U.S. Bancorp (USB) Earnings Call Transcript & Summary

Good morning, and thanks for joining us at the Morgan Stanley Virtual Financials Conference. I'm pleased to have with me this morning, Andy Cecere, Chairman, President and CEO of U.S. Bancorp; and Terry Dolan, Vice Chair and CFO of U.S. Bancorp. Andy and Terry, thanks for joining me.

Thanks, Betsy. Good morning.

So I have a disclosure to read and then we'll get into it. For important disclosures, please see Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley sales rep.

So Andy, again, thanks for joining us this morning. I wanted to just see if you wanted to open up with a few comments. I know you recently had an announcement about rebuilding Minneapolis, and maybe you could give us a sense as to what you're hoping to do there.

Yes, Betsy. Good morning, everyone, and thanks for asking. The George Floyd tragedy certainly shone a light on Minneapolis as well as the issues that we're all trying to address from a society standpoint. And we announced earlier this week that -- a couple of important components. One is that -- and probably most importantly, we're going to rebuild the branches that were damaged or destroyed in both North and South Minneapolis, which was the sort of focal point of some of the activity 2 weeks ago. And that's important because the communities need the banking services from a job standpoint and from a financial education, it's hugely important so we've committed to that. We committed to $15 million in community grants focused on economic and racial inequalities. We're going to ensure that we have $100 million annually in available capital to the African-American-owned businesses and as well as community development on financial institutions for affordable housing. And finally, we, like many others, are very focused on advancement opportunities for people of color in our organization. So it's calmed down a bit. I think there's a tremendous focus on trying to close some of the gaps. And what's great about what's happening is the banking community and really, the business community is coming together to try to come up with solutions and I think it's a positive step in the right direction. So thanks for asking.

Okay. Appreciate it. All right. Let's flip to just outlook for the quarter. Wondering if you had any updates. I know you give a lot of guidance on a Q-on-Q basis. Maybe you could tell us how you're thinking about the outlook for 2Q now.

Yes. Thanks, Betsy. So let me start with net interest income, which we expect to be relatively stable relative to the first quarter, maybe down a little bit depending upon how loan mix plays out over the rest of the quarter during June. Our net interest margin will be lower in the second quarter versus the first quarter, so on a linked-quarter basis, it will be down. And it will be down about 15 basis points because of decisions that we've made related to maintaining higher levels of liquidity because of the extent of deposit inflows that we have seen during the first quarter. It'll also be down during the quarter, in addition to that, because of the yield curve being down pretty substantially since kind of the mid-first quarter and then just loan mix and deposit repricing, which will help to offset that a bit. So for the quarter, we expect it to be down relative to the first quarter by about 30 basis points. Now while the net interest margin is going to be down, we do think -- in the second quarter, we do think it's going to be stable as we think about the third quarter and into the rest of the year. Again, while net interest margin is going to decline in the second quarter, our net interest income is going to be relatively stable, maybe down just a little bit. From a fee income standpoint, mortgage banking and capital markets revenues were strong in the first quarter and that momentum continues into the second quarter. In payments, we now expect merchant acquiring revenue to be down 35% to 40% on a year-over-year basis in the second quarter. We expect credit card revenue to be down 25% to 30% on a year-over-year basis. And we expect our commercial payments revenues to be down about 40% on a year-over-year basis. One of the things we are seeing in terms of sales volumes, though, while they were down pretty significantly at the end of March, they have been improving in May and June. We were starting to see a steady continued improvement as the economy continues to get strong and open up. From an expense standpoint, we're closely managing expenses, and we expect expenses to be relatively flat on a linked-quarter basis. If you recall, we had COVID-related expenses included in the first quarter results, and we would expect to have COVID-related expenses in the second quarter as well. In terms of the allowance and the reserve build, we do expect to continue to build our reserve in the second quarter. At the end of the first quarter, as we discussed during our earnings call, we had assumed that unemployment rates would be kind of in the high single digits in the second quarter at that time. And obviously, since that time, forecasts for the unemployment picture have deteriorated fairly significantly. In April, it looked like unemployment rates would be in kind of the high teen level. And the most recent data, while it's been improving, would still suggest that the unemployment rate is going to be kind of in that lower to mid-teens for the second quarter. And so because of that, we're going to see an increase in the reserve. We always make that assessment at the end of the quarter based upon the information we know that there's a lot of uncertainties that continue to exist regarding the duration and the employment forecast, et cetera, et cetera. So more to come with respect to that and we'll continue to keep people updated. From a tax rate perspective, on a full year basis, we would expect our tax rate now to be about 15% to 16%, and that's on a taxable equivalent basis. So those are our updates for the quarter.

