U.S. Bancorp: Valuation And A Vanishing Deal Overhang Should Help Address Underperformance

Once one of the most well-regarded banks among the large-caps, U.S. Bancorp (NYSE:USB) hasn’t seen the same enthusiasm from investors in recent years and the shares have lagged their peers not only over the last year, but the last three, five, and 10 years as well (as well as since my last update). The bank doesn’t stand out versus its peers on metrics like ROTCE and core pre-provision profit margins like it once did, but the bank is still solidly above-average in most of the drivers that matter.

U.S. Bancorp has the “Main Street banking” exposure I still favor, but the bank’s leverage to corporate payments and merchant processing could be a near-term weakness if the economy slows more than expected, and I’m likewise still concerned about the bank’s deposit leverage through this next phase of the cycle. On the other hand, closing the Union Bank deal should relieve at least one sentiment overhang, and I think the shares are priced for a sub-2% core earnings growth rate that I believe the bank should be able to beat by a decent margin in the years to come.

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U.S. Bancorp: Valuation And A Vanishing Deal Overhang Should Help Address Underperformance

U.S. Bancorp Looks Better Placed Than Most

In a bank sector that has been hit hard, U.S. Bancorp (NYSE:USB) has held up better than most. I thought valuation and operating leverage were looking more interesting in late February, and though the shares are down about 20% since then, they’ve outperformed many of their large peers.

I do believe that U.S. Bancorp shares look undervalued today for longer-term shareholders. I expect bank stocks to remain under a cloud a little while longer, particularly with so much uncertainty about the economy in 2023. Like PNC (PNC), though, I think U.S. Bancorp is a more conservatively-run “Main Street”-focused bank that has operating leverage drivers and opportunities to post above-average loan and fee income growth even in a tougher environment.

 

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U.S. Bancorp Looks Better Placed Than Most

U.S. Bancorp Looks Undervalued On Recovering Loan Growth And Opportunistic M&A

 

Writing about U.S. Bancorp (USB) last July, I thought there were more interesting candidates among this bank’s large bank brethren, and the shares have since underperformed by around 10%, with others like PNC (PNC), Truist (TFC), and Wells Fargo (WFC) outperforming, though I also tapped JPMorgan (JPM) and Citigroup (C), which haven’t done as well.

That underperformance comes despite the announcement of what should be a value-creative deal with Mitsubishi UFG (MUFG) Union Bank, and I believe reflects both some ongoing lackluster operational results at U.S. Bancorp and the market’s general skepticism around whole bank deals.

With that underperformance, I’m finding more to like in these shares. I do think U.S. Bancorp could be setting itself up for disappointment again on operating leverage in FY’22, but I do like the Union Bank deal, the ongoing investments in IT and fee-generating businesses like payments, and U.S. Bancorp’s ability to use a digital-backed “land and expand” branch-lite model to enter new markets.

 

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U.S. Bancorp Looks Undervalued On Recovering Loan Growth And Opportunistic M&A

U.S. Bancorp's Leverage To A Spending Recovery Starting To Emerge

 

I was bullish when I last wrote on U.S. Bancorp (USB) shares, and since the stock has outperformed its large bank peer group by a little more than 1,000bp – not bad for a roughly half-year performance. With the economy coming back to life, I believe U.S. Bancorp is finally getting some credit not only for its revenue growth leverage to consumer and business spending, but the operating leverage those high-margin payments businesses can generate.

With the standout year-to-date performance (Wells Fargo (WFC) is one of the relatively few to have meaningfully outperformed U.S. Bancorp), I can’t say that the upside I saw earlier this year is still there, and the potential returns seem more on par with other high-quality large banks. That said, if U.S. Bancorp can leverage more growth out of its fintech investments (and/or more operating leverage), there could still be some upside here.

 

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U.S. Bancorp's Leverage To A Spending Recovery Starting To Emerge

Conservative And Consumer-Oriented, U.S. Bancorp Isn't In Vogue

Valuation is a tricky thing. As I’ve said on multiple occasions, stocks don’t go up simply because they’re cheap (nor down simply because they’re expensive), and while U.S. Bancorp (USB) does look undervalued on a long-term earnings basis, the company’s conservative approach and consumer-oriented business model is definitely out of step with the risk-on focus of bank investors today.

I continue to believe that U.S. Bancorp can generate long-term earnings growth in the neighborhood of 3%, and that the shares are meaningfully undervalued on that basis. I also believe, though, that it could take some time for this stock to work, as the bank’s robust payments business is more tied to a consumer spending recovery and some analysts and investors continue to fret that management’s priorities are out of step with the new realities of the banking sector.

