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SunTrust Banks (STI) Q3 2011 Earnings Call October 21, 2011 8:00 AM ET

Operator

Welcome to the SunTrust Third Quarter Earnings Conference Call. [Operator Instructions] Today's conference is being recorded. If you have any objections, please disconnect at this time. I would now like to turn the conference over to Mr. Kris Dickson, Director of Investor Relations. You may begin.

Kristopher Dickson

Thanks, Wendy, and good morning, everyone. Welcome to SunTrust Third Quarter Earnings Conference Call. Thanks for joining us.

In addition to the press release, we've also provided a presentation that covers the topics we plan to address during our call today. The press release, presentation and detailed financial schedules are available on our website, www.suntrust.com. This information can be accessed by going to the Investor Relations section of the website.

Discussing our earnings presentation today will be Bill Rogers, our President and Chief Executive Officer; and Aleem Gillani, our Chief Financial Officer. Also joining us today, among other members of our executive management team, are Tom Freeman, our Chief Risk Officer; C. T. Hill, our Head of Consumer Banking, and Mark Chancy, our Head of Wholesale Banking.

Before we get started, I need to remind you our comments today may include forward-looking statements. These statements are subject to risks and uncertainty, and actual results could differ materially. We list the factors that might cause actual results to differ materially in our press release and SEC filings, which are available on our website.

During the call, we will discuss non-GAAP financial measures in talking about the company's performance. You can find the reconciliation of these measures to GAAP financial measures in our press release and on our website.

Finally, SunTrust is not responsible for and does not edit nor guarantee the accuracy of our earnings teleconference transcripts provided by third parties. The only authorized live and archived webcasts are located on our website.

And with that, I'll turn the call over to Bill.

William Henry Rogers

Thanks, Kris. I'll keep my introductory comments brief this morning and then let Aleem get right into the review of the quarter so we can get grounded in the numbers. I'll come back on afterwards and share my perspective before the Q&A.

If you turn to Slide 3, I think that's a good summary of the quarter, and I'm pleased to report we have momentum in several key areas, fueled in part by our intense client-centric focus. Loans were up again this quarter with targeted portfolio growth exceeding planned declines in higher-risk categories. We continued to grow deposits with a favorable mix shift, and key credit quality metrics improved across-the-board. We are pursuing initiatives to help drive better performance over time, including, but not limited to, our expense reduction program. I'll revisit that topic later in the call.

But first, let me turn it over to Aleem to provide some color on this quarter's financial results.

Aleem Gillani

Thanks, Bill, and good morning, everybody. I'll begin my comments today with the summary income statement on Slide 4. I'll provide you greater detail into the primary performance drivers on subsequent slides. So for now, I'll just hit the highlights.

Earnings per share this quarter were $0.39. That's a $0.06 per share increase from the second quarter, primarily due to a lower provision resulting from improved credit trends. Compared to the third quarter of last year, earnings per share increased $0.22. The largest drivers were higher net interest income, a lower provision and the elimination of the TARP drag. The improving profitability trends that we've reported over the past couple of years are evident in the year-to-date figures. 2011 earnings per share were $0.81, which obviously compares favorably to the net loss that we reported during the first 9 months of last year.

If you'll turn to Slide 5, we'll drill down further into our performance beginning with net interest income and net interest margin trends. Third quarter net interest income increased sequentially by $7 million or 1%. This was due to an additional day during the third quarter and a decline in interest expense, which was primarily attributable to lower deposit rates and the continuation of the favorable deposit mix shift. The net interest margin decline of 4 basis points was consistent with our guidance and primarily driven by lower earning asset yields. Relative to the third quarter of last year, net interest income increased $27 million or 2%, and the margin increased 8 basis points. This was the result of a 29 basis point decline in interest-bearing liability costs due to favorable deposit trends and a reduction in longer-term debt. This benefit more than offset the 17 basis point decline in earning asset -- in interest-earning asset yields due to lower rates.

On a year-to-date basis, net interest income increased 5%, again due primarily to lower liability costs. As we look to the fourth quarter, particularly in light of the low rate environment, we expect a similar decline in the net interest margin to that experienced in the third quarter.

