PNC FINANCIAL SVCS GROUP INC PNC.WS
July 26, 2010 - 11:32pm EST by
olivia08
2010 2011
Price: 14.64 EPS $0.00 $7.45
Shares Out. (in M): 17 P/E 0.0x 8.3x
Market Cap (in $M): 33,000 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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Description

PNC is a strong regional bank franchise trading $61.85 or just 8.25 times my earnings power estimate of $7.50. I am playing PNC via warrants, which the US Treasury obtained through the TARP program and subsequently auctioned to investors. The warrants are attractive for their relatively low cost and long-duration. Obviously, warrants are highly speculativeand the position should be sized appropriately.   
PNC warrants:
Price: $14.64
Strike: $67.33
Expiration: 12/31/2018
Implied volatility: 21
***PNC's earnings power is ~$7.50 per share. This assumes a 1.5% ROA, $262B assets and 527M shares. Earnings power should grow at a GDP+ type number annually. However, PNC is likely to find ways to enhance their growth rate. For example, they are well positioned for rising interest rates. They are asset sensitive, liquid (86% loans/deposits, securities/cash represent 32% of earning assets) and well-capitalized (9% pro forma tier one common equity). They are poised to benefit from financing the ultimate restructuring of underwater commercial properties through real-time intelligence gained via their Midland loan servicing business. Their acquisition of NCC has been a home run and I believe their cost savings goal of $1.8b annually remains a low-balled estimate (15% of combined costs for an in-market deal). They are also in a good position to make acquisitions once the National City deal is fully integrated. The main caveat is that it may take as long as two to three years for PNC to return to normalized earnings power and the pacing will be dictated by the economy.
***PNC's balance sheet has been recapitalized and it has one of the strongest balance sheets among large US banks, which will provide protection against a weakening economy and fire power to act opportunistically as the economy improves. A secondary source of strength is significant pre-tax pre-provision profits as a percentage of loans - the ability to earn through troubled times.  Important financial strength ratios are:
*9.0% tier one common equity ratio (pro forma for the sale of a securities processing division)
*5.6% marks/reserves for loan losses to gross loans (includes $3.3B PCI mark)
*1.7X reserve coverage to net charge offs
*4.9% PTPP as a percentage of loans
***There is evidence that loan losses are peaking, but this is not a certainty. 30-89 and 90+ delinquencies are down for two straight quarters; non-performing loans are down; current loans transferred to non-performing are off sharply (see p11 of q2 earnings supplement).
***In addition to a strong balance sheet, PNC possesses other positive attributes:
       *Low cost raw material generated by a strong regional deposit franchise
              *0.54% cost of deposits 
              *0.79% total cost of liabilities
       *Nice mix of fee oriented businesses (~40% of revenue)
       *Significant liquidity and capacity for new loans or investments
              *86% loan to deposit ratio
              *Short-duration securities are 32% of earning assets
              *Asset sensitive balance sheet mitigates the risk to higher interest rates
       *PNC owns 35% of BLK or 22.5M shares worth $3.6B or $6.83 per share.
***Banks are complex and opaque businesses with a lot of leverage, obviously. A good, trustworthy jockey is important in banking because of the abnormally large risk due to information asymmetry compounded by leverage. Bill Demchak is the Vice Chairman of PNC. He is a very bright guy and - cross your fingers - hopefully he will become the next CEO of the bank. He was courted for the BAC job and declined. The CEO Jim Rohr leaves much to be desired when listening to him speak. However, he is at least smart enough to keep a guy like Demchak around (most CEOs like Ken Lewis would feel threatened by a smarter guy being #2). Demchak made an impressive presentation at the Boston BancAnalyst conference in November - check it out.
***My valuation assumption is 10-12X EPS or $80-95 in FY12. The warrants should be worth $27-39 in that scenario using a 25 vol and about $2 less using 21 vol. 
Stock sensitivity to EPS and P/E
                     2010   2011   2012
EPS power     7.50    7.73    7.96
10X               75.00  77.25  79.57 <---- stock price at this multiple
12X               90.00  92.70  95.48

Warrant value @ 25 vol
10X              25.88   26.23  $26.50 <--------using above stock value, warrant is "worth" approx this figure
12X              37.71   38.54  $39.35

Returns
10X - common  21%   25%    29%  <-----------using current securities pricing and above valuation assumptions, simple return is this figure
10X - warrant    77%    79%    81%

12X - common 46%    50%     54%
12X - warrant 158%  163%   169%
Note if PNC increases the dividend the value of the warrants will theoretically decline, but I would submit that such a scenario would be quite positive for the stock price which is the primary determinant of warrant value. Warrant holders are protected from quarterly dividends above $0.66 per share at which point the warrant holder receives more warrants and a lower strike price.

