U.S. Bancorp

Welcome to the U.S. Bancorp's Second Quarter 2020 Earnings Conference Call. Following a review of the results by Andy Ciceri, 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 touch phone and press the pound key to withdraw. This call will be recorded and available for replay beginning today at approximately 12 p.m. Eastern through Wednesday, July 22nd at 12 midnight Eastern. I would now like to turn the conference over to Jen Thompson, Director of Investor Relations and Economic Analysis for U.S. Bancorp.

Thank you, Ametris, and good morning, everyone. With me today are Andy Ciceri, 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 Richard and our Chief Credit Officer Mark Runkel. 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 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'll now turn the call over to Andy.

Thanks, Jen, and good morning, everyone. Thank you for joining our call. Following our prepared remarks, Terry, Jody, Mark, and I will take any questions you have. I'll begin on slide three. In the second quarter, we reported earnings per share of 41 cents. Consistent with the industry, our performance is being impacted by the current economic environment. Loan growth reflected the impact of defensive draws by corporations in March and early April, strong mortgage loan growth, and the impact of the paycheck projection program, which should support small businesses impacted by the COVID-19 situation. Increased liquidity in the financial system and a flight to quality dropped strong, deposit growth in the quarter. Our healthy fee income growth this quarter is a testament to our diversified business model. Some fee lines, including our payments businesses, were negatively impacted by slower economic activity. However, we saw very strong growth in our mortgage and commercial products businesses. And while consumer spend activity remains pressured compared with a year ago, volume trends in each of our payments businesses have improved as some economies have started to reopen. Expenses were held relatively flat compared with the first quarter. We continue to manage our cost structure prudently and in line with the slower revenue growth environment. Credit quality metrics in the second quarter reflected increased economic stress offset by the beneficial impact of governance, stimulus, and forbearance and deferral programs. During the quarter, we increased our allowance for loan losses in response to economic conditions. We believe our reserve level of June 30th is appropriate based on the information we have available. Changes in the allowance will be dependent on actual credit performance and changes in economic conditions. In the lower right quadrant of this slide, you can see that book value per share grew .8% compared with a year ago, and we remain well capitalized. Slide 4 provides key performance metrics. We delivered a .1% return on tangible common equity in the second quarter, impacted by lower earnings owing to the current economic environment. Slide 5 shows our continually improving digital uptake trends. Shelter in place orders early in the quarter and temporary branch closures due to the COVID-19 have increased and increased in digital adoption. Digital now accounts for more than three quarters of all service transactions and about 46% of all loan sales. We expect digital adoption by customers to stick even after the economy fully reopens. Now let me turn it over to Jerry who will provide more color on the quarter.

Thanks, Andy. If you turn to slide 6, I'll start with a balance sheet review followed by a discussion of second quarter earnings trends. Average loans grew .9% on a link quarter basis and increased .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 .4% on a link quarter basis and .5% year over year. Excluding PPP, link 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 equity 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 the 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 spend activity. Turning to slide 7, average deposits increased .2% on a link quarter basis and grew .8% year over year. Average noninterest-bearing deposits increased .1% year over year, driven by corporate commercial banking, consumer and business banking, and wealth management and investment services. Turning to slide 8, while the net charge-off ratio was relatively stable on a link quarter basis, nonperforming assets increased 24% sequentially, reflecting increased economic stress. The nonperforming assets to loans plus other real estate-owned ratio totaled .38% at June 30th compared with .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 losses. 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 nonperforming 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 .0% in the fourth quarter of 2020 and to .8% by the fourth quarter of 2021. Slide 9 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 produces consistent results. Slide 10 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 11, 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 balance of 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 12 highlights trends in non-interest income. Strength in mortgage banking and commercial product revenue more than offset the clients in the 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 13 provides information about our payment services business, including exposures to impacted industries. Payments revenues 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 .2% year over year and merchant processing services revenue declined .2% year over year, both categories performing somewhat better than we had expected. Corporate payment products revenue declined .5% year over year in line with our expectations as business spending continues to reflect cautious sentiment. Slide 14, turning to slide 14, non-interest expense was essentially flat on a one quarter basis in line with our expectations. Second quarter expense reflected an increase in revenue related costs for mortgage and capital markets production and expense related to 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 15 highlights our capital position. At June 30, our common equity tier one capital ratio calculated in accordance with transitional regulatory capital requirements related to the current expected credit loss methodology implementation was .0% at June 30. Our common equity tier one capital ratio reflecting the full implementation of the current expected credit loss 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 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 allowance, 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. Thanks, Jerry.

