U.S. Bancorp: A Sluggish Margin And Credit Deterioration Leaves Me Uninspired

Investment Thesis

Headquartered in Minneapolis, Minnesota, U.S. Bancorp (USB) is a $547 billion asset holding company and parent to U.S. Bank N.A., the 5th largest commercial bank in the United States. USB provides everything from commercial to real estate loans, wealth management, card services and personal banking. It has more than 2,700 locations located throughout the United States.

While most peer banks have seen continued growth through both organic strategies and acquisition, USB hasn’t really been all that acquisitive when partnering up to grow assets. More recently, USB has focused on building out its insurance and card payment solutions through joint ventures and acquisitions.

When I think about USB, I do so in the light of knowing that fee income is a higher percentage of overall revenue than most banks. I think USB does have some minor credit issues, but that could be due to the quick trigger to charge the loan off entirely. From a core banking perspective, I see little upside in the margin over the near term. When thinking about the bank as a whole, I think the current valuation is appropriate and see little upside in the shares when compared to peer banks.

Revenue Outlook

In the second quarter, the spread revenue (fully taxable equivalent) was $3.2 billion. Driven by the margin compression, net interest income was actually down $23 million (or less than 1%) relative to the first quarter. While average earning assets were up significantly, more than 10%, the mix change and precipitous fall in interest rates led to having lower-yielding loans and other earning assets, like municipal and corporate-backed bonds.

While the quarter did have significant loan growth, largely driven by PPP loans, the overall portfolio composition did change a bit more than I expected. Total commercial loans (which include PPP loans) were up nearly 24%, along with the bank deciding to add personal mortgages to the balance sheet. While adding mortgage does help stem the net interest margin (NIM) compression in an interest rate free fall, it does limit the upside until they are sold. Adding to this complication, when they are sold, it will create an unnecessary headwind to overall loan growth. Partially offsetting the residential and commercial loan growth was the reduction in personal credit card loans and “other” loans (which typically include auto, personal lines of credit, etc.).

In the second quarter, the NIM of 2.62% compressed about 29 basis points relative to the first quarter. This fairly substantial decrease was driven by higher cash balances from companies being flush (from PPP loans) and lower yields. While “lower yields” is fairly obvious given the very accommodating Federal Reserve, yields on loans and securities, along with deposits and interest-bearing liabilities all fell from their respective first quarter levels.

While spread revenue was a bit of a disappointment, fee income did report positive quarter-over-quarter growth. Like spread revenue, fee income does come with some major puts and takes. Driven by historically-low interest rates, mortgage was a bright spot for the company, along with commercial products, simply due to the market’s excessive volatility. Lower card fees were a bit of a drag, along with payment services, corporate payment products and deposit services.

Source: SEC Filings and Author’s Estimates

While I’m not expecting any material upside to the margin, I do expect it to flatten out pretty quickly near current levels. The overall margin is predicated on two things: interest-earning assets and interest-bearing liabilities. This quarter proved a pretty sizable imbalance in excess liquidity (i.e. more interest-bearing liabilities). Going forward, I do expect the margin to hold steady, even when yields continue to fall. USB is likely going to deploy the billions of excess cash into securities (not loans). While bond yields are incredibly low, they would more than cover the cost of the cash, thus stemming that outflow and supporting the NIM.

Also, I would expect mortgage to continue to perform well and the service charge shortfall seen in the first quarter to bounce back. When adding all the moving parts of fee income together, I would expect similar results for the third quarter, before abating a little before we finish out the year as mortgage cools a bit.

Credit Review

Getting a sense of how USB views credit is pretty clear from the chart below. Even though it is in the top 5 largest commercial banks in the United States, it operates and acts like the largest regional banks, relative to the other four money center banks. As one can garner from the chart, USB very much follows the regional banking trends with slightly more net credit-offs (NCOs). Because of this consistently elevated NCOs’ nature, it’s difficult to get excited about the future credit prospects.

Source: SEC Filings

In the second quarter, USB had a $1.7 billion loan loss provision expense. This expense was significantly higher than the first quarter’s $1.0 billion level. While COVID fears did accelerate throughout the second quarter and GDP did free-fall, it begs the question why did management wait so long when other banks had a much more equally-balanced first and second quarter provision. Nevertheless, NCOs in the second quarter were $437 million relative to $393 million from the first quarter. This equates to 0.55% and 0.53% of total loans, respectively. However, an astute investor would realize that “0.55%” is unnaturally compressed since PPP loans boosted the balance sheet, but pose no credit risk.

Source: SEC Filings

In my mind, the most concerning credit trend is not the NCOs, those have already been resolved and ejected off the balance sheet. To me, criticized loans and the relative trajectory give me the greatest bit of insight into future credit trends.

When looking at USB, one can see criticized loans have climbed pretty rapidly over the past six months. However, the good news is that criticized loans over total reserves (black line) is still rather muted. The muted effect was caused by the pronounced elevated provisioning earlier in the year.

When I think about a potential investment, I try to remember two things. The first being the actual fundamentals and second being the investor response. In my mind, I think USB is likely to have elevated NCOs from here until the middle of next year. While these are likely to be more than mitigated by the strong reserve, I think investors are likely to shy away from USB since NCOs are elevated and there is no downward trajectory. If NCOs do continue to stay elevated, the provision is likely to stay high too, putting a lid on any profitability improvement.

Conclusion

While I do think that USB is a well-run organization, I don’t think this bank is well-suited for the type of credit environment for which we currently find ourselves in. USB is a very large banking player and it will take a while before credit cleans itself up. I think investors would be willing to look past slightly elevated credit problems (relative to peers) if the margin was better than average (but it is not)

The bottom line is this: Since USB has a slightly worse margin than the average bank and credit has historically trended a little more on the risky side, I think the current valuation is appropriate. USB is likely to trade in-line with peer banks for the foreseeable future.

Source: SEC Filings and Author’s Estimates

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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