Welcome to U.S. Bancorp's Second Quarter 2021 Earnings Conference Call. Following a review of the results by Andy Cecere, Chairman, President, and Chief Executive Officer; and Terry Dolan, Vice Chair and Chief Financial Officer, there will be a formal question-and-answer session. Operator Instructions: Participants may queue for questions at the appropriate time. This call will be recorded and available for replay beginning today at approximately 11:00 AM Central Time through Thursday, July 22, 2021 at 10:59 PM Central Time. I will now turn the conference call over to Jen Thompson, Director of Investor Relations and Economic Analysis for U.S. Bancorp.

Thank you, Ashley, and good morning, everyone. With me today are Andy Cecere, our Chairman, President and CEO; and Terry Dolan, our Chief Financial Officer. Also joining us on the call are our Chief Risk Officer, Jodi Richard; and our Chief Credit Officer, Mark Runkel. During their prepared remarks, Andy and Terry will be referencing a slide presentation. 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'd 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'll now turn the call over to Andy.

Thanks, Jen. Good morning, everyone, and thank you for joining our call. Following our prepared remarks, Terry, Jodi, Mark and I will take any questions you have. I'll begin on Slide 3. In the second quarter, we reported earnings per share of $1.28. We released $350 million in loan loss reserves this quarter supported by our outlook on the economy and continued improvement in credit quality metrics. The pace of improvement has been better than expected. Net revenue totaled $5.8 billion in the second quarter. As expected, net interest income grew in the second quarter, while our fee businesses benefited from improving consumer and business spending trends. Notably, as of late June, total sales volumes for each of our three payments businesses—credit and debit card, merchant acquiring and corporate payment systems—were above 2019 levels for the first time since the beginning of the pandemic. Our expenses were relatively stable compared with the first quarter. Turning to capital, our book value per share totaled $31.74 at June 30, which was 4% higher than March 31. During the quarter, we returned 79% of our earnings to shareholders in the form of dividends and share buybacks. Following the results of the Federal Reserve's stress tests in late June, we announced that management will recommend that our Board of Directors approve a 9.5% increase in our common dividend in the third quarter payable in October. Slide 4 provides key metrics including a return on tangible common equity of 20.9%. Slide 5 highlights continued strong trends in digital activity. Now let me turn the call over to Terry, who will provide more detail on the quarter.