I'll end my remarks on slide 16 which highlights a few of the recent actions we've taken as a company to help support our customers, communities and employees. We are operating in uncertain times, not only for the economy but for our society in general. However, I am confident that together we can make lasting and impactful changes that will leave us all better on the other side of these trying times. We are well positioned for near-term challenges and we continue to manage this company with a long-term lens and focus on maximizing shareholder value. Our capital and equity positions are strong and our unique business model remains a differentiator for us. I would highlight three things that will continue to support our ability to deliver industry leading returns through the cycle. First, as our second quarter results indicate, our diversified business mix reduces revenue and earnings volatility and this quarter it allowed us to deliver good revenue growth even against a challenging interest rate backdrop and an industry-wide slowdown in consumer spending activity. Second, our time-tested credit underwriting discipline puts us in a strong position to navigate through an economic downturn while setting us up to return to prudent and consistent growth in a more favorable economic environment. And third, our culture remains the foundation which informs not only what we do at U.S. Bank but how we do it. I couldn't be more proud of our employees who have come together to support our customers and communities and they face significant economic and social disruption. I want to take this opportunity to thank them for all their hard work and resiliency. We'll now open up the call for Q&A.

At this time I would like to remind everyone in order to ask a question please press star then the number one on your telephone keypad. To withdraw your question press the pound key. Please stand by while we compile the Q&A roster. Your first question comes from the line of Scott Seifers with Piper Sandler.

Morning Scott. Morning guys. Hey, thank you for taking the question. Let's see, I guess Terry, a question for you just on you gave the NII expectations for the third quarter. I wonder if you could talk a little bit about the sort of the puts and takes meaning balance sheet growth and where you'd see the margin projecting from here.

Yeah, you know, from a loan perspective, again, we would expect that we'll see year over year growth, but on a link 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 link quarter basis. PPP will actually probably help from a growth standpoint as we think about second quarter. But, you know, it does start to dissipate in third and fourth quarter simply because of the loan forgiveness program. So on the consumer side, you know, auto lending has generally been a little bit. It was weak in April and May, but it's gotten stronger in June. So, you know, 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 loan growth. You know, margin we believe is going to be relatively stable. It will be helped a little bit by PPP, but the impact in a little bit. There'll be a little bit of pressure on the yield curve side equation, but relatively stable to the second quarter.

OK, perfect. Thank you. And then just given the absolute level of interest rates, do fee waivers start to become an issue for in 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. If they're sort of something you guys are thinking about, where would they show up and what's kind of the impact you guys would see?

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

OK. All right. Perfect. Thank you guys very much.

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

Good morning.

Just to

clarify on the net interest income outlook of stable quarter to quarter, does that include some of the kind of benefit from PPP repaying or for bearing? And if so, what are your assumptions on that in terms of the next couple of quarters?

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

OK. And then I am wondering on the PPP, it seems like your kind of approach was more granular or to go after kind of smaller, really the small, small businesses. If I just look at your total amount funded versus applications and 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 those loans.

Matt, this is Andy. We took the applications as they came in, serving our customers and initially and then ultimately outside of the bank. As you saw, we had over one hundred one thousand applications and the average balance was in the seventy thousand. So a lot of our customers are small business and we helped a lot of employees. So the team did a great job. We started with a bit of a manual process and went to a much more automated process, certainly in the second round. So it was just based on the the request that came in and the priority was really time

based. OK. And it just the cost to originate. Was it just kind of moving resources from one part of the bank to another?

Yeah. Yes, it was. Matt, we we actually had individuals from throughout the entire company help us through this process, particularly the manual process that started and the technology as well. But yes, the entire bank was supportive.

OK, thank you.

You bet.

