U.S. Bancorp (NYSE:USB) is a large regional bank with attractive profitability metrics, highly effective management, and embedded conservatives in loan portfolio should ensure stable income for investors seeking low-volatile returns.
Residential mortgage constitutes 43.6% of total retail loans so a decline in mortgage market can have a significant impact on USBs' performance. We believe that in such course of events its negative influence will be mostly mitigated by the high quality of this portfolio: [i] sub-prime borrowers account for only 2% of residential mortgages and (ii) below mentioned geographic mix.
Loan portfolio does not have high geographic concentration but the largest exposure is to California-based borrowers (16.6% of total loans, well ahead of the runner-up region's 5%). The highest exposure to California is in residential mortgage (22.4%, almost all the growth in FY2015 was attributable to this area - an increase of balances by 20.6%). We view such alignment as a positive factor due to the prospering Californian economy though not a very significant one.
Low utilization rate of credit card limit (21.9% of total $95.8bn at end-FY2015) can be the possible source of further growth in retails business. Such usage rate is much lower than average and just a slight increase can have a positive impact on USB's earnings (the company does not disclose average interest rate on credit cards but assuming APR of 18% utilization growth just to 25% can lead to a valuable rise in net interest income.
Earnings stability is supported by high (75.8%, down from 79.8% YoY) share of non-interest income. While NIM is stable at slightly above industry's average of 3%, USB is trying to diverse its income sources. Transactional business, (such as merchant processing) investment and trust services can be the possible source for future growth. The latter is supported by the fact that wealth management is the fastest growing business line for USB (net income +56.9% YoY, such impressive increase is partly attributable to the low base effect).
We believe that interest rates rise (which is most likely postponed to 3Q'16 but is still anticipated to happen this year) should reflect positively on USB's performance - 56.1% of loans maturing in more than 1 year are floating rate loans and should adjust quickly. On the other side, cost of deposits was only 0.18% so they should be much less affected by rate change.
Portfolio quality is high which is evidenced by NPL90+ rate of just 0.84%. The situation can worsen should deterioration in energy sector loan quality continue. Currently, 8.0% of loans outstanding are nonperforming and significant 34.9% of credit commitments to this sector are criticized. Loan portfolio is provisioned by 1.46% (173% NPL coverage, drop from 190% at end-FY2015). Excess provisions allow USB to withstand roughly $1.6bn additional credit losses which should be sufficient (given that total open exposure (less provisions) to energy sector was just $3.1bn or minor 6.6% of equity).
USB's key competitive advantage is its effective cost structure. Excellent Cost/Income ratio is persistently in the lower half of 50% range (54.6% at end-1Q'16) which is much better than industry average. We do not anticipate any significant improvement in this metric as effectiveness is currently high but believe that such low cost is sustainable mostly due to effective management (Fitch "views USB's management team as one of, if not, the best in the industry").
Dividend payout ratio is high (31.6%) and the above-mentioned factors support that it will likely be maintained in the medium term. USB's share price has rebounded since the beginning of 2016 after a sharp decline in February (maximum drawdown was -12.2%, still much lower than sector average) which was supported by active buyback ($518mln in 1Q'16). Both factors reduced dividend yield but it still remains at above-average 2.38%.
Some risks for earnings stability can arise from the following: (i) decline in residential mortgage market (mitigated by negligible 4% share of mortgage fees in total revenue) and (ii) further deterioration in overall loan quality. The latter is partly offset by a diversified portfolio which is aligned towards low-risk products (only 27% or retail loans other than mortgage). We do not expect any liquidity-related issues to affect USB's performance in the medium term due to its franchise size and derived diversification benefits.
To sum up: USB can be an attractive investment for stable income-minded investors due to its stability - stock price rebound since February negatively affected dividend yield but it could still be acceptable for such low-risk investment.
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