Welcome to U.S. Bancorp's first quarter 2018 earnings conference call. Following a review of the results by Andy Cecere, Chairman, 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. If you'd like to ask a question, please press *1 on your touch-tone phone and press the pound key to withdraw. This call will be recorded and available for replay beginning today at approximately noon Eastern Daylight Time through Wednesday, April 25th at twelve o'clock 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, James, and good morning to everyone who's 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 risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on page two 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.
Good morning, everyone. Thank you for joining our call. Following our prepared remarks, Terry and I will open up the call for questions. I'll start on slide three. In the first quarter, we reported earnings per share of $0.96, which compares with $0.82 reported in the first quarter of 2017. During the quarter, a lower-than-expected tax rate offset by a transitional change in vesting provisions within our stock-based compensation program increased earnings per share by $0.01. On a year-over-year basis, first quarter net revenue increased by 3.4% to $5.5 billion. Excluding the impact of tax reform on our net interest income, revenue growth would have been 3.9%. Loan growth is seasonally lowest in the first quarter of every year.
Paydowns have been a headwind in recent quarters due to capital markets activities by customers and our disciplined underwriting in commercial real estate at this stage of the business cycle. In the first quarter, loan demand has been lower across the industry. These factors offset solid growth in our retail loan portfolios and underlying strength in new business and market share gains in our commercial portfolios. We believe the early part of this year will prove to be a transition period. Tax reform impacted not only loan growth this quarter but also commercial products revenue, as it influenced the timing and level of corporate bond issuance and deal funding. Combined with strong growth in pipelines, conversations with our customers gives us confidence that commercial loan trends will improve as we move further into the year.
Although the timing of more robust growth tied to a resurgence in CapEx investment remains uncertain. In the meantime, we are focused on gaining market share across our lending and fee products. This quarter, we saw improved sales volume growth in merchant processing, higher sales growth in credit card and commercial payment services, and strong growth in new customer accounts and client balances in our wealth management and investment services businesses. We expect this momentum to continue into the year. On the right side of slide three, you will see that the credit quality was stable in the first quarter, and our book value per share increased by 5.9% from a year ago. During the quarter, we returned 68% of our earnings to shareholders through dividends and share buybacks.
Slide four highlights our best-in-class performance metrics, including a 14.9% return on average common equity, a 1.5% return on average assets, and our tangible return on common equity was 19.3%. Our efficiency ratio rose modestly from a year ago to 55.9%, reflecting increased investment in spending on technology and innovation and certain transitional matters related to stock-based compensation that Terry will address in a moment. As we discussed previously, we are stepping up our business investment in digital-first capabilities, revenue-enhancing initiatives, and business automation. We expect a 55.9% efficiency ratio to be the high for the year. Now let me turn the call over to Terry who will provide more detail on the quarter as well as forward-looking guidance.
Thanks, Andy. If you turn to slide five, I'll start with a balance sheet review and follow up with a discussion of earnings trends. In the first quarter, average loans grew 2.3% compared with the first quarter of 2017, but declined by 0.1% on a linked-quarter basis. During the quarter, we reclassified $1.5 billion of student loans originated under the federal loan program to held-for-sale. As you know, we exited the student loan origination business in 2012, and the runoff portfolio is not strategically important to our future businesses. The reclassification did not materially affect our average balance sheet for the quarter. However, it did affect ending loan balance growth. Turning to core trends, average loan growth is slowest in the first quarter for each year, reflecting seasonality affecting credit card, auto lending, and mortgage banking in particular.
This quarter, mortgage loans increased 0.9% sequentially, but were up 3.9% year over year. Similarly, retail loans declined 0.2% sequentially, but increased 6.1% year over year. Retail and mortgage loan growth is seasonally stronger in the second quarter of each year, and we feel good about core trends in auto lending and leasing, where we continue to gain market share and credit card balances. Adding to the impacts of seasonality on retail loan growth this quarter were a few factors. Commercial and commercial real estate portfolios continued to be impacted by elevated levels of paydown. While average commercial loans increased 4.0% from a year ago, average balances declined to 0.1% sequentially. Pipelines improved as the quarter developed, and we continued to grow commitments.
Line utilization remains at historical lows, and pay-down activity was exacerbated this quarter by corporate clients flush with cash on the heels of tax reform and continuing to deleverage their balance sheet. Turning to commercial real estate, average loans declined 6.5% year-over-year and 1.6% on a linked-quarter basis. The risk-reward dynamics in commercial real estate remain unfavorable in our view, particularly in multifamily and certain areas of commercial mortgage lending. That discipline is influencing decisions to not extend credit on unfavorable terms and adding to the elevated pay-down pressures driven by customers accessing the secondary market. This quarter, commercial real estate contributed a 25 basis point drag to linked-quarter average loan growth and a 160 basis point drag to year-over-year average loan growth. In the near term, we intend to remain disciplined in our commercial real estate lending.
Turning to slide six, average total deposits increased 1.9% year-over-year but declined 1.4% on a linked-quarter basis. The linked-quarter decline partly reflects typical first quarter seasonality that we see in corporate and commercial banking and wealth management and investment services. Within our corporate trust business, CLO issuances and deal closings tend to be seasonally lower in the first quarter, impacting balances. Investment managers deployed funds for loan and other asset purchases, taking advantage of favorable debt market conditions in the early part of the first quarter. Recently, our deal pipeline strengthened within the corporate trust business, and ending deposits began to seasonally increase across the business lines. Slide seven indicates that credit quality was relatively stable. Net charge-offs as a percentage of average loans increased three basis points on a linked-quarter basis and were down one basis point compared with the first quarter of 2017.
