U.S. Bancorp. (USB) — Q2 2015 Earnings Call Transcript

Thank you, Kalea, and good morning to everyone who has joined our call. Richard Davis, Kathy Rogers, Andy Cecere and Bill Parker are here with me today to review U.S. Bancorp's second quarter 2015 results and answer your questions. Richard and Kathy will be referencing a slide presentation during their prepared remarks. A copy of the slide presentation as well as our earnings release and supplemental analyst schedules are available on our website at usbank.com. I would like to remind you that any forward-looking statements made during today's call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on page two of today's presentation, in our press release, and in our Form 10-K and subsequent reports on file with the SEC. I will now turn the call over to Richard.

Thank you, Sean. Good morning everyone, and thank you for joining our call. I will begin with our review of U.S. Bank's results as a summary of the quarter's highlights are available on page three of the presentation. U.S. Bank reported net income of $1.5 billion for the second quarter of 2015, or a record $0.80 per diluted common share, a 2.6% increase year-over-year. Total average loans grew 4% year-over-year and 0.7% linked quarter, excluding student loans, which were reclassified to held for sale at the end of the first quarter. In addition, we continue to experience strong growth in total average deposits of 8.9% over the prior year and 2.6% linked quarter. Net new DDA account growth was especially strong this quarter, growing 4% annualized. Credit quality remains strong. Total net charge-offs decreased by 15.2% from the prior year and increased modestly from the previous quarter. The increase from the previous quarter is a result of lower recoveries. Total non-performing assets declined compared to both the prior year quarter and on a linked quarter basis. We continue to generate significant capital this quarter. Our common equity tier 1 capital ratio under the Basel III standardized approach as if fully implemented was 9.2% at June 30. I'm also pleased that we were able to return 76% of our earnings to shareholders in the second quarter through a combination of our dividend and the repurchase of 14 million shares of common stock. Slide four provides you with a five quarter history of our performance metrics, and they continue to be among the best in the industry. Return on average assets in the second quarter was 1.46%. Our return on average common equity was 14.3%. Moving over to the graph on the right, you can see that this quarter's net interest margin was 3.03%. Kathy will discuss the margin in more detail in a few minutes. Our efficiency ratio for the second quarter was 53.2%, lower than the prior quarter. We expect this ratio to remain in the low-50%s going forward as we continue to manage expenses in relation to revenue trends driven by the economic environment while continuing to invest in and grow our business. Turning to slide five, the company reported total net revenue in the second quarter of $5 billion, a 2.8% decline from the prior year. Excluding the prior year notable item, total net revenue increased 1.4%. The increase was due to the higher net interest income as well as strong growth in trust and investment management fees, merchant processing services and higher credit and debit card revenue, partially offset by lower mortgage banking revenue. I'm particularly pleased with the improving trends in our payments business, especially our merchant and credit card businesses, which Kathy will discuss in later detail.

Thanks, Richard. Slide eight gives you a view of our second quarter 2015 results versus comparable time periods. Our diluted EPS of $0.80 was 2.6% higher than the second quarter of 2014 and 5.3% higher than the prior quarter. The second quarter of 2014 included two previously disclosed notable items impacting other non-interest income and other non-interest expense that together had no impact on diluted EPS. The $12 million or 0.8% decrease in net income year-over-year was principally due to a reduction in net interest income related to the previously discussed wind-down of our checking account advance product that ended in the second quarter 2014, lower mortgage banking revenue primarily due to an unfavorable change in the valuation of mortgage servicing rights net of hedging activities, and an expected increase in non-interest expense excluding the prior year notable items. Partially offsetting these variances was a decline in the provision for credit losses. On a linked quarter basis, net income was higher by $52 million or 3.6% mainly due to increases in fee-based revenue. Turning to slide nine, net interest income increased year-over-year by $26 million or 0.9%. The increase was a result of growth in average earning assets of 9.1%, partially offset by lower net interest margin including lower loan fees. Approximately $40 million of the reduction in loan fees was due to the checking account advance product wind-down. The net interest margin of 3.03% was 24 basis points lower than the second quarter of 2014. The decline was primarily due to growth in the investment portfolio at lower average rates, as well as lower reinvestment rates on investment securities, lower loan fees due to the checking account advance product wind-down, lower rates on new loans and a change in loan portfolio mix, partially offset by lower funding costs. Net interest income was higher linked quarter principally due to an additional day in the current quarter relative to the prior quarter with higher average earning assets, offset by a lower net interest margin. The net interest margin of 3.03% was 5 basis points lower than the first quarter. The reduction in the net interest margin was principally due to continued change in loan portfolio mix, the impact of higher cash balances as a result of continued deposit growth along with growth in lower rate investment securities and lower investment portfolio reinvestment rates. We expect that the net interest margin will be relatively stable in the third quarter.

