Pinnacle Financial Partners' (PNFP) CEO Terry Turner on Q2 2014 Results - Earnings Call Transcript

Jul.16.14 | About: Pinnacle Financial (PNFP)

Pinnacle Financial Partners (NASDAQ:PNFP)

Q2 2014 Earnings Call

July 16, 2014 9:30 am ET

Executives

M. Terry Turner - Chief Executive Officer, President, Director, Chairman of Executive Committee, Member of Directors Loan Committee, Chief Executive Officer of Pinnacle National Bank, President of Pinnacle National Bank and Director of Pinnacle National Bank

Harold R. Carpenter - Chief Financial Officer, Principal Accounting Officer, Executive Vice President, Chief Financial Officer of Pinnacle National Bank and Executive Vice President of Pinnacle National Bank

Analysts

Jefferson Harralson - Keefe, Bruyette, & Woods, Inc., Research Division

William Curtiss - SunTrust Robinson Humphrey, Inc., Research Division

Michael Rose - Raymond James & Associates, Inc., Research Division

Stephen Scouten - Sandler O'Neill + Partners, L.P., Research Division

Kevin B. Reynolds - Wunderlich Securities Inc., Research Division

Brian Joseph Martin - FIG Partners, LLC, Research Division

Peyton Nicholson Green - Sterne Agee & Leach Inc., Research Division

Kevin Fitzsimmons - Hovde Group, LLC

Mikhail Goberman - Portales Partners, LLC

Operator

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 Pinnacle's 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 Pinnacle's website for the next 90 days. [Operator Instructions]

Before we begin, Pinnacle does not provide earnings guidance or forecasts. 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 achievement of Pinnacle Financial to differ materially from any results expressed or implied by such forward-looking statements. Many of 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 the comparable GAAP measures will be available on a Pinnacle Financial's website at www.pnfp.com.

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

M. Terry Turner

Good morning. For roughly 2.5 years, we've 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 3 years, while growing noninterest expenses at a substantially slower rate, which was intended to result in dramatically improved profitability as a result of operating leverage that, that provides. So again, this morning, I thought I'd start with a 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're getting outside the balance sheet growth in the form of average loans, up 9.9% in the second quarter 2014 compared to the same quarter last year. You can also see that we've increased average transaction accounts by 17.3% during that same time frame, so that transaction accounts now represent 47.8% of total deposits. And by the way, DDAs, as a subset of transaction accounts, are now 29% of total deposits. That's 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 2013, we've 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've been able to translate that balance sheet growth into real earnings growth, with organic revenue growth of 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 and I'll 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 a steep as the reduction in nonperforming loans. The allowance covers nonperforming loans a whopping 427%. So consequently, we anticipate that we'll 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've also been highlighting this chart since January 2012. It was our belief at that time that our then existing relationship managers, 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 3-year period beginning in 2012. In this chart we're plotting the actual production today against that 3-year target that we outlined more than 2 years ago.

In total, during the first 2.5 years since we announced our 3-year loan growth target, we've 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 3-year target barring any economic event that would warrant a significant reduction in business activity. So I'm 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've been talking about now for 2.5 years.

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

Harold R. Carpenter

Thanks, Terry, and good morning, everyone. As Terry mentioned, we still believe our 3-year loan target is within reach by year-end 2014, and anticipate that our relationship managers will produce outsized loan growth in the second half of this year. We've 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 sales force 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 managers are very much out in the market discussing capital needs with their clients. Although it's 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 incurred significant levels of payoffs during the second quarter. As most of you know by now, this has been the most significant headwind for us in 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're 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 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 2 years, we embarked on selected strategies to help mitigate the impact of any sudden unforeseen and meaningful increases in rates. As an example, we've 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 5 to 7 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've been talking about our loan floors for years. We're 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 believe 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 2 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 of greater than 2 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 see 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 opportunities 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 cost. We've 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 further reduction, but we have reason to believe they can make it happen.

As to deposit balances, we continue to grow our noninterest-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 noninterest-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 fund rates increase next year, the higher growth banks may see stress on their deposit costs in order to hold on to 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, or 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 number of 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 time deposits or seek other non-bank investments with higher returns.

