PITTSBURGH — The ghosts of past regulatory troubles, accounting snafus, and risky loans are behind it, but PNC Financial Services Group Inc. still has to convince investors it can gather and sustain earnings momentum.
The Pittsburgh company’s senior executives said in a recent interview that they are confident they can perform, and do it alone. “The important thing for us to do now is to deliver” growth, said James E. Rohr, its chairman and chief executive officer.
Last year “was a year of accomplishments,” he said, despite the low interest rates and soft economy that made business conditions “unfriendly and challenging.” During the last year and a half PNC cleaned up its balance sheet by exiting loans that did not fit its risk profile, brought an end to a period of regulatory supervision related to its accounting of off-balance-sheet entities, and realigned various businesses to make for more cohesive risk management at the top.
Mr. Rohr said PNC can deliver earnings growth of 10% to 12% over the next three to five years, and it will pursue both acquisitions and branch-building.
In January PNC completed its purchase of United National Bancorp of Bridgewater, N.J., its first banking acquisition in nine years. Buying United National gave PNC a boost in the lucrative North Jersey market, with $2.2 billion of deposits and 47 branches there.
Mr. Rohr said more such deals could come. “United was a good example” of the acquisition strategy. PNC ranks first or second among banks in its Middle Atlantic home markets, which would remain the area of focus for expanding retail and commercial banking.
Though PNC’s retail banking area stretches to Ohio, Kentucky, and Delaware, it is mostly concentrated in Pennsylvania and New Jersey. It competes with National City Corp., Bank of America Corp., and Wachovia Corp. in some of these markets, but PNC sees its biggest competition in small banks with more entrepreneurial cultures, including Commerce Bancorp Inc. of Cherry Hill, N.J.
Joseph C. Guyaux, PNC’s president, said its growth areas are in central Pennsylvania, the Lehigh Valley, and to a “lesser extent” Delaware, New Jersey, Cincinnati, and Kentucky.
PNC is more likely to make small, fill-in acquisitions in its existing markets than go for bigger deals or a merger of equals, he said. “I wouldn’t rule out any of the markets” where it already operates. “There is room for us to add to our franchise. There are lots of small institutions” in these markets.
Its ability to acquire is a reversal of fortune for a company that until recently was seen as vulnerable to a takeover. Two years ago this month PNC revealed it had agreed to a cease-and-desist order and extra scrutiny by the Federal Reserve Bank of Cleveland and other regulators after an accounting snafu that forced it to restate financial results for the prior year.
The Cleveland Fed lifted its order after a year, and the final regulatory clearance came last month, when the Department of Justice said it has dropped criminal charges against PNC relating to the matter.
Despite several management changes and questions about the remaining leaders’ credibility, Mr. Rohr and Mr. Guyaux survived the crisis and led a restructuring.
A significant addition to the top echelon was William Demchak, a former J.P. Morgan & Co. executive, who became PNC’s chief financial officer in October 2002. He has spent much of his time reorganizing the accounting systems, financial reporting standards, and risk management methods.
Mr. Demchak said his arrival coincided not only with the discovery of accounting problems but also with the stricter corporate governance rules brought on by the Sarbanes-Oxley Act.
The overhauling of the internal reporting systems “gave us a head start” in terms of meeting the governance requirements, he said. One of the main changes was instituting a system that looks at each business as part of a big unit, rather than as individual silos. This helped strengthen risk management and controls.
This year PNC also changed its external reporting systems to align with the newly created internal structure. It separated core businesses from capital management activities to reduce volatility in retail banking earnings. It removed securities earnings from its regional community banking division, consolidated its wholesale division to reduce “noise,” and implemented risk-based allocation of capital to various units.
The new systems not only improved the $74 billion-asset company’s internal controls and risk management, but it also “sharpened our strategy and strategic choices,” said Mr. Guyaux, who oversees retail and commercial banking. He now has a conference call every Monday with sales personnel from all lines of business, including commercial and retail banking and the wealth management unit PNC Advisors, to discuss their cross-selling goals.
However, analysts and investors are questioning whether PNC can meet its goals.
Earnings per share were $3.86 last year excluding charges. That compares to earnings of $4.15 in 2002. But first quarter results of $1.15 per share were up 25% from the same period last year. (Analysts complained the results this year were filled with “noise.”)
Frank J. Barkocy, an executive vice president and the director of research at Keefe Managers Inc., said PNC has disappointed investors with shortfalls in its earnings and with regulatory issues, so it will take a while “for investors to again feel a degree of confidence” in the company. “I think what investors are looking for now is a period of earnings continuity and earnings improvement.”
John Kline, an analyst with Sandler O’Neill & Partners LP, said a lot of investors are not paying much attention to PNC. “It has really fallen beneath the radar screen of most investors.”
A lot of investors are frustrated with the management and waiting for them rebuild credibility with Wall Street, he said.
While PNC’s revenue mix is more diverse than those of other banks its size, (65% of its revenue comes from noninterest income), its main revenue driver remains the basic banking business. The regional community bank unit contributed 59% of PNC’s net income last year, followed by wholesale banking, which brought in 30%. (That division includes corporate banking, real estate finance, and asset-based lending.)
Mr. Guyaux said that even if the retail business grew only in the mid- to high-single digits, that would mean significant growth for the whole company. “If you do it right, it should be relatively a low-risk, high-quality, high-return” investment.
PNC plans to do that by focusing on the “most predictable, stable, lowest cost funding” — checking accounts. It is a price leader in that area, because “we are unwilling to lose a customer.”
He pointed out that PNC was the first banking company on the East Coast to have permanent free checking for personal accounts, whereas Commerce Bank, which he called “our strongest competitor on the East Coast,” offers it for just one year. Last month PNC started offering free checking for small-business accounts.
Richard X. Bove, an analyst with Hoefer & Arnett Inc., said PNC’s emphasis on retail banking might be misplaced at this time. “They missed the big surge in retail banking earning in 2001” because of the regulatory issues. “Now, in my view, the cycle is over for retail banking.”
Similarly, BlackRock, the institutional fixed-income asset manager which is majority owned by PNC and has been contributing significantly to net income, is likely to suffer from a rise in interest rates, said Mr. Bove, who has a “reduce” rating on PNC’s stock. Last year BlackRock generated 15% of PNC’s earnings, up from 11% in 2002.
Analysts also pointed out that the processing unit PFPC is struggling to hold down expenses, even though it is bringing in more revenues.
PNC’s management counters this criticism by saying its diversified business mix will help it weather a volatile interest rate environment.
“In our case, growth is not tied to our regional businesses, but also to our national businesses,” including BlackRock, PFPC, real estate finance, and asset-based lending, Mr. Rohr said.
PNC’s managers say they do not have to be huge to stay competitive.
“We don’t want to be a big national bank, nor could we be,” said Mr. Demchak, who oversees the acquisition strategy and notes that he has looked at the books of more potential sellers in the last six months than PNC ever has before.
PNC will never be the same size as Bank of America Corp., he said. “That is not our strategy.”
