Wells Fargo’s Q3 Earnings Will Depend On Progress In Cutting Costs

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Wells Fargo (NYSE:WFC) reports its third quarter results on Wednesday, October 14, and the banking giant’s results will provide some valuable insight into the key trends that affected traditional banking services over the period. With the hike in benchmark interest rates not coming yet, the bank’s interest income is likely to remain depressed yet again – shifting the responsibility of driving profits to its fee-based revenue streams. While Wells Fargo stands to gain from improved activity in the mortgage industry over recent months and also from higher card payment volumes, the overall equity market volatility would have dragged down revenues at its investment banking and asset management divisions.

That said, the aspect of Wells Fargo’s Q3 results that we are most interested in is the progress made in improving its operating efficiency. Wells Fargo arguably has the most efficient business model among the country’s largest banks, but an increase in staff to handle stricter regulatory and supervisory requirements has had a negative impact on the bottom line over recent quarters. The impact of this was evident in Q2, and how well Wells Fargo manages its costs in the current environment will have a tangible impact on its long-term value.

We maintain a $60 price estimate for Wells Fargo’s stock, which is about 15% ahead of its current market price.

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See our complete analysis of Wells Fargo here

Net Interest Margin Woes Remain For The Time Being

Wells Fargo’s single biggest source of concern over recent 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 on Wells Fargo is aggravated due to its reliance on the traditional loans-and-deposits banking model.

The chart below summarizes Wells Fargo’s reported NIM figures for each quarter since early 2005.

WFC_NIM_15Q2

The steady decline in Wells Fargo’s NIM figures over the last decade stands out clearly from the chart above. It should be noted that the sharp reduction in the figure in Q1 2009 was due to Wells Fargo’s acquisition of Wachovia. Taking this into account, the reduction since early 2012 is notable. The NIM figure has fallen by more than 100 basis points (1 percentage point) over this period. Thankfully, the impact of this decline on the top line has been cushioned by the steady increase in interest-earning assets – allowing Wells Fargo to report quarterly net interest incomes of around $11 billion throughout this period. It should be noted that the NIM figure witnessed a one-off uptick of 2 basis points in the last quarter, and with the situation in Q3 remaining unchanged compared to Q2, the NIM figure is likely to shrink marginally this time around. The interest margin should only begin rising once the Federal Reserve hikes benchmark rates.

You can gauge 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.

Have Things Improved On The Cost Front?

Wells Fargo reported total employee-related expenses of $7.6 billion in Q2 2015, which was well above the $7.4 billion in employee costs for the bank a year ago. The reason for the higher employee costs over recent quarters is primarily the increased headcount from stricter regulatory and supervisory requirements. As employee-related payments account for around 60% of Wells Fargo’s total non-interest expenses, it is imperative that the bank keep this figure in check to ensure long-term profitability.

The bank is looking to address investor concerns about a growing cost base in an environment that necessitates tight cost controls though its five-year “Efficiency and Effectiveness” program. [1] The program is aimed at cutting operating costs, and although it will take some time for its full benefits to show, we expect it to marginally improve operating costs this time around. You can see how sensitive Wells Fargo’s share price is to its non-interest expenses by making changes to the chart below.

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Notes:
  1. Wells Fargo streamlining effort could mean job cuts, Charlotte Observer, May 13 2015 []