Wells Fargo Earnings Preview: Immediate Impact of Sales Scandal Will Make Q3 A Rare Bad Quarter

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Wells Fargo (NYSE:WFC) reports its third quarter results on Friday, October 14, and things don’t look too good this time around for the banking giant. With the Fed’s interest rate hike remaining elusive, net interest margins are likely to shrink further this quarter – hurting revenues for Wells Fargo’s traditional loans-and-deposits business model. Wells Fargo’s cornerstone mortgage division is also expected to continue its weak run due to below-average activity in the mortgage industry. Moreover, the reduction in total debt origination volumes for Wells Fargo from the previous quarter point to a reduction in the bank’s investment banking fees too.

While the third quarter is already a seasonally slow period for the banking industry, direct costs related to the bank’s sales scandal are only going to erode profits further. There will be some respite for the bank, though, from its asset management division. Wells Fargo has been building this business over recent years as the resulting fee-based revenues can offset increasing pressure on its top line from shrinking interest margins, and should reap the benefit of the recent rally in equity markets in the form of higher asset management fees.

While the sales scandal will have a negative impact on Wells Fargo’s operating performance in the near- to mid-term, we believe that the bank’s shares are currently oversold and do not capture the bank’s intrinsic value accurately. We maintain a $60 price estimate for Wells Fargo’s stock, which is about 30% ahead of its current market price.

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See our complete analysis of Wells Fargo here

Net Interest Margin Won’t Improve Until Fed Hikes Interest Rates

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 magnified due to its higher reliance on loans and deposits to make money compared to its peers. The bank’s NIM figure has fallen by more than 100 basis points (1 percentage point) since early 2012 – reaching an all-time low of 2.86% in Q2 2016. And the figure is only expected to shrink further in Q3.

While the impact of this decline on the top line has been cushioned to a large extent by the steady increase in interest-earning assets (especially loans) over this period, backlash from the sales scandal likely hurt Wells Fargo’s loan growth figure towards the end of the quarter. We believe that this will result in a decline in net interest revenues for the bank year-on-year as well as sequentially. The only factor that will result in a meaningful improvement in Wells Fargo’s interest revenues going forward is an increase in benchmark interest rates by the Fed – expected later this year or early next year. 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.

Fee-Based Revenues Should Partially Mitigate Decline In Interest Revenues

Wells Fargo’s fee-based revenues for its asset management, investment banking and card business have grown in importance over recent quarters as they have increased steadily to contribute over 20% of the bank’s total revenue figure. A majority of this comes from the asset and wealth management arm (~14%), which should have benefited  from the improvement in equity market conditions for the quarter. It should be noted that the loss in Wells Fargo’s reputation from bad press surrounding the sales scandal would very likely have resulted in outflows from the bank’s assets under management in September, but this is unlikely to have much of an impact on fee revenues for the period.

However, Wells Fargo witnessed a sizable reduction in debt origination volumes for the third quarter. Data compiled by Thomson Reuters shows that Wells Fargo’s share of the industry fell from 3.4% in Q2 2016 to 2.7% in Q3 as the total volume of debt capital market deals in which it participated fell from almost $66 billion to $53 billion – even as the overall industry saw a slight improvement. [1] This is expected to drag down the bank’s investment banking fees by 13% q-on-q. This implies a reduction from $421 million in Q2 2016 to around $370 million now.

Things Are Likely To Be Bad On The Cost Front Too

Wells Fargo has one of the most efficient business models among the country’s largest banks, but an increase in staff to handle stricter regulatory and supervisory requirements has had a visible negative impact on the bank’s bottom line over recent quarters. To put things in perspective, non-interest expenses for the bank jumped from under $12.5 billion in Q2 2015 to almost $12.9 billion in Q2 2016 – a trend that stands out in comparison with the overall reduction in operating costs for all major commercial banks over the same period.

Wells Fargo tried 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 initiated in mid-2015. [2] But one year on, the program is clearly making very little headway. To make matters worse, the bank will most likely have to set aside millions in legal and settlement costs in Q3 to provision for impending costs from its sales-related misgivings. Although the bank had already accrued sufficient legal provisions to cover the $185 million in regulatory fines and an additional $5 million in customer redress announced in September, it will have to replenish these funds in view of the ongoing investigation by the DoJ and several class action lawsuits by customers. [3]

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. Global Debt Capital Markets Q3 2016, Thomson Reuters Deals Intelligence []
  2. Wells Fargo streamlining effort could mean job cuts, Charlotte Observer, May 13 2015 []
  3. Consumer Financial Protection Bureau Fines Wells Fargo $100 Million for Widespread Illegal Practice of Secretly Opening Unauthorized Accounts, CPFB Website, Sep 8 2016 []