US Bank - The Good, the Bad and the Ugly
This is what I want to see from a bank in our portfolios: growing assets - a source of loans, growing checking accounts - a source of free (cheap) funds, growth of fees - provides stable income, which is not sensitive to interest rate volatility. In addition I would like to see expenses as a percent of revenues (efficiency ratio) constantly declining - gratitude of operational leverage, which a banking business has plenty of. Oh, and I would like to get a nice, fat return on assets and return on equity. On top of all that, I want that bank to be well capitalized and not be in the practice of giving out loans to people that don't pay them back. Is that so much to ask?
On the surface US Bank (USB) met Street's estimates of $0.57. However, a quick under the hood look shows that the results were very mixed at best.
- Asset growth was 4.2%: retail loans were up 9.5% (nice growth), commercial loans were up 7.3% (I like it), and investment securities declined 4.3%. I am willing to ignore the decline in investment securities and focus on a big picture - loan growth.
- Fee revenues are up 4.9%. Credit card fees are up 8.5%, consumers are not giving up. European acquisition contributed about half of the growth in this segment (not as good as it appears).
- Non-interest expense is down 8.5% - great news. However, a big chunk of it was driven by a change in valuation of MSR (mortgage servicing rights). Also in the Q1 2005, USB took a charge for early debt repayment. Excluding the charge and MSR, expenses were about flat.
- Lower charge offs - loan charge off declined. Net charge offs inched 3bp higher, but it is still very close to an all-time low level of 0.55% of average loans. Overall credit quality is improving. This trend is very consistent across most banks. However, charge offs are likely to increase as interest rates rise.
- Acceleration of deposit growth, however, non-interest bearing deposits declined 2.1% where most growth came from time deposits greater than $100,000.
- Tier 1 ratio is at 8.6%, though 3 bp lower than it was last year but still a very solid number.
- Returned 108% of earnings to shareholders in the form of dividends and share buy backs. The dividend yield stands at an already high 4.3% and share buy backs added another 3.1%, resulting in a 7.4% return to shareholder yield.
- Efficiency ratio has declined to 41.7% - one of the lowest ratios I have ever seen - very good news.
- Interest margin has declined 21 bp:
- Part of it was attributed to the flattening of the yield curve. This got me thinking: further decline in the dollar and the Chinese possible de-linking their currency is likely to send U.S. interest rates higher, normalizing the yield curve. Another question, does the Fed really have control over interest rates?
- The rest was due to increased competition. Did USB originate that nice loan growth by undercutting competition?
- There was nothing ugly in this quarter - I just like the title. But that is what is so great about USB - investors are unlikely to see anything ugly from this company. On another hand, half of "the good" bullets should be in the "the mediocre" column. I really like seeing asset growth, but I don't put as much value on that growth when it comes at the expense of net interest margins. USB has one of the lowest cost structures in the industry, a big plus considering this is a commodity cut-throat business. Thus being a low cost producer allows the company to compete on price.
Very few positives in this quarter were organic. I am not accusing USB of using pesticides, but there is limit to the 'non-organic.' There were plenty of 'one time' items that helped to deliver the bottom line growth. The problem with one time items - they are non-recurring and they don't provide great visibility into the future.
On a positive note, this quarter performance was a significant improvement from last quarter and last year's. Deposits, loans and net interest income stopped declining and showed a sign of growth. I cannot really tell if the current performance is a fluke or if USB has been resuscitated. As ugly as the chart looks, USB doesn't scare me. It seems that downside risk is minimal in this stock: it trades at 12 times 2005 earnings and is yielding 4.2%. It is very likely that interest margins will decline in the next quarter, as spreads are still very low. Contrary to common perception in the long-run interest rate spreads have little correlation with banks' profitability (see chart below).
This less than spectacular performance placed USB on my probation list. If deposits, non-interest income and assets don't start showing a more meaningful growth next quarter, I'll have to part with USB. In the meantime, I welcome suggestions for a better bank with high a dividend, attractive valuation and great quality.
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