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Bank to basics

In July Mellon Financial Corp. an-nounced that it was selling its branches to Citizens Financial Group and exiting the retail banking business. The move completed the venerable Pittsburgh institution's transformation over the past decade into an asset management company.

In July Mellon Financial Corp. an-nounced that it was selling its branches to Citizens Financial Group and exiting the retail banking business. The move completed the venerable Pittsburgh institution's transformation over the past decade into an asset management company.

Mellon certainly is not the first to follow a nonbanking path in pursuit of higher profits - and more attractive multiples on the stock market. But don't expect fierce hometown rival PNC Financial Services Group to do anything like that anytime soon.

Maintaining a business mix that looks much like Mellon's before the sell-off - a multistate consumer banking network, a small-business and middle-market-oriented commercial loan portfolio and growing asset management and securities-processing subsidiaries - PNC is settling in for the long haul as a more traditionally diversified bank holding company.

Indeed, to PNC chief executive officer James Rohr, Mellon's repositioning represents vindication: a competitive victory for PNC in its core banking markets and a reinforcement of its stick-to-the-knitting strategy. Rohr says PNC won't make such a "franchise-risking bet" that goes against banking sensibilities. "If there's one thing you learn as a banker, it's never to put all your eggs in one basket," he says.

Make no mistake about it, Rohr is placing a big bet of his own that isn't paying off in the stock market. Investors have been punishing regional banks like his for years. And PNC's shares reflect that. As of mid-December they were, at 56, down 20 percent for the year; PNC's forward price-earnings multiple of 13 is merely average for regional banks. By contrast, Mellon, in its year of transition, took a 21 percent hit in its stock price, to $38 - but its forward P/E is a healthier 22.5. Two other banks that had preceded Mellon in exiting traditional banking and emphasizing asset management, Chicago-based Northern Trust Corp. and Boston-based State Street Corp., trade at 25 and 24, respectively.

Rohr, though, is keeping the faith in the more traditional structure, and particularly in retail banking, which produces almost half of PNC's revenues. That basic deposit-taking business may be unexciting, and undervalued, but Rohr sees plenty to appreciate. "Some people don't like branch banking, but we've stayed consistent with it, and it's growing," he says. "This looks like a pretty good business to be in." Good enough that PNC saw fit to pay $30 million over 20 years for the naming rights to PNC Park, Pittsburgh's new baseball stadium, which opened last spring.

For the 53-year-old Rohr, that faith in retail is a leap if not a gamble. A 30-year PNC lifer, Rohr, like most bank CEOs of his generation, is a commercial banker by training. When the flagship subsidiary PNC Bank, then called Pittsburgh National Bank, was making corporate loans nationwide in the 1970s and 1980s, Rohr criss-crossed the country to call on big customers. And when the bank followed its customers into international markets, Rohr helped to lead that charge.

But banking fashions change. As PNC - the company shortened its name from Pittsburgh National Corp. in the 1980s - retreated from the large-corporate and international arenas in the 1990s, Rohr helped lead efforts to diversify and gained an appreciation for mundane retail deposit taking. Today, with profits in PNC's Midatlantic and Midwest branch network holding steady, Rohr is learning to love retail all the more.

Such affection isn't misplaced, according to John Lyons, a veteran bank analyst and investor and now president of the New York-based Keefe Managers hedge fund. "I think PNC should expand its retail bank. Deposits are now easily gotten after ten years when they were as scarce as hens' teeth," says Lyons. He disagreed with Mellon's gambit so strongly that he sold his shares after it announced its intention to get out of the retail business.

With $72 billion in assets, PNC ranks as the 13th-biggest U.S. bank, and it certainly doesn't have all its eggs in retail - or even in banking. In the 1990s, under CEO Thomas O'Brien, it successfully moved into fee-based businesses.

Of PNC's $1.35 billion in third-quarter revenues, 63 percent, or $849 million, came from banking activities, including consumer and small-business services and real estate lending. Most of that 63 percent, or $585 million, came from the retail segment that PNC calls regional community banking.

The rest of the revenues were from asset management - PNC Advisors and the renowned fixed-income shop BlackRock, which PNC acquired in 1995 - and from the bank's PFPC back-office securities processing unit. These operations have contributed mightily to making PNC a stronger generator of fee income than most banks. Fee, or noninterest, income tends to be highly valued by investors, because it is less cyclical than interest income.

The irony for PNC is that it earns a higher percentage of its income from fees than do most rivals - but investors haven't seen fit to bid up its share price. To be sure, no traditional bank has a noninterest-income ratio approaching the 71 percent of Northern Trust, the 72 percent of State Street or the 83 percent of the revamped Mellon. Yet PNC, at 58 percent as of the third quarter, is well above regionals such as FleetBoston Financial Corp. and Fifth Third Bancorp, which are in the 40s, and it is even two points better than Citigroup, which is seen as a paragon of financial services diversification and trades at a P/E of close to 20.

