U.S. Bancorp Continues To Perform Strongly, But Is It Overpriced?

| About: U.S. Bancorp (USB)
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The performance of the U.S. banking industry has been steadily improving over the last year and this has seen renewed investor interest in the much maligned industry. Renewed interest has seen the KBW Bank Index (^BKX), a capitalization index composed of 24 leading bank stocks, increase by almost 21% for the year-to-date (YTD). With the much anticipated U.S. housing recovery now gaining greater traction, I believe there are growing opportunities for investors in the industry, making this an opportune time to analyze industry participants, particularly large regional banks in order to identify investment opportunities.

One bank that has attracted my interest is U.S. Bancorp (NYSE:USB) which, like Wells Fargo (NYSE:WFC), is another bank in which Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) has a considerable holding. At the time of writing, Berkshire Hathaway is the fifth-largest institutional shareholder with 63 million shares or around 3.3% of all shares outstanding. However, unlike with Wells Fargo, during the third quarter 2012 Buffett reduced his holding in the bank by around 7% or almost 5 million shares. In this article, I am going to take a closer look at U.S. Bancorp and compare it with the four major U.S. commercial banks, Wells Fargo, JP Morgan (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC), in order to see how it shapes up.

U.S. Bancorp's financial performance continues to be strong despite economic headwinds

The first aspect of U.S. Bancorp that I have examined is its financial performance, with a focus on its third-quarter 2012 results. For this period the bank continued to perform strongly, reporting earnings-per-share (EPS) of 74 cents, in line with the consensus forecast. However, this was the first quarter for some time where the bank did not exceed the consensus forecast.

This consistently strong financial performance is underpinned by the bank's growing net income which, surprisingly, has continued to grow over the last year despite revenue remaining essentially flat as the chart below illustrates.

Source data: U.S. Bancorp Financial Statements Third Quarter 2011 to Third Quarter 2012 & Federal Reserve Bank of St Louis.

For the third quarter, U.S. Bancorp's gross revenue growth remained relatively flat, with it increasing by 1% in comparison with the previous quarter (QoQ) and falling by almost 1% in comparison with the same quarter in the previous year (YoY). But net revenue, which is made up of net interest income and non-interest income, grew 2.2% (QoQ) and 8% (YoY). For the same period, net income was reported as $1.5 billion, which is a 4% increase QoQ and an impressive 16% increase YoY.

Another aspect of U.S. Bancorp's financial performance that stands out is that the bank has continued to grow its core lending business. For the third quarter, total loans grew 1% QoQ and 7% YoY to $217 billion, a greater rate of growth than any of the four major U.S. commercial banks, as the chart below illustrates.

Source data: U.S. Bancorp, Bank of America, JP Morgan, Wells Fargo, Citigroup Financial Statements Third Quarter 2011 to Third Quarter 2012 & Federal Reserve Bank of St Louis.

I am also expecting U.S. Bancorp to be able to continue growing its total loans over the next year, particularly if the housing recovery gains further traction, because this will act as a powerful tailwind for increased home-lending activity.

U.S. Bancorp has also experienced strong growth in total deposits, which were up by 1% QoQ and 11% YoY, which as the chart below shows is less than the increase in deposits reported by the four U.S. major banks QoQ.

Source data: U.S. Bancorp, Bank of America, JP Morgan, Wells Fargo, Citigroup Financial Statements Third Quarter 2011 to Third Quarter 2012 & Federal Reserve Bank of St Louis.

More importantly the bank's deposits are growing at a faster rate than total loans, indicating that the bank is focused on deleveraging, strengthening its balance sheet by increasing liquidity and reducing its dependence upon wholesale credit to fund its lending operations. This has seen the bank's loan-to-deposit ratio continue to fall to just under 91% in the third quarter. All of which will continue to see a reduction in the bank's risk profile and the degree of risk for investors.

Continues to maintain a fortress balance sheet

U.S. Bancorp has a particularly conservative balance sheet, which in many ways is superior to the four major U.S. banks, with a focus on high asset quality, low levels of long-term debt, a solid funding mix and high liquidity, all of which is contributing to the bank's strong profitability.

