Falling Revenues, Rising Loan Provisions And Elevated Expenses Drag Down U.S. Bancorp’s Q1 Results

U.S. Bancorp’s (NYSE:USB) results for Q1 2016, reported on Wednesday (April 20), reiterated the same tell-tale signs of weak market conditions that its larger peers have detailed over recent weeks. ((U.S. Bancorp Reports First Quarter 2016 Earnings, U.S. Bancorp Press Releases, Apr 20 2016)) Net interest margins remained under pressure, mortgage banking revenues fell due to lower production volumes, and the bank added to its loan reserves to compensate for increased credit risk on energy loans. To make things worse, non-interest expenses increased by more than 3% year-on-year to drag down quarterly pre-tax profits for the regional banking giant to well below the $2-billion level it was at over the previous three quarters.

However, it must be noted that the factors that hurt revenues this time around are all tied to macro-economic conditions, and have affected the entire industry. We believe that things should start improving for all banks in the second half of 2016. Also, operating expenses are seasonally high for the first quarter of the year due to elevated compensation expenses – a trend that was also demonstrated by U.S. Bancorp’s larger rival Wells Fargo (NYSE:WFC).

All things considered, U.S. Bancorp’s business model remains sound. It does not promise huge returns, but the low-risk, steady growth promise it delivers provides comfort to investors. We maintain a $46 price estimate for U.S. Bancorp’s stock, which is about 10% ahead of the current market price.

See our complete analysis for U.S. Bancorp

U.S. Bancorp’s Interest Income Upbeat Despite Continued Pressure On Interest Margin

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 over the last couple of years has been the sequential decline in its net interest margin (NIM). The extended low interest-rate environment has dried up safe investment options with reasonably high rates of return – squeezing margins. Although the NIM figure nudged up slightly over the second half of 2015, it remained level at 3.06% in Q1 2016.

However, U.S. Bancorp has been able to mitigate the impact of declining NIM figures on its top line to a great extent through steady growth in its loan portfolio. The chart below captures U.S. Bancorp’s reported NIM as well as net interest income figures for each quarter since early 2011:

As seen here, the bank’s NIM fell from 3.70% to an all-time low of 3.03% between Q1 2011 and Q2 2015, before recovering marginally to 3.06% now. At the same time, loan growth ensured an overall trend of rising interest income for U.S. Bancorp over recent years. Although benefits of the Fed’s first rate hike last December have yet to reflect in the NIM figure, things should change in the near future. Subsequent rate hikes will only add to the interest spread for the bank in the long run.

You can understand the partial impact of falling net interest margins on the bank’s total value by making changes to the chart below, which represents U.S. Bancorp’s NIM on credit card loans.

Steady Loan Growth Remains The Primary Source Of Strength

U.S. Bancorp reported $264.5 billion in total loans at the end of Q1 2016 – a 7.8% improvement over the figure a year ago and 1.4% growth sequentially. The sequential growth figure is also significant here, as loan portfolio for banks tends to shrink in the first quarter as many people use bonuses and tax refunds received over the period to reduce their debt burdens – especially card loans. The rapid growth in the bank’s commercial lending portfolio is particularly impressive, as it has swelled to over $91 billion now from under $83 billion a year ago – a 10% jump year-on-year. The retail loan portfolio also grew by over 10% compared to the year ago period thanks to continued strength in the auto lending industry.

As most bank loans employ a floating interest rate, the rapidly growing loan base positions U.S. Bancorp for huge potential gains once the interest rate environment improves in the future.

Depressed Mortgage Banking Activity Continues To Hurt

U.S. Bancorp was one of the few banks in the country that increased its focus on the mortgage industry after the economic downturn of 2008. The strategy paid off for the regional banking giant over subsequent years, as the mortgage refinancing wave of 2011-2012 drove its revenues to record levels. U.S. Bancorp originated $21 billion in mortgages (fresh as well as refinanced) on average in each quarter over the Q1 2012 – Q1 2013 period. But with refinances dying out and with the demand for new mortgages not growing appreciably over 2013-2014, origination volumes sunk to a low of $6.2 billion in Q1 2014 – the lowest level since early 2007.

While things have improved since then, the mortgage industry has seen notable fluctuations in origination volumes between quarters. Origination volumes have fallen for two consecutive periods now to under $11 billion in Q1 2016. There are hints of possible improvement in this figure for the next quarter, though, as the pipeline of fresh mortgage applications improved in Q1 after shrinking for each of the last three quarters. The bank received applications for $16.7 billion new mortgages in Q1 2016 compared to less than $14 billion in the previous quarter. What remains to be seen is whether the trend continues over coming quarters, or reverses again – as mortgage production volumes are expected to be driven almost entirely by fresh mortgages as the Fed slowly hikes benchmark interest rates.

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