US Bancorp, Inc. (USB) RBC Capital Markets Global Financial Institutions Conference Call Transcript

US Bancorp, Inc. (NYSE:USB) RBC Capital Markets Global Financial Institutions Conference March 7, 2023 10:00 AM ET

Company Participants

Terrance Dolan - CFO

Shailesh Kotwal - Vice Chairman, Payment Services

Conference Call Participants

Gerard Cassidy - RBC Capital Markets

Gerard Cassidy

Started with our second fireside chat today with the management of U.S. Bancorp. As many of you know, U.S. Bancorp recently completed the Union Bank acquisition. And as a result, it currently has about $675 billion in assets, market cap of over $72 billion. And on a price to adjusted book value, when you add back the AOCI, we calculate price to book is about 1.3x, price to tangible is 1.9. And it trades on a forward P/E basis of 9.4x.

I know many of you know the gentleman to my far left, Terry Dolan. As you know, he's Vice Chair and Chief Financial Officer for U.S. Bancorp. He became CFO back in 2016. And he's been very active with the bank for many years of his career.

To my left is Shailesh Kotwal. Shailesh joined U.S. Bancorp in 2015, and he leads the U.S. Bancorp Payment Services, which we know is one of the unique parts of the U.S. Bancorp story is the payments business that many of your peers don't have.

Question-and-Answer Session

Q - Gerard Cassidy

But to kick it off, I'll start with Terry. And maybe, Terry, you can share with us what are your broader views on the macro economy? And what do you think about what's happening? Are we heading into a recession or a soft landing? We just had David Solomon on before you. He's thinking may be more of a soft landing than he was 6 months ago. What are your thoughts?

Terrance Dolan

Yes. Maybe just kind of very broadly, if you think about at the end of 2022, inflation was starting to moderate and all sorts of things. I think there's a few surprises kind of in the January, February time frame with respect to a number of the different indicators.

And so I think what that tells you is that inflation is just something that's very stubborn. And as a result of that, I think from a Fed policy perspective, being sufficiently restrictive, I think that's going to be their mantra for a while. What that tells us is that maybe in terms of our base case, from an interest rate perspective, we would expect rates to probably continue to move up in the near term, closer to that 550 sort of range and then probably stay there for a while before starting to come down.

I think kind of earlier this year, there was an expectation that we'd move into a recession and rates would start to drop at the end of 2023. And I think that while we would still expect the recession probably to occur, I would say it's -- soft landing is not a bad way of describing it. It's a mild sort of recession, probably at best a moderate recession.

But the timing of that is something that I think we're continuing to kind of push out a little bit. If it does occur, probably late 2023, early 2024 kind of in that time frame. So that would be kind of a couple of different things. The other things that I would just say maybe from a macro perspective, and Shailesh will talk a little bit about this is, is that consumer spend continues to, I think, be pretty healthy.

While I would -- I think our expectation is during the year that, that continues to moderate. And that will moderate for a couple of different reasons, one of which is that consumers have been spending a lot of their excess savings relative to pre-COVID. Savings still continue to be at a level, on average, higher than what we saw pre-pandemic, and they continue to kind of spend that down. So consumers, they're fairly bullish with respect to their spending.

I think the other thing that we're seeing in terms of excess savings coming down is that some of the revolve rates are starting to move up, and that will help on the credit card side of the equation. But I do think that there's probably a recession. There's certainly, I would say, and what we have been talking about is the fact that there's just a lot of uncertainty out there, Gerard, and we need to be prepared for whatever comes our way.

Gerard Cassidy

Yes. Maybe taking it down to U.S. Bancorp, where kind of a few weeks left in the first quarter. Could you provide us an update with any first quarter '23 guidance? And also, any update for the full year '23 guidance?

Terrance Dolan

Yes. Let me kind of hit that right on. And I'll maybe start with really both of them. We're going to reiterate our guidance that we gave at the beginning of the first quarter, both for the first quarter as well as for the full year. So no change to either of that. And I'd refer you back to the guidance that we had in the presentation that we did back in January.

But for the first quarter, specifically, that guidance fundamentally said earnings -- or excuse me, earning assets in that 605 to 610 range, in terms of -- $605 billion to $610 billion. The margin expanding 5 to 10 basis points. Revenue in the $7.1 billion to $7.3 billion range. Core expenses at 43 to 44, and then merger and integration costs of somewhere between $200 million and $250 million. So essentially all unchanged.

