decreased by $23 million or 1% as higher personnel costs were more than offset by lower equipment and marketing expense, as well as the benefit of our continued focus on expense management. Personnel expense increased primarily due to higher headcount related to business growth and an additional day in the quarter. Compared to the third quarter last year, expenses increased by $62 million or 3%. This reflects investments in technology and our business initiatives. Additionally, our expenses reflected the impact of operating costs associated with the ECN acquisition which closed in April of this year. Turning to slide nine. Overall credit quality remained benign in the third quarter. Total non-performing loans were down $84 million or 4% linked quarter and continue to represent less than 1% of total loans. Total delinquencies, however, were up $93 million or 7%. Although this is primarily due to higher early-stage consumer delinquencies in hurricane-affected states. Provision for credit losses was $130 million in the third quarter. As I mentioned, the increase included $10 million related to hurricanes Harvey and Irma. It also reflected loan growth and seasonal credit performance within the consumer loan categories. Net charge-off decreased $4 million to $106 million in the third quarter and the annualized net charge-off ratio was 19 basis points, down 1 basis point linked quarter. In summary, PNC posted a successful third quarter driven by growth in loans, deposits, and revenue along with well-managed expenses. For the remainder of the year, we expect continued steady growth in GDP and a 25 basis point increase in short-term interest rates in December. As you can see on slide 10, looking ahead to the fourth quarter of 2017 compared to the third quarter of 2017 reported results, we expect modest growth in loans; we expect net interest income, fee income, and expenses to each be up in the low single digits; and finally, we expect provision to be between $100 million and $150 million. And with that, Bill and I are ready to take your questions.

Operator, could you please poll for questions?

Good morning.

Hey, good morning, John.

Just regarding the CIP program, wanted to see if you can give a little bit of color there in terms of how you’re thinking about 2018. I know you’re confident in the 350 for 2017. How should we think about the likelihood of a new program in 2018 and the magnitude of the efficiency that you can get off of that? Thanks.

Yes, sure. John, this is Rob. Well, we’re going to refrain on this call, and I will just state this upfront, from 2018 guidance. So that’s just for the future people in the line there. The continuous improvement program obviously has worked well for us. It’s been in place for several years. It’s a mechanism that we use to hold expenses in check, particularly those expenses that are targeted towards investments and technology and business growth. So, we have just started our budgeting process for 2018. We’re far from complete. My sense is we will continue to use the tool but I don’t have a number for you this morning for 2018.

Okay. All right, thanks Rob. And then separately, just on the loan growth side. Just wanted to get an idea, if you could help size up the new market initiative, how much in loan balances do you have in these newer markets right now? And how much of the loan growth that you saw in the quarter came from this expansion into some of the corporate relationships in these newer markets?

Yes. Again, this is Rob, John. The new markets unquestionably, what we call our underpenetrated markets, are contributing at a greater rate than our legacy markets. The balances themselves are pretty small as an overall percentage, but the growth rates in those southeast markets, and we include in those underpenetrated markets Chicago as well, are running at about two times the legacy growth rates. So, they’re a big part of our loan growth story in the commercial side.

Hey. I’ll kick off with my typical question and then a follow-up. But the typical question is excess liquidity. You’ve got a decent amount; I know that rates were not that attractive this quarter. And so, you’re kind of hoarding a little bit on the cash side. Could you give us a sense as to what kind of rates curve, shape you’re looking for? And how you think about the fed balance sheet normalization? I know it’s not going to impact your deposits too much, but how you’re thinking about whether or not that gives you opportunities on the reinvestment side?

Start Rob. There is a lot of questions…

Okay. I can handle the hoarding part. I don’t know if much has changed. I mean, as you saw in the third quarter there, the yield curve flattened out a bit more than we would have liked, which in essence had us dial back a bit in terms of how we deployed into investment securities. It’s improved somewhat off of those levels. So, we’ve begun some more purchases than we had then. But, I don’t know, when we look forward, Bill, the yield curve is pretty flat, so we don’t see anything dramatically changing there.