Again, concerning balance sheet positioning and our effort to work toward neutrality, the best good news is that growth we've experienced in noninterest-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 noninterest 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 number of accounts and related fees. If you think about the long-term profitability targets that we've 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 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 a meaningful increase in mortgage activity, as home buying picked up in our markets during the second quarter.

As we mentioned last time, we also have several tactical items aimed at interchange credit card that we hope will boost these fee businesses in 2014. We've 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 to 547,000 for the first half of 2014, or almost 40% greater than the 393,000 for the 6 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 tightened 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 ROE 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're likely to see modest increases in our 2014 expense base, given we expect to continue to hire people. We hired 9 new revenue producers thus far in 2014, with most of those during the second quarter. We're 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-to-asset ratio, which we calculated at 2.38% for the second quarter. As we have stated for the last 2 years, the primary strategy is to decrease and to ultimately achieve our long-term expense-to-asset ratio target. We'll 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-provision 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'll turn it back over to Terry to focus on our outlook for the future.

M. Terry Turner

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'd like to take just a few minutes to provide some insight on our future outlook. So here's 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 advantaged markets. Thirdly, we're uniquely positioned to take advantage of the persistent dissatisfaction that continues among business clients at our competitors. And lastly, we're positioned to protect our clients 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 who've 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 the 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 establish an ongoing performance targets is tightly linked to shareholder returns.

I indicated earlier that it's our expectation that we'll meet or exceed the 3-year growth target we disclosed 2.5 years ago and that, hopefully, by the fourth quarter this year, in addition to achieving our targeted ROAA, we should have each of the 4 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. And so this summer, as a part of the 2014 to 2016 strategic plan, we've actually increased the target range for our ROAA to 1.20% to 1.40%, and the fees to asset target range to 0.80% to 1.00%. We'll continue to report against the originally disclosed targets for the remainder of 2014 and actually begin reporting against these updated targets with the 1Q '15 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 buy siders I've 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 the 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's an outstanding number. Fortunately, in our markets, we're the best positioned to capitalize on that dissatisfaction.

Starting on the left side, you can see the primary reasons that small businesses, ones with annual sales from $1 million to $10 million, switch. As an example, the #1 reason is that they're unsatisfied with their relationship manager. 25% of those that switch leave for that reason. Again, that's national research. Now in the middle of the slide, you see how our national-based clients rate our actual performance. We get better scores on our relationship managers than any of our major competitor get on theirs. We rank #1 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 midsized businesses switch. We're 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 midsized businesses. Many believe the economy may be picking up, but I think virtually everybody still agrees we're in for a relatively slow growth economy for quite some time. It's my belief that it's 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 rapid share movement, since nearly 40% of business clients are willing to switch. Of course that willingness to switch stat should concern every business bank. We see some banks who run these hard-driving sales cultures that fail to advance market share, cause clients are running out the back door as fast as they can bring them in the front door. But here's more data that lead us to believe that our net share movement should exceed competitors due to our high client retention rates. 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 of our competitors.

So there you have it, our rapid growth strategy to create meaningful operating leverage is working as we had hoped. In 2Q '14, 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 3-year growth targets and reach our long-term profitability targets. And our aspirations remain high looking forward based on the fact that we're in advantaged markets, and the fact that we appear best positioned to take advantage of this strong willingness among business clients to switch, we're nearly 40% at play.

Operator, I'll stop there and we'll take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Jefferson Harralson with KBW.

Jefferson Harralson - Keefe, Bruyette, & Woods, Inc., Research Division

I wanted to ask about the other 9 new producers. Maybe if you can just kind of go through kind of who they are, where they came from a little bit and maybe be specific, if possible, on your new senior Knoxville hire?

M. Terry Turner

Okay. Just kind of trying to talk through the 9 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 might know we're 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're located, that group of 9 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're still in early stage growth cycle there. And so we're excited about the hiring that we're 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've also announced a meaningful hire in Knoxville, Missy Wallen. There’s a press release, I guess, that went out a 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'll join Harvey White, Mike DiStefano, who have been running that market for some time. As an executive leader there, she'll have primary responsibilities for our client service group. There's not an exact parallel with other banks but, generally, it would be most highly correlated with the retail bank. But we're excited about Missy and believe she opens great client opportunities and further hiring opportunities in that market. So Jefferson, I hope that's helpful.

