U.S. Bancorp (USB) Q1 2017 Earnings Report, Transcript and Summary

Welcome to U.S. Bancorp’s First Quarter 2017 Earnings Conference Call. Following a review of the results by Andy Cecere, 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. [Operator Instructions] This call will be recorded and available for replay beginning today at approximately noon, Eastern Daylight Time, through Wednesday, April 26 at midnight Eastern Daylight Time. I will now turn the conference call over to Jen Thompson, Director of Investor Relations for U.S. Bancorp.

Thank you, Melissa 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.

Thank you, Jen. Good morning, everyone and thank you for joining our call. I am going to start off by giving you some high level commentary, Terry will then provide more detail in the first quarter results and some forward-looking guidance, and after that, we’ll take your questions. In the first quarter, we reported net income of $1.5 billion or $0.82 per diluted share. Slide 3 of our presentation provides a summary on the quarter. As is typical in the first quarter, seasonal factors impacted sequential results. However, on a year-over-year basis, we reported solid growth in revenues, earnings, loans and deposits. Turning to Slide 4. I would like you to focus your attention on profitability and returns. In the first quarter, our return on average assets was 1.35%, our return on common equity was 13.3%, and our efficiency ratio was 55.6%. We are proud of these industry leading results and we continue to focus on enhancing our performance. We expect our return to shareholders and our efficiency ratio to improve throughout the year as we gain market share in core business lines and benefit from the funding advantage afforded by our high debt ratings and superior deposit franchise. We expect to do this while maintaining the same expense and credit risk discipline our shareholders have come to expect from us. The U.S. economy continues to improve. Interest rates are finally in an upward trajectory and consumer sentiment reflects optimism for potential actions by the new administration. So, there is a lot of change and potential opportunity on the macro front, much of which could be to the benefit of the banking industry. I believe we are well positioned for this next phase of the cycle. During the first quarter of 2017, commercial loan growth was sluggish across the industry. Our large corporate customers tell us that they are optimistic about the future, but are awaiting more clarity regarding potential changes in tax and regulatory reform, infrastructure spend and trade policies. Additionally, some of our clients are actively accessing the capital markets, which pulls some financing from the bank lending arena or result in reduced line utilization. However, we expect commercial loan growth to be better in the second quarter versus the first and we expect more robust commercial loan growth in the second half of the year. Let me talk more about profitability and returns. We are not interested in growing just to get bigger. We are focused on profitable growth. And that mindset is deeply ingrained in our culture. As a result, we are willing to forego volume growth to maintain an appropriate level of profitability. We have been doing this for years in our company. In the wholesale bank, we often acquired new customers by allowing them to utilize their balance sheet for some amount of time, but if we can transition that into a more profitable relationship, we call the relationship. That strategy has translated into client growth, higher revenue per client and better profitability. We apply this same logic in our payments business and every business line for that matter. High volume, low margin business can impair profits. So as an example, we are purposely allowing less profitable business in [indiscernible] to runoff. In the near-term, that’s a headwind to top line merchant acquiring services sales and revenue growth, but those clients are being replaced by more profitable relationships. And that transition is setting us up well for the future. Terry will give more detail on merchant processing revenue during his remarks. Turning to expenses. Our efficiency ratio remains best-in-class, but it’s higher than we would like it to be. As we said last quarter, we expect expense growth to moderate as certain risk management programs are fully implemented later this year. We are committed to delivering positive operating leverage for the full year 2017 with the support of top line revenue growth, careful management of expense and reduced cost pressures from compliance programs. And we will deliver that positive operating leverage without pulling back on prudent investment spending. We remain diligent on the topic of risk management. We feel very good about our credit quality and the overall credit environment. Our net charge-off ratio continues to be stable and the non-performing asset ratio improved on both the linked quarter and year-over-year basis in the first quarter. But we will never take our eye off the ball or fool ourselves into thinking we will be able to predict when the churn in the business cycle will come. Finally, our capital position remains solid. We haven’t been burdened by an excessive amount of capital that has weighed on the returns. That said we have sufficient capital to support growth, effectively manage through periods of economic stress and continue to return capital to our shareholders. Our tangible book value per share of $19.13 at March 31 was up 6.6% versus a year ago. With that, let me turn it over to Terry to provide details on the quarter.