Yes, regarding the Fed's unwinding of its balance sheet, like everyone else, we are waiting to see how this will impact interest rates. We anticipate an upward trend, but the extent and speed of that increase remain uncertain, which will also depend on who the Fed chairman is. We have been effective in managing our cash deployment within the generally stable term rate environment. In the third quarter, the yield we reinvested at was lower than the average book yield of our remaining securities. We had previously hoped to surpass that point and then improve upon it, and we are eager to return to that situation.

And then, how you’re thinking about the loan-to-deposit ratio? I think you’re currently running at about 85%. I know it’s a new world with the LCR and everything, so it’s hard to use history as a guide. Just want to understand how you’re thinking about managing the loan growth, the deposits and how you’re thinking about the deposit betas and competing there?

I think, it’s interesting. Loan-to-deposit in some ways ends up being a byproduct these days to compliance with the LCR. So, it almost is an outcome and not directly relevant, depending on how many of our deposits come from corporate deposits which are less impactful to the LCR. We purposely got ahead of LCR compliance going back more than a year, thinking it would be easier to do it when rates were low than in the rising rate environment, and that has proven to be true. As we see rates go up and other people move toward compliance, at the same time as the Fed taking cash out, we are starting to see at the margin pretty competitive pricing on the retail side. We haven’t had to react to that yet. We will continue to watch and see if we do so. But right now, what we focus on is making sure we stay in compliance with LCR, which we are and that loan-to-deposit will end up being sort of an outcome from that as much as anything else.

And just to extend on that, Betsy, around the betas. We see a continuation of what we talked about in July on the second quarter call, following the June rate hike, more activity on the commercial side and the beginning of activity on the consumer side, although it’s still very low.

Yes, hi. Good morning. Just a question on some of the loan trends this quarter. On both on average and spot basis, your loan growth was best-in-class. I am wondering, under the financial services category, I understand that some of that growth has been for warehouse financing for CRE. And I am wondering if that level of growth in that category is sustainable, is there a seasonality that we should think about going forward?

It bounces around. I guess what I would say on loan growth, and I’ve kind of put this in my opening comments, is we continue across the board to win clients and do new deals, and it becomes harder to predict into which buckets we’re going to see growth. So, this quarter, we did see growth in the CRE warehouse line, but we also saw in asset-backed lending which had been down in the second quarter, we saw some of it in utilization, we saw middle market continue to grow, and we saw pretty big increases in equipment finance, but it bounces around. So, we’ve put kind of low guidance on loan growth and get comfortable with the notion that if we just keep growing clients, it will show up, albeit kind of across the categories, so without a real clear ability to predict which ones.

Yes, Erika, and I can add to that. On the financial services category, it does represent the warehouse lending. But in addition to that, it includes asset-backed transactions which were substantial in the third quarter. So, even though they are extended and used by companies outside of financial services, the structure requires a categorization in financial services.

Got it. And my follow-up question is, Bill, since after the crisis, PNC has been known to manage exposures very well and not grow for the sake of growth. And I am wondering, and you’re also one of the few regional bank CEOs that have been talking about the Fed balance sheet reduction. There has been a lot of discussion on the impact of deposits. But I am wondering if you could give us a sense on how you are anticipating the impact to commercial real estate. If we do get some steepness to the curve, how you think that would impact first growth and then credit?

Yes. Let's consider the impact of rising interest rates on the real estate market. Higher rates can be problematic as they affect capitalization rates. As rates increase, particularly for projects that have floating rate borrowings, the coverage ratios on those loans become more vulnerable. Many real estate developers implement interest rate caps and other strategies to mitigate this risk, but not all do. Consequently, I anticipate that higher rates will lead to an increase in delinquencies in the real estate sector, which is partly why we have slightly reduced our growth expectations. However, I want to emphasize that our real estate portfolio is in excellent shape. Looking at the statistics, delinquencies and non-performing loans are...

All of this. Typically growth has slowed; commercial real estate growth has slowed, reflecting some of that.

I was hoping that you could for a second, just talk about the lower corporate service line. I mean I definitely get that you come off the record 2Q, but it’s just become a little uncharacteristic for you guys to have any year-over-year decline in that line item. So, just curious, if you can impart any more color and sort of how we should be thinking about it?

