PNC Financial Services Group, Inc.

Moat: 2/5

Understandability: 4/5

Balance Sheet Health: 3/5

PNC is one of the largest diversified financial services companies in the U.S., operating primarily in retail banking, commercial banking, and asset management.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

PNC’s business model revolves around interest income from loans and deposits, fee-based income from various services, and trading gains, with a focus on serving retail and commercial customers, primarily within the US. The bank is trying to improve its tech initiatives and increase growth and profitability.

Business Overview:

PNC operates through three main segments:

Retail Banking: This segment provides a variety of financial products and services to consumers, including checking accounts, savings accounts, credit cards, mortgages, and personal loans. It also includes small business banking services.

Retail banking faces intense competition, including from national retail banks, community banks, and fintech companies. This part of the business is less likely to have a sustainable advantage over the others due to the generic nature of the offerings, and therefore the market share is determined by convenience and prices.
Corporate & Institutional Banking: This division caters to mid-sized and large businesses, governments, and institutional clients. It offers a range of services including corporate lending, equipment financing, treasury management, capital markets, and advisory services.

Corporative and institutional banking can create durable competitive advantages through the provision of more unique and specialized services to a specific set of customers and building long-term relationships. These services often require large investment in equipment or personnel making entry tougher for new incumbents.
Asset Management Group: PNC’s asset management group provides investment management, fiduciary, and wealth-planning services to individuals and institutions.

The asset management business has a high potential to create economic moats given its ability to control or allocate capital and build a long term reputation among its customers.

Industry Trends:

The financial services industry is undergoing significant transformation due to several factors:

Technological Disruption: Fintech companies are rapidly changing the landscape, offering innovative products and digital channels. Banks are forced to make heavy investment and adopt these new technologies to stay in the game.
Interest Rate Volatility: Changes in interest rates can impact net interest income. With the recent change of tone from the Federal Reserve and a possible increase in rates for an extended amount of time, this will cause problems for banks.
Regulatory Changes: Banks face increasing regulations, which can create compliance costs.
Increased Competition: The banking industry is becoming increasingly competitive, with new players and expanded offerings in each service area.

Competitive Landscape:

PNC competes with national, regional, and community banks, as well as non-bank financial providers such as:

Other Banks: Citigroup, JP Morgan Chase, Wells Fargo, Bank of America. Regional banks like M&T Bank, US Bancorp etc.
FinTech Companies: Companies that offer mobile and digital first solutions in payments, lending, investing and banking. These companies may have less regulatory scrutiny and less overhead costs giving them significant advantages.
Brokerage Houses: Investment firms such as Merrill Lynch, Goldman Sachs, Morgan Stanley.
Other Financial Institutions: Credit unions, insurance companies, and other diversified financial companies.

The competition is very fierce and comes from almost every direction. All the competitors are also trying to achieve the same thing and it is a difficult problem to have any meaningful differentiation.

What Makes PNC Different:

Regional Focus: PNC has a strong focus on several key markets in the United States, allowing it to build deep relationships and market share in these regions.
Diversified Business Model: PNC’s diverse operations, including retail, commercial, and asset management, provide some stability and potentially reduce overall exposure to any specific market or sector.
Tech Initiatives: PNC is trying to catch up with technology and digitize a major part of its operations to compete with tech-first banks and financial service providers.

Financial Deep Dive

The following analysis places more emphasis on information from the 10-Q released November 8th, 2023, the earnings calls of October 17th, 2023 and January 17th, 2024, and recent news articles about the bank.

Revenue Streams: PNC’s revenue is mainly generated by:
- Net interest income (NII) which represents the difference between the interest earned on loans and securities and the interest paid on deposits. This accounts for a little less than 2/3 of the revenue in the past few years.
  - In 2022 NII was 70%. In 2023, net interest income represented a similar chunk of its revenue.
  - This aspect of the bank is very sensitive to changes in interest rate. Banks have been taking advantage of higher interest rates and expanding this income, however, as the interest rates begin decreasing, banks will not be able to make as much money from the interest that they get on their loans.

This makes PNC’s results highly cyclical. As the central bank increase interest rates to control inflation, bank profits increase, but as rates begin to drop again, they will also see similar decreases in revenues, as fewer loans and less profit from interest will be available.
Non-interest income, including fees from various service activities, asset management, and card services. * Non-interest income accounts for a little over a third of the company’s revenues, and this part of the business is less exposed to the whims of interest rates. * While fee revenues have slightly decreased in recent times, the overall number for the year is close to what the company expects, and the company is increasing emphasis on growing the wealth and asset management side of their business in order to diversify and grow non-interest income.
- Trading gains/losses * The bank generates profits (or losses) from its trading activities in financial markets.
Profitability: PNC has had mixed profitability trends, mostly due to macroeconomic factors. Some major highlights are:
- The bank reported a diluted EPS of $3.14 for 3Q 2023 and $2.86 for 4Q 2023.
- In 2022 the diluted earnings per common share was $12.96, and this figure increased to 13.02 in 2023.

Overall, PNC has had modest growth and profitability in the last few years. Net income did increase slightly in 2023 compared to 2022, despite a lot of changes in economic conditions. This signifies stability, and perhaps a good management of the business, but also lack of significant growth potential.
Operating Expenses: These include compensation, occupancy, marketing, technology, and other general operating expenses.
Expenses also increased from 2021 to 2022 and again in 2023.
- The bank had a noninterest expenses of $16.1 Billion in 2021, $18.4 billion in 2022, and $18.3 billion in 2023.
- The bank is actively investing in digitalization and automation to decrease operational costs.

