U S Bancorp USB CEO Andy Cecere on Q2 2020 Results

Welcome to the U.S. Bancorp second quarter 2020 earnings conference call. Following a review of results by Andy Cecere, our chairman, president and chief executive officer, and Terry Dolan, vice chair and chief financial officer, there will be a formal question-and-answer session. If you would like to ask a question, please press star 1 on your telephone keypad and press the pound key to withdraw. This call will be recorded and available for replay beginning today at approximately 12:00 p.m. Eastern through Wednesday, July 22nd at 12:00 midnight Eastern. I will now like to turn the conference over to Jen Thompson, director of investor relations and economic analysis for U.S. Bancorp.

Thank you, and good morning everyone. With me today are Andy Cecere, our chairman, president and CEO, and Terry Dolan, our chief financial officer. Also joining us on the call today are our chief risk officer Jody Richards and our chief credit officer Mark Runkle. During their prepared remarks, Andy and Terry will be referencing a slide presentation. 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. These are described on page two of today's presentation, in our press release, in our Form 10-K, and subsequent reports on file with the SEC. I'll now turn the call over to Andy.

Thanks, Andy. Turn to slide six. I'll start with a balance sheet review, followed by a discussion of second quarter earnings trends. Average loans grew 6.9% on a linked quarter basis and increased 10.0% year-over-year. Growth includes $7.3 billion of loans made under the SBA's Paycheck Protection Program during the second quarter. The average loan size to these small businesses was approximately $73,000. Excluding the impact of PPP, average loans grew 5.4% on a linked quarter basis and 8.5% year-over-year. Excluding PPP, linked quarter growth was primarily driven by growth in commercial loans and in mortgage loans. In late first quarter, business customers drew down their lines to support business activity and future liquidity requirements. We started to see paydowns of commercial loans in May, and the paydown activity accelerated in June as many customers accessed the capital markets. As of last week, about two-thirds of the defensive draws we saw in late first quarter and early second quarter have been repaid. Strong residential mortgage growth reflected the low interest rate environment. Credit card balances declined in the quarter due to lower spending activity. Turning to slide seven, average deposits increased 11.2% on a linked quarter basis and grew 16.8% year-over-year. Average non-interest bearing deposits increased 30.1% year-over-year, driven by corporate and commercial banking, consumer and business banking, and wealth management and investment services. Turning to slide eight, while the net charge-off ratio was relatively stable on a linked quarter basis, non-performing assets increased 24% sequentially, reflecting increased economic stress. The non-performing assets to loans plus other real estate owned ratio totaled 0.38% at June 30th, compared with 0.30% at March 31st. We have taken a proactive approach in evaluating credit quality across the entire commercial loan portfolio and considered risk rating changes in the evaluation of our allowance for credit loss. Our loan loss provision was $1.7 billion in the second quarter, inclusive of $437 million of net charge-offs and a reserve build of $1.3 billion. The increase in the reserve was related to changes in risk ratings and deterioration in economic conditions driven by the impact of COVID-19 on the U.S. and global economies, and our expectation that credit losses and non-performing assets will increase from current levels. The increase in the allowance for credit loss is considered our best estimate of the impact of slower economic growth and elevated unemployment, partially offset by the benefits of government stimulus programs as of June 30th. While estimates are based on many quantitative factors and qualitative judgments, our base case outlook assumes an unemployment rate of 13% to 14% for the second quarter, declining to 9.0% in the fourth quarter of 2020, and to 7.8% by the fourth quarter of 2021. Slide nine highlights our key underwriting metrics and exposures to certain at-risk segments given the current environment. We have a strong relationship-based credit culture at U.S. Bank, supported by cash flow-based lending that considers sensitivity to stress, proactive management, and portfolio diversification, which allows us to