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

Hey, guys. Good morning. Hey, good morning. I wanted to drill down a little bit on your comments, carry on on the payments business and sort of a gradual improvement there. I guess, first of all, could you could you just give us a little bit of a sense for the how much the consumer recovered and, you know, they seem like in June, the the year on year declines in acquiring volumes and in card volumes, it really, really lessened. But can you just give a sense of what, say, the exit rates were in terms of volumes and in those categories in June versus versus March? And 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 and issuing and acquiring revenue versus at least the second quarter, obviously, year on year is tough, but versus the second quarter, it would seem to suggest that you could see a nice improvement sequentially. And I just wanted to get your sense as to whether I'm thinking about that right.

Yeah, so I think you're right on. I think when we end up looking at our payments business on a sequential basis, we will see growth, particularly in the credit card and the merchants, the corporate payments, we would also expect growth, but maybe not at the same level, simply because sales volumes there are commercial spend or commercial customers are still fairly cautious. But it kind of gave you some perspective at the end of or in April, you know, we saw on the merchant side of the equation, consumer spend was down almost between 50, 55 percent kind of in that ballpark. And today, you know, it's really back to spend levels that are closer to about 20 percent, you know, so that has come back really very nicely. You know, 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. Your point on sequential growth is right on with respect to credit card. You know, credit card, we had said was down kind of in that 30 percent range in April. And, you know, that has come back nicely as well in terms of credit card. You know, it is still down. It's down around 10 to 12 percent. We would expect that trajectory to continue. So in the third quarter, debit card revenue or sales, excuse me, actually have been pretty strong. And, you know, the sales on the debit card side has been, you know, kind of up 10 percent, 12 percent, kind of in that range. And, you know, while we wouldn't expect it to be maybe quite at that higher level in the third quarter, it is still, I think, going to be relatively strong. And then on the CPS side of the equation, CPS, again, the commercial spend has been pretty cautious. It was down kind of in the magnitude of, you know, 30 to 35 percent in that April sort of time frame. And, you know, it's still down around somewhere between 25 and 30 percent. We do expect it to get a little better than that in the third quarter for a couple of reasons, simply because government spend tends to be strongest in the third quarter. So hopefully that gives you some insights or perspective.

Yeah, I know that that's super helpful. If I could squeeze another one in on fees, the deposit service charge is obviously down a lot. And you commented about fee waivers related to customer regular COVID. I mean, how do we think about that going forward? And I don't know if you can quantify that or how do we, you know, or or just give us a sense of how that I think 133 million dollars, how that could compare to to maybe a more normalized level in the coming quarters.

Yeah, you know, similar sort of similar sort of impacts, you know, as consumer spend and just 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 has 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, you know, merchants or credit card.

So so it'll take some time to get back to that sort of a more normalized or what was a more normalized

level?

Yes, that's right. All right. All right. Awesome. Thank you very much.

Yeah, thank

you.

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

Hi, Erica. My first question is on on the reserve. And, you know, this is a question that all your peers have been getting during this earnings season. So, you know, I always like to think in the Cecil world that your reserve to loan ratio of two point five four percent represents, you know, a cumulative loss rate for the recession that represents, let's say, let's say two years. And I guess the question here is that is that your view? I guess it's 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, let's say, five or so different scenarios. And those scenarios are weighted. And so I'm wondering if you could give us some insight in terms of as you had built your reserve, you know, how much weight that base case was taken to account versus perhaps other scenarios.

Yeah, so let me let me take the first question. And, you know, when we think about the reserving, you're absolutely right. You know, you 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, you know, we believe that the reserve is appropriate for the cumulative losses that are there. So, you know, 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 our, you know, our credit quality changes differently than what we had expected. So, you know, the important thing is that, you know, 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. You know, theoretically, that is how CESA works and that's how we're trying to apply it. Coming to your second question, you know, the information that I end up giving you with respect to unemployment. Now, keep in mind, unemployment is an important factor, but there's like 200 different multiples that are a part of the modeling process. So it's pretty complex because you got a lot of different types of portfolios, et cetera. But unemployment, you know, 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, et cetera, et cetera. We develop a base case, if you will, but then we look at multiple scenarios around that base case and weighted. But the information that I gave you was weighted based upon those multiples. So it should give you some comparability when you think about that. Andy, anything to add? No, you said it well.