The first aspect of U.S. Bancorp's balance sheet that I find appealing is its lower level of long-term debt than the four major commercial banks. This indicates that the bank has a superior funding mix, and a lower reliance upon wholesale credit to fund its business operations and lending activities. The chart below illustrates this with U.S. Bancorp having a long-term debt-to-equity ratio of 77%.

Source data: U.S. Bancorp, Bank of America, JP Morgan, Wells Fargo, Citigroup Financial Statements Third Quarter 2012.

This ratio is significantly lower than Citigroup, Bank of America, JP Morgan or Wells Fargo and allows U.S. Bancorp to benefit from having a less volatile and lower cost funding mix. Since the occurrence of the great financial crisis (GFC) and now the European financial crisis, global credit markets have become increasingly risk averse, which has seen the supply of wholesale funding decrease while costs have increased.

Liquidity is lower than its peers

Another aspect of U.S. Bancorp's strong balance sheet is the bank's high level of liquidity as represented by its loan-to-deposit ratio. At the end of the third quarter U.S. Bancorp had a loan-to-deposit ratio of 91% which, as illustrated by the chart below, is the least liquid of the five largest commercial U.S. banks.

Source data: U.S. Bancorp, Wells Fargo, Citigroup, Bank of America & JP Morgan Financial Statements Third Quarter 2011 to Third Quarter 2012.

This loan-to-deposit ratio is marginally lower than what it is generally considered to be the optimal range of 95% to 105%. But in my view this is a positive, because it leaves U.S. Bancorp better equipped to deal with any further financial shocks in an increasingly uncertain global and domestic economic environment.

Ideally, I would like to see U.S. Bancorp boost its liquidity in the current environment and it appears that this process is under way with, as noted earlier, total deposit growth exceeding total loan growth. This is also reflected in the chart above, showing U.S. Bancorp's loan-to-deposit ratio falling by just under 2% QoQ and just over 3% YoY.

The high level of liquidity in U.S. banks, at this time, also reflects the current regulatory environment for banks in the U.S. This is because the Federal Reserve has placed greater emphasis on banking liquidity and capital adequacy as a means of strengthening the U.S. banking system. The industry wide move to deleverage and increase liquidity can be seen in the chart below obtained from SNL Financial. As the chart illustrates, loan-to-deposit ratios across U.S. banks have fallen significantly since June 2008, from a mean of 96.5% to 79.5% at the end of the second quarter 2012.

Source: SNL Financial.

Significant increase in liquidity serves to further insulate the U.S. banking system and individual banks from further external and internal financial shocks. It will also contribute to boosting regulator, investor and consumer confidence in the banking system particularly since it was considered broken at the time of the GFC.

Asset quality remains high

Another key indicator of the strength of a commercial bank's balance sheet and the degree of risk being carried by the bank is the quality of its assets which, in the case of a commercial bank, are predominantly the loans made to customers. The quality of these loans is measured by the bank's non-performing loan ratio (NPL), which for U.S. Bancorp at the end of the third quarter was reported as 1.7% as illustrated by the chart below.

Source data: U.S. Bancorp, Wells Fargo, Citigroup, Bank of America & JP Morgan Financial Statements Third Quarter 2011 to Third Quarter 2012.

This NPL ratio is lower than either Bank of America or Citigroup but higher than the other two major commercial banks JP Morgan and Wells Fargo, as the chart illustrates. It is also significantly less than the U.S. industry wide national NPL ratio of 3.7%. By having such a low NPL ratio, U.S. Bancorp is able to minimize both the accounting and economic costs associated with having non-productive assets, as well as the level of loan loss provisions it is carrying.

Another important risk indicator when assessing a bank's asset quality, and the degree of risk associated with those assets, is the non-performing loan coverage ratio. This is because this ratio measures a bank's ability to absorb losses from its NPLs, which means the higher the ratio the better the bank is able to absorb the losses.

U.S. Bancorp has a particularly solid coverage ratio of 202%, only marginally lower than Citigroup's 203%, which is the highest of the four major U.S. commercial banks as the chart below illustrates.

Source data: U.S. Bancorp, Wells Fargo, Citigroup, Bank of America & JP Morgan Financial Statements Third Quarter 2011 to Third Quarter 2012.