Non-performing assets were essentially flat compared with the fourth quarter and down 19.5% from the first quarter of 2017. Slide eight provides highlights of first-quarter earnings results. Please note that during the first quarter, the company adopted accounting standards related to revenue recognition, and certain revenue and expense categories have been recast to reflect the change in accounting standards. The adoption had no material impact on operating income, as you can see on slide nine. Slide nine also shows how tax reform impacted our first quarter net interest income and the related revenue growth rates. In the first quarter, net revenue of $5.5 billion was down 2.3% compared with the fourth quarter and up 3.4% versus the first quarter of 2017. Adjusting for the impact of tax reform on our taxable equivalent net interest income, revenue increased 3.9% on a year-over-year basis.
On slide 10, net interest income on a fully taxable equivalent basis was $3.2 billion in the first quarter, essentially flat compared with the fourth quarter and up 5.5% year-over-year, which was in line with our guidance. Linked-quarter growth was impacted by two fewer days, while year-over-year growth was supported by growth in loans and higher loan yields. In the first quarter, the net interest margin was 3.13%. This is two basis points higher than the fourth quarter net interest margin of 3.11%. Both periods include the impact of the reclassifications related to the revenue recognition standards. Excluding the impact of tax reform on tax-exempt earning assets, the net interest margin increased by four basis points on a linked-quarter basis. The increase was driven by higher yields on earning assets due to higher rates and a steeper yield curve, partly offset by higher funding costs.
Our interest-bearing deposit betas continue to perform in line with past experiences and our expectation after the December rate hike. We expect the total interest-bearing deposit beta following the most recent rate hike will be about 40%. As future rate hikes occur, we continue to expect our deposit beta will gradually trend toward a 50% level. Slide 11 highlights trends in non-interest income, which decreased by 4.1% on a linked-quarter basis and increased 0.6% on a year-over-year basis. Linked-quarter results are affected by seasonality within our credit and debit card, merchant processing, and mortgage banking businesses. On a year-over-year basis, we saw growth in credit and debit card revenue and corporate payments revenue due to higher sales volume. Merchant processing services revenue increased 2.5%, supported by strong volume growth. Merchant processing revenue continues to be impacted by exiting two joint ventures in the second quarter of 2017.
We continue to expect that merchant acquiring revenue will return to a more normalized mid-single-digit pace by the third quarter of 2018. Trust and investment management fees increased 8.2% year-over-year, driven by business growth, net asset inflows, and favorable market conditions. Strong growth in payments revenue, trust and investment management revenue, and deposit service fees was partly offset by an 11.1% decrease in mortgage banking revenue, which was affected by lower refinancing activity and lower gain on sale margins and a 10.9% decrease in commercial product revenue. Treasury management fees declined 2%, reflecting the impact of changes in earnings credit, which is a trend typical in a rise in rate environment. Client behavior related to tax reform was a headwind to our commercial products revenue this quarter. Meaningful de-leveraging by clients flush with cash led to reduced corporate bond issuance and investment-grade underwriting activity.
There was also a significant reduction in municipal market activity due to a pull forward of issuance into the fourth quarter of 2017 related to tax reform. Corporate bond market conditions have improved in the early weeks of the second quarter, and announced M&A activity continues to pick up. Turning to Slide 12, non-interest expense decreased 0.6% on a linked-quarter basis, excluding notable items included in the fourth quarter. On a year-over-year basis, expenses grew by 5.0%, in line with our expectations for the quarter. Personnel expenses were the biggest driver of costs, while non-personnel expenses declined 1.2% from a year ago. Compensation expense increased 9.5%, principally due to the impact of hiring to support business growth and compliance programs, merit increases, higher variable compensation related to business production, and the impact of changes in vesting provisions related to stock-based compensation programs.
This vesting change was related to changes in our compensation programs in response to shareholder feedback and to ensure competitive programs within the employment and (by market). The vesting change negatively impacted year-over-year expense growth by 130 basis points. Excluding this impact, total non-interest expense would have increased by 3.7%, and compensation expense would've increased 6.9% from a year ago. Notably, within non-personnel expenses, professional service expense declined 13.5% from a year ago, primarily due to fewer consulting services as compliance programs near maturity. As we discussed previously, we hit an inflection point in the growth rate of costs related to the build-out of programs related to our consent order in the second half of 2018. Compliance-related costs will continue to moderate through the year. We have started to deploy increased investment dollars towards digital capabilities and innovation projects, multicultural initiatives, and brand.
The impact of these investments will occur over the next several quarters, the magnitude will depend upon the timing of our investment opportunities. Including the impact of these business investments, we still expect full year 2018 expense growth will be within the 3%-5% range we think of as normalized. As a result of our investments, we expect stronger revenue growth, improved productivity, and expense efficiencies in the future. With respect to income taxes, our tax rate on a taxable equivalent basis declined from approximately 29% in 2017, excluding notable items, to a tax rate on a taxable equivalent basis of 18.9% in the first quarter of 2018. This tax rate was slightly lower than expected due to the accounting impact of stock-based compensation and the resolution of certain tax matters during the quarter. Slide 13 highlights our capital position.
