I own a position in the warrants of PNC Financial (PNC), which under performed during the 2nd quarter and cost about 80 bps of performance for my portfolio. PNC is a large regional bank headquartered in Pittsburgh with operations in the Mid-Atlantic States, the Midwest and Florida. The company is conservatively run and performed better than average through the financial crisis. I bought the position in May 2010.
My investment thesis for PNC was and still is relatively simple: bank stocks as an industry will perform well going forward and among bank stocks, PNC is positioned to outperform the industry. Generally, bank stocks as an industry are positioned for strong performance from a cyclical standpoint. Valuations are historically low. Problem loans have peaked across the industry. Historically, banks and bank stocks have done well in the early stages of an expansion. Plus, banks should have attractive loan growth with the continued shutdown of the loan securitization market on Wall Street.
Among bank stocks, PNC is attractive. It is a high-quality, conservatively-run regional bank. It trades for just 1.3 times tangible book value. The acquisition of National City Bank at the height of the financial crisis was one of the great bargain purchases from that time period. The Nat City deal expanded PNC’s branch system throughout the Midwest. PNC has been able to increase the productivity of the former Nat City branches with its better products and management structure. Plus, the hugely discounted purchase price for Nat City more than offset losses from the bad loans in Nat City’s portfolio. Now, PNC is internally generating capital at a high rate. PNC is under earning due to its conservative interest rate positioning. If the Fed Funds rate rises to just 2%, it could add as much as $1.50 to PNC annual earnings per share or 25%. Finally, PNC could trade between 2.0x and 2.5x tangible book if investors get more confidence about the economic environment and about the prospects for loan growth at banks.
The story with PNC during the quarter was the announcement of PNC’s purchase of RBC’s (RY) U.S.-based bank (RBC USA). RBC USA has a branch network located in some fast growing states like NC (#5 market share), AL (#6) and GA (#9) and $19 billion in loans. The deal expands PNC’s footprint into these states at a slight discount to book value prior to purchase accounting marks on RBC USA’s loan portfolio. After adjusting for the purchase accounting marks, PNC is paying about 1.26x book value.
Although the market did not react favorably to PNC’s purchase of RBC USA, I like this transaction for several reasons:
- It expands PNC’s branch footprint with low financial risk,
- Assuming that PNC is accurate with its purchase accounting marks, it should not have any further losses from RBC USA’s loan portfolio,
- There is potential upside to the deal if PNC can make RBC USA’s branches more productive with its superior corporate cash management and consumer deposit products,
- PNC should be able to have better success larger corporate clients in the RBC USA footprint because RBC’s commercial bankers had no incentives to sell capital markets solutions to their large corporate clients and prospects,
- The deal gives PNC the ability to invest more capital into loans at a time when loan growth is tough to find,
- The deal doesn’t close until 1st Quarter of 2012, so PNC will be able to implement most of the expense reduction prior to closing,
- The purchase price will be adjusted to account for losses, if any, over the next three quarters prior to the deal closing; and,
- PNC will be able to leverage its infrastructure and headquarters costs over a larger branch system.
Other investors were disappointed with the deal for different reasons. Some investors expected that PNC was on the verge of announcing a large stock repurchase, so the deal eliminates the chance of a large buyback announcement. While there will not be a large near-term stock buyback announcement, I disagree that share repurchases are the best use of capital at the moment for PNC. I’d rather have management take advantage of the current low-priced M&A environment to expand the bank’s franchise. Other than organic loan growth, the best way for PNC to create shareholder value is to make low-priced acquisitions like the RBC USA deal. I believe that PNC can earn returns in the mid-to-high teens in their core banking business.
Another reason investors don’t like this transaction is that they calculate the payback period to be 16 years based on financial guidance given by PNC. To calculate this payback, investors make the simplified assumption that PNC’s tangible book value declines by $1.66 due to the deal and the deal is 10 cents accretive to PNC’s EPS, so it takes 16 years to earn back the dilution. I disagree with this analysis because the ten cents accretion is just the estimated accretion to PNC’s 2013 earnings. There is another possible 17 cents in accretion if PNC is able to get the revenue synergies they think are possible by cross-selling their superior product portfolio into the RBC USA customer base. Then, there is the possibility of additional accretion from higher interest rates, which I calculate could be another 23 cents. With these two additional sources of accretion, the payback for this deal moves from 16 years to three years, which is obviously more attractive.
Yet another reason investors don’t like the deal is the prospect of PNC issuing $1 billion of new common shares. There are two reasons investors misunderstood management on this issue. First, as part of the acquisition agreement, PNC has the right to issue the $1 billion of stock to Royal Bank of Canada at $59 per share. This is effectively a nine month $1 billion put with a $59 strike that RBC has given to PNC. My calculation of the value of this put at the time of the deal announcement was $110 million. Because PNC has this option to issue stock to RBC Canada does not mean they will definitely issue common shares to fund the deal. Second, given the current regulatory environment with bank capital, PNC management was not in a position to say publicly that the bank doesn’t need to raise capital to complete the deal. If management had said they didn’t need to raise capital, it would have been premature because the bank’s regulator has final authority on the capital levels. I am confident as PNC continues to generate excess capital as we approach the deal’s closing, that management will demonstrate to the regulators that they don’t need to issue the common stock to complete the deal. I am less concerned with these three criticisms of the deal; instead, I like the RBC USA acquisition because it enhances PNC’s franchise in a low cost manner. I continue to maintain the position in PNC despite the performance in the quarter.