Thanks, Andy. If you turn to Slide 6, I'll start with a balance sheet review followed by a discussion of second quarter earnings trends. Average loans were stable compared with the first quarter in line with our expectations. Strong demand for our installment loans drove other retail loan growth, while commercial and industrial loans increased 0.9% supported by strong growth in asset-backed lending, partly offset by continued paydown activity in other C&I categories. We saw a decline in residential mortgage loans and increased paydowns. Average credit card loan balances were stable compared with the first quarter as payment rates remained high at 38%, reflecting a significant level of consumer liquidity. However, period-end balances increased 4.5% on a linked-quarter basis as we saw some pickup in activity toward the end of the quarter. Turning to Slide 7. Average deposits increased 0.7% compared with the first quarter and grew by 6.4% compared with a year ago, reflecting the significant level of liquidity in the financial system. Our overall deposit mix continues to be favorable. In the second quarter, our non-interest-bearing deposits grew 5.9% linked quarter, while time deposits declined by 8.1%. Time deposits now account for 6% of total deposits compared with 11% a year ago. Slide 8 shows credit quality trends which continued to be better than expectations. Our net charge-off ratio totaled 0.25% in the second quarter compared with 0.31% in the first quarter. The ratio of nonperforming assets to loans and other real estate was 0.36% at the end of the second quarter compared with 0.41% at the end of the first quarter. We released reserves of $350 million this quarter reflective of better-than-expected credit trends and a continued constructive outlook on the economy. Our allowance for credit losses as of June 30 totaled $6.6 billion, or 2.23% of loans. The allowance level reflected our best estimate of the impact of improving economic growth and changing credit quality within the portfolios. Slide 9 provides an earnings summary. In the second quarter of 2021, we earned $1.28 per diluted share. These results include the reserve release of $350 million. Slide 10: net interest income on a fully taxable-equivalent basis of $3.2 billion increased 2.4% compared with the first quarter, primarily driven by higher yields and volumes in our investment securities portfolio and favorable earning asset and funding mix shifts, partly offset by lower loan yields. Our net interest margin increased 3 basis points to 2.53%. The impact of lower loan yields was more than offset by a favorable mix shift in both our investment portfolio and funding composition as well as lower premium amortization expense. Slide 11 highlights trends in non-interest income. Compared with a year ago, non-interest income was relatively stable as the expected decline in mortgage banking revenue and commercial product revenue was offset by higher payments revenue, trusted investment management revenue, treasury management fees and deposit service charges. On a linked-quarter basis, non-interest income increased 10.0% driven by higher business and consumer spending activity reflecting broad-based reopenings of local economies. Both year-over-year and linked-quarter mortgage banking revenues were negatively impacted by slowing refinancing activity and reduced gain-on-sale margins. Linked-quarter mortgage revenue growth of 15.7% was primarily driven by the favorable linked-quarter impact of a change in fair value of mortgage servicing rights net of hedging activities. Slide 12 provides information on our payment services business. In the second quarter, total payments revenues increased 39.5% versus a year ago and were higher by 16.4% compared with the first quarter. Each of our three payments businesses saw strong revenue growth on both a linked-quarter and a year-over-year basis reflective of the strengthening economy and the increased spend activity. Credit and debit card revenue increased 39.4% on a year-over-year basis driven by stronger credit card sales volumes and higher prepaid card processing activities related to government stimulus programs. Sales volume trends, which are the primary driver of payments revenues, are encouraging. The bottom charts on Slide 12 indicate that as of the end of June, total sales volumes across each of the three payments businesses exceeded comparable 2019 levels. Certain pandemic-impacted spend categories continue to lag, in particular corporate travel and entertainment. However, consumer travel and hospitality spend volumes are rebounding faster than we expected, and the pace of improvement in recent weeks has accelerated a bit. Turning to Slide 13, non-interest expenses were relatively stable on a linked-quarter basis as expected. Slide 14 highlights our capital position. Our common equity Tier 1 capital ratio at June 30 was 9.9% compared with our target CET1 ratio of 8.5%. Given improving economic conditions in the second quarter, we bought back $886 million of common stock as part of our previously announced $3.0 billion repurchase program. I will provide some forward-looking guidance. For the third quarter of 2021, we expect fully taxable-equivalent net interest income to be relatively stable compared to the second quarter. We expect total payments revenues to be relatively stable compared to the second quarter, but we'll continue to track favorably on a year-over-year basis. While we expect sales volume growth in each of our three payments businesses to continue to improve sequentially, prepaid card volumes are expected to decline toward pre-pandemic levels as the impact of government stimulus dissipates. We expect non-interest expenses to be relatively stable compared to the second quarter. Credit quality remains strong. Over the next few quarters, we expect the net charge-off ratio to remain lower than normal. For the full year of 2021, we currently expect our taxable-equivalent tax rate to be approximately 22%. I'll hand it back to Andy for closing remarks.

Thanks, Terry. Our second quarter results came in as expected and there are many reasons we are optimistic as we head into the second half of the year. The economy continues to recover toward pre-pandemic activity levels and consumer and business spending activity continues to improve. Credit quality trends have been a positive surprise. And our payments volumes have come back a bit faster than we expected as recently as a few months ago. We are well-positioned for the cyclical recovery that we expect to play out over the next several quarters. More importantly, we are well-positioned to deliver on superior growth and industry-leading returns on equity over the next several quarters, given our business mix, our comprehensive and holistic payments and banking capabilities, and our expansive distribution model supported by world-class digital capabilities. I'd like to thank our employees for their hard work and dedication throughout the year. We will now open up the call to Q&A.

Operator Instructions: At this time, we will open the lines for questions. Your first question comes from Betsy Graseck with Morgan Stanley.

Hi, Betsy.

Hi, good morning. I just wanted to dig into the guidance and some of the discussion around the payments business. I think you mentioned that payments came in a little faster than expected. I know you were expecting that payments revenues would accelerate in 2Q, so it came in a little faster than you were expecting, but then I think you're guiding to flat quarter-on-quarter for 3Q. I just wanted to dig into that. Is that because the acceleration rate you think is slowing down here, or are you being conservative with the guide for 3Q?

