The first image I often get of U.S. Bancorp (NYSE:USB) is an old man snoozing in a leather armchair, but that's really not fair to this well-run bank. As decidedly "meh" as second quarter results were, it takes a lot of effort to do this well in the given banking environment and I think the better analogy is a surfer floating and paddling around while waiting for a good wave to come in.
I think the wave will come in time, and when it does, U.S. Bancorp should be able to generate mid-teens ROEs and mid single-digit earnings growth (with EPS growth likely to be in the high single digits due to buybacks). I also believe the company has the capital to get more aggressive with M&A and add a few more bricks to the walls of what is already a strong banking fortress. Today's opportunity is okay; I think the shares should be able to generate high single-digit to maybe low-double digit total annual returns, but these shares don't look dramatically undervalued.
Good Enough Is Good Enough
U.S. Bancorp didn't have a blow-out third quarter, but then nobody expected it to. Loan growth was a little sluggish relative to my expectations and expenses were a little high, but U.S. Bancorp still basically delivered the goods.
Core revenue rose 6% year-over-year and about 1% sequentially, with both net interest income and core fee income up modestly from the second quarter (around 2% and 1%, respectively). Unlike BB&T (NYSE:BBT), and more in line with PNC (NYSE:PNC) and Wells Fargo (NYSE:WFC), U.S. Bancorp did grow its balance sheet a bit, while net interest margin slipped four basis points. Growth was mixed across the fee-generating businesses, as merchant processing was up 2% sequentially, trust fees were up 1%, card fees were up 1%, and ex-MSR mortgage revenues were up 17%.
I was a little surprised to see the 3% sequential growth in expenses, but holding the line on costs has been difficult for many banks during this prolonged period of lower rates. Making matters more challenging for U.S. Bancorp is ongoing compliance costs related to remediating a money laundering issue.
With just 1% sequential growth in average loan balances (and similar growth in period-end balances), U.S. Bancorp's loan growth was a little underwhelming. Granted, the bank still outperformed BB&T on this metric, and it wasn't as though PNC or Regions (NYSE:RF) set the world on fire with their loan performances either. The biggest culprit was in C&I lending, which was barely up and where management says they've already seen improvement in the fourth quarter. CRE and mortgage lending were both up around 1% and card lending grew more than 2% - continuing a possibly concerning trend around the sector of more and more card debt being underwritten.
Credit looks like a non-issue to me. The company shrank its energy loan portfolio by about 10% (which probably also explains some of the pressure on C&I lending) and this portfolio is close to 9% reserved. Reserves to loans were basically stable from the prior quarter, as was the NPA ratio and the charge-off ratio.
The More Things Change, The Less Things Change
U.S. Bancorp hosted a rare Investor Day back in September, and the biggest takeaway from that was a lower set of expectations for the future. Management dropped its ROA target by a quarter-point, lowered revenue growth expectations by 1% in Wholesale Banking, Consumer Banking, and Payments, and lowered ROE expectations by 250bp. If there was a bright side to that, it's that my own modeling assumption has long called a long-term mid-teens ROE and not the mid-to-high teens target management had used since 2013.
Management is looking for the yield curve to steepen in 2018, which means a lot more waiting around for banks like BB&T, PNC, and Wells Fargo that really need healthier spreads to get their businesses moving again. U.S. Bancorp seems less fixated to me than BB&T on cost/expense reduction at this point, and management did talk about looking for M&A targets.
Continuing to build the payment and trust businesses is not surprising, and so neither is the notion that U.S. would be looking in Europe for possible targets for those businesses. Management also said, though, that it wanted to look more at U.S. branch banking acquisitions. Specifically, management is not looking to add new territories (probably a relief for rivals like BB&T and PNC) but rather to deepen its share in its existing footprint. U.S. Bancorp already holds strong (number three to number five) share in many markets, but California, Illinois, Tennessee, Arizona, and Utah would all look to me like potential target markets for future USB M&A.
Importantly, U.S. Bancorp believes that they have a model that already works well and that they largely just need to keep fuel in the tank and keep doing what they've been doing. I happen to agree. I think U.S. Bancorp is in a good spot in terms of size; big enough to compete with PNC, BB&T, Fifth Third (NASDAQ:FITB), et al, quite effectively, but smaller than the likes of Wells Fargo and Bank of America (NYSE:BAC) and thus able to avoid the higher capital costs/requirements. Likewise, while U.S. Bancorp's merchant acquiring business is probably undervalued as part of USB (it's the fifth-largest, with strong share in segments like hotels and airfare where there's less price competition), but management has no need or desire to spin it out yet (it's a great source of capital-advantaged earnings).
Nothing has really changed about my expectations regarding U.S. Bancorp, so neither has my model. I'm still looking for long-term earnings growth in the mid single-digits, with ROE likely to be fairly flattish for a few years before eventually climbing toward the mid-teens. Discounted back, those adjusted cash earnings support a fair value of around $43 to $44 today. A price/tangible book based on return on tangible equity likewise now supports a similar fair value (a bit unusual, as this metric often undershoots with U.S. Bancorp).
The Bottom Line
BB&T shares look a little cheaper, but you can argue that U.S. Bancorp is at least a little better of a company so maybe that balances out for some readers. I don't dislike U.S. Bancorp as a hold, but it seems priced about where it should be. There aren't a lot of bargains within this peer group, though, so investors face the choice of more moderate near-term returns or simply looking elsewhere as conservatively-run businesses like U.S. Bancorp are largely on "pause" until/unless rates start moving.
Disclosure: I am/we are long BBT.
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.