Digging Into PNC Financial's Annual Shareholder Letter

4/17/17

Courtesy of Motley Fool

Every year, the CEOs of major companies publish a letter to shareholders, detailing the companies' successes and failures. But some CEOs are better at this than others.

Listen in to the following segment of Industry Focus: Financials, as The Motley Fool's Gaby Lapera and contributor John Maxfield discuss why PNC Financial's (NYSE:PNC) annual letter is one of the better letters written by a CEO in the bank industry.

A full transcript follows the video.

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This video was recorded on April 3, 2017.

Gaby Lapera: Let's talk about the shareholder letter. For those of you unfamiliar, the shareholder letter generally appears at the beginning of a company's 10-K every year. The 10-K is the SEC filing that the companies put in at the end of the year that's basically like, "This is how are company did for the whole year," and it has all the numbers for the whole year and year-over-year metrics and explanations of where they think the company is going, stuff like that. So, pretty important SEC filing in general. This is just the very front half of it. Normally, shareholder letters are what you would expect them to be, because they are, in theory, written by the CEO, but they're probably written by a media team in conjunction with the CEO, which is full of corporate-speak and not very transparent to people reading them. But this was a very interesting shareholder letter, because it had less...what's a safe for work word for B.S.? [laughs]

John Maxfield: Corporate jargon.

Lapera: Corporate jargon, it had less corporate jargon than the average letter. I know that John and I have talked about this quite a bit. We love writing; there was that great writing episode we did over a year ago now. One of the most important things about writing is that, when you write, you need to be well-organized. This was probably one of the best-organized shareholder letters that I've ever seen. What about you, Maxfield?

Maxfield: I agree. I was struck, I have never read, their CEO is a guy named William Demchak, who used to be at JPMorgan Chase for a while, and did stuff in their investment bank. I've read a lot of letters, but I hadn't read one of his before, so when I opened this up last week, or a couple weeks ago, I was really surprised by the quality of it. The first thing that struck me, to your point, Gaby, was the organization of it. I'm a writer; I'm an editor. You're a writer; you're an editor. So we appreciate these nuances. And what I found is, that very first paragraph -- and this is a tip for people who are interested in improving their writing -- that very first paragraph in Demchak's letter lays out his case, it totally provides a summary conclusion of his case, right out of the gate. What that allows you to do is test his perspective, his conclusion, relative to the facts that he lays out in the letter. And what that shows is, he is confident enough in PNC's performance that he's willing to lay it out and have people test what he has to say about that. So I think it's a great letter.

But the other reason that is such a good shareholder letter, in my opinion, is that it does a really good job teasing out the natural tension that bank CEOs and executives have between growing aggressively and growing responsibly. You have to grow as a business. And as a bank, it's really easy to grow because all you have to do is jack up your loan volume by reducing your credit standards. But the problem with that is, you then take on these riskier loans, which then, in a crisis, can subject you to an existential issue. But you still have to grow. You have to balance these competing objectives. And I think Demchak does an excellent job in his letter teasing out that tension.

Lapera: Yeah. Something else, for people who are looking for writing tips, one of the other really impressive things about this letter is that he really keeps in mind who his audience is. He lays out his thesis, and then right away, he hits all of the really important numbers, and then he lays out his framework, his road map for where he sees the company going, along with the letter, which is a really great way to lay anything out. But as with all things, we encourage you to think critically about this, before we sound just like an ad for William Demchak and PNC bank. One of the most important things to do when you read anything written by a company is look at it with a critical eye, because you have to understand that there's more going on than what they're saying here. And I think one of the best examples, there's a few, but a really interesting example is share repurchases. I'm on page 2 of the shareholder letter, and it says, "In 2016, we returned more than $3 billion in capital to shareholders. Repurchases for the full year totaled 22.8 million common shares for $2.3 billion, and we paid $1.1 billion in common stock dividends." Maxfield, what is PNC currently valued at? It's like 2.1 times book or something, right?

Maxfield: Right, 2.1 times book.

Lapera: So the question is, most people would look at that and be like, "Was that actually a really good move, for them to repurchase shares at 2.1 times book?" If they even think to think that, and they're like, "Oh, that's nice, they returned value to the shareholders by buying stock purchases." But the savvy investor would think, "Hey, does that actually make sense, to buy your stock when it's so expensive?"

Maxfield: Right. Ideally, when a company buys back its stock, it wants to buy it back cheap, because that's the way that a buyback is accretive to the book value of remaining shareholders. So in the banking world, you want to buy back, and this is ideal, but, in an ideal situation, you want to be buying back your stock at one times or less than one times book value, because that means you're basically buying dollars for $0.90 or $0.80, depending on what the valuation is. Then, once you get up to that two times book value and above, your repurchases actually start to destroy value for the remaining shareholders. But here's the problem that banks run into when it comes to allocating their capital.

Generally, the Federal Reserve doesn't want a bank to distribute their dividends more than a third or 40% of their earnings. That leaves two-thirds to 60% of their earnings that a bank either has to retain on its balance sheet, or in some other way, get it off its balance sheet. And the only other way to get that capital off its balance sheet is through share repurchasing. So the question is, is it still a good idea when there's a high valuation, to be repurchasing shares as a bank? And the answer is, they really don't have a choice. If they retain all of that capital on their balance sheet, it will drive down the return on equity, and thereby potentially incentivize the executive to reduce their credit standards and jack up their loan volume, jack up their revenue, to offset the downward pull on their return on equity by all this additional capital that's on the balance sheet. So, a bank, in terms of buying back their shares at a high valuation, is it ideal? No. But do banks have any other choice? Not really.

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