mrjo2405/iStock via Getty Images
Patient, if not long-suffering, U.S. Bancorp (NYSE:USB) shareholders may finally have some light at the end of the tunnel that isn’t an oncoming train. Between the synergistic acquisition of Union Bank from Mitsubishi UFJ (MUFG) and the opportunity to leverage years of investment spending into the business, I believe U.S. Bancorp is now poised for some of the best operating leverage and pre-provision profit growth in the large bank category. There are still things that could go wrong from here – a recession would hit the payments business, the investments into IT may not produce the hoped-for leverage, and rates could fall back – but the risk/reward looks attractive.
These shares are up about 8% since my last (positive) update on the company, outperforming other large banks by about 5%. Long-term core earnings growth can support a double-digit annualized return from here (and a near-term fair value in the mid-$50’s), and while the return potential looks similar to several other super-regional and regional banks, I like the underlying quality here and the extent to which upside is tied to operating leverage as opposed to loan growth or rates.
A Messy Fourth Quarter
With the close of the Union Bank deal early in December, U.S. Bancorp’s reported fourth quarter results aren’t particularly useful, even in comparison to sell-side expectations. Still, taking a closer look at some core results suggests that this wasn’t a particularly strong quarter for this bank.
Underlying core net interest income grew about 5%, which was weaker than average for the quarter. Likewise, the 2% contraction in core fee income, led by weak payments-related revenue (down 5%), was not particularly strong. Operating expenses were higher than expected, a common occurrence this quarter, and grew about 4% qoq. Put that all together and core underlying pre-provision profits actually fell slightly on a sequential basis (about 1%), which is a decidedly unimpressive performance in a quarter where the likes of M&T Bank (MTB), PNC (PNC), Truist (TFC), and Wells Fargo (WFC) managed to deliver growth (rather good growth for M&T, Truist and Wells Fargo).
Some of the challenges came from the macro environment – U.S. Bancorp’s large payments business is rather sensitive to the economy, and this wasn’t a superb holiday shopping season. Beyond that, management was also very active in restructuring its balance sheet, selling $15B in loans and $16B in securities. The point of this exercise was to delay the company’s ascension to a Category II bank (and the changes in capital requirements that would bring), and it gives the company some breathing room on growth and capital returns through 2025.
On balance, I think it was a good move. Doing this allows the company to lean harder toward some higher-yielding securities and loans, while also reducing its exposure to auto and CRE (and low-margin C&I) at a point in the cycle where that seems like a good move on balance.
Double-Barreled Leverage
A big part of my bullishness on U.S. Bancorp is predicated on the company unlocking some significant leverage in the coming years and driving what could be peer-leading mid-to-high teens pre-provision profit growth (possibly even to 20% or beyond).
Synergy and operating leverage from the Union Bank deal is a high-probability opportunity. U.S. Bancorp is very familiar with this bank and its operating footprint, and not only does Union Bank bring a lot of non-interest-bearing deposits (which will reduce USB’s funding costs), it also brings some outdated and inefficient operating systems. When U.S. Bancorp converts the systems over Memorial Day, it will be a “lift and shift” that will spare USB from having to upgrade inadequate systems and it will pretty much immediately improve the efficiency and profitability of Union’s operations.
Following that, there will be your routine back-office synergy opportunities (shedding duplicate costs), as well as significant cross-selling synergies for USB’s cards, mortgage, wealth management, payments/merchant acquiring, and treasury services. Given all of this, I see a possibility (of high single-digit to low double-digit accretion just from the Union Bank deal.
Then there’s an expense leverage opportunity with the core bank. I think part of the reason that U.S. Bancorp has been an underperformer in recent years has been the significant increase in opex spending at the bank (roughly twice the rate of revenue growth). Some of this was required due to shortfalls in AML/BSA compliance, but most of it was for investments into revenue-generating and support systems.
Around the time of the Union Bank deal close, U.S. Bancorp’s CEO said something that I thought was noteworthy but not really widely reported – he believed the bank had reached a tipping point where the benefits of IT investment would start exceeding the ongoing reinvestment needs.
Just how much leverage U.S. Bancorp ends up seeing is absolutely up for debate, and it will take a healthy economy to facilitate, but I believe these investments will ultimately drive improved loan growth and profitability (better underwriting capabilities will lead to faster decisions, better pricing, and lower losses), improved fee revenue (particularly in payments and treasury), and better customer satisfaction scores on the retail side, which should in turn drive better deposit costs/betas and increased cross-selling (if you like your bank, you’re more likely to do more of your business with them).
While I’ve talked bullishly about the operating leverage potential at banks like M&T, KeyCorp (KEY), and so on, U.S. Bancorp could potentially lead the back. “Potential” is a tricky word, I grant, but this is the best outlook this bank has had in a while.
The Outlook
Rates and the economy remain key unknowns and risk factors. The market is pricing banks as if there will be a relatively swift and sharp return to lower rates – maybe not back to the virtually zero rates of a couple years ago, but certainly nothing close to the almost-5% rates of now. Likewise, the economy is slowing and that is a threat to loan growth (including C&I and card lending), fee income from payments and similar businesses, and credit quality.
I haven’t changed my FY’23 or FY’24 assumptions all that much (less than 1%, actually), and my FY’23 EPS estimate changes by all of a penny. At this point I’m looking for $5.16 in EPS, more than the $4.93 sell-side average, and my FY’24 EPS estimate is likewise higher ($5.45 versus $5.38), but in neither case am I above the high end of the estimate range (I may be wrong, but I won’t be lonely). Looking at the somewhat longer term, I expect mid-teens annualized pre-provision profit growth over the next three years (few banks of this size even come close), and over the long term I’m still expecting core earnings growth of around 4%.
Discount that back and I get a near-term fair value of $57.50. I get similar results with my ROTCE-driven P/TBV approach (a $57 FV) and my P/E approach ($54, using a 10.5x multiple).
The Bottom Line
There are several regional and super-regional banks that offer broadly similar potential returns as U.S. Bancorp, including KeyCorp, M&T, PNC, and Truist. All of these banks have their positives (and negatives), but I like what looks to me like lower-hanging fruit at U.S. Bancorp from merger synergies and IT investment leverage. U.S. Bancorp is arguably more economically-sensitive given its payments business (offset partly by rock-solid credit quality), but all in all I think this is a super-regional well worth watching again.
To read my recent articles on banks mentioned here, please click here (KEY), here (MTB), here (TFC), and here (WFC).
Source: seekingalpha.com
