Robert Way/iStock Editorial via Getty Images
My last article on U.S. Bancorp (NYSE:USB), Opportunity Knocks: Why I’m Banking On U.S. Bancorp, rated the stock as a Buy. That Buy rating was largely based on the stock’s historically low valuation and high yield.
Since then, the total return on USB is well over 17%. However, before you write me a “Thank You” note, know that the S&P 500 has risen just over 40% in that time frame.
Far from being humbled by those poor results, I view the relatively lackluster return on my USB investment as an opportunity to add to my position in the stock. In this article, I hope to make a solid case that U.S. Bancorp is one of the most conservatively run U.S. banks, that it trades for a reasonable margin of safety, and that it has a business model that will likely outperform most rivals.
The Commercial Real Estate Conundrum
Commercial Real Estate (‘CRE’) or more specifically, the office market, is mired in one of its worst downturns since World War II. Twin culprits are besieging landlords. The first is the work from home culture that has companies bent on downsizing their offices. The second is the stubbornly high-interest rates that prevent landlords from refinancing their properties.
These trends are largely to blame for a meteoric drop in downtown office valuations. According to MSCI Real Assets, downtown office properties are worth half of their 2022 peak valuations.
Office vacancy rates for central business districts throughout the US stood at 10% in January 2019. As of January 2024, that number hit 18.5%. According to Colliers, a real estate consulting firm, demand for downtown office buildings has remained below the demand for suburban locations for eight consecutive quarters, a phenomenon that has not occurred in the US in this century.
To buffer the potential losses posed by CRE loans, many banks built up their reserves. According to a report by Autonomous Research, the median reserves held by banks for office loans in the first quarter stood at 8%.
Investors can better understand the headwind this poses for banks when one considers that loan-loss reserve ratios for all banks are well under 2%.
In the first quarter, U.S. Bancorp’s commercial real estate nonperforming loans increased to 1.71%, up from 1.45% in Q4. However, USB’s reserve coverage ratio on office loans is over 10%, so I view issues related to CRE as minor over the long run.
The thing to keep in mind with respect to commercial real estate office space is that we’ve aggressively reserved for that. So even as nonperforming asset levels tick up, “we don’t see that as a real impact from a [profit-and-loss] standpoint.
Terry Dolan, Vice Chair and Chief Administration Officer for USB
The Latest Stress Capital Buffer Requirements
Late last month, USB revealed the bank would be subject to a preliminary stress capital buffer (SCB) of 3.1% starting on Oct. 1, 2024. This will follow the Federal Reserve’s stress test, which reviews whether banks are sufficiently capitalized to absorb losses during stressful conditions.
In addition to the 3.1% SCB, USB will be required to add the Basel III Common Equity Tier 1 minimum of 4.5%, bringing the bank’s CET1 ratio at or above 7.6%. The company’s CET1 ratio was 10% as of March 31, 2023, so USB has already set aside more than sufficient funds to meet the Federal Reserve’s requirements.
The Union Bank Deal
The $8 billion acquisition of Union Bank was the largest deal executed by USB in two decades. Union increased the company’s size by 20% and markedly increased USB’s presence in the faster-growing West Coast and Rocky Mountain states.
It also added $58 billion in loans and $90 billion in deposits, as well as one million consumer accounts, 190,000 business clients, and 280 new branches in the state of California.
Management projects Union Bank will eventually be 8%-9% accretive to EPS, with cost synergies estimated at $900 million.
Moody’s downgraded USB’s credit rating due to costs associated with the acquisition. Even so, USB’s credit remains solidly investment-grade, with a stable outlook by Moody’s.
How USB Stands Out Among Regional Banks
With $684 billion in assets, $528 billion in deposits and operations in 26 states, USB is the largest regional bank and the fifth-largest bank in the US.
This places the bank in a sort of sweet spot: as the largest regional bank, USB benefits from economies of scale. The bank has the highest deposit market share in Oregon, Ohio, Minnesota, and Wisconsin and holds a top-5 deposit market share in 17 other states.
However, USB is small enough that it does not suffer from the additional regulatory burdens associated with global, systemically important banks.
One of the bank’s strengths lies in its relatively high level of diversification. As of the end of last quarter, 37% of revenues are generated by consumer and business banking, 26% from payment services, and 37% from wealth, corporate, commercial and institutional banking.