Gerard Cassidy

And speaking of the merger costs, maybe you can give us an update on how the Union Bank deal is progressing. Obviously, you closed the deal in December. The big day is Memorial Day weekend for the conversion, which is coming up, obviously. Any surprises at this point from the acquisition? Or any additional color you can provide?

Terrance Dolan

Yes. No surprises. I mean I think it's -- the integration process is progressing as we would have expected. Everything is on track. As you say Memorial Day weekend, is the large system conversion that we'll go through.

But we're making good progress on a lot of different fronts. Our employee systems were all integrated already. We did that right away in December and January. So we're making decisions with respect to employees and leadership adjustments and some of those sorts of things that are all pretty much on track.

We needed to close -- or excuse me, sell 3 branches as part of the DOJ order. We've done that. And we're in the process of starting the communications with respect to branch consolidations. There are a lot of branches that are within kind of a 1-mile radius. And so we'll be making -- we are making decisions and we'll be making announcements related to that soon.

And that things like our credit card, sales origination, our mortgage origination, those are already going through our U.S. Bank platforms. So everything is very much on track. The cost synergy, estimates, that we have articulated are still on track and the integration itself is progressing very well.

Gerard Cassidy

Maybe answer this question. U.S. Bancorp over the years has done a number of transactions, obviously, with Union being the most recent. And it also, I think, took the longest to get the approval. What's your view on just the whole process when you just went through with Union versus your memory of the prior deals seemingly to go quicker?

Terrance Dolan

Yes. Well, definitely, the regulatory approval process is elongated. And not only are we -- did we experience that, but I think others are going through it or have gone through it, have experienced it as well.

I think that in our situation, while a lot of what I would say, the regulatory processes were completed fairly early, they were waiting for Michael Barr to kind of get into his position and all sorts of things. I think the -- the challenge with that is that, especially in this sort of an environment when rates are moving up, as it puts more pressure with respect to capital management and things like that because of the mark-to-market that we experienced as part of that process. But it is what it is. You just kind of manage through it.

Gerard Cassidy

Yes. Yes, very true. Coming back to the Union Bank deal. Obviously, you've created an extra level of protection with the marking to market of the loan book of Union Bank and the way the AOCL works with CECL accounting. Can you share with us some of your thoughts on that whole process and what you actually did?

Terrance Dolan

Yes. So as part of the closing, you go through the process of evaluating the portfolio. Of course, we did a lot of that in due diligence. And actually, the credit mark that we booked in December was a little bit less than what we had originally estimated.

For a couple of different reasons and maybe just kind of give you a little bit of background, we ended up selling any of the loans that were originated through the Lending Club kind of channel. We did that right away as part of the closing process. We also sold about $1 billion worth of commercial real estate and did a number of different balance sheet optimization, securitization, risk transfer sort of structures to move another about $4 billion worth of assets off the balance sheet.

So we did some things from a balance sheet positioning perspective to align the portfolios from a credit risk profile a little bit better. At closing, we ended up booking -- in terms of the reserve, we ended up building at about $819 million. So it's a little over 1.9% at the end of the year. So we think that, that's a good healthy reserve coverage, especially when you look at it relative to nonperforming assets and some of the other credit quality sort of metrics. So we feel pretty good about that.

As you know, in CECL, one of the things you end up having to do is you end up having to look at your performing loans and your nonperforming loans. We ended up booking a little over $170 million related to nonperforming type of assets. And then for performing assets, we booked another $646 million associated with that. Now the -- and part of the CECL processes that you book that reserve and then you have a little bit of a double count in the sense that you set up a credit discount, and that piece of it ends up accreting back in income over time.

So -- but overall, I would say that the portfolios are fairly consistent in terms of risk profile, and the reserve coverage is strong.

Gerard Cassidy

Interesting on the loans you sold at the time of the deal, you mentioned Lending Club. What kind of commercial real estate? Were they mortgages on retail or what, any...

Terrance Dolan

Yes. It was -- we ended up looking at different things in the portfolio. What we are most focused on is where did we have kind of overlap with respect to customers and from a hold perspective, we didn't want that to be too large. So as much of that as anything else.

Gerard Cassidy

Got it. Shailesh, maybe turning to you and, obviously, the business you run, Payments. As I mentioned, it's a real differentiator for U.S. Bancorp. It accounts for about 30% of annual revenue. Maybe -- can you give us an overview of the payments business?

Shailesh Kotwal

Yes, sure. So let me just kind of big picture that 30% that you talked about. Breaks up there are 4 compartments that make up the payments business. The first and the largest is our issuing business. RPS is what we call it, that's about 65% of our revenue.