Got it. And my second my follow up question is to Andy. So, Andy, I think what was particularly impressive about this quarter is your PP and our resiliency. And obviously, the forward look would imply that this will continue. You know, and Terry just told us that, you know, we could be done in terms of reserve building. You know, 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?

Well, Erica, first, as you mentioned, I think our diversified revenue mix helps a lot. And this is a this quarter probably represented it very well. You know, we had some pressure on payments because of the spend activity that Terry talked about. But mortgage and commercial products had hit it out of the park this quarter in terms of positive. So and then, you know, the other part of a diversification is how much of our revenue comes from the balance sheet or net interest income as well as fee revenue. Sort of a mixed back 50-50 there. So that really helps in environments like this and different businesses do well in different economic cycles. As we think about the future, I think we are planning for a future that has continued low rates. It'll take a while for spend to get back to normal. So we're going to manage our expenses in that with that thought in mind, which is what we're doing today. And we're going to continue to invest in the businesses that have opportunity as well as the digital initiatives I talked about. And those digital initiatives will offer not only the opportunity for our customers to connect with us in virtual means, I think it will also offer expense opportunities in the long run. So those are the ways we're thinking about it.

And just any thoughts on inorganic strategies, acquisitions?

Yeah, you know, more bluntly. Yeah, thanks for being blunt. So we will look we will look at opportunities that come up. The only thing I'd say is in this environment, Erica, there's a lot of uncertainty and it's certainly not a clear vision in terms of the future, even for us. So to look at someone else with that plans will be will be challenging. But, you know, I do think opportunities will come up because of the stresses that are out there and we'll take a look.

OK, thank you.

You bet.

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

Hey, Mike. Hi.

Just I want to challenge your look. You're one of the most conservative banks, but I want to challenge some of your conservatism. So on the your base case again, nine percent 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 than that. And I know that's the Fed base case. There's nothing crazy about it. It's just, you know, I thought, you know, why not be more conservative if you have flexibility or or when you take the weighted average in the different scenarios. I'm pushing back a little bit more like this seems like peak reserve builds. 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 your payments comment that it should improve sequentially kind of makes sense. But look, we just had a big increase in covid cases, which leads to more deaths, which leads to some closing down. And, you know, how are you feeling about that progression?

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

Yeah, and I'd add on, Mike, you know, I think you're right. Things are changing every day and the facts change daily, weekly, sometimes hourly. So we're just going to continue to assess and manage the company given the changes are out there. What Terry's telling you, what are you seeing right now? And as he said, we're going to we get data every day and we're going to continue to assess what we think is going to happen. We're running a lot of models. We're sharing with our board a lot of scenarios, including a much harsher scenario and understanding what would occur in that. So but you're right. I mean, there's a lot of unknown yet. And and we are being conservative in the way we're approaching our financial modeling.

And then one follow up question. Look, your third slide of substance is slide number five, but the digital engagement trends. I mean, you're certainly putting that front and center. Can you bring us up to date, like, you know, as of 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 I know it's always been important, but it seems like it's now being put in on steroids in terms of the way you're highlighting this, which must mean some bigger, you know, part of the strategy.

So, like, it has always been important, but I do think the recent events and the customer behavior changes has even accelerated that further. And, you know, you can see that in the numbers of nearly 80 percent of transactions now occurring in a digital fashion. The branch activity as far as transactions is down a lot in the sales side. I talked about the loan sales, but actually total sales in the branches have doubled since you're excuse me, on a digital platform have doubled versus a year ago. And so we do expect those digital investments both do it yourself and do it together. In other words, co-browsing or virtual activity is going to continue to be important, not just for the consumer, but across many business lines. So that investment that we're making is important on two fronts. It's important to make sure we're giving the customer the best experience and connecting with them in the ways they choose to. And it's also offering efficiencies in the long run. As we talked about, we do, we announced over a year ago that we expect to have 10 to 15 percent fewer branches, and I would expect that number to increase in terms of the number of fewer branches that we have because of these changing customer behavior. The branches will still be important, but the number of them and the size of them will be fewer and less.

Any number on those branches, the updated number?

We don't have a number on it yet. We continue to assess, and as we think about the changes that are occurring and, you know, the closures that are out there, we'll continue to assess what we expect, but I do expect it to be higher than the 10 to 15 percent.

Okay, thank you.