Description

This idea is to go long PNC warrants, which I believe are significantly mis-priced relative to the underlying common shares.  Before offering a short review on PNC, let me first lay out the pricing relationship between the warrant and the stock.  PNC stock closed on Friday at $91.96. The warrants closed on Friday at $25.81.  The warrants have a strike price of $67.33 and expire on December 31, 2018, which means there is roughly 3 years and nine months of time to expiry.  Subtracting $67.33 from the stock price of $91.96 gives us an intrinsic value of $24.63 for the warrants, which means that we are paying less than $1.20 for participating in any stock appreciation for the next 3 years and 9 months. This is an extraordinarily low cost for such a long period of time.  An investment of roughly 1% of portfolio assets in the warrants provides approximately 3.6X leverage, which means that one can take a position equivalent to 3.6% of your portfolio in PNC via a 1% portfolio weighting in the warrants.

Also, let me note that PNC warrants don't offer a ton of liquidity, and often trade 15-20K per day.  To my mind this is why the opportunity exists.  

There are a lot of bank warrants out there, but PNC strikes me as one of the more attractive, in part due to the low time value paid and the substantial leverage to the upside, but also because the bank itself strikes me as well solidly managed.  PNC is a Pittsburgh-based super-regional bank with a large retail banking and residential mortgage operation as well as corporate and institutional banking.  PNC also offers asset management and wealth management services.  PNC reported 2014 full year revenue of $15.4B and net income of $3.95B, or $7.30 per share. The ROA was around 1% and ROE was just shy of 10%, though PNC has historically done ROAs of 1.2% and ROEs in the 11-12% range. Reported book value at year-end 2014 was $77.61, and TBV was $59.88.  Based on these figures, PNC currently trades at roughly 12.6X earnings, 1.18X BV, and 1.5X TBV.  PNC appears to be a reasonably priced stock on all these metrics given its very strong regional market position and solid history of performance, but it does not appear to be a screaming bargain.

PNC paid dividends of $1.88 per share in 2014 and bought back 12.9M shares for $1.1B.  From the perspective of the warrant holder, the dividends paid do not help us, but the share buy backs do help us somewhat because they should reduce sharecount and increase earnings per share, thereby driving a little stock price appreciation.  Like some of the other bank warrants, there is a slight reduction in the warrant strike price for dividends paid above a given base level, but given that we are talking about fractional adjustments I have chosen to ignore this feature for now. 

In terms of potential pay-off, my hope is that PNC is able to generate something like $27 per share in earnings over the next 3.75 years (an average of $7.20 per year) of which about $5.20 per year accrues to the book value of the business; PNC will probably use a meaningful portion of these earnings to buy back stock.  Either way, this should add roughly $19.50 per share of value to the warrant over 3.75 years; this excludes any improvement in the earnings profile of the business that may have happened between now and 2018.  In any case, if we assume that PNC is capable of earning $8 per share in 2018 and has grown its BV to $97, and assuming the market continues to assign a 1.2X BV multiple on that figure, we'd be looking at $116 for the common shares.  If we back out the warrant strike price of $67.33 from this price, we get an intrinsic value for the warrant of $48.67, or roughly 2X.  This doesn't sound that impressive for a leveraged instrument, but I'm using a very modest case scenario here that assumes that the stock only goes up 26% cumulatively over the next 3.75 years, or a compound IRR of less than 6%.  If I may be allowed to throw out a little more optimistic scenario, let us assume that PNC is able to produce $8.50 per share of earnings in 2018 and the market values this at 15X, the stock would be $127.50 and the warrants would be worth $60 for a 2.4X return.

There is one final little juicer to the idea that I've considered in the scenario above, and that is that PNC owns 22% of Blackrock, which as you are probably aware is a massive asset management firm with a publicly traded stock that currently is valued by the market at $62B.  As of the most recent 10-Q (PNC's 10-K is not out yet) PNC valued its stake of BLK on its balance sheet at $6.2B, despite the fact that the market value of the stake at that time was $11.7B.  Today the market value is more like $13.5B. This represents about $7.3B of hidden value on the balance sheet (though note that PNC includes its minority interest in BLK's earnings in the income statement).   This hidden value would equate to roughly $13.70 per share of PNC, which could potentially be unlocked if PNC management were so inclined.  They don't appear to be inclined at this moment and do very little to highlight this value, but that could easily change between now and December 2018.  As a buyer of the warrant for $25.81, you are in essence getting another hidden call option on any action PNC might take to highlight this additional value. 

If we allow ourselves to imagine that PNC does something to highlight this value discrepancy and investors tack on only some portion of the difference to PNC common shares (say, adding $7 per share in value) this would take our conservative base case warrant target price to $55.678 and our good case scenario to $67.  

Obviously there are cases that a person more optimstic than myself (i.e., most everybody) could conjure that would result in even higher prices for PNC (and by extension, the warrant).  But it would not be in my nature to sell this idea that hard; still I am occasionally pleasantly surprised.   Still, let us look at the possible range of outcomes here; you bet 1% of your portfolio on the warrants; the "base case" is that you get somewhere between a double and a triple.  I would argue that there is a less than 5-10% probability that PNC stock does so poorly that it were to close below $67.33 per share and render the warrants worthless, and of course an investor has 3.75 years with which to sort of casually follow PNC's progress and watch for any signs that might portend significant value destruction between now and then.  In the current market environment, this seems a pretty decent opportunity.  In my own portfolios I have it sized at about 135 basis points which gives me roughly 4.7% exposure to the common on a look-through basis. 

Catalyst

Continued earnings generation and growth in book value over the next 3.75 years; some sort of financial engineering move to carve out, spin out, or otherwise highlight the value of the 22% stake in Blackrock is an extra bonus.  Share buybacks should be ongoing and be accretive to earnings per share.