Jefferson Harralson - Keefe, Bruyette, & Woods, Inc., Research Division

Definitely helpful. I appreciate that. And I just want to ask my other question on ROE. As your profitability is increasing, it's harder to leverage the capital. And your capital is growing, it just grew a little bit here on a -- 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? I guess, how are you thinking and planning about targeting that TCE and how you get there?

Harold R. Carpenter

Jefferson, that's a great question and we get asked that quite a bit. We're mindful of our capital growth. We're mindful that we're accreting capital. We are also approaching Basel III. We've got some -- that will take down some issues or some capital levels with respect to regulatory capital. As for the dividend, we're right now at about a 18% payout ratio. I think we've 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.

Operator

Our next question comes from the line of Will Curtiss from SunTrust Robinson Humphrey.

William Curtiss - SunTrust Robinson Humphrey, Inc., Research Division

On the margin, it looked like the security yield came under some pressure. Can you talk a little bit about that and maybe the expectation for the remainder of the year?

Harold R. Carpenter

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

William Curtiss - SunTrust Robinson Humphrey, Inc., Research Division

Okay. A high-level question here. Just 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's occurring there. And also, maybe if there's any concerns that you see?

M. Terry Turner

Will, I think, I would say that, generally, Nashville continues to be a hot market we're -- 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's 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 met product growth is 4.2%. That's the second highest out of the top 100 largest metro areas. We've talked about -- we generally include some slides in the appendix there that gives some sense on what's 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, the job growth. Job growth continues to be very strong in the national markets. So again, we're -- as I guess said in my comments, we're blessed to be in a great, great market. And if you start trying to figure out what could go wrong in Nashville, I think health care is a meaningful part of our economy here. And our -- that's a volatile area. There are lots of changes. The 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.

Harold R. Carpenter

Yes. Will, this is Harold. I'll just add a little bit. The city put out, and take this, that it came from the city, that downtown is short 3,000 hotel rooms today because of the opening of the convention center. So we're 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're 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.

William Curtiss - SunTrust Robinson Humphrey, Inc., Research Division

That's helpful. And the last one I have was I know you had a slide on the updated return targets. But I'm just curious, as you guys get closer to the end of the 3-year long-term plan how you're thinking about the next phase of the company?

M. Terry Turner

Yes. I think, I would say that our approach has not changed. When I try to just 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. And so I cannot imagine that we're going to go away from that. I think we've expressed for quite some time that we believe that we're 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. And so we believe that there's a lot of geography for us to continue to do exactly what we do which is, I say, is really to get up underneath large regional banks who are vulnerable and take clients and associates.

Operator

Our next question comes from the line of Michael Rose with Raymond James.

Michael Rose - Raymond James & Associates, Inc., Research Division

I wanted to kind of drill into the ROA guidance that you raised. I 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 the some of the fixed and floating loans, and then kind of what you're 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?

Harold R. Carpenter

Yes, Michael. Our interest rate assumption is probably consistent with just about everybody we're hearing about and that is that the steepness of the curve will eventually flatten over the next 3 years. We think the second half of 2015 we're -- we've 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're 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've gone through our strategic planning exercise. We think we're in great markets. We think we have great lenders. We think we've 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.

M. Terry Turner

Yes, I might just add to that, Michael. I think the -- I guess, over 2.5 years now, we've been pretty transparent in terms of helping people understand our company, talk about what the growth is going to be, what the return on the growth is going to be. So it's pretty simple. And I think, what we're 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've already had a number of people say, okay, well tell me what the growth is going to be. And I've 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 in my view was that the firm was severely undervalued and people underestimated what our capacity was to grow the core earnings, and so just 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 2.5 years ago is the same. In other words, we've 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'm hopeful that if you ask me that question 2 years from now, I'm going to say, "Well, I've been hiring in the last 2 years, and I have on my payroll today capacity to produce a large volume of loans." And 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 just 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.