Thank you, Andy. I will start with a balance sheet review and then discuss first quarter earnings trends. Slide 5 shows our loan growth trends. Average total loans outstanding increased 0.2% on a linked quarter basis and grew 4.1% compared to the first quarter of 2016. Strong linked quarter growth in retail leasing and residential mortgages was essentially offset by modest declines in commercial loans, commercial real estate loans and home equity lending. As mentioned earlier, the commercial loan growth was sluggish across the industry during the first quarter. Our commercial loans declined slightly compared with the fourth quarter of 2016. Excluding the seasonal decline of corporate card balances, which are included in our commercial loans, our commercial loan growth was positive 0.2%. Somewhat offsetting this headwind in the first quarter was strong growth in middle-market lending across many geographies. Loan growth in commercial real estate reflects our own prudent approach in lending to certain CRE segments, such as multifamily and retail given current market conditions. Turning to Slide 6. Total average deposits declined 0.2% compared with the fourth quarter of 2016, reflecting typical seasonal trends and lower funding requirements given the slower loan growth in the quarter. On a year-over-year basis, average deposits increased 11.0%. Following the March interest rate hike, our total interest bearing deposit beta is about 20%. As future rate hikes occur, we model that the beta will gradually trend toward a 50% level. On Slide 7, you can see the credit quality remained relatively stable in the first quarter. Net charge-offs as a percentage of average loans were 50 basis points in the first quarter, up slightly by 3 basis points compared to the fourth quarter and 2 basis points higher than a year ago. Non-performing assets declined by 6.7% compared with the fourth quarter, and NPAs as a percentage of loans plus other real estate decreased 4 basis points to 55 basis points at March 31. Improvement was driven by commercial loans, commercial real estate, residential mortgages and other real estate. Slide 8 represents some information on two areas that have received a lot of attention lately by the investment community: auto lending and retail industry exposure. First, on auto, we are a prime lender in the space and we do not originate sub-prime auto loans. The average FICO score for originations in 2016 was over 770. Our credit metrics remain very stable in auto lending. The second area is the retail industry segment, given recent pressure, as consumers alter their buying habits. Commitments related to the retail industry totaled 3.4% at year end 2016. A little over half of that is direct C&I exposure to retailers, two-thirds of which are to investment grade or equivalent clients. We have minimal exposure to retailers who make their malls. We are watching this retail segment and are comfortable with our portfolio, given the relative small exposure, geographic diversity and high quality of customers. I will now move on to earnings results. Slide 9 provides highlights of first quarter results versus comparable periods. First quarter net income of $1.5 billion was essentially flat compared to the fourth quarter, but was up 6.3% versus the first quarter of 2016. The first quarter is impacted seasonally each year and this quarter was no different. Turning to Slide 10, total revenue declined by 2.0% on a linked quarter basis and grew 5.7% compared with the year earlier. The year-over-year revenue growth was primarily driven by solid loan growth funded by strong deposit growth and strength across our fee businesses. Turning to Slide 11, net interest income on a fully taxable equivalent basis was $3.0 billion in the first quarter, essentially stable with the fourth quarter despite fewer – two fewer days in the quarter. Net interest income was up 3.7% compared with the prior year, reflecting earning asset growth from a year ago. Slide 12 highlights trends in non-interest income, which decreased by 4.2% versus the fourth quarter, reflecting typical seasonal patterns and a decrease in mortgage banking revenue of 14%. The mortgage revenue decline was in line with our guidance and reflects both seasonality and a drop in refinancing activity due to higher interest rates. On a year-over-year basis, non-interest income increased by 8.4%, driven by strength in payment services revenue, trust and investment management fees and mortgage banking revenue. I will highlight a couple of items within non-interest income. Trust and investment fees increased 8.6% year-over-year, reflecting new account growth and improved market conditions, along with lower money market fee waivers. Credit and debit card revenue increased 9.8% on higher credit card sales of 8.5% and total card sales volumes of 6.2%. Credit and debit card revenue increased 6.8%, excluding the impact of an acquired portfolio. The increase in other income was primarily due to higher equity investment income. Merchant processing revenue grew 2.7% on a year-over-year basis, adjusted for the impact of currency rate changes. This is a slower pace than we have seen in previous quarters and reflects several factors, including the impact of higher EMV related equipment sales revenue in the first quarter of 2016, the margin impact of certain interchange caps implemented in Europe in late 2015 and our decision to exit certain high volume, low margin merchant relationships last year. We are growing merchant relationships in this business, but the impact to volumes and revenue is being muted somewhat by these factors. We expect this masking effect will begin to dissipate in the second quarter. By the third quarter, merchant acquiring revenue is expected to return to a more normal rate of growth, a trajectory of same-store sales plus about 2%, excluding the impact of foreign currency changes. Turning to Slide 13, non-interest expense decreased 2.0% compared with the fourth quarter, primarily reflecting seasonally lower costs related to investments in tax advantaged projects, professional services expense and marketing and business development. On a year-over-year basis, non-interest expense increased 7.1%. Growth was driven by higher compensation and employee benefit expenses, reflecting the impact of merit increases, higher variable compensation, including performance based incentives and stock based compensation and hiring to support business growth and risk management programs. The increase in marketing and development expense reflected investment in the brand and various business initiatives. Other expense was up 6.2%, reflecting the impact of the FDIC surcharge, which began in the third quarter of 2016 and an insurance recovery last year. Slide 14 highlights our capital position. At March 31, our common equity Tier 1 capital ratio estimated using the Basel III standardized approach as if fully implemented was 9.2%, which is well above the 7% Basel III minimum requirement and our internal target of 8.5%. In the first quarter, we returned 78% of our earnings to shareholders through dividends and share buybacks. We expect to remain in our targeted payout ratio of 60% to 80% going forward. I will now provide some forward-looking guidance. In the second quarter, we look for modest growth in net interest income on a tax – fully taxable equivalent basis, driven by improved loan growth compared with the first quarter and slightly higher net interest margin. Credit card, mortgage and auto loan growth are seasonally stronger in the second quarter. Additionally, we look for improved commercial loan growth in the second quarter as well. However, the timing of anticipated policy changes are difficult to predict. Also, given the current yield curve and rate expectations, corporate clients are continuing to access the capital markets, which may impact that growth in commercial loans in the short-term. Therefore, we think meaningful acceleration in commercial loan growth is more likely to occur in the second half of 2017. Finally, we remain disciplined in lending to the CRE market and growth in that category will likely remain muted in the near-term. We look for mortgage revenue to increase compared with the first quarter. The second quarter is seasonally stronger, as home sales strengthen in the spring and we are well positioned to gain share in the purchase market over time. Industry refinancing activity is projected to continue at lower levels, reflecting higher mortgage rates. Expenses will be seasonally higher in the second quarter, but as previously mentioned, we expect to deliver positive operating leverage for the full year. Given the underlying mix of quality of our loan portfolio, we expect credit equality to remain relatively stable in the second quarter and we expect the loan loss provision to increase in line with loan growth. The taxable equivalent income tax rate was 27.0% in the first quarter compared with 28.1% in the fourth quarter of 2016. The decrease reflected the impact of new accounting guidelines related to stock based compensation effective for the first quarter of 2017. We estimate the taxable equivalent income tax rate in the second quarter of 2017 will be approximately 28%. Finally, in the first quarter, we provided notice to redeem all of our Series G preferred stock and issued $1 billion of Series J preferred stock. The total quarterly dividend – preferred dividend – the total quarterly preferred dividend for the quarter was $69 million. Included in the determination of diluted earnings per share for the first quarter of 2017 was an additional charge of $10 million related to the Series G issuance cost. Looking to future quarters, given our current capital structure, the level of preferred dividends will be about $63 million in the second and fourth quarters of each year and $70 million in the first and third quarters of each year. Of course, the $10 million issuance charge will not reoccur. Let me hand it back to Andy for closing comments.