support growth throughout the economic cycle and produce consistent results. Slide ten provides an earnings summary. In the second quarter of 2020, we reported 41 cents per share. These results were adversely affected by the current economic environment and the related impact to consumer and business spend and the expected increases in credit losses. Turning to slide eleven, net interest income on a fully taxable equivalent basis of $3.2 billion was essentially flat compared with the first quarter, in line with our expectations, as the impact of lower interest rates was partially offset by deposit and funding mix and loan growth. Also as expected, the net interest margin declined by 29 basis points compared with the first quarter. The lower margin reflected lower rates and a flatter yield curve, as well as higher cash balances being maintained for liquidity to accommodate customer demand. While loan mix put pressure on the net interest margin, the earning asset impact was mostly offset by beneficial shifts in deposit and funding mix. Slide twelve highlights trends in non-interest income. Strong mortgage banking and commercial product revenue more than offset the declines in payment revenues. Mortgage banking revenue benefited from higher mortgage production and stronger gain on sale margins, partially offset by the net impact of change in fair value of mortgage servicing rights and related hedging activity. Commercial product revenue reflected higher corporate bond issuance fees and trading revenue. Slide thirteen provides information about our payment services businesses, including exposures to impacted industries. Payments revenue was pressured by the impact of COVID-related shutdowns and reduced economic activity in the quarter. However, consumer sales trends improved throughout the quarter, and that trajectory has continued in early July. Credit and debit card revenue declined 22.2% year-over-year, and merchant processing services revenue declined 34.2% year-over-year, both categories performing somewhat better than we had expected. Corporate payment products revenue declined 39.5% year-over-year, in line with our expectations, as business spending continues to reflect cautious sentiment. Slide fourteen: non-interest expense was essentially flat on a linked quarter basis, in line with our expectations. Second quarter expense reflected an increase in revenue-related costs from mortgage and capital markets production and expense related to the COVID-19 situation. During the quarter, we incurred incremental COVID-19 related costs of approximately $66 million. These expenses consisted of about $30 million related to increasing liabilities for potential future delivery claims related to the airline industry and other merchants, and about $50 million related to premium pay for frontline workers and costs tied to providing a safe working environment for our employees. We expect these incremental COVID expenses to begin to dissipate in the second half of the year. Slide fifteen highlights our capital position. At June 30th, our common equity tier 1 capital ratio, calculated in accordance with transitional regulatory capital requirements related to the current expected credit loss methodology implementation, was 9.0%. Our common equity tier 1 capital ratio reflecting the full implementation of the CECL accounting methodology was 8.7%. I'll now provide some forward-looking guidance for the third quarter of 2020. We expect fully taxable equivalent net interest income to be relatively flat compared to the second quarter. We expect mortgage revenue to continue to be strong on a year-over-year basis in the third quarter, but it is likely to decline compared with the second quarter, reflecting slower refinancing activity for the industry. Payments revenue is likely to be adversely affected through the remainder of the year on a year-over-year basis due to reduced consumer and business spending activity. However, we expect continued gradual improvement in sales volumes. We expect non-interest expenses to be relatively stable compared to the second quarter. Future levels of reserve build will depend on a number of factors, including changes in the outlook for credit quality reflecting both economic conditions and portfolio performance, and any beneficial offset from government stimulus. We will continue to assess the adequacy of the allowance for credit losses as credit conditions change. For the full year 2020, we expect our taxable equivalent tax rate to be approximately 15%. I'll hand it back to Andy for closing remarks.

