Back to Basics: U.S. Bancorp

U.S. Bancorp CEO Richard Davis kicks bank into growth gear.


Since the credit crunch hit last year, only a handful of America’s biggest banks have managed to maintain their equilibrium — and their reputations. One is U.S. Bancorp, and for that shareholders, including Warren Buffett, have CEO Richard Davis and his predecessor, Jerry Grundhofer, to thank.

Together they spent the past 15 years transforming a modest-size Ohio bank into a 24-state retail banking powerhouse through a combination of mergers, strict expense controls, conservative lending and the creation of an income stream that is more than 50 percent fees, in contrast to the more-cyclical loan interest that many major banks rely on. Davis and Grundhofer fashioned a relatively pristine balance sheet by not chasing the pell-mell growth of rivals and by limiting exposure to problem real estate. Not so long ago, in what seems another era entirely, market sages derided the Minneapolis-based banking company for its staid, risk-averse ways. Now USB continues to post solid results, even as many of the biggest financial institutions have racked up billions — in some cases, tens of billions — in losses. USB’s deposits and loans are growing at double-digit rates in what Davis calls a clear-cut “flight to quality.” The bank’s shares hit an all-time high of $42.23 on September 19, just four days after Lehman Brothers Holdings declared bankruptcy.

USB has “the capital wherewithal and earnings-generation capabilities to be able to weather this kind of dislocated environment,” says R. Scott Siefers, an analyst at New York investment banking firm Sandler O’Neill & Partners. “With their equity levels, the returns they’re able to generate and the diversification of their business model, they’ve got more arrows in their quiver than most big-bank peers.”

To be sure, Davis has his work cut out for him. Third-quarter earnings fell 47 percent from a year earlier, to $576 million, as USB, anticipating mounting credit woes, set aside $748 million in loan-loss provisions, a whopping $549 million increase. This, plus the horrific market rout of recent weeks, dragged U.S. Bancorp’s shares down to $30 as of early November. But the bank nonetheless stands poised to take advantage of the current financial crisis, like its conservative brethren Wells Fargo & Co., which last month won a showdown against Citigroup in the bid to acquire Wachovia Corp., and PNC Financial Services Group, which snatched up Cleveland’s National City Corp.

Davis is eager to turn on USB’s growth engines. He has been focused on organic growth; the bank is one third of the way through a plan to add $750 million in annual revenues by 2010, chiefly through a radical reengineering of its 2,500-branch retail operation, the fifth-largest in the country.


But Davis has not shied away from acquisitions. In June, USB added $2.7 billion in deposits and $1.1 billion in loans by acquiring Mellon 1st Business Bank, a Southern California subsidiary of Bank of New York Mellon Corp., for an undisclosed price. Davis’s appetite could grow as he and his colleagues survey the roiled competitive landscape, not least because they know the U.S. Treasury is looking to stable institutions like USB to lead an overdue consolidation of American banking.

“We’ll definitely buy companies that are in sound positions,” Davis says, adding that he has indicated to regulators that USB “would be willing to look at any large deal” that could boost revenues and involves an acceptable level of government assistance. USB, which announced on November 3 that it was selling $6.6 billion of preferred stock and related warrants to the Treasury as part of the latter’s Capital Purchase Program, was widely rumored to have bid $1.30 per share for National City before PNC offered $2.25. Davis asserts, though, that he doesn’t want to dilute the franchise by buying a big problem. “Our investors aren’t trading on us for size, they’re trading on us for quality,” he explains. “I have a lot to gain by not surprising anybody.”

Now with $247 billion in assets and a $53 billion market capitalization — up from $7.6 billion and $1 billion, respectively, when Davis and Grundhofer signed on — USB is the sixth-biggest U.S. banking company. Even before accepting the Treasury’s bank rescue money, which Davis says “will augment our capacity to engage in increased lending and invest for future growth,” USB was well capitalized by regulatory standards — its tier-1 capital ratio is 8.5 percent, just a shade below Wells Fargo’s 8.58 percent, and it enjoys an Aa1 rating from Moody’s Investors Service and a AA from Standard & Poor’s.

