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).

Good Non-Spread Results And Operating Leverage

Some of U.S. Bancorp’s more attractive features – solid non-spread income sources, careful cost management, good underwriting quality – played into the third quarter results and helped to drive a 6% beat on the pre-provision profit line. Core EPS were also stronger than expected, helped by lower than expected credit costs.

Revenue was up about 1% yoy and 4% qoq, which was good for a roughly 3% beat. Net interest income fell 2% yoy and rose 1% qoq, a small beat, and U.S. Bancorp was one of the relatively few banks so far to see NIM improvement, with NIM up 5bp (and 5bp better than expected) sequentially and down 35bp qoq. U.S. Bancorp was also unusual in seeing balance sheet shrinkage, with earning assets down 2% from the prior quarter.

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Fee-based income rose 4% yoy and 7% qoq on a core basis, beating by better than 5%. Card income rose 6% yoy and 37% qoq, while merchant processing fell 15% yoy but rebounded 30% qoq. Trust was flat sequentially, while mortgage banking declined 13% (but rose 99% yoy). Relative to other card companies, U.S. Bancorp was on the good end of volume declines at 5.4% (compared to Bank of America (BAC) at a 10% decline, Citi (C) at 9%, JPM at 5%, and Wells Fargo (WFC) also around 5%). On the merchant processing side, though, U.S. Bancorp’s greater skew to travel and hospitality is still having a negative impact, with business down 20% compared to the 7% growth at JPMorgan this quarter.

Operating expenses rose 7% yoy and 2% qoq, and although costs were a little higher than the published estimates, the higher revenue compensated, with underlying efficiency ratio about 70bp better. Pre-provision profits fell 7% yoy and rose 7% qoq, and with PPOP at almost 3.4% of loans, versus Truist (TFC) at 2.8% and PNC (PNC) at 2.7%, U.S. Bancorp is one of the most profitable banks in its weight class.

Loan Growth Remains A Serious Challenge, But Credit Is Holding Up

I didn’t expect robust loan growth from U.S. Bancorp this quarter, and I didn’t get. Loans rose 4% yoy and fell 1% qoq on an end-of-period basis and rose 6% yoy and fell 2% qoq on an average balance basis, with loans missing sell-side expectations by about 1%. Absent loan growth opportunities, U.S. Bancorp increased its securities balances by 6% qoq.

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C&I lending, which was down 10% qoq, was worse than the average large (top 20) bank this quarter, and worse than peers like JPMorgan, PNC, Truist, and so on. High corporate paydowns (with large corporations accessing public capital markets to replace bank debt) were the primary cause, but underlying demand is still weak as well. The 1.1% qoq decline in CRE lending was more sector-typical, while the nearly 7% qoq growth in mortgages was a standout on the positive side.

Loan yields held up better than most peers, declining just 2bp qoq, and I believe U.S. Bancorp is in the trough of the cycle – I don’t know if this will be the bottom, but I believe spreads are near the bottom.

Like Truist, I believe U.S. Bancorp is getting more aggressive with its deposit pricing as a way of managing excess liquidity and preserving spreads. Deposits were up 1% qoq on an average balance basis, but non-interest-bearing deposits increased 15%, helping drive deposit costs even lower.

There really weren’t many surprises on the credit side. I thought there might be a little more reserve-building, and U.S. Bancorp did add another $120 million, bringing its reserve ratio up to 2.6%. Provisioning was still about 10% lower than expected, though. While non-performing loans rose 10% qoq, delinquency trends look pretty good overall and the charge-off ratio, while up 18bp yoy and 11bp qoq, was as expected.

The Outlook

With few options to stimulate revenue growth, U.S. Bancorp management is focusing even more attention on costs through accelerated and expanded branch closures. Adding another 15% of its branches to the chopping block, U.S. Bancorp is now looking to close about 25% of its branches from the spring 2019 starting point. Many of the branches closed were already closed due to COVID-19, and management has seen significant increases in digital engagement (customers using digital services) during the pandemic. With more customers becoming more comfortable with digital banking, U.S. Bancorp is taking advantage by stripping out even more physical costs.

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Although I do still believe M&A figures into U.S. Bancorp’s future, I don’t have reason to believe that a deal is imminent. Government stimulus has helped most banks bridge this credit cycle, and with valuations near historical lows, I don’t think there are many eager sellers at prevailing prices.

I’m still expecting U.S. Bancorp to generate long-term core earnings growth around 2.5% annualized, with double-digit recovery growth in 2022/23 eventually slowing into the mid-single-digits. I’m also still expecting low double-digit ROTCEs in both 2020 and 2021.

The Bottom Line

U.S. Bancorp looks a little pricey on ROTCE-driven P/TBV, but that’s not historically unusual for the bank. On discounted core earnings, the shares do still look undervalued, with a double-digit annualized prospective return. Given outperformance from some peers on a year-to-date basis, U.S. Bancorp’s relative valuation is looking a little better, and the accelerated cost cuts should improve the relative growth over the next couple of years. U.S. Bancorp is still not my favorite pick in the group, but it’s certainly a name worth some consideration.

Disclosure: I am/we are long JPM, TFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.