Five Reasons to Buy This Banking Giant

By Adnan Khan - January 29, 2013 | Tickers: BAC, C, WFC | 0 Comments

• Email
• Print

Wells Fargo (NYSE: WFC) stands to be one of America’s largest banks by providing a variety of financial products nationwide. Despite headwinds from the ultra-low interest rate environment and losses from Sandy, I believe the bank has successfully positioned itself to continue the growth trend in its net income. Going forward, the bank will continue to benefit from its highly diversified business model, rebounding US housing markets, growth in low cost deposits, improved expense management and the Boxer-Menendez Bill. Therefore, I recommend investors buy Wells Fargo.

Bank Description

The San Francisco based bank has $1.38 trillion in assets as of the end of the fourth quarter. Wells Fargo also has the largest exposure in the US housing market compared to its peers, as it serves one in three households and stands to be America’s largest mortgage lender.

Recent Quarter’s Performance

The stronger-than-expected results for the fourth quarter were positively affected by lower core expenses, though continued strength in mortgage business was partially offset by weaker fee income and higher provisions. Both the bottom line and the top line exceeded consensus estimates. Against estimates of $0.88 per share, the company reported EPS of $0.91. The bank’s consistent ability to generate earnings growth reflects the benefit of its well diversified business model.

Diversified Business Model

At the end of the fourth quarter, exactly 48% of the revenues came from interest income, while the rest accrued from non-interest sources. Around 55% of the bank’s loans portfolio, which forms the primary source of the bank’s interest income, is composed of consumer loans, followed by commercial loans at 40%, while foreign loans are only 5% of the entire loan portfolio. Non-interest income comes from a well diversified fee-based sources as illustrated in the graph below, making the bank less reliant on a single source.

Source: Bank Presentations

With the exception of the year 2008, the balanced business model of the bank has led Wells Fargo to consistently grow the bottom line over the past 11 years.

Source: Bank Presentations

Potential Headwinds

1)      The bank expects a further decline in its net interest margin as a result of continued downward pressure due to the prolonged record low interest rate environment. The Fed is committed to keep the rates at the prevailing levels until 2015, while it continues to flatten the yield curve through various initiatives. The net interest margin of 3.56% at the end of the fourth quarter declined 10 basis points when compared to the linked quarter. Despite the expectations of a further decline in net interest margin, the bank expects to increase its net interest income by growing its loans portfolio and investing more in relatively high yielding securities.

Drivers for Future Growth

1)      The bank continues to benefit from higher low cost deposits with average deposit costs at around 18 basis points during the third quarter. Deposit costs plunged 1 basis point sequentially, while they were down 7 basis points when compared to the same quarter of 2011. Besides, the bank was able to increase deposits for the past eight consecutive quarters. The graph below illustrates the increase in deposits and the decline in the cost of deposits. The bank will benefit in the coming quarters from this favorable situation.

Source: Bank Presentations

2)      The bank continues to be the largest mortgage lender in the US, and the rebounding US housing markets have benefited Wells Fargo during the second and the third quarter of the current year. The unclosed mortgage pipeline at the end of September 2012 stood at $81 billion. This represents a strong starting point for the bank’s first quarter.

3)      With 30-year mortgage rates as low as 3.42%, a significant number of homeowners would be encouraged to refinance their home loans. However, other factors, including homeowner payment history and HARP limitations, restrict in-the-money borrowers from refinancing. Once the Boxer-Menendez Bill is passed, it will remove all such barriers restricting homeowners from refinancing at the prevailing, record-low mortgage rates.

4)      Expense management will continue to play an important role in the performance of the fourth quarter. The nationwide expense management program, which was announced at the end of the second quarter of 2011, is focused on eliminating duplication, removing complexities and improving customer experience and work process. The efficiency ratio of 58.8% at the end of the fourth quarter improved 1.7% from the ratio of the previous quarter. The bank expects the efficiency ratio to improve further for the first quarter of 2013.

5)      Wells Fargo has one of the smallest exposures to the Euro-zone of its peers in the US. Foreign loans represent only 3% of total assets, while 1% of the loans are exposed to the United Kingdom. Therefore, any deterioration in the Euro-zone would not have a significant negative impact on the performance of the bank.

Capital Position

The bank had a strong capital position at the end of the fourth quarter. This we say after looking at the bank’s Tier 1 capital ratio, which stood at 11.75%. This is against Tier 1 capital ratios of 12.89% and 14.1% for Bank of America (NYSE: BAC) and Citigroup (NYSE: C). At the end of the third quarter of 2012, the Tier 1 capital ratio for Wells Fargo was 11.5%.

Analyst Sentiments

Currently, seven out of 35 analysts covering the stock have an outperform rating for the bank, while 17 recommend that investors hold the stock. Only one analyst has a sell rating for the stock.

Bullish Case

Analysts at Barclays have a price target of $44 per share. If the US housing markets recover better than expected and the same is the case for mortgage banking activities, then Barclays expects EPS growth. Barclay’s estimates the probability of such a bullish scenario to be 29.3%.

Bearish Case

In case improvement in US housing and mortgage banking activity is not as strong as expected, then analysts at Barclays have a $25 target price for Wells Fargo, while the consensus low price target is at $35. Barclay’s estimates the probability of such a bearish scenario to be 26.5%.

Valuations

Wells Fargo, which has seen around 3% appreciation since the beginning of the year, trades at a 28% premium to its book value, compared to 30% and 43% discounts for Citigroup and Bank of America. Wells Fargo has expensive valuations based on its growing low cost deposit base and its potential to grow its bottom line on a consistent basis.

In conclusion, I believe the bank will benefit from the aforementioned drivers despite headwinds from the prolonged ultra-low interest rate environment. The bank’s highly diversified business model enables it to grow its bottom line in such challenging times. Therefore, I recommend investors buy Wells Fargo.

• Email
• Print
• Feedback