PNC Financial Has A Better Mix Of Drivers (NYSE:PNC)

The bank sector has done a little better since my last update on PNC Financial (NYSE:PNC), but the story remains pretty similar – investors are favoring smaller “Main Street” banks that they believe have better rate leverage, stickier deposits, better prospects for loan growth, and more benign capital requirements. As a more Main Street-type bank than many of its large peers, PNC has continued to outperform, beating the large bank group and the S&P 500 since my last article, but underperforming smaller regional banks.

This is an interesting time to evaluate PNC’s investment prospects. The valuation doesn’t stand out as exceptional relative to many other large banks (not to mention many smaller banks), but I like PNC’s skew to commercial lending and its strong credit quality history. If the economy does better than expected next year, PNC will likely be a laggard, but PNC is a good option for investors who may have a less robust outlook for 2023, but still want some bank exposure. I’d also note that in terms of P/TBV, P/E, and so on, PNC is trading below longer-term averages.

So Far, Q4’22 Looks Like More Of The Same

Thus far, bank loan and deposit data look pretty similar to third quarter numbers and are developing more or less in line with the averaged out expectations of bank managements in their comments on guidance.

Loans are still growing at a little more than 2% sequentially, with large banks (the top 25 banks in the country) seeing about half the loan growth of the overall banking system (around 1.3%). Commercial and industrial (or C&I) loan growth continues to lead (up around 2%), commercial real estate (or CRE) is about on par with the average, and mortgage lending is a little weaker (up about 1%), with certain consumer lending categories (like auto) weaker still but still positive. Card lending is also still strong (up more than 2% qoq), but this isn’t an especially large category for PNC (about 2% of total loans, and far less than for banks like Bank of America (BAC), Citigroup (C), and JPMorgan (JPM)).

Deposit trends, too, are heading in a familiar direction. Overall, bank deposits are trending down slightly for the quarter, with “core” deposits down closer to 2%. The numbers are worse for larger banks, with a roughly 2% average sequential decline in total deposits.

Given this backdrop, PNC should be well-placed for another solid quarterly report. With the impact of past rate hikes continuing to work through, and with PNC much more skewed to commercial lending (close to 70% of lending), where loan betas are higher (meaning that loan yields are rising more quickly relative to underlying changes in the Fed funds rate), net interest income could be at the high end or above management’s guidance range of 6% to 8% sequential growth. With flattish expenses, pre-provision profits should grow nicely in Q4’22 and PNC should be on the better side of average for its peer group in terms of pre-provision growth.

But 2023 Remains A Much Bigger Question

Banks like PNC are enjoying a tailwind from their asset sensitivity, as loans reprice and yields on earning assets outpace deposit costs. How much that changes in 2023 remains a huge question, not to mention what happens with overall loan demand and banks’ ability to fund that demand.

While the leverage banks have to higher rates has gone down almost across the board, banks like PNC still have positive leverage to rates in 2023. The first question, then, is whether rates will keep heading higher or at least not start declining – depending on the severity of the slowdown in 2023, there’s definitely a perceived risk that rates could start declining again before too long (even though current rates aren’t all that high on a longer-term basis).

Another risk to consider is that of overall balance sheet shrinkage. My call from the beginning of the cycle has been that deposit betas (the rate at which deposit costs increase relative to underlying Fed funds) would be higher than expected, and while banks with high-quality deposit franchises are holding up better, that thesis does seem to be playing out.

PNC doesn’t have a funding problem, and the loan/deposit ratio is still fine, but I do expect to see banks running down their available-for-sale (or AFS) securities holdings in the face of deposit declines, and I likewise expect to see banks turning to more expensive sources of funding – PNC’s use of FHLB borrowings jumped from $10B to $30B between Q2’22 and Q3’22, and the 2.6% rate on these borrowings (up from 1.24%) is quite a bit higher than the bank’s overall 0.45% cost of interest-bearing deposits (not to mention its 0.31% total cost of deposits).

As deposit betas head higher and deposits flow out of banks, a lot of banks will have to make difficult choices between accepting weaker spreads (and the underwriting risk of making more loans) or forgoing growth. Historically PNC has acted conservatively, so if there’s a choice to be made between growth, margins, and credit quality, growth will be the first to go.

The Outlook

In terms of the core operating trends for PNC, not much concerns me today. The bank’s credit quality remains quite sound, and the bank’s recent presentation at the Boston Bank Conference emphasized not only the long-term superiority of PNC’s underwriting, but management’s ongoing focus on this metric.

Looking at loan growth, PNC is more or less keeping pace with its peer group and doing well with commercial lending – helped, I believe, by the company’s ongoing strategic expansion program into new commercial lending markets. Deposit betas are trending okay, and while PNC isn’t a leader either in net interest margin or efficiency ratio, the bank isn’t too far off the averages and the bank still has a better-than-average return on tangible common equity.

I expect PNC to continue to generate okay loan growth, with management’s conservative underwriting balanced by growth opportunities in new commercial lending markets. I do also still see opportunities for cross-selling into the acquired branches from BBVA (BBVA) and for further expense leverage opportunities there.

I was above-Street with my 2022 and 2023 core earnings, and haven’t really changed my expectations much at this point. I’ve cut back 2024 on more conservatism about a slowdown in ‘23/’24, but my long-term outlook doesn’t change meaningfully, and I’m still looking for long-term core growth in the 4% to 5% range. Discounted back, I believe PNC is priced for a double-digit long-term annualized return, but still a lower return than many peers.

Looking at shorter-term approaches like ROTCE-driven P/TBV and P/E, I believe fair value for PNC shares is in the $160 to $175 range, with the ROTCE-TBV approach on the lower end and the P/E approach on the higher end.

The Bottom Line

I believe investors can still make money in PNC shares, but just not as much as I see with other banks. A key “but” here is the macro outlook – I think I’m generally more pessimistic on 2023 than most, and if that scenario plays out (or it’s even worse than I expect), PNC could outperform on its credit quality superiority and its lower dependence on rates and loan growth. If 2023 is a better year, though, PNC could lag.