Okay. Just to make sure, a couple of points I had a few questions come in. On the reserve, you're going to raise the -- increase the allowance. I guess I'm wondering, are you saying the reserve build in 2Q will be higher than the reserve build in 1Q?

Yes.

Yes, the reserve build in the second quarter will be higher than the reserve build in the first quarter and is primarily driven by how economic outlooks have changed since late March.

Okay. And then on the NIM, you're saying that NIM will be down 30 basis points Q-on-Q?

Yes. On a linked-quarter basis, it's going to be down 30 basis points. And then our expectation for the third quarter is that it will be relatively stable from the second quarter on.

Got it. Okay. And then when we're talking about the outlook for NII going forward, that's really going to be a function of deposit growth. And is that the main driver?

Yes, it will be driven by the balance sheet dynamics and primarily in terms of how earning asset growth ends up playing out over the course of the second half of the year, both loan and investment portfolio.

We've seen PPP loans come in, obviously and been getting the question in other sessions about how those PPP loans are likely to flow through the balance sheet obviously providing some initial boost when they get forgiven to NII. Is that -- could you give us a sense as to whether or not that's important for you and your outlook here on NII?

So Betsy, this is Andy. I'll start with the big-picture facts, and Terry will talk about how we expect it to flow through the income statement. So as of today, we're at about $7 billion, about 92,000 loans and our average loan size is about $77,000. So while there's still some application volume coming in, it's slowed a fair bit. And as you know, the program is expected to end on June 30. So we're going to take some more applications in, but that's what we have thus far. And then from an accounting standpoint, Terry, why don't you talk about how that will work?

Yes. So from an accounting perspective, it obviously is going to flow through net interest income in terms of the recognition of both the spread as well as the fees associated with it. What we would expect to see kind of in the second quarter, maybe from a loan perspective overall, is we had some significant drawdowns at the end of the first quarter, and that lift will continue on primarily in the C&I portfolio through the second quarter. But one of the things we are seeing in May and June, as the capital markets have started to open up, is those C&I loans that were drawn down primarily on a defensive sort of basis by investment-grade sort of companies. As the capital markets have opened up, they have been paying down those loans. What we would expect in the second quarter is the PPP loans will substantially kind of offset that impact. We would expect a little bit of lift going into the third quarter with respect to PPP. But in terms of the kind of the timing of those PPP loans, we are currently kind of forecasting that they will run off by the end of the fourth quarter principally. I mean obviously, there's a tail on it but we'll see some significant paydowns or forgiveness in the third and fourth quarter.

Got it. Okay. All right. Andy, maybe we could talk a little bit about how you've been managing the line in this work-from-home environment, COVID crisis environment. You have a budget at the beginning of the year. This happens. Do you throw it out the window? Do you rewrite it? Do you change the top line goals? Maybe give us a sense as to how you're managing your team.

Yes. Betsy, let me take a step back. So this is certainly an unusual and challenging time for the industry, but we've been through this before. And our core strengths, which are around financial discipline, credit underwriting and business mix, are really shining through in this as we talked about. Terry talked about the fee income. While we have some areas of a little bit of weakness, we have capital markets and mortgages doing well. So this mix of businesses and diversification of revenue is really helpful. That, coupled with what I think are some of the new things since the last crisis, we built out our compliance and risk management systems much stronger than they were back in 2009 and '10. And probably most importantly, our digital capabilities are much stronger. So what we're focused on is managing what we can from an expense standpoint. We're very focused on sort of what I'll call all the blocking and tackling, T&E and prioritization of investment spend. But we're continuing to invest in digital. And I think the opportunities to continue to focus on activity around digital transaction, servicing and account openings will continue to be a big component of this. And at a high level, branches are still important, and they will continue to be a component of the way we deliver our services. But what's happening is consumer behaviors are changing, and they're changing more rapidly with the virus and I think they'll continue to be that way. So while branches still have a role, because of customer preferences and the digital capabilities, I think we'll have more of an accelerated branch closure. And what occurs in a branch will be much more advice and counsel-based versus transaction-based, which will allow for some expense opportunity as well. And then finally, as Terry talked about, we are just very actively servicing our customers' needs. Loan activity was strong. Deposits are very strong, as we talked about, and across all our fee businesses, we're, again, meeting the customer needs.

