U.S. Bancorp's Extending Its Advantage in 2014

We think the competitive advantages behind  U.S. Bancorp's (USB) narrow moat remain firmly in place and the firm will continue to create significant value for shareholders. We think management is not content to rest on its laurels, but rather is focused on continuing to build market share and deepen relationships with customers. Over the past six years, U.S. Bancorp has been investing in growth in order to have the scale necessary to deliver outstanding experiences for customers and outsize returns for shareholders. Having met its targets, U.S. Bancorp is positioning itself to continue to increase market share, which we think will lead to high returns and lower earnings volatility than competitors. We think the shares may be particularly attractive to income investors; U.S. Bancorp has been among the more aggressive banks in terms of capital return to shareholders, historically returning more than 70% of annual net income in the form of dividends and common stock repurchases.

U.S. Bancorp is a diversified financial services provider operating in 25 states in the Western and Northern United States. With $353 billion in assets, it is the fifth-largest commercial bank in the U.S., operating more than 3,000 offices and 5,000 ATMs in 25 states and generating approximately 45% of its revenue through fee-based businesses. The company is divided into four operating segments: wholesale banking and commercial real estate, consumer and small-business banking, wealth management and securities services, and payment services.

Both during and after the financial crisis, U.S. Bancorp has an enviable record of performance among U.S. banks. With most peer banks earning near their cost of capital, the excess returns earned by U.S. Bancorp are notable.

Strong Credit Culture Generates Less Volatile Loan Losses
One of the critical elements contributing to the success of U.S. Bancorp is its overall lower risk profile. In terms of minimizing credit risk, U.S. Bancorp has established a credit culture that is driven, in part, by adept and well-defined credit policies, ongoing risk monitoring and review, and independent credit examinations. This has resulted in not only low charge-offs, but also very little volatility over the past 10 years compared with bank peers.

U.S. Bancorp's Business Mix Leads to More-Stable Revenue Compared With Peers
Another element of U.S. Bancorp's lower risk profile is its diversification from a business and revenue perspective. Approximately 45% of U.S. Bancorp's revenue is generated from fee sources. Perhaps even more important, U.S. Bancorp's revenue composition from fees is much different than its peer banks'.

For U.S. Bancorp, approximately 15% of revenue is generated from its payment services segment, compared with 3% for peer banks. The payment services division provides trusted electronic payment processing services to consumers and corporations through credit, debit, and prepaid cards for consumers and provides merchants the ability to accept various card payments. For these services, U.S. Bancorp receives a fee for moving money. This is a very stable revenue source, as the need to move money does not change much over an economic cycle. Peer banks have a much larger portion of fees generated from investment banking and trading activities (12% for peers versus 2% for U.S. Bancorp). With peers having a larger portion of fees generated from those riskier activities, we think the revenue sources for U.S. Bancorp present themselves as much less volatile and thus less risky. With electronic payments becoming more popular, we think U.S. Bancorp is well positioned to take advantage of this change.

U.S. Bancorp Relies on Stable Fees…

…While Peers Gamble in the Markets

Scale Creates Cost Advantages
CEO Richard Davis clearly understands the importance of low-cost operations, stating that banking is "a scale business." He emphasized that U.S. Bancorp would achieve scale in its various businesses, expand to get to scale, or get out of the business altogether.

In terms of technological scale, all of U.S. Bancorp's processing is done under one platform at one location. For each of the bank's segments, there is one processing system. According to U.S. Bancorp, many of its competitors have multiple systems in multiple locales. The efficiency takes place when changes to products or pricing are implemented. From a systems maintenance viewpoint, a change in U.S. Bancorp's system is implemented only once, where competitors would have to implement the same change many times.

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Another advantage that this scale brings is in the payment systems segment. Currently the payment systems merchant platform accommodates 100 currencies and settles in 26 currencies. This means that very large multinational global customers can move their payments with U.S. Bancorp and eliminate processors in other countries. This is a huge advantage for U.S. Bancorp, which can then attract a large customer such as ExxonMobil. Exxon came to U.S. Bancorp for its payment systems scale and capabilities because it eliminated 17 separate payment processors.

In terms of overall size, U.S. Bancorp is not looking to double the size of the bank or expand its current geographical footprint. We think U.S. Bancorp is prudent for not pursuing a rapid expansion of the overall bank through an acquisition at this time. However, there are areas of the bank, specifically in wealth management, where we think M&A would be effective in achieving growth and scale.

Wealth Management Still in Its Early Stages
If there is one area of U.S. Bancorp that has room for improvement, we would point to its wealth management operations. To its credit, U.S. Bancorp has divided its wealth management market into three distinct segments by the level of investable assets, with each segment receiving a cost-efficient level of service that yields an appropriate return to the bank. However, the key drivers to build advantages in wealth management rely on providing superior customer experiences for those clients to help foster deeper relationships. Outside of increasing referral levels from other areas of the banks (for example, wholesale banking and commercial real estate), it is difficult for us to find compelling reasons to expect improved results. Given the reach and strong reputation of the wholesale banking segment, it is puzzling to us why these referrals have not happened sooner.

In any case, the opportunity is present for U.S. Bancorp to make strides in generating revenue from its wealth management business. Penetration of current U.S. Bancorp affluent banking clients, even clients in the lowest investable asset segmentation--the private client group, with customers having $3 million or less in investable assets--presents a significant opportunity in that each incremental 5% penetration of 1.6 million affluent clients represents $250 million of revenue. Currently, U.S. Bancorp has less than 5% penetration of its 1.6 million affluent clients. With a target of 20% penetration, this translates into at least an additional $750 million of annual wealth management revenue, or $0.40 per diluted share.

Overall, wealth management remains an area of focus for U.S. Bancorp as a means to earn stronger returns and deepen the client relationship.

We Expect U.S. Bancorp to Continue Delivering Value for Shareholders
The ultimate goal for U.S. Bancorp is to create shareholder value. It has demonstrated its ability to build its advantages with a lower risk profile to achieve scale in several businesses that make U.S. Bancorp the company of choice for an array of financial needs of both retail and commercial customers. We have no reason to believe that this superior record of creating value cannot continue in the medium term. We have confidence in this management team to continue the good work it has accomplished over the past several years. For investors, U.S. Bancorp provides consistent, outsize returns compared with every bank in its peer group. We think a long-term investment in U.S. Bancorp will only serve to benefit shareholders.

During the last Comprehensive Capital Analysis and Review by the Federal Reserve earlier this year, U.S. Bancorp was approved to pay dividends approximating 30% of its net income and repurchase $2.25 billion in common shares. If U.S. Bancorp reaches those levels of capital return over the next three years, it will have returned more than $12 billion in cash to common shareholders, or approximately $7 per current diluted share.