Pinnacle Financial Partners: Time For A Downgrade After A Great Run Higher (NASDAQ:PNFP)

From my experience, it’s always better to lock in a solid gain than to continue clinging on to an investment with the hopes of just a little more profit. This is a hard habit to break and one that I still fall prey to every so often. But one firm that I do believe now makes sense to pull back from is a fairly small financial institution by the name of Pinnacle Financial Partners (NASDAQ:PNFP). In July of 2023, as many of the banks that are out there faced downward pressure because of the banking crisis that began in March of that year, I identified Pinnacle Financial Partners as an attractive opportunity. I ultimately rated the business a ‘buy’ because of how shares were priced and because of the stability that the company exhibited.

Fast forward to today, and it does appear as though the worst for the company is now long behind it. Financial performance has been fairly solid considering how volatile the industry has been over the past year. On top of this, shares have seen tremendous upside totaling 37.8%. That dwarfs the 15.8% increase seen by the S&P 500 over the same window of time. Although the company continues to show signs of growth and I believe that trend will continue in the long run, I would argue that now makes sense to downgrade it to a ‘hold’. While the company still has some attractive features to it, shares look much closer to being fairly valued. Add on top of this some mixed quality indicators, and while I do believe further upside is possible, I believe that the prudent investor should take a more cautious approach.

It’s always important, as an investor, to be flexible in our thinking. This means to change our opinion as the data changes. The good news, or perhaps bad news depending on result, is that new data is just around the corner. After the market closes on April 22nd, the management team at Pinnacle Financial Partners is expected to announce financial results covering the first quarter of the 2024 fiscal year. Leading up to that time, analysts have rather mixed expectations. They expect net revenue to increase year over year. While that in and of itself is positive, they expect profits to decline. While this may seem peculiar, it actually conforms with recent financial performance and is indicative of some of the issues the company is facing.

Why a downgrade makes sense now

Fundamentally speaking, Pinnacle Financial Partners is doing quite well for itself. For starters, we should touch on how its balance sheet looks today compared to what it was in the past. For 2023, deposits came in at $38.54 billion. That’s $3.58 billion, or 10.2%, above the $34.96 billion the institution generated in 2022. This is rather remarkable growth considering the havoc that the industry faced. Some banks to this day are continuing to see deposits decline. And others, have only recently stabilized. Of course, uninsured deposit exposure is unfortunately a bit higher than I would like it to be at 31.3%. I tend to prefer 30% or lower. But that’s still pretty close and it marks a nice improvement over the 39.2% of deposits that were uninsured at the end of 2022.

Outside of deposits, there are other metrics we should be paying attention to. One example would be loans. On a net basis, these totaled $32.32 billion at the end of last year. That’s a nice improvement over the $28.74 billion of net loans that the institution had at the end of 2022. This growth is comparable to the growth seen with deposits, which is not surprising given that loans are often issued from deposits. At the same time that net loans have increased, so too has the value of securities at the bank. These managed decline from $7.15 billion to $7.88 billion. All of this occurred at the same time that cash and cash equivalents ballooned from $1.18 billion to $2.23 billion. The only downside from a balance sheet perspective has been debt. This managed to grow from only $1.08 billion to $2.77 billion. But when you look at the increase in loans, securities, and deposits, that’s a small price to pay.

Moving onto the income statement, the picture wasn’t quite as positive. Net interest income did increase, climbing by 10.1% from $1.06 billion to $1.17 billion. This occurred largely as a result of the increase in assets that the institution has. Unfortunately, the net interest margin at the bank did work against it. But the drop from 3.29% to 3.18% was not terribly large. Also on the rise was non-interest income. Based on the data provided, it managed to increase from $416.1 million to $433.3 million. This came about even as investment losses worsened to the tune of $19.8 million and as income from equity investments declined from $145.5 million to $85.4 million. The primary culprit behind the increase was a gain on the sale of certain fixed assets. This gain expanded by $85.6 million year over year. You would think that the increase in net interest income and in non-interest income would cause a nice move higher when it came to overall profits. But net income only managed to inch up from $545.6 million to $547 million. This was because of higher expenses, including other non-interest expense that grew from $120.8 million to $174.5 million, and it was also thanks to higher expenses related to salaries, benefits, equipment, and occupancy.

