The Good, Bad and Ugly: USB
The light at the end of the tunnel appears very bright for banking stocks as aging baby boomers will likely demand more of their products and services as they get deeper into the retirement stage of their lives. However, in the meantime the light is flickering somewhat as banks are going through some tough times with net interest margins under pressure due to the flattening of the yield curve. However, considering attractive valuations, appealing long-term prospects and above average dividend yields, this group may indeed represent a very attractive investment alternative.
Last quarter following less-than-spectacular performance I placed USB on "double secret probation". Thus I studied USB's performance with some extra curiosity.
In general banks' financials are very complex and require a multidimensional analysis, linking the balance sheet and income statement, while filtering out the noise created by various balance sheet adjustments. USB's financials are not any different so I had to make a lot of adjustments to get to the true operating performance.
- Credit losses have been on a positive trend for a while at USB (true for most banks), further declining to 0.44%. That's a very good sign however, we are probably close to the bottom of that trend, as the benefits from declining credit losses have primarily run their course.
- Higher interest rates (something I would not rule out considering the fact that interest rates are sitting at an all-time low) tend to make borrowing more expensive putting more stress on companies and consumers and resulting in higher credit losses. Interestingly as interest rates rise, credit spreads are likely to widen on the new loans as banks price higher expected default rates. However, the benefits from higher interest margins are likely to be somewhat offset by increased credit losses in existing loan portfolios.
- The most impressive part of the company's second quarter earnings report was a nice 8.3% growth in loans - a rough proxy for future earnings growth. However, about 2% of that growth came from residential mortgages, likely driven by a recent drop in long term rates. On a positive note, growth in loans in most business lines was very solid.
Side note: investors should be cautious of banks which derive a large portion of profitability from their mortgage business and refi business as higher rates are likely to have a significant impact on that area.
- Reported EPS was up 10.9% year over year which looks great on the surface. But this is an instance where the surface needs some serious scratching. In my analysis, I'd like to exclude one-time and non-operating items to get to a better measure of true operating performance. Why do we do that? True operating performance presents an accurate scorecard of management and the company's performance and is therefore the best indicator of achievable future results. One time items (good or bad) will eventually run their course.
So here it is (all comparison with the second quarter 2004):
- Net interest income (before the provisions for losses) declined 1% - nothing to be excited about - though not utterly unexpected considering the flattened yield curve and intensified competition. According to my estimates the flatter curve shaved 5% from USB's net income growth.
There are several ways a company can deal with a flatter curve (net interest margins declined 29 basis points to 3.99%): cut costs (more on that later), originate more loans (check), and drive fee revenues (check).
- On the surface, non-interest income (fee revenues) grew 24.1%. However, after excluding security gains, growth was lower but still a very impressive 8.9%. This figure is extremely important for several reasons: in the current flat yield curve environment, fees become a great source of profitability. Also they are not subject to the whims of the external factors and therefore are very predictable and a stable source of growth.
The majority of the growth in that segment was organic, as it was fueled by increases in the payment services segment growing at a very fast pace due to increasing popularity (and acceptance) of debit and credit cards. USB is the third largest merchant processor in U.S. after First Data (FDC) and Bank of America (BAC).
- Non-interest expense rose 29.4%, however, after excluding intangibles and debt repayments, the figure was only up 6.4%. I would like to see that number lower, as the banking business lends itself to substantial operational leverage (large fixed costs), thus growth in expenses ideally should lag behind the growth in top line.
Intangibles were mostly comprised of Mortgage Servicing Rights (MSRs) write-downs caused by recent dip in interest rates, something the company has little control over.
- Actually if one assumes that rates will not stay at an all-time low level forever, MSRs may be an undervalued long-term asset as they become more valuable in the higher interest rate environment. (Rising interest rates cause loan refinancing to decline thus increasing the life of the loans).
- Reported income after taxes was up 8.1%, however, that was mostly driven by a lower tax rate in the current quarter, where operating income before taxes was up only 1.3% (excluding one time items, see my calculations.)
After factoring a 3.1% share count decline in the quarter (share buy backs), true EPS growth was about 4.5% - far below the company reported number of 10.9%. Again based on my estimates, in the absence of flattening of the yield curve, USB's EPS would have grown more than 9%. Add to that a 4% dividend yield and we are talking about a very good rate of total return.
- USB returned 92% of net income to shareholders through stock buy backs (share count declined 3.1%) and dividends - very good as long as it doesn't jeopardize USB's future growth (which doesn't seem to be the case here.)
- Tier 1 ratio (capital to adjusted total assets - the higher the ratio the more capitalized the bank is) has continued to decline to 8.1% from last year's level of 8.7%. This is in large part due to the payout of the bulk of the net income in dividends and share buy backs, paying of some preferreds and issuing new debt. Overall, the tier 1 ratio still stands at a very respectable level and is likely to normalize here in my view.
- Efficiency ratio - very important (the lower the better) - as it is indicative of the company's cost structure. A lower cost structure obviously provides a competitive advantage in the banking industry as choosing one bank over another is often decided on price (interest rates)
USB's efficiency ratio increased in the quarter from 38.6% to 48.3%. However, it is grossly distorted by a write down of MSRs and debt pre-payment, (in absence of which it increased only slightly by about 1%.)
Expenses grew at a faster rate than sales:
USB is still in the midst of a very aggressive program of building new branches in grocery stores, and that in part is responsible for higher expenses in the quarter. According to management it takes 18-35 months for the inside grocery store branches to reach profitability. In addition, about a third of the increase in expenses is attributable to the integration of several acquisitions that USB made in the payment processing business. Once those acquisitions are switched to the USB platform the expense structure should normalize.
Management stressed on the conference call that investors should start seeing revenue growth outpacing expenses (operational leverage at work) - resulting in margin expansion and acceleration of EPS growth. I will be watching for those numbers over the next several quarters.
Non-interest businesses (especially payment services) are likely to be the driver of growth in both the short and long runs, as the majority of them showed double digit growth in the quarter. Though some of the growth in that business came from acquisition, the bulk of the growth was organic (the cheapest way to grow.)
Overall, this quarter was not spectacular but it provided a favorable glimpse into the future as management demonstrated its ability to grow loans and fee revenues. USB's footprint is OK but not the best in the industry as only about half the branches are located in the faster growing states. However, most of the new branch growth is coming from higher growth states - a long term positive. USB's valuation is still very attractive as it trades at 11.6 times 2006 earnings. There some room for P/E expansion and very little risk of P/E compression in my view. A 4% dividend yield and 8-10% long term EPS growth rate make USB an interesting company to consider further.
Side note: Zions Bancorporation (ZION) - has one of the best footprints i.e. California, Arizona, Nevada, Colorado. I'll be watching Zions very carefully as a stock decline may present a buying opportunity. Not advice.
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