Can Wells Fargo Stay Ahead Of The Curve?

By Stephen D. Simpson, CFA | January 15, 2013 AAA

It is not news that Wells Fargo (NYSE:WFC) is among the best-run large banks in the country, nor that the company has a huge franchise in residential mortgages. While the company delivered relatively good results for the fourth quarter, near-term trends will be challenging for this bank. Wells Fargo still offers pretty appealing long-term potential, but investors should be prepared for some challenges in 2013.

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Good Fees and Asset Growth in the Fourth Quarter
On balance, Wells Fargo had a good Q4, with adjusted earnings coming in a few pennies above most sell-side estimates. Operating revenue rose 6% from last year and 1% from Q3, with pre-provision revenue up 11% and 4%, respectively.

Net interest performance was soft, with net interest income down 3.76% from last year and flat sequentially. Although average earning assets were up strongly (7% and 3%), net interest margin slid more than 30 basis points from last year and 10 BPS from Q3. Fee income was quite strong (up 13% and 3%), with very strong performance in mortgage banking (up 30% and 9%), trust/investment fees (up 20% and 8%) and service charges (up 15% and 3%). Insurance was weak (down 15% and 5%), but is only about 4% of the fee income base.

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Expense control is seeing OK progression. While reported efficiency ratio worsened by 190 BPS from last year and almost three points sequentially, there were items that inflated this figure that shouldn't repeat in the coming years.

While interest rates aren't great right now, Wells Fargo isn't shying away from making loans. On a reported basis, loans grew about 4% from last year, though real underlying growth was more on the order of 1%, with commercial stronger than residential. Mortgage originations were down 10%, however, and applications were down 19%.

On credit, Wells Fargo is seeing the same sort of improvements that have been boosting results at other banks such as US Bancorp (NYSE:USB), Fifth Third (Nasdaq:FITB) and Citi (NYSE:C). Non-performing loans were down 4% from last year (and 3% sequentially), and non-performing loan and non-performing asset ratios all improved annually and sequentially. OREO also declined about 14% from last year and 4% from the prior quarter.

Will the Spread Squeeze Harder?
One reason I am cautious about Wells Fargo is the extent to which its net interest margin could be at risk. With "QE infinity" and the zero interest rate policy, it's harder and harder to make money from the traditional banking business.

To that end, loan yields dropped about a quarter-point from last year, with nearly identical moves in commercial and consumer lending. On the flip side, the cost of interest-bearing deposits dropped from 0.30% to 0.23%, and total deposit cost (including non-interest deposits) fell to 0.16%. While non-interest deposits increased 16% (against 7% deposit growth), it's pretty clear that there's not much room here - deposit rates won't go below zero, and there's not much left to wring out.

While I think Wells Fargo is more vulnerable to NIM compression than Fifth Third or Key (NYSE:KEY), the good news is that Wells Fargo is, on balance, not a hugely spread-exposed bank - particularly not in comparison to banks such as Zions (Nasdaq:ZION) or Comerica (NYSE:CMA). That said, a lot of Wells Fargo's non-interest income is tied to mortgages (about 30%), and declines in mortgage activity would pinch and mitigate that fee income offset.

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Spend Capital or Return It?
Management commented on the quarter about petitioning regulators to return more capital to shareholders (a higher dividend and/or a buyback). I don't think that's the only area of capital deployment that the company should consider. I'm not advocating for Wells Fargo to try to emulate the trading/i-banking exposure of banks such as Citigroup, but I believe there are opportunities to expand in wealth management, merchant processing and treasury services. There's nothing wrong with Wells Fargo taking a long-term position that rates and spreads will recover in time, but this bank could still take a page from US Bancorp's playbook, where the quality non-banking business seems to be rewarded by the market.

The Bottom Line
Among the large high-quality banks, Wells Fargo was among the leaders in stock price performance in 2012. More troubled banks such as Citigroup and Bank of America (NYSE:BAC) did even better. Even so, I can see an argument for holding on to WFC shares. A long-term, low-to-mid teens ROE implies a fair value in the $40 range, and that's not a bad return in this space today. That said, with concerns about the flat yield curve and mortgage market mounting, don't be too surprised if Wells Fargo is a little more volatile in 2013.

At the time of writing, Stephen D. Simpson did not own shares in any company mentioned in this article.

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