At March 31st, our common equity Tier 1 capital ratio, estimated using the Basel III standardized approach, was 9.0%. This compares to our capital target of 8.5%. I will now provide some forward-looking guidance. For the second quarter, we expect net interest income to increase in the mid-single-digit range on a year-over-year basis. We expect fee revenue to increase in the low single-digit range year over year. As a reminder, fees are seasonally higher in the second quarter. We expect expense growth to be in the mid-single-digit range year over year, within our long-term growth target of 3%-5%. We expect to deliver positive operating leverage for the full year 2018. We expect credit quality to remain relatively stable compared with the first quarter, and our full-year tax rate on a taxable equivalent basis is estimated to be about 21%. I'll hand it back to Andy for closing remarks.
Thanks, Terry. The early part of 2018 is shaping up as we thought it would. The economy is on solid footing, consumer and business confidence is strong. While the business confidence has not translated into increased lending activity yet, we believe it will. Strong consumer spending, supported by a strong job market, higher wages, and lower taxes, should drive more business activity and business investment in technology and infrastructure, we are well-positioned to win the lending business that comes with it. Business optimism is evident in the conversations our bankers are having with our clients, we are seeing that in terms of increased commitments and more robust pipelines. I feel very good about the outlook for our fee businesses. We are reaching an inflection point in merchant processing revenue, our focus on retail-driven purchase mortgages is enabling us to capture market share in mortgage banking.
While reduced headwinds are a positive development, I'm most excited about the sales and volume trends we are seeing in some of our higher return fee businesses like payments and trust and investment services, which provides fuel to an already good momentum heading into the second quarter and beyond. As we have discussed previously, we are accelerating technology and innovation investment spend on initiatives aimed at enhancing the customer experience and leveraging our competitive positioning, with a particular focus on payments, digital and mobile banking, and B2B capabilities. These investments will position us at the forefront in banking and drive improved operating leverage over the next several years.
In closing, I'm confident that our business model, combined with the hard work, dedication, and integrity of our entire U.S. Bank team, will enable us to deliver improving returns on equity for shareholders in the near term and over the longer term without compromising our risk profile. That concludes our formal remarks. Terry, Bill, and I will now be happy to answer your questions.
At this time, I'd like to remind everyone, in order to ask a question, please press star followed by the number one on your touch-tone phone. To withdraw your question, please press the pound key. Your first question comes from the line of Matt O'Connor with Deutsche Bank. Go ahead, please. Your line is open.
Hey, guys. This is actually Ricky Das from Matt's team. Just a quick question on expenses. Appreciate the color you gave. Just wondering if you could talk about expense growth as we exit 2018. Had an uptick in cost this year and in recent years. I was wondering if we could see expense growth sort of at the lower end of your long-term range in 2019 or maybe even below that. Thanks.
This is Terry, thanks for the question, Ricky. With respect to expenses, we certainly expect them to be in 2018 kind of on the higher end of that range, as we said. As we get into 2019, one of the things that we expect and we think is important is that we would start to see revenue accelerate because of some of the investments that we're making, as well as some of the efficiencies that we would expect from business automation and other activities that we are investing in. I don't know whether it'll come down to the lower end of that range in 2019, but I think we'll start to see an inflection point where it will start to come down in the range during 2019.
Got it. Thank you. Maybe a follow-up, sort of switching gears, just thoughts on mortgage banking for the year. It was a bit weaker than we had expected in the first quarter. I'm just wondering if there's any read-throughs there, and then just overall thoughts as we move throughout 2018.
Yeah. Again, let me kind of take that question. On mortgage banking, I think we're kind of seeing a couple of different things. One is that we've had a very strong focus on enhancing the retail channel and focusing on purchased mortgages over the last couple of years. What we are seeing in our particular business is we've actually seen applications increase on a year-over-year basis by about 11%, but the revenue coming down on a year-over-year basis. That's principally because in the industry, it's very competitive in terms of the gain on sale margins that we are seeing and that the industry is seeing, particularly in the correspondent banking. I think that as the year progresses, that margin compression is placing a lot of pressure on our competitors. We're continuing to capture market share.
As capacity in the industry starts to go down, we should start to see improving margins, the timing of that is hard to know.
Terry, I'd add that our capabilities in the digital front, specifically our loan portal position as well for that gain and share on the retail side.
Thanks, guys.
You're welcome.
Your next question comes from the line of John Pancari from Evercore. Go ahead, please. Your line is open.
Morning.
Morning, John.
To the deposit topic, on the non-interest bearing deposits, down about 6%. I know you mentioned that's seasonality, but the year-over-year balance is still down about 3.5% or so. Is there something else going on there? Is this more of the impact of higher rates and deposit betas picking up? I just want to get some color on that. Thanks.
Yeah. John, this is Terry again. When we look at deposit trends, for us, it's really kind of important to kind of look at the business mix of our deposits. We typically, in the first quarter, see deposits being down on a seasonal basis, and that's because deal flow within corporate trust tends to be higher in the fourth quarter and then lower in the first quarter. We always see kind of a runoff. If we look at kind of the deposit outflows that we saw in the first quarter, we didn't see anything significant in the consumer or the retail side at all. In fact, they were pretty stable from fourth quarter to first quarter. The wholesale, our corporate and commercial banking deposits were down. If you end up looking year-over-year, seasonally, it's about the same.