Thanks Terry. So to summarize, we feel good about where we are and how we are positioned and even better about where we are headed. I look forward to leading this company through the next phase of its evolution. Our Chairman and former CEO, Richard Davis’ leadership has set us up well for the future. And I am grateful for his guidance and partnership over the last 10 years that we have worked together. Our businesses are strong and our culture of innovation is intact. So as I transition into my new role, you should not expect major changes to the strategic direction of this company, given our industry leading performance. You should expect an ongoing focus on innovation, continuous improvement in our customers and employees. That concludes our formal remarks. Terry, Bill and I will now be happy to answer your questions.

[Operator Instructions] Your first question is from John McDonald with Bernstein.

Good morning John.

Good morning guys. I am wondering about the expenses Terry, what kind of step-up in expenses should we kind of be thinking about for the second quarter and just remind us, where does that seasonality occur, which lines?

Yes. So if you end up thinking about the second quarter, we are going to typically see it growing probably 3% to 4% in the second quarter relative to first quarter. As John, we have talked in some of our investor conferences, we still expect pressure with respect to risk programs, at least through the end of the second quarter, with the trajectory of that growth starting to slow as we get later into the year. So when we think about positive operating leverages as far as expenses are concerned, we are pretty confident that we are going to deliver on positive operating leverage for the full year.

Okay. But maybe we shouldn’t expect efficiency ratio improvement in the second quarter and it probably gets better late in the second half?

That’s the way that we are thinking about it. I think it’s going to probably start to plateau and then as it gets later into the year, it’s going to start to come down.

So, John, this is Andy. I do think we are sort of at our high level. It will be flattish in the second quarter and then start to come down as we achieved that positive operating leverage in quarters three and four.

Okay. And Andy, what kind of loan growth outlook do you have nearer term? How much do you think you can get better in the second quarter and what drives your confidence that we could accelerate further in the back half of the year?

Sure. So first of all, our starting point is a little higher versus where we ended the fourth quarter. Secondly, our pipelines are stronger. As Terry mentioned, a lot of our corporate clients were accessing the Capital Markets, so that did put a bit of a damper on loan growth. But the seasonality on home equity, what we are seeing on auto and what’s going on with the corporate loan growth tells me that the second quarter is going to be stronger than the first quarter, but probably not as strong as what we achieved some quarters last year, but I do see acceleration here in quarter two.

Okay. And then last thing, Terry, can you just give us some thoughts on the net interest margin? What are the puts and takes going forward for next quarter and how much improvement could you see? We got the March hike. And what do you think for the second quarter NIM?

Yes. I think net interest margin as we said is going to end up expanding, but it’s going to end up expanding slightly, I think in the second quarter. We do see growth in the net interest margin as we get into the third and fourth quarter. Part of the growth in the first quarter of 5 basis points, some of the factors that will help us as we go into second quarter is we are starting to see that inflection point in terms of the investment security portfolio, so that will help us a little bit. Cash balances will be a little bit higher, which will put some pressure on it. When we end up looking at kind of all of those, the growth quarter-over-quarter is going to be in the basis point or so.

Okay, thank you.

Thanks, John.

Your next question is from John Pancari with Evercore.

