Wells Fargo’s Fee Revenues Unlikely To Make Up For Shrinking Interest Margins In Q2

Earnings season for banks kicks off on Friday, July 11, with Wells Fargo (NYSE:WFC) reporting its second quarter results before the market opens. While Wells Fargo’s results will provide investors with a good idea of what to expect from retail-focused banks for the period, the expectations for the more diversified banking giants will be set by Citigroup’s (NYSE:C) earnings release on Monday, July 14. That said, Wells Fargo’s performance figures will provide some invaluable insight into the growth of different loan portfolios – especially mortgages and commercial loans – for the banking industry as a whole over the period.

Coming to the expected quarterly performance, Wells Fargo is unlikely to better the record earnings it reported in the previous quarter – breaking the bank’s achievement of churning out 17 successive quarters of improving net income figures. The bank has struggled over the last few quarters to counter the impact of shrinking net interest margins and declining mortgage origination figures on its bottom line. Over the last four quarters, it has been one-time factors such as gains on equity investments and lower tax rates that have played an important role in boosting results. While the bank has done well to improve revenues from its asset management arm and also to slash costs over this period, we believe that the benefits from these are unlikely to nullify the negative impact of the low interest-rate environment on Wells Fargo’s businesses.

We maintain a $54 price estimate for Wells Fargo’s stock, which is slightly ahead of its current market price.

See our complete analysis of Wells Fargo here

Net Interest Margins Likely To Shrink Further

As we have pointed out on numerous occasions over the past two quarters, Wells Fargo’s biggest concern is its rapidly shrinking net interest margin (NIM) figure. While the current prolonged low-interest rate environment has impacted interest incomes for the banking industry as a whole, the impact on Wells Fargo is aggravated due to its reliance on the traditional loans-and-deposits banking model.

The table below summarizes Wells Fargo’s reported net NIM figures for each of the last thirteen quarters:

As can be seen here, Wells Fargo’s NIM figure has fallen 85 basis points (0.85%) over this period. Thanks to a steady increase in interest-earnings assets, the bank has been able to maintain its net interest revenues of between $10.5 billion and $11 billion throughout this period. As the Federal Reserve intends to hold benchmark rates at low levels into 2015, margins are expected to remain under pressure over the next couple of quarters too. While the Fed’s decision to taper its asset purchase program will benefit interest margins, the effect will likely not be visible in the economy at large until the second half of 2014. Consequently, the bank will most likely report a fall in its NIM figure for Q2 2014 as well.

You can better understand the partial impact of changing net interest margins on the bank’s total value by making changes to the chart below, which represents Wells Fargo’s NIM on outstanding mortgages.

Noninterest Expenses Most Likely Increased In Q2

Wells Fargo reported total noninterest expenses of $11.9 billion in Q1 2014 – the first time the figure fell to below $12 billion since Q3 2011. This represents an efficiency ratio 57.9% for the period, down from 59.1% in Q3 2013. The bank defines efficiency ratio as the ratio of noninterest expense to total revenues, so a reduction in efficiency ratio shows an increase in profitability.

Now Q1 2014 showed a notable reduction in equipment and professional services costs – a phenomenon we believe was seasonal. With such a benefit unlikely in Q2, total noninterest expenses should be higher at around $12.1-12.2 billion. This increase in expenses, coupled with a reduction in revenues due to the factors we outlined earlier, implies that the efficiency ratio will increase in Q2 2014 (i.e. profit margins for Wells Fargo will shrink). Although the bank will meet its efficiency ratio target of between 55% and 59%, the impact of this on the net income figure will be significant. As you can see by making changes to the chart below, Wells Fargo’s share price is very sensitive to this ratio, and a notable increase in the figure can trigger a sell-off in the bank’s shares among investors.

See More at Trefis | View Interactive Institutional Research (Powered by Trefis) | Get Trefis Technology