Yes, I think it's a combination of things, Betsy. Let me talk a little bit about payments overall. Three things to keep in mind for the payments business in total: first, sales volume momentum continues to be very strong, especially when you exclude airline and travel and entertainment activities. Airlines and travel and entertainment continue to be lagging, but are getting stronger. In fact, if you listen to quarterly results from airlines, leisure travel is really back to pre-pandemic levels and business travel is starting to pick up nicely. Corporate travel and entertainment continues to be the one area that is still down quite a bit, but it is improving a little faster than we had expected. The other thing to highlight is the three components of payments. First, credit and debit card revenue: sales volumes are particularly strong. As an example, credit sales in the second quarter, excluding travel and entertainment, were about 20% above prior periods; debit card sales were about 27% higher. The second quarter was particularly strong, and we expect that type of momentum to continue, though perhaps at a slightly lower rate. The one area to note is prepaid card processing: third quarter of last year was the peak related to government stimulus, and prepaid has been slowly normalizing. We really expect third quarter to be closer to a normal level. The second factor impacting credit and debit card revenue for third quarter is that we are taking the opportunity to invest in growth. That means giving up some near-term revenue to generate customer account acquisition. Also, on a normal basis, prepaid represents about 10% to 11% of the overall credit and debit card revenue category. That normalization, plus the investment we're making, is really going to cause the overall payments revenues to be fairly stable relative to the second quarter.

Okay. So even though you've got travel and entertainment ramping, the prepaid normalization is really offsetting that as you go into 3Q. That's the conclusion?

Yes, that's right.

Okay. Got it. And then maybe you could talk a little bit about the credit box and how you're thinking about that with regard to not only the card space, but the overall loan book?

Yes. We mentioned this last quarter: we're now back to fundamentally the credit box we had at pre-pandemic levels across all product categories.

And your C&I was good, especially if I consider the PPP. So just wondering what's going on there to generate the strength you saw in the quarter?

There's a couple of things. Asset-backed lending has been strong and continuing to improve, and that's one of the drivers in that category. The one thing we're continuing to watch is that paydowns continue to occur, largely because capital markets activity has been fairly strong. It will take a little time for C&I to develop given the level of liquidity customers have. So that's the dynamic: strong asset-backed loan growth partly offset by paydowns elsewhere.

Got it. Okay. Thanks so much, Terry. Thanks, Andy.

Your next question comes from Matt O'Connor with Deutsche Bank.

Good morning.

Hey, Matt.

So good to see costs flat last quarter, even though you had the beat in fees and you guided to similar in the third quarter. As fees pick up—hopefully driven by payments—and if rates rise and loan growth picks up, can you get outsized operating leverage? Last quarter you thought you could. Thematically, is that still the case that while there are investments to make, you'd hope for outsized operating leverage as revenues pick up?

Yes. We certainly have that expectation. We've made investments across many parts of our business—mortgage digital capabilities, payments investments like treasury management capabilities—and we're starting to see benefits. I think the investments we've made will allow us to generate fee growth going forward, so yes, we feel confident those investments will enable some nice fee growth and operating leverage as revenue normalizes.

And Matt, we'll continue to manage expenses relatively stable given headwinds in revenue—flat yield curve, margin pressure, and modest loan growth—but we will manage flat in this environment and then deliver positive operating leverage in a more normal revenue environment.

Okay. And then separately, you recently announced a deal to acquire part of PFM. Can you explain what that exactly is, how it fits into U.S. Bank? I had to remind myself you sold an asset management company about 10 years ago. Is this a return to a certain business or a different investment in the wealth management segment?

A few years ago we did sell an equities and bond business, though we retained the money market business and today have about $161 billion of assets under management. This acquisition essentially doubles that base with a particular focus on government investment pools. It fits nicely into our government banking and treasury management business, particularly corporate trust. It's a nice add-on to a business we're already in and provides additional scale for customer acquisition.

Okay. That's helpful. Thank you.

Your next question comes from John Pancari with Evercore ISI.

Good morning, John.

