Pinnacle Financial Partners Inc (PNFPP) 2014 Q2 法說會逐字稿

Good morning, everyone, and welcome to the Pinnacle Financial Partners second-quarter 2014 earnings conference call. Hosting the call today from Pinnacle Financial Partners is Mr. Terry Turner, Chief Executive Officer, and Mr. Harold Carpenter, Chief Financial Officer. Please note Pinnacles' earnings release and this morning's presentation are available on the Investor Relations page of their website at www.pnfp.com. Today's call is being recorded and will be available for replay on Pinnacles' website for the next 90 days. (Operator Instructions).

Before we begin, Pinnacle does not provide earnings guidance or forecast. During this presentation, we may make comments which may constitute forward-looking statements. All forward-looking statements are subject to risks, uncertainties, and other facts that may cause the actual results, performance, or achievements of Pinnacle Financial to differ materially from any results expressed or implied by such forward-looking statements. Many such factors are beyond Pinnacle Financial's ability to control or predict and listeners are cautioned not to put undue reliance on such forward-looking statements. A more detailed description of these and other risks is contained in Pinnacle Financial's most recent Annual Report on Form 10-K.

Pinnacle Financial disclaims any obligation to update or revise any forward-looking statements contained in this presentation whether as a result of new information, future events, or otherwise. In addition, these remarks may include certain non-GAAP financial measures as defined by SEC Regulation G. A presentation of the most directly comparable GAAP financial measures and a reconciliation of non-GAAP measures to comparable GAAP measures will be available on Pinnacle Financial's website at www.pnfp.com.

With that, I am now going to turn the presentation over to Mr. Terry Turner, President and CEO.

Good morning. For roughly 2 1/2 years, we have been discussing our strategic approach to growth and profitability. Essentially that we'd grow our balance sheet primarily in the form of loans at an annualized double-digit pace for a period of three years while growing noninterest expenses at a substantially slower rate, which was intended to result in dramatically improved profitability as a result of the operating leverage that that provides.

So, again, this morning, I thought I would start with the dashboard that provides a simple snapshot of how that strategy has worked through the second quarter of 2014.

As you can see on the first row of graphs, we are getting outsized balance sheet growth in the form of average loans, up 9.9% in the second quarter of 2014 compared to the same quarter last year. You can also see that we have increased average transaction counts by 17.3% during that same timeframe. So the transaction accounts now represent 47.8% of total deposits. And by the way, DDA's as a subset of transaction accounts are now 29% of total deposits.

That is real franchise value in my opinion, growing loans organically at a double-digit pace and then growing transaction accounts organically at an even faster rate.

And lastly, even after having initiated a dividend payout in December of 2013, we have been accreting both regulatory and book capital with tangible book value per share up 13.7% year over year, which is generally highly correlated to share price increases.

On the second row of graphs, you can see further evidence that we have been able to translate that balance sheet growth into real earnings growth, with organic revenue growth just under 9% year over year in the face of pretty stiff volume and margin headwinds. Fully diluted EPS was up 16.7% year over year. I will also add that net income is up 20% year over year. Our return on assets climbed to 1.21% and our return on tangible capitals climbed to 13.5%, both records for our Firm.

And then on the third row of graphs, you can see the dramatic improvement in asset quality over the last several years which continued through the second quarter and has provided meaningful credit leverage for our Firm over the last few years. And as you can see the slope of the allowance recapture to date is not nearly as steep as the reduction in non-performing loans. The allowance covers non-performing loans, a whopping 427%.

So consequently, we anticipate that we will continue to have meaningful credit leverage throughout the remainder of 2014 and 2015 as our loan portfolio continues to produce consistently strong asset quality metrics.

In terms of our published long-term growth targets, we have also been highlighting this chart since January 2012. It was our belief at that time that our then-existing relationship manager, plus several new sales associates that we intended to and indeed did hire, had the capacity to produce approximately $1.27 billion in net loan growth over the three-year period beginning in 2012.

In this chart, we are plotting the actual production to date against that three-year target that we outlined more than two years ago. In total, during the first 2 1/2 years since we announced our three-year loan growth target, we have added a total of $1.02 billion, which equates to a CAGR of 11.5%. Based on these results, we still expect to meet or exceed our three-year target barring any economic event that would warrant a significant reduction in business activity.

So I am generally pleased with our second-quarter 2014 effort as we continue to take market share and produce outsized growth in net loans and DDAs. We continue to grow revenues and we continue to advance our ROAA and ROTCE, consistent with the approach to operating leverage that we have been talking about now for 2 1/2 years.

With that, I want to turn it over to Harold now to review in somewhat greater detail the results of the second quarter.

Thanks, Terry, and good morning, everyone. As Terry mentioned, we still believe our three-year loan target is within reach by year-end 2014 and anticipate that our relationship managers will produce outsize loan growth in the second half of this year.

We have said it many times. Net loan growth will be lumpy between quarters and that we will not achieve our loan growth targets on a straight line. That said, we remain very pleased with the energy of our salesforce as new loan originations during the second quarter equated to almost $459 million, which is the highest originating quarter since the end of 2012.

Our markets remain stronger than many others and our relationship manager is very much out in the market discussing capital needs with their clients. Although it is early in the quarter, our pipelines are strengthening, thus providing the source of our optimism for the remainder of 2014.

As for the red bars, we expected and encouraged significant levels of payoffs during the second quarter. As most of you know by now, this has been the most significant headwind for us and the achievement of our net loan growth targets.

To sum it all up, based on discussions with our relationship managers and their line leadership, we are looking forward to having another good quarter of loan production during the third quarter of this year.

