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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Welcome to U.S. Bancorp’s First Quarter 2018 Earnings conference call. Following a review of the results by Andy Cecere, Chairman, President and Chief Executive Officer, and Terry Dolan, U.S. Bancorp’s Vice Chairman and Chief Financial Officer, there will be a formal question and answer session. If you would like to ask a question, please press star, one on your touchtone phone, and press the pound key to withdraw. This call will be recorded and available for replay beginning today at approximately noon Eastern Daylight time through Wednesday, April 25 at 12:00 midnight Eastern Daylight time.
I will now turn the conference call over to Jenn Thompson, Director of Investor Relations for U.S. Bancorp.
Thank you, James, and good morning to everyone who has joined our call. Andy Cecere, Terry Dolan, and Bill Parker are here with me today to review U.S. Bancorp’s first quarter results and to answer your questions. Andy and Terry will be referencing a slide presentation during their prepared remarks. A copy of the slide presentation, as well as our earnings release and supplemental analyst schedules are available on our website at usbank.com.
I would like to remind you that any forward-looking statements made during today’s call are subject to risks and uncertainties. Factors that could materially change our current forward-looking assumptions are described on Page 2 of today’s presentation, in our press release, and in our Form 10-K and subsequent reports on file with the SEC.
I will now turn the call over to Andy.
Good morning everyone, and thank you for joining our call. Following our prepared remarks, Terry and I will open our call for questions. I’ll start on Slide 3.
In the first quarter, we reported earnings per share of $0.96, which compares with $0.82 reported in the first quarter of 2017. During the quarter, a lower than expected tax rate offset by a transitional change in vesting provisions within our stock-based compensation program increased earnings per share by one penny. On a year-over-year basis, first quarter net revenue increased by 3.4% to $5.5 billion. Excluding the impact of tax reform on our net interest income, revenue growth would have been 3.9%.
Loan growth is seasonally lowest in the first quarter of every year. Pay downs have been a headwind in recent quarters due to capital markets activities by customers and our disciplined underwriting in commercial real estate at this stage of the business cycle. In addition, in the first quarter loan demand has been lower across the industry. These factors offset solid growth in our retail loan portfolios and underlying strength in new business and market share gains in our commercial portfolios. We believe the early part of this year will prove to be a transition period. Tax reform impacted not only loan growth this quarter but also commercial products revenue as it influenced the timing and level of corporate bond issuance and deal funding. Combined with strong growth in pipelines, conversations with our customers gives us confidence that commercial loan trends will improve as we move further into the year, although the timing of more robust growth tied to a resurgence in capex investment remains uncertain.
In the meantime, we are focused on gaining market share across our lending [indiscernible] products. This quarter, we saw improved sales volume growth in merchant processing, higher sales growth in credit card and commercial payment services, and strong growth in new customer accounts and client balances in our wealth management and investment services businesses. We expect this momentum to continue into the year.
On the right side of Slide 3, you will see that credit quality was stable in the first quarter and our book value per share increased by 5.9% from a year ago. During the quarter, we returned 68% of our earnings to shareholders through dividends and share buybacks.
Slide 4 highlights our best-in-class performance metrics, including a 14.9% return on average common equity, a 1.5% return on average assets, and our tangible return on common equity was 19.3%. Our efficiency ratio rose modestly from a year ago to 55.9%, reflecting increased investment in spending on technology and innovation and certain transitional matters related to stock-based compensation that Terry will address in a moment. As we discussed previously, we are stepping up our business investment in digital-first capabilities, revenue enhancing initiatives and business automation. We expect the 55.9% efficiency ratio to be the high for the year.
Now let me turn the call over to Terry, who will provide more detail on the quarter as well as forward-looking guidance.
Thanks Andy. If you turn to Slide 5, I’ll start with a balance sheet review and follow up with a discussion of earnings trends.
In the first quarter, average loans grew 2.3% compared with the first quarter of 2017, a decline by 0.1% on a linked quarter basis. During the quarter, we reclassified $1.5 billion of student loans originated under the federal loan program to held for sale. As you know, we exited the student loan origination business in 2012 and the runoff portfolio is now strategically important to our future businesses. The reclassification did not materially affect our average balance sheet for the quarter; however, it did affect ending loan balance growth.
Turning to core trends, average loan growth is slowest in the first quarter for each year, reflecting seasonality affecting credit card, auto lending, and mortgage banking in particular. This quarter, mortgage loans increased 0.9% sequentially but were up 3.9% year-over-year. Similarly, retail loans declined 0.2% sequentially but increased 6.1% year-over-year. Retail and mortgage loan growth is seasonally stronger in the second quarter of each year and we feel good about core trends in auto lending and leasing, where we continue to gain market share, and credit card balances.
Adding to the impacts of seasonality on retail loan growth this quarter were a few factors. Commercial and commercial real estate portfolios continued to be impacted by elevated levels of pay downs. While average commercial loans increased 4.0% from a year ago, average balances declined 0.1% sequentially. Pipelines improved as the quarter developed and we continue to grow commitments, however, line utilization remains at historical lows and pay down activity was exacerbated this quarter by corporate clients flush with cash on the heels of tax reform and continuing to deleverage their balance sheets.
Turning to commercial real estate, average loans declined 6.5% year-over-year and 1.6% on a linked quarter basis. The risk-reward dynamics in commercial real estate remain unfavorable in our view, particularly in multi-family and certain areas of commercial mortgage lending. That discipline is influencing decisions to not extend credit on unfavorable terms and adding to the elevated pay down pressures driven by customers accessing the secondary market.