Let's turn to noninterest income on Slide 6. As in previous quarters, we have made certain adjustments to our noninterest income for items like securities gains and mark-to-market impacts, and the details of these adjustments are included within the appendix. The major components of this quarter's $63 million adjustment included $78 million in valuation gains that were recognized on the company's fair value debt and index-linked CDs, partially offset by $21 million in valuation losses on previously secured securitized loans and illiquid securities. On an adjusted basis, noninterest income declined by $21 million this quarter. Investment Banking revenue was down $27 million, coming off a high second quarter as transaction volume decreased in light of the market volatility. That same market volatility in August also resulted in somewhat lower core trading revenue. Mortgage production income was up by $37 million this quarter on an adjusted basis. Core production income rose by about $65 million as a result of increased origination volume as well as wider margins. Partially offsetting this was $27 million of higher mortgage repurchase costs, which I'll discuss in more detail momentarily.

Notwithstanding the stronger sequential quarter mortgage performance, mortgage-related revenue was lower than the third quarter last year when we saw extremely high levels of refinance volume, as well as very strong MSR hedge performance. These were the primary drivers of the approximate $200 million decline in adjusted noninterest income from a year ago.

On a year-to-date basis, noninterest income was stable with 2010 levels. Double-digit growth in core consumer and commercial fee categories like Investment Banking, card fees and retail investment services was offset by lower mortgage revenue, as well as lower deposit service charges due to Reg E.

As you are aware, our debit interchange revenue will decline beginning in the fourth quarter. As mentioned last quarter, we expect about a 50% reduction, which equates to approximately $45 million to $50 million per quarter. We continue to expect to mitigate about 50% of the approximate $300 million combined annual revenue reductions from Reg E and debit interchange. Most of that mitigation should be in the run rate by early 2012, with the balance late in 2012 and in 2013.

Let's turn to Slide 7 for a discussion on mortgage repurchase trends. As shown in the top left portion of the slide, new repurchase demands increased to $440 million during the quarter with the 2007 vintage continuing to be the largest component. Demands remained difficult to predict and they were elevated this quarter, which is a trend that may continue in the fourth quarter. As you can see in the bottom row of the table, almost all of the demand this quarter were agency related.

The top right part of the page shows that pending demands ended the quarter at $490 million. That's up only modestly from the prior quarter despite the increase in new demands as we worked hard to actively resolving these issues. You can see evidence of this in the bottom left portion of the page as charge-offs increased from second quarter levels. This was largely expected as a significant portion of last quarter's new demands came late in the month of June, thus driving up the second quarter pending population. As such and despite the fact that charge-offs declined that quarter, we had built the second quarter reserve in anticipation of this quarter's increase in resolutions. As the losses were recognized, we were able to utilize a portion of that reserve increase. The mortgage repurchase provision during the third quarter was $117 million, and the ending reserve level was $282 million.

Let's take a look at expenses now. Expenses increased by $18 million or 1% on a sequential-quarter basis due to mortgage-related costs. Specifically, operating losses and credit and collections expense were up a combined $19 million. Other expense line items were essentially stable. Relative to the prior year, adjusted noninterest expense increased by $74 million. Operating losses increased by $45 million, largely attributable to mortgage servicing. Employee compensation was the other major driver, up $41 million, due to staff additions in client interfacing and mortgage loss mitigation and servicing roles. Higher incentive compensation due to improved revenue in certain businesses also contributed to this increase. Partially offsetting this was a $15 million decline in other real estate expense. And as Bill mentioned, he will provide you an update to our expense program later in the call.

Let's move on to the balance sheet, starting on Slide 9. Average performing loans increased by over $1 billion or about 1% from the prior quarter. Growth was driven by targeted loan categories, including C&I and consumer loans, while higher risk elements of the portfolio continued to be managed down. Commercial loan growth came from the C&I category, which increased by $1.1 billion or almost 2.5%, primarily driven by our large book of borrowers. The growth was across multiple industries, mostly in the form of increased term funding. We saw a modest increase in large corporate utilization rates and a similar increase in commitment levels for our smaller commercial clients. Growth within consumer was across all loan categories with the largest dollar increases in guaranteed student loans and indirect auto.

Period-end loans were up over $2.5 billion or more than 2% from the prior quarter. Notable items included increased production volume, higher loan balances during every month of the quarter and the $500 million student loan portfolio acquisition that closed at quarter end. Relative to the prior year, average loans grew almost $3.5 billion or about 3%. This growth also came from the targeted C&I and consumer portfolios. Commercial category loans increased by about $0.5 billion as strong C&I growth more than offset declines in CRE and commercial construction. The consumer portfolio was up by approximately $3.5 billion with student and indirect auto again driving the growth. Conversely, residential loans declined due to about a $2 billion combined reduction in non-guaranteed mortgages, home equity and residential construction, partially offset by growth in guaranteed mortgage.

