Credit Quality Drops Anchor on USB

Updated from 10:22 a.m. EST on Jan. 14.

One would have expected the fourth-quarter and full-year 2007 earnings report for U.S. Bancorp (USB - commentary - Cramer's Take) not to have been the cold shower that Citigroup's (C - commentary - Cramer's Take)earnings report turned out to be. In fact, there were a few positive items that emerged for this bank this quarter, including deposit growth, growth in fee-based revenue, as well as relatively healthy net interest margins and return on assets.

But the big news was hidden in the figures on asset quality, especially for the bank's commercial real estate, residential mortgage and retail leasing portfolio.

First, the big picture: Fourth-quarter EPS declined year over year by 14.5%, to 53 cents. Excluding special charges, earnings remained stable at 67 cents per share. Full-year 2007 earnings declined by 7%, to $2.43 per share. Fourth-quarter revenue was reported at $3.5 billion, a 3.4% increase year over year.

Regarding key ratios, the fourth-quarter report revealed a mixed bag. (All of the figures, except where otherwise indicated concern yearly figures.) Net interest margins declined by 18 basis points, to 3.47%, while return on assets declined by 30 basis points, to 1.93%. Efficiency ratios increased by 390 basis points, to 49.3%, reflecting a lack of ability to contain costs. The Tier 1 capital ratio declined by 50 basis points, to 8.3%, barely above recommended norms.

On the positive side of the ledger, overall fourth-quarter deposits grew by a strong 3.7%, most of that originating from a 7.2% year-over-year growth in interest-bearing deposits offset by a 0.3% decline in non-interest-bearing deposits. Full-year deposit growth, however, was reported at a much more muted 0.4%.

Most of the revenue growth was driven by a 4.8% growth in non-interest income. Decomposing these results further, most of this growth originated from an 18.6% growth in credit card revenue and a 34.9% increase in mortgage banking revenue, the latter mostly due to higher mortgage servicing revenue.

Current credit quality concerns will likely continue to have an impact over fiscal 2008, as the bank continued to report an increase in the net charge-off ratio by 12 basis points over fourth quarter 2007, to 0.59%, primarily due to credit-card-related consumer charge-offs.

Non-performing loans for commercial mortgages increased over fiscal 2007 by 95%, for residential mortgages by 50% and overall by 18%. In short, credit quality issues will continue to be a concern in credit cards, as well as residential mortgages and commercial real estate.

I will conclude with a brief summary of earnings division by division:

• Net income for wholesale banking (25% of net income) declined by 8.4%, due primarily to provisions for credit losses in commercial real estate.
• Consumer banking income (40% of income) declined by 2.5%, originating from stability in interest income earnings coupled with an increase in provisions for credit losses and growth in non-interest expense.
• Wealth management income (14% of income) grew by 0.8%, these relatively stable earnings being primarily due to valuation losses.
• The only positive element came from the 11.3% reported increase in net income from payment services (25% of income), driven by strong growth in retail credit card fees and balances.

U.S. Bancorp shareholders can expect fiscal 2008 results to get worse before they get better.

USB Preview: The Best of the Worst

Midrange bank U.S. Bancorp (USB - commentary - Cramer's Take) will report fourth-quarter and full-year 2007 earnings on Jan. 15. So far, it is being touted as one of the few banking sector longs in Berkshire Hathaway's (BRKA - commentary - Cramer's Take) portfolio of stocks.

Claims have been made that the balance sheet looks relatively solid for this bank compared to the likes of Citigroup (C - commentary - Cramer's Take) or Washington Mutual (WM - commentary - Cramer's Take), but closer examination reveals that, while U.S. Bancorp is relatively more protected than the others, it will not emerge unscathed from the subprime tempest.

Fourth-quarter 2007 earnings will find this bank treading water, since analysts expect fourth-quarter and full-year earnings to be down, at 59 cents per share and $2.52 per share vs. their respective 2006 values of 66 cents per share and $2.61 per share. Fourth-quarter and full-year revenues are expected to be slightly higher, at $3.5 billion and $13.79 billion vs. their respective 2006 values of $3.42 billion and $13.64 billion.

On top of everything else, U.S. Bancorp's fourth-quarter earnings will be reduced by two exceptional charges -- one related to the $2.25 billion collusion lawsuit brought against Visa and MasterCard (MA - commentary - Cramer's Take) and the other relating to the company's position in asset-backed securities. Both of these items will reduce fourth-quarter earnings by 9 cents per share and 4 cents per share, respectively.

In the meantime, U.S. Bancorp stock declined last year by 25%. Most of the nine-month and third-quarter 2007 ratios of U.S. Bancorp were mediocre at best.

Net interest margin declined by 23 basis points, to 3.4%, due to the fact that a surprising 28-basis-point increase in yields on residential mortgage loans was more than offset by an increase in both short-term and long-term bank borrowings alongside a 22-basis-point increase on the interest paid on bank liabilities.

The company relied on non-interest income growth for its revenue growth (nine-month EPS declining by 3%). Most of this non-interest revenue growth was driven by credit card and merchant processing services revenue, which increased, respectively, by 13% and 14%. This negative report card on U.S. Bancorp's nine-month 2007 income statement can also include a 280-basis-point increase in its efficiency ratio, to 47.5%.

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At the time of publication, Vijayraghavan had no positions in the stocks mentioned.

Vasu Vijayraghavan was an academic finance professor at the University of Paris who has now turned to a new career as a financial consultant. As an academic, she wrote on corporate governance issues, especially in the European context, and she believes in a long-run and balance sheet approach to stock picking.

Currently, Vasu is working as a consultant for lawyers, doing business valuation. She is a Level II CFA candidate and enjoys writing long/short and earnings calls pieces for TheStreet.Com.

Vasu holds a Ph.D. from the University of Michigan and a B.A. from Harvard University.