Stuck between his regional banking peers and the high-fee earners, Rohr simply can't get the market to buy his reasoning. But he remains convinced that traditional banking is a haven for all seasons, all economic cycles. And why not: Through its 716 branches in Pennsylvania and several nearby states, PNC consistently increases its transaction account deposits by 10 percent year over year; after the third quarter they stood at roughly $26 billion out of $45 billion in total deposits. "Those are the best kind to have," says Rohr, noting that they cost little or nothing in the way of interest. Their low cost contributed to a 3.86 percent net interest margin, 32 basis points better than in 2000's third quarter and about 20 basis points better than the average for U.S. banks with more than $10 billion in assets. And the retail bank's earnings were up 25 percent in the third quarter, to $186 million, while income from asset management and processing was flat, at $78 million.

In fact, PNC has been a consistent moneymaker. Consolidated net income hit $298 million in the third quarter. At $1.02 a share, it fell 3 cents shy of the Thomson Financial/FirstCall analysts' consensus, but Rohr deemed it a strong showing "in a very challenging environment." Indeed, PNC had to more than triple its third-quarter provision for credit losses, to $110 million. That was the main reason for a $24 million, or 7 percent, year-over-year decline in the net, but the company still posted a respectable 1.71 percent return on average assets and 17.92 percent return on average equity.

If there is any bank Rohr admires, it's Cincinnati-based Fifth Third Bancorp, a longtime darling of analysts, which is the same size as PNC and trades at a multiple of 34. Rohr notes that his bank has many similar strengths; like Fifth Third, it has not devoted itself only to traditional consumer banking; it has also reduced its loan revenues to about one fourth of the total, thereby becoming more reliant on fees. Selling this line to Wall Street analysts hasn't been easy, especially considering PNC's overhead. PNC still looks like just another middling bank in its efficiency ratio, which measures costs as a percentage of revenue. It stood at 54.7 in the third quarter; Fifth Third, which for years has served as an industry benchmark at close to 40, was at 48.4, a figure inflated by its recent merger with Old Kent Financial Corp. of Grand Rapids, Michigan.

Rohr and PNC are suffering in a generally difficult climate for banks; the recession has crimped loan growth, pushed credit losses higher and hurt the valuations in securities and venture capital portfolios. Prudential Securities analyst Michael Mayo, though relatively bullish on PNC's long-term prospects, downgraded the stock from hold to sell in September. In December J.P. Morgan Securities analyst Catherine Murray lowered her PNC fourth-quarter earnings-per-share estimate, to 91 cents from $1, because of anticipated loan-loss provisions. Merrill Lynch & Co. analyst Sandra Flannigan recently cut her full-year PNC estimate by 15 cents, to $4.60 (versus $4.34 in 2000). But she rated PNC a long-term buy.

Rohr argues that the retail-heavy strategy is bound to pay off over time. "You're only going to get 14 times earnings," he concedes, but he adds that the risks in retail are low and the returns on capital are attractive at 18 percent - average for the company though below the 26 percent from asset management and processing. "We have put together a diverse set of businesses that can deliver premium earnings-per-share growth, which will get us a premium valuation," Rohr declares.

For all his traditional banker talk, Rohr's company is much less a bank than it used to be. PNC has largely eschewed the large-corporate lending that traditionally defined a commercial bank. And there is more downsizing to come: PNC disclosed in a third-quarter Securities and Exchange Commission filing that its communications industry loans and portions of its energy, metals and mining and large-corporate portfolios were likely to go. Merrill's Flannigan says that those moves could require a $400 million to $500 million aftertax charge for the fourth quarter, but PNC's capital levels are healthy enough that "the charge could be readily absorbed."

PNC has also backed away from the credit card and mortgage lending that have been bonanzas to larger companies like Citigroup and Wells Fargo & Co. Having reduced its total loan balances by 23 percent over three years, to $46 billion, PNC now keeps more deposits than loans on its books - its 94 percent loan-to-deposit ratio on September 30, down from 105 percent a year earlier, is a sign of growing conservatism. That lower-risk bias was evident in a deal PNC announced in November to acquire $1.6 billion in U.S. asset-based loans, as well as several offices, from National Bank of Canada. Rohr describes that as "a high-quality, high-return portfolio" that will expand PNC's network of business credit offices from 13 to 19 states.

Today's more risk-averse and fee-dependent PNC began to take shape in the 1980s, particularly after O'Brien became CEO in 1985. Two years earlier, when O'Brien was running the lead bank in Pittsburgh and Merle Gilliand headed the parent holding company, PNC acquired Philadelphia-based Provident National Corp. With that deal, PNC signaled that it intended to control its destiny as the banking industry consolidated.