Overall, we are pleased with our traction in growing selected areas of the portfolio this quarter. And currently, we were also able to continue to reduce risks, and further information of this is shown on Slide 10.

The portfolios that we've categorized as higher risk have accounted for about 50% of our net charge-offs over the past couple of years. As may be seen on this slide, these balances are down by almost $13 billion or about 55% since the fourth quarter of 2008. These portfolios fell by another $700 million this quarter with declines across all the categories, especially the commercial construction and higher-risk home equity portfolios. Overall, these higher-risk portfolios now constitute only 9% of our total loans. Less than $1 billion of this is nonperforming and has been written down or reserved for while the remainder of the book is exhibiting more favorable characteristics. For example, the performing higher-risk home equity portfolio has a refreshed averages FICO score in excess of 700.

At the same time that we've been managing these high-risk balances down, we've also been reducing our risk further by increasing our government-guaranteed loans. Government-guaranteed loans increased this quarter by about $650 million. And they now total $9.8 billion or 8% of our loan portfolio.

Let's move on now to a discussion on deposits. Average client deposits were up again, increasing by over $1 billion or about 1% from the second quarter. Favorable mix shift continued as growth was again concentrated in lower-cost categories, most notably via the $2.1 billion or 7% single quarter increase in DDA balances. Time deposits were down, and we also saw a decline in NOW balances, many of which migrated into DDA. Relative to the prior year, average deposits were up $5.7 billion or about 5%. Lower-cost deposit accounts increased by about $10 billion, which primarily came from 20% growth in DDA and 8% growth in money market. And currently, higher-cost time deposits declined by about $4 billion or 17%.

Moving on to credit quality. All of our primary asset quality metrics improved this quarter, largely due to favorable trends in the commercial portfolio. Early-stage delinquencies, excluding government-guaranteed loans, declined 3 basis points from the prior quarter. Commercial loan delinquencies were down 7 basis points while residential loans improved by a modest 2 basis points. You can see this detail in the Appendix where we've provided you the usual supplementary slides. Commercial and consumer early-stage delinquency rates of 15 and 67 basis points, respectively, are at relatively low levels. So we expect any further improvements in overall delinquencies to be driven by residential loans and to be influenced by the overall economy, particularly by changes in unemployment, and to a lesser extent, home value. We saw another quarter of meaningful improvement in nonperforming loans and nonperforming assets, which were down 10% and 8%, respectively. I'll share with you the drivers of this momentarily.

Net charge-offs were $492 million. This was a 3% improvement from the prior quarter and consistent with our prior guidance. In light of the overall continued credit quality improvement and risk reduction in the portfolio, we decreased the allowance for loan and lease losses by $144 million this quarter. The allowance ended the quarter at 2.22% of loans. Of note, if you exclude government-guaranteed loans from the denominator, this ratio is about 20 basis points higher.

Slide 13 provides some additional detail on nonperforming loan and net charge-offs [ph].

Sequential quarter decline in nonperforming loans marked their ninth consecutive quarterly decrease and was driven by commercial loans. Commercial construction NPLs fell $242 million or almost 40% as the result of continuing risk-mitigation activities. C&I and CRE NPLs declined by almost $60 million each or over 10%. Nonperforming residential loans were essentially unchanged. Relative to the prior year, nonperforming loans declined by $1.1 billion or 26%. Every loan category was down with the largest dollar declines coming from commercial construction, non-guaranteed mortgages and C&I. Net charge-offs declined by $13 million from the prior quarter, driven by residential loans as home equity and residential construction fell by a combined $17 million. Commercial charge-offs were relatively stable as an approximate $40 million sequential quarter increase in commercial construction was largely offset by about a $35 million combined decrease in C&I and CRE. Compared to last year, net charge-offs were down by about $200 million or about 30%, which was driven primarily by lower residential losses, most notably in the non-guaranteed mortgage loan category.

Overall, NPL declines in recent quarters have been driven by commercial category loans as the higher-risk commercial construction portfolio has been reduced while the C&I book has generally performed well overall. Residential loans have been the largest driver of our lower net charge-offs. This portfolio has seen notable improvements over the past year, although that stabilized somewhat this quarter. Taking this together, we expect the third quarter trends to be similar in the fourth quarter, specifically additional declines in nonperforming loans with generally stable net charge-offs.

