PNC FINANCIAL SERVICES GROUP, INC. quarterly report, Q2 FY2010

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PNC Financial Services Group, Inc. — Second Quarter 2010 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2010. Financial statements are unaudited; amounts are in U.S. dollars unless stated otherwise. Comparisons are with the corresponding 2009 period, or December 31, 2009 for balance-sheet figures.

Business context

PNC is a diversified U.S. financial services company with retail and corporate banking, asset management, residential mortgage banking, a BlackRock investment, and a distressed-assets portfolio. The filing reports completion of the National City customer and branch conversions. PNC sold PNC Global Investment Servicing (GIS) on July 1, 2010, after quarter-end; GIS is presented as discontinued operations.

Financial results and key metrics

  • Second-quarter earnings: Net income was $803 million versus $207 million; net income attributable to common shareholders was $786 million versus $65 million. Diluted EPS was $1.47 versus $0.14, including discontinued-operations EPS of $0.04 versus $0.03.
  • First-half earnings: Net income was $1.474 billion versus $737 million; diluted EPS was $2.15 versus $1.16. First-half common earnings included a $250 million, noncash TARP preferred-stock discount accretion charge.
  • Revenue and margins: Second-quarter revenue was $3.912 billion, up 3%; net interest income was $2.435 billion, up 11%, and net interest margin was 4.35% versus 3.60%. Noninterest income declined 8% to $1.477 billion. First-half revenue was $7.675 billion versus $7.489 billion; first-half net interest margin was 4.29% versus 3.70%.
  • Expenses and credit costs: Second-quarter noninterest expense fell 20% to $2.002 billion; provision for credit losses fell to $823 million from $1.087 billion. Pretax, pre-provision earnings, a non-GAAP measure, were $1.910 billion versus $1.311 billion. For the first half, expense was $4.115 billion versus $4.650 billion and provision was $1.574 billion versus $1.967 billion.
  • Cash flow: For the first half, operating activities provided $4.268 billion and investing activities provided $9.276 billion; financing activities used $14.274 billion. Cash and due from banks decreased $730 million to $3.558 billion. These cash-flow totals reflect banking and securities activity and should be considered alongside the balance sheet and funding disclosures.
  • Balance sheet and funding: At June 30, assets were $261.7 billion, down from $269.9 billion at year-end 2009. Loans were $154.3 billion, deposits $178.8 billion, and borrowed funds $40.4 billion. The loan-to-deposit ratio was 86%. Deposits declined $8.1 billion from year-end, while loans declined $3.2 billion.
  • Liquidity and capital: Liquid assets were $54.0 billion, of which $25.2 billion was pledged. Unused secured borrowing capacity was $23.4 billion at the Federal Reserve and $7.5 billion at the FHLB. Tier 1 risk-based, Tier 1 common, total risk-based, and leverage ratios were 10.7%, 8.3%, 14.3%, and 9.1%, respectively. PNC estimated that the GIS sale would raise Tier 1 risk-based and Tier 1 common ratios to 11.3% and 9.0% on a pro forma basis.
  • Asset quality: Nonperforming assets were $5.904 billion, down from $6.316 billion at year-end; nonperforming loans were $5.110 billion. The allowance for loan and lease losses was $5.336 billion, 3.46% of loans and 104% of nonperforming loans. Second-quarter annualized net charge-offs were 2.18% of average loans.

Material changes versus comparable periods

  • Higher net interest income reflected lower deposit and borrowing costs; the improvement in margin was partly offset by lower loan volume and securities yields.
  • Lower provision expense and lower noninterest expense supported earnings growth. Expense reductions reflected National City integration savings and, in the second quarter, reversal of accrued liabilities.
  • Noninterest income weakened, particularly residential mortgage revenue: first-half residential mortgage revenue was $326 million versus $676 million, amid lower loan-sale revenue and mortgage-servicing-rights hedging gains.
  • Segment results were mixed. Second-quarter Corporate & Institutional Banking earnings rose to $443 million from $107 million; Retail Banking earned $85 million versus $61 million. Residential Mortgage Banking earned $92 million in both periods. The Distressed Assets Portfolio recorded an $86 million loss versus $155 million of earnings.
  • Common equity increased following a first-quarter offering of 63.9 million shares for net proceeds reflected as a $3.4 billion increase in equity. Common shares outstanding were 525 million versus 462 million at year-end.

Guidance, management commentary, risks and unusual items

  • Management expected full-year 2010 revenue to be broadly consistent with 2009, excluding the $1.1 billion pretax gain from BlackRock’s BGI acquisition recorded in fourth-quarter 2009. It expected third-quarter net interest income and margin to be below second-quarter levels, citing lower purchase-accounting accretion, soft loan demand and low rates.
  • Management said second-half provision expense might be lower than first-half expense, dependent on nonperforming loans, coverage, economic recovery and regulatory changes. It expected third-quarter expense to rise from second-quarter levels because of accrued-liability reversals.
  • PNC reported $1.6 billion of annualized National City acquisition cost savings in the second quarter and set a goal of $1.8 billion by year-end 2010. Integration costs were $100 million for the quarter and $213 million for the first half.
  • Expected revenue pressure included an estimated $145 million second-half impact from Regulation E overdraft rules, about $65 million for full-year 2010 from the Credit CARD Act, and adverse effects on federally guaranteed education lending following the July 1, 2010 effective date of HCERA provisions.
  • The July 1 GIS sale generated $2.3 billion in cash. PNC estimated an after-tax gain of $335 million for recognition in the third quarter and a $1.4 billion addition to regulatory capital. The filing also estimated a favorable $89 million tax benefit for the third quarter, expected to bring the full-year effective tax rate to 25%–26%.
  • A $105 million pretax second-quarter adjustment primarily related to purchase-accounting interest income and expense should have been recorded in 2009; management said it was not material to prior, current or estimated full-year statements. The quarter also included reversals of $73 million for a franchise-tax settlement and $47 million related to Visa litigation indemnification.
  • Credit quality showed signs of stabilization, but commercial real estate, residential real estate, distressed assets and purchased impaired loans remain important exposures. A planned sale of distressed residential mortgage and brokered home-equity loans, with about $2.0 billion unpaid principal, led to $109 million of additional second-quarter provision and $75 million of charge-offs.
  • Dodd-Frank was signed into law on July 21, 2010. PNC expected regulatory implementation to affect revenue, operating costs and business activities, but said the magnitude and timing were uncertain. Other sensitivities include interest rates, economic recovery, market liquidity and valuations, credit performance, litigation, and regulatory capital requirements.
  • Legal matters include overdraft-fee class actions and other proceedings. The filing states that possible losses in many matters cannot be meaningfully estimated; a tentative overdraft-litigation settlement was subject to notice and court approval.

Most important facts for investors to verify

  • Whether credit stabilization continues, particularly in commercial real estate, residential lending and the distressed-assets portfolio, and how charge-offs and allowance coverage develop.
  • Whether loan demand and deposit balances stabilize, and whether deposit repricing and funding costs sustain net interest income as purchase-accounting accretion declines.
  • Completion and financial impact of the GIS sale, including the realized gain, capital benefit and removal of GIS earnings and assets.
  • Delivery of National City savings targets and the sustainability of lower expenses after the second-quarter liability reversals.
  • Actual effects of Dodd-Frank, Regulation E, the Credit CARD Act and education-lending changes on revenue, costs and capital.
  • Potential changes in mortgage-servicing-rights and securities valuations, including further impairment charges, and developments in legal, repurchase and indemnification exposures.