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US Bancorp's Masked Momentum

US Bancorp (NYSE: USB  ) is like the hero in an action movie. It may endure tough trials and tribulations, but invariably, it'll win in the end and get the girl. Or something like that.

US Bancorp, against the headwinds of an extremely difficult banking environment, reported slightly tepid second-quarter earnings, and missed earnings estimates by $0.02 per share. However, the earnings call once again reminded me that I've seen this movie before, and the protagonist doesn't lose for long.

Quick recount
For the second quarter, US Bancorp earned $1.15 billion and $0.65 per share, down 1.5% from a year ago.

Net interest margins (NIM), which measure a bank's interest income margins, declined 24 basis points versus last year, and seven basis points sequentially. The company expected net interest margins to be squeezed by five to 10 basis points, and expects this slow slide to continue. NIMs were also hurt because non-interest-bearing deposits ticked slightly down, as business customers reduced excess liquidity in their cash accounts.

A well-oiled bank
By now, you're probably well aware that Bear Stearns (NYSE: BSC  ) , Washington Mutual (NYSE: WM  ) , HSBC (NYSE: HBC  ) , and H&R Block (NYSE: HRB  ) have gotten hit by some soured subprime exposure. In addition, the flat yield curve, abundant liquidity, and overly competitive environment for loans and deposits has put a huge squeeze on banks' ability to make money by borrowing from depositors and lending to borrowers.

US Bancorp has sidestepped credit issues, because its total subprime exposure amounts to 2.8% of its portfolio. The company has traded some of its interest margins for credit quality, and that bet is paying off quite nicely. Net charge-offs of average loans came in at 53 basis points, a mere 3 basis points higher sequentially, and nonperforming assets decreased $17 million to $565 million versus a quarter ago.

During the earnings call, management also revealed that chief credit officer Mike Doyle had resigned. The company made it clear that Doyle's exit had nothing to do with US Bancorp's credit quality. Although you'd expect a bank to say this after its credit officer resigns, US Bancorp's track record speaks for itself, and I have no reason to doubt.

US Bancorp also remains a paradigm of efficiency, with returns on assets of 2.09% in the second quarter, returns on equity of 23%, and efficiency ratio (a measure of a bank's noninterest expenses; the lower, the better) of 46.8%. All of these measures put US Bancorp near the top of its industry. The company stays lean and mean partly thanks to its capital allocation decisions. In the first quarter, the company bought back 18 million shares. If you believe that shares are undervalued, this is a great use of the company's excess capital.

You best recognize
During the earnings call, management was asked how US Bancorp could unlock some of the hidden value of its nonspread lending businesses. CEO Richard Davis mentioned that US Bancorp's payment and processing businesses help insulate it from some of the vagaries of the interest rate curve, and help it outperform less diversified banks. As a result, he figures that the stock market will eventually recognize the quality and stability of US Bancorp's earnings and reward it with a higher multiple. (He just doesn't know when it will happen.)

Industry publication The Nilson Report ranked US Bancorp as the third-largest merchant acquirer in the U.S. as of last year. It ranked Global Payments (NYSE: GPN  ) and Heartland Payments (NYSE: HPY  ) fifth- and sixth-largest, respectively. Global and Heartland trade at 20 and 25 times forward earnings, while US Bancorp trades at an 11 forward multiple.

It doesn't take a Harvard MBA to figure out that the market might be undervaluing the company. Its pretty clear that US Bancorp has a lot of hidden gems underneath a well-run bank masked by mediocre results, and I believe it's only a matter of time before the quality of the company shines through. I predict this particular financial flick will have a happy ending.

Further Foolishness from the vault:

US Bancorp and Washington Mutual are Motley Fool Income Investor recommendations. Investors who enjoy their capital appreciation with a dose of dividends can try out the market-beating service free for 30 days.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool's disclosure policy is plagued by a surplus of inexplicable doves.

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