I think you've talked in the past around branch consolidation of 10% to 15%. So you're saying you could do more than that at this stage?

Yes. I think we can. So again, they'll still -- the branches will still be out there. They'll still have a role for sure. And activities will occur there. But there'll be different activities, less transaction-based and more advice-based. And because of that, the size of the branches and the number of branches will just be less than what we would have needed in the past.

Got it. What about on Commercial Real Estate that you hold for headquarters, processing operations, that kind of thing? Is there opportunity there as well?

Yes. We're going through an analysis on that right now. I think we're calling it sort of our second scenario, which is how will we look like when the new normal -- when we come back. And I do expect that we'll have more jobs that will be more flexible in nature, in other words, a hybrid of work-from-home as well as office, which will allow for a reduced office space across the board. That's from both a front-line perspective, a backroom perspective and an operational perspective. So I think that does present an opportunity.

Got it. Okay. And then what about just bigger picture or strategic opportunities? These kinds of environments can open up opportunities to expand footprint or product, and wondering if this is something that you would take advantage of. Is there any need that you see or desire that you have for expanding your footprint or product that you're watching for?

Well, it's a good question. So in a few weeks, we're actually going to close on our State Farm strategic alliance, which is an example of expanding our footprint. We're going to acquire some loans and deposits, but importantly, it allows us to have an alliance with State Farm. They have 19,000 agents. We have great digital banking capabilities, and the opportunity is to expand our capabilities to those customers from a digital banking perspective. So that's an example of expanding our footprint through an alliance, and I think we'll look for more of those. I think from a traditional M&A standpoint, this part of the cycle is a little challenging because there's a lot of uncertainty in terms of credit and exactly how quickly things will return back to normal. So if opportunities will come up, we'll take a look at them but they have to be material. They have to be substantial in terms of changing our direction. And they have to fit into our both risk dynamics as well as our capabilities. And so it's something we'll look at, but I think we'll look at it very carefully, given where we are in the cycle.

Yes. My question on State Farm was, does it answer your strategy to be national in Consumer and Business Banking? Is that -- does it get you to where you think you need to be?

I think it's very much in line with our strategy to expand beyond our traditional footprint, which just gives us the opportunity to do. So in some ways, it's getting to that national footprint. But yes, it allows us to expand using our core capabilities partnered with State Farm's great relationships.

And then you have also the strategy that you're working on, which is to start -- launch branches in new locations. I think Charlotte is an example of that for you. Would you continue to do that? And how does that kind of overlap with the State Farm footprint? Through that combination, could you have both State Farm relationships as well as USB branch proper relationships?

Short answer is yes, Betsy. We're going to continue to focus on that. Charlotte was our first entrance. We're calling it the digital-first, branch-light strategy where we have maybe 10 or a dozen branches in some major metropolitan areas where we have a presence and also already a customer base and employees. Charlotte was the first. It's probably slowed a little bit because of what's happened in the -- with the virus and some of the other activities, but that's still an area of emphasis and focus for us.

Okay. Maybe we can switch gears and talk a little bit about what you're hearing and seeing from your customers. What are your borrowing or payments customers asking for? Let's start with just on the commercial side, your corporate clients. There is some at-risk industries that you outlined in the 1Q earnings release. And how are you working with these institutions?