RPS essentially is the debit and credit card issuing that most banks do for our own customers, but we also have the plastic co-brand business. In addition to that, there's also a business within our RPS where we issue credit cards for other financial institutions. That's a big piece of our business that's unique to us, that no other large institution has.

We distribute our products through 1,300 financial institutions, so that's a big asset for us. Second is our merchant-acquiring business that most people are familiar with, that's another differentiator versus our peer group. That's about 25% of our business. Merchant acquiring obviously, we help merchants of different categories except payments, classic debit, credit, et cetera. But we also have merchants accept ACH and eChecks and all other what we call a large area of adjacent payment products that provide merchants more holistic solutions. So that's helpful to our merchants.

But in addition to that, our merchant business also provides point-of-sale devices that are now becoming central to particularly at the small business, and we call it talech, I'll get into that in a little bit. But that's another area for our merchant acquiring business.

And then the third piece is our corporate payments business, which is about 10% of our revenue. Corporate payments, services, middle market, large market customers all the way to the federal government. Federal government is, in fact, our biggest customer actually all the way around to, we are the largest provider of commercial cards, the federal government. It's a big customer, long-standing relationship well over several decades now.

And the fourth component, which is not included in that 30% that we just talked about, is our treasury management business. We include that in payments because there's natural synergies with the other payment products that we have, but the revenue is accounted for in the respective areas that manage that relationship. Because of the adjacency that, that particular product category has with other products, working capital would be the best example. So that lines up with our corporate commercial business for the most part.

So those 4 parts make up what we call payment services. We serve everybody from consumers at one end, small businesses, which is a big component. And as I said, all the way to the federal government. A couple of interesting areas you guys are probably familiar with kind of general market share. We are 5%, 6% for the main product categories that people are familiar with: Debit card, credit card, merchant acquiring.

For the few sets, I said we are the #1 provider of commercial cards for the federal government. We're also the largest freight payment processor, which is a big business for us, unique to our business. So these are a couple of areas that make up our payments business and pieces that are somewhat unique to our payments business versus most of our peer group.

Gerard Cassidy

When you look at the different buckets in payments, once you get -- build that relationship, how hard is it for a competitor to like pick off one of your customers once you really get into it? I think it's -- just from our own personal accounts, we know we have our payments lineup, and it's very hard to dislodge us.

Shailesh Kotwal

It is very hard, isn't it? And what is true in our consumer lives is true of most pieces. And that's largely because payments has really evolved. Payments has become so much more embedded in the businesses that we serve. And typically, most of our payment products are intertwined into our customers' technical environment. That provides them a more holistic solution, but it also makes the relationship that much more sticky.

That's just from a payment standpoint. But the equally important part is it's not just payments. Payments more and more is becoming an entry point into these relationships, and then allows us to broaden that relationship with other banking products.

And those banking products are another glue that helped that relationship become that much more secure from our perspective, provide value, a broader value to our customers. So it's a good mutual exchange of value for us with our customers.

Gerard Cassidy

When you look at some of your differentiators -- differentiated products, how is your competitive advantage over your customers and over your competitors, I should say? And how much do you have to invest annually or just on a go-forward basis to maintain that edge?

Shailesh Kotwal

Yes. So let me take the second part first, how much do we need to invest? I'd say most of you might remember, we stepped up our investments several years ago, and that's in our run rate. And I think I feel pretty good about the investment envelope that we are operating with allows us to stay competitive from a marketplace standpoint. So that's kind of a simple answer to the investment profile.

The former part, which is more interesting in terms of what allows us to be differentiated in the marketplace, a few things come to my mind. One is the breadth of offering. We really cover the waterfront when it comes to payments. And that's important because when we work with our customers, it's not whether we have the best ACH processing or we have the best corporate card offering or we have the best whatever.

Oftentimes, customers are looking for optimization, particularly when you get to middle market and above. And having that suite of products and allow -- allowing our customers to optimize that payment, this is a big cost difference between an ACH payment versus a commercial card. There's also a different value derived from these.

RTP is another example, which is emerging quite rapidly now. So oftentimes, what happens is we work with our customers and they send us what we would say, it's a payment file exchange. And we take that off the customers' hands and then optimize the payments for our customers to say, well, of these payments that you're looking to make, here is the best way to split it that will allow you to get the best value and then allow us to most -- make the most of that relationship as well. So breadth of payments optimization is important.