We feel very good about that line. The second quarter was particularly high in two categories, which the combination effect made it a significant high point. So, loan syndications and Harris Williams. Within that, treasury management and our other capital markets are all doing well. So from the quarter-over-quarter, there was a bit of decline just because the second quarter was so good in both of those categories. So, we feel very good.

Yes. I think importantly if you track that line just through time, recognizing that it’ll be volatile, we continued to gain share and grow the underlying businesses. But it does bump around quarter-to-quarter.

And importantly, as part of our guidance, we expect future growth.

Could you provide some quick thoughts on the provision and the slightly higher guidance? It seems there is a normalization happening, and you're experiencing steady loan growth. I'm curious about your perspective on why a higher provision is needed at this point in the cycle, despite no significant decline in credit trends.

Yes. This is Rob, Scott. So, a couple of things there and mostly in terms of just sort of the high level. You’re right on, it’s the gradual normalization that we’ve expected for some time off of really, really low levels. So, in this quarter, obviously on the top, it’s the hurricane-related QFR that aside, we did have growth and in this quarter, the growth tended to be more in the secured transactions within corporate banking which carry a higher provision. And then, we had some seasonality on the consumer side. So, no big changes, I would say, most of it for the quarter and in our guidance reflects the gradual normalization that we’ve been talking about for some time.

I was wondering if you could just give us an update where you stand on the home lending transformation and also on some of the other consumer lending initiatives.

John, good morning, it’s Rob. On the home lending, that’s a big work set for us and we continue to do a lot of work in that regard and we are making progress. Although, the results that you’re most interested in are probably a late-stage 2018 kind of occurrence. But we are making progress in terms of combining our mortgage operations with our home equity operations. Here in the fall, soon we’ll be able to do mortgage originations off our new platform. Next spring, we’ll be able to do servicing on both home equity and mortgage and then later in the year originations on the home equity. So, we’re making progress. We have a lot of confidence and conviction it’s the right thing to do. It’s just a lot of hard work and it takes time.

We are making significant progress on the consumer lending transformation. This includes enhancing the digital delivery of products, with improvements expected in mortgage and home equity, as well as in card and auto services through our mobile platform. Our volume metrics reflect this progress in policies and procedures aligned with our credit appetite, which we had not adequately addressed before. We also underestimated the effort required for core servicing and the automation necessary for new regulatory compliance, which is currently causing delays in consumer fulfillment. Overall, we are making strides as we delve into the core operations and explore how to effectively implement automation, which is proving to be more challenging than anticipated.

And Bill, maybe a little more color similarly on your tech investments and the kind of platform transformation. I think back office-wise, I think you shift to data centers is complete this year. How should we think about your kind of trajectory of tech investments and transforming the customer experience as well as the back office?

We’re reallocating our spending towards enhancing customer experience and enabling employees. This will be reflected in our servicing platforms. During our budgeting process, we consistently observe a decline in technology spending, but I believe it will either stabilize or increase. This is crucial as we aim to adapt to a digital-driven financial services environment. As for 2018, we will discuss that in detail later, but I anticipate that we will redirect our financial resources towards client acquisition and servicing, rather than focusing solely on building core infrastructure.

It’s the foundation.

Got it. And then one quick follow-up, Rob, I don’t know if you’ve got this earlier on deposit betas. Just on the retail side, have you guys seen anything in terms of deposit beta just on retail banking and if you could just comment on the wealth management side as well?

Beta for… Yes. We did at the front of the call, John. So, following the June rate hike where consumer beta had been zero, we are seeing some activity and some pick-up but still very, very low. It is our expectation that they’ll continue to rise; we’ll just have to see at what pace. But our folks feel and we’ve said this for most of the year that it’s probably another rate hike or two before they totally normalize.

Got it.

No, it’s fairly consistent there. Our wealth book in terms of our deposits is about $12 billion. So, it’s relatively small and it’s married basically to consumer behavior, maybe a little bit more.

Good morning. In regards to your auto loan growth, you guys have been outpacing most peers the past few quarters, despite what we’ve seen is a decline in overall new car sales and auto originations. You’ve obviously pulled back in 2014 and 2015 as the industry was getting very heated, remained in the space. Could you just talk about the state of the auto industry and what your expectations are for loan growth going forward?