 

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Conservative And Consumer-Oriented, U.S. Bancorp Isn't In Vogue

U.S. Bancorp Focusing On Costs To Offset Spread Income Headwinds

Third quarter results (and guidance) from the large banks underline why I've been preferring banks with meaningful non-spread income sources and/or meaningful operating leverage - in an environment where spread income growth is so difficult, these other areas can drive above-peer pre-provision growth. And so it remains for U.S. Bancorp (USB), where healthy fee-based income and operating leverage helped drive a better-than-expected result for the third quarter.

I was neutral on USB last time around as more of a "slow and steady wins the race" pick, and the shares have since tracked just a bit better than the sector. I like management's more aggressive stance on operating costs and I do still see some options on the M&A side if management wants to go that way. As far as valuation goes, having underperformed most of its peers on a year-to-date basis, I'm seeing a little more relative value here, but I wouldn't call it my favorite idea among larger banks (it's tough to beat JPMorgan (JPM) there).

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U.S. Bancorp Focusing On Costs To Offset Spread Income Headwinds

U.S. Bancorp Beats, But Underlying Performance Is Still Lackluster

As seen in the first bank earnings of the reporting season, core banking operations are struggling, and U.S. Bancorp (USB) is no exception. While U.S. Bancorp does have a sizable collection of fee-generating businesses, most of those businesses are tied closely to economic activity (as opposed, say, to Truist’s (TFC) insurance operations or the trading operations of Bank of America (BAC), Citi (C), and JPMorgan (JPM)), and don’t do much to offset the core weakness that the banking sector is seeing now.

I thought U.S. Bancorp was undervalued three months ago, but also a somewhat lackluster near-term prospect, and the share price performance has been basically inline to slightly below its peer group, with Citi and Truist doing noticeably better. While I think U.S. Bancorp has made the right decision in accelerating its reserve-building, the bank’s heavier skew toward consumer banking could still be a relative headwind for sentiment. The shares offer above-average long-term potential, but I would underline the “long-term” part of that statement.

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U.S. Bancorp Beats, But Underlying Performance Is Still Lackluster

U.S. Bancorp Likely Needs More Reserves

As I said in another piece on the banking sector, I’m reluctant to overly nitpick the reserve-building decisions that bank management teams are making, as they’re likely doing the best they can in an environment that could only charitably be called “murky.” Still, I think U.S. Bancorp (USB) may be pulling the Band-Aid a little too slowly, making it likely that further reserve additions will be necessary. On top of that, the bank’s payments business is getting hammered on the COVID-19 shutdowns, and the first quarter of results reported in the crisis weren’t great.

Sentiment was already a challenge for U.S. Bancorp and worries about whether there’s another shoe to drop with reserves won’t help. With a thinner capital cushion than at some of its peers/comps, I can understand why U.S. Bancorp shares would trade at a somewhat larger discount. While I do think U.S. Bancorp shares are now pricing in a forward outlook that is too bearish, I don’t like these shares as much on a relative basis to names like Bank of America (BAC), JPMorgan (JPM), or PNC (PNC).

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U.S. Bancorp Likely Needs More Reserves

Rate And Operating Leverage Challenges Counterbalancing U.S. Bancorp's Valuation

The trouble with excellence is that once you attain a high standard of performance, the improvements that follow don’t seem quite as impressive. Start an exercise program today, and you’ll probably see rapid improvement over the first few months … but after a year or so, those improvements will be slower and harder-earned. That may well be one of the primary issues for U.S. Bancorp (USB) now, as this well-regarded and highly profitable bank struggles to offset spread headwinds and operating leverage challenges.

I still wonder whether investor frustration with the slow progress here may eventually force management toward a more dramatic step like a large acquisition or merger of equals. Management certainly seems more open to the idea than before, but I wouldn’t make that a base-case assumption. In any case, U.S. Bancorp does appear to offer better-than-average upside here, but with sentiment in a “what have you done for me lately?” sort of place, it may take time for this more defensive name to shine.

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Rate And Operating Leverage Challenges Counterbalancing U.S. Bancorp's Valuation

U.S. Bancorp Doing Fine, With Opportunities To Counterbalance Spread Pressure

For the most part, U.S. Bancorp (USB) thrives on consistency. That makes quarter-to-quarter reporting a little less exciting, but if you want excitement, U.S. Bancorp really isn't the stock for you anyway. Second quarter results were another solid performance from a reliably solid bank, and U.S. Bancorp's combination of low spread compression and healthy fee-based revenue growth was encouraging relative to increasing spread pressure.