Good morning. On the payment side, as the rebound continues, can you help us think about the long-term growth potential of the various payments businesses? What's a reasonable growth rate to expect beyond this year? And separately, are you viewing competition any differently today than a couple of years ago, given intensifying fintech competition?

When we think long-term about payments, we believe mid-single-digit growth is a reasonable target. We've been making investments: tech-led fees within Elavon, our merchant acquiring business, represent about 28% of Elavon revenue and are growing at a similar pace. Our investments in digital account acquisition, treasury management, and real-time payments are opportunities for growth, with our digital or forward-leaning products growing around 10% to 11%. So mid-single digits overall is a reasonable ballpark. There's additional upside from these digital and tech-led initiatives.

I agree. In addition to what Terry said, our focus on business banking and weaving banking and payments into a comprehensive product set is important. We have just over a million business banking customers with less than 40% penetration—there's a lot of opportunity. We expect to grow that revenue base 25% to 30% over the next few years, which is additional to the mid-single-digit payments growth Terry described.

Great, thanks. Then on the capital front with the CET1 ratio at 9.9% and your internal target at 8.5% with a 0.5% buffer, how should we think about the timing and factors influencing migration toward that target?

We currently have capacity under our $3 billion buyback program and have purchased about half of that thus far. We'll continue to buy back under that program and have the option to expand it in the future. Our capital deployment priorities are: organic growth first, dividends second, then inorganic opportunities to the extent they make sense, and then buybacks. Timing will be opportunistic based on economic and market conditions.

Got it. Thanks, Terry.

Your next question comes from Scott Siefers with Piper Sandler.

Good morning, guys. I wanted to revisit competitive positioning in payments. USB's payments business is often cited as a differentiator versus other banks, but some fintech competitors have strong volume trends. How do you view competitive positioning overall? What are you doing especially well and where might you need to improve?

Scott, we have strong investments on the digital front and in software and tech-led capabilities, which has put us in a good position. More importantly, our ability to weave banking and payments together into a comprehensive product set for businesses differentiates us. That combination—strong banking capabilities plus strong payments capabilities—helps companies run their business, and it's a key differentiation. We aim both to extend capabilities to current customers and to drive customer acquisition at higher growth rates.

Okay. And maybe separately, you mentioned institutional deposit inflows. Are you seeing customer acquisition on the deposit side in the institutional area when loan growth is not robust?

It's hard to know the precise implications of other banks' actions. Our strongest deposit growth is coming from consumer and business banking rather than institutional. Institutional deposits have been relatively flat or down based on offered rates. Consumer and business growth reflects our digital capabilities and customer acquisition strategies combined with the liquidity customers have.

Okay, perfect. Thanks very much.

Your next question comes from Bill Carcache with Wolfe Research.

Good morning, Bill.

Hey, good morning, Andy and Terry. I wanted to ask if you could juxtapose the growth outlooks in consumer and commercial and talk about where you see the greater potential for inflection, given supply chain dynamics, pent-up demand and liquidity.

Bill, on the consumer side, the opportunity continues to be the economic recovery and the strengthening payments trends—card spend, travel and hospitality rebounding. On the commercial side, there's a secular opportunity tied to business banking and the combination of payments and banking capabilities. Those are the two areas to emphasize: consumer recovery and the secular business banking opportunity.

Got it. And any thoughts on the executive order from the White House on open banking—making it easier for customers to switch banks by requiring transfer of data? Any high-level thoughts?

One reason we're investing in digital capabilities is to be best-in-class in digital services. Combined with the human element—financial services are complex—having both digital and people is critically important. That's how we plan to compete over the long run.

Got it. And one last quick one: any concern around child tax credits and their impact on payment rates or consumer behavior?

The child tax credit payments are often lump sums, and spreading them out quarterly or more frequently gives people an opportunity to use those funds more consistently to pay lifestyle bills. It may change timing but it's not a major driver in our view.

I agree with Terry. We saw payment rates in the high 30s, about 38% in the second quarter; they've stabilized. Stabilization of payment rates combined with increased spend should support growth on the card side over the next few quarters.

Got it. Thank you for taking my questions.

Your next question comes from John McDonald with Autonomous Research.