The most significant decrease that we saw was within our corporate trust business, and we really think that's tied to three factors. The first is the fact that a lot of CLO deals got pulled forward because of tax reform into the fourth quarter. Fourth quarter balances were higher. In the first quarter, the CLO investment managers started to deploy those deposit balances out of the trust. That's pretty natural, but I think because of the pull forward, it was more pronounced in the first quarter. Second is just timing of M&A activity. We have escrow balances, we saw an outflow of escrow balances, which is really tied to M&A deals. With the pipeline of M&A strengthening, we would expect that to get stronger. Just normal seasonality.
It's kind of three different factors that are happening in the corporate trust business, not as much really tied to deposit pricing.
Terry, I'd add our deposit beta assumptions are consistent with our expectations. Approaching 40, we still expecting to get 50 towards the middle and last part of 2018. The other point I'd make is that we saw acceleration in deposits actually here early in the second quarter.
Yep.
Got it. Thank you. Separately on the loan front, in terms of your expectation around the trajectory of loan growth, are you still comfortable with GDP plus level of loan growth as you look at 2018? Could it be weaker just given the trends we saw this quarter? Thanks.
Well, it does appear to be a little stronger in the second quarter than the first quarter. We still think it's probably going to pick up mostly in the second half of the year. We did see in the C&I side, for example, earning balances were higher at the end of the quarter. There are signals that it's starting to pick up.
Okay, you still go with the GDP plus range for the full year?
Yeah. That's something we talked about last. We'll see loan growth, for example, in many of our retail categories, and that's going to be more tied to what GDP is doing, et cetera. I think we see a number of signs that would still make us feel comfortable at this point.
Okay, thank you.
Thanks.
Your next question comes from the line of John McDonald from Bernstein. Go ahead, please. Your line is open.
Hi, guys. I wanted to follow up a little bit on the expenses, just maybe bigger picture. Andy, the 3%-5% kind of normalized expense growth, you mentioned that a few times, and something you targeted at the Investor Day in 2016. Just remind us, like what are the foundational assumptions of why 3%-5% is what you target over time? The reason I'm asking is, we get the question, other regional banks seem able this year and maybe next year to self-fund their tech investments and keep expenses pretty flattish this year and next. What's different about U.S. Bank in terms of maybe where you are in the cycle that you're kind of at 3%-5%, and in an elevated year, you're at 5%, when others are kind of doing flattish?
Well, John, I'll start from the fact that we're starting from an efficiency ratio a bit lower than those other banks that you're describing. I do think we are going to focus on positive operating leverage and making sure that our expense growth is below our revenue growth. At the same time, we want to make sure we're balanced in terms of then making investments for the longer term. We're factoring in all those things into our number of 3% to 5%. I do think it'll range in there for sure. I do think that there are periods it'll be at the low end of the range, but we want to make sure we're thinking about things not only in the short term but in the long term.
Yeah. John, the other thing that I would just add to that is, it's important to remember our business mix relative to a lot of our regional banks that we end up competing against. With the payments business and the investment management business in particular, but in payments business, a lot of those expenses are more variable in nature. As revenue grows, expenses will grow with that, not to the same level. The business mix ends up impacting that a little bit.
Okay, that's helpful. Just as a reminder, what do you guys think is an appropriate medium-term efficiency target for you guys, say, over the next one, two, three years?
Well, as I said in the prepared remarks, John, I do expect that this first quarter is the high point for the year, and we continue to expect it will be in the mid to low 50s in terms of our efficiency ratio. I expect it to migrate down principally because we're going to have positive operating leverage.
Okay, great. Then just a reminder, Terry, where you stand on interest rate sensitivity. Has anything changed there? Can you kind of remind us of the split between the long and short end sensitivity?
Yeah. If you end up looking at our balance sheet, probably about 50% of our assets benefit from the short end of the curve in terms of movements in interest rates, about 50% of it benefits more on the long end of the curve. That's really what our business mix has been, overall. From an asset liability sensitivity perspective, one of the things I would kind of maybe point out, Andy talked a little bit about our deposit betas. If you think about our corporate trust business, we're getting closer to what I would call that terminal beta level, and that's kind of starting to be baked into our rate movements, as well as kind of the wholesale side.
The movement up of deposit betas for us, I think will be impacted by that to some extent, favorably, I think, relative to maybe some of our competitors. That's the way we kind of think about it.
For about half of our balances, it's already at the highest level.
Yep.
Great. Just one follow-up on that. You mentioned the overall retail beta or the beta assumptions getting to, I think you said 40 later in the year. Can you just talk about the retail beta and is that kind of the terminal assumption there, or would you expect to go kind of higher than the terminal on retail over time since it's been so low for the first part of the cycle?
Yeah. The movement from 40 to 50 is probably going to be more so an assumption that retail deposits are going to start to move upward, in terms of deposit betas. Through the most recent rate cycle or rate hike, we have seen very little movement in terms of deposit pricing. I do think that with the March rate hike and as we get into the rest of the year, we are going to see more competition with respect to retail deposits, and we're just going to be pricing to meet that competition.
Okay. Thanks, guys.
Thanks, John.
Your next question comes from the line of Betsy Graseck from Morgan Stanley. Go ahead, please. Your line is open.
Thanks. Good morning. Couple questions. One, just to continue the last conversation. Your loan to deposit ratio appears to be pretty low. I think it's in the low 80s. I'd wonder if that's something you can use strategically to hold back on deposit beta at all.