U.S. Bancorp might have more going for it than you'd think at first glance. With net interest margins likely to narrow even more over the next year, investors will do well to find banks that can offset that pressure. For U.S. Bancorp, growing fee-based businesses, organic de novo branch growth, and branch consolidation can all help offset that pressure. Like PNC Financial (PNC), which also has some valuable spread counterweights, U.S. Bancorp isn't particularly cheap, but the shares still look like a decent hold here.

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U.S. Bancorp Doing Fine, With Opportunities To Counterbalance Spread Pressure

JPMorgan Building On Strengths Outside Of Banking

JPMorgan (JPM) is one of the largest, and in my opinion also one of the best-run, banks in the U.S., but core deposit/lending banking operations are only part of the story. JPMorgan also has a significant payments business, and management has made it clear that they view growing this high-margin, high-returns business as a core priority. To that end, the company recently announced its largest deal since the financial crisis, and I expect further investments (both organic and M&A) to grow this business.

Although I continue to believe that core banking has more or less plateaued for this cycle, JPMorgan continues to stand out for the quality of its operations. Looking ahead a bit, I believe the company’s plan to drive organic growth (new branch openings) and leverage its substantial IT investments will drive better-than-average growth and cost leverage. There are bigger bargains in the banking sector today, but in terms of quality and value, I believe JPMorgan’s double-digit discount to fair value still makes it a name worth considering.

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JPMorgan Building On Strengths Outside Of Banking

Quality, Value, And A Little Bit Of Growth - Bank Of America Seems To Offer Quite A Bit

There are some exceptions, of course, but investors who want to invest in U.S. banks today have to make some choices and trade-offs between quality, value, and growth. JPMorgan (JPM) has quality and growth, but not as much value. U.S. Bancorp (USB) has quality and maybe more growth potential than believed, but also not much value. Citi (C) and Wells Fargo (WFC) may offer more value, but quality is certainly an issue with both franchises.

And that brings me to Bank of America (BAC). Bank of America has the scale (#2 overall in deposits and assets) to keep up with the likes of JPMorgan and Wells Fargo in IT investments and drive operating scale, but it also done quite well with expenses and deposit costs without overly compromising loan growth. I don’t wish to position or suggest Bank of America as a scintillating growth story, because it’s not, but management continues to invest in growth opportunities like digital banking and opening branches in new strategic markets, and I believe Bank of America can beat the average large bank in pre-provision profit growth over the next three to five years.

All that, and a stock I think should trade closer to the mid-$30’s.

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Quality, Value, And A Little Bit Of Growth - Bank Of America Seems To Offer Quite A Bit

A Recent Rally Has Soaked Up South State Bank's Undervaluation As It Repositions

I was a little surprised to see South State Bank (SSB) outperform so well since my last article – up more than 25%, beating regional banks by about 5% overall and a more direct set of peers by about 10%. While I thought the shares were undervalued on a longer-term basis, the Street isn’t famous for taking a longer-term perspective, particularly when near-term earnings growth potential is more limited by the bank’s ongoing restructuring efforts. Still, with many large regional banks announcing plans to expand into the U.S. Southeast, and the bank close to the end of that repositioning process, I suspect this outperformance could be due in part to expectations that a regional bank may look to M&A to accelerate its expansion plans.

I do think South State could make an attractive buyout candidate; while the loan-to-deposit rate isn’t perfect, the bank has an attractive core deposit franchise in attractive growth markets like Charleston, SC, and Charlotte and Raleigh, NC. While a bank like U.S. Bancorp (USB) could offer as much as a 20% premium in a cash deal and still see some accretion, South State’s valuation isn’t exactly cheap on a stand-alone basis. Much as I like the long-term story at South State, with a lot of smaller banks offering 10%-20%-plus discounts to fair value today, it’s hard to call this a must-buy at this price.

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A Recent Rally Has Soaked Up South State Bank's Undervaluation As It Repositions

With More Earnings Reports In Hand, Wells Fargo Looking Even Worse

Expectations have been relatively low for Wells Fargo (WFC) ever since the asset cap was put into place, but this large bank has nevertheless managed to disappoint, with the shares underperforming banking indices by about 12% over the last six months and 10% over the last three months. With a sizable number of Wells Fargo’s peers now having reported their first quarter earnings, a look back at Wells Fargo does not look so good for this struggling bank.

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With More Earnings Reports In Hand, Wells Fargo Looking Even Worse

BB&T Basically On Track Ahead Of Its Game-Changing Merger

Despite the significant long-term potential benefits of BB&T’s (BBT) merger of equals with SunTrust (STI), the market is still generally against M&A in the banking sector, and BB&T shares have lagged regional bank indices a bit since the deal announcement (about 300bp of underperformance). I continue to believe this is a strong merger, though, and I think BB&T shares remain one of the more interesting values among banks in its weight class.