Yes. So Betsy, obviously, when you think about this particular situation, there are certain industries that are being more affected than others. And I would say, in general, small businesses are being more impacted or struggling more than some of the larger companies, at least in terms of what we're seeing today. When you think about the at-risk, some of those were struggling before, to some extent, in terms of the industry, simply because of structural changes that were occurring and they were being impacted by the transition to digital, et cetera. When you think about the energy or the retail sectors, those were already being impacted, and I think that the health care crisis has accelerated some of those issues that they're facing. And then you have other industries where you think about the entertainment or lodging, et cetera, those are clearly impacted. We're continuing to work with them. About 5% of customers overall in the corporate side of the equation have had some form of forbearance. That is more heavily weighted to small businesses. So from a small business perspective, about 11% of customers have asked for some form of forbearance, and we'll have to kind of see how that ends up playing out. If you think about Commercial Real Estate, Commercial Real Estate is more stressed in areas where -- or industries like lodging or retail. And the impact of the stimulus program, the duration of the health care crisis, all those things are going to kind of come into play with respect to the customer base. What I would say is that when you think about our portfolio, whether it's -- let's take Commercial Real Estate as an example. For the last 2 years or so, we have actually seen fairly flat growth in Commercial Real Estate, and that's because from an underwriting perspective, we have continued to be very focused and very strong, knowing that at some particular point in time, a recession was going to come. Now in addition, if you end up looking at the loans to value that we have in our portfolio, it's about 60%. So we feel like we're in a pretty good position with respect to Commercial Real Estate. Our corporate customers are generally strong, middle-market, investment-grade sort of companies. And we think that they have both the financial resources and the liquidity in order to be able to sustain through this cycle. But it's going to -- they clearly are going to be stressed. And maybe just as a reminder, the at-risk industries represented about 11% of our overall portfolio in terms of commitments. So we believe that, that's going to be manageable as we go through the crisis.

And then, Betsy,this is Andy. On the consumer side, maybe I'll give you the high level there. So about 7.5% of our mortgage loans are in some sort of forbearance. But it's slowing. The amount of new activity there is slowing from where it had been in the months of April and early May. And only about 1% of our credit card loans are on deferral. And importantly, on both these forbearance and deferral, still about 30% of customers are actively paying. So I think the stress levels are slowing and we're seeing some slight improvement in the overall trends.

Okay. I guess the other question I have here on the consumer side is how are you seeing spend? Obviously, you've got a big card business and platform. Maybe give us some color on what you're seeing there, different types of spend as well as geographies, open versus closed.

Yes. And maybe kind of playing off of spend a little bit in terms of loan balances or maybe what we're seeing on the consumer side. Clearly, the credit card balances are down a bit and that's tied to the fact that the consumer spend is lower. But we're also seeing, on the auto side of the equation, some strengthening occurring here now in May as some of the markets have been opening up. Coming back to your question with respect to spend patterns. Again, maybe it's helpful, I'll talk about our payments business and kind of the 3 components. And as a reminder, merchant represents about 7% of our overall revenues. Credit card and debit card revenue represents about 6% from a fee-based perspective, and then CPS represents about 3% of our revenues. At the end of April -- or excuse me, at the end of March, merchant was actually down about 50% to 60%. And now at the end of May and June, that's more like 30%. So it's actually continually and steadily gotten better during the May-June -- May and early June sort of time frame. In terms of credit card spend, that was down at the end of March by about 34%. And today, it's recovered to being down about 16%, so again, steady, continuous improvement. In terms of debit card spend, it was actually down about 16% at the end of March. And it's up, at this particular point in time, about 5%. So we've seen debit card spend being fairly robust, coming back. The last area I would just talk about is in the commercial payment space. At the end of March, that was down kind of in that 30% range. In the first week in June, it's down about 27%. So that hasn't recovered quite as fast, and we think it's companies continuing to manage their discretionary spend. And as consumer spend gets stronger, the corporate spend will start to get stronger. So we're actually feeling better today than we were certainly 90 days or 60 days ago.

Okay. And that corporate spend that you're seeing, that is -- is it skewed more to T&E or does that have a decent amount of supply chain in there as well?

Well, it's more skewed towards the T&E side of the equation. T&E and our CPS revenue represents about 21% overall. From a total company perspective, that represents less than 1% of the total company. So T&E spend impact is relatively insignificant to the company. But certainly, the CPS, it is impactful.

Okay. All right. Let's talk a little bit about how you're thinking around capital and capital sufficiency. You have a very strong capital level. And -- but I still do get questions from investors on how you're thinking about capital, given the upcoming CCAR stress test. The Fed's going to be running this COVID-19 through the baseline. Do you think that, that would impact what you think your baseline capital ratio should be when you consider the stress that we just went through or in the middle of really today?

So Betsy, we -- as you know, we had a CET1 ratio of 9% at the end of the first quarter. And our target is between 8.5% and 9% so we're at the high end of the range. And importantly, as you also know, we generate a significant amount of PPNR each quarter. So we have a strong earnings flow, which allows us to retain that capital level and still distribute. So as we sit today, we expect to continue to have the capacity to pay our dividend at the current level even under the stressful economic scenario we see playing out. So we'll wait to see what the Fed will show us on June 25, but that's our expectation.

