PNC

Business Context and Reporting Period

Company: The PNC Financial Services Group, Inc.
Filing Type: Form 10-Q (Unaudited)
Reporting Period: Quarter and six months ended June 30, 2006
Overview: PNC is a diversified financial services company operating in retail banking, corporate and institutional banking, asset management (BlackRock), and global fund processing (PFPC). The company is executing the "One PNC" initiative to improve efficiency and customer focus, targeting $400 million in annual pretax earnings benefits by mid-2007. A significant strategic development is the pending transaction where Merrill Lynch will contribute its investment management business to BlackRock, expected to close around September 30, 2006.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total revenue increased 22% in Q2 2006 compared to Q2 2005, driven primarily by a 32% increase in noninterest income. Asset management fees were the largest contributor to noninterest income growth.
• Net Income: Net income rose 35% in Q2 2006 ($381 million) versus Q2 2005 ($282 million). This improvement was aided by strong operating leverage and a $53 million loan recovery in Q2 2005 that is not present in the current period.
• Net Interest Margin (NIM): NIM declined to 2.90% in Q2 2006 from 3.00% in Q2 2005. The decline was caused by a 106 basis point increase in the average rate paid on deposits and a 158 basis point increase in the rate paid on borrowed funds, which outpaced the 81 basis point increase in yields on earning assets.
• Asset Quality: Nonperforming assets to loans, loans held for sale, and foreclosed assets increased slightly to 0.44% from 0.42% in the prior year. Net charge-offs to average loans were 0.24% for the quarter.
• Balance Sheet: Total assets grew to $94.9 billion, with loans increasing $1.4 billion and deposits increasing $3.2 billion compared to the prior year period-end.

Guidance, Outlook, and Risks

• BlackRock Transaction: PNC expects to recognize an after-tax gain of approximately $1.6 billion upon the closing of the Merrill Lynch/BlackRock transaction, which will significantly enhance capital and tangible common equity ratios. PNC will transition to the equity method of accounting for BlackRock post-closing.
• One PNC Initiative: The company expects to capture approximately $265 million in cumulative value by the end of 2006. Cost savings are being realized through workforce reductions (approx. 2,400 of 3,000 targeted positions eliminated as of June 30, 2006).
• Interest Rate Outlook: Management expects taxable-equivalent net interest income to be relatively flat to up through the remainder of 2006. NIM may continue to face pressure in the latter half of 2006 due to a flat or inverted yield curve and competition for deposits.
• Asset Quality Outlook: Management does not expect to sustain current asset quality levels and anticipates an increase in nonperforming loans and credit loss provisioning in future quarters, though overall quality is expected to remain strong by historical standards.
• Accounting Changes: Adoption of FASB Staff Position FAS 13-2 effective January 1, 2007, regarding leveraged leases, is expected to result in an after-tax charge to opening retained earnings of approximately $140 million to $160 million.
• Legal Proceedings: PNC is involved in litigation related to the Adelphia Communications bankruptcy and a patent infringement suit by Data Treasury Corporation. Management believes the potential liability for the Adelphia settlement is insignificant and intends to defend other matters vigorously.

Investor Verification Checklist

• BlackRock Deal Closing: Verify the status of regulatory approvals and the expected closing date (targeted for late September 2006) for the Merrill Lynch/BlackRock transaction.
• Interest Rate Sensitivity: Review the impact of rising deposit costs on future Net Interest Margins, particularly given the liability-sensitive balance sheet position.
• Asset Quality Trends: Monitor the trajectory of nonperforming loans and the provision for credit losses, as management explicitly stated current quality levels are not sustainable.
• One PNC Execution: Track the realization of the targeted $400 million annual pretax earnings benefit and the associated cost savings versus implementation costs.
• Accounting Impact: Assess the potential impact of the FSP 13-2 adoption on 2007 earnings and retained earnings.