USB has taken some knocks. Third-quarter earnings per share of $0.32 were $0.15 below analysts’ consensus estimate, and the share price is in the high 20s to low 30s, where it has been stuck for most of this decade. The latest quarter also was not kind to USB’s crucial fee-based businesses, among them credit card, debit card and ATM processing services, investment management and corporate treasury. Although card-processing revenue jumped 13.5 percent year over year, to $269 million, and merchant processing rose 3.8 percent, to $300 million, total noninterest income sagged by 25 percent, or more than $400 million, both quarter to quarter and year over year, to $1.4 billion.

The results — hurt by $250 million in impairments on structured investment vehicles, $97 million of charges on stock holdings in mortgage giants Fannie Mae and Freddie Mac and $45 million of losses on preferred shares issued by Lehman Brothers and Washington Mutual — marked a sharp reversal from previous quarters. In the first half of 2008, USB earned a total of $2.04 billion, or $1.14 a share. That was off 10 percent from the 2007 period, but it translated into a 1.71 percent return on average assets and a 19.6 percent return on equity, among the best profitability ratios of large-capitalization banks. The third-quarter ROE slid to 10.8 percent and the ROA to 0.94 percent. Still, USB easily beat the median 5.07 percent ROE and 0.52 percent ROA of its ten-bank peer group, according to Sandler O’Neill’s Siefers.

Davis, who referred to the first-half returns as “almost an embarrassment of riches,” now states the obvious: “We are not immune to the challenges of the current environment.”

As bleak as the economic and credit outlook may be, the CEO insists it’s “manageable.” USB’s net charge-offs in the third quarter totaled 1.19 percent of the loan portfolio, more than double the 0.54 percent of a year earlier and up from 0.98 percent in the second quarter. The nonperforming assets ratio similarly jumped, to 0.88 percent from 0.43 percent in 2007’s third quarter and 0.68 percent in this year’s second quarter. But Davis sees good news there: The figures are the best in USB’s peer group, and they worsened from second-quarter levels at a slower rate than they did between the first and second quarters.

Davis, 51, is not smug or boastful by nature. But lately he has been acting a bit, shall we say, vindicated. According to James McCormick, president of First Manhattan Consulting Group, a New York firm that has worked with USB, Davis and Grundhofer followed a “profit maximization” formula. That meant avoiding excessive risks, controlling costs, growing fee income, eschewing rate competition and emphasizing quarterly returns. They delivered consistent profits but caught flak from analysts for not growing USB as fast as its peers.

“The excesses in the system were apparent, and yet our company took a lot of heat,” the retired Grundhofer recalls. “But we were committed to putting good assets on the books.” And there was an upside to that. “Shareholders have known that while they won’t get double-digit earnings growth, they will get a relatively high return on equity and a strong dividend,” notes Siefers. “That’s been very comforting in the present environment.”

Indeed, in January, USB hiked its annual dividend by 6.25 percent, to $1.70, at a time when Citigroup, Wachovia and National City were slashing theirs. Only a few other banks — PNC, Wells Fargo and BB&T Corp. of North Carolina — also boosted dividends. “Year to date we have returned 89 percent of earnings to shareholders,” Davis points out.

In a presentation to investors in September, the CEO referred to “all the years we stood before you, telling you why we weren’t growing well and not taking balance-sheet risks.” Now he is in a position to push for growth — without repudiating the bank’s cost-conscious, slow-and-steady, risk-averse heritage.

“A lot of people would say, ‘You’ve given up part of what’s made you great,’” Davis says. But he believes that efficiency and conservatism are so deeply ingrained in USB’s culture that they can’t be lost. USB is the most cost-efficient of the big banks, spending less than 48 cents for every dollar in revenue, compared with a peer average of about 60 cents. “In a couple of years, this company will still be known for its high levels of profitability, efficiency and operating leverage,” he asserts. “What will be different is that they’ll finally start calling us good revenue-growers too.”