Your first question comes from the line of Scott Siefers with Piper Sandler.

Good morning, guys. Thank you for taking the question. I guess a question for Terry. Just on the NII expectations, you gave that. So I wonder if you could talk a little bit about the puts and takes, meaning balance sheet growth and where you'd see the margin projecting from here.

Yeah, from a loan perspective, again, we would expect that we'll see year-over-year growth, but on a linked quarter basis, clearly it's going to be down. We're going to continue to see paydowns associated with those defensive draws that we had at the end of the first quarter and early second quarter, so that'll put downward pressure on a linked quarter basis. PPP will actually probably help from a growth standpoint as we think about second quarter, but it does start to dissipate in third and fourth quarters simply because of the loan forgiveness program. On the consumer side, auto lending has generally been a little weak in April and May, but it's gotten stronger in June, so we believe that's going to be a bright spot as we think about the third quarter. But overall consumer lending is likely to be down simply because consumer spending has been down. So that's kind of the puts and takes you think about for loan growth. Margin, we believe, is going to be relatively stable. It'll be helped a little bit by PPP, but impacted a little bit by pressure on the yield curve side. But relatively stable to the second quarter.

Okay, perfect. Thank you. And then just given the absolute level of interest rates, do fee waivers start to become an issue for the money market area? And if I recall correctly from the last time rates were this low, I think those show up in trust fees. Is that something you guys are thinking about? Where would they show up and what's the kind of impact you guys would see?

Yeah, I think the impact would be probably similar to what we saw last time, but maybe a little bit more simply because of the level of rates. But it will show up in trust and investment management fees because that's where our money market fund revenue gets recognized.

All right, perfect. Thank you, guys very much.

Our next question comes from the line of Matt O'Connor with Deutsche Bank.

Good morning. Could you clarify on the net interest income outlook of stable quarter over quarter? Does that include some of the benefit from PPP repaying or forbearing, and if so, what are your assumptions on that in terms of the next couple quarters?

Yeah, so it includes all the puts and takes. Like I said, it'll reflect a decline on a linked quarter basis in terms of commercial loans because of the draws, but there will be some benefit associated with PPP. So it includes essentially all the puts and takes associated with net interest income.

Okay. And then I am wondering on the PPP, it seems like your approach was more granular or to go after kind of smaller, really small businesses, if I just look at your total amount funded versus applications. Just wonder if you could talk to that approach and maybe give us some insight in terms of the cost that you've incurred to originate this.

Okay. And the cost to originate, was it just kind of moving resources from one part of the bank to another?

Okay, thank you.

Your next question comes from the line of Saul Martinez with UBS.

Hey guys, good morning.

I wanted to drill down a little bit on your comments, Terry, on the payments business and a sort of gradual improvement there. I guess first of all, could you just give us a little bit of a sense for how much the consumer recovered? It seems like the year-on-year declines in acquiring volumes and card volumes have really lessened. But can you just give us a sense of what the exit rates were in terms of volumes in those categories in June versus March? And I guess as an adjunct to that, why wouldn't that suggest that at least sequentially you should see pretty sharp improvements in terms of the sequential growth in issuing and acquiring revenue versus the second quarter? Obviously year-on-year is tough, but versus the second quarter it would seem to suggest that you can see a nice improvement sequentially. I just want to get your sense as to whether I'm thinking about that right.

Yes, I think you're right on. I think if we look at our payments business on a sequential basis, we will see growth, particularly in the credit card and the merchant. The corporate payments we would also expect growth, but maybe not at the same level simply because sales volumes there, commercial spend, commercial customers are still fairly cautious. But to give you some perspective, at the end of April, on the merchant side, consumer spend was down almost between 50% and 55%, kind of in that ballpark. And today, it's really back to spend levels that are closer to about 20% down. So that has come back really very nicely. The things that are going to continue to impact for a while is the mix associated with the airline industry and some of the entertainment, but it has come back very nicely. So your sequential growth is right on. With respect to credit card, we had said it was down in the 30% range in April, and that has come back nicely as well. It is still down around 10% to 12%. We would expect that trajectory to continue. In the third quarter, debit card sales have actually been pretty strong, up 10% to 12% kind of in that range. While we wouldn't expect it to be quite at that higher level in the third quarter, it's still going to be relatively strong. And then on the CPS side, commercial spend has been pretty cautious. It was down in the magnitude of 30% to 35% in the April timeframe, and it's still down around somewhere between 25% and 30%. We do expect it to get a little better than that in the third quarter for a couple reasons, simply because government spend tends to be strongest in the third quarter. So hopefully that gives you some perspective.

Yeah, no, that's super helpful. And if I could squeeze another one in on fees, the deposit service charges obviously down a lot. You commented about fee waivers related to customer relief. How do we think about that going forward? If you can quantify that or just give us a sense of how that, I think it's $3 million, how that could compare to a more normalized level in the coming quarters?

Yeah, similar sorts of impacts. As consumer spend and activity has declined, and then you have the stimulus checks and all sorts of different things, just incidence levels related to NSF and fee waivers in terms of helping our customers have impacted the second quarter. On a sequential basis, we would expect that will come back nicely in the third quarter, but on a year-over-year basis it's still going to be down simply because consumer activity is down, similar to merchant or credit card. So it's a little time to get back to a more normalized level.

All right, awesome. Thank you very much.

Yeah, thank you.

