Wednesday, October 19, 2005
October 19th 2005 - Minyanville.com
In the first quarter of 2005 I put USB stock on double secret probation. After the second quarter I took it off probation. This quarter's performance earns USB a get-out-of-jail-free card.
As I've mentioned previously I have a checklist of things I look for in a bank. Specifically, 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 – as a function 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 follow the pesky practice of giving out loans to people that don't pay them back. Is that so much to ask?
Evidently I am not asking too much as US Bank’s (USB) third quarter performance was an example that with EPS up 10.7% to $0.62. Performance was solid on all fronts:
Growing assets: Loans grew 10.1%. Growth was consistent in almost every segment, with mortgages leading the pack by growing 28.6%. Though mortgage growth is unlikely to be sustained going forward, excluding mortgages, loans still grew 7.6% - still a very respectable performance.
Side Note: home equity and second mortgages went up only 4.9% in the quarter and actually were down 0.1% sequentially. USB has a large enough company wide geographic presence that speaks to the overall the state of the economy. The aforementioned growth in loans and the relatively slow growth in home equity loans maybe a leading indicator that housing market is still growing very fast, but consumer spending is likely to slow down as consumers reliance on home equity loans (the main engine of “other people’s money” growth) showed signs of fatigue.
In my approximation unsecured consumer loans is roughly 11% of USB’s total loans. Any exposure to unsecured consumer lending is a negative if one is concerned with the consumer’s ability to keep spending other people’s money. Let me correct myself, spending is not the issue - paying those liabilities back is. However, in the context of the overall impact on USB’s profitability, unsecured consumer exposure is not nerve racking considering that a very large portion of USB’s earnings (46%) come from fee income which is somewhat insensitive to consumer solvency.
Growth of fees: On the negative side, net interest margin decreased in the quarter by 27 basis points to 3.95% due to the flattening yield curve and increased price competition. Though USB was not the one who started the price war, it can take on any competitor as it has one of the lowest cost structures in the industry. This is a great competitive advantage for a company in a commoditized industry. Even after the decline USB’s net interest margin is still better than most banks (i.e. AmSouth’s (ASO) 3rd quarter net margin was 3.31%).
On a positive note: after taking out a security gain taken in 2004, interest income grew 9.7% with the bulk of that growth was organic. Fee income is somewhat independent of interest rate structure thus it brings a welcomed predictability to earnings.
Expenses as a percent of revenues (efficiency ratio) constantly declining: Non interest expense was up 3.1% (after normalizing for intangible value changes) - that is what I want to see. Operating expenses grew at a lower pace than revenues. This is operational leverage at its best. Tangible efficiency ratio (non interest expenses divided by revenues) declined to 40% from 40.6%. US Bank has one of the lowest efficiency ratios in the industry, thus seeing it decline even further speaks highly of a quality of the management.
Giving out loans to people who pay them back: credit quality has improved – as net charge offs declined to 0.46% from 0.52%. This number is probably seen its bottom (or very close to it) as net charge off are likely to start rising as interest rates increase.
Well capitalized: common equity declined to 9.6% from 10.2% as USB was an aggressive buyer of its stock, returning 102% of earnings to shareholders since 2003. Though equity as a percent of total assets is still very high, USB cannot continue to buying back stock and paying a dividend at the pace it has in the past. Management indicated that its goal to return at least 80% of USB earnings back to shareholders, a more sustainable practice. (Note: Lloyds TSB (LYG) has a similar payout resulting in an 8% dividend.)
USB is a very shareholder friendly company: it bought back 2.8% of shares, thus combining that with its 4.3% dividend it returned 7.1% of capital back to shareholders.
Growing checking accounts: total deposits grew 4.9% (good), however, similar to last quarter, depositors shifted to higher yielding products, driving the cost of funds higher – not a positive development. As interest rates increase an opportunity cost of holding funds in non-interest bearing checking account rises as well, thus driving customers to shift they deposits to higher interest paying demand deposits or CDs.
Nice, fat return on assets: Both return on assets and return on equity went up in the quarter to 2.23% and 22.8%, respectively. High return on capital allows USB to maintain payout a very large payout ratio and still grow its loans at very respectable rates.
Quality: USB is one of the most conservatively run banks in the US. It has a very diverse customer base, stable and predictable fee business. It is not involved in proprietary trading game that turned many money center banks into leveraged hedge funds. Its low cost structure provides the company a sustainable competitive advantage.
Value: At 10 times projected 2006 earnings USB is cheap. It trades at a comparable valuation to money center banks, but has a no waking-up-one-morning-seeing-equity-wiped-out-due-to-trade-gone-bad risk. Nor does it have a large acquisition integration risk still hanging over Bank of America (BAC) and JP Morgan (JPM). In fact, on the conference call USB management stated that it is not interested in making any large acquisitions. For these reasons USB deserves to trade at a premium to the aforementioned banks in my view. I would not rule out 20-40% PE expansion as historically USB traded at about 14 times earnings.
Growth: with 4.3% dividend and 3% share buyback, USB doesn’t have to do anything heroic to deliver a total return in excess of 10% to its shareholders. Let’s go through the numbers: 3-5% loan growth should translate to 5-7% net income growth due to operational leverage abundant in banking business, adding 3% share buyback brings us to 8-10% EPS growth, combine that with a dividend and we are looking at 12-14% total return without taking a lot of risk. Our kind of stock!
Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.