INVESTMENT SUMMARY

I. Investment concerns

Poor regulatory capital ratios. PNC’s tier one capital ratio and total risk based capital ratio at 7.7% and 11.4% are one of the lowest among its peer group of over 330 banks and thrifts, which could exert pressure on the bank’s ability to sustain losses. In the event of prolonged losses, PNC may be forced to raise additional capital and cut down its lending activities, impacting its net interest income.

Significant real estate loan exposure.  PNC’s 54.2% loan exposure towards real estate related loans, including 20.2%, 13.1% and 20.8% exposure towards home equity, residential mortgages and commercial real estate (including real estate related loans), respectively, could lead to higher NPAs (Non-Performing Assets) for the bank in the wake of falling residential and commercial real estate prices and weak economic outlook for the US.

Expected increase in provisions to affect bank’s profitability. The banking industry in general, and PNC in particular have inadequate provisions to meet their expected loan losses. For the US banking industry, allowances for loan losses declined to 1.16% of gross loans in 2006 from 2.67% in 1991. PNC’s allowances for gross loans stood at 1.21% at the end of 2007 versus 1.12% as at the end of 2006. Though reflecting an increase from 2006 levels, we believe that the bank’s current provisioning may not be sufficient to cover its charge-offs expected to increase from rising delinquency rates. In addition, PNC’s provisions for credit loss have not kept pace with the corresponding rise in the bank’s NPAs (NPAs increased 188% while allowances increased by a lower 25% in 1Q2008 over 4Q2007) which could lead to a need for higher provisioning in the coming quarters putting a strain on the bank’s profitability in the near-to-medium term.

Sluggish growth in net interest income off slower loan growth. As consumer and business spending continues to soften in response to US economic hard-landing, growth in consumer and business lending is expected to remain passive, particularly in the spheres of real estate home equity loans, construction and development loans and commercial loans, which form a major part of PNC’s loan portfolio. We expect PNC’s net interest income to witness downward pressure due to an expected decline in its interest bearing assets.

Fee based income to remain under pressure. PNC drives more than 50% of its revenues from non-interest income. However, with the loss of confidence in credit and capital markets, the bank’s fee-based income is expected to witness a decline as a result of lower transaction volumes and decline in investors’ appetite for high yield securities.

II. Investment positives

Diversified revenue stream through acquisition strategy. PNC has followed a strategy of growth via acquisitions to expand its asset base and product offerings. Since 2005, PNC has made a number of strategic acquisitions including those of Riggs National Corporation, Harris Williams, Mercantile, ARCS Commercial Mortgage, Yardville National Bancorp and Sterling Financial Corporation. As a result of the constant drive to increase its product offerings, PNC has significantly diversified its fee-based income, with its non-interest income contributing nearly 53.1% of its total revenues in 1Q2008, which is among the highest in its peer group.

BlackRock investment to provide downside support to valuation. In February 1995 PNC purchased BlackRock for $240 mn. BlackRock is one of the largest publicly traded asset management companies in the US having $1.3 tn of assets under management and a total market capitalization of $24.9 bn as of May 1, 2008. Subsequent to BlackRock’s merger with Merrill Lynch Investment Managers in 1999, PNC’s stake in BlackRock came down to 33.5% with Merrill Lynch holding a 49.8% stake in the company. Based on our estimated target price of BlackRock of $166.83, PNC’s stake in the company is valued at around $6.5 bn translating into a per share valuation of $19.25 for PNC.

Limited geographic exposure to troubled markets. PNC’s branch banking operations are concentrated in the eastern states of Pennsylvania, New Jersey, Washington DC, Maryland, Virginia, Ohio, Kentucky and Delaware. An absence of exposure to the highly troubled markets of California, Florida and Texas shields PNC from drastic averse impacts of the current US housing crisis. I would suggest readers take note that the markets in the north and central eastern US, primarily New Jersey, Pennsylvania (particularly the Poconos area and Philly metro), Virginia , Maryland and the DC Metro/Beltway areas, Ohio (due to its manufacturing and industrial base) are now showing significant weakness in their housing values and I expect this to accelerate in the near future.  

Stable net interest margin. Federal Reserve’s initiatives to cut fed funds rates have resulted in a 3.25% rate cut since September 2007, helping the US banking sector improve its net interest margin. US banks’ cost of borrowing has declined significantly in the recent quarters due to reduced rate on deposits. In 1Q2008, PNC’s net interest margin increased to 3.14% compared with 2.98% in 4Q2007 and 2.76% in 1Q2007. Though Fed Reserve has signaled that it may not continue with rate cuts for the next few months due to rising inflationary concerns, we do not even anticipate Fed to increase the fed funds rate in the near term. This would result in stable net interest margin for the US banks for coming quarters.

III.   Valuation