PNC Financial Services Group Inc (PNC) — Q3 2020 Transcript

Well, thank you and good morning everyone. 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 CFO. Today's presentation contains forward-looking information. A cautionary statement about this information, as well as reconciliations of non-GAAP measures, are included in today's earnings release materials, as well as our SEC filings and other investor materials. These materials are all available on our corporate website, pnc.com, under Investor Relations. These statements speak only as of October 14, 2020, and PNC undertakes no obligation to update them. Now I'd like to turn the call over to Bill.

Thanks, Bryan, and good morning everybody. I hope everyone is safe and well. Amidst continued uncertainty on many fronts, PNC delivered solid third quarter results. We grew revenue led by noninterest income, which included a bounce back in consumer fees on higher volumes. We managed expenses, which allowed us to generate positive operating leverage of over 4% in both the quarter and year-to-date period. Our provision for credit losses was substantially less than last quarter. On the flip side, net interest income fell from the second quarter given the low-interest rate environment and weak loan demand. Despite growth in customers and commitments, our loans outstanding declined due to lower utilization rates, including the pay-off of commercial lines of credit that were drawn early in the pandemic. While we continue to experience strong deposit growth, the current environment has made it more challenging to put those deposits to work. Nonperformers continue to rise, especially in high-impact COVID areas that Rob will discuss in a little bit more detail. Notwithstanding these challenges, we feel that PNC is well positioned with very strong capital, liquidity, and loan loss reserves. There are several significant upcoming events including the next round of stress tests, the election, and PPP forgiveness that may impact the industry and our borrowers, underscoring the importance of our strong position. We're confident that the actions we've taken position us to support our clients and communities and take advantage of potential opportunities if they arise to enhance shareholder value. I want to thank our employees, who despite the various challenges of the pandemic, continue to execute on our strategic priorities including ongoing investments in our national expansion and digital offerings while helping our customers navigate financial hardship and other challenges. During the quarter, we opened retail solution centers in Nashville, Houston, Denver, Boston, and Dallas and filled out corporate teams in the recently opened Seattle and Portland markets. In 2021, we will continue our middle market expansion into San Antonio, Austin, and San Diego. The ability to expose our model to these demographically attractive markets continues to generate strong returns. With that, I'm going to turn it over to Rob for a closer look at our third quarter results, and then we'll be happy to take your questions.