Our next question comes from the line of Erika Najarian with Bank of America.

Good morning. My first question is on the reserve. This is a question that all your peers have been getting during this earnings season. I always like to think in the CECL world that your reserve to loan ratio of 2.54% represents a cumulative loss rate for the recession that represents, let's say, two years. I guess the question here is, is that your view? Another way of asking, are you done in terms of reserve building? And related to that, your peers have also talked about the base case, but that the base case tends to be one of five or so different scenarios, and those scenarios are weighted. So I'm wondering if you could give us some insight in terms of as you built your reserve, how much weight that base case was taken into account versus perhaps other scenarios.

Yeah, so let me take the first question. When we think about the reserving, you're absolutely right. You make your estimates at the end of any particular quarter based upon the information that you have available at that particular point in time. And certainly at June 30th, we believe that the reserve is appropriate for the cumulative losses that are there. So we wouldn't expect future increases in the reserve, but again, that is going to be highly dependent upon what changes either in terms of economic factors or if our credit quality changes differently than what we had expected. So the important thing is that we're going to continue to assess the reserve every quarter based upon the information that we have available to us. But you are right, theoretically that is how CECL works, and that's how we're trying to apply it. Coming to your second question, the information that I gave you with respect to unemployment, keep in mind unemployment is an important factor, but there are like 200 different models that are part of the modeling process, so it's pretty complex because you have a lot of different types of portfolios. But unemployment, the information I gave you was really the weighted average across many different multiple scenarios that we ended up looking at. So you're right, when we look at this, we look at information from many sources in terms of things like unemployment, GDP, etc. We develop a base case, if you will, but then we look at multiple scenarios around that base case and weight it. The information that I gave you was a weighted average based upon those multiple scenarios, so it should give you some comparability when you think about that.

Got it. And my second follow-up question is to Andy. Andy, I think what was particularly impressive about this quarter is your PPNR resiliency, and obviously the forward look would imply that this will continue. And Terry just told us that we could be done in terms of reserve building. As we think about the future and as we think about a more difficult operating environment for banks, how are you thinking about inorganic growth strategies from here?

And just any thoughts on inorganic strategies, acquisitions?

Okay, thank you.

Our next question comes from the line of Mike Mayo with Wells Fargo Securities.

Hi. I want to challenge your conservatism. You're one of the most conservative banks, but I want to challenge some of your conservatism. On your base case, again, 9% unemployment by the end of this year. I know it's a lot of scenarios and it's weighted average and all that, but at least one of your peers was more conservative than that, and that's the Fed base case. So there's nothing crazy about it. It's just, I thought, why not be more conservative if you have the flexibility? Or when you take the weighted average in the different scenarios, I'm pushing back a little bit. This seems like peak reserve build, and you said that, but if your economic assumptions are wrong, then that won't be the case. So why not be more conservative there? And along those lines, your payments comment that it should improve sequentially kind of makes sense, but we just had a big increase in COVID cases, which leads to more deaths, which leads to some closing down. How are you feeling about that progression?

So maybe to address the first question, when you establish the reserve, you have to establish what you believe is appropriate based upon the information you have available to you. We use things like Moody's Analytics and other sources in order to come up with that projection of what unemployment, as an example, looks like. So you have to make sure that your reserve is appropriate based upon the information that you have. You can't build in tons of conservatism, so to speak, into it. But again, part of it is we'll have to wait and see. On the payment side, in terms of COVID cases, based upon our estimates right now, I think that this go-round versus last go-round, states are continuing to try to stay open to the best that they can. I think you have different health treatments and all sorts of different things that exist based upon better information or different information than what existed before. But quite honestly, we're going to find out. There's a lot of uncertainty, and it's too early to know.

And then one follow-up question. Look, your third slide of substance is slide number five, the digital engagement trend. You're certainly putting that front and center. How can you bring this up to date, like to the moment of what's happening with your digital engagement? And what does that mean in terms of branches and national expansion and anything else? Because if you're putting this as your third slide in your earnings deck, it's clearly important. It's always been important, but it seems like it's now being put on steroids in terms of the way you're highlighting this, which must mean a bigger part of the strategy.

Any number on those branches, the updated number?

Okay, thank you.