That growth is showing up. In the third quarter net interest income rose 16.7 percent, to $1.97 billion. Total loans jumped 12.9 percent, to $166.6 billion, and deposits climbed 12.1 percent, to $139.5 billion — increases far in excess of what could be attributed to the Mellon 1st acquisition. Davis says that investments in marketing and in upgrading the branch system are bearing fruit, and that USB is attracting customers uneasy about their relationships with struggling rivals. Among those ripe for the picking, he says, are city or county treasurers managing deposit balances above federally insured limits who “want their money to be safe.”

USB has succeeded by being “extremely careful about credit-quality risk,” says analyst Nancy Bush of NAB Research in Aiken, South Carolina, who recommends USB as a “defensive holding in the bank stock market.” Jason Goldberg, a Barclays Capital banking analyst, says that the stock, at a price-earnings multiple above 13, is worth a premium because “you get one of the industry’s best ROEs, ROAs and credit quality metrics, and the best efficiency.”

In contrast, Sandler O’Neill’s Siefers maintains a sell rating on USB. “It is well positioned and a premium is warranted, but I don’t think the market has priced the risks of the current credit cycle into the stock,” he says.

Davis argues that the loan book remains high-quality and, thanks to the third-quarter loss provision, has a comfortable reserve cushion of $2.9 billion, up from $2.23 billion a year ago and equal to 222 percent of nonperforming loans. But the bank is exposed in some categories that have caused others grief. It reports average commercial real estate loans of $31.7 billion as of the third quarter, 11.5 percent more than a year earlier; residential mortgage balances of $23.3 billion, up 5 percent; home equity and second-mortgage loans of $17.9 billion, up 11.3 percent; and credit card loans of $12.2 billion, an increase of 23.5 percent. Net charge-off percentages have gone up substantially in each of those areas: commercial real estate to 0.81 from 0.03 in the comparable 2007 quarter; residential mortgages to 1.21 from 0.30; home equity and second mortgages to 1.07 from 0.49; and credit cards to 4.85 from 3.09. Siefers points out that although USB’s total net charge-offs of 1.2 percent are right at the peer group median, its 0.88 percent of nonperforming assets is less than half the median 1.96. “They’re holding up pretty well,” he says.

Davis notes that with the exception of a $300 million sliver of bad home equity loans originated by correspondent lenders, even the poorest-performing real estate credits are making money because they were priced appropriately for the risk. “The only real material change about our bank from a year ago is that we’re continuing to experience increased loan losses — but at a very manageable, lower-than-average rate,”he asserts.

Observes Grundhofer: “The yield curve has bottomed out for the first time in four years. That’s incredibly positive. With credit being tight we’re one of the few banks that can lend, and we can do it at a fair price.”

Davis made his way up from the bottom rung of banking: a teller job that he took when his original career aspiration didn’t pan out.

The son of a truck driver father and a secretary mother, Davis grew up in working-class Hacienda Heights, just east of downtown Los Angeles. Most of his Glen A. Wilson High School classmates graduated, got married and went straight into the workforce. Ambitious, Davis was accepted to the U.S. Air Force Academy, a dream come true for a self-described math geek who wanted to be a fighter pilot. “I really like speed,” he explains.

But the academy was making room for its first class of women, and Davis’s enrollment was deferred a year. He couldn’t afford to wait. He went to work as a stocker in a local Toys “R” Us outlet. Then, on his 18th birthday, he interviewed at a local branch of Security Pacific National Bank, one of California’s major statewide banks, and began work as a teller the same day, canceling a scheduled interview at a Wells Fargo branch that afternoon.

He advanced rapidly. At 21 he was a branch manager, and at 24 he oversaw the launch of a small-business banking unit. “I’d take every job they wanted to give me,” he recalls.

Davis was a man in a hurry. Married at 21 to his high school sweetheart, Theresa, he helped raise three kids while attending night school for eight years at California State University, Fullerton, earning a degree in economics in 1983. “I did things totally backwards — got a job first, then got married and had kids, and then I got my degree.” He says he has “never had a free night or weekend in my life.” By 30 he was an executive vice president of retail banking at Security Pacific.