On last quarter's conference call, we mentioned there would likely be some decline in the margin in the second quarter of 2014. We saw decreased margin results for several reasons, but primarily because the number of days in the first quarter of any year is typically a margin booster and we also experienced reduced loan and investment yields in the second quarter. We continue to believe our margin will remain within a 3.70% to 3.80% range in 2014 and that it will be based on loan growth and maintenance of our loan yields as well as small decreases in cost of funds.

More importantly, we did see continued improvement in our net interest income run rates in the second quarter. We are reporting a record $47.2 million in the second quarter and believe we should see continued increases in quarterly net interest income throughout the remainder of 2014.

Concerning loans specifically as the chart indicates, average loans were $4.25 billion while EOP loans were approximately $64 million greater than the average balance, signaling that we are hopeful to see average loan balances continue their quarter-to-quarter increases as we head into the third quarter.

As to loan yields, we are still in a very competitive loan pricing environment. Our average loan yields did decrease modestly from 4.3% last quarter to 4.27% this quarter. Although it was a decrease, we were pleased with that result. We remain hopeful that loan yields have stabilized somewhat at least for the remainder of 2014. We may or may not be at the bottom, but it does appear to us we have reason to have continued optimism about loan yields for the remainder of this year.

Concerning balance sheet positioning, there's a lot of disclosure about asset and liability sensitivity these days, and many banks have structured their balance sheets for quite some time with a view toward asset sensitivity. That said, our fundamental belief is that we should work towards neutrality, but this rate environment has been unusual and somewhat long-winded.

Over the last few years, we embarked on selected strategies to help mitigate the impact of any sudden, unforeseen and meaningful increases in rate. As an example, we have reduced our dependence on fixed-rate bonds from approximately 22% in assets a few years ago to around 13.5% this quarter, which seems about where we will stay. We were fortunate that we had loan growth to lean on in which to invest those bond book cash proceeds.

Secondly, last year, we executed a fixed rate cash flow hedge on future federal home loan bank borrowings, which will begin in the second quarter of 2015. Thus, we have locked in approximately $200 million in future funding costs over the next five to seven years at a rate of approximately 2.1%. Both of these tactics were executed with a view toward interest rate neutrality.

Two things have impacted our ability to be more interest rate neutral from a lending perspective. We have been talking about our loan floors for years. We are fortunate to have relationship managers that can garner loan floors, and we believe we have a significant amount of loan floors on our floating-rate loans in comparison to other banks which is a great, great thing.

We had believed that over time the value of our floored loan book would decrease due to market forces and it has, to some extent. As of June 30, we have approximately $1.3 billion of floating-rate loans on our books with an average difference between the floor rate and the contract rate of 72 basis points. That equates to over $9 million in earnings annually.

The absolute level of floored floating-rate credit has not moved significantly over the last few years, but we have seen some decrease in the difference between the floor rate and the contract rate as this difference has decreased from 133 basis points in December 2010 to what it is today.

The other item, which is no real surprise, is that increase in fixed-rate lending that has occurred in the marketplace over the last few years. Our fixed-rate lending with a maturity greater than two years has increased from 31.2% to 34% of total loans, almost a 10% increase in allocation to the fixed-rate loan portfolio. As rates increase and eventually normalize, we believe that clients will be looking at the floating- versus fixed-rate algebra with more objectivity and will likely -- we will seek the percentage of fixed-rate loans decrease as clients opt for the cheaper floating-rate alternative.

Before I start talking about deposits, there are numerous tactical initiatives available to us to create a more interest rate neutral balance sheet and we will continue to explore these matters in time. However, our key focus is to continue to attract customers to the Firm as we believe more customers create more opportunity to position our balance sheet, regardless of the interest rate cycle and, thus, enhance shareholder value over the long term.

As to deposits, again, here in the second quarter we were able to continue our lowering of our funding costs. We have mentioned for several quarters that our pace of reduction will slow and it has in fact done that. We continue to believe we have an opportunity to continue our gradual reduction in cost of funds for the remainder of this year. It will require another significant effort on the part of our relationship managers to accomplish other reductions, but we have believe -- reason to believe they can make it happen.

As to deposit balances, we continue to grow our non-interest-bearing deposit business which we believe may be the most valuable product in our bank and that our business strategy continues to work with, year-over-year average non-interest-bearing demand deposit balances are now up 18.8%. These are core operating accounts that we intend to keep, regardless of the rate environment.

Many believe that as Fed Funds rates increase next year, the high-growth banks may see stress on their deposit costs in order to hold onto their funding, and I believe that may well be the case. We continue to explore the stickiness of our deposit balances, particularly our operating accounts. Despite the fact that some money will undoubtedly find a higher yielding home [are] used to fund some business investment, we believe we are relatively less vulnerable because we continue to grow transaction accounts organically at a pretty rapid pace, both in terms of numbered accounts and balances. We also believe we are less vulnerable to deposit volatility as the bulk of our deposit business is commercial, not consumer, thus we believe our deposits are impacted by -- more by the seasonality of a particular client's cash flows and not necessarily rate volatility, whereby consumers may want to purchase higher-priced [home] deposits or seek other non-bank investments with higher returns.

Again, concerning balance sheet positioning and our effort to work towards neutrality, the best good news is that growth we have experienced in non-interest-bearing deposits. We continue to emphasize the value of depositors to our relationship managers ever since we started this Firm and continue to believe it will again be a significant driver of the core value of our franchise.