Yeah. I think the way that I would kind of think about it, Betsy, I do think that there's that opportunity. I think we can be a little bit more targeted and more focused with respect to how we think about retail deposits. We price in 120 different markets, and so we surgically kind of look at where the competition is moving rates, and then we only really have to move in those particular markets. I think your point is correct in the sense that we can be more targeted, we can be a little bit more focused with respect to deposit betas as they end up changing.
I think that, again, we haven't seen a lot of movement yet, that's something that we're expecting.
Okay. Separately on capital return, dividend payout ratios, that kind of conversation. Obviously, the Fed put out the SCB proposal recently. Maybe you could talk a little bit about how you see that proposal impacting you and your minimum capital ratios that you have been targeting. Because obviously your SCB is well below the ratios that the Fed has been putting out there, the SCB 2.5%, you're well below that, I believe, right? Maybe we can talk a little bit about that as well as how you think about the dividend payout ratio over the next couple of years here, given that the soft cap is likely to be removed.
Betsy, this is Andy. We continue to be bound by the base case, not the stress case. Our base case target's 8.5% common equity Tier 1. We're at 9%, we're in the range. Our capital distribution has been in the range of our long-term targets of that 30 to 40. I do think the one change that this may offer an opportunity to do is to increase the dividend component of that share versus the buyback. You will see us increasing the dividend piece as this rule becomes more clear.
Okay. Any kind of expectation for how much that could move over time? I know I'm not asking for the specific CCAR because I know you can't talk about that, but you've been in the low 30s. If I look pre-crisis, 10 years ago, you did run with a much higher dividend payout ratio. Just wondering how you think about what kind of over time payout ratio your business can handle given the low earnings volatility that you typically have.
Sure. Betsy, as we think about the 30 to 40 on dividends and 30 to 40 on buybacks, I could see our dividend component migrating towards that 40.
Okay. All right. Thanks so much.
You bet.
Your next question comes from the line of Erika Najarian from Bank of America. Go ahead, please. Your line is open.
Hi, good morning.
Morning, Erika.
My first question is a follow-up to what John was asking, appreciate, Andy, that you're reminding us sort of the medium-term efficiency target of mid to low 50s. As we think about 2019, I'm wondering if you could give us sort of a sense of timing of the investment spend relative to the revenue that you would reap from that investment spend. I guess really the question I'm asking is, as we think about the efficiency ratio migrating over time lower, what that rate of change is going to look like in the initial year beyond 2018?
Erika, I think we're making these investments, as we talked about, with the particular focus on customer experience in digital, B2B, all those things I've talked about. Those expenses are now starting to be baked into the run rate that you're seeing in the first quarter and you'll continue to see for the rest of the year. We're going to work on the expense growth to be in that 3%-5% range under the assumption that our revenue growth is above that, we've talked about our revenue growth assumptions. To the extent the revenue growth is robust, I would expect, and as expected, I would expect our expense to be 3%-5%. If the revenue growth is below that, we'll manage expenses down consistent with what our revenue opportunities are.
With the objective of continuing to deliver positive operating leverage and a lower efficiency ratio over time.
Okay. I just wanted to ask a little bit about the commercial real estate dynamics. You're typically the bellwether in terms of credit inflection trends, and I'm wondering if you could give us a little bit more detail on some of the unfavorable terms that you're seeing as some of these loans come up for refinancing. I think the worry that the industry or the market has is that a lot of commercial real estate loans had been struck at ultra-low rates. I'm sort of wondering whether or not part of your decision to not refinance is that the developers have other options for continued low rates outside of the banking industry and outside of U.S. Bank, and you're refusing to underwrite it under market rate.
This is Bill. That's certainly part of it. It's either rate, it's often the tenor and just the lack of recourse structure on these long tenor deals that whether it's insurance companies or the securities markets are offering. That's where we've seen the runoff in what we call the standing loan side or mortgage loan side. On the construction side, we're still very active. We actually did see our ending construction loans up a little bit in the first quarter, that was encouraging. That's where we focus. That's where we can add the most value.
Got it. Thank you.
Thanks, Erika.
Yep.
Your next question comes from the line of Ken Usdin from Jefferies. Go ahead please. Your line is open.
Thanks. Good morning, everyone. Can I follow up on the payments and the restatement for the revenue and expense recognition? It would seem that you're taking out that rewards payment that was in short-term borrowings and also putting that back in, and that's what changed out of the NII side. Is that right to say?
That's correct.
As a go forward then, Terry, can you help us understand that now that that's going to be netted inside the payments lines, how does that change either the seasonality and the variability of payments revenues as we look ahead from this restated basis?
In terms of the seasonality, I don't think it's going to end up impacting it a lot. The rebates that you're talking about are principally related to our corporate payments businesses. When you end up looking at the seasonality of that and then just how those rebates will match up against it, I think the seasonality will be the same. You just have to kind of reset your first quarter expectations regarding the line item.
Okay. Just more broadly on payments, I know you've talked about the merchant processing getting back to mid-single by mid-year. On a restated basis, it looks like it was back to comping positive. Corporate and debit is already doing 8%, Corporate credit and debit's up at 8%, Corporate's up 12%. Can those also continue to post improving rates of growth as we also move into the second half of the year? Just how coincidental is this overall rise in the payments business? Can you get back to those historical growth rates overall in an aggregate for each of them?