This quarter, commercial real estate contributed a 25 basis point drag to linked quarter average loan growth and a 160 basis point drag to year-over-year average loan growth. In the near term, we intend to remain disciplined in our commercial real estate lending.
Turning to Slide 6, average total deposits increased 1.9% year-over-year but declined 1.4% on a linked quarter basis. The linked quarter decline partly reflects typical first quarter seasonality that we see in corporate and commercial banking and wealth management and investment services. Within our corporate trust business, CLO issuances and deal closings tend to be seasonally lower in the first quarter, impacting balances. In addition, investment managers deployed funds for loan and other asset purchases, taking advantage of favorable debt market conditions in the early part of the first quarter.
Recently, our deal pipeline strengthened within the corporate trust business and ending deposits began to seasonally increase across the business lines. Slide 7 indicates that credit quality was relatively stable, net charge-offs as a percentage of average loans increased three basis points on a linked quarter basis, and were down one basis point compared with the first quarter of 2017. Non-performing assets were essentially flat compared with the fourth quarter and down 19.5% from the first quarter of 2017.
Slide 8 provides highlights of first quarter earnings results. Please note that during the first quarter, the company adopted accounting standards related to revenue recognition and certain revenue and expense categories have been recast to reflect the change in accounting standard. The adoption had no material impact on operating income, as you can see on Slide 9.
Slide 9 also shows how tax reform impacted our first quarter net interest income and the related revenue growth rates. In the first quarter, net revenue of $5.5 billion was down 2.3% compared with the fourth quarter and up 3.4% versus the first quarter of 2017. Adjusting for the impact of tax reform on our taxable equivalent net interest income, revenue increased 3.9% on a year-over-year basis.
On Slide 10, net interest income on a fully taxable equivalent basis was $3.2 billion in the first quarter, essentially flat compared with the fourth quarter and up 5.5% year-over-year, which was in line with our guidance. Linked quarter growth was impacted by two fewer days while year-over-year growth was supported by growth in loans and higher loan yields.
In the first quarter, the net interest margin was 3.13%. This is two basis points higher than the fourth quarter net interest margin of 3.11%. Both periods include the impact of the reclassifications related to the revenue recognition standards. Excluding the impact of tax reform on tax exempt earning assets, the net interest margin increased by four basis points on a linked quarter basis. The increase was driven by higher yields on earning assets due to higher rates and a steeper yield curve, partly offset by higher funding costs.
Our interest bearing deposit betas continued to perform in line with past experience and our expectation after the December rate hike. We expect the total interest bearing deposit beta following the most recent rate hike will be about 40%. As future rate hikes occur, we continue to expect our deposit beta will gradually trend toward our 50% level.
Slide 11 highlights trends in non-interest income, which decreased by 4.1% on a linked quarter basis and increased 0.6% on a year-over-year basis. Linked quarter results are affected by seasonality within our credit and debit card, merchant processing, and mortgage banking businesses. On a year-over-year basis, we saw growth in credit and debit card revenue and corporate payments revenue due to higher sales volume. Merchant processing services revenue increased 2.5%, supported by strong volume growth. Merchant processing revenue continues to be impacted by exiting two joint ventures in the second quarter of 2017. We continue to expect that merchant acquiring revenue will return to a more normalized mid-single digit pace by the third quarter of 2018.
Trust and investment management fees increased 8.2% year-over-year, driven by business growth, net asset inflows and favorable market conditions. Strong growth in payments revenue, trust and investment management revenue, and deposit services fees was partially offset by an 11.1% decrease in mortgage banking revenue, which was affected by lower refinancing activity and lower gain on sale margins, and a 10.9% decrease in commercial product revenue. Treasury management fees declined 2%, reflecting the impact of changes in earnings credit, which is a trend typical in a rising rate environment.
Client behavior related to tax reform was a headwind to our commercial products revenue this quarter. Meaningful deleveraging by clients flush with cash led to reduced corporate bond issuance and investment-grade underwriting activity. There was also a significant reduction in municipal market activity due to a pull forward of issuance into the fourth quarter of 2017 related to tax reform. Corporate bond market conditions have improved in the early weeks of the second quarter and announced M&A activity continues to pick up.
Turning to Slide 12, non-interest expense decreased 0.6% on a linked quarter basis, excluding notable items included in the fourth quarter. On a year-over-year basis, expenses grew by 5.0%, in line with our expectation for the quarter. Personnel expenses were the biggest driver of costs while non-personnel expenses declined 1.2% from a year ago. Compensation expense increased 9.5% principally due to the impact of hiring to support business growth and compliance programs, merit increases, higher variable compensation related to business production, and the impact of changes in vesting provisions related to stock-based compensation programs. This vesting change was related to changes in our compensation programs in response to shareholder feedback and to ensure competitive programs within the employment and [indiscernible] market. The vesting change negatively impacted year-over-year expense growth by 130 basis points. Excluding this impact, total non-interest expense would have increased by 3.7% and compensation expense would have increased 6.9% from a year ago.
Notably within non-personnel expenses, professional service expense declined 13.5% from a year ago, primarily due to fewer consulting services as compliance programs near maturity. As we discussed previously, we’ll hit an inflection point in the growth rate of costs related to the build out of programs related to our consent order in the second half of 2018. Compliance related costs will continue to moderate through the year.