The bank continues to focus on efficiency efforts to keep operational expenses at bay, which is a good sign.
Capital: The total capital is approximately $50B for the bank.
- Common equity Tier 1 capital is $41.7B which represents almost 90% of the bank’s total capital.
  - This shows a good strength of the banks as it holds considerable reserves.
Leverage: PNC’s leverage has been above average over the past few years which could expose it to some potential dangers. However, given the nature of its business, it is well-capitalized with sufficient equity to withstand any financial pressures.
- The bank has a debt to total capital of .273 in 2023.
- However, it must be noted that some of the debt are also covered through securities or other assets with market values, meaning the net debt could be lower.

The bank has been trying to grow its business, especially in the wealth and asset management side. This is a good sign that the bank is not ignoring the need for long term growth and profitability.

Moat Analysis

Intangible Assets: PNC has an established brand and a long operating history, both of which help retain customers and attract new ones. However, the financial sector is filled with banks that also have strong reputations, so the brand alone is not sufficient to create an economic moat.
Switching Costs: While switching banks is not that painful for average consumers, businesses and large corporations are more reluctant to switch banks because of the risk involved in transferring vast amounts of capital. This is probably an important moat factor for PNC’s corporate and institutional banking business.
- The sticky relationships with existing customers helps retain customers for longer.

The presence of some degree of switching cost, mainly for corporate customers, is a positive factor for PNC. However, as this business is not a monolith and has varied customers, this is not sufficient to make up a durable economic moat.
Network Effect: PNC does not benefit from direct network effects in most of its business lines. There may be an indirect benefit that more customers leads to more data leading to better services for everyone, but this effect is minimal.
This effect may improve with the increased use of digitalization and AI tools, but these systems are also available to competitors.
Cost Advantages: PNC, like most other large banks, benefits from some cost advantages due to economies of scale. It has a long established network of physical branches and relationships which new players will find difficult to replicate.

Overall, the banks moat is based on some level of economies of scale, and a relatively sticky customer base in their established markets. However, they are not that differentiated from other large players in the field. The most important thing for the company is to use its scale and resources to diversify into better and more reliable long-term investments which the management has been trying to do. * Moat Rating: The combination of the previously stated aspects grants the company a ‘Narrow Moat’. The bank has some strengths, but not enough to create a durable moat.

Risks to the Moat and Business Resilience:

Technological Disruption: PNC faces disruption from new technology including from fintech, which could reduce its competitive position. This is why the bank is working on digitalization and trying to adopt AI. However, if the implementation is not quick, and does not generate actual results, the bank may lose out to competitors.
Interest Rate Risk: Changes in interest rates can significantly impact PNC’s net interest income, particularly if rates do not move as predicted. The recent increase in interest rate is something that is happening now, and the bank will need to focus on more stability as the rates decrease again.
Credit Risk: There is always a risk of loan defaults and credit quality issues, especially in a recessionary environment. While the bank has a diversified loan portfolio, there is a chance of increase in risk if a specific area or sector is affected. The recent increase in interest rates and possibility of a slow down of the economy will surely increase this risk for the bank.
Operational Risk: Banks can be targets for fraud and security breaches, that could damage the brand and cause serious financial losses.
- PNC has also been subjected to a series of cyber attacks recently. While the attacks were not that severe, and the bank was able to counter them, these attacks prove that they are particularly vulnerable to such cyber intrusions. This is a big risk for the bank as attacks become more frequent, sophisticated and harder to combat with each new day.
Macroeconomic Risk: A recessionary environment, low consumer confidence, or a general economic downturn could negatively affect the bank’s business. Any change in economic conditions might result in a decline of customer activity leading to fewer transactions, less revenue or an increase in loan defaults.
A continued increase in the unemployment rates coupled with elevated inflation can lead to decrease in profitability, especially for the retail banking part of the business.

It is very likely that, if a recession occurs, the banks profits and revenues will reduce and their moat will be much more vulnerable.
Regulation: There is a constant threat of regulatory changes that may harm the banks ability to operate in various locations, and may impact how much income the bank is able to generate.

Management of PNC is actively working on various risk mitigation programs, and has been taking various measures to reduce the severity of impact from these risks. The bank is working on diversifying its revenue stream, and actively engaging with the regulators to minimize risks from changes in regulation. However, the intensity of competition and the constant change in the banking sector is a big challenge.

Understandability:

The overall business of PNC can be relatively easily understood by an outsider. The processes through which the bank makes money are straightforward and do not involve many complex mechanisms. However, the details of their financials and the influence of regulatory environment makes the whole picture somewhat harder to understand for a normal investor, hence the 4/5 rating.

Balance Sheet Health:

PNC has a decent level of equity, and a satisfactory leverage ratio. Their cash and short-term investments are at suitable levels. However, the bank has substantial assets and liabilities that might get impacted severely in case of a downturn of the economy or another recession. For this reason, it is not possible to label them as a top-tier for balance sheet health. Hence, the bank gets a rating of 3/5 for its current balance sheet health.

Summary:

The bank has a somewhat stable business and revenue structure, while the management also tries to incorporate various new strategies to diversify revenues and increase its profits. As interest rates play a huge role in their profit, they are very dependent on macroeconomic conditions. While the bank is well-run and possesses some unique characteristics, it still faces huge threats and intense competition from all kinds of players. Their financial standing is relatively healthy. However, the bank’s moat is not that strong, and management should focus on strategies to improve it in order to become a safer investment in the long run.