U.S. Bancorp Q3: Growing CRE Headwinds (Rating Downgrade) (NYSE:USB)

U.S. Bancorp (NYSE:USB) delivered better than expected third-quarter earnings this week due to strength in its fee businesses as well as expense control. While the bank delivered an all-around solid third-quarter earnings sheet, the biggest news for the regional bank came a day before the Q3’23 earnings release which is when the Federal Reserve informed U.S. Bancorp that it is taking Category II capital requirements off the table, causing a 7% share price increase last Tuesday. Given the increased headwinds to the commercial real estate sector, however, and risk of seeing increased loan write-offs, I am lowering my rating to buy.

Previous rating

I previously rated U.S. Bancorp a strong buy and suggested that the bank could have surprise potential related to its Q3’23 earnings report, specifically because the lender has upside surprise potential related to its merger with Union Bank. While U.S. Bancorp did submit a robust Q3’23 earnings report, I am a bit more careful now about regional bank’s commercial real estate exposure.

U.S. Bancorp beat top and bottom line estimates

U.S. Bancorp reported better than expected results for the third-quarter and the regional lender beat estimates for both the top and the bottom line. U.S. Bancorp earned an adjusted $1.05 per-share on total revenues of $7.03B, meaning the bank beat EPS estimates by $0.05 per-share while revenues came in $10M above the average estimate.

Exemption of Category II requirements, implications for U.S. Bancorp and shareholders

In an 8-K Material Event filing with the SEC, dated October 17, 2023, U.S. Bancorp disclosed that the regional lender was informed by the Federal Reserve that it won’t be regulated as a Category II bank.

This means that U.S. Bancorp, following the acquisition of MUFG Union Bank, faces less strict capital and liquidity requirements. Instead, going forward, U.S. Bancorp will be regulated as a Category III bank — which are those banks that are not classified as systemically-important and have assets of more than $250B.

In short, the classification of U.S. Bancorp as a Category III financial institution reduces the risk of shareholders that the bank will have to raise new capital and it also clears the way for higher returns on equity for shareholders. Banks are not subjected to stricter capital and liquidity requirements can afford to invest more capital into riskier assets (loans) which could boost their total returns.

Deposits are growing

The deposit situation continued to improve in the third-quarter for U.S. Bancorp after the bank saw some deposit outflows during the first-quarter. In Q3’23, U.S. Bancorp reported average deposits of $512M, showing an increase of 3.0% quarter over quarter. The restoration of U.S. Bancorp’s deposit base, following the financial crisis in Q1’23, was one reason why I recommended the regional bank as a recovery play.

Moderate NII outlook

U.S. Bancorp continues to expect headwinds from higher interest rates and has submitted a moderate outlook for its net interest income. The regional bank generated $4.3B in net interest income in the third-quarter (a decline of 4.3% quarter over quarter) and has guided for $4.1-4.2B in NII in the fourth-quarter. The outlook for NII came in slightly below consensus expectations of $4.2B.

One potential problem: commercial real estate

My attitude towards the regional banking sector has softened a bit lately, in part due to growing concerns over the commercial real estate market. In my work on Wells Fargo — Risks Are Growing — I wrote the following passage:

“High interest costs and falling commercial real estate valuations (Source) are reasons for increasing headwinds in the commercial property sector, especially in the office market. Continual rate increases will likely add pressure on the commercial real estate market and potentially lead to higher default rates (and higher non-accrual loans for Wells Fargo).“

The commercial real estate market is in a troubling state and numerous investors have warned about the possibility of growing defaults if interest rates remain elevated (Source 1, Source 2).

A number of banks have reported rising (or elevated) provisions for credit losses, including Truist Financial (TFC), which I covered here, and Wells Fargo. U.S. Bancorp’s also reported elevated credit provisions in the third-quarter and the trend points in the wrong direction…

In Q3’23, U.S. Bancorp recognized $515M in provisions for estimated credit losses, resulting in a 16% year over year drop in net income to $1.5B. Credit provisions increased 42% year over year, but dropped 37% on a sequential basis.

Commercial real estate is now the second-largest credit loss category for U.S. Bancorp, after credit cards.

Offices are likely the weak spot for U.S. Bancorp because this sector has been hurt especially hard by higher interest rates. About 13% of U.S. Bancorp’s commercial real estate loans were made to the office sector at the end of the September quarter, exposing investors to potentially deteriorating loan quality going forward. The amount of non-performing loans in the CRE loan book also increased from 0.41% in Q3’22 to 1.33% in Q3’23, so investors do have a reason to be at least a little bit concerned here.

U. S. Bancorp’s valuation: 13% earnings yield

U.S. Bancorp is attractively valued again after a two-months long consolidation period and after the bank failed to sustain gains following the Federal Reserve regulation announcement. Shares of the regional lender trade at 7.6X FY 2024 earnings and imply an 13% earnings yield. I have previously said that I calculate a $43-47 fair value for U.S. Bancorp… a valuation range that I still find reasonable after U.S. Bancorp’s solid third-quarter earnings report.

Given the headwinds in the commercial real estate market and a growing share of non-performing CRE loans, I see a fair value at the lower end of this range. With a fair value of $43, shares of USB still have a decent amount of upside revaluation potential… if the CRE problem doesn’t spiral out of control.

Risks with U.S. Bancorp

U.S. Bancorp’s deposits are growing and the bank not too long ago completed the acquisition of Union Bank for which it sees $900M in synergies (the bank confirmed this in its Q3’23 earnings report). I do see continual risks from higher interest rates, weakening net interest income and higher credit provisions for credit losses.

Closing thoughts

The Federal Reserve’s decision to not impose Category II capital requirements is a major win for the regional lender and a huge gift which could clear the path for higher equity and capital returns for shareholders going forward. U.S. Bancorp also presented decent third-quarter earnings that showed positive signs regarding the regional lender’s deposit base, but also higher credit provisions and growing problems in the CRE segment. Shares of U.S. Bancorp still offer dividend investors a solid 6.1% yield and, in my opinion, are undervalued at 7.6X FY 2024 earnings. My updated fair value estimate is ~$43, due to growing CRE risks. I see USB as a buy, although headwinds in the commercial real estate market are growing!