We have started to deploy increased investment dollars towards digital capabilities and innovation projects, multi-cultural initiatives and brand. The impact of these investments will occur over the next several quarters and the magnitude will depend upon the timing of our investment opportunities. Including the impact of these business investments, we still expect full-year 2018 expense growth will be within the 3 to 5% range we think of as normalized. As a result of our investments, we expect stronger revenue growth, improved productivity, and expense efficiencies in the future.
With respect to income taxes, our tax rate on a taxable equivalent basis declined from approximately 29% in 2017, excluding notable items, to a tax rate on a taxable equivalent basis of 18.9% in the first quarter of 2018. This tax rate was slightly lower than expected due to the accounting impact of stock-based compensation and the resolution of certain tax matters during the quarter.
Slide 13 highlights our capital position. At March 31, our common equity Tier 1 capital ratio estimated using the Basel III standardized approach was 9.0%. This compares to our capital target of 8.5%.
I will now provide some forward-looking guidance. For the second quarter, we expect net interest income to increase in the mid-single digit range on a year-over-year basis. We expect fee revenue to increase in the low single digit range year-over-year. As a reminder, fees are seasonally higher in the second quarter. We expect expense growth to be in the mid-single digit range year-over-year, within our long-term growth target of 3 to 5%. We expect to deliver positive operating leverage for the full year 2018. We expect credit quality to remain relatively stable compared with the first quarter, and our full-year tax rate on a taxable equivalent basis is estimated to be about 21%.
I’ll hand it back to Andy for closing remarks.
Thanks Terry. The early part of 2018 is shaping up as we thought it would. The economy is on solid footing and consumer and business confidence is strong. While the business confidence has not translated into increased lending activity yet, we believe it will. Strong consumer spending supported by a strong job market, higher wages and lower taxes should drive more business activity and business investment in technology and infrastructure, and we are well positioned to win the lending business that comes with it. Business optimism is evident in the conversations our bankers are having with our clients and we are seeing that in terms of increased commitments and more robust pipelines.
I feel very good about the outlook for our fee businesses. We are reaching an inflection point in merchant processing revenue and our focus on retail-driven purchase mortgages is enabling us to capture market share in mortgage banking. While reduced headwinds are a positive development, I am most excited about the sales and volume trends we are seeing in some of our higher return fee businesses like payments and trust and investment services, which provides fuel to an already good momentum heading into the second quarter and beyond.
As we have discussed previously, we are accelerating technology and innovation investments spent on initiatives aimed at enhancing the customer experience and leveraging our competitive positioning with a particular focus on payments, digital and mobile banking, and B2B capabilities. These investments will position us at the forefront in banking and drive improved operating leverage over the next several years.
In closing, I’m confident that our business model combined with the hard work, dedication and integrity of our entire U.S. Bank team will enable us to deliver improving returns on equity for shareholders in the near term and over the longer term without compromising our risk profile.
That concludes our formal remarks. Terry, Bill and I will now be happy to answer your questions.
[Operator instructions]
Your first question comes from the line of Matt O’Connor with Deutsche Bank. Go ahead, please, your line is open.
Hey guys, this is actually Ricky Dodds from Matt’s team. Just a quick question on expenses. Appreciate the color you gave. Just wondering if you could talk about expense growth as we exit 2018. You’ve had an uptick in costs this year and recent years, and I was wondering if we could see expense growth sort of at the lower end of your long-term range in 2019, or maybe even below that. Thanks.
Yes, this is Terry, and thanks for the question, Ricky. With respect to expenses, we certainly expect them to be in 2018 kind of in the higher end of that range, as we’ve said. As we get into 2019, one of the things that we expect and we think is important is that we would start to see revenue accelerate because of some of the investments that we’re making, as well as some of the efficiencies that we would expect from business automation and other activities that we are investing in. So I don’t know whether it will come down to the lower end of that range in 2019, but I think we’ll start to see an inflection point where it will start to come down in the range during 2019.
Got it, thank you. Maybe a follow-up, sort of switching gears, just thoughts on mortgage banking for the year. It was a bit weaker than we had expected in the first quarter, and just wondering if there’s any read-throughs there; and then just overall thoughts as we move throughout 2018.
Yes, so again let me take that question. On mortgage banking, I think we’re kind of seeing a couple of different things. One is that we’ve had a very strong focus on enhancing the retail channel and focusing on purchased mortgages over the last couple of years. What we are seeing in our particular business is we’ve actually seen applications increase on a year-over-year basis by about 11% but the revenue coming down on a year-over-year basis, and that’s principally because in the industry, it’s very competitive in terms of the gain on sale margins that we are seeing and that the industry is seeing, particularly in the correspondent banking.
I think that as the year progresses that margin compression is placing a lot of pressure on our competitors. We’re continuing to capture market share and as capacity in the industry starts to go down, we should start to see improving margins, but the timing of that is hard to know.
And Terry, I’d add that our capabilities in the digital front, specifically our loan [indiscernible] positions us well for that gain on share in the retail side.
Thanks guys.
You’re welcome.
Your next question comes from the line of John Pancari from Evercore. Go ahead, please, your line is open
Good morning.
Morning John.
To the deposit topic, on the non-interest bearing deposits, down about 6%, I know you mentioned that’s seasonality, but the year-over-year balance is still down about 3.5% or so. Is there something else going on there? Is this more of the impact of higher rates and deposit betas picking up? Just want to get some color on that, thanks.
Yes John, this is Terry again. When we look at deposit trends, for us it’s really kind of important to look at the business mix of our deposits. We typically in the first quarter see deposits being down on a seasonal basis, and that’s because deal flow within corporate trust tends to be higher in the fourth quarter and then lower in the first quarter, so we always see kind of a run-off. If we look at the deposit outflows that we saw in the first quarter, we didn’t see anything significant in the consumer or the retail side at all; in fact, they were pretty stable from fourth quarter to first quarter. The wholesale or our corporate and commercial banking deposits were down, but if you end up looking year-over-year, seasonally it’s about the same.