We should take a moment to emphasize that we haven’t altered our core approach. Previously, this strategy allowed us to increase our volume, as we continued lending when others were not, and the industry itself was also generating more volume. Now, however, we've maintained our parameters while a growing number of products have shifted towards leasing, longer terms, or higher loan-to-value ratios. This has resulted in a decrease in our market share and growth. As we venture into new markets, we see an opportunity to capture market share, even though the overall market size is shrinking. Additionally, as we look at our growth rates in direct versus indirect lending and the rollout of mobile Check Ready, which we will enhance in the upcoming months, we are shifting how customers obtain financing for their vehicles. I believe this trend will likely accelerate, particularly as overall lending volume stabilizes in the industry, but for us and others, direct lending and mobile usage will likely grow.

And the attractiveness of the product to the consumer. In terms of our auto book, which totals approximately $12.5 billion in outstanding loans, we have confidence in the credit quality. The average FICO score for our prime book is 730, and this quarter's originations were even higher, around 750. The tenures are 70 months, and the loan-to-values are at 90%, and we do not engage in leasing. Overall, we are optimistic about the credit quality of our portfolio.

Okay. I’d like to follow up on commercial real estate. You've experienced a significant increase in your asset yields in this area, rising by nearly 40 basis points over the past year. Could you discuss the changes in your portfolio and where new money yields are?

I believe what you're observing is simply the effect of increasing chart rates. There hasn't been a significant change in our portfolio. We have seen some growth in fixed-rate term products, but largely what you're witnessing is just an increase in LIBOR. The underlying spreads have perhaps slightly widened in real estate, but our new volume is such that it hasn’t affected the overall market, as our volumes have remained flat year-on-year.

Yes. And that’s true just for commercial yields in general beyond commercial real estate, it’s rate driven.

Thanks. Good morning, guys. Follow-up on the balance sheet. You guys talked about kind of restarting little purchasing on the securities and obviously you’ve had good loan growth, which has been matched nicely by the deposit growth. As we go forward, and I know you’ve talked about this a little bit, again, I just wanted to get your updated thoughts. Do you anticipate seeing mix shift on the balance sheet as we look ahead and effects from Fed normalization? And are the deposits you’re getting still just coming from new customers or you’re still getting more money from existing customers? Thanks, guys.

I’m not sure where to begin with that. I don’t see any immediate impacts from the Fed unwind; Bill expressed it well, and we’ll have to wait and see. This situation is new, and we need to observe the outcomes. Putting that aside, I don’t anticipate a major change in the balance sheet. However, I do notice some intensifying around deposits in relation to pricing betas, and I believe that will increase, though I don’t foresee anything drastically changing. Bill?

Yes, I don’t think so. In an ideal scenario, we would utilize more of our liquidity for loan growth that aligns with our credit capacity. We are still experiencing growth, but not at the rate at which we are generating liquidity. We have liquidity available to deploy, and much of it would be directed towards level one securities if and when yields become attractive to us. Currently, we are managing the balance sheet very conservatively in relation to interest rates, which is functioning well for us; we will continue to approach it this way. We hope to move towards higher rates as the Federal Reserve begins to unwind its balance sheet.

Yes, I can clarify my second question. I was wondering if you are noticing a shift in customer behavior, specifically if you are seeing customers moving from non-interest bearing accounts to interest bearing ones. I know we are observing that in the betas.

Yes.

Growing your commercial customers, and I'm more wondering just about where the incremental deposit is going as far as the deposit mix? That’s really what I meant to get at.

Yes. So, obviously, very different on the corporate side versus the consumer side. The corporate side, there continues to be a bit of differentiation between the larger corporates who are frankly shopping rates a little bit more, and that’s a product that has effectively had a beta of 1 since the beginning. Some of our more active treasury management clients who use balances to offset fees are a little bit less sensitive to that. On the consumer side, at the margin, we’ve seen growth in our interest-bearing through time as people see that hey there’s money on the table to…

This has been a case for a while.

Okay. Well, thank you all for participating on the call.

Thanks a lot.

Thank you.