This certainly reflects U.S. Bancorp's ability to absorb losses from its NPLs, and is indicative of the relatively low level of risk in the bank's operations and balance sheet.

Another positive aspect concerning the bank's operations are that its loan loss provisions have continued to fall over the last year, with loan loss provisions down by 11% both QoQ and YoY, as illustrated by the chart below.

Source data: U.S. Bancorp Financial Results Third Quarter 2011 to Third Quarter 2012.

Any significant and continued fall in provisions is particularly important for a bank's profitability, because provisions come with both an accounting cost and economic cost. This arises because not only must the bank incur a cost for holding the funds on the balance sheet, but they also cannot be used for revenue generating activities.

The other indicator that is an important measure, not only of the degree of risk in a bank's balance sheet but also of the profitability of its assets, is the ratio of loan loss allowances to total loans. Loan loss allowances are those loans, or portions thereof, that a bank is unlikely to recover, therefore the ratio gives an indication as to the productivity of the bank's loan portfolio. The higher the ratio, the higher the economic cost associated with the portfolio, and ultimately the less profitable it is.

U.S. Bancorp's loan loss allowances, as a ratio to total loans, is lower than the four major U.S. commercial banks, at 2.2% for the third quarter as the chart below illustrates.

Source data: U.S. Bancorp, Wells Fargo, Citigroup, Bank of America & JP Morgan Financial Statements Third Quarter 2011 to Third Quarter 2012.

The chart indicates that U.S. Bancorp's loan portfolio is more profitable than those banks, although both Wells Fargo and JP Morgan have ratios that are only marginally higher at 2.3% and 2.6% respectively, than U.S. Bancorp. All of this indicates that U.S. Bancorp not only has a solid balance sheet, but also that it has a high quality and profitable loan portfolio. The final aspect of the bank's balance sheet to be considered is its level of capital adequacy.

Capital adequacy is sufficient but not optimal

The capital adequacy of banks has become a particularly hot topic in light of the subprime crisis, the GFC, and the European financial crisis. This has seen a renewed focus by prudential regulators around the globe, on the capital adequacy of the banks that they regulate and increased prudential oversight of capital adequacy requirements. It has also become a particularly important indicator for the U.S. prudential regulator, the Federal Reserve, for measuring the health of the institutions that it regulates. This in combination with the impending introduction of the Basel III regulatory requirements has seen the majority of banks focus on boosting their capital adequacy.

This was seen earlier this year when four U.S. banks, including Citigroup and regional bank Sun Trust (NYSE:STI), failed the Federal Reserve stress test. They fell short of meeting the capital adequacy requirements, and as a result they were prevented from increasing dividend payments or returning capital to shareholders by way of share buybacks. But U.S. Bancorp was one of the institutions that passed the stress test because it was found to meet the capital adequacy requirements. As a result the bank was able to increase its quarterly dividend by 56% to 19.5 cents per share.

For third-quarter 2012, U.S. Bancorp reported a tier one capital ratio of almost 11%, which is above the minimum regulatory requirement of 8% and as the chart below illustrates, superior to Wells Fargo but less than either JP Morgan, Citigroup or Bank of America.

Source data: U.S. Bancorp, Wells Fargo, Citigroup, Bank of America & JP Morgan Financial Statements Third Quarter 2011 to Third Quarter 2012.

However, my preferred method for measuring a bank's capital adequacy is its tier one common capital ratio rather than the tier one capital ratio, because it is a more accurate measurement of a bank's core capital. This is because it is calculated by taking the bank's tier one capital and then deducting the value of preferred stock, trust preferred securities, hybrid securities and minority interests, with the result being dividend the bank's risk weighted assets.

U.S. Bancorp's tier one common capital ratio at 9%, is almost two full percentage points lower than its tier one capital ratio and is lower than the four major U.S. banks as the chart below shows.

Source data: U.S. Bancorp, Bank of America, JP Morgan, Wells Fargo, Citigroup Financial Statements Third Quarter 2012.

While this is above the required minimum, I would like to see U.S. Bancorp boost its tier one common capital, particularly given the impending introduction of Basel III and the increased emphasis on capital adequacy. Although, I would expect U.S. Bancorp to pass the 2013 stress test, which will be conducted using third-quarter 2012 results, with the results being published in March 2013.

