PNC FINANCIAL SERVICES GROUP, INC. quarterly report, Q1 FY2010

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

Reporting period: Three months ended March 31, 2010. Unaudited results are compared primarily with the three months ended March 31, 2009; balance-sheet changes are compared with December 31, 2009. PNC is a diversified U.S. financial services company. Global Investment Servicing (GIS) is reported as discontinued operations because it is pending sale.

Financial performance

Metric	Q1 2010	Q1 2009
Total revenue	$3.763 billion	$3.686 billion
Net interest income	$2.379 billion	$2.320 billion
Net interest margin	4.24%	3.81%
Noninterest expense	$2.113 billion	$2.158 billion
Provision for credit losses	$751 million	$880 million
Income from continuing operations before noncontrolling interests	$648 million	$520 million
Net income	$671 million	$530 million
Net income attributable to common shareholders	$333 million	$460 million
Diluted earnings per common share	$0.66	$1.03

Pretax, pre-provision earnings, a non-GAAP measure defined as revenue less noninterest expense, were $1.650 billion versus $1.528 billion. The efficiency ratio improved to 56% from 59%. Common earnings and diluted EPS fell despite higher net income, primarily because PNC recorded a one-time, noncash $250 million preferred-stock discount accretion when redeeming its TARP preferred stock; preferred dividends also increased to $93 million from $51 million.

Operating cash flow was $2.272 billion, compared with $870 million; investing activities provided $5.617 billion, versus $822 million; financing activities used $8.614 billion, versus $2.587 billion. Cash and due from banks declined $725 million during the quarter.

Balance sheet, capital and liquidity

• At March 31, 2010, total assets were $265.4 billion, loans $157.3 billion, deposits $182.5 billion, borrowed funds $42.5 billion and shareholders’ equity $26.8 billion. Assets were down $4.5 billion and deposits down $4.4 billion from year-end; borrowed funds rose $3.2 billion.
• Loans were nearly unchanged from year-end. PNC attributed a $3.5 billion increase from consolidating Market Street and a credit-card securitization portfolio to soft loan demand, repayments and distressed-portfolio payoffs that offset it. The loan-to-deposit ratio was 86%.
• Tier 1 risk-based, Tier 1 common, total risk-based and leverage ratios were 10.3%, 7.9%, 13.9% and 8.8%, respectively. The Tier 1 common ratio rose from 6.0% at year-end, supported by a $3.4 billion common-stock offering. PNC redeemed $7.6 billion of TARP preferred stock; the redemption reduced the Tier 1 risk-based ratio from 11.4% at year-end.
• PNC reported $53.1 billion of liquid assets, of which $25.3 billion was pledged. Unused secured borrowing capacity was $24.3 billion at the Federal Reserve and $7.4 billion at the Federal Home Loan Bank. Management described bank-level liquidity as strong.

Asset quality and material period comparisons

• Nonperforming assets were $6.54 billion, up $224 million from year-end; management said the increase was lower than in each of the prior three quarters. Nonperforming loans were $5.76 billion, or 3.66% of loans, versus 3.60% at year-end.
• The allowance for loan and lease losses increased to $5.32 billion, or 3.38% of loans, from $5.07 billion and 3.22%. The allowance equaled 92% of nonperforming loans. Net charge-offs were $691 million; the annualized ratio was 1.77%, compared with 1.01% a year earlier.
• The provision declined year over year as economic conditions began to stabilize. PNC noted that purchased impaired loans from National City are treated as performing under purchase accounting and are excluded from nonperforming-loan measures; this affects reported asset-quality comparisons.
• Net interest margin rose year over year, reflecting deposit repricing and fewer low-yield interest-earning deposits. Noninterest income was broadly stable: higher asset-management and corporate-service fees and lower securities impairment losses were largely offset by lower residential mortgage revenue and deposit service charges.
• Residential Mortgage Banking earnings fell to $82 million from $227 million, mainly on lower mortgage-servicing-rights hedge gains and lower loan-sale revenue. BlackRock segment earnings increased to $77 million from $23 million, while the Distressed Assets Portfolio improved to $72 million from $3 million. Retail Banking earnings declined to $24 million from $50 million; Corporate and Institutional Banking was broadly flat at $360 million versus $359 million.