Good morning, John.

On the – back to the loan growth expectation, I know you indicated that as the capital markets weighed near-term, but you expect that could be strengthening. What type of annual growth rate do you expect for this year in overall loan growth? And then as you look into a more normalized macro improving type of environment, what is the go-forward loan growth that you think USB is capable of for next year, for example?

Right. So, one of the things that we talked about last quarter is that we thought that loan growth for the year would probably be in the 6% to 8% sort of range. And certainly, as we look at where the first quarter has occurred, that’s going to be hard to achieve, but we think it’s going to be middle single-digits, if you will, for the year. We also do believe that second quarter is going to start to get stronger and that’s going to start to accelerate as the year progresses. And so as we think about 2018, we certainly believe that, that 6% to 8% is very reasonable as we think about the future.

Okay, great. Thanks. And then back to the expense topic. Appreciate the color you gave, but just looking at the efficiency ratio, more of on a long-term basis as well. I know you are sitting there at 55.5% for the quarter. How could we expect that, that will trend as we look into ‘18, if you can give a little bit of color? Thanks.

So John, as we have said, we expect our efficiency ratio to be in the low 50s and that’s still our goal and our target and that’s what we are planning to. I would say, again, that this quarter was at our highest level, our high point and we are going to start to achieve downward trend, particularly in the second half of this year and I would expect the same trend next year as we achieve positive operating leverage.

Okay, great. And then lastly on the credit side, I know you indicated you don’t originate sub-prime auto, but do you have a component of your auto book that is sub-prime that is migrated that way?

No. I mean, obviously, if somebody goes delinquent and they get scored out, they will wind up with a FICO below 620, but that’s just normal migration. So – but I mean, we have a very high-quality auto loan book. The origination FICOs are 770 plus. On the leasing side, it’s even a higher credit quality portfolio. FICOs are over 780. So anybody that winds up with a 620 or less FICO is just somebody that’s probably lost their job and has payment issues.

Okay, great. Thank you.

Thanks, John.

Your next question is from Matt O’Connor with Deutsche Bank.

Good morning, Matt.

Hey, guys. This is actually Ricky Dodds from Matt’s team. Just a quick question on the professional services line down quite a bit on a linked quarter basis, I was just wondering how should we be thinking about that line going forward and If the first quarter number is a good starting point to sort of model off of? And then maybe another question on the other fees line item, obviously that line item is a little lumpy historically. Wondering if you could remind us maybe what is in that line item that makes it so lumpy and then perhaps provide a good run-rate going forward? Thanks.

Yes. So, let me take the professional services fee piece first, Ricky. And if you end up thinking about that, that is an area where a lot of business initiatives comes through and a lot of expense related too, for example, some of the risk compliance programs. It’s also very seasonal. It’s very – it’s seasonally high in the fourth quarter. First quarter comes down to the levels that you are seeing and then it starts to ratchet up as business initiatives are put into place and as the year kind of progresses. So, we do expect that it’s going to be a line category that is going to go up. As we get later into the year and especially as we kind of start getting into 2018 though I think some of the pressure related to professional fees as is related to risk management compliance programs is going to start to alleviate. And so I think that is an area for opportunity as we start looking at next year, but second quarter definitely is going to be seasonally up third quarter and then fourth quarter is usually the high watermark for professional services fees. In terms of other revenue, other revenue is a combination of a whole variety of different things. It ends up including equity investment income, some trading income, sometimes syndications – part loan syndications is a part of that, retail product revenue, insurance product revenue. And so it can be very lumpy depending upon what’s happening that particular quarter. Year-over-year, it’s up a little bit, but relative to the fourth quarter, we had some CDC syndication fees that were a part of that. So, it tends to be a little bit lumpy.

Okay, thanks, guys.

Thanks.

Your next question is from Saul Martinez with UBS.

Hi, good morning. Thanks for taking my question. Couple of questions. First, sort of a bigger picture strategy question. I know, Andy, you mentioned that you shouldn’t expect any meaningful change in strategy, but wanted to ask about your branch strategy specifically. You haven’t, since the crisis, really changed your branch count that much, especially relative to peers. You have also had very strong deposit growth over this time period and continue to. So maybe that’s playing a role. But going forward, how do you think about the ideal network size, especially given changes in consumer behavior and frankly some pressure to achieve positive operating leverage?

So Saul, you are right. The branches are a great source of deposits. We recognize that. And I think that will become even more important as we move into a higher interest rate scenario. At the same time, you are also right that transactions in our branch are reducing. So, 60% of transactions today are done digitally outside of the branch. So what we have done and we will continue to do is change the footprint of the branch in terms of reducing the square footage and we have done that for the past few years and we continue to focus on that. We have also had some reductions in the number of branches and I would expect that to continue. So, overall, the footprint space, so to speak, in our branch network will come down. The number of people handling transactions will come down, but it does continue to be an important source of deposit growth. And for that reason, we will have branches as we do, but fewer square footage, fewer branches, less space.

Okay. Do you give any sort of magnitude or sense of the magnitude of how much you are reducing square footage or the proportion of branches that are being refurbished or remodeled?