Aside from creating a $10 billion-in-assets statewide holding company, the merger brought into PNC Provident Financial Processing Co., the nucleus of today's PFPC, a leading provider of mutual fund accounting, administration, custody and related processing services. But before the bank could focus on beefing up PFPC, it had to wrestle with its home city's - and its own - industrial legacy. After World War II, Rohr asserts, "we rebuilt Japan, Germany, France, Italy. And all of those steel mills and all of that equipment came from Pittsburgh. We got into the export finance business and ended up with offices in a whole bunch of places." Among those distant outposts: Hong Kong, Paris, São Paulo and Sydney.

By the early 1990s the relevance of PNC's international department had declined along with Pittsburgh's rusted old industrial base. O'Brien assigned Rohr, then head of PNC Bank, to break up and sell off the multinational division, which he accomplished in a series of small deals with banks around the world.

But trouble was brewing on the balance sheet at home. O'Brien, whom Rohr succeeded as CEO in May 2000 and as chairman a year later, had made a risky bet that interest rates would decline; when rates rose in 1994, PNC had to take a $135 million charge for derivatives losses.

O'Brien gets higher marks for his diversification moves. Although one went sour - a consumer lending venture with the American Automobile Association, which PNC sold to credit card giant MBNA Corp. in 1998 for $450 million - PNC scored big with BlackRock, which it purchased from Blackstone Group for $240 million. That was only about one tenth the total that Mellon spent in acquiring Boston Co. in 1993 and Dreyfus Corp. in 1994, which were its first big moves down the asset management road. And the contrast between the Pittsburgh banks came to epitomize the great debate over banking diversification and over the merits of a retail branch strategy.

As of early December, when Mellon sold its 345 retail branches in Pennsylvania, New Jersey and Delaware to Citizens, the rivals had gone decidedly separate ways.

Although PNC executives have set a goal of getting asset management and processing up to 40 percent of revenues over the next five years from roughly 35 percent now, there is no questioning the company's firm grounding in retail. Says PNC vice chairman Walter Gregg Jr., who oversees New York-based BlackRock and other nonbanking activities, "The community bank is a very, very large part of what we do. It continues to be and will continue to be."

Rohr takes great delight in Mellon's departure. He expects Providence, Rhode Island-based Citizens, a subsidiary of Royal Bank of Scotland Group, to lose some business in the transition. Deposits often erode when banks merge; Rohr notes that PNC gained $1 billion after First Union Corp. (now Wachovia Corp.) bought CoreStates Financial Corp. of Philadelphia in 1998.

But that merger was notorious for its level of mismanagement. The Mellon-Citizens transition seems to be off to a better start, as Mellon reported that its retail deposits rose $1 billion in the third quarter. And Citizens asserts that it is experienced at integrating acquisitions, having completed 17 in ten years. It aims to repeat the pattern of its parent's March 2000 purchase of London's National Westminster Bank, which by all accounts went seamlessly, with minimal customer disruption or loss of market share.

Still, "we're pretty excited about it [competing against Citizens]," says PNC retail banking chief Joseph Guyaux. "We'll advertise, do direct mail and have our people hitting the street," he insists.

Rohr is serious enough about the nonbanking side of the equation to be exploring other deals. He wouldn't mind repeating the experience of BlackRock, which, he boasts, is "the best acquisition of an asset manager ever done." Since PNC bought BlackRock, assets under management have increased more than tenfold, to $226 billion, and the 30 percent of BlackRock shares that PNC issued in a 1999 IPO at $14 each - half to the firm's management and half to the public - have appreciated to $41. That gives BlackRock a market capitalization of $2.6 billion; PNC's is about $16 billion.

Gregg is working on a plan to similarly spin off part of PFPC. "The reality is that these things trade at higher multiples than traditional banking and will always trade that way. It isn't going to be very appealing to the guys at BlackRock or PFPC to get PNC equity. They want a piece of what they are building," Gregg explains.

Gregg adds that PNC would ultimately like to buy a publicly traded processing company and merge PFPC into it. He won't discuss potential acquirees, but there aren't too many, and they would not come cheap. Investors Financial Services Corp., for example, a Boston-based global custody specialist, has a market cap of $2.2 billion, and its stock trades at 48 times earnings. SEI Investments Co., another possibility cited by analysts, has a $4.5 billion market cap and a P/E of 40.

As intriguing as those ideas might seem, Rohr knows the core banking business too well to allow it to be overshadowed by nonbanking concerns.

"We think this is a good place to be," says Rohr, referring both to the Pittsburgh region and to the retail business.

But traditional bankers have a hard time persuading investors to share the love.