A Lot Has Gone Wrong For Wells Fargo, But The Bank Still Looks Undervalued

by Trefis Team
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Wells Fargo (NYSE:WFC) did well to report an earnings beat for the first quarter of the year late last week despite facing headwinds on several fronts. We have summarized the bank’s Q1 2018 earnings and also detailed the major takeaways from the announcement in our interactive dashboard, the key parts of which are captured in the charts below.

In February, the Federal Reserve passed an enforcement order prohibiting the bank from growing any larger until it fixes its internal governance issues, and over recent months several federal and state agencies have been investigating the bank’s different operating divisions – leaving it with a lot to fix over the coming months. The bank will likely forego millions in profits directly due to the enforcement order and could end up paying multi-billion dollar fines to settle with regulators. Add to this the impact of poor industry activity on the bank’s cornerstone mortgage banking operations, and the fact that the bank’s net interest margin figure remains under pressure in a positive interest rate environment, and Wells Fargo looks like it’s in a bad position relative to its peers JPMorgan, Bank of America and Citigroup.

That said, we believe that the bank will be able to put substantially all its troubles behind it by the end of this year, and should leverage the strength of its core loans-and-deposits operations over the coming years to return to its stable growth trajectory. Accordingly, we maintain our $65 price estimate for Wells Fargo’s stock, which is about 25% ahead of its current market price.

See our full analysis of Wells Fargo

Net Interest Income Trends Lower Due To Growth Restrictions

The single biggest impact of the Fed’s enforcement order on Wells Fargo’s Q1 results was that its interest-earning assets declined – especially its loan portfolio. It should be noted that the first quarter of the year is a slow period for loan growth, as many retail customers close out their outstanding loans using the bonus payments and tax refunds they receive. Given that the industry has also seen loan growth slow down for the quarter, the sequential decline in Wells Fargo’s loan portfolio (which fell to below $940 billion for the first time since Q1 2016) was largely unavoidable.

As Wells Fargo also had to sell off some of its asset base to ensure that its balance sheet does not grow, its net interest margin (NIM) figure remained at 2.84% for another quarter – as opposed to the uptick in NIM figures for its peers thanks to the Fed’s rate hike. This drove Wells Fargo’s net interest income figure lower for Q1 2018. However, we believe that this key operating metric will recover by the end of the year as the bank resolves its ongoing regulatory issues.

Mortgage Industry Headwinds Hurt Origination Fees

Wells Fargo’s business model focuses considerably on the mortgage industry, with the bank making a sizable chunk of its net interest revenues from residential mortgages in addition to generating fees from originating and servicing mortgages. However, the weak level of activity in the U.S. mortgage industry over the last few quarters has weighed on its top line. The situation did not improve in Q1, with the bank only originating $43 billion in mortgages for the quarter – down from $53 billion in the previous quarter, and worse than the already weak $44 billion figure a year ago. This resulted in mortgage origination fees falling to just $466 million for the quarter – the lowest since the bank’s acquisition of Wachovia in late 2008.

Still, Wells Fargo remains the single largest player in the U.S. mortgage industry, and it should see its fortunes improve considerably once mortgage activity levels pick up over subsequent quarters.

Seasonally Elevated Compensation Fees, Higher Compliance Costs Drag Down Margin

Wells Fargo’s compensation expenses were seasonally higher, as the bank handed out annual bonuses and other incentive pay to its employees. At the same time, the bank had to set aside more cash to cover legal costs from its ongoing investigations. While this increased total operating costs for the bank, the lower revenues ended up lowering operating margins to 35% from almost 37% a year ago. Thankfully, smaller loan provisions mitigated the impact on the bottom line.

Going forward, as revenues improve and Wells Fargo doesn’t need to incur one-time legal and compliance costs, the margin should return to its historical average of around 40%.


We expect Wells Fargo to report EPS of $4.82 for full-year 2018. Taken together with a P/E ratio of 13.5 (which we believe is appropriate for the bank given its operations and regulatory challenges), this works out to a price estimate of $65 for Wells Fargo’s shares, which is 25% ahead of the current market price.

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