3 Numbers PNC Investors Need to Watch

I have some good and bad news for PNC Financial (PNC -0.06%) shareholders. The good news is, your bank has consistently beaten earnings estimates over the last few quarters. And with earnings season right around the corner, you might even expect another positive surprise.

Now, the bad news: If you really look at what's going on beneath the surface earnings numbers, there is plenty to worry about.

The huge growth that wasn't
The first worry for PNC investors is that the bank's most recent earnings beat estimates thanks to one-time items. For the quarter, PNC reported an eye-popping 103% increase in earnings per share. This might seem like cause for celebration, but if you dig into why the earnings increased so much, the merriment gets cut short very quickly.

The bank's net income improved by $577 million, but $233 million of this was from an improvement in residential mortgage banking. This unit benefited from lower residential mortgage repurchase obligations, so a favorable year-over-year comparison made up more than 40% of the improvement.

Of the other $296 million in net income improvement, the majority came from the "other" category. This was primarily related to the sale of Visa shares that the bank was holding. When you add it all up, $529 million -- or more than 90% -- of the $577 million improvement in net income was due to one-time items. Investors will need to watch the company's next earnings report and read beyond the headline EPS figures to see if real growth is occurring.

You can't fake this
Even if you can get past the concerns about PNC's earnings growth, a second worry facing PNC investors is the company's non-performing loan issues. Take a look at the difference between PNC and some of its competitors.

Source: S&P Capital IQ.

As you can see, though we are now years removed from the Great Recession, PNC's non-performing loan percentage has remained stubbornly high.

Part of the challenge is that PNC had to reclassify some loans as recently as the first quarter of this year. The bank said that, "regulatory guidance increased nonperforming assets by $426 million." Needless to say, it's hard for any bank to cut its nonperforming loan percentage when almost half a billion dollars in problem assets are added to the mix.

A second reason PNC's nonperforming loan percentage is higher than those of its peers is because the bank isn't ridding itself of these problem assets as quickly as other banks. The two simplest ways for a bank to lower its percentage of nonperforming assets are to grow the total portfolio or dispose of problem loans and real estate. To say that PNC is making slower progress in moving its problem assets is an understatement.

Source: SEC filings.

This is only the change over one quarter, but if the bank doesn't get more aggressive about shedding these assets, investors can expect the higher-than-peer nonperforming ratio to persist.

The bank lags in this measure
When it comes to net interest income, PNC reported a year-over-year decline of 11%. By comparison, Bank of America and M&T reported net interest income growth, while BB&T reported a decline of just 5%.

Historically low short-term interest rates are part of the problem, but there are a few specific issues at PNC that caused this greater decline in net interest income compared to its peers.

First, PNC has more than 55% of its total loan portfolio in commercial and commercial real estate loans. Among the four banks we've looked at, only M&T carries a higher percentage, at more than 67%. With a high percentage of commercial loans, PNC's interest income is more sensitive to short-term interest rates than some other banks'.

Secondly, PNC's average commercial yield has dropped significantly.

Source: SEC filings.

PNC's average yield declined by nearly 20% year over year, whereas its competition witnessed declines of 6% or less. A prime reason PNC witnessed a steeper decline in net interest income is that the bank grew its commercial and commercial real estate loans by a faster rate than the peer banks we've looked at. With fast growth occurring at historically low commercial rates, it's no surprise that PNC's net interest income suffered.

The direction of PNC's average yield going forward will depend on whether the bank wants better margins, or continued commercial loan growth. If rates stay at their current levels, the bank may be forced to continue growing the commercial loan portfolio at the expense of its net interest margin. The Federal Reserve seems intent on keeping rates low at least in the short term. In this environment, PNC's faster commercial loan growth will continue to put pressure on the bank's average yield and net interest income.

When you put it all together, PNC's investors have plenty to worry about. The bank's earnings quality last quarter was less than ideal. With the bank also struggling with both a net interest income decline and nonperforming asset challenges, shareholders should be careful to temper their expectations. Investors need to keep an eye on these challenges when PNC reports earnings in a few weeks. If the bank can begin to solve these problems, the stock may continue to do well, if not, disappointment could follow.