Hey, John.

Hey, John.

Hi, good morning. Terry, can you unpack the outlook for next quarter's net interest income—thoughts on puts and takes for margin versus volume given your stable NII guidance?

A big part is what rates do. We had a strong quarter driven partly by investment portfolio growth; we were opportunistic when the 10-year was around 1.75% and put some cash to work. We also had some benefit from lower premium amortization expense. For next quarter, we expect loan growth to be relatively flat but modestly stronger than the linked quarter in Q2. We expect the long end of the curve to come up a little but not much, and margin to be relatively stable. Loan growth is occurring in asset-backed lending and consumer lending should get a bit stronger as consumer spend activities increase. Credit card payment rates may have peaked and could come down a bit, which would help card balances. Auto lending remains strong. It's a combination of these dynamics.

Okay. Any color on the outlook for mortgage banking volumes and revenues in the near term?

Mortgage banking hit its high in the second quarter of last year and has since slowed as refinancing activity declined. Today the mix is about 60% purchase and 40% refinance. Mortgage banking revenues are roughly back to pre-pandemic levels—around Q4 2019 and Q1 2020 levels. Our digital investments in retail mortgage have helped us compete, and we've been taking market share on the purchase side.

Okay, thank you.

Thanks, John.

Your next question comes from Ken Usdin with Jefferies.

Good morning, Ken.

Hi. On PFM, can you help us think about the type of contribution it might bring to revenues, pretax income, earnings and use of capital?

We haven't disclosed full financial details. From a capital usage perspective, it will be relatively insignificant. One benefit is that if rates rise, there's upside from recapturing fee waivers the business has been experiencing. It's a nice acquisition to get into the local government investment pool market, where we'll have a number-one market share in that space. Overall, it's complementary to our money market asset management business.

And do you know what your second quarter fee waivers were in the core trust and investment management business, and how that changed sequentially and should improve?

$73 million was Q2, up a bit from Q1. We believe $73 million is the peak.

And on PPP specifically, were loan fees meaningful in the second quarter and any color on PPP loan balance deltas as you exited the quarter?

The delta from Q1 to Q2 on PPP fee recognition wasn't significant. Loan fees were not meaningful in the second quarter. You sometimes get small benefits from recoveries, but nothing of significance related to PPP.

Your next question comes from David Long with Raymond James.

Good morning, everyone. Loan growth in your auto portfolio has been strong. Can you provide color on the split between new vehicle loans versus used vehicle loans?

Most of our auto activity is from our dealer finance business and is mostly new vehicle activity. There is some used, but the majority is new.

Got it. And do you have the dollar amount of the favorable impact from the MSR valuation adjustment in the second quarter?

I believe the net impact was roughly in the $100 million to $140 million range across quarters. If I recall correctly, the first quarter had about a $120 million negative and the second quarter had about a $28 million benefit—so on a differential basis roughly in that neighborhood.

Got it. Thank you.

Your next question comes from Vivek Juneja with JPMorgan.

Good morning, Vivek.

Hey, Vivek.

Hi, Andy and Terry. You mentioned giving up some near-term card growth due to investments. Can you talk about what investments and for how long? Why would that slow down your card growth?

When you're investing in customer acquisition and growth, you incur near-term costs like rebates, residuals and card acquisition costs which can moderate quarter-over-quarter growth. We're constantly investing in the business; it's a matter of timing and how much we choose to invest in any given quarter. Given strong sales momentum, we believe investing now to drive acquisition is the right approach.

So that might hurt third quarter but shouldn't be a drag in the fourth quarter—should we model it that way?

I don't think the drag increases in the fourth quarter relative to the third quarter. The effect should be similar quarter to quarter.

Different topic: you said lower MBS premium amortization helped in Q2. Any color on how much and how it compares to pre-pandemic levels and how much further it can come down?

I would expect the reduction in premium amortization in Q3 to be similar to what we saw in Q2. The margin impact was roughly 2 to 4 basis points on a linked-quarter basis. You can expect a similar benefit in Q3, though it will start to dissipate or moderate into late Q4 and into 2022.

Okay, great. Thank you.

Your next question comes from Mike Mayo with Wells Fargo Securities.

Hey, Mike.