Outlook, management commentary and risks

• PNC expected full-year 2010 revenue to be relatively stable with 2009, excluding the $1.1 billion BlackRock/Barclays Global Investors transaction gain recognized in Q4 2009. Management expected net interest income and margin to remain relatively flat at least through the first half of 2010.
• Management believed the provision for credit losses may have peaked in Q4 2009 and expected full-year 2010 provision to be below 2009; actual levels depend on nonperforming loans, economic recovery and regulatory changes.
• PNC expected to exceed its $1.5 billion annualized National City cost-savings goal by Q4 2010, with annualized savings of about $1.4 billion reported by Q1. It expected approximately $285 million of pretax National City merger and integration costs in 2010. The filing separately reports $113 million of Q1 costs in the executive discussion and $102 million of integration costs in noninterest expense.
• PNC agreed to sell GIS for $2.3 billion cash, anticipated closing in Q3 2010, and expected an after-tax gain of approximately $455 million. The sale was subject to regulatory approvals and other closing conditions. If it did not close by November 1, 2010, PNC said it would need to raise $700 million of additional Tier 1 common capital. Pro forma for the sale, management estimated Tier 1 common capital at 8.6%, versus 7.9% reported.
• PNC cited expected Retail Banking headwinds from Regulation E and the Credit CARD Act, estimating 2010 earnings impacts of approximately $115 million and $40 million, respectively, before potential offsets. Legislation was also expected to essentially eliminate the federally guaranteed FFELP education-lending program from July 1, 2010; PNC originated $2.6 billion of FFELP loans in 2009.
• Key risks include continued weakness in the economy and real estate markets, credit deterioration and losses, interest-rate and market movements, securities valuation and further impairment, National City integration execution, GIS sale completion, regulatory reform and capital requirements, litigation, and counterparty performance. PNC reported no material change in risk factors from its 2009 Form 10-K.

Contingencies and unusual items

• Available-for-sale securities had a $1.6 billion net unrealized loss at March 31, improved from $2.3 billion at year-end. Q1 other-than-temporary impairment losses totaled $240 million, including $116 million of credit-related losses recognized in earnings and $124 million of noncredit losses recorded in other comprehensive income.
• PNC adopted new variable-interest-entity consolidation guidance on January 1, 2010, consolidating Market Street, a credit-card securitization trust and certain tax-credit investments. Adoption included $4.1 billion of assets, $4.2 billion of liabilities and a $92 million after-tax cumulative adjustment to retained earnings.
• Estimated residential mortgage repurchase and indemnification liability was $188 million. Total estimated liability for loan repurchase and indemnification claims, including agency-program reserves, was $317 million. PNC also reported $6.0 billion of potential exposure under commercial mortgage loss-sharing programs, with a $65 million reserve, and a $194 million Visa indemnification liability.
• PNC disclosed $96.4 billion of net unfunded credit commitments and $10.1 billion of net standby letters of credit. These are commitments, not expected cash outflows; actual funding depends on contractual conditions and customer activity.
• PNC’s first-quarter common dividend was $0.10 per share, compared with $0.66 in Q1 2009. The 2009 amount reflected a higher dividend before it was reduced.

Most important facts for investors to verify

• Whether the GIS sale closed on schedule, the realized gain and capital benefit, and whether the $700 million capital-raise requirement was avoided.
• Whether credit quality and provision costs continued to improve, including commercial real estate performance, charge-offs, nonperforming assets and reserve coverage.
• Whether National City integration savings exceeded the stated target and whether integration costs remained within expectations.
• How much reported earnings and asset quality depend on purchase-accounting accretion and the treatment of National City purchased impaired loans.
• Whether deposit funding, liquidity buffers and regulatory capital remained adequate after the TARP redemption and amid changing regulatory requirements.
• Whether mortgage repurchase claims, securities impairment exposure, legal matters and other disclosed commitments resulted in losses materially above recorded reserves.