With first quarter earnings just around the corner, analysts on Wall Street are happy to prognosticate and offer the insight they have to the investing community. With Wells Fargo (WFC) set to release its report first among the big banks, JPMorgan (JPM) analyst Vivek Juneja is out with his relatively cautious note on the residential mortgage king. Juneja's premise is that since WFC is so reliant on the mortgage market, where it generates a disproportionate amount of its revenue and enjoys overwhelming market share, it is also subject to a material slowdown in earnings growth as a confluence of events sets in motion a slowdown in refinances and new purchases. While no one can disagree with Juneja's overall premise, the way he then describes the relatively muted impact of the slowdown seems to serve Wells Fargo bulls more than bears.
Anyone who has followed the banking industry since the financial crisis knows that WFC is dominant in the residential mortgage market. WFC enjoys a 25.4% market share in the mortgage market as of the most recent quarter, generating enormous sums of revenue and profit in the process. This has been the main driver of growth for WFC since the financial crisis where the bank has seen its return on assets jump from 0.97% to 1.41% and return on common tangible equity rise to a staggering 16.95%, with both metrics dwarfing it's too-big-to-fail brethren. It stands to reason, then, that if the driver of WFC's growth is slowing down, that those and other profitability metrics may begin to moderate. However, given that WFC has proven over many years that it can operate profitably even in the face of a financial crisis gives me confidence that a slowdown off of breakneck growth levels in the mortgage market is nothing to get excited about.
Juneja is estimating that Wells' mortgage origination revenue will fall from $12.2 billion in 2012 to just over $8 billion this year. This is a massive drop in revenue for one segment of a business but keep in mind that this represents just over 13% of WFC's 2012 revenue, so we are not talking about Armageddon here. To be fair, Juneja also notes that WFC will experience expense offsets in response to lower mortgage revenue as well, helping to dampen the blow to earnings. He notes: $1.2 billion decrease in servicing expenses, $0.7 billion decline in putback expenses, and $1.6 billion reduction in origination expenses. This means Juneja thinks roughly $3.5 billion of the $4.2 billion revenue lost this year will be offset by smaller expenses.
While a 34% decline in revenue in a bank's largest segment is somewhat disquieting for investors, there is a silver lining: the fact is that 2012 was a banner year for WFC and other originators and some drawdown from 2012 levels is expected. The fact that the lost profit for Wells is expected to be in the $300 to $400 million range is actually encouraging, as this represents only 2% of WFC's net income last year. With Paul Miller of FBR Capital saying that the sky is falling for mortgage originators, a panic decline in WFC shares following earnings would be a boon for longs.
Wells Fargo is run by very intelligent people who know better than any Street analyst, pundit or me that the mortgage market is changing. I have complete confidence that other lines of business will pick up the slack of losing 2% of the bank's earnings power due to a slower mortgage market. No one should expect that the HARP-induced mortgage boom would last forever but it has helped to propel WFC shares to highs not seen since the financial crisis. It has also cemented WFC as the undisputed leader in the ever-important residential mortgage market, a competitive advantage shareholders will reap the benefits from for years to come.
If we are fortunate enough to get a selloff in WFC shares following the first quarter earnings announcement, consider it a gift and add to your position or get long. Wells already pays a nice dividend that easily beats Treasuries and is on pace to continue to increase its payout in years to come. In addition, housing in the US is on a tear both on the new and existing fronts where Wells is the biggest player around.
If you are long WFC and are concerned about a post-earnings selloff, you can sell calls against your position in order to mitigate some risk. With shares trading at multi-year highs and the indexes likewise, perhaps a bit of caution is warranted. Indeed, you can sell calls against your shares in order to provide some protection to the downside and generate some income in the process. I like the June 38 call selling for $0.61 here. Selling this call against your stock will provide $0.85 of potential capital gains upside while still collecting $0.61 of premium in just over two months. In addition, it provides 1.6% of downside protection in case there is a bit of a selloff after earnings. Either way, you will generate a 1.6% nominal return from the short call in just over two months and potentially gain another $0.85 of capital gains if the stock trades above $38 by June expiration.