The most significant decrease that we saw was within our corporate trust business, and we really think that’s tied to three factors. The first is the fact that a lot of CLO deals got pulled forward because of tax reform into the fourth quarter, so fourth quarter balances were higher, and in the first quarter the CLO investment managers started to deploy those deposit balances out of the trust, so that’s pretty natural, but I think because of the pull forward it was more pronounced in the first quarter.
Second is just timing of M&A activity. We have escrow balances and we saw an outflow of escrow balances, which is really tied to M&A deals. With the pipeline of M&A strengthening, we would expect that to get stronger. And then, just normal seasonality, so it’s kind of three different factors that are happening in the corporate trust business, not as much really tied to deposit pricing.
Terry, I’d add our deposit beta assumptions were consistent with our expectations, approaching 40. We still expect them to hit 50 towards the middle and last part of 2018. The other point I’d make is that we saw acceleration in deposits actually here early in the second quarter.
Yes, yes.
Got it, thank you. Separately on the loan front, in terms of your expectation around the trajectory of loan growth, are you still comfortable with a GDP-plus of loan growth as you look at 2018, or could it be weaker just given the trends we saw this quarter? Thanks.
Well, it does appear to be a little stronger in the second quarter than the first quarter, but we still think it’s probably going to pick up mostly in the second half of the year. We did see in the C&I side, for example, our ending balances were higher at the end of the quarter, so there are signals that it’s starting to pick up.
Okay, so you’ll still go with the GDP-plus range for the full year?
Yes, I mean, that’s something we talked about last--you know, we’ll see loan growth, for example, in many of our retail categories, and that’s going to be more tied to what GDP is doing, etc. I think we see a number of signs that would still make us feel comfortable at this point.
Okay, thank you.
Thanks.
Your next question comes from the line of John McDonald from Bernstein. Go ahead, please, your line is open.
Hi guys. I wanted to follow up a little bit on the expenses. Just maybe bigger picture, Andy, the 3 to 5% normalized expense growth, you mentioned that a few times, and it’s something you targeted at the investor day in 2016. Just remind us, what are the foundational assumptions of why 3 to 5 is what you target over time, and the reason I’m asking is we get the question, other regional banks seem able this year and maybe next year to self-fund their tech investments and keep investments pretty flattish this year and next. What’s different about U.S. Bank in terms of maybe where you are in the cycle that you’re at 3 to 5 and in an elevated year you’re at 5, when others are doing flattish?
Well John, I’ll start with the fact that we’re starting from an efficiency ratio a bit lower than those other banks that you’re describing. I do think we’re going to, and we are going to focus on positive operating leverage and making sure that our expense growth is below our revenue growth, but at the same time we want to make sure we’re balanced in terms of making investments for the longer term. If we’re factoring all those things into our number of 3 to 5%, I do think it will range in there for sure. I do think that there are periods it will be at the low end of the range, but we want to make sure we’re thinking about things not only in the short term but in the long term.
John, the other thing that I would just add to that is it’s important to remember our business mix relative to a lot of our regional banks that we end up competing against. With the payments business and the investment management business in particular, in the payments business a lot of those expenses are more variable in nature and so as revenue grows, expenses will grow with that, not to the same level, but--so the business mix ends up impacting that a little bit.
Okay, that’s helpful. Just as a reminder, what do you guys think is an appropriate medium term efficiency target for you guys, say over the next one, two, three years?
Well, as I said in the prepared remarks, John, I do expect that this first quarter is the high point for the year, and we continue to expect it will be in the mid to low 50s in terms of our efficiency ratio, so I expect it to migrate down principally because we’re going to have positive operating leverage.
Okay, great. Then just a reminder, Terry, where you stand on interest rate sensitivity. Has anything changed there, and can you remind us of the split between the long and short end sensitivity?
Yes. If you end up looking at our balance sheet, probably about 50% of our assets benefit from the short end of the curve in terms of movements in interest rates, and about 50% of it benefits more on the long end of the curve. That’s really what our business mix has been overall.
From an asset liability sensitivity perspective, one of the things I would kind of maybe point out, and Andy talked a little bit about our deposit betas, but if you think about our corporate trust business, we’re getting closer to what I would call that terminal beta level, and that’s kind of starting to being baked into our rate movements, as well as on the wholesale side. The movement up of deposit betas for us, I think will be impacted by, and I think relative to maybe some of our competitors, so that’s the way we think about it.
Because for about half of our balances, it’s already at the highest level.
Yes.
Great, and then just one follow-up. You mentioned the overall retail beta, or the beta assumptions getting to, I think you said 40 later in the year. Could you just talk about the retail beta and is that the terminal assumption there, or would you expect to go higher than the terminal on the retail over time since it’s been so low for the first part of the cycle?
Yes, so the movement from 40 to 50 is probably going to be more so an assumption that retail deposits are going to start to move upward in terms of deposit betas. Through the most recent rate cycle or rate hike, we have seen very, very little movement in terms of deposit pricing. I do think that with the March rate hike and as we get into the rest of the year, we are going to see more competition with respect to retail deposits and we’re just going to be pricing to meet that competition.
Okay, thanks guys.
Thanks John.
Your next question comes from the line of Betsy Graseck from Morgan Stanley. Go ahead, please, your line is open.