Michael Rose - Raymond James & Associates, Inc., Research Division

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

Harold R. Carpenter

Yes, I just tell you how we think about it. What we're going to do is, we're going to track trends in potential problem loans, we're going to track trends in nonperforming loans, we're going to track our charge-offs. We go through all 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've experienced over the last few quarters. Now where the absolute bottom is, and where we stop, I'm not sure. Like you said, Michael, we got down into the low 1% range. I think this is, like you're inferring, a new time. That it's unlikely that we will get down that far. But at 1.55% today, we think we still have some room to go.

Operator

Our next question comes from the line of Stephen Scouten with Sandler O'Neill.

Stephen Scouten - Sandler O'Neill + Partners, L.P., Research Division

If I could just follow-up one additional question on the credit costs. Specifically with the OREO expense which was a good bit lower, is that a decent run rate there? Or were there potentially some write-ups to some of that book within that number?

M. Terry Turner

Can you repeat the question?

Stephen Scouten - Sandler O'Neill + Partners, L.P., Research Division

Yes. Just in terms of the carrying cost on the OREO, looks 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 just what it's going to cost to carry the remaining OREO? Or there were some valuation adjustments in there that brought that number down?

Harold R. Carpenter

I don't think we had any meaningful appraisals come in on ORE property at 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's 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're hopeful to see some more meaningful declines in that book here in the third quarter, Steve. But I'm not sure, and I apologize, I just don't think we had any meaningful ORE transactions at all this quarter.

Stephen Scouten - Sandler O'Neill + Partners, L.P., Research Division

Okay, fair enough. And with that remaining book, I guess, I saw in your presentation it's -- fair value is maybe 161% of the book value currently. I mean, does that lead you to try to more rapidly dispose of those properties, given that you might be able to take some gains on their dispositions?

Harold R. Carpenter

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, 3 to 4 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 their property.

M. Terry Turner

Steve, I think just -- it probably works the opposite of that, I think, because of the core earnings capacity of the firm and the fact that the 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 the whole time here.

Stephen Scouten - Sandler O'Neill + Partners, L.P., Research Division

Makes sense. Okay, and I'm looking at loan growth. I saw where you put in a slide about the pace of pay-downs, 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 pay-downs? Or is that kind of it is what it is and that's the business environment?

M. Terry Turner

Well, I think, first of all, I think we do see large pay-downs and have over a number of quarters in 2 principal categories: CRE and C&I. I think in the case of the CRE, generally what happens there is you're being taken out by more traditional and perhaps better providers of long-term financing for commercial real estate. The insurance companies, REITs and the like, the markets are wide open for low, fixed-rate, nonrecourse lending. And so you do get a payoff in commercial real estate. We -- I think, we talked about it before, probably the thing that's more astounding in this period of pay-downs is the volume of C&I pay-downs, and they're 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've been looking for an exit for some period of time. And through the recession, there was no exit. So you 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've seen a -- an unusual volume of pay-downs from that angle as well. I think in terms of our opportunity to mitigate, I'm not aware of what our opportunity to mitigate is. Again, I suppose, we could take on a greater interest rate risk and greater credit risk to scotch the pay-downs in commercial real estate. But in the case of those C&I pay-downs, I'm not sure there's much that can be done there.

Operator

Our next question comes from the line of Kevin Reynolds with Wunderlich Securities.

Kevin B. Reynolds - Wunderlich Securities Inc., Research Division

So a couple of questions. Most of my questions have been answered, and so really, it's a sort of more market-based questions about how things are going right now, what your outlook is. First that Volkswagen announcement in Chattanooga, do you think that -- does that change your outlook? I know you mentioned that is a market that you're attracted to longer term. But do you think that might accelerate any activity you have headed that way or any discussions? I'll let you sort of talk about that. I don't want to put words in your mouth. And then the next question I had after that was on the housing market locally. Here, it looks like months of supplies is 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's driving it? Is there any speculation creeping in? And how is it playing out with the residential builders around town?