Now as rates rise, just like loans, there are literally hundreds of volume and rate assumptions built into our deposit areas in our models. On those assumptions we think we are being conservative, but no bank will know until the short end of the curve heads north and we get back to a more normalized operating environment. What we do believe is that deposit gathering will be the fundamental challenge for us and all high-performing banks over the long term.

Switching now to non-interest income, our second-quarter core fee income was up 3.9% over the same quarter last year. Service charges were up primarily on volume growth and a number of accounts and related fees. If you think about the long-term profitability targets that we have set for each major element of the P&L statement, for the algebra to work, it is critical that we grow our fee income as fast as we are growing our loans and deposits. We think we can continue to do that in our fee businesses.

Wealth management was down this quarter compared to last quarter, due primarily to insurance contingency fees received in the first quarter. The decrease in wealth management was offset by meaningful increase in mortgage activity as homebuying picked up in our markets during the second quarter.

As we mentioned last time, we also have several tactical items aimed at interchange (technical difficulty) credit card that we hope will boost these fee businesses in 2014. We had experienced a year to date 6% increase in the number of debit cards from the end of last year while net interchange revenue was essentially flat at $1.62 million in the second quarter of 2014 with the same quarter last year.

As to credit cards, the number of cards is up 11.2% from the end of 2013, while credit card interchange is up 500 -- up to $547,000 for the first half of 2014 or almost 40% greater than the $393,000 for the six months of last year.

The key tactic is to get cards in the hands of clients and encourage clients to use them which our consumer bankers are all about doing. Our Titan sponsorship will afford us another opportunity to increase consumer debit card issuances with football season fast approaching.

Now as to operating leverage, our core efficiency ratio remains at 56.3% excluding ORE expense, consistent with the fourth quarter of 2013 and the first quarter of 2014. We believe our efficiency ratio as it stands today compares favorably to most peer groups, but we also believe we can do better.

Second-quarter expenses came in about where we anticipated. As far as the remainder of 2014 is concerned, we are likely to see modest increases in our 2014 expense base, given we expect to continue to hire people. We hired nine new revenue producers thus far in 2014 with most of those during the second quarter. We are excited about the significant adds we have made in our Knoxville footprint this quarter and have correspondingly increased our optimism for that market.

We continue to have great confidence in the senior leadership of this Firm and they will continue to find appropriate ways to increase the operating leverage of the Firm.

Terry mentioned our expense asset ratio which we calculate at 2.38% for the second quarter. As we have stated for the last two years, the primary strategy is to decrease and to ultimately achieve our long-term expense to asset ratio target will be growing the loan portfolio of this Firm with a corresponding increase in operating revenues and earnings.

As it sits right now, we need slightly more than $200 million in additional assets for our expense to asset ratio to be at the high end of the targeted range. Thus, we believe we are getting within reach of our target provided we remain disciplined on expense growth, which we fully intend to do.

Finally, our adjusted pretax pre-provisioning increased to $26.2 million in the second quarter of 2014, up from the $25.6 million in the first quarter, a linked-quarter increase of 2% which equates to a healthy annualized growth rate of almost 8%.

With that, I will turn it back over to Terry to focus on our outlook for the future.

Thanks, Harold. Rightly so, most quarterly earnings calls focus on quarterly earnings, but since I personally really focus more on long-term value creation, I would like to take just a few minutes to provide some insight into our future outlook. So, here is what shapes our outlook.

First of all, as we have for most of our existence, we continue to target and consistently deliver top quartile returns. Secondly, we truly are in advantage markets. Thirdly, we are uniquely positioned to take advantage of the persistent dissatisfaction that continues among business clients at our competitors'. And, lastly, we are positioned to protect our client from competitor encroachment despite high willingness to switch among business clients.

Most of you are proxy readers. Most everyone's favorite section is Executive Compensation. For those of you that have been following our CD&A, you know that in addition to the asset quality threshold, our executive compensation is linked to producing top quartile revenue and EPS growth among our peer group. And, by the way, for most return metrics, our peer group outperforms the industry at large. So that results in high targets and it results in dogged execution. I believe that approach to establishing an ongoing performance targets is tightly linked to shareholder returns.

I indicated earlier that it is our expectation that we will meet or exceed the three-year growth target we disclosed 2 1/2 years ago and that hopefully by the fourth quarter this year, in addition to achieving our target at ROAA, we should have each of the four components. The NIM, the fees to assets, the expenses to assets, and the net charge-offs -- all operating better than or within the targeted range.

Those targets were originally established in July of 2011 in conjunction with our 2011 to 2013 strategic plan. So this summer, as a part of the 2014 to 2016 strategic plan, we have actually increased the target range for ROAA to 1.20% to 1.40% and fees to asset target range to 0.80% to 1.00%. We will continue to report against the originally disclosed targets for the remainder of 2014 and actually begin reporting against these updated targets with the 1Q 2015 earnings release.

So in short, our outlook and our aspirations for returns have increased.

I won't take time on this call to read each of the recent accolades for our markets, but it seems apparent to me that we are blessed to operate in markets that offer potential for outsized growth.

Most buysiders I talked to want to focus exclusively on financials and frankly on short-term financials, but if I can be honest, this is the stuff that really turns me on. It seems to me to offer the greatest insight into sustainability of our growth; nationally, according to Greenwich and Associates, 38% of businesses are currently willing to consider switching. Think about that.

Among businesses with sales from $100 million to $500 million, nearly 40% are in play. That is an astounding number. Fortunately in our markets, we are the best positioned to capitalize on that dissatisfaction.