The fact that net profits rose is still encouraging. But unfortunately, they didn’t rise enough to make the stock attractively priced relative to earnings. The price to earnings multiple of the institution is approximately 12 as I type this. To put this in perspective, I compared the company to five similar firms as shown in the chart above. In it, you can see that three of the five firms ended up being cheaper than Pinnacle Financial Partners in this regard. As a value investor, it’s also important to me that this number not significantly exceed 10. The fact that this does by 20% is quite discouraging. There are, of course, other ways to value the institution. In the chart below, you can see the company compared to five similar firms using both the price to book approach and the price to tangible book approach. While it was the cheapest of the group on a price to book basis, three of the five companies ended up being cheaper than it relative to tangible book value.

In addition to pricing, we also need to be paying attention to the quality of assets. Unfortunately, this muddies the waters some. In the first chart below, you can see the return on assets for the institution relative to the same five firms I have been comparing it to all article. Based on the calculations, four of the five institutions ended up having a lower return on assets than our candidate. This is great in and of itself. But when we look at the return on equity in the subsequent chart, we see that only one of the institutions was lower than our candidate. This gives us a mixed understanding of the institution. Relative to assets, the bank is very appealing. But relative to shareholders equity, it’s nothing special.

As I mentioned at the start of this article, management is expected to announce financial results for the first quarter of the 2024 fiscal year after the market closes on April 22nd. From a net revenue perspective, the expectation is continued growth from the company. Analysts believe that this figure will come in at $422.2 million. For context, this metric is defined as net interest income, before any provisions for losses, plus non-interest income. In the first quarter of 2023, this metric was $401.7 million. That implies a year over year growth rate of 5.1%. If you recall results for 2023 relative to 2022, you will see that net interest income had risen nicely on a year over year basis. A lot of that growth could be attributed to an overall expansion of the company’s balance sheet. Offsetting this to some extent should be a decline in the company’s net interest margin. For context, from the final quarter of 2022 to the final quarter of 2022, the net interest margin for the institution fell from 3.60% to 3.06%. In the first quarter of last year, it came in at 3.40%. So a similar contraction could be on the table.

On the bottom line, the exact opposite is expected to occur. Analysts believe that earnings per share will be $1.53. That would be down from the $1.76 per share reported in the first quarter of 2023. That would translate to a decline in net income from $133.5 million to $117.5 million. It’s unclear exactly why this decline is expected. We do know that last year the company booked a $42.1 million increase associated with FDIC insurance, with $29 million of that attributable to a special assessment applied to the banking industry to cover bank failures that occurred last year. Those issues have largely died down, but some further increase in insurance costs is probable. Also, one thing that has been problematic for the institution in recent years has been both salaries and employee benefits, and equipment and occupancy costs. Just from 2022 to 2023, salaries and employee benefits expenses jumped by 4.2%, or $21.7 million. Meanwhile, equipment and occupancy costs skyrocketed 26.7%, or $29.3 million. There have been other expense increases as well, but they have been far less significant in size.

Takeaway

As you can see, Pinnacle Financial Partners has had a great run. However, the bullish argument is becoming less clear by the day. The institution is growing nicely, though profits have flatlined. Relative to assets, the institution is attractive. But the opposite is true when using the return on equity. Using both the price to earnings approach and the price to tangible book value approach, the bank also looks to be more or less fairly valued compared to comparable firms. Add all of this together, and it’s easy for me to downgrade it to a ‘hold’ at this time. Of course, if the picture changes for the better when management announces financial results in the coming days, my mindset could change. But I don’t see that as being terribly likely.