U.S. Bancorp Looks Better Placed Than Most (NYSE:USB)

In a bank sector that has been hit hard, U.S. Bancorp (NYSE:USB) has held up better than most. I thought valuation and operating leverage were looking more interesting in late February, and though the shares are down about 20% since then, they’ve outperformed many of their large peers.

I do believe that U.S. Bancorp shares look undervalued today for longer-term shareholders. I expect bank stocks to remain under a cloud a little while longer, particularly with so much uncertainty about the economy in 2023. Like PNC (PNC), though, I think U.S. Bancorp is a more conservatively-run “Main Street”-focused bank that has operating leverage drivers and opportunities to post above-average loan and fee income growth even in a tougher environment.

A Solid, Relatively Balanced Beat

Apart from some concerns about higher-than-expected deposit beta (a sector-wide concern) and maybe some flattening in the payments business, there wasn’t much to pick at in U.S. Bancorp’s second quarter results, as the bank beat on pretty much on all of the metrics an investor would expect.

Revenue rose 4% year over year and 7% quarter over quarter, contributing $0.03 to the earnings beat. Net interest income rose almost 10% yoy and more than 8% qoq, a $0.02/share beat, with net interest margin improving 6bp yoy and 15bp qoq to 2.59%.

Fee-based income declined 3% yoy and rose 6% qoq, chipping in a penny to the beat. Card revenue rose 1% yoy and 18% qoq, a little less than expected, but payment and processing revenue was better than expected, as was trust revenue. Mortgage banking was weaker than expected, but I’m honestly surprised the Street didn’t anticipate a bigger decline here.

Operating expenses rose 4% yoy and 1% qoq, adding $0.08/share relative to Street expectations, and although the expense ratio was slightly higher than the year-ago period (58.7% vs. 58.6%), USB does look well on its way toward delivering the hoped-for operating leverage in 2022 (the first full-year positive operating leverage in six years).

Pre-provision profits rose about 4% yoy and 19% and beat expectations by 9%, good for an $0.11/share beat. The bank gave back some of that in higher provisions and taxes, but still managed a roughly $0.05/share core earnings beat.

Good Loan Growth, With A Healthy Pipeline

U.S. Bancorp reported over 4% qoq growth in end-of-period loans and close to 4% qoq growth on an average balance basis, and EOP loans were about 2% higher than the Street expected. U.S. Bancorp slightly outgrew the overall banking sector, with better C&I lending offset by slightly weaker (but still positive) CRE lending and in-line mortgage lending. Card lending (up almost 7% qoq) was a bit ahead of the pack, and management’s efforts to grow this business are bearing some fruit despite pretty significant competition.

Loan demand doesn’t look like it’s about to taper off soon. As discussed by other banks, loan pipelines heading into the second half are strong, with companies still needing to borrow to fund working capital growth (inventories, mostly).

One watch-item is the deposit situation. Deposits rose just 1% qoq on an end-of-period basis, and declined 0.5% on an average balance basis, with non-interest-bearing deposits down almost 6%. While that’s not a sizable miss relative to the Street (around 1%) and the bank still has good liquidity (including a loan/deposit ratio around 70%), I do think the concerns I expressed earlier this year about higher-than-expected deposit betas through this cycle are starting to bear fruit.

What that will likely mean for U.S. Bancorp is a little less leverage on NIM than previously hoped for (and U.S. Bancorp wasn’t an especially asset-sensitive bank to start with), and perhaps some cherry-picking in the lending operations; deprioritizing less profitable or less strategically compelling lending opportunities.

Union Bank Uncertainties Aren’t A Problem … Until They Are

Management is still targeting a 2H’22 close for its acquisition of Union Bank, but as has been the case for a while now, the approval process for large bank deals has slowed significantly. I see less of the main risk here being about whether the deal will go through as opposed to when it happens – with a risk that more of the synergy benefits get pushed into 2023 and that there could be some minor inefficiencies due to the delay.

One item worth watching is a notification in the last quarter’s 10Q that the company could be facing an enforcement action from the CFPB related to its consumer sales practices. No details were offered, and no reserves have been taken for this, but some politicians have tried to grandstand on the issue and it’s at least conceivable to me that there could be political pressure to delay merger approval ahead of the resolution of this (whatever it may be).

The Outlook

U.S. Bancorp has done a little better than I expected in the first half of 2022, but not by so much that it’s driving major modeling changes. My full year core earnings estimate is about 1.5% higher now (around $0.07/share) and my 2023 number is slightly higher, while my 2024 number is 3% lower, as I do think an economic slowdown is more likely than not. All told, though, my five-year and 10-year core earnings growth rates change by a few tenths of a percentage point, and I’m looking for growth rates of around 5% and 4%, respectively.

As far as valuation goes, I believe discounted core earnings and forward P/E (13x ’22 earnings) support a fair value in the high $50s to low $60s. ROTCE-driven P/TBV is less supportive now, as tangible book has been hit by lower AOCI tied to gains/losses on the securities portfolio. I’d call this “non-core” but still worth noting.

The Bottom Line

I think U.S. Bancorp’s valuation is pretty interesting right now, and that’s from someone who has never really loved this bank. Still, given the strength of “Main Street” banking today and the opportunities to realize synergies from Union Bank while also growing businesses like cards and merchant/payments, not to mention operating leverage, I see a lot to like. I do think banks will likely be under a cloud for at least another quarter or two, but investors looking at long-term ideas and unwilling to try to time the market should take a closer look.