Yes. From the number of perspectives, we have been calling branches in the neighborhood of 50 to 100 last few years and I would expect this to continue for the next couple of years.

Got it. And then a more specific question on credit quality, credit card specifically. The charge-off rates didn’t move up, 37, I think a year ago, it’s 32.6. So, obviously, there is some seasonality component quarter-on-quarter, but year-on-year, there is some increase, and I know you talked about retail and sub-prime auto, but anything there? What’s driving that, anything to be worried about in terms of the trajectory on your credit card book?

Short answer, nothing to be worried about. As you recall, we have grown our – all of our loan portfolios throughout this cycle. So we do have seasoning impact there. We have had good – that acquisitions. We have had good organic growth, especially out of the branches. So there is nothing there that – we saw the same seasonal patterns and delinquencies, so we see nothing that concerns us. It’s all within expectation. We expect that the latter half of the year, those rates will come back down depending upon the balance.

Got it, right. Okay. Can you remind me what you – I think you mentioned in your Investor Day, but what the through the cycle charge-offs are for your credit card book?

Yes. I think we tagged that. It’s either, like, 4.75 or 5, somewhere in that range.

Okay. So you are still well within that?

Yes.

Alright, very good. Thanks a lot.

Thanks.

Your next question is from Ken Usdin with Jefferies.

Good morning Ken.

Hi, this is Amanda Larsen on for Ken. Can you talk about the pushes and pulls on balance sheet growth, average earning assets were down quarter-over-quarter for the first time in many years and I guess that balance sheet size the product of deposit growth in the opportunities that growing loans, but you remain out of cash into loans and securities also shrinking the balance sheet this quarter and I am wondering if this is – if this will be more indicative of your future plans and lower deposit, lower growth quarter as you focus on profitability over volume?

Yes. I mean, so if you are all looking at just kind of the shifting of earning assets, I mean we are holding a little bit more cash balances than what we have in the past and that’s for things like liquidity purposes, etcetera and the fact that we have had stronger deposit growth over the course of last couple of quarters. In terms of loan growth, I think we have kind of talked about the mechanics of that. Our investment securities is really going to grow in line with what our liquidity requirements are at any particular point in time. From a deposit standpoint, in terms of pricing, we are just really looking at being very competitive with respect to deposit pricing. But right now, deposit beta has been fairly inelastic. So we don’t see a lot of changes relative to where we are at. I think it is fairly indicative in terms of what you are going to see going forward.

And Terry, I would say most of the fluctuation occurred in the fourth quarter was function of cash levels. And that can be volatile given the deposit flows and given the loan growth. So if you look at our loan portfolio that was up 7.2% [ph]. Our securities were relatively stable. And cash from around a bit, probably up a little bit more cash as we were before.

Okay, great. And then fees were good across the board, can you talk about pipelines and commercial product revenue and also some of the headwinds and tailwinds in the payment line, it looks like corporate payment products may turn into growth, but that merchant processing slowed?

Yes. No, I think that is true. I mean we did see really nice growth with respect to credit card. And one of the areas that I would also kind of focus on is in the commercial payments space. We saw some very nice growth. Linked quarter is about 4.7%. On a year-over-year basis is about 5.3%. It’s one of the things we are seeing and we started making some business investment in that, a little over a year ago in terms of technology. We rolled out kind of virtual card offerings and innovations. And we are also seeing a little bit of a tailwind as a result of fuel prices getting a little stronger. So that’s some of the things that are benefiting us. In terms of commercial business sort of spend, in that particular category. And then in the first quarter, we are starting to see government spend expanding a little bit up, which is a little bit unusual for the first quarter. It was up about 2.2% year-over-year. And we are seeing stronger defense spending in the sense of the election, it’s maybe the way that we would categorize that. On the merchant – merchant acquiring and merchant processing revenue, I did talk a little bit about it. But again, the drivers behind the 1.3%, part of that is the foreign currency, so that gets you to about 2.7%. We, as part of the kind of chip and PIN sort of rollout in the whole – in that whole topic, our EMV equipment sales were strong at the end of 2015 and the first quarter of 2016. But relative to the industry, we are more penetrated in terms of chip technology with about 66%, 67% penetration at this particular point in time relative to the industry, which is closer to about 40%. And so in the first quarter of this year, we are kind of just continuing to see that. Now, that will abate as we get into the second quarter and into the third quarter as well. And then I think the other thing that’s been – the other two things that’s been impacting that is that we just have margin compression that’s been occurring in Europe because of the interchange caps that were put into place in late 2015. That’s getting close to the end, which is good to see. And then as we said, we have been exiting some high volume, low margin sort of merchants. And so that has impacted revenue a little bit, but it certainly has impacted volumes. And so when we think about merchant acquiring revenue for the second quarter, we do believe that, that is going to get stronger as some of these factors start to abate. And it’s going to become more normalized in the third quarter. And we think about that – we usually think about it in terms of same-store sales plus 1% to 2% in terms of what the revenues should look like.

