Wells Fargo Looks Undervalued Despite Lukewarm Q2 Results

Wells Fargo’s (NYSE:WFC) results for the second quarter of the year were fairly ordinary, with the banking giant reporting revenues and earnings which were in line with the low expectations investors had from the banking sector as a whole for a soft period. ((Wells Fargo Q2 2016 Results, Wells Fargo Investor Relations, Jul 15 2016)) What stood out in Wells Fargo’s performance for the quarter was the continued pressure on net interest margins and elevated loan provisions, even as the bank’s cornerstone mortgage banking business saw revenues dip due to depressed market conditions. Although total fee revenues saw a sizable improvement year-on-year, this was due to a one-time gain in Q2 2016 compared to a sizable one-time charge in Q2 2015.

That said, it should be noted that Wells Fargo’s weak performance over recent quarters can be attributed almost entirely to poor economic conditions. We believe that Wells Fargo’s risk-averse business model, which relies primarily on traditional loans-and-deposits services to make money, will allow the bank to notch sizable gains once the Fed resumes its rate hike process. Also, the bank’s proven ability to grow its loan base steadily while maintaining operational efficiency will be key to generating value for investors in the long run. This is why we maintain our $60 price estimate for Wells Fargo’s stock, which is around 25% higher than the current market price.

See our complete analysis of Wells Fargo here

Mortgage Origination Activity Was Actually Upbeat

The single biggest factor that weighed on the bank’s profits was a reduction in mortgage banking fees (combined origination and servicing fees). Wells Fargo’s business model focuses considerably on the mortgage industry, with the bank making significant gains in market share over 2010-2012 even as key competitors like Citigroup and Bank of America slashed their mortgage operations – which is why the bank’s profits are very sensitive to mortgage banking fees. However, a closer examination of mortgage fees shows that the bank actually witnessed a sizable improvement in net origination fees after three quarters thanks to an increase in mortgage origination volumes. The decline in total fees was only due to lower mortgage servicing fees. Wells Fargo originated mortgages worth $63 billion in Q2 2016 – much better than the $44 billion figure for the previous quarter and even edging past the $62 billion figure for Q2 2015. In fact, mortgage application volumes for the quarter reached $95 billion in Q2 2016 – the highest in nearly three years. The bank still has an open mortgage pipeline of $47 billion, which will help boost mortgage origination fees for the next quarter too.

Shrinking Net Interest Margins Will Hurt For A Few More Quarters

Among the largest U.S. banks, Wells Fargo’s results are the most sensitive to changes in interest rates as the bank relies primarily on the traditional loans-and-deposits model to drive revenues. With the Fed holding benchmark interest rates at record low since the economic downturn of 2008, the bank saw its net interest margin (NIM) figure shrink sharply from 4.05% in Q1 2011 to 2.92% in Q4 2015. Although the Fed finally hiked rates in December 2015, Wells Fargo’s business has yet to realize the benefit of this, as the NIM figure fell to a new all-time low of 2.86% for Q2 2016. With the global economy entering a phase of uncertainty related to the U.K.’s Brexit vote, the Fed is unlikely to hike rates anytime soon – putting further pressure on NIM figures for the second half of the year.

Interestingly, the shrinking net interest margin figure has not translated into lower interest income for Wells Fargo, thanks to the bank’s efforts to swell its interest-earning asset base. Total interest-earnings assets reached a record high of $1.7 trillion in Q2 2016, largely thanks to continued growth across loan categories. Once the Fed resumes its rate hike process, the massive loan base will help Wells Fargo post sizable improvements in its NIM figures – boosting interest incomes. You can see the impact of an increase in yield from investment securities on Wells Fargo’s total value by making changes to the chart below.

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