Great. Thanks, Bill and good morning everyone. As you’ve seen, we've reported third quarter net income of $1.5 billion or $3.39 per diluted common share. Our balance sheet is on Slide 4, and is presented on an average basis. On the asset side, total loans declined $15 billion to $253 billion linked quarter. Investment securities of $91 billion increased $2 billion or 2% linked quarter. But on a spot basis, declined $7 billion, primarily due to significant prepayment activity and maturities at quarter-end. Our cash balances at the Federal Reserve average $60 billion compared with $34 billion in the second quarter. The increase was a result of continued deposit growth and the full-quarter impact of proceeds from the sale of our equity investment in BlackRock. On the liability side, deposit balances averaged $350 billion, an increase of $15 billion or 5% linked quarter. Borrowed funds decreased $10 billion compared to the second quarter as we used our strong liquidity position to reduce borrowings primarily with the Federal Home Loan Bank. Our tangible book value was $95.71 per common share as of September 30, an increase of 2% linked quarter and 16% year-over-year. Our capital reserve and liquidity positions remain strong. As of September 30, 2020, our CET1 ratio was estimated to be 11.7%. Our Board recently approved a quarterly cash dividend on common stock of $1.15 per share. The Fed has authorized dividends for the fourth quarter, again subject to amounts not exceeding the average of net income for the preceding four quarters. Our fourth quarter dividend is 26% of that rolling number. In regard to share repurchases, and in accordance with the Federal Reserve's directive, we'll continue to suspend repurchases through the fourth quarter of 2020. Our loan loss reserve levels are 2.58%, up slightly from 2.55% at the end of June. Our liquidity coverage ratios continue to significantly exceed the regulatory minimum requirements as we remain core-funded with a low-cost deposit base. Slide 6 shows our average loans and deposits in more detail. Average loan balances of $253 billion in the third quarter were down $15 billion or 6% compared to the second quarter. This decline reflected a $13.7 billion decrease in commercial loan balances as new loan production was more than offset by broad-based lower utilization. In our C&IB segment, virtually all of the draw-downs that occurred in the first quarter have since paid back, and our utilization rates are currently running approximately 1% below pre-pandemic levels. Consumer loans declined approximately $1.3 billion across all categories except for residential mortgage which increased. Compared to the same period a year ago, average loans grew 6% or $15 billion. As the slide shows, the yield on our loan balances is 3.32%, a 5 basis point decline in the second quarter, and the rate paid on our interest-bearing deposits was 12 basis points, an 11 basis point decline linked quarter. Average deposit balances of $350 billion increased $15 billion or 5%. Commercial deposits grew reflecting the enhanced liquidity positions of our customers, and consumer deposits also grew primarily due to government stimulus and lower consumer spending. Year-over-year, deposits increased $71 billion or 26%. As you can see on Slide 7, third quarter total revenue was $4.3 billion, up $205 million linked quarter or 5%. Net interest income of $2.5 billion was down $43 million or 2% compared to the second quarter as lower earning asset yields and a decline in loan balances more than offset the benefit of lower funding costs and an extra day in the quarter. Our net interest margin decreased to 2.39%, down 13 basis points linked quarter, reflecting the impact of higher balances held with the Federal Reserve Bank, which averaged $60 billion for the quarter. Fed cash balances in excess of our LCR requirements were approximately $40 billion, which represented 25 basis points of compression to our net interest margin. Noninterest income of $1.8 billion increased $248 million or 16% linked quarter. Fee revenue of $1.3 billion increased $62 million or 5% compared to the second quarter. Asset management revenue increased $16 million or 8% primarily due to higher average equity markets. Consumer services and services charges on deposits in total increased by $100 million due to higher consumer activity and a decrease in fee waivers. Corporate services declined $33 million or 6% as higher treasury management product revenue was more than offset by lower advisory-related fees. Residential mortgage revenue declined $21 million or 13% driven by both lower servicing fees and lower loan sales revenue. Other noninterest income of $457 million increased $186 million and included a positive valuation adjustment of private equity investments compared with a negative valuation adjustment in the second quarter of a similar magnitude. The positive valuation adjustment was partially offset by lower capital markets-related revenue. Noninterest expense increased $16 million or less than 1% compared to the second quarter. Provision for credit losses was $52 million, a decrease of $2.4 billion, as the provision expense for our commercial portfolio was largely offset by a provision recapture in our consumer portfolio. Our effective tax rate was 9.8%. The lower rate was primarily related to increased tax credits during the quarter. For the fourth quarter, we expect our effective tax rate to be approximately 13%. Turning to Slide 8. During the third quarter, we generated positive operating leverage of 4% in both the year-over-year quarter and the year-to-date comparisons. As a result, our efficiency ratio improved to 59% in