I'm going to hit corporate payments, Terry will talk about retail payments. On the corporate payments side, they've had an exceptional year last year and continue to see that in the first quarter. We had sales growth of 12%, revenue growth of 10%, and you're seeing really strong growth in both the government as well as the corporate sector. A lot of that's driven by some of the technology investments we've talked about, one of which is Virtual Pay, which is up about 20% on a year-over-year basis. I would continue to see strong growth in those categories in corporate payments at the very high end of that single digit or low double digit range.
When you think about the retail credit card, we've been talking about mid-single digits sort of revenue growth for the year. That business tends to be a little bit seasonal in the sense that the fourth and first quarter tend to be a little bit higher in terms of the revenue growth. I think it's important to kind of keep that in mind. To the extent that we haven't seen strengthening with respect to consumer spend in that specific space, I think that based upon everything that we're seeing, we believe that that can continue. It'll be really tied to what does that retail customer spend look like over the course of the year.
Okay. Thanks, guys.
Thanks again.
Your next question comes from the line of Mike Mayo from Wells Fargo Securities. Go ahead please.
Hi.
Your line is open.
Can you hear me?
Yeah, Mike, we can hear you.
Okay. Is this new information or are you reiterating the old information about accelerating investing in tech and innovation? I thought, and correct me if I'm wrong, your tech budget is $1 billion each year, and it's gone up to $1.2 billion-$1.3 billion. When you're saying you're accelerating investing there, is this a little more of a step change than you were thinking before, and if so, why?
No, Mike, it's not new information. It's reiteration of what we talked about in the fourth quarter.
If we could just get a little bit more kind of meat on the bones. In terms of the areas where you're investing, if you could just give us a little more granularity, and what are the outcomes that you expect? You clearly said you want revenues to grow faster than expenses over time, that you're playing the long game.
Right. Yeah.
In terms of mobile and online users or other metrics like that, some banks disclose that, others don't. What should we look for on the outside to monitor your progress?
Thanks, Mike. Let me break it into the 3 categories. I'll start with the payments categories. In there, it's going to be a focus on increasing our capabilities around e-commerce and integrated software providers. We're good there. I want to be even better in those categories because that's where the growth is. On the retail side of the equation is increasing our digital capabilities. Today, about 65%-70% of transactions occur on our mobile device, but under 20% of sales. We want to continue to enhance our capabilities around the sales side of the equation, offering convenience and speed for customers as we think about a digital-first world. On the business side of the equation, it's all focused on B2B and the new rails that are being built and our capabilities around those rails. Those are the three areas of focus.
The outcome of those would be increased sales activity and customer acquisition on all three fronts, and particularly on the consumer front, a more central relationship with those consumers and our ability to expand beyond our footprint with consumer customers.
Mike, I might add maybe just a couple of things. Obviously, on the retail side, the areas of focus, we started in mortgage because we have an important business there in terms of our loan portal, bringing online capabilities for people to be able to acquire autos online and be able to get the lending within essentially kind of minutes associated with that, and then checking deposits and those sorts of things. A lot of the digital capabilities in the industry today are very service-oriented, though, and so a big significant focus for us is really more on the sales side as we go forward.
All right. That's helpful. Just big picture, are you doing this because you have the money with the tax reduction to catch up or to get ahead of the industry? How do you think about it?
Mike, I'm doing this because I think this is where the industry is headed, and I want to be at the forefront.
Got it. All right. Thank you.
Your next question comes from the line of Brian Foran from Autonomous Research. Go ahead please. Your line is open.
Hi. Most of my question's been asked, but maybe just two quick ones. First, on the guidance, all the year-over-year comparisons you're referencing are based on the newly reported numbers, not like what was in the 2Q release, right?
That's right. Based upon all the recasted numbers.
In the NPR schedules, there was a little bit of a jump in C&I. I appreciate it was fully offset by improvement elsewhere, but just any color on what drove that and broader C&I credit views?
Well, the credit's very stable, but yeah, we did have one commercial account. It's a consumer products account that did go non-performing. It was just an isolated incident. Overall, credit metrics are very, very stable.
Perfect. Thank you.
Thanks, Brian.
Your next question comes from the line of Vivek Juneja from JPMorgan. Go ahead, please. Your line is open.
Hi. Thanks. Couple of quick questions. Number 1, merchant processing. In the past you've highlighted when the dollar was strengthening that you had a negative impact from FX translation. Given that the dollar's been weakening, can you give us some color on how much of a benefit you got from FX translation now?
Yeah. If you end up looking at revenue in merchant acquired is on a year-over-year basis, up about 2.5%. What we have been guiding for the first half of the year is really that merchant acquired revenue on a core basis would be relatively flat on a year-over-year basis. That's essentially what the difference is between the two is the FX. Saying that, again, when we end up looking at the second half of the year and we think about the core growth within that business, we think about that in terms of the mid-single digits. We do expect it to continue to strengthen. The things that we end up looking at in particular is new business activity and sales volumes, and sales volumes continue to strengthen that business as well.
Great. Second one, the deposit betas on the whole wealth management side, where are those running now? What level is it? 70%?
Yeah.
Any color on that? Obviously that's a different business.
Yeah. Within our wealth management business, we started increasing deposit betas in the last rate cycle, and where there was literally no movement in earlier rate hikes. We started to see betas in the 10%-15%, but they're well below what you see on the wholesale side or the other institutional side. That's kind of what we've been experiencing.
When you say institutional, and when I was referring to wealth management, I was referring to the whole sort of wealth and corporate trust.