M. Terry Turner

Okay. I think as it relates to Chattanooga, Kevin, I think my answer would be that Volkswagen announcement does not increase our interest in Chattanooga. But I say that because our interest is high, and we've tried to communicate that in the past. So we have, Kevin, you've 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've added Chattanooga to the list and it's 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'd like that market a lot. And so my comment about it -- not necessarily increase in our interest, it's just to say that we 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, you 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 low 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 a lots of real estate to be developed, and so we're not particularly concerned about whether or not lot inventories will exist. They might not exist in Davidson County, but they exist in the MSA. I think in terms of what's going on among in the construction sector among contractors, homebuilders, 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's constrained by lending. I think it has been really constrained just by the risk takers in the market, the developers and builders, and so forth. So that they might have thought about it.

Kevin B. Reynolds - Wunderlich Securities Inc., Research Division

Okay. And then, I guess, a follow-up on the Chattanooga comment, the views that you have. If you were to enter chat Chattanooga, I mean, I know that you've had this sort of business model from day one of lifting out the experienced lenders and maybe even teams of folks as you talked about doing in places like Knoxville. Is Chattanooga a lift-out market? Can you remind us of that -- do you think it will be more of a small bank acquisition if it came about? I mean, how do you enter that particular market? And is it different than maybe some of the others that you mentioned?

M. Terry Turner

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 lift-out opportunities, and there are also targets there that we have an interest in. So I can see us going to Chattanooga, either through de novo lift-out or through a merger transaction. We'd like to be there. We're willing to go either way. It's just a matter, at that point it's just about opportunity, where do you find your first and best opportunity.

Kevin B. Reynolds - Wunderlich Securities Inc., Research Division

Okay. And my last question, I apologize for asking so much here. But recently, I noted that there was a report, I believe, maybe a chamber report, I could be wrong about that, that projects that over the next 20 years or so, the MSA population could increase by a 1 million on top of the 1.8 million that's 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 we're anywhere close to that playing out, along those lines, do you think that, that meaningfully changes the sort of next 10 or 20 years for a company like yours? And the reason I ask is, in the past, we've asked you how much can you grow inside this market. You're already sort of #4 market share or maybe better than that on the commercial loan side of things. And I know you had mentioned that the kind of market share you had 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?

M. Terry Turner

Yes. I think -- you know this, we're excited about the national market. We're excited about the prospects. Literally, I can't imagine a place I would rather do business. Again, I'm 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, if you look at FDIC deposit share, we have the #4 position. If you look at Greenwich business share, in other words, clients with sales from $100 million to $500 million, we have the #1 share. And so I think we've 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 would tell you that, that would indicate that we're taking share faster today than we ever have. And so you're -- it's correct thought that at some point, there is a limit. You're probably not going to have 50% market share or something like that. But the fact that we're 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's a lot of opportunity of business owners who are willing to switch their buying. And so anyway, I don't mean to just ramble on, but I'm excited by the growth dynamics of this market and I can't imagine that that's not going to be a great thing. But again, what I like best is the competitive landscape.

Operator

Our next question comes from the line of Brian Martin with FIG Partners.

Brian Joseph Martin - FIG Partners, LLC, Research Division

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

Harold R. Carpenter

Yes, on the fee side, other fees did go down because of those matters we talked about in the press release. As far as the run rate, we think we're 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're looking at third quarter on mortgage and think they'll have 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 kind of 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 9 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're looking at about half the run rate in the second quarter going into the third quarter, if that makes sense.

Operator

Our next question comes from the line of Peyton Green with Sterne Agee.

Peyton Nicholson Green - Sterne Agee & Leach Inc., Research Division

I was just wondering, maybe back on the commercial real estate payoffs, would you expect that to still be -- I guess, commercial real estate to still to 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?

M. Terry Turner

Yes, I think, Peyton, I don't know what is it 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 growth production is going to exceed the payoffs and that, that category -- it'll happen faster there than the total loan book will grow.

Peyton Nicholson Green - Sterne Agee & Leach Inc., Research Division

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

M. Terry Turner

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

Peyton Nicholson Green - Sterne Agee & Leach Inc., Research Division

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

Harold R. Carpenter

Yes, I don't have it with me. But the loans, we've talked about the loans in Knoxville on several occasions. We think we're 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're real pleased with where they are with respect to their deposit generation. You factor that the through a contribution model and you get down to it. I don't know, Kevin, I'd have to do -- I mean, not Kevin, Peyton -- I'd 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'd say, you could probably equate that across-the-board, 25% of our earnings.