Second is distribution. I touched on the financial institutions that we have. That is really unique to U.S. Bank. For another less-known fact through our partnerships that we have, we have over 40,000 different distribution points, which is in addition to the branch network that U.S. Bank has. So that provides us unique distribution capabilities. We now have increasing capabilities of working with software vendors. Tech-led is a terminology you probably hear a lot from us. That provides added distribution.

So we don't have kind of single dependency on a particular partner, widely distributed distribution capabilities. Tech platform is increasingly important. All of these things are dependent on technical capabilities. We own all of our tech platforms, and that allows us to move money from left pocket to right pocket to make sure we are staying close to what our customer needs are and whatever the market demands might be.

So the third and the last one, probably the most important one, again something you perhaps hear a lot, which is our payment ecosystem point. And that is -- in the simplest of context, it is bringing best of payment capabilities that I talked about with best of banking, and providing that in some simple holistic solutions. We're starting that with small businesses, obviously, with the acquisition of talech. That's where that journey really began in earnest.

But increasingly, we're finding that, that is also true in the middle market area, where providing one-stop holistic solutions of putting payments and banking together is really meaningful to our customers. This is a classic case where the whole is materially more valuable than the sum of its parts. So those are the 4 kind of big picture differentiators.

Gerard Cassidy

Yes. And to follow up on that holistic approach, how do you bring your commercial bankers together with your payments people so that they work as a unified team?

Shailesh Kotwal

It truly -- I think unified it's the best way to capture it. It truly is a collective effort. Our corporate commercial bankers typically are broader relationship managers, and they have good reach into the C-suites of the organization. So we understand from them kind of what is the big picture that the customer is looking for.

And then depending on what their needs are, they'll bring in the subject matter experts, and that is really where our payments people will fit in, in terms of understanding their particular payment needs. Once that need is established, then the payments relationship managers, our product experts in many cases, will take over the conversation and say, well, again, oftentimes, it starts in one place, but it ends up in kind of how are you going to help me optimize A, B or C? How are you going to -- and you get to the smaller end of middle market, most often, it ends up in sort of, okay, help me run my business better? Can you do that for me?

And I think that is where the magic of banking and payments together really comes in.

Gerard Cassidy

Following up on Terry's comments earlier about the Union Bank deal, can you share with us the opportunities that you see here for the payments part of the business?

Shailesh Kotwal

We are quite excited for a couple of reasons. One is, obviously, California is a very attractive market. And this customer base is a more affluent customer base. Union Bank really brings in great customer base and terrific relationship managers. I think those are -- at 40,000 feet is probably the best adds to our franchise.

But we have terrific products and great technology much better than what Union Bank was offering. So the combination of giving those RMs that have got great relationships with these customers, feeding them with best-of-breed products coupled with terrific technology, I think it's a powerful combination.

Let me give you a couple of examples. Credit card, simple example. Their penetration into their DDA-based offering credit cards is half of what U.S. Bank is. So we can easily see that doubling in a very near future. That's what I would say, easy, low-hanging fruit. We know how to do that really well.

Another example, corporate commercial payment products that I just talked about. There too, their penetration into their base is 1/3 of what our penetration is into our customer base. So again, these are businesses, these are products we know how to run really well and they've got great relationships. So I think these are 2 kind of simple examples of why I am excited about what this franchise brings to us.

Gerard Cassidy

When you dive into why their numbers are so much lower than your folks, is that they just didn't make the investments into the payment space, so they really weren't that competitive?

Shailesh Kotwal

So this is my understanding, I think a few things. One is you have to have best-of-breed products in order to be able to make valuable inroads into your relationships. Technology plays a big role in payments. So even if you have the interest and the aptitude or the relationships, if you don't have the underlying technology, that road becomes that much harder.

And then it's -- payments, once you've got the capabilities and the technology in place, it's a lot of blocking and tackling. It's working with our customers. Because payments has really evolved from what used to be, maybe 10 years ago, sort of point-of-sale get the device quick and you got the relationship. It is working on these technical integrations with the customers that becomes so much more important. That's why having the platform capabilities that we have that are all in-house, are a key differentiator. I think Union Bank didn't have that.

Gerard Cassidy

Got it. Speaking of technology, I noticed in your fourth quarter when you guys have your slide deck out on payments, you talked about e-commerce and the tech-led payments businesses. And you've shown how they've grown quite meaningfully. Maybe you can share with us just how you're looking to expand those businesses going forward?

Shailesh Kotwal

So tech-led is really trying to bring to life, in a simple way, these elements that I talked about, which is how do we integrate into the customers' environment. So that's really what tech-led is about, and that's what e-commerce is about in order to get the e-commerce business, you really need to be embedded into your clients' environment, technical environment.