Davis’s big break came in 1987, when Grundhofer arrived at SecPac from Wells Fargo to run retail banking. Then head of quality assurance, Davis had a sit-down with his new boss that lasted three hours. “We had that moment where we were truly aligned,” he recalls. Grundhofer went on a cost-cutting spree and put Davis in charge of a broad portfolio of activities that included marketing, human resources, operations, fraud prevention and oversight of the corporate culture.

Grundhofer left in 1993, shortly after BankAmerica Corp. acquired SecPac. He landed as CEO of Star Banc Corp., which had recently survived a hostile takeover attempt by crosstown Cincinnati rival Fifth Third Bancorp. He soon reached out to Davis, saying, as Davis recalls, “You know how we’ve always talked about building something from scratch and doing it right? Well, this is it.” Within days, Davis, who was then running BofA’s Southern California retail banking business, became Star Banc’s executive vice president of consumer banking.

The duo, along with David Moffett, another SecPac veteran who retired as USB’s chief financial officer last year and in September was named CEO of Freddie Mac, fixed Star Banc in short order, cleaning up some balance-sheet problems and vowing to deliver community-bank-style service quality.

By 1998, Star’s stock was sailing at nearly 30 times earnings. Grundhofer used that currency to barnstorm the Midwest in a rapid-fire string of acquisitions. He wanted Star to be able to survive a major wave of banking industry consolidation, and he believed that Star’s business model and cost structure would transfer well. In 1998, Star bought $20.4 billion-in-assets Firstar Corp., taking its name and Milwaukee headquarters. A year later it added Mercantile Bancorp., a $35.5 billion-in-assets St. Louis lender. And in 2000, Grundhofer acquired USB, a Minneapolis company with $84 billion in assets that was run by his brother, Jack, again adopting the acquiree’s name and headquarters.

The flurry of deals left Grundhofer and Davis atop what was in 2001 the nation’s eighth-largest commercial banking company, with $165 billion in assets. It also put a serious dent in the company’s market multiple, and in Grundhofer’s reputation for keeping costs low. As his team imposed Star’s efficiency formulas on acquirees, they ran into integration headaches and inherited credit-quality issues — some of them tied to the technology bust — that hurt earnings and punished the stock. Investors and analysts worried that USB wouldn’t stop its acquisitions binge.

USB spent the better part of three years in the penalty box, its share price languishing in the low 20s. Grundhofer and Davis, by then vice chairman of consumer banking and payment services, pledged to investors not to pursue another big deal. The team turned inward — though in 2001 the bank paid $2.1 billion for Atlanta-based Nova Information Systems, now called Elavon, a leading card processing and payment services provider. The unit accounted for 32 percent of USB’s net income in the first nine months of 2008.

At the bank, Grundhofer worked on instilling and refining cost controls and accountability throughout the USB empire in the West and the Midwest. Under his approach branch managers are given latitude to run their own shops but are held responsible for meeting specific numbers. They’re provided with weekly updates and metrics sliced and diced in various ways to make the task easier.

“The management of information is very robust and well thought out,” notes vice chairman Richard Hartnack, 63, who arrived in 2005 from San Francisco–based UnionBanCal Corp. to head the retail bank. Individual managers “get the information they need to manage their businesses, [but] there’s a culture of letting them figure out how to get things done.”

The retail bank, home to the bulk of USB’s 15 million customers, is where Davis is placing his big bet for revenue growth. He has split the retail business into four parts, each focused on a broad geographic or market segment. The highest-profile of these, dubbed PowerBank, aims to recapture or build on the bank’s dominance in eight metropolitan markets — Boise, Idaho; Cincinnati; Denver; Milwaukee; Minneapolis; Portland, Oregon; St. Louis; and Seattle. USB had lost market share in many of those areas after acquisitions. The strategy includes refurbishing branches, extending hours, advertising more heavily and increasing staffing. “In those markets we’re reclaiming our status as big dogs,” asserts Davis.

A second retail group encompasses more than 600 in-store branches, typically in supermarkets or on college or corporate campuses, in 19 states. The sales approach there centers on reaching a captive audience. A third unit deals with so-called stealth markets — growing communities such as Reno, where USB is a bit player and wants to build market share through aggressive pricing.

