PNC Financial Services Group (PNC) Claudina Tesouro and David Leighton November 11 th, 2009 Company Profile PNC Financial Services Group (PNC) is one of the largest diversified financial service companies in the United States with over $270 billion in assets. PNC has seven different lines of businesses, it provides retail banking, corporate and institutional, and asset management services to clients at its branch locations located throughout the Midwest, Northeast, and certain locations in Florida. The company also provides investment servicing support for other asset management firms through its Global Investments Servicing segment. PNC owns about a 35% stake in BlackRock, Inc. PNC acquired National City Corporation on December 31 st, 2008. With the acquisition of National City PNC gained access to a wider customer base and more exposure to residential and commercial real estate as well as consumer loans. Balance Sheet Analysis PNC Financial Services Group Current Price $53.47 Price Target $59.18 - $61.70 Market Cap 24.65 Bil 52 Week High $68.95 52 Week Low $16.20 Avg Volume 5,890,720 EPS $1.00 P/E 20.73 Assets PNC has a well diversified loan portfolio; their risk exposure is well distributed among all sectors. Most of their loans reside in manufacturing and retail sector and are performing well and improving with the economy. Loan syndications did not exceed $10 million loans so credit risk is not concentrated in any one specific deal. Under current economic conditions, we want to carefully evaluate credit quality and how companies have reacted to credit risk exposure. PNC has reserves for loan losses of 3% for total loans. Even though this value is similar to the industry average, we believe that PNC has higher loan quality compared to its peer group. PNC s commercial real estate (CRE) exposure is at 9% of total assets and is among the lowest in its peer group. This includes Real Estate projects but excludes commercial mortgages that have been performing well. Many banks have not been moving CRE loans into nonperforming status even if the loan-to-value reached 125%. This has deferred many of the CRE losses while providing some extra time to restructure these loans.
PNC employed a different strategy, taking a proactive stance to move distressed CRE into the nonperforming class immediately, well before LTVs reached unhealthy levels. Based on this action, Pittsburgh-based PNC forecast its credit costs would decline faster than those of its rivals as the U.S. economy recovers. We agree that their disciplined underwriting practices, slowdown in new construction supply and well-reserved marked assets should reduce their Loan Breakdown credit costs. 13% 4% They have also cut their exposure to the financial sector by selling assets that were dragging down their profits. The company was able to sell part of this exposure at a relatively low discount of $0.10 on the dollar. 33% PNC has been very active in selling Other Real Estate Owned (OREOs) properties, and they have allocated resources to continue selling bank-owned assets. They anticipate further activity resulting from ineffective government-sponsored programs such as HAMP. This program may have provided extra time and improved short term liquidity associated with eligible assets but may prove to be ineffective over time. The National City acquisition has strengthened PNC franchise value via its expansion in core deposits. Besides the intangible value, we will also discuss the funding benefits associated with these deposits in the next section. We believe that low-cost funding and the cross-selling ability provided by the different product lines represent part of the significant value resulting from PNC-National City synergy. Total assets shrink is consistent with current economic conditions; loans are running off and not being renewed. This allows the company to stay well-capitalized instead of taking unnecessary risk. Liabilities We believe that PNC has positioned their balance sheet to benefit from core deposits and we believe that their business model is paying off. Their core deposits, short-term funding that includes interest checking and money market accounts, have grown $11 billion while time deposits, that includes both retail and brokered CDs have decreased $20 billion. The deposits decline is associated with a recent divestiture of 61 branches as agreed when completing National City s deal. Other borrowings show the same pattern; short term other borrowings have increased while long-term borrowings have decreased. This shift in debt allocation allows PNC to benefit from lower funding cost 15% 35% Equipment Leases Commercial Commercial Real Estate Consumer Residential Real Estate
or, in other words, it allows them to widen their net interest margin. We expect those improvements to continue as they reprice about $7Billion of higher rate CDs. PNC has benefited from the National City acquisition in at least two ways. First, they have expanded their ability to raise short funding and second, they bought these deposits at a discount. They accreted over $1 billion since the deal was closed and they still have over $6 billion in accretion remaining on their books. We will discuss more benefits related to deposits when we discuss cross-selling implications under our income analysis. Capital PNC remains well-capitalized and it has strengthened its capital ratio as fair value of its assets improved. Earnings The Bank has been profitable in most quarters since the crisis started in 2007. The fourth quarter of 2008 was the only unprofitable quarter and those earnings were driven by conforming provisions required to complete the National City acquisition. The latest quarter provided strong improvements in operating performance. Revenues increased while expenses decreased at surprisingly higher levels. Credit deterioration was moderate. We believe that during this quarter PNC has proven to have a strong earning generation capability. 3 Month Performance 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% August-09 September-09 October-09 November-09 PNC XLF S&P 500
Income Interest income has dropped but at a lower rate than interest expense. As a consequence, current net interest margin is well above its historical levels. Furthermore, gain on sales of short term investments helped covering the higher provisions for loan losses resulting from the crisis and National City s acquisition. Given the high current balance of short term investments and the high demand for these securities, the company could sell more of these instruments if necessary. Non-interest income of $1.8 billion represents 45% of total revenue. This is primarily customer related and it s expected to grow as the company becomes more aggressive in their cross-selling strategy. Prior to National City purchase, PNC was successful at cross-selling products and they expect to expand that value into National City s activity. Now their lenders have more incentives to offer deposits products and we expect to continue seeing improvements as PNC strengthens its long term customer relationships through different lines of businesses. Customer conversions are expected to start in November and if the integration continues its smooth course, it should strengthen customer relationships. Refinance pools are shrinking and mortgage-fee income has slowed down as a result. However, the drop in mortgage banking income was offset by an increase in retail banking fee-income. We believe that a lower rate environment, together with PNC increasing market share, will provide a unique opportunity to strengthen long term customer relationships across the different business segments. Under lower rate scenarios, the company is originating loans that have no incentives to prepay. As a consequence, those loans and their corresponding customer relationship will stay in the company s books for a long time. This natural increment in customer retention rate provides the opportunity to offer them other products from other business segments. For example, a customer that was originally a mortgage applicant can become a retail-banking customer as well if his/her expectations on the first product were met. PNC owns approximately 35% of fixed-income specialist BlackRock. This is one of the largest publicly traded asset management firms who has significantly improved its profitability in recent months. We expect PNC to continue benefiting from this asset holding. Expenses As discussed earlier, lower funding costs have significantly reduced PNC s interest expenses. Noninterest expense reduction has beaten the company s estimates. They have made significant progress in their cost-saving plan related to National City acquisition. The company is ahead of their cost-cutting schedule, allowing to profit from those improvements for a longer period of time; year-to date, the company has realized $460 million in cost savings from the merger and expects to end the year saving up to $690 million. Besides the time frame of cost-saving benefits, the company also plans to increase their cost-savings targets early in 2010. We view this as a positive indicator of their disciplined cost management practices.