Starting on the left side, you can see the primary reasons for small businesses, ones with annual sales from $1 million to $10 million, switch. As an example, the number one reason is that they are unsatisfied with their relationship manager. 25% of those that switch leave for that reason. Again, that is national research.

Now, in the middle of the slide, you see how our national base clients rate our actual performance. We get better scores on our relationship managers than any of our major competitors get on theirs. We rank number one in the market. And so you can just go down the page and see that Pinnacle really is best positioned to capitalize on this high willingness to switch among small businesses, component by component.

On the right side of the slide, you see the top reasons that midsize businesses switch. We are talking about those with annual sales from $10 million to $500 million. And as you can see, the reasons for switching are generally the same as they were for small businesses. However, the relative rank of importance is slightly different.

But the conclusion is the same. Pinnacle is best positioned to capitalize on this high willingness to switch among midsize businesses.

Many believe the economy may be picking up, but I think virtually everybody still agrees we are in for a relatively slow growth economy for quite some time. It is my belief that it is going to be hard for many banks to grow in this kind of environment. But we believe, based on third-party research, that we provide a distinctive alternative for what matters most to businesses and, therefore, should be able to continue [RapidShare] movement since nearly 40% of business clients are willing to switch.

Of course, that willingness to switch stat that should concern every business bank. We see some banks who run these hard-driving sales cultures that failed to advance market share because clients are running out the back door as fast as they can bring them in the front door. But here is more data that lead us to believe that our net share movement should exceed competitors due to our high client retention rate.

As you can see our clients' overall satisfaction with us is better than that of our competitors'. They view us as easier to do business with than our competitors' clients view them. A greater percentage of them believe that we value long-term relationships than do our competitors' clients. And their loyalty to us is higher than the clients by our competitors.

So, there you have it, our rapid growth strategy to create meaningful operating leverage is working as we had hoped. In 2Q 2014, we produced double-digit growth in EPS, loans, DDAs, and tangible book value per share.

At this point it looks like we should hit our three-year growth targets and reach our long-term profitability targets. And our aspirations remain high, looking forward, based on the fact that we are an advantage market and the fact that we appear best positioned to take advantage of this strong willingness among business clients to switch where nearly 40% are at play.

Operator, I will stop there and we will take questions.

(Operator Instructions). Jefferson Harralson, KBW.

I wanted to ask you about the nine new producers. Maybe you can go through who they are, where they came from a little bit and maybe be specific if possible on your new senior Knoxville hire.

Okay. Just trying to talk through the nine revenue producers, one would be a meaningful revenue producer in our trust business and one would be a mortgage originator. But generally, the remainder would be involved in the mainline banking business. A couple would be office leaders, branch managers. You may know we are opening a new office in Knoxville prior to year-end. And the remainder would be financial advisors or relationship managers as you would think about them.

I think in terms of geographically where they are located, that group of nine would have a greater concentration in Knoxville than in Nashville. I think Harold mentioned in the call that we had some great hires in our Knoxville market during the quarter and I think, as we think about our growth, the Knoxville market we are still in the early stage growth cycle there. And so, we are excited about the hiring that we are doing there. And it was borne out in those hires that occurred during the second quarter.

Jefferson, as you alluded to, since the conclusion of the second quarter, we have also announced a meaningful hire in Knoxville, Missy Wallen. There is a press release that went out day before yesterday on Missy.

Missy was BB&T's State President for Tennessee. She retired there roughly a year ago and so we have hired Missy. She will join Harvey White and Mike DiStefano, who have been running that market for some time, is an executive leader there. She will have primary responsibilities for our client service group.

There is not an exact parallel to other banks, but generally it would be most highly correlated with the retail bank. And, but, we are excited about Missy and believe that she opens great client opportunities and further hiring opportunities in that market. So, Jefferson, I hope that is helpful.

Definitely helpful and I appreciate that. I want to ask my other question on ROE. As your profitability is increasing, it is harder to deleverage the capital and your capital is growing. It just grew a little bit here from a TCE standpoint. Do you plan on just using a higher dividend over time to keep that TCE within a target range? Or do you think that the loan growth maybe picks up from here and generates a lower TCE from there? How are you thinking and planning about targeting that TCE and how you get there?

Jefferson, that is a great question and we get asked that quite a bit. We are mindful of our capital growth. We are mindful that we are accreting capital. We are also approaching Basel III. We have got some -- that will take down some issues, some capital levels with respect to regulatory capital.

As for the dividend, we are right now at about an 18% payout ratio. I think we have said for a long time we like 20 or thereabouts. So I think our Board is in discussions on that and we might could see our way to see doing something like that in the near future.

All right, thank you.

Will Curtiss, SunTrust Robinson Humphrey.

Good morning. On the margin it looks like the security yields came under some pressure. Can you talk a little bit about that and maybe the expectation after the remainder of the year?

Yes, Will, I think the securities portfolio, we have been working to reduce the duration of that portfolio in terms of maturity. And so, it came down. I think we are believing it will be fairly consistent from this point forward. So we don't expect to see those types of decreases going into the rest of the year.

Okay. A high-level question here. If you can, maybe provide us a little bit of an update on the national market and give us a sense for the growth that is occurring there. And also, maybe if there are any concerns that you see.

I would say that, generally, Nashville continues to be a hot market. We are just in terms of building permits, I think one of the things we included on slide 16 that would give you a sense for what is going on here, building permits in the most recent fiscal year here in Nashville set a new record. So they exceeded back in the 2006, 2007 period and I think that would speak for itself.