We started this journey a few years ago. And as you pointed out, it's been terrific from ultimately driving success for us and for our customers. What it really adds is it allowed us to integrate with key software vendors. That partnership is critical in order to provide that integrated solution to the ultimate buyer or user of that service. That's one area that we have invested in is providing results.

The second is distribution, obviously, that I touched upon. We're also bringing that complete omni-commerce capability. Omni-commerce, for those of you that might not be familiar, classic example, you order something online, but you want to go return it at the mall close to your home.

Gerard Cassidy

Or Walmart.

Shailesh Kotwal

Walmart, yes, whichever your choice. Just don't return to Walmart so that would be a problem. But that's really what it is. It's that closing that loop from online purchases to off-line returns or vice versa. Bringing those capabilities together is what our tech-led businesses has -- will continue to be.

The other area that is evolving from a tech-led standpoint is the other acquisitions that we have done. Bento is a piece of technology we bought recently. talech we bought several years ago. TravelBank is another one. But what those pieces are, are adjacencies around payments. Payments is really changing. Payments is no more about, can you make the payment on time effectively. Of course, we can and many can.

Payments is increasingly about the surround sound that goes around the activity of payment, and that is where capabilities like Bento and TravelBank have really come in. Bento is early innings. You will see a big announcement coming later this year on how we are -- it's going to be the first of its kind where we are bringing for the benefit of small business operators combining payments, classic small business cards, but adding a very powerful expense management capability that small businesses are screaming for. And so I think that is kind of the evolution of our tech-led journey.

Gerard Cassidy

Yes. Maybe you can talk a little bit more about TravelBank. You just mentioned what's going on with Bento and maybe some more information.

Shailesh Kotwal

Because TravelBank is -- again, as I said, payments was really evolving from the act of payment to, can you help me manage the activity around payment? TravelBank, what Bento is to small business, TravelBank is to middle market. That's a simple way. It is about combining plastic corporate commercial payment product with expense management, which is a big deal for middle market.

Now there are a lot of -- when people like Terry and I travel, we have a corporate card in our wallet. And there's a significant expense management capability that caters to large companies like U.S. Bank. When you get to middle market, those solutions are really overdone, overwhelming, and don't fit the needs of middle market.

So that piece of business, which is a very attractive piece of business is kind of -- they don't fit the small business profile because it's too simple, and they can't use what large companies use.

So that middle market is where TravelBank will fit in very nicely with combining commercial corporate card payments, together with this expense management that I just talked about.

Gerard Cassidy

Very good. In the last few minutes, maybe, Terry, pivoting back to you. Obviously, U.S. Bancorp has earned a reputation of being a very good underwriter in credit. Through the cycle, you guys kind of stand out. What are you guys seeing in credit and it seems incredibly strong for the industry and for you guys as well. What are your thoughts there?

Terrance Dolan

Yes. Maybe to kind of put a little bit of context, we have been through a period of historically low charge-offs. I think if you're looking at the third quarter, 19 basis points, our core charge-offs in the fourth quarter was 23 basis points. And pre-pandemic, it was closer to 50 basis points.

So we continue to perform at very low levels. Our expectation is that, that will continue to moderate over time, in 2023, but it will continue to kind of move up. Broadly, though, across our particular portfolios, we're not necessarily seeing any, what I would say, hotspots. I do think that delinquencies with respect to credit cards will slowly start to move up. And we saw a little bit of that in fourth quarter, and we'll see that in the first quarter. And I think that progression will continue.

But generally, the portfolios for us have been performing very well. I think one area that people are concerned about is just in the commercial real estate space, specifically in the office space. For us, that represents 3 percentage points of the overall commitment. So it's not major. But it is one of those things that, over time, structurally, we do expect that is going to have to go through some evolution, I guess, if you will.

And a big part of that is just the whole return to office. What sort of progression does that take over the course of the next several years? The positive thing and maybe the challenge is that it is going to have some stress, I think some structural stress there. The positive thing is that it is structured, it will take time.

Those leases come due over an extended period of time. And that I think will give the industry the opportunity to be able to kind of work through it.

Gerard Cassidy

Which is so different than the last commercial real estate, debacle in 1990 when it was construction loans that couldn't be termed out and everything came on the market.

Terrance Dolan

All at the same time.

Gerard Cassidy

Just, of course. I see we get the red blinking light. So Terry and Shailesh, I really thank both of you for joining us. Join me in a round of applause thanking these gentlemen.

Terrance Dolan

Thank you.