2023-12-19 06:54:12 ET
Summary
- U.S. Bancorp's shares have surged lately, in part due to the Federal Reserve's announcement of interest rate cuts in 2024.
- The end of the tightening policy will further pressure the bank's net interest margin, but loan operations may benefit from a normalization in interest rates.
- U.S. Bancorp's share price has now rebounded to the pre-crisis valuation in Q1'23.
- With a negative NIM catalyst ahead in 2024, I believe the risk profile for USB stock is no longer attractive.
U.S. Bancorp's ( USB ) shares have soared more than 40% since November, in part because the Federal Reserve announced that it would end its tightening policy next year. The end of the Federal Reserve’s tightening policy is set to further pressure U.S. Bancorp's net interest margin, although its loan operations may benefit from a normalization in the interest rate environment in the long term. Since shares of U.S. Bancorp have now recovered all their losses sustained during the regional banking crisis in the first-quarter and have reached my mid-point fair value estimate of $43, I believe the strength in pricing results in a selling opportunity!
Previous rating
I started to recommend regional banks, and U.S. Bancorp especially, in the first and second-quarter of 2023 as they appeared to have been unduly punished by a market that worried excessively about the stability of them, including First Republic Bank (which was taken over by JP Morgan Chase), PacWest Bancorp (which just merged with Bank of California) and Western Alliance Bancorporation ( WAL ). The Federal Reserve’s decision to lower interest rates in 2024 has led to a surge in bank valuations last week which I don’t believe is sustainable considering that net interest margins are going to see more contraction pressure. As a result, I have sold my shares in U.S. Bancorp. and no longer recommend them.
Loan balances to rise, net interest margins set to contract further
Interest rates obviously affect a bank’s income potential considerably on a number of levels. The most direct effect can be felt on the net interest income and margin level which are key drivers of profitability for banks. U.S. Bancorp achieved $4.3B in net interest income in the third-quarter which showed a decline of 0.09 PP compared to the second-quarter.
U.S. Bancorp's net interest margin, given the Fed’s effective rate guidance from last week, is set for further contraction in FY 2024. According to U.S. Bancorp’s guidance for the fourth-quarter, the regional bank expects its net interest income to decline to a range of $4.1-4.2B, with further declines in successive quarters now a very distinct possibility.
U.S. Bancorp
On the other hand, lower interest rates are set to boost U.S. Bancorp’s loan balances as demand for loans obviously increases in markets that offer consumers lower interest rates. Therefore, U.S. Bancorp’s loan balances are set for positive growth in 2024, in my opinion. In Q3'23, U.S. Bancorp's average loan balance was $377B, showing a Q/Q decline of 3%.
U.S. Bancorp
Decreasing commercial real estate risks inherent in U.S. Bancorp's portfolio
Besides the potential for loan growth in a lower-rate world, I also see lower commercial real estate loan risks for U.S. Bancorp in 2024. Commercial real estate is a bit of a troubled asset class right now as it suffered the biggest blow from changing workplace dynamics (the rise of remote working) and higher interest rates. However, with interest rates now set to drop in the short to medium term, commercial real estate loans in U.S. Bancorp's portfolio may be less risky for the regional lender as refinancing risk decreases.
In my last work on the regional lender I mentioned CRE loans as a risk factor within U.S. Bancorp’s real estate-focused loan portfolio: about 14% of all loans were made in the risky commercial real estate industry. With rates now set to see a normalization process, starting in 2024, I believe commercial real estate loan risks are on the decline as well.
U.S. Bancorp
It's time to sell when investors are greedy
Before the recent share price surge, in October, I put a $43 price target on U.S. Bancorp at which level the bank is valued in line with its historical average. Most major and regional banks have seen strong share price revaluations in the last two months… which is also the reason why I have sold almost all of my bank holdings last week.
Shares of U.S. Bancorp are currently trading at 1.51X book value, implying a more than 50% premium to book value. The longer term average P/B ratio is 1.57X and U.S. Bancorp now finally trades at about the same price level is traded at before the financial crisis in the regional banking market in March 2023... which makes it the perfect point to sell, in my opinion.
Risks with U.S. Bancorp
The Federal Reserve has guided for a change in its tightening policy and initially stated that it plans to follow through with three rate cuts. Should inflation see a reboot in the next couple of months, the Federal Reserve surely has enough flexibility to slow the pace of its pivot. Overall, I believe the decrease in interest rates is a net negative for banks because they can charge consumers less money for their loans, resulting in a cyclical contraction in their net interest incomes. While this may be offset in the long run by loan volume growth in a lower-rate world, I believe the short term earnings effects will start to weigh on U.S. Bancorp’s valuation in 2024.
Closing thoughts
The Federal Reserve last week changed the game for banks and consumers and the guidance for lower interest rates in 2024 makes large Wall Street banks as well as regional bank champions less attractive as investment targets, in my opinion. Lower interest rates are poised to hurt U.S. Bancorp’s net interest margin in the short term, but may lead to a reboot of its loan operations longer term… if the U.S. economy stays out of trouble and defaults don't rise. Since U.S. Bancorp's share price now exceeds my $43 fair value target and the bank received a negative earnings catalyst from the Federal Reserve last week, I believe investors that bought into the troubled regional banking sector during the 2023 financial crisis are now faced with a very attractive selling opportunity!
For further details see:
U.S. Bancorp: A Great Time To Exit