Many Happy Returns

The current environment is difficult for banks of all stripes. Rising interest rates and a flat yield curve are pressuring margins, and loan demand seems meek. For big banks competing on the commodity end of the business, the stresses are arguably greater. None of this seems to matter much to $204 billion U.S. Bancorp, which topped the list of big banks in the Bank Performance Scorecard. The Minneapolis-based company’s net-interest margin has taken a big hit over the past year, dropping 29 basis points, to 3.99%, in the second quarter. Nevertheless, it churned out a return on average equity of 22.61 and a return on average assets of 2.22% in the Scorecard’s four-quarter rating period, and boasts a Tier-1 capital ratio of 8.1%.

No other large bank really comes close to those return numbers. So what explains USB’s success? Two words: fees and efficiencies. About 46% of USB’s revenues come from noninterest sources. Others achieve around the same percentage, but not the quality. Chairman and CEO Jerry Grundhofer has built a powerhouse payments-processing business that contributes 20% to total revenues. That, along with corporate trust and cards, helped fuel a 24% jump in noninterest income. “The businesses they’re in generate high returns … because they don’t have to hold as much capital against them,” says John McDonald, an analyst with Bank of America Securities.

After a credit housecleaning a few years back, nonperformers now account for 0.46% of USB’s loans, dead-on average for large banks. Analysts say the company competes aggressively on price for high-quality corporate credits (which might explain the margin compression), and Grundhofer says he isn’t afraid to use the balance sheet as a tool for winning relationships, if he can get cash management, merchant processing, or other fee generators as part of the package. “The asset side of the business is under such strain from a pricing and structure standpoint, we now look at the fee business as the real reason to lend,” he explains. “Every time we lend, we want to sell those customers value-added, fee-based products.”

Cost control is another key part of the equation. Grundhofer has long been known for running a tight ship, demanding more from employees and operational synergies to keep expenses down. USB’s efficiency ratio hovers around 42%. The tangible efficiency ratio, which takes out acquisition-related amortization expenses, is more like 39%. “We’re the low-cost provider in the banking business,” Grundhofer states proudly.

Part of this is explained by the economies of scale that come with being a large institution, able to run incremental business off the same systems. Then there is USB’s state-of-the-art technology platforms in areas such as consumer banking or corporate trust. Grundhofer says the company has invested $2 billion over the past four years on infrastructure, revenue enhancements, compliance improvements, and the like.

Mostly, though, it’s a cultural thing, reinforced in budget and planning meetings, where managers are prodded to control costs. A core mantra is that revenues in any business must grow faster than expenses. “This is a difficult business to distinguish yourself in,” says CFO David Moffett. “At the end of the day, we believe the long-term winners will be those that are low-cost producers that can compete effectively on price.”

Underlying it all is a dual commitment USB’s management and board made to shareholders in 2003 to hold off on making big acquisitions and to return 80% of capital to investors. Moffett says the company now has “the right business mix and the right geography so that we don’t need a big acquisition to complete our mission in life.” The company generates more capital for its size than any other bank, he adds, and management estimates that retaining about 20% is sufficient to fund loan growth and smaller acquisitions.

In total, USB has repurchased 146 million shares, valued at $4 billion, since the third quarter of 2003. Over the same time, it has boosted its annual dividend to $1.20 per share, from 82 cents. “The best thing for shareholders was to return the capital we couldn’t deploy profitably,” Moffett says.

Starting in 1992 with tiny Star Banc in Cincinnati, Grundhofer built a top-10 franchise by acquiring several companies, including the old Firstar Corp., and then brother Jack’s USB. That 2001 deal was fraught with difficulties and integration-cost overruns. Even so, some observers were skeptical USB could refrain from dealmaking. “Give them credit,” McDonald says. “They said they weren’t going to do big deals, and they’ve maintained their discipline.”

Perhaps as a result, USB’s share price has risen 35% over the past three yearsu00e2u20ac”better than all but three other large institutions: Golden West Financial Corp., Sovereign Bancorp, and UnionBanCal Corp. At 11.5 times 2006 earnings estimates, the stock’s P/E is about average for the group. That’s something that couldn’t be said before.

What’s good for shareholders also has been good for USB’s operations. For starters, buying back shares has lowered the amount of outstanding capitalu00e2u20ac”and the denominator in the ROE equationu00e2u20ac”thus improving return ratios, says Fred Cummings, an analyst with Key Banc Capital Markets.

Better, it’s allowed management to focus on running the business, not digesting deals. Grundhofer himself says it’s almost a relief to get back to basic blocking and tackling. “For a while there, we were so involved with acquisition after acquisition. From the outside it all went well, but internally there were a lot of issues and challenges … a lot of hectic times,” he says. Today, “it’s a real treat just to manage the business.”

Among other things, that means tracking new customers and core deposits and generating loan and deposit growth. New checking accounts rose more than 6% during the past year, about double the industry average, and fees generated by deposit accounts rose 16%, versus an industry average of closer to 2%. “They’ve always been able to execute the basics of banking better than anyone,” says Cummings, who has followed Grundhofer’s team for 13 years. “It’s all a matter of being focused, and not being distracted by a big acquisition.”

The board has had a hand in all this. The 12-member group boasts eight sitting CEOs, including those from such large companies as Anheuser-Busch Cos., Cargill, and Medtronic. Management runs the company, of course, but directors conduct annual strategy reviews and are “continuously asking questions … and keeping a critical eye on our operations,” Grundhofer says. They’re also “excellent stewards of capital,” he adds.

Looking ahead, Grundhofer won’t rule out acquisitions of smaller banks, many of which, he says, are vulnerable to the flat yield curve. “We won’t do a large acquisition, but if there’s a pricing opportunity in our footprint [due to that pressure] that would add value for our shareholders, we would consider it.”

As for USB being acquired, Grundhofer finds the suggestion almost laughable. Sure, he’s got a footprint in the western U.S. that might be attractive to a handful of bigger banks. “But no one can match our numbers and returns,” he says. “When you look at performance and market cap, I can’t put my finger on anyone who could even consider [buying] us, let alone have the operating characteristics to add value.”

Thus, no matter the size, performance is the best guarantee of independence.