Additionally, fee income constitutes 40% of the bank’s total net revenue. This serves to insulate the company from swings in interest rates, and management touts the bank’s payments business as a key differentiator from competitors’ business models.
USB’s payments business has a largely fixed cost structure, resulting in very low increased costs associated with additional transactions.
With well over 1 million customers, USB processes over 100 currencies in 26 countries. This places the bank among the leaders in the payments business for the hotel and airline industries.
The segment’s issuing business issues credit cards through 1,300 financial institutions, with no other large institution operating in that space.
The corporate payments business lists the Federal government, a client of the bank for decades, as its top customer. Corporate payments have established a strong presence in the aviation, fleet, transportation, and travel industries.
A 2024 study by JD Power ranked USB number one in overall customer satisfaction for its Wealth Management services.
With $6.7 billion in revenue in the first quarter, $2.5 billion stemmed from non-interest income, with non-interest income increasing 7.7% year over year.
US Bancorp’s senior debt ratings are a rank higher than that of JPMorgan (JPM) and the Bank of America (BAC), and several ranks above Wells Fargo (WFC) and regional rivals PNC Financial (PNC) and Fifth Third Bank (FITB).
As of the end of last quarter, USB had a common equity tier 1 capital ratio of 10%, a tier 1 capital ratio of 11.6%, a total risk-based capital ratio of 13.7%, and a leverage ratio of 8.1%, indicating the bank is very well-prepared for a worst-case scenario.
USB is well established as a bank with a conservative underwriting culture. During the subprime mortgage crisis, USB’s net charge-offs never exceeded 2.5%, and then only for one quarter. Compare that to many of the bank’s rivals that recorded charge-offs of 3% or more over several quarters.
Efficiency ratios are a means to measure a bank’s profitability. The lower the number, the better with efficiency ratios, with a range of 50% to 60% considered as optimal. For the four quarters that constituted FY 2022, (the Union bank deal closed in December of that year) USB’s efficiency ratio ranged between 57.5% and 63.3%.
That compares well to the efficiency ratios of JPMorgan (JPM), Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS), and Wells Fargo (WFC) of 60%, 62%, 66%, 71%, and 77%, respectively, during the first six months of 2022.
Debt, Dividend And Valuation
U.S. Bancorp has upper medium investment grade credit with an A3 rating by Moody’s, and A ratings from both S&P, and Fitch.
USB’s dividend yields 4.92%. The payout ratio stands at 64.24%, and the 5-year dividend growth rate is 5.67%. The bank’s Board of Directors just approved a 2% dividend increase effective in the fourth quarter of 2024.
Management targets long-term earnings distributions of 35%-45% for dividends, 30%-40% for share repurchases, and 15%-35% for reinvestment and acquisitions. However, share repurchases will be halted due to the recent acquisition.
USB currently trades for $40.80 per share. The average one-year price target of the 25 analysts covering the stock is $47.19. Seven rank USB as a Strong Buy, 3 as a Buy, and the remainder as a Hold.
USB has a forward P/E of 10.71x, a bit below the stock’s 5-year average P/E of 11.80x. Yahoo! Finance estimates the bank’s 5-year PEG ratio at 1.13x, well below the 5-year average for that metric of 1.99x.
Is USB A Buy, Sell, Or Hold?
The headwind posed by commercial real estate, coupled with those associated with U.S. Bancorp’s acquisition of Union Bank, has the stock going through a rough patch.
However, it is important to note that USB did not record an unprofitable quarter throughout the 2007/2008 subprime mortgage crisis, Furthermore, for over a decade, the bank posted returns on equity well above that of peers.
I view this rough patch as the pause that refreshes. In time, the assets gained through the Union acquisition will perform on par with USB’s historical levels. And U.S. Bancorp’s efficiency ratio will then return to its prior norm. Plus, when the problems associated with office properties are resolved, that will free up significant capital.
In my last article on USB, I noted that Baird analyst David George, had upgraded USB to outperform, stating the stock provided “a rare opportunity to take a position in this high-quality regional bank with little to no downside and ~50% upside over time.”
As for me, estimate that the stock is currently trading approximately 20% below a fair value range, and I rate USB as a Buy
I’ll note that USB’s 5-year average yield is 2.59%, while the stock currently yields 4.80%. Count me as one who is willing to brave the current uncertainty surrounding U.S. Bancorp to lock in a hefty, safe yield.
USB is one of my larger investments, and I am slowly adding to that position on a regular basis.