Thanks, good morning. A couple questions. One, just to continue the last conversation, your loan to deposit ratio appears to be pretty low - I think it’s in the low 80s. I wonder if that’s something you can use strategically to hold back on deposit beta at all.
Yes, I think the way that I would think about it, Betsy, I do think that there is that opportunity. I think we can be a little bit more targeted and more focused with respect to how we think about retail deposits. We price in 120 different markets and so we surgically look at where the competition is moving rates, and then we only really have to move in those particular markets. I think your point is correct in the sense that we can be more targeted and we can be a little bit more focused with respect to deposit betas as they end up changing. I think that again we haven’t seen a lot of movement yet, but that’s something that we’re expecting.
Okay. Then separately on capital return, dividend payout ratios, that kind of conversation, obviously the Fed put out the SCB proposal recently. Maybe you could talk a little bit about how you see that proposal impacting you and your minimum capital ratios that you have been targeting, because obviously your SCB is well below the ratios that the Fed has been putting out there. The SCB of 2.5%, you’re well below that, I believe, so maybe you could talk a little bit about that as well as how you think about the dividend payout ratio over the next couple years here, given that the soft cap is likely to be removed.
Betsy, this is Andy. We continue to be bound by the base case, not the stress case. Our base case target is 8.5% common equity Tier 1; we’re at 9%, so we’re in the range. Our capital distribution has been in the range of our long-term targets of that 30 to 40. I do think the one change that this may offer an opportunity to do is to increase the dividend component of that share versus the buyback, so you might--you will see us increasing the dividend piece as this rule becomes more clear.
Okay. Any expectation for how much that could move over time? I’m not asking for the specific CCAR because I know you can’t talk about that, but you’ve been in the low 30s but then if I look pre-crisis, 10 years ago, you did run with a much higher dividend payout ratio, so just wondering how you think about what kind of over time payout ratio your business can handle, given the low earnings volatility that you typically have.
Sure. So Betsy, as we think about the 30 to 40 on dividends and 30 to 40 on buybacks, I could see our dividend component migrating towards that 40.
Okay. All right, thanks so much.
You bet.
Your next question comes from the line of Erika Najarian from Bank of America. Go ahead, please, your line is open.
Hi, good morning. My first question is a follow-up to what John was asking, and appreciate, Andy, that you’re reminding us of the medium term efficiency target of mid to low 50s. As we think about 2019, I’m wondering if you could give us sort of a sense of timing of the investment spend relative to the revenue that you would reap from that investment spend, and I guess really the question I’m asking is as we think about the efficiency ratio migrating over time lower, what that rate of change is going to look like in the initial year beyond 2018.
Erika, I think we’re making these investments that we talked about with a particular focus on customer experience and digital, B2B, all those things I’ve talked about. Those expenses are now starting to be baked into the run rate that you’re seeing in the first quarter and you’ll continue to see for the rest of the year. We’re going to work on the expense growth to be in that 3 to 5% range under the assumption that our revenue growth is above that, and we’ve talked about our revenue growth assumptions, so to the extent the revenue growth is robust, I would expect--and as expected, I would expect our expense to be 3 to 5%. If the revenue growth is below that, we’ll manage expenses down consistent with what our revenue opportunities are, again with the objective of continuing to deliver positive operating leverage and a lower efficiency ratio over time.
Okay. I just wanted to ask a little bit about the commercial real estate dynamics. You’re typically the bellwether in terms of credit inflection trends, and I’m wondering if you could give us a little bit more detail on some of the unfavorable terms that you’re seeing as some of these loans come up for refinancing. I think the worry that the industry or the market has is that a lot of commercial real estate loans had been struck at ultra-low rates, and I’m wondering whether or not part of your decision to not refinance is that the developers have other options for continued low rates outside of the banking industry and outside of U.S. Bank, and you’re refusing to underwrite it under market rate.
This is Bill. That’s certainly part of it. It’s either rate, and it’s often tenure and just the lack of recourse structure on these long-tenured deals, whether it’s insurance companies or the securities markets are offering, so that’s where we’ve seen the runoff in what we call the standing loan side, or mortgage loan side. On the construction side, we’re still very, very active - we actually did see our ending construction loans up a little bit in the first quarter, so that was encouraging. That’s where we focus, that’s where we can add the most value.
Got it, thank you.
Thanks Erika.
Your next question comes from the line of Ken Usdin from Jefferies. Go ahead, please, your line is open.
Thanks, good morning everyone. Can I follow up on the payments and the restatement for the revenue and expense recognition? It would seem that you’re taking out that rewards payment that was in short term borrowings and also putting that back in, and that’s what changed out of the NII side. Is that right to say?
That’s correct.
So then as a go-forward then, Terry, can you help us understand that now that that’s going to be netted inside the payments lines, how does that change either the seasonality and the variability of payments revenues as we look ahead from this restated basis?
In terms of the seasonality, I don’t think it’s going to end up impacting it a lot. I mean, the rebates that you’re talking about are principally related to our corporate payments businesses, and when you end up looking at the seasonality of that and then just how those rebates will match up against it, I think the seasonality will be the same, you just have to kind of reset your first quarter expectations regarding the line item.
Okay. More broadly on payments, I know you’ve talked about the merchant processing getting back to mid single by midyear, and on a restated basis it looks like it was back to comping positive. Corporate debit is already doing 8, and corporate--credit and debit is up 8, and then corporate’s up 12. Can those also continue to post improving rates of growth as we also move into the second half of the year? How coincidental is this overall rise in the payments business? Can you get back to those historical growth rates overall and in aggregate for each of them?
