Company:
A long-time favorite of Warren Buffet’s Berkshire Hathaway, U.S. Bancorp (USB), over the decades, has been considered one of the safest U.S. financial institutions in which to invest. Over the past several years, very few domestic banks could match USB’s performance, especially in light of the 2007-2009 financial crisis. As opposed to other financial institutions, USB did not incur severe losses as a result of credit charge-offs due to the financial crisis.
Coupled with its strong net interest margin, USB has historically achieved efficiency ratios of ~50 percent, as compared to an industry average of ~60 percent (the lower the efficiency ratio the better); however, USB’s strength lies not only in its efficiency ratio and its ability to avoid subprime lending messes, it also has an impressive lineup of fee-based businesses that help bolster its bottom line. From wealth management, credit card lending and payment processing, which account for ~50 percent of the company’s total revenue, USB has a broad line-up of services on which it can fallback should other areas of the banking industry begin to falter. USB’s payment processing business, which handles transactions between merchants and consumers, has a large number of merchants under contract, which provide USB with a regular and fairly steady stream of income ; and it is one of USB’s business segments that is expected to grow in coming years.
Following the bursting of the housing bubble in late 2007, and the subsequent failures of regional banks , USB became active in acquiring several small banks throughout the country via FDIC assisted deals. Given that the deals were small in nature, they have had a negligible impact on USB’s bottom line, and they have, moreover, served to strengthen USB’s market share. More recently, though, USB has been keen to acquire assets that better fit its franchise, and ones which will be accretive to its business.
Trouble In Paradise?:
On Thursday, June 6, 2013 it was reported that the Commodities Futures Trading Commission (CFTC) filed a suit against U.S. Bank National Association – a unit of U.S. Bancorp – for “illegal activities leading to the collapse of brokerage firm Peregrine Financial.” According to an article published by Yahoo! Finance:
The U.S. regulatory body alleged that U.S. Bancorp intentionally allowed Russell Wasendorf – the founder of Peregrine – to use customers’ money deposited at the bank for his personal interests. In February,Wasendorf began his 50-year imprisonment sentence for duping $215 million from customers.
The lawsuit, filed in the U.S. District Court for the Northern District of Iowa, accused U.S. Bank NA of doling out customers’ money as security for lending to Wasendorf and his construction company. Peregrine had a customer account at U.S. Bank, which the latter allegedly treated as a commercial checking account. The plaintiff demanded penalization for violations of the Commodity Exchange Act and federal regulations, along with monetary fines from the accused.
Last year, the fraud concerning Wasendorf came to the forefront and it dealt a major blow to the futures industry, which was already reeling under the collapse of MF Global in late 2011. Moreover, Wasendorf’s illegal activities were compared to New York money manager Bernie Madoff’s colossal and infamous Ponzi scheme.
CFTC alleged that U.S. Bank knowingly permitted Wasendorf to limit both access and information about an account holding millions of dollars of Peregrine’s customer finances to himself alone. Further, Wasendorf duped the auditors into believing that the account had a balance of $200 million, when in fact, since May 2005 it had roughly $15.7 million.
The outcome of the CFTC case could bear an impact on many other civil or class-action lawsuits. However, these cases tend drag on for a long time. An earlier lawsuit by regulators against U.S. Bancorp for the collapse of Sentinel Management Group has been meandering its way through the courts for almost 5 years.
However, in 2012, JPMorgan Chase & Co. (JPM) paid $20 million settlement charges to CFTC, over its unlawful handling of customer segregated funds at Lehman Brothers during the financial crisis.
Litigation overhangs have been a common problem for major U.S. banks since the financial meltdown. These lawsuits will likely tarnish the companies’ reputation, and also be an overhang on its financials over time. However, investors and other financial institutions, who have suffered as a result of the faulty practices, are expected to be duly compensated.
Source: Yahoo! Finance
Though the suit may eventually have an impact on USB’s reputation, I do not believe that it will have a material impact on the company’s operations. USB may have breached certain fiduciary responsibilities with regard to Peregrine’s deposits, but the true responsibility for the criminal activity lies at the feet of Russell Wasendorf. In the end, I believe that USB will be able to effectively defend itself in the case.
Financials:
In looking at financial figures for USB we see improvements in all of the key metrics over the pervious year (i.e. 2011): Revenue rose ~ 6.25 percent; Net Income rose ~15.91 percent; Shares declined by 1.4 percent (due to share buybacks); Book Value increased by 11.37 percent; the company’s Free Cash Flow increased 51.82 percent (on a per share basis, book value increased 57.14 percent); Net Margin increased 7.32 percent; ROE increased 2.5 percent; ROIC increased 37.38 percent and Diluted EPS increased 15.45 percent. Also noteworthy is the fact that the company’s dividend payment rose 56 percent; the Payout Ratio currently sits at a very comfortable 27.5 percent.
Technicals:
Presently, USB’ shares are trading at the upper boundary of a sideways trading pattern, and for those who may be interested in investing in USB, a naked put strategy would be a very viable option here. As of today, 6/10/2013, a January, 2014 Put could be sold naked for a premium of $0.71 per contract.
Essentially, this strategy results in the seller of the Put purchasing shares of USB at a price of $30.00 per share should USB’s stock price drop to a price of $30.01 or less by the contract expiration date (i.e. January 18, 2014). If this is the case, the Put seller’s total outlay for the shares would be $2,929.00 ($30.00 per share x 100 shares – $71.00 — the premium received at the time the Put contract was sold — less fees and commissions). If, by January 18, 2014, shares of USB are trading at $30.01 or higher, then the Put would expire worthless and the Put seller would keep the premium.
The benefit of this type of strategy is twofold: First, the Put seller makes money if USB’s stock price does not drop in value to a price of $30.01, or lower, by the expiration date and, two, the Put seller will be able to purchase shares of USB at a lower price if and when they “go on sale.” The obvious downside to this strategy is that the Put seller is obligate to purchase shares of USB at a price of $30.00 per share even if the stock’s price drops below the $30.00 per share strike price (i.e. provided the Put seller does not exit the trade in advance of the Put’s expiration date).
Conclusion:
U.S. Bancorp is one of the more solid and well run financial institutions trading in the public marketplace, and though the recent suit brought against USB could tarnish its image somewhat, I doubt that the impact will be severe or long lasting. Given that USB is a very liquid and highly traded security, there are many options strategies (many more than the one discussed here) that can be employed. However, whether purchased directly or indirectly, through options strategies, USB is a stock that long-term investors should consider as a core holding in their investment portfolios.
Note: Information for this article was taken from Morningstar.com and Yahoo! Finance. Options and charting data was provided by optionsXpress.com
Disclosure: At the time of this posting, I did not own any of the securities discussed herein and I did not have any intentions of purchasing any of the aforementioned securities at any point within the next three trading sessions (i.e. at any time before 06/14/2013).