And Terry, let me reemphasize something you said. The corporate payment systems in the past few years seems to have had a headwind either in the government side because of lower government spend or on the corporate side as some large corporations slow down their expense spending. This was a quarter that we actually saw growth in both. And that was very positive on the corporate side [indiscernible] some of that innovation on the government side because some of the increased spend. And we continue to expect growth in both of those. So that’s an important turn in terms of the growth trajectory for corporate payment systems.

Okay. And just one last one on the commercial product revenue thinking about pipelines into 2Q, I know you had a good quarter this 1Q, but then also last year 2Q is seems like a tough comp, so what you are seeing on that [indiscernible] activity, is it possible you can post year-over-year growth next February? Thank you.

Yes. Well, certainly, on a year-over-year basis, we do believe that. The second quarter tended to be a little bit stronger last year because of some of the Brexit things in terms of second quarter. But the pipeline, in terms of syndication and fixed income capital markets, continues to be strong. We do expect, given the current rate environment and just kind of some of the things our large corporate customers are doing, that they will continue to access the capital markets. Our capital market revenue was up very strong in the first quarter. We would expect it to stay at higher levels going into the second quarter. So we think that that’s a pretty good outlook. And of course, by those large corporate customers accessing the capital markets, that has been impacting our loan growth to some extent. But we do see that continuing.

Okay, great. Thanks very much.

Thank you.

The next question is from Erika Najarian of Bank of America/Merrill Lynch.

Hi, good morning.

Hi Erika.

So just wanted to ask a question on the trajectory of deposit costs from here, as you mentioned, deposit betas remained quite low, I did notice that there was a 10 basis point quarterly up-tick in money market savings and I was wondering if you can give us a little bit more color on perhaps a different competitive dynamics of the different deposit products and also you mentioned an eventual 50% deposit beta, but what is the realistic trajectory in 2017 if we only get one or two more rate hikes?

Yes. So let me kind of talk about it. Again, betas overall, if we end up looking at December of ‘15, December of ‘16, March of ‘17, typically what we have seen and we are pretty much on track on this is well in terms of the March hike, is that deposit betas have been up about 20%, 20% to 25% kind of in that ballpark. We have a strong retail deposit base that represents about 50% of our overall deposits. And the pricing from that particular standpoint has been pretty inelastic thus far. So we haven’t seen a lot of movement in terms of retail deposits. And certainly for the next rate hike, I don’t expect that we are going to see a lot of movements. There may be a little bit more pressure, but we still think there is room and opportunity there. On the wholesale side, which represents about 30% of our overall deposits, we are seeing kind of what I would say, selective competitive pressure and the deposit betas with respect to that or closer to the kind of 25% to 30% kind of in that ballpark. And then our corporate trust business, which will be unique to us, represents about 18% of our overall deposits. That tends to be a little bit more sensitive to interest rates. And so we are seeing pressure in terms of movement of interest rates is going to be in that space. As we think about kind of the rest of the year and certainly, the next rate hike or so, that 20% to 25% deposit beta probably starts to migrate to 30%, 35% and that would be – what I would think we would see kind of through this year. It’s really going to depend upon how many rate hikes and how quickly they come. I just want to point out is that when we model a rate hike movement, certainly as we get a few rate hikes out, we are going to see deposit betas. There is going to be just more competitive pressure there in the future. So that’s kind of how the way we think about it.

Thank you. And just as a second question. Andy, we totally get the message as a marketplace that it’s going to be business as usual and no large change in strategy, I am wondering if you could remind us on how U.S. Bancorp, over the next 2 years or 3 years is thinking about inorganic growth in terms of use of its excess capital, especially in a world where your consent order is listed or you don’t have any [indiscernible] restrictions in terms of inorganic growth?

Right. So we have – as you know Erika, we have been doing some portfolio deals, credit card transactions, some payments transactions as well as trust and fund services. So those types of things, we are not precluded from doing. They are high return, low capital usage businesses and we will continue to focus on them. We are precluded from branch transactions until we are out of the consent order. And we will look at opportunities there to increase market share, our depth of participation on market as that presents itself. But we are well positioned with both organic growth that we have today and our opportunities for acquisition with the current model. So we are not really prohibited from what we want to do.

Got it. Thank you.

Sure.

Your next question is from Vivek Juneja with JPMorgan.

Hi, Vivek.

Hi, Andy. Hi, Terry. A couple of follow-ups on those questions that have come up, Andy can you remind us where you are in terms of your expectations for timing on when you get out of that anti-money laundering issue?

So there are three components with the concenter and I am going to ask Bill to fill in the details. But the way I think about it simply, there is the people process side and that we are done with that. The second is the technology component, which will be done this summer. And the third is the sustainability component, which is really a function of the regulators improving the sustainability. And that one has a little bit more in terms of uncertainty of timing.

So Andy hit on it right. We got it late 2015. We had already been working on it for well over 1 year. So last year was a year of build, this year is a year of installing some of the new technology enhancements. We are pretty much at a full staffing level. So towards the end of the year, we expect to be able to demonstrate sustainability. And then from there, it’s getting all the external parties comfortable with validations and etcetera. So that’s how we think about the timing.

Do you think you get out of the whole thing from the regulators by end of this year, early next year, any sense of where you think the timing lands?

