PNC

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended March 31, 2007 for The PNC Financial Services Group, Inc. PNC is a diversified financial services company operating in retail banking, corporate and institutional banking, asset management, and global fund processing. A significant event during the period was the acquisition of Mercantile Bankshares Corporation on March 2, 2007, for approximately $5.9 billion in stock and cash, which significantly expanded PNC's presence in the mid-Atlantic region.

Key Financial Metrics

Material Changes vs. Prior Period

• Net Income Growth: Net income increased 30% to $459 million, driven by a 12% increase in net interest income and improved operating leverage.
• Revenue Composition: Total revenue decreased 7% year-over-year. This decline is primarily due to the deconsolidation of BlackRock, Inc. effective September 2006. In Q1 2006, BlackRock was consolidated; in Q1 2007, it is accounted for under the equity method, significantly reducing reported noninterest income.
• Balance Sheet Expansion: Total assets increased $20.7 billion from the prior year quarter, largely attributable to the $21 billion in assets acquired from Mercantile.
• Asset Quality: Nonperforming assets to total assets improved to 0.17% from 0.22% in Q1 2006. The provision for credit losses decreased to $8 million from $22 million.
• Unusual Items: Q1 2007 earnings included a $53 million gain from the transfer of BlackRock shares to satisfy LTIP obligations, partially offset by a $20 million mark-to-market loss on remaining LTIP obligations and $8 million in acquisition integration costs.

Guidance, Outlook, and Risks

• Outlook: Management expects full-year 2007 taxable-equivalent net interest income to grow in the mid-20% range compared to 2006, with an improved net interest margin. Total noninterest income is expected to decline significantly for the full year compared to 2006 due to the BlackRock deconsolidation, though remaining sources are expected to grow by a low teens percentage.
• Expense Guidance: Noninterest expense is expected to decline for the full year compared to 2006 due to BlackRock deconsolidation, excluding which expenses are expected to grow by a low teens percentage. Additional pretax integration costs for Mercantile are estimated at $40 million for the remainder of 2007.
• Risks:
  • Interest Rate Risk: The company is sensitive to a flat or inverted yield curve. A 100 basis point increase in rates is projected to decrease net interest income by 2.6% in the first year.
  • Integration Risk: Successful integration of Mercantile is critical to realizing anticipated synergies.
  • Legal Proceedings: Pending litigation includes matters related to the Adelphia Communications bankruptcy, ERISA claims regarding pension plan conversion, and patent infringement claims regarding check imaging.
  • BlackRock LTIP: Earnings volatility may continue due to quarterly mark-to-market adjustments on the obligation to fund BlackRock LTIP programs.

Investor Verification Checklist

• Mercantile Integration: Verify the progress of integrating Mercantile's 235 branches and $21 billion in assets, and monitor the realization of cost synergies.
• BlackRock Accounting Impact: Confirm understanding of the shift from consolidated to equity method accounting for BlackRock and its effect on revenue comparability.
• Asset Quality Trends: Monitor the allowance for loan and lease losses (currently 1.10% of loans) and net charge-off ratios, as management notes current asset quality levels may not be sustainable.
• Interest Rate Sensitivity: Review the impact of the yield curve on net interest margin, particularly given the liability-sensitive position noted in the risk management section.
• Legal Contingencies: Track the status of the Adelphia bankruptcy settlement and the ERISA pension plan litigation, as outcomes could be material.