Your tech spend is up about 20% year-over-year year-to-date. How much do you think you'll spend this year? What percent increase do you expect, what are you spending on, and any more detail on combining the banking and payment businesses?

We make about $2.5 billion in technology investments broadly; roughly half is capital expenditure and half is run-rate expense. The increase you're seeing reflects timing as investments ramp into run rate. We don't anticipate tech spend changing a lot going forward. The mix has shifted: three to four years ago it was more defense; today it's about 60% to 65% offense related to digital initiatives, tech stack modernization and forward-leaning revenue-generating activities rather than defense. That shift is beneficial.

And on combining the payments and banking businesses—any more meat on the bones? When should we expect to see it externally?

We're spending a lot of time on that internally. We'll provide more detail in the earnings release and deck by the end of the year. It's a top priority for us and represents a big opportunity for penetration of current customers and customer acquisition.

All right. I'll look forward to it. Thank you.

Your next question comes from Scott Siefers with Piper Sandler.

Just curious: in the President's executive order last week, some language regarding increased scrutiny on bank transactions was included. Any early thoughts on ramifications or how it might change your calculus on opportunities that might come up?

As we've said before, we're disciplined and opportunistic about M&A. Any potential transaction must make strategic and financial sense and be consistent with our guidelines. The executive order may bring additional attention to bank M&A, but decisions should ultimately be driven by what is best for all stakeholders, and that's how we're approaching it.

Okay, perfect. Thank you very much.

Your next question comes from Gerard Cassidy with RBC.

Good morning, Gerard.

Terry, you mentioned C&I growth driven by asset-backed lending, but partially offset by continued paydowns in other C&I categories. What are customers telling you about paydowns—are they holding elevated liquidity because of supply chain problems or lack of inventory? As supply chain issues are resolved over the next 6 to 12 months, could that lead to accelerated commercial loan demand?

I do think commercial demand will pick up; it's a matter of timing. Many companies have excess liquidity and will use it to pay down balances. We're starting to see capital expenditures increase; middle-market customers are more optimistic than a quarter or two ago, which typically leads to longer-term business investment. Supply chain issues are a factor but we view them as more transitory and expect their impact to dissipate over time.

As a follow-up, what are customers telling you about inflation—are they concerned about passing on higher prices to their customers?

Many of our manufacturing customers are passing through increased supply costs into pricing. A lot of it is being passed on. How transitory these cost increases are remains debated, but currently they are impactful.

One more: do you think tapering at the Fed later this year might pressure deposit growth, or haven't you been materially impacted by quantitative easing?

We and the industry have benefited from deposit growth due to the Fed balance sheet. As that diminishes, you may see some impact in deposits. Also, some funds moved off balance sheet to money market funds; the mix between on-balance-sheet and off-balance-sheet will evolve. Some deposits might migrate back on balance sheet as the environment changes.

Very good. Thank you.

Your next question comes from Mike Mayo with Wells Fargo Securities.

A big picture question: you had six years of negative operating leverage. Quarter-over-quarter this appears to be one of the best positive operating leverage quarters in a while. Are you willing to call a turn in that six-year trend or is it too early?

We will manage expenses flat in this challenging revenue environment driven by lower loan growth, a flat yield curve and other factors. Once revenue normalizes, we expect positive operating leverage. So we're managing flat now and will deliver positive operating leverage in a more normal revenue environment.

Your next question comes from Bill Carcache with Wolfe Research.

Thank you. Historically you've been deliberate about M&A. Looking ahead, is there an opportunity to expand into new markets and win customers without acquiring legacy branch infrastructure? In other words, might M&A look different—less branch-focused and more digital or partnerships?

We've discussed multiple routes for growth: organic initiatives including digital acquisition, digital-first branch-light expansion as we did in Charlotte, partnerships like our State Farm referral program, and traditional M&A. We'll consider all those avenues depending on what's available and how it fits our strategy.

Got it. Thank you very much for taking my questions.

At this time there are no further questions. I will now hand the call back for closing remarks.

Thanks for listening to our earnings call this morning. Please contact the Investor Relations department if you have any follow-up questions.

That concludes today's conference call. Thank you for your participation. You may now disconnect.