Pinnacle Financial Partners Paying For Growth, But The Market Wants Margins (NASDAQ:PNFP)

I wrote back in November that while I thought Pinnacle Financial Partners (NASDAQ:PNFP) was a high-quality growth bank, the company’s business model was arguably out of step with a nervous market. Since then, the shares have lost another 7% or so of their value, lagging their peer group during much of that time (though a post-earnings move has helped close the gap).

Key concerns remain around whether the company has seen a peak in net interest margin, how the company will handle growth-oriented operating spending in 2023, and how credit will continue to evolve both for Pinnacle and the Bankers Healthcare Group (or BHG) consumer finance company in which it holds a 49% stake (and includes in its non-interest income as equity investment income.

I believe Pinnacle will remain an above-average grower throughout this more challenging period, and I like the company’s dual focus on high levels of customer service and hiring away productive revenue-generators from competing banks by offering them a more attractive work culture and compensation structure. I believe the shares remain undervalued below the mid-to-high $80’s, but I also think it will take time for the Street to warm back up on this name.

Weaker Core Results In Q4 Don’t Help The Bull Case

I like the long-term prospects for Pinnacle, but the short-term results in the fourth quarter did leave something to be desired.

Revenue rose about 19% year over year, but fell about 1% sequentially, missing by more than 3% (or more than $0.15/share). Net interest income was strong, growing 34% yoy and more than 5% qoq, beating by more than $0.03/share and outgrowing similarly-sized banks. Net interest income was driven by ongoing spread improvement, with net interest margin up 64bp yoy and 13bp qoq to 3.60%, as well as earning asset growth (up 1.7% qoq).

Non-interest income was the issue, missing by close to $0.19/share. Total non-interest income fell 19% yoy and 22%, with earnings from BHG down 48% yoy and 49% qoq as the business continues to put more loans on its balance sheet (as opposed to selling them and recognizing the gain in the quarter) and continues to reserve more against loan losses. Excluding BHG, non-interest income declined about 5% qoq.

Operating expenses rose 19% yoy and close to 2% qoq, adding back more than a penny per share. Pre-provision profits rose about 19% yoy but fell 4% sequentially, missing by around $0.14/share. The rest of the miss relative to sell-side estimates (about $0.15/share, for a total core miss of about $0.29/share) was from higher provisioning, taxes, and other below-the-line items.

Continuing To Drive Loan Growth, But NIM Has Likely Peaked

Pinnacle saw loan yields improve 150bp yoy and 81bp qoq (to 5.54%) this quarter, but while the Fed likely isn’t through hiking rates yet, banks like Pinnacle likely now have more to lose in funding costs than they do to gain in earning asset yield improvement. Pinnacle’s cumulative deposit beta continues to track up through the 30%’s, and is on the high side of its peer group (likely to end up averaging out in the high 20%’s this quarter). With this, I expect to see a gradual decline in NIM throughout 2023, with margin probably stabilizing around 3.45% – 3.50% unless the Fed is dramatically more hawkish (or suddenly more dovish) than I expect.

Pinnacle isn’t letting this stop its loan share growth (and loan growth) plans. Margins come and go from year to year, but strong business lending relationships can last across multiple cycles. Loans grew about 5% sequentially this quarter, which was comfortably above average for banks of similar size. Both C&I lending (up 5%) and CRE lending (up almost 4%) were stronger than average, and multifamily lending was up a very strong 21% in the quarter. I mentioned in my last article that I thought multifamily lending could be a near-term growth driver for Pinnacle, and that seems to be playing out.

As I mentioned above, funding loan growth will get more expensive. The bank’s 83% loan/deposit ratio isn’t ideal, and while the bank does have funding sources on hand (like securities and cash), non-interest-bearing deposits are likely to continue flowing away from the bank (though the 7% decline this quarter is shaping up a bit better than average). I don’t see Pinnacle pulling back meaningfully on lending because of higher funding costs, which puts it in a situation similar to that of First Republic (FRC) or SVB Financial (SIVB), with some analysts and investors fretting about these banks paying up for growth – even though I think establishing these relationships now will more than earn back their elevated short-term costs.

One area where I’m more concerned is the near-term outlook for BHG. In principle, BHG should be a differentiated online consumer lender. It lends to more affluent borrowers (medical practitioners and other skilled professionals) and the average FICO score of 733 for its customers is appealing. And yet, looking at the credit loss ratios that Pinnacle has provided, the losses don’t seem too different than that of major credit card lenders since 2020. BHG has definitely been a positive contributor to Pinnacle’s earnings and I’m not really too concerned about credit quality there, but with the business changing its operating approach (putting more loans on the balance sheet) and boosting reserves, I can see why this business remains a point of contention with some analysts and investors.

The Outlook

Although I expect a modest decline from fourth quarter net interest margin, low-to-mid-teens loan growth over the next two years will drive double-digit net interest income growth by brute force. This year won’t be anything special for BHG, but I expect a return to growth in 2024 and beyond (though likely not at the 20%-plus rates of the past.

Operating expense spending will get a lot of attention, I suspect, as management plans to add another 125 revenue-producers in 2023 after adding 147 in 2022. Pinnacle has been actively recruiting productive loan officers from Truist (TFC), First Horizon (FHN), Wells Fargo (WFC), and Regions (RF), and while I would expect the pace of those defections to slow, Pinnacle obviously offers something that a lot of loan officers working for larger banks want. I don’t expect Pinnacle to meaningfully slow hiring unless the economy really tanks, and I think that will add a little negative pressure to efficiency ratio over the next couple of years.

A lot of what I’m saying may sound negative, and I suppose in the short term some investors will see it that way, but I think it’s well worth mentioning that I still believe Pinnacle will grow pre-provision profits at a double-digit rate over the next two years, and I can’t say that about very many banks. Likewise, I expect core earnings growth in both FY’23 and FY’24, though at a below-trend pace. Over the long term, I believe Pinnacle can grow core earnings at a high single-digit rate (around 9%).

Between discounted core earnings, ROTCE-driven P/TBV, and P/E, I still think that Pinnacle is undervalued, with the former supporting a near-term fair value near $90 and the latter two supporting a fair value closer to $87 (with P/TBV (1.8x) closer to $80 and P/E (12.5x ’23 EPS) closer to $93).

The Bottom Line

Pinnacle does have cycle risk here. I’m not terribly worried that Pinnacle is putting a lot of bad debt on the books just to burnish the growth numbers, nor am I expected a particularly bad slowdown/recession across 2023/2024. On the other hand, I do still see elevated risk to spreads here from higher deposit costs, and funding Pinnacle’s target growth (in terms of deposits and opex) could get more expensive than I currently expect.

Investors want more cautious, conservative banks right now, particularly those with positive operating leverage and bulletproof core deposit franchises. Pinnacle has neither and that’s likely going to be an issue for sentiment in the short term, but sentiment will eventually shift as the Fed ratchets down its rate hikes, and I think Pinnacle’s long-term potential is worth taking on some near-term risks.