PNC FINANCIAL SERVICES GROUP, INC. annual report, FY2009

Business context and reporting period

PNC Financial Services Group, Inc. filed this Form 10-K for the fiscal year ended December 31, 2009. PNC is a diversified financial services company with retail banking, corporate and institutional banking, asset management, residential mortgage banking, and an investment in BlackRock. The 2009 results include National City, acquired on December 31, 2008; 2008 income results generally do not include National City’s operations, making year-over-year comparisons less comparable.

Financial results and position

Unless otherwise noted, amounts are in U.S. dollars.

• Unusual earnings item: 2009 revenue included a $1.076 billion pretax gain from BlackRock’s acquisition of Barclays Global Investors (BGI), or $687 million after tax. Noninterest income also included $577 million of credit-related other-than-temporary impairment losses and $550 million of net securities gains.
• Cash flow: Operating activities provided $5.753 billion; investing activities provided $9.479 billion; financing activities used $15.415 billion. Cash and due from banks ended the year at $4.288 billion.
• Balance sheet: Total assets were $269.863 billion, loans $157.543 billion, deposits $186.922 billion, borrowed funds $39.261 billion, and shareholders’ equity $29.942 billion. Loans declined 10% from year-end 2008; deposits declined 3% and borrowed funds declined 25%.
• Credit quality: The allowance for loan and lease losses was $5.072 billion, or 3.22% of loans. Net charge-offs were $2.711 billion (1.64% of average loans). Nonperforming assets rose to $6.316 billion from $2.181 billion, and were 3.99% of loans and foreclosed assets.
• Capital and liquidity: Year-end Tier 1 risk-based capital was 11.4%, Tier 1 common was 6.0%, and total risk-based capital was 15.0%. The loan-to-deposit ratio was 84%. Liquid assets totaled $59.8 billion, of which $23.4 billion was pledged. The bank subsidiary met the regulatory “well capitalized” classification.
• Shareholder returns: PNC reduced its quarterly common dividend from $0.66 to $0.10 per share in March 2009; full-year dividends declared were $0.96 per share, versus $2.61 in 2008.

Material changes versus the prior comparable period

• Revenue and earnings increased substantially, primarily reflecting National City’s inclusion for the full year and the BGI-related gain; the increase should not be interpreted as organic growth. Net income also benefited from a higher net interest margin.
• Credit costs increased sharply: provision for credit losses rose to $3.930 billion from $1.517 billion, and nonperforming assets increased by $4.1 billion. Management said credit deterioration continued, although its pace eased in the fourth quarter.
• PNC strengthened capital and shifted funding mix toward relationship deposits. Transaction deposits grew $15 billion, while nonrelationship certificates of deposit declined approximately $16 billion.
• Investment securities increased to $56.027 billion from $43.473 billion. The available-for-sale portfolio’s net unrealized loss narrowed to $2.3 billion from $5.4 billion.
• National City integration generated $800 million of acquisition cost savings in 2009, alongside $421 million of integration costs. PNC said it had raised its annualized cost-savings target to $1.5 billion from $1.2 billion.

Outlook, commentary, risks and contingencies

• Management expected 2010 net interest income to be modestly lower, reflecting the expected run-off of higher-yielding assets and lower cash recoveries on acquired impaired loans; rising rates could partly offset the decline. PNC expected the first-quarter 2010 credit-loss provision to be similar to the third quarter 2009 level.
• PNC expected noninterest income to be relatively flat in 2010 excluding the BGI gain and residential mortgage servicing hedge gains, which it did not expect to repeat at 2009 levels. Management also expected mortgage refinancing and application volumes to be weaker.
• PNC expected approximately $285 million of additional pretax National City integration costs in 2010, while targeting further expense reductions and continuing system conversions, expected to be completed by June 2010.
• PNC agreed in February 2010 to sell Global Investment Servicing (GIS) for $2.3 billion cash, anticipating a third-quarter 2010 close and an after-tax gain of approximately $455 million, subject to approvals and other conditions. If the sale was not completed by November 1, 2010, PNC was required to raise $700 million of Tier 1 common capital through approved asset sales and/or common stock issuance.
• After year-end, PNC raised $3.0 billion through a common stock offering and issued $2.0 billion of senior notes, then redeemed its $7.6 billion TARP Series N preferred stock on February 10, 2010. PNC did not repurchase the related Treasury warrant. The redemption accelerated $250 million of discount accretion, a one-time noncash reduction in income available to common shareholders expected in first-quarter 2010.
• Major risks include a weak or faltering recovery; further deterioration in commercial real estate, residential mortgage and consumer credit; National City integration and acquired-asset valuation; securities impairments and less observable fair values; regulatory and consumer-protection changes; litigation and government inquiries; and limits on subsidiary dividends and parent-company liquidity. PNC also disclosed material off-balance-sheet commitments, including $100.795 billion of unfunded credit commitments and $10.026 billion of standby letters of credit.
• Auditor PricewaterhouseCoopers LLP issued an unqualified opinion on the financial statements and internal control over financial reporting; management also concluded internal controls were effective at year-end.

Important facts for investors to verify

• Separate acquisition-driven growth and the $1.076 billion BGI transaction gain from recurring revenue and earnings; assess the comparability of 2009 and 2008.
• Track trends in nonperforming assets, net charge-offs, reserves, and the performance and cash-flow estimates of National City purchased impaired loans.
• Confirm delivery of the $1.5 billion annualized cost-savings target, remaining integration costs, and completion of the remaining customer-system conversions.
• Monitor GIS sale approvals, closing and gain realization, and the associated $700 million capital requirement if closing is delayed beyond November 1, 2010.
• Review capital and liquidity after the TARP redemption, equity and debt offerings, and planned GIS sale; consider the continuing Treasury warrant and dividend restrictions.
• Assess future impairment charges and valuation uncertainty in non-agency mortgage-backed and other securities, mortgage servicing rights, and acquired assets, as well as the outcome of significant litigation and regulatory inquiries.