Our gross metropolitan product rose 4.2%. That is the second highest out of the top 100 largest metro areas. We talked about and we generally include some slides in the Appendix there that give some sense of what is going on in residential real estate markets, both in terms of median price and home sales and inventories and inventories are way down. And also to job growth. Job growth continues to be very strong in the national market.

So, again, we are -- as I said in my comments, we are blessed to be in a great, great market and if you start trying to figure out what could go wrong in Nashville, I think healthcare is a meaningful part of our economy here. And that is a volatile area. There are lots of changes, winners and losers in that sector change, but my own belief is that this country is going to spend more on health care going forward than it has thus far.

So how the rules shake out and who all the winners and losers are may change. But I don't think that health care is going to decline. And, so, again, our outlook is very bright.

I will just add a little bit. The city put out -- and take this, it came from the city -- that downtown is short 3,000 hotel rooms today because of the opening of the Convention Center. So we are not big hotel lenders, but we do bank the concrete companies and we bank the engineers and we bank all the people that tend to help facilitate those hotels.

So we think that we are in a pretty good spot and that we should see continued growth here, both in Knoxville and Nashville. But Nashville looks to be a pretty good spot right now.

Thanks, that's helpful. The last one I had was I know you had a slide on the updated return targets, but just curious as you get closer to the end of the three-year long-term plan, how you are thinking about the next phase of the Company.

I would say that our approach has not changed. When I try to crystallize what is it that our Company does, we like to be in urban markets that are dominated by large regional banks that are vulnerable and really try to hire the best bankers in the market and take their clients and move them from their previous employers to here.

So I cannot imagine that we are going to go away from that. I think we have expressed for quite some time that we believe that we are still in very early stage growth in Knoxville, which is a great market for us. We also like other urban markets in Tennessee, particularly Chattanooga and Memphis.

So, we believe that there is a lot of geography for us to continue to do exactly what we do which as I say is get up underneath large regional banks who are vulnerable, and take clients and associates.

All right, thanks.

Michael Rose, Raymond James.

Good morning. I wanted to drill into the ROA guidance, that you raised. Wanted to get a sense for how higher interest rates play into it. Some of what you talked about, Harold, on the FHLB side and some of the fixed and floating loans and then what you are assuming for loan growth potentially over the next couple of years. So basically, what would cause you to come in towards the lower end of the range and what would drive you to come in towards the top end of the range? Thanks.

Yes, Michael, our interest rate assumption is probably consistent with just about everybody we are hearing about. And that is that the steepness of the curve will eventually flatten over the next three years. We think the second half of 2015, we have got built into our modeling an increase in the short end of the curve.

So whether that happens or not, I don't know, but what we are trying to do with respect to our balance sheet is build more neutrality. That was the whole purpose of the $200 million we did on the Federal Home Loan Bank advances, because that essentially locks in funding on a fixed rate which is something you do with a view towards asset sensitivity.

So that is that. As far as where we think our loan growth will grow in the next few years, we have gone through our strategic planning exercise, we think we are in great markets. We think we have great lenders. We think we produced good, if not great, net loan production over the last several years. And so I would not anticipate, if I were in your shoes, and knowing this firm that we would anticipate any reduction in our anticipated volumes.

Yes, I might just add to that. I think the -- you know, we -- I guess over 2 1/2 years now we have been pretty transparent in terms of helping people understand our Company, talk about what the gross is going to be, and what the return on the gross is going to be. So it is pretty simple.

And I think what we are trying to do with updating the profitability model, if you will, is really just to say that our outlook today is that we can produce higher returns than we have in the past.

I have already had a number of people say, okay, well, tell me what the gross is going to be. And I have tried to say a number of times over the last few quarters, I probably won't do that again that we did that at a time that my view was that the Firm was severely undervalued. And people underestimated what our capacity was to grow the core earnings and so I felt obligated to provide a little more insight.

But having said that, I don't want to get into how many people am I going to hire and all those kinds of things.

The basic model that we disclosed 2 1/2 years ago is the same. In other words, we have been hiring since we said that and so we believe we have today, on our payroll, capacity to produce a large volume of loans. And I am hopeful that if you ask me that question two years from now I am going to say yes, well, I have been hiring in the last two years and I have on my payroll today capacity to produce a large volume of loans.

So while we won't be specific about the targets just because it gets too confusing over time to keep everybody updated, are you talking about the number you said last time or next time. Again, I think you ought to have an expectation that the basic thesis is we hire relationship managers generally from large regional banks, ask them to move their book of business and we have hired a good number of relationship managers and produced a good amount of capacity since we gave those previous numbers.

Okay, that is really helpful. And one follow-up. You mentioned in the press release that you expect credit leverage to continue through next year. How should we think about reserved levels in light of continued ongoing growth? You guys are at 1.55% reserve to loans at this point. You have been as low as the low 1% range. Not that we are necessarily going to go back there, but how should we think about reserves, release, or credit leverage from here? Thanks.

I will just tell you how we think about it. What we are going to do is we are going to track trends in potential problem loans. We are going to track trends in non-performing loans. We are going to track our charge-offs. We go through all of the algebra with migration models and all of that kind of stuff to come to the eventual numbers.

But I think what we have is a view that the asset quality of our firm will continue to improve and that that should correlate to credit leverage probably in a rate and pace that is likely to be consistent with what we have experienced over the last few quarters.

Now where the absolute bottom is, and where we stop, I am not sure. Like you said, Michael, we got down into the low 1% range. I think this is like you are inferring a new time, that is unlikely that we will get down that far, but at 1.55% today, we think we still have some room to go.

