In the competition for best-run bank in the U.S., at least among the heavyweights, PNC Financial (PNC) brings a pretty strong case in its favor. While I haven’t always been excited about the valuation on the shares, I liked it back in January and the shares have outperformed the major regional bank indices since then, though the sector has continued to lag the S&P 500.
Looking at the bank again in the light of first-quarter earnings, nothing really changes in my mind. The better than expected loan growth is of course nice to see, and the increases in loan provision expense and deposit costs isn’t a surprise to me. I still have sector-wide worries that we’re descending from a peak and that is going to make share price outperformance more challenging, but this remains a worthwhile holding for those investors who are less inclined to try to time market cycles and would rather have a longer-term position in American banks.
Healthy Pre-Provision Results On Better Loan Growth
In terms of operating profit, PNC did respectably well in a quarter that, thus far, looks like a pretty “in-line” quarter for banks in terms of performance relative to expectations. While the bank gave in provision expense and only met the sell-side expectation on a core basis, I think it was a respectable result in an environment where the market needed a little reassurance on bank earnings.
Revenue rose about 4% year over year on a core basis and slid about 1% sequentially, coming in about 2% better than expected. Net interest income rose about 5% yoy, beating expectations by about 2%, with most of the upside coming from the 2% yoy growth in earning assets. Net interest margin improved by 7 bps (and 2 bps qoq) on a 52 bps yoy increase in loan yields.
Fee income was up about 3% on a core basis and likewise a little better than expected. While asset management revenue was lackluster (down 4%), JPMorgan (JPM) saw some pressures here too and PNC made up for it with good results in Corp Services (up 8%), respectable results in Consumer Services (up 4%), and a jump in “Other”.
Expenses were in line (up 2% yoy), and core pre-provision profit was up 8%, largely comparable to the growth at JPMorgan this quarter. Credit costs continue to march higher, though, and loan loss provision expense more than doubled from the year-ago period. That largely chewed up the PPOP beat and core earnings were in line with expectations (up 7%), while tangible book was up 9%.
Healthy Loan Demand, But Deposit Costs Are Weighing
Loans rose 5% yoy and 3% qoq on a period-end basis, coming in stronger than expected (a roughly 2%) beat and better than the norm for large banks as per Fed data for the first quarter (where the average large bank saw almost 1% contraction).
Commercial lending, not surprisingly, continues to lead the way, and PNC reported very strong 10% yoy and 5% qoq growth in the C&I category – far ahead of peer norm (up about 1% qoq) and JPMorgan’s 3% contraction in its commercial bank segment. For its part, management said that it felt “very good” about the economy and that there weren’t many signs of flagging growth from its viewpoint. CRE lending was weaker (down 3% yoy and flat qoq) and weaker than peers, but this is a smaller category for PNC. PNC’s consumer lending results were likewise mixed. Overall, lending grew 2% yoy and stayed about flat sequentially, with growth in mortgages (up 9% and 2%) and contraction in consumer (down 1% in both comparisons). Both of these figures were about 2% better than peers on a qoq basis, though I’d remind investors that relative to JPMorgan, U.S. Bancorp (USB), and other peers, PNC has a more modest exposure to consumer lending.
The “but” to all of this remains rising credit and funding costs. Loan yields improved 52 bps and 12 bps, respectively, more or less on pace with JPMorgan and ahead of Wells Fargo (WFC), but interest-bearing deposit costs basically matched this, while overall deposit costs rose 39 bps and 10 bps. With all that, the cumulative beta continues to rise, though it remains at a generally healthy level (32% versus 30% in the fourth quarter).
Deposits rose 2% yoy on a period-end basis, but non-interest-bearing deposits fell 9% and PNC’s performance was a little weaker than JPMorgan on an sequential average balance basis (down 5% versus 3%). It’s premature to call this a sign of increasing competitive pressure from banks like JPMorgan and Bank of America (BAC) that are targeting some of PNC’s markets, but it is consistent with what is normal at this point in the cycle, as depositors move funds in pursuit of better yield.
Credit costs and deposit costs are likely going to continue to rise from here (I’d call rising credit costs a virtual certainty). It does help that PNC’s lending is growing nicely, and the bank continues to not only enter new commercial lending markets but also invest in differentiating technological and service capabilities.
Management also reiterated its disinterest in whole-bank M&A. While I do believe a merger of equals with U.S. Bancorp would be potentially transformative, PNC's management believes they have enough scale to continue to operate independently and effectively. I do agree with that assessment, but just because they don’t need a deal doesn’t mean that the right deal (a tie-up with U.S. Bancorp) wouldn’t still be a good thing.
I’ve made a few tweaks to my model, but nothing large. My five-year earnings growth rate is a little lower (closer to 2.5% now than 3%), but my long-term adjusted earnings growth rate is still between 3.5% and 4%, supporting a fair value close to $140. A ROTE-driven approach valuing the bank on its TBV produces a higher target closer to $150. I should note, though, that the direction of earnings revisions from here is more likely to be down than up, particularly if Citigroup’s (C) recent comments about the bank sector being past its cyclical peak prove accurate (which I believe they will).
The Bottom Line
Investing in a sector coming off a peak is tricky, and I generally only do so when the valuations seem overly beaten down. That’s no longer true for most large banks, including PNC. I do believe PNC is still modestly undervalued and has good attributes to argue for it as a long-term holding, but it’s not what I’d call “can’t miss cheap” relative to cyclical/economic risks and I can understand why some readers may hold off in the hope/anticipation of a better entry price and/or relative valuation down the road.
Disclosure: I am/we are long JPM. 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.