I'll conclude my comments today on Slide 14 with the discussion of capital. The Tier 1 common ratio expanded to an estimated 9.25% while the Tier 1 capital ratio ended the quarter at an estimated 11.05%. The latter was down marginally due to a modest reduction in our outstanding trust preferred securities, as well as the impact of loan growth on risk-weighted assets. Both of these ratios continue to be well above the current and proposed regulatory requirement. The tangible common equity ratio expanded by over 30 basis points due to higher retained earnings, as well as an increase in accumulated other comprehensive income due to higher unrealized gains in our securities portfolio. Those same factors drove a 4% increase in tangible book value per share, which ended the quarter at $25.60.

We told you on the last call that we intended to approach our Board requesting a modest dividend -- a common dividend increase. We did so and received their approval. And we announced during the third quarter a 4% share -- a $0.04 per share increase in the quarterly dividend. Separately, we also repurchased and retired about 4 million SunTrust warrants during a public auction conducted by the U.S. Treasury. While both of these actions were relatively small, they are consistent with our desire to increase the return of capital to our shareholders.

With that, and to lead us through a discussion of our strategic growth initiatives, I'll turn the call back over to Bill.

William Henry Rogers

Great. Thanks, Aleem. I'm going to take us to Slide 15. And as we discussed before, we're pursuing specific strategies to drive higher profitability and growth from a more diversified platform. I think this slide shows 3 of the 4 main categories and provides some examples of the success we've already garnered. The fourth category, improved expense efficiency, will be covered on the subsequent slide.

While there are certainly more to come on each of these fronts, I wanted to provide some data points to demonstrate the momentum we're generating. There are several interrelated components to our strategy for growing consumer market and wallet share. Most importantly, the initiatives are grounded in our ability to win by providing the best service to drive improved client loyalty and better relationship penetration. We believe this is a critical means of differentiating ourselves in the market place and is resonating well with our clients on a very broad basis.

As you heard earlier, evidence of this is showing up in absolute deposit growth as DDA balances are up 7% over the prior quarter. Lower-cost deposit increases more than offset the decline in higher-cost deposits, maintaining our favorable mix shift. A relative growth, however, was evidenced in the recent FDIC deposit share data as we increased share in 8 of our top MSAs.

Last quarter, I indicated that we were beginning the planning for our new checking product suite. This was the result of extensive client research and is now in full implementation mode. We discontinued free checking and introduced our new Everyday Checking product. Everyday Checking carries a monthly maintenance fee, which can be waived by holding a $500 daily balance or by simply having a direct deposit into the account. Everyday Checking also has a monthly check card fee for unlimited check card usage, which is assessed only when the card is used on a monthly cycle at the point of sale. Now as was expected, we're opening fewer accounts. However, the average balance of the new accounts are twice as high as those opened under free checking. We're also seeing triple digit growth in the sale of our higher tier accounts, which require higher balances and a greater breadth of relationship with SunTrust. So on various fronts, this conversion is meeting or exceeding our expectations.

Another strategic priority is better diversification of our loan portfolio. Our C&I and consumer books grew by combined $7 billion over the last year. More importantly, production in C&I and consumer were particularly strong this quarter, and we saw some improvement in utilization in large corporate and an increase in total commitments in core commercial. Our guaranteed portfolios, both residential and student, have also been growing and contributing to both our diversification and risk improvement. All this growth more than offset the targeted reductions in our non-guaranteed residential loans, which are down $2 billion since the third quarter of last year, including a $1 billion decline in home equity. So overall good progress toward this objective as well.

A better diversification also applies to our business mix and fee income. Expanding wholesale business is a key strategic element in this priority, and we generated significant momentum on this front. While the third quarter was impacted by an industry-wide decline in capital markets revenue, Corporate and Investment Banking year-to-date revenue was up 16% and net income was up 23%. Diversified Commercial Banking revenue is up 9% and net income is up 34%. Growing our private wealth business is also a priority and you see we've had some success here as well as retail service income was up almost 20%.

Now moving onto our expense initiatives in Slide 16. So anticipating a tougher operating environment earlier this year, we embarked upon the development of a program to uncover additional ways to make significant and permanent expense reduction throughout the organization. As a result of those efforts, we announced to you last quarter our plans to eliminate $300 million in run rate expenses by the end of 2013. Today, I'd like to provide some more specificity around what we're doing to accomplish that goal.

First, you'll notice that this program now has a name, which is the PPG Expense Initiative. PPG is an acronym for playbook for profitable growth. It's what we call the collection of initiatives across the organization that we believe, over time, will be a key component in our plan to reduce our efficiency ratio to under 60%. As you can imagine, there are numerous initiatives in place under this program, but for purposes of communicating our progress, we've categorized them into a few core buckets, which you can see depicted on the slide. As we move through the process, we'll be updating you on the status of these with increasing accuracy and transparency.