the third quarter of 2020 compared to 62% for both the prior year third quarter and the nine months ended September 30, 2019. While the current environment presents revenue challenges from low rates and pandemic-related pressures, we remain deliberate and disciplined around our expense management. As we previously stated, we have a goal to reduce costs by $300 million in 2020 through our continuous improvement program, and we are confident we will achieve our full-year target. Slide 9 provides an update regarding specific industries we've identified as most likely to be impacted by the effects of the pandemic. Our outstanding loan balances as of September 30 to these industries were $18.3 billion or $16.4 billion, excluding PPP loans. These balances declined 7% compared to the second quarter, primarily due to pay-downs. While we have still experienced material charge-offs in these industries, we do expect to see charge-offs increase over time should current economic trends continue. Commercial and industrial loan balances in this category totaled $10.5 billion on September 30, declining approximately $1 billion or 9% compared to the prior quarter. Nonperforming loans in these industries remain relatively low at 1% of loans outstanding, but we're continuing to see downgrades with the greatest stress continuing to be in leisure and recreation. Looking at the lower half of the slide, commercial real estate loans in this category totaled $7.8 billion at the end of the third quarter, declining $300 million or 4% compared to the prior quarter. Nonperforming loans increased approximately $180 million and downgrades continue to occur primarily in retail and lodging. Correspondingly, our reserves on our total commercial real estate portfolio have increased to 2.17% from 1.33% in the second quarter. Moving to Slide 10. We've seen a significant reduction in the number of consumers and small businesses requesting hardship assistance. At the peak this summer, we granted modifications to more than 300,000 consumer and small business accounts representing approximately $13.7 billion of loans. $6.9 billion of these loans were government guaranteed or investor-owned, which present very little credit risk to PNC. Of the remaining $6.8 billion of loans that did present credit risk, more than $5 billion have rolled off payment assistance, and 92% of those accounts are current or less than 30 days past due. As a result, we had $1.7 billion of consumer and small business balances in some form of payment assistance as of September 30. Of those balances, approximately 85% are secured, and more than 60% of these accounts have made a payment in their last cycle. On the commercial side, we're also continuing to selectively grant loan modifications based on each individual borrower's situation. Within our C&IB segment, approximately $700 million of loan balances were in deferral as of September 30. When combining consumer and commercial customers, loans in deferral posing credit risk to PNC approximate 1% of total loan outstandings. Our credit metrics are presented on Slide 11. Net charge-offs for loans and leases were $155 million, down $81 million from the second quarter. Commercial net charge-offs were $38 million and consumer net charge-offs were $117 million, both down linked quarter. Annualized net charge-offs to total loans was 24 basis points. Total delinquencies of $1.2 billion at September 30 declined $72 million, or 5%. Consumer loan delinquencies decreased $41 million and commercial loan delinquencies declined $31 million. Nonperforming loans increased $209 million, or 11% compared to June 30. The increase was primarily driven by commercial real estate borrowers in high impact COVID-19 industries. As you can see, the allowance for credit losses to loans was 2.58% at quarter-end, up slightly from last quarter. We believe that our reserves sufficiently reflect the life of loan losses in the current portfolio. Slide 12 highlights the components of the change in our allowance for credit losses year-to-date, which have increased $3.4 billion since December 31, 2019. As a result, our allowance for credit losses to total loans was 2.58%, and our allowance to nonperforming loans was 276%. Our reserves have increased materially this year due to the adoption of CECL, and significant changes in the macroeconomic outlook during the first half of the year. In the third quarter, portfolio changes primarily driven by lower loan balances reduced reserves by $158 million. Additionally, our economic outlook improved modestly during the quarter, but this was offset by increased reserves for both commercial and consumer borrowers adversely impacted by the pandemic. In total, this resulted in a $150 million decline in our reserves to $6.4 billion. In summary, PNC posted solid third quarter results, and we believe our balance sheet is well positioned for this challenging environment. For the fourth quarter of 2020 compared to the third quarter of 2020, we expect average loans to decline low single digits. We expect net interest income to be stable. We expect core fee income to be stable. We expect other noninterest income to be between $275 million and $325 million, resulting in our expectation that total noninterest income will be down in the high single-digit range. We expect total noninterest expense to be up approximately 1%, and regarding net charge-offs, we expect fourth quarter levels to be between $200 million and $250 million. Importantly, after taking all this into account, we're on pace to deliver positive operating leverage between 3% and 4% for the full year of 2020. With that, Bill and I are ready to take your questions.