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BB&T Basically On Track Ahead Of Its Game-Changing Merger

U.S. Bancorp Doing Fine And Ready To Start Making Some Moves

As one of the best banks out there in terms of quality, U.S. Bancorp (USB) tends to be better as a “safe haven” or a long-term holding. When bank stocks were falling apart in late 2018, U.S. Bancorp held up a little better, but the shares have also lagged peers since the start of this year as banks have largely kept pace with the S&P 500.

I expect that it is going to be harder for banks to grow going forward, as I think net interest margins are peaking and credit costs are likely to head higher from here. Loan growth is healthy now, but I do still have some concerns about the overall economy. With that backdrop, I think organic growth drivers are going to be more important, and with U.S. Bancorp now free of its consent orders, it has more options to drive growth through organic expansion and branch rationalization. U.S. Bancorp isn’t particularly cheap now, but it’s definitely a name to watch for relative underperformance.

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U.S. Bancorp Doing Fine And Ready To Start Making Some Moves

PNC Financial Posting Healthy Loan Growth, But Cycle Peak Pressures Emerging

In the competition for best-run bank in the U.S., at least among the heavyweights, PNC Financial (PNC) brings a pretty strong case in its favor. While I haven’t always been excited about the valuation on the shares, I liked it back in January and the shares have outperformed the major regional bank indices since then, though the sector has continued to lag the S&P 500.

Looking at the bank again in the light of first-quarter earnings, nothing really changes in my mind. The better than expected loan growth is of course nice to see, and the increases in loan provision expense and deposit costs isn’t a surprise to me. I still have sector-wide worries that we’re descending from a peak and that is going to make share price outperformance more challenging, but this remains a worthwhile holding for those investors who are less inclined to try to time market cycles and would rather have a longer-term position in American banks.

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PNC Financial Posting Healthy Loan Growth, But Cycle Peak Pressures Emerging

A U.S. Bancorp - PNC Financial Tie-Up Could Be A Win-Win

Speculating on M&A is a tried and true way of passing the time between major news releases, and it’s overwhelmingly just a theoretical exercise, as the number of potential deals always dwarfs the number of deals done. That said, a recent turn toward mergers of equals in the banking space, including the large proposed tie-up of BB&T (BBT) and SunTrust (STI), adds a new element to the story.

Although I don’t think you can count it as any sort of “base case”, and both banks have expressed their disinterest in large-scale whole bank transactions, I believe a merger of equals (or near-equals) between U.S. Bancorp (USB) and PNC Financial (PNC) could not only be very interesting from an EPS and TBV accretion point of view, but also from the perspective of creating a truly national bank with strong positions in commercial and retail lending, payments, wealth management, and other fee-generating businesses.

I want to emphasize again that I’m not expecting such a transaction, and I do not recommending buying either U.S. Bancorp or PNC on the basis of M&A potential. Still, these are two high-quality banks traded below my estimates of fair value as is, and a transaction could create value for both shareholder groups.

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A U.S. Bancorp - PNC Financial Tie-Up Could Be A Win-Win

The Strong Look To Get Stronger As JPMorgan Continues To Target Growth

Already one of the best-run companies I follow, JPMorgan Chase (JPM) has shown an uncanny ability to leverage its strengths and maintain a steady pace of process improvement while looking for new growth opportunities. There wasn’t much that was all that new in JPMorgan’s Investor Day presentations (nor in the 10-K), but when you’re already executing very well on a very good plan, there’s not much reason to change.

JPMorgan's shares remain undervalued in my view, even though I believe banks are no longer in the best part of their respective cycle. With a high-quality business that still has meaningful long-term growth opportunities, I still regard this as a core holding and I think the upside potential still leaves it as a name to consider for new investment.

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The Strong Look To Get Stronger As JPMorgan Continues To Target Growth

Encouraging, If Choppy, Progress At Umpqua

Orgeon’s Umpqua Holdings (UMPQ) has generally been well-liked by investors, which has often meant a less-appealing valuation compared to many peers. Between that popularity, a less asset-sensitive balance sheet than many peers, and general optimism on the company’s efficiency initiative, the shares really haven’t lagged its regional banking peers all that much over the last six or 12 months.

Looking at fourth quarter results, Umpqua seems to be going into 2019 with some decent momentum and attractive prospects for spread improvement on delayed repricings, as well as further cost-reduction benefits from the NextGen process. Although I believe Umpqua is undervalued on both a long-term earnings basis (assuming high single-digit growth) and near-term ROTE, the degree of undervaluation is less than for many banks in its peer group.

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Encouraging, If Choppy, Progress At Umpqua