Great. Thanks for taking my questions.

[Stephen Fountain], Sandler O'Neill.

Good morning. If I could follow up one additional question on the credit cost. Specifically with the OREO expense, which was a good bit lower, is that a decent run rate there or were there potentially some writeups to some of that book within that number?

Could you repeat the question?

Yes. Just in terms of the carrying cost on the OREO. It looked like it was maybe about $226,000 down from call it $650,000 the previous quarter. I mean is that a decent run rate from here? Is that what it is going to cost to carry the remaining OREO or were there some valuation adjustments in there that brought that number down?

I don't think we had any meaningful appraisals come in on ORE property this time. I just don't think there was a lot of movement. We had hoped that there's a pretty significant piece of ORE that is down in Rutherford County that we had hoped we would try to get removed from the book this quarter. But I think those negotiations are still continuing.

So we are hopeful to see some more meaningful declines in that book here in the third quarter, Steve. But I am not sure and I apologize. I don't think we had any meaningful ORE transactions at all this quarter.

Okay, fair enough. And with that remaining book I guess I saw in your presentation its fair value is maybe 161% of the book value currently. Does that lead you to try to more rapidly dispose of those properties, given that you might be able to take some gains on the disposition?

Yes, I don't think -- I think the pace of our disposition of ORE properties, I think we still have a lot of energy there. But I don't think we are where we were say three to four years ago where the first offer was the best offer, and we took that offer. I think what our guys in special assets are doing now are being a lot more diligent on finding the right buyers for those properties and trying to secure, not the best price, but a better price for that property.

Steve, I think it probably works the opposite of that I think because of the core earnings capacity of the Firm and the fact that problem assets including OREO are at relatively low levels. It gives us lots of flexibility and it probably lengthens the whole time as opposed to (multiple speakers) the whole time. Yes.

Makes sense. And looking at loan growth, I saw where you put in a slide about the pace of paydowns and obviously those were significantly elevated again this quarter.

Is that more heavily weighted towards CRE? Is that what led the growth being more weighted towards C&I than CRE this quarter? And on that is there anything that you can do to mitigate the effects of future elevated paydowns or is that it is what it is and that's the business environment?

First of all I think we do see large paydowns and have over a number of quarters in two principal categories, CRE and C&I. I think in the case of the CRE, generally what happens there is you are being taken out by more traditional and perhaps better providers long-term financing for commercial real estate, insurance companies, REITs and the like. The markets are wide open for low fixed-rate, nonrecourse lending and so you do get payoff in commercial real estate.

We have talked about before probably the thing that's more astounding in this period of paydowns is the volume of C&I paydowns, and they are largely motivated by companies that are exiting owner managed businesses that are selling their companies generally to some financial buyer or many that are doing recaps.

There is a -- you have owner managed businesses are generally run by baby boomers who have been looking for an exit for some period of time. And, through the recession, there was no exit. So you have got this pent-up demand of folks looking for an exit and that is matched against an unusual supply of private equity money. There are huge pools of money out here, chasing very small companies to either recap or take them out. And so, we have seen an unusual volume of paydowns from that angle as well.

I think in terms of our opportunity to mitigate, I am not aware of what our opportunity to mitigate is. Again, I suppose we could take on greater interest rate risk and greater credit risk to scotch the paydowns in commercial real estate, but in the case of the C&I paydowns, I am not sure there's much that can be done there.

Okay, thanks. I appreciate you taking my questions.

Kevin Reynolds, Wunderlich Securities.

Good morning. Couple of questions. Most of my questions have been answered. It is more market-based questions about how things are going right now and what your outlook is.

First, that Volkswagen announcement in Chattanooga. Do you think that -- does that change your outlook? I know you mentioned that as a market that you are attracted to longer term. Do you think that might accelerate any activity you have headed that way or any discussions? I will let you talk about that. I don't want to put words in your mouth.

And the next question I had after that was on the housing market locally here. It looks like a month of supplies now below 4. I know prices aren't necessarily gapping higher on homes, but do you -- how nervous do you get about the housing market here? What is driving it? Is there any speculation creeping in and how is it playing out with the residential builders around town?

Okay. I think, as it relates to Chattanooga, Kevin, I think my answer would be that the Volkswagen announcement does not increase our interest in Chattanooga, but I say that because our interest is high and we have tried to communicate that in the past. So, we have --.

Kevin, you have known our Firm a long time. In the early days we did not talk much about Chattanooga, we always talked about Knoxville, Nashville, and Memphis. But over the last several years, we have added Chattanooga to the list and it is because there are a world of good things going on in that part of the state.

There's lots of growth down there that Volkswagen was a catalyst for, but there's a ton of good things going on down there. And so we like that market a lot and so my comment about it not necessarily increasing our interest is just to say that we have now for several years had a very high interest in Chattanooga because we think those kinds of things will continue to happen there.

On the Nashville real estate market and the shrinking inventories, I think the -- I guess sort of look at the whole MSA. The closer you get to City Center the more difficult it would be to find land to develop for residential housing, single-family residential housing. So a lot of inventories are low in addition to home inventories being so close to town. But as you move further from City Center and you go into contiguous counties to Davidson County and then the outer loop of the MSA, there's still lots of real estate to be developed. So we are not particularly concerned about whether or not lot inventories will exist. They may not exist in Davidson County, but they exist in the MSA.

I think in terms of what is going on among in the construction sector among contractors, home builders and so forth, we still do not see a lot of speculative building. We don't see -- honestly we don't see a tremendous amount of development going on. I think -- I don't think it is constrained by lending. I think it has been really constrained by the risk takers in the market, developers and builders and so forth. So that would be my thought about it.