Thank you, Kathy. I'm very proud of our second quarter results. We delivered solid financial performance in a challenging operating environment for financial institutions. We continued to achieve industry-leading performance measures. Because of the overall strength and consistency of our results, we returned 76% of our earnings to shareholders through dividends and share buybacks in the second quarter. As we move to the second half of 2015, I'm confident we will continue to deliver solid financial results. We'll continue to take the appropriate and effective actions including tighter expense management to ensure that we are meeting our value creation objectives for our customers and for our shareholders. That concludes our formal remarks. Andy, Kathy, Bill and I would now be happy to answer your questions.

Just a question on your last comment, Richard, you used the term tighter on expense management. Does that mean you're a little less optimistic on the revenue outlook or is it just basically a similar approach? Has anything changed?

Well, yeah, I'm actually more optimistic on the revenue for the second half because things have turned the corner and I think you'll see, with NIM flattening out, with loan growth now, as I'm committing to well, at the 1% or higher because I can see already see that for quarter three, and the knowledge that our mortgages business is – the balance sheet is growing again, I think we are feeling quite good about revenue. What I'm still waiting for is the interest rate impact that would occur if the Fed increases rates. So if they don't, we're going to continue to keep in place this FTE hold we've had now for, as Kathy said, a year-and-a-half. That's worth, by the way, thousands of FTE that we haven't added and therefore we haven't had to talk about reducing either. And then all the discretionary things that we continue to do to keep ourselves at the efficiency level you come to expect. So revenues actually got a nice trajectory in the second half. Expenses will come down as we watch our nickels and dimes, but I will tell you the cost of compliance has erased a lot of the benefits I would otherwise hope to have gotten a year-and-a-half ago when we started this as we've continued to add the compliance personnel, audit personnel, and not just in those areas but in the front line where we have that same compliance responsibility that's gone up substantially. But expenses we'll continue to watch, Jon, like I promised. And I've always said that if we have to be more draconian, we will, but the FTE hold and watching our vacancies and things has served us pretty well so far.

Okay. Good. And then I guess one of the items you singled out in growth was the corporate business, and that seems to have been driving the growth. Talk to us a little bit about what's going on there; is this large corporate driving it? Or is it broader based?

Yeah, it's way broader based. So in fact, much as I like the 2.1% linked quarter in C&I, that's one of our lowest quarters in the last six quarters and I'm actually kind of satisfied with that because we're now getting competing growth from the retail consumer side, which is what we've been long waiting for and that's why, one of our reasons we can say that the margin will start to flatten out because the mix will start to be balanced. So commercial business, the bond markets are driving balance reductions, because people are driving to the bond market, and so to still get 2.1% linked quarter means we're doing real business for real customers that have other needs that aren't just M&A related. We also see that more opportunity for us in the fee business given our involvement in that M&A market on the capital market side, which we didn't have, as you know, a few years ago. So that's a kind of twofer for us; if we can't get it in loan growth, we'll get it in fees. Syndication loan market is really strong. If you notice, we were in the top four on the investment grade league table this quarter. It's our first time we've broken into the top four, so we're seeing that as a business for us that's starting to pay dividends that we invested in a few years ago. So C&I is strong.

Good Morning, guys. Let's see, Richard or Kathy, I was hoping you could add a little to your response on the expense side in Jon's question there a second ago.