Yes. Again, towards the end of this year is when we will be demonstrating sustainability. So that’s – after that, it’s up to the auditors and regulators.

Okay, great. Separate question, other income, which was up 16% year-on-year, you have mentioned in the release that higher equity investment gains, can you give us some perspective that’s pretty nice jump in other income, what is the run rate of equity investment income and what is the dollar amount of equity investments?

I have never gotten into the dollar amount associated with equity investments simply because other revenue represents the whole bunch of different categories, I will tell you that as we think about the second quarter Vivek, that we do believe that the equity investment income is we are – going to be pretty consistent based upon anything that we see right now, pretty consistent with the first quarter. So we wouldn’t expect to see a lot of movement up or down in terms of equity investment.

Okay. Lastly, auto lease residuals, can you talk a little bit about that, there has been some concerns about that item, given concerns about lot of leases coming off in the next couple of years?

So Vivek, this is Andy. That has come back. So as you know, that was in the $700, $800 level last year, migrated down to about $200 of gain in the first quarter. But I will tell you in April, it’s back up to the $800 to $900 level. So it’s bounced back. Part of that it because it will slow down in production, which has eased the pressure on used car prices, so that has bounced back.

Alright. Thanks Andy.

You bet.

Your next question is from Betsy Graseck with Morgan Stanley.

Good morning Betsy.

Hi, a couple of questions and follow-ups, one is on the deposit rates that you showed on your slide deck where for time deposits, you did increase this past quarter, but there was some outflow and I am just wondering, I know for quite a while, you have been shrinking time deposits, not necessarily most efficient way of gathering deposits, but I am wondering, from here on in is that strategy still hold or should we expect that you are going to try to regain some activity there?

Yes. From a time deposit standpoint, that’s really kind of a function of what sort of funding we need in order to be able to support loan growth. So in some respect it’s kind of a function of how much loan growth we end up seeing. If we do continue to see rising rates, that we may have kind of change our pricing strategy a little bit with respect to time deposits, especially as we get into a period of time I don’t know whether it will be the next rate hike or the following where retail deposits become more sensitive to rising rates. Then you may see us kind of shifting that strategy in order to kind of lock in some of the deposit pricing associated with time deposits. But right now, based on what we are seeing in the relatively inelastic retail deposits, I don’t anticipate that we would change a lot.

Okay. And then my other follow-up is on the commercial real estate, you mentioned in your prepared remarks, not really looking to grow that line item and in fact strength of it being conservative, maybe just you can speak to some of the reasons why and touch on if any of that has to do with regulatory reviews or CCAR process, etcetera?

Betsy, this is Bill. Last part first, none of it has to do with the [Technical Difficulty] regulatory or CCAR process. If you look at the CRE line and you look at the two pieces, the piece has been declining is the standing loan or mortgage loan part. So that’s as other banks have offered long-term fixed rates or not interested in doing that, loving non-recourse. We are not – we have our set appetite for that. And then just the insurance markets, etcetera. So that’s the piece that’s been declining. On the construction, we enjoyed fairly rapid growth there for a while. That has slowed, but that’s in part because of our own client base. They are getting more cautious on multi-family side and obviously, we follow our clients. So we do look at the high asset values in some of the CRE markets right now, some of the different markets. So our borrowers are cautious, our customers are cautious, we are cautious. But we still anticipate construction, both to grow, just not at the same rates that they used to.

Okay. And then just lastly on the C&I, I saw the comments around how large corporates are refinancing in the capital markets driving pay downs, a little bit of pressure there on the C&I loan balance, but what about the mid-market side, is that – are you seeing the same thing there and what degree of interest do you think there is in increasing loan utilizations, just separating out large versus mid?

Yes. So when we end up looking at loan growth, C&I loan growth, we did see good growth in the middle market space. And so on a year-over-year basis, middle-market was actually up about 8.7%. And on a linked quarter basis, it was up about 2.5%. It represents about 13% to 15% of our overall portfolio. We are seeing that type of growth across the whole variety of different markets. We have seen good growth in places like Nevada, Utah, Colorado, here in the Twin Cities, Kansas City, Wisconsin, just kind of across the board. So as we kind of talk to our folks, we talk to our clients, we are not seeing the same level of access to the capital markets. So that impacts really more on the large corporate space. And we would expect the middle market to continue to grow. The other thing I would say is as we look into the second quarter, part of the middle market is our community banking space and we typically see lift in the second quarter as the ag lending starts to kick in and so both of those would be areas that we would look for opportunity as we think about the second quarter.

Okay, that’s great. Yes.

I was just going to add one other thing that in the first quarter, we did see several hundred million of pay-downs in our energy portfolio and we don’t expect that to repeat as the portfolio is stabilizing and improving, but we did have large number of pay-downs in the first quarter, so...

Okay, that’s very helpful. And just lastly the definition between middle-market and large corporate for you?

Yes. It’s kind of based upon size. It’s about $10 million.

$10 million in sales, Betsy.

Yes, the middle-market is the $500 million, above that’s the large corp.

Okay, super. Thank you.

Your next question is from Kevin Barker with Piper Jaffray.