Catalyst

certainty over bank capital standards
continued decline in bad loans and increases in earnings
redeployment of excess liquidity
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    Description

    PNC is a strong regional bank franchise trading $61.85 or just 8.25 times my earnings power estimate of $7.50. I am playing PNC via warrants, which the US Treasury obtained through the TARP program and subsequently auctioned to investors. The warrants are attractive for their relatively low cost and long-duration. Obviously, warrants are highly speculativeand the position should be sized appropriately.   
    PNC warrants:
    Price: $14.64
    Strike: $67.33
    Expiration: 12/31/2018
    Implied volatility: 21
    ***PNC's earnings power is ~$7.50 per share. This assumes a 1.5% ROA, $262B assets and 527M shares. Earnings power should grow at a GDP+ type number annually. However, PNC is likely to find ways to enhance their growth rate. For example, they are well positioned for rising interest rates. They are asset sensitive, liquid (86% loans/deposits, securities/cash represent 32% of earning assets) and well-capitalized (9% pro forma tier one common equity). They are poised to benefit from financing the ultimate restructuring of underwater commercial properties through real-time intelligence gained via their Midland loan servicing business. Their acquisition of NCC has been a home run and I believe their cost savings goal of $1.8b annually remains a low-balled estimate (15% of combined costs for an in-market deal). They are also in a good position to make acquisitions once the National City deal is fully integrated. The main caveat is that it may take as long as two to three years for PNC to return to normalized earnings power and the pacing will be dictated by the economy.
    ***PNC's balance sheet has been recapitalized and it has one of the strongest balance sheets among large US banks, which will provide protection against a weakening economy and fire power to act opportunistically as the economy improves. A secondary source of strength is significant pre-tax pre-provision profits as a percentage of loans - the ability to earn through troubled times.  Important financial strength ratios are:
    *9.0% tier one common equity ratio (pro forma for the sale of a securities processing division)
    *5.6% marks/reserves for loan losses to gross loans (includes $3.3B PCI mark)
    *1.7X reserve coverage to net charge offs
    *4.9% PTPP as a percentage of loans
    ***There is evidence that loan losses are peaking, but this is not a certainty. 30-89 and 90+ delinquencies are down for two straight quarters; non-performing loans are down; current loans transferred to non-performing are off sharply (see p11 of q2 earnings supplement).
    ***In addition to a strong balance sheet, PNC possesses other positive attributes:
           *Low cost raw material generated by a strong regional deposit franchise
                  *0.54% cost of deposits 
                  *0.79% total cost of liabilities
           *Nice mix of fee oriented businesses (~40% of revenue)
           *Significant liquidity and capacity for new loans or investments
                  *86% loan to deposit ratio
                  *Short-duration securities are 32% of earning assets
                  *Asset sensitive balance sheet mitigates the risk to higher interest rates
           *PNC owns 35% of BLK or 22.5M shares worth $3.6B or $6.83 per share.
    ***Banks are complex and opaque businesses with a lot of leverage, obviously. A good, trustworthy jockey is important in banking because of the abnormally large risk due to information asymmetry compounded by leverage. Bill Demchak is the Vice Chairman of PNC. He is a very bright guy and - cross your fingers - hopefully he will become the next CEO of the bank. He was courted for the BAC job and declined. The CEO Jim Rohr leaves much to be desired when listening to him speak. However, he is at least smart enough to keep a guy like Demchak around (most CEOs like Ken Lewis would feel threatened by a smarter guy being #2). Demchak made an impressive presentation at the Boston BancAnalyst conference in November - check it out.
    ***My valuation assumption is 10-12X EPS or $80-95 in FY12. The warrants should be worth $27-39 in that scenario using a 25 vol and about $2 less using 21 vol. 
    Stock sensitivity to EPS and P/E
                         2010   2011   2012
    EPS power     7.50    7.73    7.96
    10X               75.00  77.25  79.57 <---- stock price at this multiple
    12X               90.00  92.70  95.48

    Warrant value @ 25 vol
    10X              25.88   26.23  $26.50 <--------using above stock value, warrant is "worth" approx this figure
    12X              37.71   38.54  $39.35

    Returns
    10X - common  21%   25%    29%  <-----------using current securities pricing and above valuation assumptions, simple return is this figure
    10X - warrant    77%    79%    81%

    12X - common 46%    50%     54%
    12X - warrant 158%  163%   169%
    Note if PNC increases the dividend the value of the warrants will theoretically decline, but I would submit that such a scenario would be quite positive for the stock price which is the primary determinant of warrant value. Warrant holders are protected from quarterly dividends above $0.66 per share at which point the warrant holder receives more warrants and a lower strike price.

    Catalyst

    certainty over bank capital standards
    continued decline in bad loans and increases in earnings
    redeployment of excess liquidity
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