Write about American bank (USB) back in July, I thought there were more attractive candidates among that bank’s big brothers, and stocks have since underperformed by about 10%, with others like ANC (PNC), Truist (TFC), and Wells Fargo (WFC) overperforming, although I also exploited JP Morgan (JPM) and Citigroup (C), which did not do as well.
This underperformance comes despite the announcement of what should be a value-creating agreement with Mitsubishi UFG (MUFG) Union Bank, and I believe reflects both some ongoing lackluster operating results at US Bancorp and general market skepticism of global transaction banking.
With this underperformance, I find more to like in these stocks. I think US Bancorp might be disappointed with its operating leverage again in FY22, but I like the deal with Union Bank, the ongoing investments in IT and fee-generating businesses like payments, and US Bancorp’s ability to use a digital-enabled “land and expand” branch-lite model to enter new markets.
Sluggish results despite strong loan growth
US Bancorp’s fourth quarter results were an odd mix of good and bad news, but fundamentally disappointing results on a basic operating basis, with surprising (to me) weakness in the payments sector despite the ongoing recovery after the slowdown caused by the pandemic.
Revenue was down 2% year over year and 4% quarter over quarter, missing about 1% or $0.03/share. Spread income was down 2% YoY and almost 2% YoY, but it was still good for a small pace. Spread revenue was driven by strong growth in earning assets (up 4% QoQ, driven by strong lending), but low spreads, with net interest margin down a further 13bps to 2.40% – well below the average sell-side estimate of 2.47%. Much of this was driven by the impact of deploying PPPs and more forgivable or understandable in my book.
Fee-based revenue was down 1% yoy and more than 6% yoy, missing about 3% or $0.045/share. There was weakness in many areas, including a 3% decline in cards on sequential volume growth of 7% which was weak compared to Citi, JPMorgan and Wells Fargo, although more on par with Bank of America (BAC), as well as a 7% drop in merchant processing revenue and a 1% drop in business payments.
Operating expenses were again higher than expected, rising 5% yoy and 3% yoy and missing about 2% (or nearly $0.03/share). Pre-provision earnings were down 10% year-on-year and 13% quarter-on-quarter, a poor performance against many peers and about $0.06/share below Street expectations.
Loan growth is coming back nicely
US Bancorp posted average loan growth of 2% on a quarterly basis, but more than 5% on an adjusted basis at the end of the period. Residential mortgages increased by around 2%, card loans by just under 2% and auto loans by around 6%, while end-of-period adjusted C&I loans increased by almost 13 %. Unsurprisingly, US Bancorp reported a significant improvement in the use of trade lines.
US Bancorp’s ability to maintain loan growth will be an important revenue driver in FY22. This bank is at the lower end of the asset sensitivity curve, and I don’t expect that rates have a transformative effect on near-term growth (loan yields were actually lower here qoq than for most other banks I’ve analyzed).
Loan growth will also be an important driver elsewhere in the income statement. Management is asking for “at least” 100 basis points of operating leverage in FY22, and that’s a projection investors would do well to take with a grain or two of salt, given the poor US Bancorp’s history over the past few years lived up to its operating leverage targets.
Union Bank looks like a good use of capital, but maybe not a Slam Dunk
There had been a lot of speculation in recent years about whether or not USB would be more active in whole-bank mergers and acquisitions, especially growth-oriented mergers and acquisitions to expand the company’s presence in the fast-growing southeastern United States. For my part, I thought that mergers and acquisitions of entire banks was an option but not a necessity, and management could afford to wait for the right deal.
The September announcement of its agreement to acquire Union Bank from MUFG in an $8 billion cash and stock deal was surprising in some ways, but makes sense to me. Union Bank will give USB a big boost in terms of scale in California, and while the Southeast gets all the press for growth (among banking analysts at least), the reality is that the vast majority of MSAs California also exceed national averages, and average household incomes compare quite favorably.
US Bancorp is certainly paying a premium over Union Bank’s recent low ROTCE (about 6%), but the cost synergies should be significant given that 80% of Union Bank’s branches are within three miles of a US Bancorp branch. Additionally, I see some potential for modest revenue synergies given Union’s low leverage on commission revenue. Likewise, I think Union Bank has been “under-managed” and the addition of USB’s top team should generate better results.
There is a risk here. While this deal strengthens US Bancorp’s presence in a key state, it won’t make it easier to compete with Bank of America, JPMorgan or Wells Fargo. A consent order is also in place at Union Bank, although USB management’s decision to essentially replace all Union systems with their own should help resolve this issue.
Between an improving economy and the addition of Union Bank, my long-term earnings growth rate for US Bancorp ends up going from about 3% to closer to 4%. Capital returns will be limited until the deal closes, but management expects to resume share buybacks in the second half of 2022. I expect Union Bank to be an accretive deal for US Bancorp , and I see a 20% chance of ROTCE as quickly as 2023.
Between updated baseline earnings, ROTCE-based P/TBV and P/E, I think US Bancorp shares should trade in the $60 range, with a near-term valuation range of $59 to around $63. and long-term total annualized return potential now in the high single digits to low double digits. I see some operational challenges for US Bancorp to overcome, including a lack of reliability/credibility on operating leverage targets, but given recent underperformance and improving earnings outlook, this is a bank that deserves another look.