Wells Fargo: Expect High Growth This Year

Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Wells Fargo (NYSE: WFC) was among the big banks giving presentations at last month's Citigroup Financial Services Conference. And the news Wells Fargo shared, surprised no one, and pleased everyone, expect perhaps short sellers. Yet I am concerned about some of the bank's growth initiatives, so let’s take a look.

 

Wells Fargo is the country's fourth largest bank by assets, with just over $1.3 trillion. It is among the Financial Stability Board's list of 29 Global Banks Too Big to Fail, but I was disappointed it was not among the handful of American banks listed on Global Finance's 2012 list of the 50 safest banks. It had no trouble with the Federal Reserve Stress Test, in which the Fed determined Wells Fargo currently has a then current Tier One Capital Ratio of 9.3%, which would fall to as low as 6.6% if the hypothetical financial Armageddon actually occurred. Then the ratio would fall a bit further to 5.7% once considering both the hypothetical financial problems and Wells Fargo's plans for distributing capital to shareholders through 2013. I regard all these ratios as acceptable, of course, but far from stellar.

 

Wells Fargo is an extremely well diversified and balanced retail bank. Much of that was due to its $15.4 billion purchase of Wachovia in 2008. Unlike other large bank purchases by competitors like Bank of America's (NYSE: BAC) of Countrywide Financial, or Fifth Third Bancorp's of First Charter Bank, the Wachovia purchase was a master stroke.It was enabled by Wells Fargo's aggressive write off of billions of the acquired Wachovia's mortgage and goodwill, and took a record at that time quarterly loss for any United States bank in the third quarter of 2008 of $24 billion. But after taking that medicine, Wells Fargo has utilized the merger to increase its profitability commensurately. People seem to have forgotten just how big a bank Wachovia was before the merger, or how the merger was the result of a competitive bidding process between Wells Fargo and Citigroup (NYSE: C). Wells Fargo has now increased its profits, and profits per share, nine consecutive quarters, and I do not see that streak ending soon.

 

At the conference, Wells Fargo boasted first of its “leading franchise.” No argument there, as it has a retail bank, mortgage office, or finance office in every state. It ranks first in the country in mortgage origination, mortgage servicing, small business banking, used car financing and commercial real estate financing, among other areas.  It ranks number two in deposits, mortgage servicing, debit cards issued, overall auto loan market share, and annuity sales. It also owns a top ten investment bank.

 

Next, management pointed to “strong, consistent, high quality earnings.” There, I have a bit of a problem. Yes, Wells Fargo did post 2011 earnings of $2.82 per share, a 28% leap from the year earlier. But what drove the earnings? Net interest income in 2011 fell by $2 billion from the 2010 level, due to narrowing yield margins. Non-interest income fell $2.3 billion, due to litigation costs and the impact of new federal regulations. Helping offset this combined revenue loss of $4.3 billion was reduced expenses, but that amount fell year to year only $1.2 billion. So why did Wells Fargo post earnings, after tax, up $3.4 billion to $15.02 billion for the year? Simply, it spent $7.9 billion less, pretax, on funding its loan loss provision in 2011 than in did in 2010. Also a 2% lower marginal income tax rate provided a boost. This provision reserve, the prime mover of earnings growth, is not sustainable, and I hardly consider that strong, consistent, or high quality. 

Next up for management is 'broad based revenue growth with additional opportunities.” Certainly, the Wachovia purchase has enhanced the revenue stream. Wells Fargo now ranks number one in the country in used car financing. Yet, net interest revenue and non-interest revenue have both declined two years in a row.

 

Next is “significant credit quality improvement.” Obviously, most any bank in the country has experienced credit improvement the past two years as the economy has slowly lifted. Charge offs should continue to decline, though the bulk of reductions in loan loss provisions is behind most banks, as discussed earlier. Actually, Wells Fargo stands to benefit less from credit improvement than its peers, Citigroup, Bank of America and JP Morgan Chase (NYSE: JPM). Over the ten year period ending December 31, 2011, Wells Fargo's average charge off to loan ratio was 1.25%. For Citigroup, Bank of America and JP Morgan Chase the average charge offs to loan ratios were 2.38%, 1.67%, and 1.51%, respectively. Wells Fargo just does not have the “recovery” room in its charge off ratios that its peers have.

 

The final two goals of Wells Fargo are strong loan growth, and a strong capital position. Its capital position is discussed above, but as for loan growth, the picture is murky. Wells Fargo labels the weaker parts of the Wachovia related loan portfolio as “non core loans.” So, while the overall loan portfolio grew a very modest $16 billion, or 2% in 2011 versus 2010. Most of that growth was in the second half of the year, and all was in the “core” portfolio as the “non core” assets are being liquidated. Taken as a whole, loan growth was uninspiring, but momentum is in place for 2012 and beyond.

 

I see in the future the recent narrowing of the yield margin reversing itself, partially on the back, of Wells Fargo's auto loan business. The bank's 2011 numbers allowed a return on assets of 1.15%, and only once in the past 12 years has it posted a return of less than 0.90%. It recently raised its dividend by 83% to a quarterly $0.22 per share, giving the issue a yield of 2.6%. The bank is not running on all cylinders yet, but it is the best of the trillion plus dollar large domestic banks for sure, and I can see its stock appreciating another 35% to its all-time high of $44.70 in the next 24 months.


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