I’m going to hit corporate payments and Terry will talk about retail payments. On the corporate payments side, they’re having an exceptional--they had an exceptional year last year and continue to see that in the first quarter. We had sales growth of 12%, revenue growth of 10%, and you’re seeing really strong growth in both the government as well as the corporate sector. A lot of that is driven by some of the technology investments we’ve talked about, one of which is virtual pay, which is up about 20% on a year-over-year basis, so I would continue to see strong growth in those categories in corporate payments at the very high end of that single-digit or low double-digit range.
Then when you think about retail credit card, we’ve been talking about mid-single digit revenue growth for the year. That business tends to be a little bit seasonal in the sense that the fourth and first quarters tend to be a little bit higher in terms of the revenue growth, so I think it’s important to keep that in mind. To the extent that we--I mean, we have been seeing strengthening with respect to consumer spend in that particular space, and I think that based upon everything that we’re seeing, we believe that that can continue but it will be really tied to what does that retail customer spend look like over the course of the year.
Okay, thanks guys.
Thanks Ken.
Your next question comes from the line of Mike Mayo from Wells Fargo Securities. Go ahead, please, your line is open.
Hi, can you hear me?
Yes Mike, we can hear you.
Okay. Is this new information or are you reiterating the old information about accelerating investing in tech and innovation? I thought, and correct me if I’m wrong, your tech budget is $1 billion each year and it’s gone up to $1.2 billion to $1.3 billion, so when you’re saying you’re accelerating investing there, is this a little more of a step change than you were thinking before, and if so, why?
No Mike, it’s not new information. It’s reiteration of what we talked about in the fourth quarter.
Okay. If we could just get a little bit more meat on the bones, in terms of the areas where you’re investing, if you could just give us a little more granularity, and what are the outcomes that you expect? You clearly said you want revenues to grow fast and expenses over time, that you’re playing the long game. In terms of mobile and online users or other metrics like that, some banks disclose that, others don’t. What should we look for on the outside to monitor your progress?
Thanks Mike. Let me break into the three categories. I’ll start with the payments categories, and in there it’s going to be a focus on increasing our capabilities around ecommerce and integrated software providers. We are good there and want to be even better in those categories, because that’s where the growth is. On the retail side of the equation is increasing our digital capabilities. Today about 65 to 70% of transactions occur on our mobile device but under 20% of sales. We want to continue to enhance our capabilities around the sales side of the equation, offering convenience and speed for customers as we think about a digital-first world. Then on the business side of the equation, it’s all focused on B2B and the new rails that are being built and our capabilities around those rails, so those are the three areas of focus. The outcome of those would be increased sales activity and customer acquisition on all three fronts, and particularly on the consumer front a more central relationship with those consumers and their ability to expand beyond our footprint with consumer customers.
Mike, I might add maybe just a couple of things. Obviously on the retail side, the areas of focus, we started in mortgage because we have an important business there in terms of our loan portal. Bringing online capabilities for people to be able to acquire autos online and be able to get the lending within essentially minutes associated with that, and then checking deposits and those sorts of things. A lot of the digital capabilities in the industry today are very service oriented, though, and so a significant focus for us is really more on the sales side as we go forward.
Right.
All right, that’s helpful. So just big picture, are you doing this because you have the money with the tax reduction to catch up or to get ahead of the industry? How do you think about it?
Mike, I’m doing this because I think this is where the industry is headed and I want to be at the forefront.
Got it. All right, thank you.
Your next question comes from the line of Brian Foran from Autonomous Research. Go ahead, please, your line is open.
Hi, most of my questions have been asked, but maybe just two quick ones, first on the guidance. All the year-over-year comparisons you’re referencing are based on the newly reported numbers, not what was in the 2Q release, right?
That’s right, based upon all the recasted numbers.
Then in the NPL schedules, there was a little bit of a jump in C&I. I appreciate it was wholly offset by improvement elsewhere, but just any color on what drove that and broader C&I credit views.
Well, the credit is very stable, but yes, we did have one commercial account, it’s a consumer products account, that did go non-performing, so it was just an isolated incident. But overall, credit metrics are very, very stable.
Perfect, thank you.
Your next question comes from the line of Vivek Juneja from JP Morgan. Go ahead, please, your line is open.
Hi, thanks. A couple of quick questions. Number one, merchant processing, in the past you’ve highlighted when the dollar was strengthening that you had an impact, a negative impact from FX translation. Given that the dollar has been weakening, can you give us some color on how much of a benefit you got from FX translation now?
Yes, so if you end up looking at revenue in merchant acquiring on a year-over-year basis, it’s up about 2.5%, and what we have been guiding for the first half of the year is really that merchant acquiring on a core basis would be relatively flat on a year-over-year basis. That’s essentially what the difference is between the two, is the FX.
Saying that, again when we end up looking at the second half of the year and we think about the core growth within that business, we think about that in terms of the mid single digits, so we do expect it to continue to strengthen and the things that we end up looking at in particular is new business activity and sales volumes, and sales volumes continue to strengthen in that business as well.
Great. Second one, the deposit betas on the whole wealth management side, where are those running now? What level is that, is it 70%? Any color on that, because obviously that’s a different business.
Yes, so within our wealth management business, we started increasing deposit betas in the last rate cycle, and where there was literally no movement in earlier rate hikes, we started to see betas in the 10 to 15%, but they’re well below what you see on the wholesale side or the other institutional side. That’s kind of what we’ve been experiencing.