The bar across the top of the page will be filled in overtime with real dollar progress towards our program goal. As we've previously stated, only a small portion of the savings will actually be realized in 2011 and as such the dollar impact of our efforts, thus far, has not been meaningful. We have, however, made significant progress on our overall plan and are in full implementation mode on several large and dozens of smaller initiatives. I'll remind you that the $300 million in expense reductions are above and beyond the expected credit-related expense and mortgage repurchase reserve normalization that undoubtedly will occur -- undoubtedly occur as the economic environment improves. The sub-60 efficiency ratio goal is the culmination of both the program and these expected normalizations.

So let me move to some of the specific initiatives. So first, starting with the strategic supply management effort. That's focused on not only securing even more competitive pricing from our supply base, but also proactively further managing down our own demand and assessing value received for costs incurred. Nearly all outside spend areas are in scope and the entire enterprise is in the game. The broad categories for which we are providing status updates are: Discretionary spending, demand management and outsourcing. Immediate actions have been taken to further reduce expense in obvious discretionary areas. But more importantly, we're enhancing our engagement model focused on sustaining these new lower levels of spending.

The next key component of the program is the consumer bank efficiencies initiatives, which includes channel optimization, alternative channel management and sales and service productivity. As we've articulated previously, we've made numerous investments in client-facing technology such as mobile and ATM enhancements, which have supported and enabled a meaningful shift in clients' willingness to use self-service channels. As clients utilize these channels, it allows us to evaluate other aspects of our consumer delivery model such as our branch network. This is not a widespread branch-reduction exercise, though it will include some branch rationalization and core changes to our branch staffing model. There are going to be increases in key opportunity branches, but overall, net reductions to reflect reduced transaction volume. The changes are underway, and we'll begin to see the results early next year. The objective is to accomplish this while maintaining the key momentum we've established in our industry-leading loyalty.

Operations staff and support is the final of the 3 main categories of savings and includes our shared service initiatives along with digital technology and lean process design and management.

Within our corporate operations, there will be strategic consolidation of certain areas where redundancies have been identified. Today, some aspects of our corporate functions are performed in multiple parts of our organization like corporate staff within the lines of business and/or within the geographic units. Our future model will use a more centralized approach for support functions with more centers of excellence while preserving our key local sales and service delivery model. We expect that this will enable us to perform functions like marketing, procurement, technology and human resources more efficiently and more effectively.

We're also pursuing other opportunities such as standard reporting through all elements of the organization.

Digital technology, in this case, refers to a set of initiatives designed to significantly increase both our internal and our clients' use of digital solutions. We're uncovering means of reducing the amount of printed material in our interactions with clients in the day-to-day operations of our branches and across the bank. It also includes efforts to improve adoption rates of our more robust digital solutions by our clients.

While many of the initiatives are very specific like consolidations, redundancy eliminations and spans and layers analysis, we're also incorporating lean tools and technologies in to virtually the whole bank to boost productivity. We've had much success in using lean process principles in our technology and operations area to help drive large-scale transformational improvements. We plan to adopt these on a more widespread basis across more disciplines.

As the PPG expense program progresses, we'll provide status updates on each of the major initiatives outlined on this slide along with the real dollars that are coming out of our expense base as they are realized. I want to assure you this program has my full attention, and I'm confident that we've built the resources and have the intensity to accomplish our objective.

So in conclusion and before we open up the call for Q&A, I'll note that while our bottom line performance is not yet where we'd like it to be, progress is being made. Momentum is building around the initiatives we have in place to grow targeted businesses, better diversify the loan portfolio and reduce expenses. While the future may be a little less certain, virtually all of our asset quality metrics improved this quarter. Our client first mandate and focus on having a talented, highly engaged workforce is being recognized and rewarded by our clients. And all that's being done with an eye towards driving better return for our shareholders. I have great confidence we've got the right priorities in place. We have a great team leading our company. We have focused teammates working towards a common objective.

Now before we turn it over to Q&A, I'd like to take a little liberty to thank the teammates who are on this call as they are what define SunTrust.

So with that said, Kris, let me hand it back over to you, and we'll start the Q&A

Kristopher Dickson

Thanks, Bill. When we're ready to open up the call for Q&A, I'd like to ask the participants to please limit yourself to one primary question, followed by one follow-up.


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