During bull markets, investors typically prize growth more than anything and that would seem to explain a lot of the relative valuations I'm seeing in the banking sector these days. To wit, investors don't seem nearly as concerned about quality or long-term business prospects as the they do about the near-term growth and capital returns potential. That may be frustrating for Wells Fargo (NYSE:WFC) shareholders in the short term, but I think it does leave some long-term potential in the shares today.

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First Quarter Results Looked Good, But The Underlying Performance Wasn't Great
Details matter with bank earnings, and that's certainly the case at Wells Fargo. While the results weren't bad, what growth there was was more of the “non-core” or non-repeatable variety.

Operating revenue declined 1% both annually and sequentially, driven by a 3% and 2% decline in net interesting income. Wells Fargo continues to see significant net interest margin erosion (down 33bp and 8bp), while earning asset balances increase (up 9% and 2%). Non-interest income was less impressive, growing just 2% from last year and flat with the prior quarter. Mortgage banking in particular was weak, with revenue down 3% and 9% on a 13% sequential decline in mortgage originations. 

With expenses up 4% sequentially (but down 2% from last year), the company's efficiency ratio (on an adjusted basis) still stands at a not-so-great level in the high 50%'s (over 57%). Pre-provision net revenue (essentially operating income) rose just 1% from the year-ago period and fell 7% sequentially on the higher expenses, leading to an operating earnings miss of between two and four cents relative to most analyst models.

SEE: The Industry Handbook: The Banking Industry

Credit Saves The Day Again
While core operating performance is suffering from sluggish loan demand and declining rates, improving credit quality is helping offset this. Wells Fargo saw a $200 million reserve release, and lower credit/provisioning costs compensated for the PPNR miss.

The company's non-performing asset ratio declined another 60bp (and moved below 3%), while the net charge-off ratio improved by more than a half-point and slipped below 1%.

Core Lending Is Soft, And Management Intends To Do Something About It
Mortgage lending is still a substantial part of Wells Fargo's business mix, so it's not surprising that less mortgage activity would hamper the company's growth. To that end, core loan balances increased almost 8% from last year, but less than 1% from the December quarter, with very minimal commercial lending growth.

To its credit, Wells Fargo management knows that it must step up its non-mortgage activities. Wells Fargo has almost 30% share of the U.S. mortgage market, and more than the next four companies (JPMorgan (NYSE:JPM), U.S. Bancorp (NYSE:USB), Bank of America (NYSE:BAC), and Intuit's (Nasdaq:INTU) Quicken Loans) combined. It's also the largest auto lender in the country and the second-largest student loan originator.

One of the major areas of focus is to expand the credit card business. Management has talked about doubling its loan volume (to around $50 billion) and has hired a new team to lead the way. Certainly there will be competition from the likes of JPMorgan, U.S. Bancorp, and Capital One Financial (NYSE:COF), but Wells Fargo's huge branch network and nationwide deposit share does give it an edge in terms of cross-selling with existing customers.

I would also look for the bank to expand its wealth management and overseas interests. Because it has more than 10% national deposit share, banking M&A in the U.S. is pretty much a non-starter. But acquisitions in wealth management or outside the U.S. would not be similarly encumbered. The challenge for Wells Fargo is one of capital management – many attractive assets (like say T. Rowe Price (Nasdaq:TROW)) would cost a pretty penny.

SEE: Analyzing An Acquisition Announcement

The Bottom Line
With weak lending trends (particularly in mortgage) and a very unhelpful yield curve, Wells Fargo has its work cut out growing in this environment. That said, the shares look undervalued relative to the long-term profitability of the franchise. The company's return on tangible assets suggests a fair value in the low $40's, while a long-term ROE-based model that assumes a 13.5% ROE suggests something closer to the mid-$40's.

Either way, I think this is a good time to let the aggressive investors pay too much for growth while more value-conscious investors scoop up the strong long-term stories that are trading below fair value. Wells Fargo looks like one such opportunity to me, and I'm bullish on these shares for the long term.

At the time of writing, Stephen D. Simpson owned shares of JP Morgan.