Solid cost control sees best of class operational efficiency

While the bank's solid balance sheet underlines the lower degree of risk that investors can expect to experience should they choose to invest in U.S. Bancorp, a solid balance sheet is only one consideration when making an investment in a bank. Another important consideration is, how efficiently and effectively a bank deploys its capital in order to generate a return and how profitably it does this.

The first key measurement of how effectively a bank is deploying its capital, which indicates whether it is operating profitably, is the efficiency ratio. This ratio shows how much the bank has to spend for each dollar of revenue it generates. Typically, the lower the efficiency ratio the better and an optimal efficiency ratio is considered to be 50% or less. Generally, I don't expect U.S. banks at this time to operate this efficiently, primarily because of a combination of additional regulatory and operational costs being incurred in a low interest rate environment.

But U.S. Bancorp has defied this view reporting for the third quarter an impressive efficiency ratio of just over 50. Furthermore as the chart below illustrates, this is superior to the four major U.S. commercial banks, and U.S. Bancorp has consistently been operating at a high level of efficiency, with its efficiency ratio remaining at this level for the last year.

Source data: U.S. Bancorp, Wells Fargo, Citigroup, Bank of America & JP Morgan Financial Statements Third Quarter 2011 to Third Quarter 2012.

The efficiency ratio is also lower than the average industry wide efficiency ratio of around 62% for U.S. banks, and a clear indication of why U.S. Bancorp has been able to maintain a solid level of profitability, as evidenced by its double-digit return-on-equity, while other banks have struggled.

Net interest margin remains high despite the zero interest rate environment

Another key indicator of a bank's profitability is its net-interest-margin (NIM), which essentially shows how profitably a bank is able to generate returns on the capital it raises to operate its business. Just like conventional profit margins, the higher the margin the better. But the margins of U.S. banks are currently under considerable pressure, primarily as a result of the zero interest rate environment, which the Federal Reserve has now extended into 2015.

Despite this, U.S. Bancorp has been able to deliver a reasonable NIM of almost 3.6% in the third quarter, which as the chart below illustrates, is only marginally lower than that of Wells Fargo and higher than the remaining three majors.

Source data: U.S. Bancorp, Wells Fargo, Citigroup, Bank of America & JP Morgan Financial Statements Third Quarter 2011 to Third Quarter 2012.

This is also higher than the industry wide NIM of 3.5%, which was reported for the U.S. banking industry at the end of the second quarter 2012. Furthermore, U.S. Bancorp has been able to consistently maintain its NIM in this range for the last year, and given its tight control of costs combined with the outlook for the U.S. housing market improving, I expect it to maintain a solid NIM.

Profitability consistently remains high

Then finally, and most importantly, measures of a bank's profitability are its return-on-assets and its return-on-equity. The return-on-assets measures how profitably a bank utilizes its assets to generate a return. Typically investors should be seeking to invest in a bank that is able to generate a return-on-assets of 1% or greater, and any ratio higher than 1.5% is considered to be exceptional.

For the third quarter, U.S. Bancorp reported an impressive return-on-assets of 1.7%, which as the chart below indicates is significantly higher than any of the four U.S. majors including Wells Fargo, which I believe is one of the better performing U.S. banks.

Source data: U.S. Bancorp, Wells Fargo, Citigroup, Bank of America & JP Morgan Financial Statements Third Quarter 2011 to Third Quarter 2012.

In addition, U.S. Bancorp's return-on-asset ratio is considerably higher than the industry wide average for all U.S. banks, which was reported by the Federal Reserve as 1% for the third quarter.

Not only is the bank producing a solid return-on-assets, but it is also producing an exceptional return-on-equity, particularly when the current economic headwinds are considered. For the third quarter 2012 the average industry wide return-on-equity for U.S. banks was almost 9%, but U.S. Bancorp's return-on-equity was significantly higher than this, with the bank reporting a solid double digit a return-on-equity of almost 17%. This is significantly higher than any of the four major commercial U.S. banks as the chart below illustrates.

Source data: U.S. Bancorp, Wells Fargo, Citigroup, Bank of America & JP Morgan Financial Statements Third Quarter 2011 to Third Quarter 2012.

