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The long-term ratings for U.S. Bancorp (NYSE:USB) were cut by Moody's on 6 December 2012. This articles aims to explore on the rationale behind the downgrade and look into the diverse business mix of the bank. Despite the downgrade, U.S. Bancorp remains one of Moody's highest rating banks, both globally and domestically. This reflects the credit rating agency's confidence in the bank's diverse business mix resulting in improved operating efficiency, stability in the bottom line and limited concentration risk. The bank has not posted a loss since 2006. The bank had a solid recent quarter performance along with a strong capital base. Therefore, with a mean price target of $36.80 per share, I recommend investors buy the stock.

Bank Description

Operating as a diversified multi-state financial services company, U.S. Bancorp is the fifth largest bank by deposits in the U.S. and is headquartered in Minneapolis. The bank provides treasury & corporate services, wealth management and securities services, wholesale banking and consumer & small business banking.

Moody's Downgrade

Moody's Investor Services, one of America's premier credit rating agencies has downgraded the long-term ratings for U.S. Bancorp and its subsidiaries as pressure from ultra-low interest rates continues to endanger the bank's net interest margin. The bank's senior debt rating was slashed from A1 to Aa3, while its long term deposit rating was cut from Aa2 to Aa3. The ratings were cut on 6 December 2012. Following the ratings cut, Moody's said the outlook for U.S. Bancorp is stable.

Ultra-low interest rates, evolving operating constraints affecting revenues and expenses, new regulations and heightened competition in lending from peers are said to be the rational for this credit rating downgrade. Besides, the rating agency believes, U.S. Bancorp's expanding mortgage banking exposes it to increase volatility, as gain on sale margins decrease from their prevailing highest levels.

Most Recent Quarter's Performance

The third quarter EPS of $0.74 for U.S. Bancorp exceeded its estimate of $0.73 per share, while the top line of $5.2 billion met the consensus estimates. Net interest income and net interest margins held up better than expected, while credit quality trends continued to improve and capital ratios strengthened.

The bank relies more on interest income for its revenues than on non-interest income. The following graph shows the contribution of each towards the top line of the bank in the third quarter of the current year.

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Total net revenue for the third quarter remained $384 million higher than a year ago, reflecting a 6.1% increase in net interest income and a 10.4% increase in non-interest income. U.S. Bancorp has the unique advantage of having low cost core deposits. Growth in low cost deposits resulted in the improvement in net interest income. Much of the improvement in non-interest income was the result of higher revenues from mortgage banking.

(click to enlarge)

The graphs above compare the non-interest incomes for the bank at the end of the third quarter of the current year with the same quarter of the previous year. At the end of the third quarter of current year, the bank generated $512 million worth of revenues from mortgage banking, which was 22% of the entire bank's non-interest income. Compared to this, at the end of the same quarter of the previous year, the bank generated $245 million in revenues from mortgage banking, which was only 11% of the entire non-interest income a year ago. The more than twofold improvement in revenues from mortgage banking was a result of higher originations and sales revenues. During the most recent quarter, the bank increased its residential mortgages by $4.8 billion. This well-timed growth in U.S. Bancorp's mortgage banking has attracted regulatory and political attention. The bank's increased concentration to the U.S. mortgage market exposes it to heightened volatility, says Moody's.

Strong Capital Position

The bank's Basel I tier 1 common capital ratio of 9% improved 20 basis points sequentially. The bank resumed its share buyback program and repurchased $581 million share, targeting a Basel III tier 1 common ratio of above 8%. During the most recent quarter, U.S. Bancorp returned 67% of earnings to shareholders through dividends and share buyback.

Price Target

Analysts have a consensus mean price target of $36.8 for U.S. Bancorp's stock. It is currently trading at $31.81 per share. This means an upside of 16%.

Disclosure: I 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.

Source: Downgraded U.S. Bancorp Still Presents Excellent Opportunity