When you say institutional, you’re talking--when I was referring to wealth management, I was referring to the whole side of wealth and the corporate trust, so--
Ah, okay.
Yes, sorry. I realize different definitions, language.
Yes. So if you end up looking at corporate trust, when we get to more of a terminal sort of deposit beta in that 70 to 75% range, and we’re pretty much there already, that’s why as we think about the future, we believe from our asset liability sensitivity standpoint, that’s pretty much baked in. That’s kind of on the corporate trust side of the equation. Then what I would say on the core wealth management side is it’s closer to that 15%.
Okay, thanks.
Your next question comes from the line of Saul Martinez from UBS. Go ahead, please, your line is open.
Hi, good morning guys. I think in the last quarter, you highlighted that you expected to be sort of at the high end of the 3 to 5% expense guidance because of the reinvestment of a portion of the profit windfall. Sorry if I missed it, but is that still the expectation for 2018, or is it more revenue dependent?
No, that is still our expectation.
Okay, thanks. I guess a little bit more of a detail question, the other non-interest income line, you mentioned this quarter was off because of lower equity investment. Could you help size that up? I know it’s a difficult line item to gauge on a quarter to quarter basis, but this quarter it was light relative to last year, even on a restated basis. Can you just give us a sense or help us understand what a more normalized level should be going forward?
Yes, so in terms of giving the specifics regarding equity investments, we’ve never really provided that specific type of guidance. I will say in other revenue, there is many different categories of types of revenues that are part of that, including for example end of term gains and losses on residuals, etc. It tends to be lumpy because of not only equity investments but just the way that all those different categories end up interacting from one quarter to the next, so I think what I would suggest is kind of look over a period of time and you can see a range, and I would just look within that range as kind of a way of getting some sense on other income.
Got it. It’s just the number is about $30 million lower this quarter than the average of last year, so just wanted to make sure I understood that a little bit better.
Yes, it tends to be lumpy.
Got it. Just a final one, quick one on the consent order. Any update there in terms of how that’s progressing, and just anything you can share on that?
Nothing different. We are in our sustainability phase, things are going as expected. We expect to be done with our part of the equation midyear, June 30, and then the regulators will continue what they’re doing, and that timing is uncertain. But we are right on track with what we expect.
Great, thanks a lot.
Your next question comes from the line of Kevin Barker from Piper Jaffray. Go ahead, please, your line is open.
Thanks. Just a follow-up on the deposit beta. Can you give us an idea of where your deposit beta on wholesale side stood this quarter and where it was the previous quarter, and where you expect that terminal rate to be?
Yes, on the wholesale side, the betas are kind of in that 55 to 65% range, and that’s getting pretty close to the terminal level that we have experienced in the past. That’s where it is today, Kevin.
So overall, your wealth management combined with the wholesale are getting pretty close to the terminal side--
Yes.
--and then it’s just basically catch-up on the retail?
That’s exactly right.
Okay. Then a follow-up on some of the mortgage questions. You mentioned the correspondent has seen heavy competition. Could you give us an idea of where your gain on sale margins dropped on a correspondent basis from 4Q to 1Q, and what your expectations are at least for the next couple of quarters?
Yes, if you end up looking at margins on the correspondent side, they’re in the high single to low double-digit range, and that’s probably 20 to 30 basis points lower than what we would normally see. Our expectation is that as we get into the latter half of the year and probably more so into the fourth quarter that they will start to rebound, because there’s a lot of pressure on the smaller players and the players that just don’t have the capacity to be able to deal with margins that low. But that’s kind of where they’re at, and our expectation is it will start to improve, it’s just a matter of timing.
Okay, all right. Thank you for taking my questions.
Thank you.
Your next question comes from the line of Gerard Cassidy with RBC Capital Markets. Go ahead, please, your line is open.
Thank you. Good morning, Andy, good morning, Terry.
Hey Gerard.
On the terminal betas that you guys have been talking about on the call, it sounds like the terminal level, and please correct me if I’m wrong, is around the 65% range. Is that fair, or is it a little lower, a little higher?
Well, it would be--on the wholesale side, it’s probably just a bit lower, but kind of in that ballpark. On the corporate trust side, it tends to be a little bit higher because we end up having--the substitute investment is government funds, for example in the money market fund area or T-bills, so you have to kind of track to that, but that tends to be closer to the 70 to 75%.
Okay, thank you. Could we ever see them get to 100%? I mean, in your experience, because obviously we’re in a rate environment we have not seen before, being so low, could these terminal betas ever get to 100%?
Yes, that certainly isn’t our expectation based upon both our experience in the business and also from a client standpoint. There are certain operating needs in cash flow, so there’s a benefit to having those deposits with the bank, so I don’t think from the perspective of having to be competitive in terms of what they’re accomplishing that we have to go that high. I think we’re at or very close to what where we need to be.
Very good. I apologize, Terry, if you addressed this - in prior calls you had talked about the impact that the hurricanes and natural disasters had on your merchant processing and acquiring businesses. I think you pointed out in the spring of this year, you thought that would get back to normal. If you haven’t addressed it, where are we on that timeline?
Yes, good follow-up. In terms of the impact of Irma and Harvey, that has pretty much dissipated, so certainly early in the first quarter any effect associated with that has pretty much worked its way in. Puerto Rico is much smaller for us, it really isn’t that significant, but it will take more time for that to recover.
Great, than just lastly, you guys have addressed the commercial real estate lending, how you guys obviously have conservative underwriting standards. What are you seeing in the other areas, whether it’s retail or commercial? Is there any evidence of those underwriting standards getting a little too aggressive from your competitors that makes you wonder what they’re doing?