The bank's high return-on-equity and return-on-assets, indicates that it is operating extremely profitably in what has been a difficult operating environment for banks. I would also expect the bank to be able to maintain this level of profitability for the foreseeable future, given management's focus on costs and the bank's high degree of efficiency. Furthermore, the bank's strong balance sheet, high asset quality and falling loan loss provisions will further enhance profitability.

Shareholder remuneration

U.S. Bancorp at this time pays a moderate but consistent dividend, which at the time of writing is 20 cents per quarter. With total dividend payments for the year-to-date totaling 59 cents. This gives investors a handy trailing-twelve-month dividend yield of just over 2%. This yield is lower than either JP Morgan or Wells Fargo, which both have dividend yields approaching 3%, but it is considerably higher than Citigroup and Bank of America, which both pay nominal dividends giving them yields of 0.1% and 0.4% respectively.

Furthermore, U.S. Bancorp has consistently paid a quarterly dividend since August 1998 as the chart below illustrates, and until the GFC this dividend was steadily increasing in value.

Source data: U.S. Bancorp Investor Relations

Had it not been for this dividend cut that occurred at the time of the GFC, U.S, Bancorp would have been able to lay claim to an impressive dividend payment that had steadily grow in value year-on-year. But, because of that cut, it has compound annual growth rate of less than half a percent.

Given that the bank currently has a conservative payout ratio of 25%, there is definitely room for the dividend payment to increase. Therefore, I would expect to see the bank continue rewarding shareholders as the bank's financial results and capital position improves. It could do this either by increasing the dividend payment and/or return capital through a share buyback. While a yield of just over 2% would certainly not make U.S. Bancorp the first choice of income-hungry investors, the bank's consistent dividend payment history coupled with a significantly improved financial position make it worthy of consideration.

Calculating U.S. Bancorp's indicative fair value

It is clear that U.S. Bancorp is one of the strongest performing commercial banks in the U.S, and that it is outperforming the four major commercial U.S. banks. This can be attributed to its solid balance sheet, conservative approach to risk management, high asset quality, efficiency and solid profitability. While all of these attributes can make it a compelling investment, the key litmus test is to determine whether the bank is fairly valued by the market at its current price.

On initial impressions from reviewing the bank's valuation ratios in comparison with its peers, it appears to be fairly valued by the market and the most expensive of the top five commercial banks. Due to a price-to-book value of 1.8 it is trading at a considerable premium to its book value per share, along with a moderate trailing-twelve-month PE of 11 as the chart below shows.

While these valuation ratios give some indication as to whether U.S. Bancorp is fairly valued, they don't tell the full story because of their simplistic and backward-looking nature. As a result, I have set out to determine U.S. Bancorp's indicative fair value using my preferred valuation methodology for banks, which is an excess return valuation. To do this I have calculated the bank's tangible book value as the starting point, and then used a range of assumptions based on the data presented above, to calculate an indicative fair value.

U.S. Bancorp has a tangible book value of just over $28 billion, which equates to a tangible book value per share of $15. With the bank trading at around $32 at the time of writing, this indicates that it is trading at a 113% premium to its tangible book value per share. Using this tangible book value I have calculated U.S. Bancorp's retained earnings over a 10-year period and then into perpetuity, using the following assumptions:

  • I have discounted U.S. Bancorp's future return-on-equity, over the valuation period, to reflect both its future performance as a current value and to allow for further impacts from the current economic headwinds.
  • For the above reasons, when calculating the terminal value of the retained earnings, I have determined a discounted return-on-equity of 10% in perpetuity.
  • Applied a conservative rate of economic growth of 2%, which is lower than the U.S. historical average of 3.4%, because it takes into account the long-term impact of the current global headwinds. It is also the same as the rate that I have used previously when applying the same methodology to value Bank of America and Wells Fargo, but lower than that used for Citigroup because of its higher exposure to faster growing emerging markets.
  • I have applied a cost of equity of 6%, which was calculated using the capital asset pricing model (CAPM).
  • That the dividend will remain steady for the duration of the valuation period, although the dividend and hence the payout ratio may increase, which would obviously marginally reduce the indicative fair value.

