Revenue Drop is Good for PNC and WFC (NYSE: PNC) (NYSE: WFC)

NEW YORK - PNC Financial the nation's 6th largest lender is set to report before the open on Wednesday. The company stock has declined by 12% since it reported its earnings on July 20th. The average analyst estimate is $1.48 per share in earnings or $778.48 in net income. The high estimate is $1.64 a share and the low estimate is $1.26. PNC earned $913 million in its previous quarter.

Josh Schwartz the CEO of The Markets Are Open expects PNC to earn revenue of $3.635 billion and expects earnings of $860 million. The return on tangible equity would drop from 16.1% to 14.7%. This will because of the increased earnings PNC will be holding on its balance sheet.

Schwartz expects PNC to add $400 million to earnings in 2012 because of the RBC transaction as well as cost reductions. PNC's ROTE is coming under pressure because it has been rapidly increasing its equity base without increasing its assets. All this will change with the RBC transaction as PNC was able to buy a bank at its tangible equity and can essentially grow its returns for free since it's increasing its leverage. Leverage amplifies returns and risks but PNC's leverage is excessively low and is beginning to hurt returns.

PNC has the lowest amount of leverage of the major institutions. BAC's is at 18 to 1. JPM is also at 18 to 1. Citigroup has leverage of 14 to 1 as does WFC and USB has leverage of 15 to 1. This leaves PNC on its own with leverage of an astonishing 11 to 1. With the RBC purchase leverage should increase to at least 12 to 1 which will help PNC's returns. PNC will still have a way to go down to get to its desired leverage of 12.5 to 1. This means PNC can add assets on the cheap and continue to grow its earnings. If PNC can add another $40 billion of assets like they did for RBC at around its tangible equity it can increase returns to around 21%. This leverage would still be below where USB and WFC are operating now.

Meaning pound for pound PNC is the most efficient bank in the country on a leverage adjusted basis.

Investors have been concerned with PNC's revenue drop in their latest quarters but this is due to the loss of purchase accounting accretion. Purchase accounting accretion is simple imagine PNC buys a bank and that bank has a loan on its books for $1000. PNC says no, that loan is worth $600 and lets say the loan expires in 1 year and has a coupon of $60 and we will say the discount rate is 6% on this borrower. If the loan was issued at par the yield on that loan originally would be 6%. However since PNC marked down the loan to $600 the yield on the loan would be 76.67%. This means PNC would earn $460 in revenue on the year from that one loan instead of the $60 in revenue the other bank earned. However because this loan is at fair value PNC will likely take a large provision on that loan to offset the increased revenue. This is because the loan is likely not worth that much. So revenue would be up by $460 but provision expense would also be up by an amount say $456.

This is why PNC's revenue has dropped every quarter in the last five. Yet its distressed asset portfolio has on average lost $4.2 million a quarter. So this is why PNC's earnings go up when revenue drops. Its because they get rid of that revenue but they can use the money to make a better loan which do not have to take a large provision against. Instead of making $460 million of revenue they may make $30 in revenue but they may have earnings of $30 instead of losing money. However revenue hungry investment professionals don't really understand this and they sell stocks like WFC when they miss revenue. PNC and WFC are most exposed to declining revenues because of their large acquisition in 2008. Both banks more than doubled their size. And like PNC WFC has seen a drop in interest income almost every quarter for their last five. Go figure. Yet companies like FITB slam PNC and WFC in their presentations saying they benefit from this accretion when they do not. And USB benefits by showing revenue growth when these banks show declines. The only reason these banks look better is because they did not make acquisitions in 2008. Obviously USB would have greatly benefited had it done so. It is no wonder Buffett has not added to his USB position in 3 years.

I say avoid these analysts who talk of revenue declines they probably ask about purchase accounting accretion but don't understand it. A revenue drop is not the end of the world and likely is a positive thing.