Yeah. So I'm going to call it more flattish. It's going to be close to what you see now, if anything – it's not coming down, so let's put it that way. But I don't see any material increases either. What's happening here is the cost of compliance is at its high watermark. As you know, we are a part of that mortgage foreclosure activity that we've extended and that's going to continue to cost us and we will continue to add compliance and audit in virtually every part of the company. So that's in there. Things that will come down to offset those headwinds are continued discretionary expense control that we just never talk about here. I mean we don't have a name for it. We don't bring people to tell us how to do it. We've got a real heavy tight rein right now on discretionary expenses, marketing, travel, things that are less necessary. And from FTE being flat for a year and a half and still doing quite well to taking things like vacancies, extending vacancies, moving those up and being very prudent about how we manage the quality of our people. So I may have mentioned last time that we're also getting a pretty thorough review of our low performing employees in the company. Since FTE needs to be flat, you have your right to use your FTE but you better have the best you can. So I am encouraging people to improve the bottom performers and trade them out and get the best quality staff we can as this recovery is about to hit us. So we can keep all that in general check. With revenue moving up, that's going to help our efficiency for sure. But I don't want to leave with fact we're going to take expenses down but I think they're at a place that you can watch for and a slightly potential increase over the next couple of quarters only because of the cost of compliance if I can't out run it with vacancies.

Okay. And that's perfect. Thank you. And then maybe if I could switch gears for just a second, could you maybe expand upon the thoughts you had in your prepared remarks just in the payments businesses, just trying to distinguish how much of the better performance this quarter was the typical seasonal boost versus what I kind of interpret it as sort of a more – kind of more constructive commentary about how those businesses are going just...

Yeah. You heard it right. I'm going to give Kathy the detail, but I want to say, last quarter, the payments businesses weren't that robust. In part, by the way, it was the FX which is hard to describe. It sounds like an excuse, but in other companies, it's a real impact and then it affects us in this one category. But under a line, we saw everything get much stronger and we really like the second half for payments as we get into the second quarter's look-back now as it's improved from quarter one. But, Kathy, bring some color to that.

Yeah. I think, as Richard said, we were very pleased with what we saw in our momentum in the payments businesses. If you think about our merchant processing, I'll start there, I think that's one of our better stories right now. In the first quarter, if you take out the impact of FX, we grew about 5%. As we look into second quarter, that number grew to about 7.5%. Same-store sales were kind of in that in the North American market in about that 5.5% range. And I think that – so we are seeing some additional growth there that we think will continue as we look forward. Our credit and debit card fees were also, we saw momentum there. We've been talking about the fact that rewards costs have been a headwind for us and that was absolutely true. In the first quarter, as you recall, we had a year-over-year growth of 0.9%. This year, you will see that growth increasing. So that headwind is diminishing and as we get into the later quarters, I would expect to even see more improvement as that continues to diminish in the second half of the year. So we are very pleased with the momentum there and would expect to see some good signs of this as we look out into future quarters.

Good morning. Just on the margin. Wanted to see if you can give us a little bit of color on how you're thinking about the margin in coming quarters. Just given the competition on the loan front, could you still see similar mid-single digit compression over the next several quarters? Is that the best way to think about it?

John, I'm going to say I think we're starting to see the margin stabilize and I think that's coming from a couple of different reasons. As Richard mentioned earlier, we are starting to see a pickup in our loan growth on the retail side and that's going to help. As you recall, we've been calling out an impact of several basis points on a linked quarter basis related to the mix of our growth. So as retail starts to pick up, that's going to help us. Additionally, what we are seeing is that as loans and securities run off and we're replacing them with new, that spread between what's running off and coming on is starting to get a little closer together, so – or getting smaller. So that's going to help us as well. So I think, as I look out into the third quarter, I'm going to call that our net interest margin is going to be relatively stable.

Good morning. I had a follow-up question on cards. I've heard a lot of your comments on payments, particularly a lot of items affecting the fee income line, but I was hoping more – to focus a little bit more on the spread. And it looks like you've been seeing a pretty consistent reduction in year-over-year credit card loan growth over the last several quarters to most recently 1.3% this past quarter. That's a little bit slower relative to the rest of the industry. I was hoping you could just talk a little bit about what – give a little color around what's driving that and what you anticipate going forward.

Let's have Andy give you a brief color on that.

