Wells Fargo Churns Out Solid Q2 Performance Despite Higher Employee Expenses

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At first glance, Wells Fargo’s (NYSE:WFC) results for the second quarter do not portray a great picture – especially since this is only the second time in five years that the banking giant has reported a year-on-year reduction in its pre-tax income figure. [1] But a closer look at the underlying performance shows some notable positives in the performance for the period.

Firstly, the bank’s net interest margin figure inched higher for the first time since early 2012. This, coupled with the steady increase in interest-earning assets, helped the bank report a net interest income figure of $11.3 billion for the period – the highest in five years. Better loan quality and an improvement in economic conditions also resulted in loan provisions falling 50% sequentially. While Wells Fargo’s reported non-interest income fell from $10.3 billion in each of the last four quarters to $10 billion this time around, the reason can be primarily attributed to a one-time accounting loss related to its debt hedges (reported as a part of “All Other” revenues). In fact, adjusting Wells Fargo’s non-interest income figure for “All Other” revenues shows that fee incomes in Q2 2015 were the highest since Q2 2013 – when the mortgage refinancing wave was boosting the top line considerably.

The only real concern in Wells Fargo’s results was the notably higher employee cost figure for the quarter. But we believe that the bank’s revenue growth momentum, its ongoing efforts to cut costs, and the impending hike in benchmark interest rates justify our $60 price estimate for Wells Fargo’s stock, which is slightly ahead of its current market price.

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See our complete analysis of Wells Fargo here

Net Interest Margins Show An Uptick, Boosting Net Interest Income

Wells Fargo’s biggest concern over the last couple of years has been its rapidly shrinking net interest margin (NIM) figure. While the current prolonged low-interest rate environment has hurt interest incomes for the banking industry as a whole, the impact is particularly evident in Wells Fargo’s results as net interest revenues are responsible for more than half of its total revenues.

The chart below details Wells Fargo’s reported NIM as well as net interest income figures for each of the last eighteen quarters:

WFC_Net_Interest_15Q2

As can be seen here, Wells Fargo’s NIM figure fell drastically from 4.05% in Q1 2011 to 2.95% in Q1 2015 – a reduction of 110 basis points (1.1%) over the period. The uptick in Q2 2015 to 2.97% is the first such change since early 2012, and goes a long way in explaining how much Wells Fargo stands to gain once the Fed hikes benchmark interest rates. Wells Fargo has maintained its net interest income between $10.5 billion and $11 billion over the last five years thanks to a steady increase in interest-earning assets. With a 2 basis point increase in NIM, the interest income reached a high of $11.3 billion in Q2 2015, and could easily cross $12 billion early next year once the interest rate environment eases.

Better Mortgage Origination Volumes Translated Into Higher Production Fees

Wells Fargo benefited considerably from an improvement in mortgage activity over Q2, with total mortgage originations reaching $62 billion – the highest since Q3 2013. This helped origination revenues jump to $1.2 billion from $1 billion in the previous and from less than $700 million a year ago. Although a reduction in total mortgage application volume for the quarter ($81 billion in Q2 vs $93 billion) meant that the mortgage pipeline at the end of Q2 ($38 billion) was lower than the figure at the end of Q1 ($44 billion), there has definitely been an improvement in the housing industry with fresh originations outnumbering refinances for the period. We expect this trend to continue for the rest of the year, as we capture in the chart below.

Employee Costs Are High, But The Solution Appears Underway

Wells Fargo reported total employee-related expenses of $7.6 billion in Q2 2015. While this is lower than the $8 billion figure for the previous quarter, it is well above the $7.4 billion in employee costs for the bank in Q2 2014. Also, the first quarter of the year normally sees higher employee costs due to bonus payouts made over the period.

The reason for the higher employee costs over recent quarters is primarily the increased headcount from stricter regulatory and supervisory requirements. Wells Fargo’s share price is extremely sensitive to its non-interest expenses, as you can see by making changes to the chart below. As employee-related payments account for around 60% of total expenses, it is imperative that the bank keep this figure in check to ensure long-term profitability. Thankfully, the bank seems to be on the right path with its “Efficiency and Effectiveness” program aimed at cutting operating costs. [2] The five-year program should help long-term profitability for the banking giant, with benefits likely to show as early as next year.

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Notes:
  1. Wells Fargo Reports $5.7 Billion in Net Income, Wells Fargo Press Releases, July 14 2015 []
  2. Wells Fargo streamlining effort could mean job cuts, Charlotte Observer, May 13 2015 []