Using this approach combined with the bank's tangible book value and assumptions listed, I have calculated an indicative fair value for U.S. Bancorp of around $36 per share as set out in the chart below.

At the time of writing U.S. Bancorp is trading at around $32, which means that this indicative valuation represents just over 10% upside, a particularly small margin of safety. This is easily attributable to daily market movements and therefore, I believe indicates the bank at this time has been fairly valued by the market.

Other considerations

There are a number of other matters that have the potential to affect U.S. Bancorp's performance and share price, which investors should take into consideration. These include risks that are both specific to U.S. Bancorp and generic to the U.S. banking industry as a whole and they include:

  • Like many U.S. commercial banks, U.S. Bancorp is the subject of litigation across a range of matters relating to the management of its loan book and the provisions of mortgage backed securities. Although, the volume and depth of this litigation does not appear to be as significant as that being encountered by the four major commercial banks. Past litigation has included the July 2012 $55 million settlement of three law suits relating to its management of fees on debit card overdrafts. The city of Los Angeles has also commenced legal action against the bank alleging that it has failed to adequately maintain approximately 1,500 foreclosed properties that it possesses in the city. But overall, it appears that the litigation currently being encountered by U.S. Bancorp is within acceptable tolerances.
  • There is growing regulatory risk, with broad-based regulatory changes on the agenda, which will increase regulatory costs, reduce opportunities for revenue generation and increase the economic cost of capital. All of which, will place further pressure on profitability. Banks are also seeing growing regulatory uncertainty with the Federal Reserve recently announcing the delayed introduction of the Basel III reforms.

While it is difficult to judge the exact impact of these risks, I believe that any impact will be mitigated by the bank's continued efforts to reduce risk in the business and increase the quality of its assets.

U.S. Bancorp expands its franchise and diversifies revenue through acquisitions

Another aspect of U.S. Bancorp, that has the potential to underpin the bank's future profitability, is its strategy of expanding its franchise and diversifying revenue through acquisitions. In November 2012 alone the bank has made two announcements regarding the acquisition of two businesses.

The first relates to the acquisition of AIS Fund Administration (AIS), a provider of administration services to alternate investment managers. This acquisition will add around $25 billion in assets under administration to its subsidiary U.S. Bancorp Fund Services, LLC and increase the banks presence in the wealth management arena. However, it is difficult to determine the value this acquisition adds to the bank because the terms of the deal have not been made public and it is important to note that it is still subject to regulatory approval.

The other most recent acquisition, is the bank's announcement that it will buy FSV Payment Systems, in order to enhance its prepaid cards business and increase its market share in that product line. The acquisition is expected to be completed in December this year, but again U.S. Bancorp has not released details of the deal to the market and it is still subject to regulatory approval.

While it is somewhat disappointing that the bank has not released the details of these deals to the market, they both demonstrate that the bank is actively seeking to grow its market share and diversify its revenue. This bodes well for the bank to continue growing its market share and profitability.

Bottom line

U.S. Bancorp is a well-managed and efficient bank, with a solid balance sheet and conservative approach to risk. All of which, has combined to make it one of the most profitable U.S. commercial banks, and seen it consistently deliver a return on assets and a return on equity that are at the top of its class. This I believe makes it a worthwhile addition to any investment portfolio at the right entry price and explains why Buffett has built up a considerable holding.

But despite the bank's solid balance sheet, I have some minor reservations concerning its capital adequacy and liquidity, particularly in light of the renewed regulatory focus on this aspect of the U.S. banking industry, and the impending introduction of the Basel III requirements. Although, I don't believe that these issues will have a material impact on the bank's performance or its ability to pass the 2013 Federal Reserve stress test.

The bank's obvious strengths and ongoing solid profitability have been recognized by the market, and continued to attract investors and I believe that at this time the bank is fairly valued by the market. Therefore, I do not believe that it represents compelling value for investors, even when its moderate dividend yield is taken into account. For those investors seeking exposure to the U.S. banking sector, there are far better value investment opportunities at this time, including Wells Fargo and Citigroup. However, I do believe that for those investors who currently hold a position in the bank, it is worthwhile retaining that position for all of the reasons discussed and accumulating further holdings on any future dips in price.

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.