Shrinking Interest Margins Worry Investors Despite U.S. Bancorp’s Strong Q2 Performance

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U.S. Bancorp (NYSE:USB) reported a better-than-expected performance for the second quarter of the year on Wednesday, July 16, with the regional banking giant churning out earnings of $1.5 billion from revenues of $5.1 billion – both figures being the highest ever in its history. [1] But the fact that the bank’s shares shed 4% of their value within two days of the announcement is an indicator that investors were not too impressed by the results. This is probably justified given that the top line included a one-time gain from U.S. Bancorp’s Visa (NYSE:V) stake sale for a net gain of $214 million – a move aimed at countering the $200 million bill for settling mortgage issues with the Department of Justice (see U.S. Bancorp Settles Mortgage Issue With DOJ For $200 Million). More importantly, the bank’s net interest margin sank further to 3.27% from 3.35% in the previous quarter, raising doubts among investors’ about short term profitability of the bank which focuses largely on the traditional loans-and-deposits model to make money.

There were several factors that worked in U.S. Bancorp’s favor this quarter, though, including a record performance by its payment service offerings (merchants and corporate clients combined) as well as for its trust and investment management unit. Growth in the bank’s loan portfolio also continues at a brisk rate. Moreover, adjusting non-interest expenses for the mortgage settlement shows that costs were largely in line with the figures for Q2 2013 and Q1 2014.

We believe that U.S. Bancorp is well positioned to benefit from improving interest rates once the impact of the Fed’s tapering plan spreads. The better-than-expected increase in size of loans outstanding, continued focus on fee-based revenue streams as well as the adjusted payout ratio of 75% (including dividends and stock repurchases) are important factors behind our decision to revise our price estimate for U.S. Bancorp’s stock from $42 to $44.

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Nagging Net Interest Margin Concern Remains High on Investors’ Minds

U.S. Bancorp’s business model, due to its reliance on traditional banking operations, is very sensitive to interest rates. This is why the biggest concern among investors about its performance in recent quarters has been the sequential decline in its net interest margin (NIM). Due to the extended low interest-rate environment, safe investment options with reasonably high rates of return have been difficult to come by, which has squeezed margins.

The table below summarizes U.S. Bancorp’s reported net NIM figures for each quarter since early 2011:

Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014
3.69% 3.67% 3.65% 3.60% 3.60% 3.58% 3.59% 3.55% 3.48% 3.43% 3.43% 3.40% 3.35% 3.27%

As seen here, the bank’s NIM fell from 3.69% to 3.27% between Q1 2011 and Q2 2014, with a large part of this decline witnessed since late 2012. This has been due to lower interest income from variable sources, a steady growth in interest-bearing customer deposits and also because of actions undertaken by the bank to ensure regulatory liquidity requirements. What makes things worse for U.S. Bancorp is that the decline in NIM figures was quite significant over the last two quarters – tanking 13 basis points (0.13%) compared to the less than 7 basis points (0.07%) reduction over the same period for larger peers like Wells Fargo (NYSE:WFC), JPMorgan (NYSE:JPM) and Bank of America (NYSE:BAC). But it must be noted that U.S. Bancorp has a higher NIM figure compared to them, with the two largest banks reporting NIM figures under 2.3% for Q2 2014.

With the Fed initiating its tapering plan in January, the interest rate environment has begun showing signs of improvement over the last couple of months. As it is expected to take a few more months for the impact to spread across the economy, we believe the bank’s NIM figure will reverse its trend later this year. You can understand the partial impact of changes to net interest margins on the bank’s total value through the chart below, which represents U.S. Bancorp’s NIM on its investment securities.

Fee-Based Revenues Scale New Heights in Q2

U.S. Bancorp reported total non-interest incomes of $2.44 billion in Q2 2014 – its highest ever – representing a 7% year-on-year and 16% quarter-on-quarter improvement. While the $214 million gain from Visa stake sale played an important role here, the record performance by the bank’s merchant processing services and asset management units cannot be overlooked. U.S. Bancorp helped process a record 1.1 billion transactions in Q2 2014, to generate an unprecedented $384 million in fees. Also, the bank’s asset management arm saw its asset base swell from under $113 at the end of Q2 2013 to $124 billion now – allowing it to improve the highest-ever trust and investment management fee figure of $304 million in Q1 to $311 million in this quarter. The chart below represents the size of assets under management for U.S. Bancorp.

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Notes:
  1. 2Q 2014 Earnings Release, U.S. Bancorp Investor News, July 16 2014 []