Hi, good morning. Thanks for your time today. Just a quick follow-up on the auto side. Given the decline we have seen in used car prices, I was wondering how you are thinking about the residuals on your auto lease book and how they might be performing relative to your expectations, in particular, just maybe you have increased the depreciation rate on those leases and just really how you are mitigating the residual risk on that book?

So Kevin, I mentioned before that the residuals have actually come back here in the early second quarter, back to the normalized levels, I would say. They dipped down in the first quarter. You are absolutely correct, but they did come back. We are already very conservative in the way we think about residuals and the way we book them. So we are not changing anything there and the market has come back.

Great, thanks.

Sure.

The next question is from Gerard Cassidy with RBC.

Thank you. Good morning.

Hey, Gerard.

Can you guys share with us the AHA data as recently as this past Friday showed the home equity loans continue to shrink for the industry. Yours have pretty much held in flat now for a year. Can you tell us what your guys are seeing in their frontlines, why this portfolio is not growing faster since housing prices have obviously come back quite a bit from the lows of the crisis?

Well, couple – I mean, we still – we have actively originated our product out of our branches throughout this whole cycle. So, we still have $1.5 billion, $2 billion of originations every quarter and we do pull our folks on what their intended uses are. And it is as you would expect on a traditional home equity, people want to improve the kitchen or whatever. But as home prices have really rebounded, a lot of folks are able to refinance out both first mortgage and our home equity line, lock in a new lower fixed rate. So I think that’s what we are seeing right now is a refinancing of all, both the first and second loan, but our origination volume has held in there very steady.

And the growth in the utilization, I think, will drive growth.

Yes, right.

Very good. You guys have been very steady and predictable on the amount of capital you return to shareholders. What kind of environment would have to develop where you may lift that number closer to 100% of earnings or slightly above it?

Well, Gerard, we are in a good spot right now. Our capital levels are such that – and our returns are such that our capital formula works. In other words, we are able to generate enough to return that 60% to 80%. We are at the high 70s right now and still accommodate balance sheet growth. So, I don’t see a scenario that we are getting to that 100% as far as the near-term as long as we are continuing to achieve balance sheet growth, which is what I expect. And again, we are in a good spot. We are not sitting here in a big excess position today.

No, I agree. I totally agree. And then finally, when you guys are talking about the inorganic growth acquisitions, obviously, depositories are off the table for the time being. Are you – would you consider – or can you purchase a wealth manager if you felt that fit into your current wealth management strategies?

Components of the wealth business, we could do that and it is a level of – area of interest for us. Wealth is one of our growth businesses. We are doing a great job organically already, but if there are opportunities that present themselves, we will take a look.

Yes. And Gerard, what I would say is that in that particular space, we are not interested in what I would call traditional asset managers, but where we found a good fit in terms of a real wealth manager, I think those are things we would take a look at, because culturally, that would be a better fit for us.

Exactly.

Great. Thank you, guys.

Thanks.

Your final question is from Brian Klock with Keith, Bruyette, & Woods.

Good morning, gentlemen.

Hi, Brian.

Yes, Brian.

It’s a follow-up question. And actually I missed I had to jump off a little bit so I might have apologized if I answered this already. On the loan growth side and thinking about the NII growth for the second quarter versus the first quarter, I mean, should we be thinking about last year’s second quarter, you had a really strong 1.5% on annualized growth in total loans. Like with the commentary about maybe some slower rebound for the second half of the year in commercial, should we be thinking about with overall 1%ish maybe loan growth into the second quarter on a linked quarter basis? And does that sort of drive the NII growth quarter-over-quarter?

So Brian, we achieved 2.2% in the first quarter. What we said is given the pipelines, the expectations of some seasonality we expect that to accelerate into the second quarter, but not likely to get to that 1 and 1.5. So the way you can think about it is sort of 0.2 to the mid 0.5 somewhere in that area.

Okay, great. Thank you. And I guess kind of follow up on the auto leasing side. There has been some pretty strong growth year-over-year. Just thinking about if there is the issues around the residuals and how that may impact the amount that’s financed by the purchaser. I guess, you guys think that you may see some slowing growth in that – the auto leasing book?

Our leasing group is doing a great job. They are taking share. They have a great product. They have been consistent in the marketplace, good turnaround time. So I think that continues to be an area of opportunity for us. And as a reminder, everything we are doing there is prime. So, it’s good business and it’s good credit quality business.

Yes. Brian, the other thing that I would end up saying is that if you end up looking at the competitive landscape, we offer both the retail leasing as well as the auto lending. And so when customers come into the dealership then we also have very strong relationships with the dealership. So when they are coming into the dealer make a decision upon about buying a loan or buying a car or leasing that car, we have the ability in that prime space to be able to go either way. And I think that’s, from a competitive standpoint, one of the reasons why we see the growth.

With longstanding relationships.

Yes.

That’s very helpful. Thanks for your time guys.

Thanks, Brian.

Yes. Thanks, Brian.

Okay. Well, thank you for listening to this review of our first quarter results. Please contact us if you have any follow-up questions.

This concludes today’s conference call. You may now disconnect.