Wells Fargo’s Q3 Results Indicative Of Rough Weather Ahead, But Shares Are Extremely Undervalued
It has been a bad year for Wells Fargo (NYSE:WFC) so far. The U.S. banking giant capitalized on its risk averse, community-focused business model to grow large enough to rival the likes of JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), and Citigroup (NYSE:C) since the economic downturn. While the extended low interest rate environment has made things challenging for all traditional loans-and-deposits banks, Wells Fargo’s woes over the first half of the year were aggravated by a slowdown in its cornerstone mortgage banking business and also by the negative impact of depressed oil prices on its commercial lending portfolio. And things turned for the worse when it was revealed in September that the bank’s employees had fraudulently opened millions of deposits and card accounts between 2011 and 2015. The sales scandal has already resulted in $190 million in fines for Wells Fargo, and could lead to another $300-400 million in legal costs from the ongoing DoJ investigation and customer class-action lawsuits in the near future. [1] But more importantly, the bank’s reputation has taken a serious dent from all the bad press surrounding the fraud.
Notably, Wells Fargo reported a marked reduction in applications for new checking accounts and credit cards in September according to its Q3 earnings supplement. [2] And this is going to be Wells Fargo’s biggest problem in the near term, with existing customers also likely to switch to competitors over the coming months. But as we detailed in our recent article, we expect the bank to put this issue behind it in a few quarters. In this article, we illustrate how Wells Fargo’s results for Q3 were quite strong despite industry-wide headwinds. Taken together with expected gains from a rate hike in the near future, we believe that Wells Fargo’s shares are currently oversold. We maintain a $59 price estimate for Wells Fargo’s stock, which is around 30% higher than the current market price.
See our complete analysis of Wells Fargo here
Q3 Results Suffered Primarily Because Of Legal Costs
The table above summarizes the factors that aided Wells Fargo’s pre-tax profit figure for Q3 2016 compared to the figures in Q3 2015 and Q2 2016. As can be seen, revenues for the bank improved y-o-y as well as q-on-q – a commendable feat given continued pressure on net interest margins. Although fee-based revenues were lower, this was almost completely due to volatile revenue streams – namely gains on sale of debt securities, gains on equity investments and ‘All Other’ revenues. As for compensation expenses, the $500 million increase compared to Q3 2015 can be attributed to unusually low employee benefit costs in the year-ago period, with salaries and bonuses remaining largely flat over all three quarters.
Which brings us to the ~$370 million increase in non-compensation expenses for Q3. Wells Fargo reported nearly identical figures under various cost heads for the three quarters, with only ‘Other’ costs being ~$350 million higher in Q3 2016 compared to Q3 2015 and Q2 2016. We can safely assume that this is the cash Wells Fargo set aside this quarter as legal provisions to cover liabilities from its mis-selling scandal. The bank will potentially incur additional legal costs in the current quarter too, but we do not expect additional legal costs to spill-over into 2017.
The Mortgage Industry Is Showing Signs Of Recovery
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. After remaining below $1.1 billion for each quarter since Q2 2013, Wells Fargo reported a sharp increase in net origination fees in Q3 2016 to over $1.3 billion. The table below summarizes the changes in Wells Fargo’s mortgage-related fees for the quarter compared to Q3 2015 and Q2 2016.
Wells Fargo originated mortgages worth $70 billion in Q3 2016 – a sequential improvement from $63 billion and well above the $55 billion figure for Q3 2015. Mortgage application volumes for the quarter reached $100 billion in Q3 2016 – the highest in more than three years. The bank also has an open mortgage pipeline of $50 billion, which should help the bank tide over an expected reduction in application volume for the bank in the near future.
Massive Base of Interest-Earnings Assets Countering Shrinking Net Interest Margins
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 lows 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 2.82% for Q3 2016.
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 $1.73 trillion in Q3 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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- Consumer Financial Protection Bureau Fines Wells Fargo $100 Million for Widespread Illegal Practice of Secretly Opening Unauthorized Accounts, CPFB Website, Sep 8 2016 [↩]
- Q3 Quarterly Supplement, Wells Fargo Investor Relations, Oct 14 2016 [↩]