This is Bill. I would say not necessarily. I mean, we’re obviously in late stages of economic expansion and credit cycle. We just try to keep our underwriting consistent throughout the period. There have been--I mean, I’ve talked about the real estate and a lot of activity in that long-term fixed rate pricing, which has affected our mortgage book; but on the other side, it’s pretty much steady as she goes. There’s a lot of pricing pressure, but basically we compete to have a full relationship and bring the other commercial products to the table.
Great, thank you so much.
Thanks Gerard.
Your next question comes from the line of Matt O’Connor from Deutsche Bank. Go ahead, please, your line is open.
Thanks for the follow-up. I jumped on a little bit late here, but it sounds like you’re not committing to lower expense growth next year, which I guess is a little surprising given the increase in investment spend this year. But it also sounds like you expect a nice increase in revenues, so I was hoping you could kind of frame it in terms of operating leverage percent that you’re targeting if things go according to plan. I appreciate it’s a year out, but I think we’re all focused on the expense growth continuing to be quite high, and without having the context of the revenue expectations, it’s a little--not totally clear.
Sure Matt. This is Andy, let me clarify a little bit. So we talked about 3 to 5% this year. At the high end of the range, because there’s some of that increased investment we talked about, that increased investment will be in the run rate. We expect positive operating leverage this year, and going into next year I would continue to expect that. We’re not going to increase our tech spend again next year, so that will be baked into the run rate, and I would expect that growth rates next year will start to migrate down within that 3 to 5% range.
Okay, and in terms of the amount of positive operating leverage that you’re targeting, because it’ll likely be modest this year, I think, based on the guidance, and how much are you hopeful to achieve next year?
It will be modest this year and it will continue to increase as we go into 2019 and beyond, because our expectation is these investments will produce the revenue that we’re looking for, and that’s why we’re doing it.
Okay. I know a couple years ago, you put out some of these medium term revenue growth targets, and I think the hope was that you would achieve that in Year 3, which I think is next year. Is that something that’s still possible, and remind us how much that revenue growth was?
Our revenue growth rates and our expense growth rates, we do expect to be in the ranges. We were in the 6 to 8% range on revenue, 3 to 5% on expense, and our return numbers were already in that range. One thing I will mention, Matt, is that we intend to increase our ranges on our returns given the new tax situation that we’re in, and we’ll communicate more about that. But as you saw, we’re up in that range already, in the middle of the range.
Okay, so just to summarize, you are hopeful of the 6 to 8% revenue growth next year, 3 to 5% expense growth, but hopefully drifting below the high end of that 3 to 5% range?
That’s our target.
Okay. All right, thank you for clarifying.
Your next question comes from the line of Brian Klock from Keith Bruyette Woods. Go ahead, please, your line is open.
Good morning, everyone.
Morning.
Hey Brian.
I just wanted to follow up a little bit on that commercial loan growth from earlier in the call, and I thought it was interesting looking at your segment data. I know you guys mentioned that there’s still some corporate deleveraging, and a lot of your peers have talked about the same issue of some large pay downs on the corporate side. When we look at your corporate and commercial banking segment, though, I know this is averages versus end of period, so maybe there’s a difference on end of period, but the corporate banking and other actually--you know, balances were slightly up on average, or up almost 3.6% year-over-year, but the middle market was actually down, and it seemed like the trend--that’s a little bit different than at some of your peers. I wasn’t sure if this is just an average issue or if your end of period balances in March were showing a different trend versus the average. Maybe you can just talk about that - it’s Page 10 of your supplement.
Yes. Well, when I think about ending balances, on a spot basis, Brian, they are a little bit higher than the averages, so we do expect to see some momentum as we think about the second quarter. If you end up thinking about middle market, for us middle market, we’re continuing to grow on the commitment side, but one of the things that we have seen a little bit is just the impact of pay downs or pay-offs, and the principal driver behind that is from market to market, we see some M&A activity and that M&A activity ends up negatively impacting some of the middle market. If you’re looking across all of our markets, we’re seeing nice growth in at least half of them, a little bit stronger than that, and we’re seeing flat growth in the others, so it kind of depends market to market and it changes from quarter to quarter, too.
Got it, thank you for that, Terry. So I guess my other follow-up is just on the funding side. Everyone has been focused on the betas, and you talked about on the wholesale deposit side the larger trust deposits getting closer to your terminal expectations. On the borrowing side, on your wholesale funding side the borrowing piece of this, Terry, can you remind us how much of that is swapped out to three-month LIBOR, and what are your expectations on the borrowing side with either refinancing or work at the borrowing cost [indiscernible]?
Yes, I know there’s been a lot of conversation around the LIBOR basis risk, etc. on some of the other calls. For us, at the end of the first quarter as an example, we have very little that is floating rate on three-month LIBOR, so we don’t have the same sort of basis risk to increase three-month LIBOR at this point.
Okay, so is there anything swapped out for that, or you’re saying just overall it’s more fixed on that borrowing base?
Yes, well typically when we go into the marketplace in kind of a normal cycle, we have gone about 75% fixed, 25% LIBOR or floating, and tied to the three-month, but we have substantially swapped that out to fixed at this point.
Got it, great. Thanks for your time.
Thanks Brian.
With that, I’d like to turn the call back over to Jenn Thompson for closing remarks.
Thank you for listening to our call this quarter. Please call us if you have any follow-up comments or questions.
This concludes today’s conference. You may now disconnect.