On the loan loss reserve, it looks like you released reserves a bit in the quarter, although your ACL percentage increased, given the loan balance decline? Is it fair to assume that if we do see charge-offs continue to increase from here, like in the fourth quarter, that we would expect that you probably still will not match those charge-offs with provision and accordingly continue to put up loan loss reserve releases?

There are a lot of variables that go into that answer, John. But remember again, when we put up the second quarter reserve, the assumption was based on our economic forecast in the model, that we covered all of the losses we knew about at that point in time. The economy has improved a little bit on the forecast. So, as charge-offs go up, we are using the effective reserves that we provided for in the second quarter. All else equal, this should continue unless we have deterioration in our current forecast and what's going on in the economy. The general principle is that as loans run down and charge-offs occur, that's what we've reserved for.

Yes, that's right.

And on that same topic, regarding charge-off trajectory, just given what you expect in terms of the ongoing migration you indicated that nonperformers saw some pressure. When do you expect to see the greatest pressure in charge-offs build as this plays out? Are we looking more like the first half of next year as where we get the greatest upside pressure in terms of loss content?

Again, it depends on a lot of factors, not the least of which is what fiscal stimulus they put out there, if any. All else equal, it will probably start showing up in the second half of next year. I believe we are likely to see more pressure on COVID-sensitive industries and real estate first, and then consumers later as we move into the latter half of next year. It really depends on consumer numbers, which I think will be highly dependent on whether they provide more fiscal stimulus, which I think they absolutely need to do.

I would just add on that, I think it is all speculation at this point, but mid-2021 feels about right.

If I could just ask one more, just to approach the M&A question from a different angle, Bill, if we get a Biden victory next month, and the political environment could potentially move against large bank deals, how does that influence your appetite for a larger deal? Could you pursue smaller bank deals given that, or possibly just view buybacks more attractively? Just want to get your thoughts.

Look, you're making a lot of assumptions in there. The regulation as I understand it, is basically that as long as we do a deal and it does not cause systemic risk to the economy, it has to go through an approval process. They can delay it, hold hearings, do all sorts of different things, but it will ultimately get approved. So even with a change in administration, I don’t know that there’s a real risk. As we've always said, smaller deals aren’t off the table, but they require a fair amount of work for less total return. Can we do a bunch of them? Yes, we could do a bunch of them over time.

Got it, okay, that's helpful. Thank you.

There are a lot of things to play out. I'd say, John, a lot of things to play out, and our thinking generally hasn't changed.

Yes.

Thanks for taking the question. Just a quick couple of questions on NII. It's nice to see that you guys are expecting NII to be stable sequentially. Could you help us understand what parts of the loan book you expect to see come down? How is that being offset by other parts of the earning asset statement in terms of keeping the NII stable? Thanks.

Rob?

Yes, hey Ken, good morning. When we take a look at the NII being stable, there is obviously the earning asset side and the liability side. We’ve made a lot of progress on the liability side, and I think we can still do some more there. When we look at the fourth quarter in terms of loan balances, we expect commercial to remain relatively flat. This all depends on what happens. For consumer, we could see some uptick there particularly if there is some stimulus. Another factor for us and the industry in terms of the fourth quarter will be the rate at which PPP loans are forgiven. We have an expectation built into our guidance that about half of those will be forgiven, and that's built into our fourth-quarter guidance and the other half in the first quarter of 2021. So, that’s probably the biggest play in terms of how NII and total loans drop.

Funding costs.

Yes, I said that, got it.

My follow-up, actually Rob, is on that PPP front.

Yes.

The C&I loan yields were actually stable, down 1 basis point. I was wondering if you could help us understand the contribution from PPP-related interest income this quarter versus last? Again, how does that play through in terms of the yields and the forgiveness in fees and all that get quite tricky, right? Thanks.

It does get a little tricky. A good number for us in terms of our guidance would be about $100 million in NII related to PPP forgiveness in the fourth quarter. So, that will help you gauge size.

But straight C&I loan spread, I think we're up 7.

Spreads are up - yields are down.

Still gradually down as we roll down in lower LIBOR’s.

