There are worse things than owning a quality well-run business that Wall Street knows is well-run, but it isn't often a source of major investment alpha. With that in mind, San Francisco-based Wells Fargo (NYSE:WFC) continues to look like a good core holding in banking but not necessarily a significant near-term market-beating opportunity.
Still Beating, But It's Getting Harder
In contrast to JPMorgan (NYSE:JPM), which has been logging a run of earnings misses, Wells Fargo continues to report better-than-expected results. There's a lot of adjustment that goes on with large bank earnings, though, and that gap between reported results and “core” results is getting pretty thin. All of the following numbers are reported on an adjusted basis, and it's worth mentioning that no two analysts or investors seem to make exactly the same adjustments.
Core results were fairly soft, in line with the reports of other large banks so far. Revenue fell 6% yoy and 2% from the prior quarter. Net interest income fell 2% sequentially as a modest increase in earning assets was offset by another decline in net interest margin (down 7bp to 3.20%). Fee income fell 3% sequentially as Wells Fargo saw a widely-expected large drop in mortgage-related fees, but less-expected weakness in trading, insurance and deposit service charges.
Expense control was okay, with the end result being a 6% decline in core pre-tax pre-provision earnings.
Loan Growth Is Crawling Along
Wells Fargo reported a sub-1% sequential growth rate in loans, with slightly better performance (above 1%) in commercial lending. This is still somewhat early in the reporting cycle, but it looks like smaller banks are gaining some share in lending. Pittsburgh-based PNC (NYSE:PNC) and Dallas-based Comerica (NYSE:CMA), neither of which are small but are smaller than Wells Fargo and JPMorgan, both reported better loan growth on a sequential basis. On the call, management sounded a little more optimistic about the prospects for stronger loan growth (particularly resi mortgages) throughout the rest of the year.
While the loan book isn't growing much, at least the bad debt isn't either. NPLs were down 6% for the quarter and the non-performing asset ratio (or NPA) improved 11bp, while the net charge-off ratio improved 6bp to 0.41%.
Strong And Diverse
One of the real positives to the Wells Fargo story is that this is a fairly diverse business with a strong core franchise and a good capital position. Wells Fargo came out of the recent Fed stress testing looking pretty good and given what the Fed has indicated about its preferred payout ratios for banks, the underlying earnings power for Wells Fargo may be on the order of $4.60 – well ahead of the $4.09 average estimate for 2014.
Keep in mind that this is one of the largest banks in the country. Only Charlotte, N.C.'s Bank of America (NYSE:BAC) and New York-based JPMorgan have larger branch networks and Wells Fargo ranks second in national deposit market share (between B of A and JPMorgan). To add some perspective, Wells Fargo has more than twice the deposit market share of #4 Citigroup (NYSE:C), based in New York, and more than three times the share of #5 U.S. Bancorp (NYSE:USB), based in Minneapolis. Bank of America also has a large insurance operation, a growing wealth management business, and relatively little of the volatile trading and underwriting operations that create so much earnings variability for JPMorgan, Citi, and B of A.
This is not to say that Wells Fargo has no challenges ahead. The company has roughly 30% share in mortgage banking and that is not likely to grow much further. At the same time, banks like PNC and Comerica are working hard to grow their businesses in many of the same markets that Wells Fargo considers important to its long-term plans. Wells Fargo also wants to expand its card business, but JPMorgan and Citi are unlikely to go down without a fight.
The abiding issue I have with Wells Fargo is valuation. An excess returns model based on a long-term ROE of 15% leads to a fair value of $52 today (with a 16% ROE estimate leading to a $55 target). Using the company's return on tangible common equity to calculate a “fair” multiple to tangible book, I come up with a multiple of nearly 2x, leading to a target of about $48.50. It's worth noting, though, that Wells Fargo is one of the strongest of the large banks in terms of return on tangible equity.
The Bottom Line
I don't see anything wrong with Wells Fargo or its stock; I just don't think it's priced to generate substantial returns above and beyond the market. That's no reason for long-term holders to sell today, though investors considering new investments in the banking sector may want to shop around a bit more.
Disclosure – The author owns shares of JPMorgan.