And a follow-up on the Chattanooga comment, or the views that you have. If you were to enter Chattanooga, I know that you have had this business model from day one of lifting out the experienced lenders and maybe even teams of folks as you have talked about doing in places like Knoxville and -- is Chattanooga a liftout market? Can you remind us of that or do you think it would be more of a small bank acquisition if it came [to pass]? How do you enter that particular market and is it different than maybe some of the others that you mentioned?

I think we -- I would say that our interest is balanced, which is just to say that we continue to understand and we continue to try to understand and find liftout opportunities and there are also targets there that we would have an interest in. So I could see us going to Chattanooga either through de novo liftout or through merger transaction.

We would like to be there. We are willing to go either way. It is just a matter at that point it is just about opportunity, where you find your first and best opportunities.

My last question and I apologize for asking so much here, but recently I noted that there was a report -- I believe it may be a Chamber report, but I could be wrong about that -- that projects that over the next 20 years or so the MSA population could increase by 1 million on top of the 1.8 million that is here right now and that brings a whole host of issues in terms of infrastructure and all.

Do you think -- if that is in fact if that -- if we are anywhere close to that playing out along those lines, do you think that that meaningfully changes the next 10 or 20 years for a company like yours? And the reason I ask is in the past we have asked you how much can you grow inside this market. You are already number four market share, maybe better than that on the commercial loan side of things. And I know you had mentioned the kind of market share you have achieved at First American back in the day and how much room you had to get there.

Does -- is the going forward environment materially better than what it was back then? If we still see that kind of inflow of population over time?

Yes. I think -- you know this. We are excited about the Nashville market. We are excited about the prospects. Literally, I can't imagine a place I would rather do business. Again, I am not a Texan, I'm a Tennessean, but Nashville is a fabulous market, growth prospects are good. And we expect to be a beneficiary of that.

In terms of our ability to grow share as you mentioned, you look at FDIC deposit share we have a number four position. If you look at Greenwich business share, in other words, clients and sales from [1] to $500 million, we have a number one share. And, so, I think we have been getting questions for quite some time about how big can you grow, how much share can you take.

And I don't know what the answer to that is, but I will tell you that data would indicate that we are taking share faster today than we ever have. And so you are ? it is a correct thought that at some point there is a limit. You are probably not going to have 50% market share or something like that, but the fact that we are currently taking share faster than we ever have would tell me there's still significant running room because it would certainly slow down before it stops. And so, even slowing down it would be a meaningful growth opportunity here.

So, I think I honestly -- we talk about the size and growth dynamics of the market, certainly we benefited by a large market that grows rapidly. But if you ask me, Terry, what do you mainly think about, I think more about the competitive landscape than I do the size and growth dynamics of our market. That has really been the gift that keeps on giving.

And then when you match that idea with the fact that 40% of businesses are willing to switch, 40%, Kevin -- I mean that is a lot of opportunity of business owners who are willing to switch their bank.

So, anyway, I don't mean to just ramble on, but I am excited by the growth dynamics of this market and I can't imagine that that is not going to be a great thing. But again, what I like best is the competitive landscape.

Okay, thanks a lot. Good quarter.

Thank you.

Brian Martin, FIG Partners.

Most of my stuff has been answered, maybe one housekeeping question, Harold. On the fee income side, the other category was down a fair amount linked-quarter and maybe on the press release you talked about vendor rebates. Is there anything that is seasonal with that? Was that the biggest component of that or just that level? And then maybe the second one was on the expense side, are most of the new hires you talked about outside of Missy included in the run rate for the -- for the second quarter?

Yes, on the fee side, other fees did go down because of those matters we talked about in the press release. As far as a run rate, we think we are going to -- the second quarter is probably a good base for the run rate. We ought to see growth in that going forward. Mortgage -- depending on where mortgage goes, but we are looking at third quarter on mortgage and think they will have a pretty good third quarter as well.

So I think the service fee line will grow. I think wealth management will grow. I think mortgage may be the one that may be more volatile as we go towards the end of the year.

On expenses, salaries did go up only about $23,000. I think most of the nine people that we hired, the revenue producers were largely hired throughout the second quarter. I think if you had to average it all out, so give me a lot of latitude here, Brian, but probably you are looking at about half the run rate in the second quarter going into the third quarter. If that makes sense.

Yes, that's helpful. Thanks, Harold.

Peyton Green, Sterne, Agee.

Good morning. I was wondering maybe back on the commercial real estate payoffs, would you expect that to still be -- commercial real estate to still be flat? Or would you think that a lot of payoff activity has happened as insurance companies have reentered the market and now improved market conditions might drive volume? Or maybe if you could differentiate between the production versus the payoffs on the CRE end.

Yes, I think -- I don't know what is going to happen, but it would seem to me that CRE as a percent of the loan book ought to accelerate. Which, I guess, is a way to say that I believe that the gross production is going to exceed the payoffs and at that category it will happen faster there than the total loan book will grow.

Okay. So you don't see anything long term that says it can't remain at a relatively consistent mix of a portfolio?

No, I don't. In fact I would, again, I am not trying to give you an answer of what is going to happen in the next 30 days, but I would think over time commercial real estate would probably get a bigger slice of our total loan book than it has today.

Okay. In terms of Knoxville, what is the current loan and deposit base? And I don't even know if you look at it this way, but what would the ROA contribution be from them?