Yes, that's right. So about $100 million Ken on the PPP.

Do you have just what that was in the third quarter versus the $100 million?

Yes, it was very much smaller.

Another firm that is going through this downturn solidly, JPMorgan, was essentially chomping at the bit in terms of appetite for buybacks once the Fed lifts its restrictions. Bill, I'm wondering, given the amount of excess capital you're sitting on, if the Fed does lift its restrictions by the first or second quarter of next year? How patient are you going to be in terms of thinking about your inorganic opportunities versus buying back your stock here, at a narrower premium to tangible book than the stock usually enjoys?

So, you should assume that we would otherwise be in the market, but you should also assume we will be patient in looking at acquisitions over time. The environment, notwithstanding COVID, for banks is going to be tough going forward for all the obvious reasons. We continue to assess that there will be a lot of opportunities out there. With respect to buybacks, the only thing I think you ever know for certain is trying to spend as much capital as we have all in a hurry almost never works out, and makes sense. So, we'll be in the market to a certain degree, but not enough to change our focus on the opportunities that we see and expansion through acquisition.

Got it.

It's quite conceivable we can do both.

Yes.

Yes, got it.

In fact falling back.

As a follow-up question, this management team has always been ahead in warning us about the excesses that we're building up in the system pre-COVID. I'm wondering as we think about the charge-offs that are coming as a follow-up to John's question, do you think the current programs from the government and the Fed have effectively redefined cumulative credit losses lower for this cycle, or are we just kicking the realization down the road?

Look, they've definitely helped, but with PPP really winding down and with CARES Act having run out, we're going to see an acceleration. We did a survey into small business, and I think 60% of respondents said that if this continues for another year, they will be out of business.

Alarming high.

Yes, an incredible percentage. Many of these businesses have survived either through PPP or simply drawing on reserves and operating at a non-sustainable level. Something needs to give. My guess is, and that's why we talked about charge-offs ramping up as we enter the mid to back half of next year; my guess is there is going to be a lot that shows up.

Got it. Thank you.

Future fiscal support is a big variable.

Yes.

Bill, can you share some thoughts? You've pointed out that you've had $60 billion up at the Federal Reserve, and clearly that's weighing on your net interest margin like your peers because of the influx of deposits. Can you give us some color if that level, if your customers stop using their deposits, is there anything you can do to shift that money out of there to get a higher yield without taking too much interest rate risk?

Actually, it’s $70 billion there, I think on a spot basis. No, look, you're seeing it, not just on the deposit side, but our utilization rate on credits is down 1.6% from the pre-COVID levels. The economy just isn't running, right. Corporates are using less on their lines, carrying less inventory, and holding more cash. I don't know that this will abate, particularly with the Fed's balance sheet likely to remain at least stable. In terms of redeployment, it's tough to define good opportunities that offer risk returns. We're doing a lot at the margin on the lending side and some specialty finance areas and even on the security side that offer value, but they're not enough to dent the overall amount.

Substantially faster.

Yes, and trying to force that outcome, we could just go out and buy $70 billion worth of 10 years at 70 basis points, and make a lot of money for some short period of time; it's just a lousy risk return trade-off. We'll be opportunistic, but my best guess is we are going to be sitting on a lot of cash for a pretty long period, as will the whole banking industry.

Very good. Moving over to credit. Obviously, you guys have been through cycles before. Aside from the unique causes of this downturn, when you look at the commercial credits and commercial real estate that you've had to write-down, has there been any notable differences between what you've seen in the last cycle or the 1990s in terms of write-downs that have surprised you, or is it very similar to past downturns?

No, historically most real estate problems came from projects. Office buildings that were built but were never occupied, you can remember Boston when you could see straight through Downtown because nobody was in. Big losses historically came from that. This is an instance where real estate is struggling, even though theoretical occupancy is high. But if you think about retail, nobody is paying rent. Malls are getting killed, and they were already on a decline. Hotels are obvious. A lot of things that would have been fine in a normal downturn are struggling from a cash flow perspective. Interestingly in this instance versus previous ones, the loan to values for the assets, notwithstanding the lack of cash flow, still look pretty good.

