The $553 billion asset U.S. Bancorp (NYSE:USB) has long been a banking powerhouse, consistently generating strong returns for investors. For its consistency and earnings strength, the bank has been rewarded with a rich premium and currently trades at 243% to tangible book value (equity minus intangible assets and goodwill).
Even with bank valuations trending higher in recent months, that's a very strong valuation, likely leaving investors wondering how much upside the stock has. Let's take a look at whether or not the bank still has tailwinds left in its business and where the stock can ultimately go from here.
From a traditional banking perspective, U.S. Bancorp is well positioned like most banks right now to generate higher earnings in a rising rate environment. Like most of the industry, the bank saw net interest income decline between the the fourth quarter of 2020 and the first quarter of this year, as it anxiously waits for some loan growth.
But management expects net interest income to be at a low point and to only go up from here. Additionally, at the end of 2020, U.S. Bancorp disclosed that if the Federal Reserve were to raise its federal funds rate by half a percentage point, it would realize an additional 4.58% of net interest income over the next 12 months.
But sensitivity to interest rates and the yield curve is not unique to U.S. Bancorp. What is unique is the bank's burgeoning payments business that it has been significantly investing in and building up in recent years. U.S. Bancorp has built the necessary infrastructure to provide business credit and debit cards, stored-value cards, merchant processing, and corporate, government, and purchasing card services. The bank makes money on these products through credit and debit interchange fees, interchange on commercial cards used by its corporate customers, and other transaction and account management fees charged to merchants for electronic processing.
In 2020, U.S. Bancorp said payment services contributed $1.3 billion to the bank's net income, the equivalent of roughly a quarter of net income. And that number declined by $185 million, or 12.7%, from 2019. Additionally, payments in industries that got hurt during the pandemic such as travel, hospitality, and airlines still have not bounced back yet. U.S. Bancorp CFO Terrance Dolan said on the bank's most recent earnings call that he expects payments revenue across all industries to get back to pre-pandemic levels by the end of the year or early 2022.
U.S. Bancorp CEO Andrew Cecere also sees significant opportunity for its payments customers to drive revenue. He noted on the earnings call that less than 40% of the bank's merchant customers have a business banking product and an even lower number of business banking clients have a merchant product, presenting significant cross-sell opportunities.
U.S. Bancorp is also one of the first banks to offer the RTP platform to its payments customers, which is a real-time payments platform that enables customers to send and receive payments that are cleared and accessible instantly. Real-time payments is one of those things that isn't widespread yet, but will eventually be in the years to come, so the bank is well positioned to take advantage of this trend as well.
Room for improvement
One area for improvement that has caught the eye of analysts is the bank's efficiency ratio, a closely watched metric by bank investors that looks at a bank's expenses expressed as a percentage of total revenue. So, the lower the efficiency ratio, the better.
U.S. Bancorp has always had a strong efficiency ratio, but it has begun to tick up in recent quarters. In the first quarter of 2021, the efficiency ratio hit 62%. For the year of 2020, the efficiency ratio was 57.8%, up 2% from 2019. Most banks saw their efficiency ratios rise in 2020 because expenses generally rose as a result of COVID-related expenses, and revenues declined in the low-rate environment. The efficiency ratio should improve as COVID expenses eventually roll off and bank revenues bounce back and grow.
However, increased revenues typically come with increasing expenses, and the increase in U.S. Bancorp's efficiency ratio has come after the bank has cut roughly a quarter of its total branches over the last few years. However, the bank has taken a good chunk of those savings from branch consolidation and invested them into its digital capabilities, so hopefully U.S. Bancorp will realize those benefits soon. Management has also said that its long-term efficiency target is in the low 50s percentile. Considering the bank has long had one of the best efficiency ratios for its asset size, I think it deserves the benefit of the doubt.
Where can the stock go from here?
Despite U.S. Bancorp's high valuation, I do believe there are enough tailwinds in its business to send the stock higher. The bank should see the traditional benefits from rate hikes in its loan business, some of which could be currently priced in. But I also think its unique payments business presents a significant opportunity and could warrant a higher valuation. It will be important to see if the bank can hit its long-term efficiency ratio goals in the low 50s.
It's also important to note that U.S. Bancorp has traded at three times its tangible book value before in a rising rate environment. Not only is the bank arguably stronger now, but I think the banking sector in general is finally escaping the dog house it has been in since the Great Recession. If U.S. Bancorp traded at three times tangible book right now, its stock price would be around $70.40 per share, which is nearly 24% upside from here. And remember, the bank is also ideally growing its tangible book value through earnings every quarter.