Yes, I don't have it with me, but the loans -- we have talked about the loans in Knoxville on several occasions. We think we are around $700 million or so in loans. In Knoxville, their deposit base is still growing. So their loan to deposit ratio would be well over 100%, but we are real pleased with where they are with respect to their deposit generation.

You factor that through a contribution model and you get down to it, I don't know, Kevin, I would have to do -- not Kevin, Peyton, I would have to do some more scratching on that one to figure it out. But they have got roughly call it 25% of our loan book over there. So I would say I would say you could probably equate that across the board. 25% of our earnings.

Okay. And is it -- the outlook for the Knoxville market, as you have gotten to the productive capacity and so that is the reason for the additional hires or you would have hired these people two or three years ago, they just happen to come available closer to now? Is that -- how should we think about that?

Yes, no, it is about availability in mass and the market. Both of those things are important, but it wasn't that we were sitting, waiting for the right time to hire them. We would have hired them two years ago if we had had the opportunity. I think you know this, a lot of our recruiting, we still hire people. One of the people that we hired here in the second quarter happened to be here in Nashville, but it is somebody we chased for seven years.

You know them, you talk to them, you keep after them and many times, honestly, most of the people that we talk to do have some loyalty to their organization. And so, we just have to state after them until we get them. So a combination of frustration with existing employers and growing confidence and comfort with us in that market lets you win more today than you could win a year ago.

Okay. And with regard to the hiring of Missy. I mean, took a year out on retirement. What do you think she will -- what do you expect her to do for you that is maybe in addition to what you were doing or what will she accentuate?

Yes. I guess to put into perspective, Missy grew up in a banking family. Her dad really was the large shareholder and ran a bank in Oneida, Tennessee, which is just north of Knoxville. And her family is a well-known banking family in the state of Tennessee. She went to University of Tennessee and went to work in a bank in Knoxville right out of school. So she has been at it about 40 years in that market as a banker. And her most recent assignment, as you alluded to, and as we have talked about was running State of Tennessee for BB&T.

What she does for us, Peyton, I think you know this, through Rob's very deep ties to the market and the fact that I was a banker in Knoxville for a number of years, we have, we are generally well-connected in that market and Harold indicated, I guess, in a five-year period of time we built a $700 million bank. So we have done pretty well over there, but there are a couple of things that Missy does for us.

Number one, Missy was running BB&T, which in that market it -- we and BB&T are the fastest growers and so, she knows how to grow a bank. That is additive. It is true that her -- she -- we know most of the same people, but the folks that we are best connected to and the folks that she is best connected to are a little different. So she opens up a set of commercial clients to us that probably would have been more difficult. And I think that we have an expectation that our hiring in Knoxville will probably accelerate.

She is a very well-known and popular leader among her people in the state. So she will help us with hiring there, but she will help us in other markets in terms of hiring people. She has recruited people all over the state of Tennessee for BB&T. So she will be helpful to us primarily in Knoxville, but she will be helpful to us in other markets as well.

I think specifically in terms of skill sets, we only have five offices in that Knoxville market, soon to be five market -- offices in the Knoxville market. And I think we have said before that we -- right now we are just running to know both branching strategy where we add a branch a year until we fill out distribution over there. I am unclear on what the total distribution is, but we've said for some time it is a number like 10. Maybe it is eight, maybe it is 12, but it is a number like 10 offices that we would need over there.

So, Missy will take on those retail banking functions and easily bring the energy and emphasis to that function that hasn't been so important here to date.

Okay, great. Harold, looking at the overall expense growth and the overall revenue growth year-over-year, you get to a marginal efficiency ratio of about 54% and that is adding back the effect of the off-balance-sheet reserve a year ago. Is that the right way to think about it over the next two or three years? Or do you think that kind of marginal expense growth or marginal expense dollar versus a revenue dollar created could drop into the 40s?

Yes, I don't know if we can get down into the 40s, Peyton, but I think what we have got over here now is an energy and a culture towards folks increasing that operating leverage. So I don't think we will get to the 40s, but we will definitely be mindful of expense creep with basically trying to make sure that we have got the proper allocation between our salesforce, our service force, and our support force, so --.

Okay, great. Thank you very much for taking my questions.

Kevin Fitzsimmons, (inaudible).

My questions have all been answered. Thanks.

Mikhail Goberman, Portales Partners.

A quick one on something that we discussed in prior quarters about [animal spirits] from clients and potential CapEx expansion. Are you starting to see any glimmers of sunshine there or is it still the same situation?

I think -- I wouldn't want to -- those kinds of questions are hard to answer sometimes because just a little movement is that and if you say there's a little movement people say, okay, well here we go, we have got great optimism.

I would say this. We do see a little more of our business. I think Harold talked about it on the call. We had record originations, a very high level of originations during the second quarter. And in terms of the mix between picking that business up from new clients or prospects versus picking it up from our existing clients, that mix shifted a little more towards our existing clients than it had in the past. So it is still a meaningful part of market share movement, but we did see a little more loan borrowing from our existing client base. Which we'd say, okay, we are getting a little more activity than we have had in the past.

But with that, I would tell you that our line utilization continues to be extraordinarily low and generally matches what it was during the trough of the recession. And for me, that is a principal barometer to watch to see when there is bona fide traction. Because that is the indication that the selling cycle is working and working assets in the form of inventory and receivables are expanding and those kinds of things. And we are just not seeing growth in that measure.

So kind of a mixed report. A little optimism in terms of new activity, but I am still cautious about what the true loan demand is.

Okay, thank you very much. That's very helpful.

I am not showing any further questions at this time. This does conclude the question-and-answer session. Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a good day.