To your point, the nature of this pandemic crisis and these loan to values supports that.

Yes.

Regarding the COVID vaccine, can you share your view on how an effective vaccine by mid-2021 would impact your view of ultimate loss content within CRE? There's a lot there; I’d appreciate your thoughts.

At the margin, banks have always been more willing to work with borrowers than a contractual CMBS relationship. We’ve been surprised by the turnover we've seen in our special servicing portfolio. One, the BP's buyer's willingness to work with borrowers probably in a way they haven’t in past environments. Two, to the extent they say no, they take the asset. There is a lot of capital on the sidelines from traditional buyers, who are effectively writing it off in one fund and rebuying it in another. The turnover has been high. There seems to be a fairly active secondary market for real estate properties at the moment, probably not across all types. I doubt there is a good bid for strip malls, but for other property types, there is.

To your point, the nature of this pandemic crisis and these loan to values support that.

The COVID vaccine has no predictions, assumptions on when, if, how, and whether it works. So, I'll just pass on that.

Yes, we know what you know on that.

Yes, that's fair. If I can squeeze in one last one. Bill, can you share your thoughts around the direct Neobanks, like Chime and similar, that operate exclusively online without traditional branch networks in this post-COVID environment? How do you see their presence impacting the competitive environment over the next three to five years? Is there potential benefit to deploying some of the BlackRock proceeds on Neobank capabilities? Are those things that you think you can build on your own?

I'm trying to contain myself. I wish we had the opportunity to essentially not have to make any money and grow customers by giving things away and running our back office on a third-party bank system that was written in COBOL from 50 years ago, but we don’t have that luxury. I assert that none of these Neobanks offer anything that we don’t have or can’t produce. Our platforms are more modern than theirs. They all run on third-party banks, which raises issues that frustrate me. They offer free accounts and no overdraft, targeting very low balance customers, and I just don't think that model works long-term. The delivery model that includes real care centers, customer service, and multiple delivery channels is going to win.

It's a good question.

That's great. Thank you.

So, Bill, you certainly have been ahead in expressing concern about how the COVID situation plays out. Just gauging the last three months, on one hand, you see the fixed income market securities improving, and I know you’re familiar with that market? You have low line utilizations, which means firms probably aren’t ready to go bankrupt. You see your charge-off rate being exceptionally low. However, who knows if we have a second wave, or if it’s a W or how that will transpire. So what's your temperature on the outlook over the next couple of years? Do you have seller's remorse for selling BlackRock, or do you think, you know what, I feel even better today?

A couple of things to keep in mind on the corporate side: notwithstanding utilization being down, Corporate America is levered four times today. We went into the crisis levered three times, which we all thought was high. The one thing that provides comfort, certainly relative to my initial concerns, is that we've defined the downside. Initially, we had no idea of how the downside would appear. We had no insights on mortality rates, effective treatments for COVID, or the vaccine. I think we've defined the downside, with the economy muddling along at our current state. Losses will likely materialize over time. As we mentioned, we think we’re currently reserved for that environment. Do I have seller's remorse? I do not. Not surprisingly, I've been asked this question, but with hindsight, I wish we were selling BlackRock today at $650 as opposed to when we sold at the onset of this crisis. However, given the information we had, it was the right decision. I hope many of our shareholders who purchased BlackRock at that time have profited as that was always an option. We want to avoid a tax burden, face regulatory pressure, and concentrate on assets that are in our control. I still believe that having capital in this environment will be incredibly advantageous and open up many inorganic opportunities for us.

Which, to your point, there's a lot of game left to play.

Yes.

Do you have any other questions?

All right well, thank you everybody. We'll see you again in the fourth quarter.

Yes. Thank you.