Okay.
Yeah. Sorry.
Yeah.
I realize different (definition length).
Yep. If you end up looking at corporate trust when we get to more of a terminal, there are certain deposit betas in that 70%-75% range, and we're pretty much there already. That's why as we think about the future, we believe that from our asset liability sensitivity standpoint, that's pretty much baked in. That's kind of on the corporate trust side of the equation. Then what I would say on the core wealth management side is closer to that 15%.
Okay, thanks.
Yeah.
Your next question comes from the line of Saul Martinez from UBS. Go ahead please. Your line is open.
Hi. Good morning, guys. I think in the last quarter you highlighted that you expected to be sort of at the high end of the 3%-5% expense guidance because of the reinvestment of a portion of profit windfall. Sorry if I missed it, is that still the expectation within that guide for 2018 or is it more revenue dependent?
No, that is our expectation.
Okay. Thanks. I guess a little bit more of a detail question. The other non-interest income line you mentioned this quarter was off because of lower equity investment income. Can you help size that up? I know it's a difficult line item to gauge on a quarter-over-quarter basis, but this quarter was light relative to last year, even on a restated basis. Can you just give us a sense or help us understand what a more normalized level should be going forward?
Yeah, Saul, in terms of getting into specifics regarding equity investments, we've never really provided that specific type of guidance. I will say in other revenue, there's many different categories of types of revenues that are part of that, including, for example, end of term gains and losses on residuals, et cetera. It tends to be lumpy because of not only equity investments, but just the way that all those different categories end up interacting from one quarter to the next. I think what I would suggest is kind of look over a period of time and you can kind of see a range and I would just kind of look within that range as kind of a way of getting some sense on other income.
Got it. It's just the number is about $30 million lower this quarter than the average of last year. Just wanted to make sure I understood that a little bit better.
Yeah, it tends to be lumpy.
Got it. Just a final one, quick one on the consent order. Any update there in terms of how that's progressing? Just anything you could share on that.
Nothing different. We are in our sustainability phase. Things are going as expected. We expect to be done with our part of the equation in mid-year, June 30th, and then the regulators will continue with what they're doing, and that timing is uncertain, but we're right on track with what we expect.
Great. Thanks a lot.
You bet.
Your next question comes from the line of Kevin Barker from Piper Jaffray. Go ahead please. Your line is open.
Thanks. Just to follow up on the deposit betas, can you give us an idea of where your deposit beta on the wholesale side stood this quarter and where it was the previous quarter, and where you expect that terminal rate to be?
Yeah. On the wholesale side, the betas are kind of in that 55%-65% sort of range. That's getting pretty close to the terminal level that we have experienced in the past. That's kind of where it is today, Kevin.
Overall, your wealth management combined with the wholesale are getting pretty close to the terminal side.
Yep.
It's just basically catch up on the retail, right?
That's correct. That's exactly right.
Okay. Follow-up on some of the mortgage questions. You mentioned the correspondent has been seeing heavy competition. Could you give us an idea of where your gain on sale margins dropped on a correspondent basis from 4Q to 1Q, and what your expectations are, at least for the next couple of quarters?
Yeah. If you end up looking at margins on the correspondent side, they're in the high single to low double digit sort of range. That's probably 20-30 basis points lower than what we would normally see. Our expectation is that as we get into the latter half of the year, and probably more so into the fourth quarter, that they will start to rebound because there's a lot of pressure on the smaller players and the players that just don't have the capacity to be able to deal with the margins that low. That's kind of where they're at, and our expectation is it will start to improve. It's a matter of timing.
Okay. All right. Thank you for taking my questions.
Thank you.
Your next question comes from the line of Gerard Cassidy with RBC Capital Markets. Go ahead, please. Your line is open.
Thank you. Good morning, Andy. Good morning, Terry.
Morning.
Gerard.
On the terminal betas that you guys have been talking about on the call, it sounds like the terminal level, and please correct me if I'm wrong, is around the 65% range. Is that fair, or is it a little lower, a little higher?
That would be kind of on the wholesale side. It's probably just a little bit lower, but kind of in that ballpark. On the corporate trust side, it tends to be a little bit higher because we end up having the substitute investment is government funds, for example, in the money market fund area or T-bills. You have to kind of track that. That tends to be closer to the 70%-75%.
Thank you. Could we ever see them get to 100%? I mean, in your guys' experience, because obviously we're in a rate environment we've not seen before being so low, could these terminal betas ever get to 100%?
Yeah. It certainly isn't our expectation based upon both our experience in the business and also from a client standpoint. There are certain operating sort of needs and cash flow, there's a benefit to having those deposits with the bank. I don't think from the perspective of having to be competitive in terms of what they're accomplishing, that we have to go that high. I think we're at or very close to where we need to be.
Very good. I apologize, Terry, if you addressed this. In prior calls, you've talked about the impact that the hurricanes and natural disasters had on your merchant processing and acquiring businesses. I think you pointed out in the spring of this year, you thought that it would get back to normal. If you haven't addressed it, where are we on that kind of timeline?
Yeah. Good follow-up. In terms of the impact of Irma and Harvey, that has pretty much dissipated. Certainly, early in the first quarter, any effect associated with that has pretty much kind of worked its way in. Puerto Rico is much smaller for us and really isn't that significant, but it will take more time for that to recover.
