Will PNC Financial's Potential For Improvement Translate Into Real Value?

| About: PNC Financial (PNC)

Even though they rarely get them nowadays, investors want clean reports from banks and PNC Financial's (NYSE:PNC) inability to deliver them has turned into an issue when it comes to the stock's multiples and valuation. Where investors understand that Bank of America (NYSE:BAC) still has a big mess to clean up and generally believe U.S. Bancorp (NYSE:USB) management when they call an item "one time," PNC has put investors through something more like "death by paper cuts."

The good news for the PNC bulls is that this company's credit profile is in generally good shape and commercial loan growth has been strong. On the bearish side, though, is persistent spread pressure, increasing competition, and incrementally more doubt about the company's long-term return on equity potential.

Q4 - Everything But A Kitchen Sink

PNC warned investors a little while ago that there would be a lot of items in this quarter, and there certainly were. A mortgage repurchase provision, a goodwill impairment, TruPS redemptions, merger expenses, gains on the sale of Visa (NYSE:V) shares, security gains and so on all muddied the quarter a bit. That said, the underlying performance was pretty solid.

Operating revenue increased by about 5% on a sequential basis (different analysts will have different numbers, based on what they include/exclude). Although a little soft compared to regional rival Fifth Third (NASDAQ:FITB), that's a good result in a quarter with plenty of near-zero growth stories. Net interest income was sluggish, up about 1%, as PNC coupled modest NIM improvement (up 3bp to 3.85%) with flat average earning assets. Investors should note that purchase accretion added about 10bp to NIM, but PNC still compares well to Wells Fargo (NYSE:WFC), U.S. Bancorp and M&T Bank (NYSE:MTB) here.

In addition to solid net interest income (relatively speaking), fee income jumped 11% on an adjusted sequential basis, with high-teens growth in corporate services. Expenses ticked up again, but the company improved its efficiency ratio - although the company reported its efficiency ratio at 70, I think the real (adjusted) number is closer to the low-to-mid 60%s.

Mixed Loan And Credit Performance

PNC reported that its end-of-period loan balance increased 2% - an exceedingly common result across the sector. As has been the case with most every bank, stronger commercial lending led the way (up 4%), while consumer lending was flat. Those not closely familiar with the PNC story should note that commercial lending (that is, lending to businesses) is about 60% of PNC's loan book.

I was impressed to see how PNC's reported loan yields held up - staying almost flat sequentially (down 1bp to 4.58%) and declining only about a quarter-point from last year.

On a less positive note, PNC's cost of funds aren't improving as much as other banks. Despite lowering the cost of its subordinated debt by more than a point from last year, the total cost of interest-bearing funds is still about 0.50%. Deposit costs (including non-interest bearing deposits) aren't terrible at 0.27%, and non-interest deposits increased about 5% sequentially against 3% overall sequential deposit growth.

Credit was a mixed bag as well. The company increased its provisions by almost $100 million sequentially (about 39%) and saw almost no reserve release this quarter after releasing $100 million last quarter. I suspect this sort of back-and-forth performance is what investors mean when they complain about not really being able to get comfortable with PNC at this point in the cycle.

Nevertheless, while PNC's NPA ratio is still high relative to its peers, it did improve sequentially. Likewise, the company's net charge-off ratio continues to improve. Said differently, PNC still has cleaning up to do, but its credit quality situation is getting better.

Trying To Do Better In A Worse Environment

PNC has several avenues to better reported results in the coming years. The company still has an elevated level of bad debt on its books, and working that down will help reported results. Likewise, it would seem that the company has underutilized lending capacity, though I think it needs to hold some back to boost its capital ratios. Last and not least, PNC's expenses are still relatively high and running a tighter ship should drop more to the bottom line in the coming years.

All of that said, there are going to be challenges that the company really cannot escape. Purchase accounting accretion helps the NIM look better (also true for BB&T (NYSE:BBT)), but this won't last forever and this is not a healthy environment for interest rate spreads. I also wonder how much competition will limit PNC's ability's to grow its loan portfolio - seemingly every bank wants to boost its commercial lending, and rivals in PNC markets like Fifth Third, BB&T and M&T aren't going to be pushovers.

The Bottom Line

There really seem to be valuation tiers in the bank sector today. Lower-quality (or at least more troubled) banks like Bank of America enjoyed strong runs in 2012 and don't look like tremendous values today unless you project significant near-term improvements in performance.

On the flip side, quality regional banks seem to be getting over-punished for the sluggish near-term market at the expense of solid long-term ROE improvement potential. PNC is somewhere in the middle - I don't think it is as strong operationally today as BB&T, U.S. Bancorp or Fifth Third, but it's getting better and definitely has a path to improvement. Unfortunately the valuation isn't so compelling.

Using a 10% long-term ROE estimate (slightly higher than most sell-side estimates), fair value on PNC seems to be around $69 today. If PNC can regain more of its former glory, though, and get back into the low teens with ROE, the valuation quickly jumps into the $80s. Now, it's not fair to assume that banks as a group will all recapture past glories - new regulations and capital requirements make it far less likely - but the point stands that PNC could deliver for patient investors who think they have a strong case for the company delivering on its potential to produce better results in the coming years.

Disclosure: I am long BBT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.