PNC efficiency ratio shows an optimistic trend and is expected to improve even more as the cost-saving plan continues its course. TARP expense in Q3 was $95 million and the company shows no intention to repay TARP until 2011. Management believes that the recovery is too fragile so keeping TARP money is in the best interest of the shareholders. We expect to continue seeing similar levels of spending related to TARP Money; this level is expected to be around $400 Million a year. Company Key indicators vs. Competition PNC has outperformed its competitors in recent months. Given PNC s lower Commercial Real Estate Exposure, we expect this trend to continue. 3 Month Stock Performance 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% 8/6/2009 9/6/2009 10/6/2009 11/6/2009 PNC BAC USB JPM WFC
PNC BAC WFC JPM USB Industry P/E 20.73 n/a 13.43 28.42 24.26 23.89 P/B 1.20 0.65 1.40 1.11 1.92 1.25 Tier 1 Capital (Core) 10.80% 12.46% 10.60% 10.20% 9.50% 11.70% Return on Assets 0.40% 0.14% 0.28% 0.26% 1.12% 0.32% Return on Common Equity 5.32% 1.81% 4.62% 3.82% 14.70% 3.19% Efficiency Ratio 56.19% 46.79% 51.60% 50.15% 48.31% 57.79% Net Charge Offs to Total Loans 0.40% 1.04% 0.63% 0.96% 0.57% 0.41% Reserve for Loan Losses to Total Loans 2.99% 3.92% 3.00% 4.69% 2.64% 1.97% Expectations We believe this company has a positive outlook, and we expect to capitalize from their operations. Credit Ratings Long Term Issuer S&P A 6/17/2009 ( changed its outlook to stable from Watch Negative) Moody's A 3 5/12/2009 DBRS Ltd. A (high) 12/31/2008 Fitch Ratings A+ 12/31/2008 Greed vs. Fear Below is a summary of the Greed and Fear factors that we have identified in our analysis. Greed PNC is well capitalized and its conservative loan portfolio going into the recession has provided it with strength coming out. We believe their balance sheet positioning make this company highly liquid. Short term investments and BlackRock s attractive holding provide a liquidity guarantee. We expect low funding to continue benefiting the company by keeping attractive net interest margin levels. The acquisition of National City expands PNC s deposit base while also providing cross-selling opportunities. The acquisition of National City also provides economies of scale and cost savings. The Bank rally has stopped amid commercial real estate risk exposure but we believe that PNC s lower CRE exposure will allow them to continue its rally regardless of common sector challenges. Noninterest income has historically accounted for about half of PNCs revenue which has allowed it to be more selective in its loan origination.
Fear PNC still has TARP funds outstanding in the amount of $7.6 billion. Short term rate increases can significantly deteriorate their net interest margins The loans acquired in the National City acquisition deteriorate at a much higher rate than expected National City integrations risks may be significant during future customer conversion Political reform on the financial industry due to the recession could adversely affect PNC s ability to remain profitable. Due to its large stake in BlackRock, PNC is affected by adverse changes in BlackRock s profitability. Valuation We have a price target range of $59.18 - $61.70 for PNC going forward. This represents a 10.5% to 15% discount to the current price of $53.47. This range was calculated using a combination of Price to Earnings Multiple approach and a modified Dividend Discount Model. A discounting of future earnings was used due to the lack of a reliable and steady dividend. Future earnings were calculated based on future diluted EPS growth as shown below. Date Estimated Diluted EPS ($ per share) Estimated Earnings (in thousands) 4 th Quarter 2009 $0.95 $368,800 2010 3.45 1,589,528 2011 4.34 2,000,740 2012 4.77 2,200,143 2013 4.93 2,275,000 This model assumes the realization of the accretive value of the National City acquisition and is based on a very conservative 3% terminal growth rate. This model also assumes that PNC repays TARP funds by the end of 2010. These funds currently cost the firm $0.84 per share annually. The price to earnings multiple model is based on a 20.73 P/E multiple for PNC which is currently below the industry average of 23.89. The model also assumes that PNC has a 2009 EPS of $3.12 per shares which would be a fourth quarter earnings of $0.95 per share. We strongly believe this stock is currently undervalued, and we would like to make a Buy Recommendation.