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Writing about U.S. Bancorp (NYSE:USB) just ahead of the bank sector meltdown precipitated by the failure of Silicon Valley Bank, I said that I thought the bank was unvalued on what looked like unusual operating income growth potential relative to peer banks. To paraphrase an analyst I worked for early in my career, “that and a nickel will get you a nickel,” as the market has clearly been less focused on core earnings potential and more survival and capital requirements.
Even allowing that the environment is different now (and certainly not favorable to banks), I don’t think the nearly 30% decline in the share price (one of the worst of banks I’d consider peers or true comps) is reasonable; at a minimum I don’t think U.S. Bancorp’s prospectives have worsened correspondingly relative to those peers. U.S. Bancorp will never be an exciting bank, and I can find nits to pick, but I think the shares are just too cheap at today’s price assuming you think the bank can manage low double-digit ROEs and at least some core earnings growth in the future.
Building Up Capital, But The Rules Are Still In Flux
The Fed’s proposals for new capital rules (the Basel IV or Basel III “endgame” regime) that were unveiled on July 27 weren’t much of a surprise relative to what the Street was expecting, and what surprises there were skewed more positive, including better capital requirements (lower than at least some expectations) and multiyear phase-in period. At a minimum, it should have been a wash relative to expectations.
To boil down a complicated set of rules, banks like U.S. Bancorp are going to have to hold more capital than in the past, and that’s going to reduce their earnings potential. Moreover, in the case of banks like USB with sizable non-bank operations (a large payments operation in this case), you can make a good argument that the new rules unfairly punish these banks relative to the actual risk of the operations.
These rules have already generated some pushback, with several bank CEOs arguing that they go too far and now Congress is pushing back as well – though whether this will lead to a meaningful revision in the proposed rules is still up for debate (and there are numerous reports circulating that there is even substantial disagreement among regulators about the right path).
Specific to U.S. Bancorp, management is currently focused on building capital in anticipation of conversion to a “Category II” bank. Management has been looking to boost its CET1 ratio to 9.0% by year-end (from a starting point around 8.5%) and has already taken steps to achieve that. These steps have included meaningful risked asset sales ($8.6B of sales in Q2’23) and the issuance of 24M common shares to Mitsubishi UFJ Financial (MUFJ) to settle some of its debt obligations to Union Bank’s former parent as part of the two companies’ purchase agreement.
U.S. Bancorp is now ahead of schedule and likely to end FY’24 with a CET1 ratio of 8.7% under Category II rules, putting it in the middle of management’s target for 2024. The good news here is that the company may not have to take other earnings-compromising moves to reach its capital targets, and that may leave the bank better-placed to raise capital returns to shareholders (buybacks and dividends) sooner than expected – multiple sell-side analysts are calling for basically no improvement here until 2025 at best.
Operating Conditions Remain Tough
As far as the basic drivers of USB’s performance go, the news isn’t exactly good these days. Although the Fed recently decided to hold steady on rates, deposit rates continue to climb (measured by average and highest CD rates). This is normal and past cycles have seen a roughly one to two-quarter lag between the end of Fed hikes and the peak in deposit costs.
U.S. Bancorp is certainly feeling some pain here. Average deposits declined modestly in the second quarter (down almost 3%), but non-interest-bearing deposits declined more than 12% and the bank continues to see deposit costs rise (up 37bp qoq in Q2 after rising 30bp in Q1). That, in turn, has continued to push up the bank’s deposit beta, with U.S. Bancorp seeing its cumulative beta on interest-bearing deposits climbing to 39% from 34% in Q1’23 and 16% in Q2’22.
Management once again raised their full-cycle estimate for peak beta (to the low-40%’s) and while I do think management’s guidance is credible, I wouldn’t rule out the risk that the bank could retest the 47% peak beta of the last cycle. While U.S. Bancorp’s beta is still a little better than average (39% vs. 44%) and better than specific names like Fifth Third (FITB) (44%), Truist (TFC) (44%), Citizens (CFG) (42%), and M&T Bank (MTB) (40%), the bank compares less well in terms of non-interest-bearing deposits (23% of total deposits, near the bottom of its comp group).
Loan growth is also slowing across the industry, with the latest Fed data showing 2% year-over-year growth in lending among large banks. Business lending has slowed significantly, with C&I loans up about 1% and commercial real estate (or CRE) down slightly), and growth is mostly in mortgages (up 3% for large banks and 6% for banks overall) and cards (up about 11%).
Management has already reduced guidance a couple of times this year and recently (at a sell-side conference) guided net interest income toward the lower end of the range, with both weaker lending and higher deposits costs contributing to the outlook.
The Outlook
It’s not all doom and gloom, though. I still believe that U.S. Bancorp has some unique opportunities to drive core (pre-provision) earnings leverage over the next couple of years. These opportunities center on Union Bank, including cross-selling to the bank’s large consumer and small business customer base and post-merger cost savings. Unlike the savings program recently launched by Truist, these savings shouldn’t meaningfully threaten revenue generation potential.
The bank’s exposure to payments is also something of a wild card. If the U.S. economy fares better than expected, that payments business should outperform, though a stronger economy could create more uncertainty around the timing of a Fed rate cut (which typically marks the turn of a cycle where bank stocks start performing well again).
Factoring in a weaker outlook for loan growth and net interest margin (relative to the last time I wrote about the stock), I have reduced my near-term earnings expectations. I’m not looking for much net growth from 2022 to 2027 given a likely double-digit decline in earnings this year and a modest decline next year, but I do think U.S. Bank can nevertheless outperform many of its peers on pre-provision earnings and I believe earnings should accelerate again in FY’25 and FY’26. Long term, I’m only assuming low double-digit ROEs from this bank, and that generates a core growth rate of just 2.2% (or 2.8% using the last pre-pandemic year as a starting point).
Discounting those core earnings streams gets me to a fair value in the mid-$40’s, and that’s also assuming a meaningful increase in capital returns in the coming years. I also note that the shares look undervalued on traditional multiples-based approaches. Bank stocks currently trade a little below 6x pre-provision profits and that usually marks a bottom for the sector. Using a 10.5x multiple on FY’23 earnings (and 10.2x on FY’24) as well as an ROTCE-driven P/TBV multiple of 2.45x (based on a high-teens ROTCE in ’24) also gets me to a mid-$40’s fair value.
The Bottom Line
U.S. Bancorp will probably never be my favorite bank, but I do believe there’s a fair price for all going concerns, and I think today’s valuation is too low. This is a bank that has historically skewed more conservative, and that’s arguably a positive today, and I like the company’s leverage to revenue and expense synergies from the Union Bank deal, as well as longer-term organic growth opportunities in payments, cards, and expansion into new corporate and consumer lending markets (like the Southeast U.S.).
Nobody seems to want to own bank stocks now, and I can’t rule out risks like a weaker macro environment that drives even higher loan losses and weaker loan demand. Likewise, who knows what the Fed will do with respect to rates and new capital requirements. Even considering all of those risks and unknowns, though, I think today’s valuation embeds very little in the way of expectations, and I think that gives U.S. Bancorp a better-than-average chance of delivering good returns once this sector turns.