Sure, Bill. On a quarterly basis, it's down principally due to seasonality, so that is not uncommon from quarter one to quarter two to be down; on a year-over-year basis, it's about 2%. Part of the factor that is impacting that is auto sales, and spend is up closer to 5%, 5.5%. People are paying down more of their balances with perhaps some of the excess they're getting from the fuel side of the equation, so we're seeing pay it down rates being higher, revolve rates being lower, even though sales are up.

I had a follow-up question on cards. I've heard a lot of your comments on payments, particularly a lot of items affecting the fee income line, but I was hoping more – to focus a little bit more on the spread. And it looks like you've been seeing a pretty consistent reduction in year-over-year credit card loan growth over the last several quarters to most recently 1.3% this past quarter. That's a little bit slower relative to the rest of the industry. I was hoping you could just talk a little bit about what – give a little color around what's driving that and what you anticipate going forward.

Yeah. So as you stated, we had a really good quarter from a year-over-year basis. We grew our app volume about 35%. As we look forward into quarter three, I do think that we'll probably see a decline in our refi balances. So I would expect as we look into quarter three, on a linked quarter basis, our application volumes will be probably down a little bit. I would say from a fee standpoint, we may be – our fee income might be modestly lower than what it is this quarter, but it's very early in the quarter. It's going to depend a lot on what we see in the rate – with the rate market and the appetite for purchases. So we'll give you a little bit of – more heads up on that as we go further into the quarter.

Yeah. Ken. This is Richard. The applications up 34% in quarter two will show through in quarter three as bookings in some measure so quarter three has a lot to do with paying off quarter two. Quarter three, I think, will be a tale of interesting to watch because we will see what happens as rates start to move or the threat of rates start to move and more on the psychology of the consumer behavior. But I thought you'd find this interesting. I was, a couple of weeks ago, in California with our homebuilder business. They were there for our national conference and we had a large gathering. And I asked them, what interest rate level in terms of a mortgage rate would cause them to worry about the impact of future homebuilding? And they all were comfortable that 200 basis points doesn't move anybody's needle on either the affordability or the belief that they could still get into a home that they want. And that's a pretty nice range of safety for a while because I don't think any of us think rates whenever they do move up are going to move 200 basis points real quick. So that provides me a little confidence that the purchase market by those who actually build and live off of it is feeling pretty strong and they're not typically worried at this stage of rates moving up if they don't move more than 200 basis points. Refi is just typically what you see in the vagaries of whether people still haven't refi'd yet or whether they have a reason to take advantage of a rate they didn't heretofore. So we will learn more. I think this quarter three will tell a big story and probably a month from now, we'll have a really good sense of what the mortgage business looks like, but it's a little early now.

Hi. Thanks. A couple of questions. You had very strong growth in auto loans, just wanted to understand if you could give me how much of that is prime versus non-prime?

It is all prime, Vivek. We started a little initiative about a year-and-a-half ago to pursue the subprime, but the volume and the opportunity there was not sufficient, so we're no – we're completely a prime shop.

Okay. So if that's the case, how is the yield on that retail loans staying flat quarter-over-quarter, Andy, because prime is seeing a lot more competition from what we're hearing from everybody?

Yeah. Leasing is strong, lending is more pressured; and the net of the two is flattish.

And then, lastly, my question, Richard Davis versus the 10-year. Maybe, Richard, you're winning the recent round. I'm not sure. But what's the check on you're feeling about the growth of the U.S. economy? Are we stepping out, or is it kind of same as it's been?

Yeah. I think it's same as it has been, which is still slow but steady progress, right? So it's not going backwards. There's no inertia to jump it forward. My long philosophy is the minute it's known that rates are moving up whether they have to move or not, it starts to create a catalyst for people to take the action that they have heretofore been holding off on. And my hope is frankly that the consumer blinks first and starts consuming as they should and that incentivizes businesses to start investing and growing and that kind of cycle starts up again. So I'm still optimistic that we're making progress and everything's going in the right direction and I think I'm hopeful that the Fed sees it the same way and if they do, then rates start to move up. We benefit from the balance sheet being only half of our company's balance sheet, so we'll benefit just as much from the fee businesses as it relates to a stronger economy, so I'm optimistic.