The last retail group includes some 1,000 small-town “community banking” branches, whose local managers are given the final word on most lending decisions. Operating expenses are 20 percent higher than in the bigger cities, Davis notes, “but the margins are better, the loyalty is deeper, and price points are more reasonable.”

Operating four retail entities under one roof adds some overhead, not to mention complexity. No other big bank runs its operations this way. Even so, observers like the idea of breaking away from a one-size-fits-all approach. Consultant McCormick points out that USB’s rural offices face starkly different competitive situations and customer needs than do those in urban markets. Individual banks “should tailor their rates and approaches by region,” he says.

Other revenue-raising programs are less conspicuous. A recently implemented data-mining system, known in-house as Blast, combines what USB already knows about its customers with information purchased from third parties — such as whether a homeowner is building an addition — to anticipate customers’ needs and tailor sales pitches to them. In September 2007, Davis also established a 15-member enterprise revenue office, which serves as a central clearinghouse for employee-generated ideas that have the potential to build deeper customer relationships and boost cross-selling. The office has overseen the launch of a series of account packages for different customer segments. One, for instance, is aimed at young families and includes a checking account and preferred rates on savings and credit products. “We want to think about how the customer relates to us as a whole, as opposed to how they react to a specific business unit,” says Mac McCullough, executive vice president and chief strategy officer.

Davis notes that in the first half of 2008, 45 percent of new consumer checking customers in eight test markets bought multiproduct account packages, and that attrition declined by 13 percent. (Davis will not say what the baseline attrition figure is, but banks typically lose 20 percent of their customers each year.) “Deepening relationships slows attrition,” he explains. Small-business customers who choose a package are buying 50 percent more products than those who don’t. The bank has also instituted a “relationship review” program for corporate clients to identify cross-selling opportunities in such areas as payments and cash management. To date, 373 meetings with such customers have produced $13 million in incremental revenue.

To make all this work, Davis has had to overcome the bank’s slash-and-burn reputation. To mark the change in culture, he has embraced the notion of employee engagement, trying to create a better work environment. He believes that USB’s profitability is a good place to start: “Our employees aren’t wondering if the bank is in harm’s way or if they’ll have a job next month.”

Meanwhile, USB has added leadership training and other educational programs. Davis is also boosting incentive compensation and tying it more directly to individual and business unit performance. Over the past five years, the bank has paid out about $130 million a year in discretionary bonuses; in 2008 that figure is expected to reach $234 million if employees hit their targets.

Along the way the high-energy Davis has become cheerleader-in-chief — communicating with the 54,000-strong workforce via town hall meetings and a weekly “Ask the CEO” column on the USB intranet. Historically, generating new ideas “wasn’t something we asked people to do,” says Davis. “To break the bonds of history, we need to make a big deal of every success.”

Davis has turned over a new leaf in investor relations as well. Almost immediately after being named CEO, he reinstituted live conference calls (Grundhofer hated them). In September 2007, Davis hosted the company’s first analyst day in six years. “Our investors should not need to guess what we’re doing or where we’re going,” he says.

But Davis’s changes have come at a cost. Noninterest expenses, for everything from branch renovations to salaries and incentive pay, rose 8.7 percent this year through the third quarter, to $5.4 billion. There are also risks — not just that USB could fail to hit its growth targets, but also that it could lose the cost and credit discipline that distinguished it in past cycles. “Making these investments at a time when industry credit costs and revenues are under so much stress is bound to put additional pressure on the earnings base,” explains Sandler O’Neill’s Siefers.

Davis, however, draws a contrast with the 2003–’05 period; loans and deposits were rising at slow, single-digit rates, and investors said, “We’re not going to celebrate you if you don’t grow.”

Today, Davis acknowledges that the economy is so uncertain that he has trouble projecting credit conditions much more than 30 days out, but that doesn’t divert him from his quest: “We’re working every week on finding new organic revenue opportunities, as opposed to discussing which lines of business to get out of, or which people to fire. It’s a huge luxury.”