Great. Just lastly, you guys have addressed the commercial real estate lending. You guys obviously have conservative underwriting standards. What are you seeing in the other areas, whether it's retail or commercial? Is there any evidence of those underwriting standards getting a little too aggressive from your competitors that makes you wonder what they're doing?
This is Bill. I would say not necessarily. We're obviously in late stages of economic expansion and credit cycle. We just try to keep our underwriting consistent throughout the period. I've talked about the real estate and a lot of activity in that long term fixed rate pricing, which has affected our mortgage book. On the other side, it's pretty much steady as you go. There's a lot of pricing pressure, but basically, we compete to have a full relationship and bring the other commercial products to the table.
Great. Thank you so much.
Thanks, Gerard.
Your next question comes from the line of Matt O'Connor from Deutsche Bank. Go ahead, please. Your line is open.
Thanks for the follow-up. I jumped on a little bit late here, but it sounds like you're not committing to lower expense growth next year, which I guess is a little surprising given the increase in investment spend this year. It also sounds like you expect a nice increase in revenues. I was hoping you could kind of frame it in terms of operating leverage % that you're targeting if things go according to plan. I appreciate it's a year out, but I think we're all focused on the expense growth continue to be quite high. Without having the context of the revenue expectations, it's not totally clear.
Sure, Matt, and then this is Andy. Let me clarify a little bit. We talked about 3%-5% this year at the high end of the range because of some of that increased investment we talked about. That increased investment will be in the run rate. We expect positive operating leverage this year. Going into next year, I would continue to expect that. We're not going to increase our tech spend again next year, that will be baked into the run rate. I would expect that growth rates next year will start to migrate down within that 3%-5% range.
Okay. In terms of the amount of positive operating leverage that you're targeting, because it'll likely be modest this year, I think based on the guidance, how much are you hopeful to achieve next year?
It will be modest this year. It will continue to increase as we go into 2019 beyond, because our expectation is these investments will produce the revenue that we're looking for. That's why we're doing it.
Okay. I know a couple of years ago, you put out some of these medium-term revenue growth targets. I think the hope was that you would achieve that in year three, which I think is next year.
Yep.
Is that something that's still possible? Remind us how much that revenue growth was.
Our revenue growth rates and our expense growth rates, we do expect to be in the ranges. We were in the 6%-8% range on revenue, 3%-5% on expense. Our return numbers were already in that range. One thing I will mention, Matt, is that we intend to increase our ranges on our returns given the new tax situation that we're in. We'll communicate more about that. As you saw, we're up in that range already, in the middle of the range.
Okay. just to summarize, you are hopeful of the 6%-8% revenue growth next year, 3%-5% expense growth, but hopefully drifting below the high end of that 3%-5% range.
That's our target.
Okay. All right. Thank you for clarifying.
You bet.
Your next question comes from the line of Brian Klock from Keefe, Bruyette & Woods. Go ahead, please. Your line is open.
Good morning, everyone.
Morning.
Hey, Brian.
I just wanted to follow up a little bit on the commercial loan growth from earlier in the call. I thought what was interesting looking at your segment data is, I know you guys mentioned that there's still some corporate de-leveraging and a lot of your peers have talked about the same issue of some large pay downs on the corporate side. When we look at your corporate and commercial banking segment, though, I know this is averages versus end of period, so maybe there's a difference on end of period. The corporate banking and other actually balances were slightly up on average. They're up almost 3.6% year-over-year, but the middle market was actually down, and it seems like that's a trend that's a little bit different at some of your peers.
I wasn't sure if this is just an average issue or if your end of period balances in March were showing a different trend versus the average. Maybe you can just talk about that in that page 10 of your supplement.
Well, when I think about kind of ending balances on a spot basis, Brian, they are a little bit higher than the averages. We do expect to see some momentum as we think about the second quarter. Thinking about middle market, for us, middle market, we're continuing to grow on the commitment side. One of the things that we have seen a little bit is just the impact of pay downs or payoffs. The principal driver behind that is from market to market, we see some M&A activity, and that M&A activity ends up negatively impacting some of the middle market. If you're looking across kind of all of our markets, we're seeing nice growth in at least half of them, a little bit stronger than that. We're seeing flat sort of growth in the others.
It kind of depends market to market, and it changes from quarter to quarter, too.
Got it. Thank you for that, Terry. I guess my other follow-up is just on the funding side. Everyone's been focused on the betas, and you talked about on the wholesale deposit side, the larger trust deposits getting closer to your terminal expectations. On the borrowing side, on your wholesale funding side, the borrowing piece of this, Terry, can you remind us how much of that is swapped out to three-month LIBOR? What are your expectations on the borrowing side with either refinancings or work at the-
Yeah
borrowing cost, Bill?
I know there's been a lot of conversation around the LIBOR basis risk, et cetera, on some of the other calls. For us, at the end of the first quarter, as an example, we have very little that is floating rate on the three-month LIBOR. We don't have the same sort of basis risk to increases in three-month LIBOR at this point.
Okay. Is there anything swapped out for that? Are you saying just overall it's more fixed on that borrowing base?
Yeah. Well, typically when we go into the marketplace in kind of a normal cycle, we have gone about 75% fixed, 25% LIBOR or floating and tied to the three months. We have substantially swapped that out to fixed at this point.
Got it. Great. Thanks for your time.
All right.
With that, I'd like to turn the call back over to Jen Thompson for closing remarks.
Thank you for listening to our call this quarter. Please call us if you have any follow-up comments or questions.