Okay. And then as you think about the dividend going forward, just give us a sense as to with the kind of payout ratios that make sense for you. Because I feel like your payout ratio right now today is in a good spot, but people want to hear from you, not me.

Yes. So again, we're in an unusual time with these CECL charges and everything else that we've talked about occurring. But we already have our -- we've articulated and been paying out in total capital distribution of 60% to 80%, a little higher weight to dividends versus buybacks on a go-forward basis. And I think when we get back to the new normal, we'll be back in that range.

Okay. So the fact that the payout ratio might be a little higher now just because of CECL upfronting of the reserve build, that's a temporary thing and you can look through that as you think through dividend policy?

That's correct.

Yes.

Okay. All right. We had a few questions just coming in over the web and it's back on credit. The question that's come in is, we have CECL obviously today. We're making estimates for lifetime losses. How should we be thinking through the cadence of reserve build over this credit cycle? It's a brand-new thing, CECL. So should we be anticipating that 2Q could be the peak level here of reserve build? Or how do you feel investors should think through what you're anticipating here?

Yes. It's a great question. I think it's one of the things that the industry is struggling with as well, but it does tend to front-end load the recognition of the losses in terms of a reserve build. We do expect again, that in the second quarter that we are going to see an increase in the reserve build relative to the first quarter. And it's primarily because the economic outlook getting worse. Our expectation at this particular point in time is that, that would be the peak of the reserve build based upon what the information that we have currently today. The question about future reserve build is a hard one to kind of get your arms around because of the fact that there are so many factors, so many variables and uncertainties that still exist. Those would be things like what is the duration of the higher levels of unemployment? What is the duration associated with the health care crisis? How effective is the stimulus package going to be? How does the forbearance play out? And you just -- there's so many different parts that are a part of the calculus, I guess, if you will, in terms of how you come up with it. But we do think the reserve build will be at its peak in the second quarter. And there may be reserve build in the future quarters but it's hard to know at this particular point in time.

One of the things that investors look at is the 2018/2019 bank run stress test scenarios to get a sense as to what you were anticipating for reserve build during other kinds of stress environments. How does this current environment stack up to, say, the 2018 or the 2019 stress test scenario? And is it a good way to think through the risk in the reserve? Or would you have a different point of view on that?

Well, this is Andy. As Terry said, you can use that as one of the guideposts or one of the components to inform your overall credit reserve, but this is different. The unemployment rates are higher, which is a negative, but the stimulus is more significant, which is a positive. And how those 2 things interplay is difficult to know. So that's why you use the models but you also have to use some judgment because these are different times. And the models, frankly, weren't constructed for this environment.

Right. So the efficacy of the fiscal comes through in your assessment of kind of the overlays that you put on to the model. Is that just how you're thinking through it?

Yes, that's exactly right, Betsy.

That's right, Betsy.

And then what about the forbearance side? We have a question coming in on how you think through the length of the forbearance that you're giving. How do you determine when to take it off and when those delinquencies start to show through in the accounting that we see?

So most of the forbearance is in the mortgage category. Those are 90 days at a time as customers' requests or issues from their perspective come up. They could be extended for up to 4 periods or 1 year, and that's the way the mortgage forbearance works. Repayment on the other end can be a set of different components. It could be a lump sum. It could be spread out over a year or over a longer time frame. These are added on to the end of the loan. So there's a lot of flexibility really taking into account customers' needs and the situation they're in. But on the mortgage side, to keep it simple, it can be up to a year.

And then the other asset classes like credit card or auto?

Credit card is in the 90 days category. And again, we address those 90 days at a time, but those are a little shorter in duration.

Right.

And so then since this is going to require a little bit more manpower to watch and assess these loans, how should we think about the expenses associated with that? Will we have kind of an uptick in expenses? Or is your view that you'll be able to manage that through what you discussed earlier with a more efficient brand structure and Commercial Real Estate peel back?

We will be able to manage through that. You're right, the collections staff as well as some of these folks dealing with the customers in forbearance are a little higher, but they're more than offset by other opportunities.

Okay. Well, thank you so much for your time this morning. That's it with questions from the web and we went through our list. So really appreciate your time, Andy and Terry, and I hope you have a good rest of your day.

Thanks, Betsy.

Thanks, Betty. Have a great day. See you.

All right. Take care. Bye.

Bye-bye.