U.S. Bancorp: Kicking The Can?

By Finalytiks:

US Bancorp (USB) reported $1.1 billion in profits for Q1 2020, falling almost a quarter sequentially and by a third compared to a year earlier, as credit costs jumped.

As for provisions, the bank recorded $1 billion, implying a credit cost of just under 130bps - much lower than its larger peers. I believe that the under-provisioning was done partly to keep CET1 regulatory ratios within the target range. I see the company halting the repurchase program and slowing dividend growth rate in the short term if the economic woes continue into 2021.

Revenues face strong headwinds

Headline revenues were up 2% QoQ and 4% YoY. But if we exclude the Visa-related (V) losses in Q4 2019, revenues were 1% lower QoQ. On a year-on-year basis, the top-line was higher due to the increase in mortgage banking revenue, but this could head lower later this year as the management expects mortgage production to decline.

The bank was anyway set to witness revenue slowdown due to lower net interest income, even if COVID-19 had not struck, given the slow loan growth momentum and pressure on margins. The pandemic just put oil into the fire. While net interest margins, or NIM, contracted a mere 1bp QoQ this time, a much bigger margin squeeze is coming, starting in the second quarter.

Period-end loan balances jumped $22 billion, or 8% QoQ, while the bank raked in $33 billion in deposits during the same period. Business customers have been drawing on their lines of credit, fearing liquidity issues, which explains the brisk loan book growth. On the other hand, these customers have parked a chunk of the drawn funds into their deposit accounts. However, this does not fully explain the absolute changes in deposits ($22 billion loan increase vs. $33 billion deposit inflow). Non-interest-bearing deposits contributed almost half these inflows, jumping 21% and improving its proportion to total deposits by 230bps to 23.2%. This augurs well for overall funding cost and, therefore, to net interest margins - some consolation in an otherwise terrible rate environment.

USB also has a large non-interest income stream, contributing over 40% of yearly revenues, though this is slightly lower than PNC's. Within this, just under 40% comes in from the payment services division (cards & others), while the consumer unit brings in close to 25%. In times of lower interest rates, large non-interest income streams are touted as bright spots helping to offset net interest income declines. However, this time it's different. Consumers are staying indoors and businesses have shut. The payment business will be particularly hit, given the lower consumer and business spending.

Cost control is not USB's forte

Rise in opex continues to be a key pain point for USB. Opex grew 7% YoY, resulting in a cost-to-income ratio worsening more than 200bps. But the bank incurred an extra $100 million due to COVID-19, as it provided for potential delivery claims related to the airline industry and other merchants (for example, payment reversals due to customer cancellations), increased payments to frontline workers and also incurred additional expenses to enable a safe working environment amid the pandemic.

Even excluding the COVID-19 related expenses, the cost base was up more than 4%. The bank really needs to tighten the ship, especially given the strong headwinds to revenue.

Provisions vs. regulatory capital level: A trade off?

Wells Fargo (WFC) saw credit costs of 160bps while Bank of America's (BAC) was 190bps. USB provided for a much lower 130bps. I am especially surprised by the 310bps credit cost in the payments division when 2018-19 recorded 330-350bps. Are they saying that things are going to be better for the credit card portfolio during COVID-19? Seriously?

But to its credit, USB's portfolio coverage - the proportion of accumulated loan loss allowances as a percentage of gross loans - stands at 2%, much higher than Wells Fargo's 1.1% and BofA's 1.5%. By providing much less this quarter, the management is implying that the built-up provisions are enough. Analysts on the call probed the management quite a bit, and the answers they got were vague.

The bank's CET1 ratio was 8.6% at the end of the quarter if the CECL adjustment is fully phased in. That's towards the lower end of the management target of 8.5% to 9%. Reading the under-provisioning along with the lower CET1 ratio, I guess that the management would have decided to go for lower provisions partly due to the fear that it might fall below the CET1 target.

Assuming that USB goes for provisioning somewhat midway between WFC and BAC for the entire year, the bank could end up with 8% CET1 towards the end of 2020. That is much below the management target range, though above the 7% regulatory minimum requirement. By under-provisioning vs. peers, the management is hoping that things will get better soon. But it might be actually kicking the can down the road.

On March 15th, all the banks, including USB, halted share repurchases until the end of Q2 2020. The bank had already bought back stock worth about $1.7 billion during the quarter until then. If the economic troubles continue well into 2021, I see the bank halting the share repurchase program entirely in the short term (2-3 years). However, dividends remain safe, but I expect a much slower growth rate (<5% likely).

Thoughts on valuation

USB is among the best return-generating businesses in the US banking space, with a consistent track record of 17-18% return on tangible equity. But things have changed. Assuming a bad 2020-21, I do not see the bank earning above the cost of equity in the next 3 years and, therefore, expect the prices to reflect that sentiment. At the current valuation of 1.5 times of my estimated one-year forward tangible net book value, I hesitate to recommend the stock.

What could change my view? A better-than-expected economic impact from COVID-19 - that is, things recover fast towards the last quarter of this year.

See also 4 Closed-End Funds That Will Pay You 8%+ Monthly Dividend Yields on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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