Peyton Nicholson Green - Sterne Agee & Leach Inc., Research Division

Okay. And is the outlook for the Knoxville market, I mean, have you kind of gotten to the productive capacity and so that's the reason for the additional hires? Or you would've hired these people 2 or 3 years ago, they just happened to become available closer to now? Is that -- and how should we think about that?

M. Terry Turner

Yes. No, it's about availability and mass in the market. Both those things are important. But it wasn't that we were sitting waiting for the right time to hire. I mean, we would have hired them 2 years ago if we'd had the opportunity. I think you know this Peyton, 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's somebody we chased for 7 years. You know them, you talk to them and 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 stay after them until we get them. And so I think a combination of frustration with the existing employers and growing confidence and comfort with us and that market, lets you win more today than you could win a year ago.

Peyton Nicholson Green - Sterne Agee & Leach Inc., Research Division

Okay. And then with regard to hiring of Missy, I mean, took a year on retirement. I mean, what do you think you she'll -- what do you expect her to do for you that is maybe an addition to what you were doing? Or what will she accentuate?

M. Terry Turner

I guess, just kind of put in 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's been at it about 40 years in that market as a banker. And her most recent assignment, as you alluded to, as we talked about, was running the 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're generally well connected in that market. And Harold indicated, I guess, in a 5-year period of time, we built a $700 million bank. So we've done pretty well over there. But there are a couple of things, I think that Missy does for us. Number one, Missy was running BB&T, which in that market, we and BB&T are the fastest growers, and so she knows how to grow a bank and that's additive. It is true that -- to her -- she -- we know most of the same people, but the folks that we're best connected to and the folks that she's best connected to are a little different, so she opens up a set of commercial clients to us that probably would've been more difficult. And I think that we have an expectation that our hiring in Knoxville would probably accelerate. She is a very well-known and popular leader among her people in the state, so she'll help us with hiring there. But she'll help us in other markets in terms of hiring people. She recruited people all over the State of Tennessee for BB&T. And so she'll be helpful to us primarily in Knoxville, but she'll be helpful to us in other markets as well. I think specifically, in terms of skill sets, we only have 5 offices in the Knoxville market, soon to be 5 market -- 5 offices in Knoxville market. And I think we've said before that we right now we just run a de novo branching strategy where we add a branch a year until we fill out the distribution over there. I'm unclear on what the total distribution is, but we said for some time, it's like number 10. Maybe it's 8, maybe it's 12, but it's a number like 10 offices that we would need over there and 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 today.

Peyton Nicholson Green - Sterne Agee & Leach Inc., Research Division

Okay, great. And then, Harold, I guess looking at the overall expense growth and the overall revenue growth year-over-year, you get to kind of a marginal efficiency ratio of about 54%, and that's adding back the effect of the off-balance sheet reserve a year ago. Is that kind of the right way to think about it over the next 2 or 3 years? Or do you think that, that kind of marginal expense growth or marginal expense dollar versus a revenue dollar created could drop into the 40s?

Harold R. Carpenter

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

Operator

Our next question comes from the line of Kevin Fitzsimmons with Hovde Group.

Kevin Fitzsimmons - Hovde Group, LLC

Guys, my questions have all been answered.

Operator

And our next question comes from the line of Mikhail Goberman with Portales Partners.

Mikhail Goberman - Portales Partners, LLC

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

M. Terry Turner

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 got a great optimism. I would say this. We do see a little more of our business, I think Harold talked about on the call, we had a 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 shift is a little more toward our existing clients than it had in the past. And so it's still a meaningful part of market share movement, but we did see a little more loan borrowing from our existing client base, which would say, "Okay, we're getting a little more activity than we've 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's a principal barometer to watch to see when there is a bona fide traction, because that's the indication that the selling cycle is working and working assets in the form of inventory receivables are expanding and those kinds of things. And we're just not seeing growth in that measure. So kind of a mixed report, a little optimism in terms of new activity, but I'd still -- I'm still cautious about what the true loan demand is.

Operator

I'm not showing any further questions at this time. This does concludes 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.

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