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U.S. banks have shown signs of strength recently with the help of slow and steady economic recovery. The record low interest rate has been a significant factor that affected these banks. The low interest rates have been a headwind for banks' net interest margin, or NIM, in the last 2-3 years. But, the rise average spending in the U.S. will boost credit card revenue and provide some relief for banks. The banks' main challenge is to maintain their earnings growth in the coming years. How will one of the largest U.S. banks rise to this challenge?

Wealth segment to bring more wealth

Wells Fargo (NYSE:WFC) is one of the largest banks in the U.S. with a total average deposit of $1.0 trillion, as of the second quarter of 2013. It posted net income of $5.5 billion, a 19% year over year increase in its second quarter of 2013, and a 14th consecutive quarter of rising profits. The most notable growth driver was the 27% increase in net income to $434 million in its Wealth, Brokerage, and Retirement segment.

Asia-pacific issuers have raised $1.8 trillion from bond sales with the help of low interest rates prevailing in the market since the beginning of 2012. Looking at such high economic growth and potential opportunities, in August 2013 Wells Fargo planned to increase the number of fund clients in Asia by 20% every year from 2013 onwards. This region represents 15% of its global fund services. The focus is to develop a relationship with long-term clients, who would be profitable for its global fund services.

Overall, Wells Fargo has client assets of $1.4 trillion, which is only 5% of the total global market potential of $25 trillion. This gives Wells Fargo significant opportunity to tap higher market in the future and increase revenue from this segment.

Credit to the growing credit card user-base

Wells Fargo is the U.S.'s seventh largest general purpose credit card issuer. Its revenue from card fees was $2.84 billion in 2012 and is expected to increase to $3.10 in 2013. This is due to the rise in the number of the cardholders, who prefer cashless transactions. The U.S. economy is in a recovery phase, which means more people are getting jobs or starting their own ventures, thus increasing their spending. Wells Fargo is capitalizing on this opportunity by offering more rewards and loyalty programs. Currently 78% of U.S. residents own credit cards, and these numbers are likely to go up with the rise in average spending among U.S. residents. The total credit card debt is only 16% below the high of $1.02 trillion in July 2008, just before the financial crisis. The card fee will provide a boost to Wells Fargo's credit card segment, which is expected to increase its revenue contribution.

Wells Fargo has entered an agreement with American Express (AXP) to launch credit cards that will be accepted on the Amex network. The pilot launch of the credit cards will start in the third quarter of 2013, and a full launch will take place in the first half of 2014. American Express used to issue cards through its own subsidiaries, American Express Centurion Bank and American Express Bank, but it has taken the third party route for expansion into foreign markets. It will charge fees based on credit card transaction volume and earn royalties from Wells Fargo.

Under the agreement, Wells Fargo will issue cards through its own network, while leveraging American Express's infrastructure and brand image. American Express will help design Wells Fargo's loyalty programs, which offer a range of merchandise and gift cards to its credit card users. The Amex credit cards will be available for subscription to 70 million Wells Fargo customers. Currently, only one-third, around 23.3 million, of Wells Fargo customers own a Visa (V) brand credit card, giving further opportunity to expand its credit card offerings to all its customers. The average spent on an Amex card spend annually is $15,000, much higher than Visa's $1,000 average. This gives Wells Fargo a huge earning potential in the future.

To read our detailes report on Visa, click here.

NIM: Still a concern for U.S. banks

Net Interest Margin of three U.S. banks

Banks

Q1 2012

Q2 2012

Q3 2012

Q4 2012

Q1 2013

Q2 2013

Wells Fargo

3.91%

3.91%

3.66%

3.56%

3.48%

3.46%

JPMorgan (JPM)

2.61%

2.47%

2.43%

2.40%

2.37%

2.20%

Citigroup (C)

2.90%

2.81%

2.86%

2.93%

2.94%

2.85%

Net interest margin, or NIM, is a cause of concern for all banking giants such as Wells Fargo, JPMorgan Chase, and Citigroup. Net interest margin is the difference between interest earned and the interest expense on its assets. With the exception of Citigroup, NIM of all these banks has been declining. This is due to the low interest environment maintained by the Federal Reserve since 2008. Citigroup has been able to sustain its margins owing to its globally diversified business, earning better interest rates in emerging economies. Even though Wells Fargo has shown the highest year over year decline in second quarter of 2013, it has the highest margin among its peers. This is due to the high loan-to-deposit ratio of 80.2% in comparison to Citigroup's 69% and JP Morgan's 60% in the second quarter of 2013. Loan-to-deposit ratio is ratio of a bank's total loans and total deposits. This means that Wells Fargo is making better use of its deposits by lending it out and generating interest income.

In addition, the interest rate decline has been slowing down, and is expected to rise once interest rates go up. The Federal Reserve has considered increasing interest rates once the inflation and employment situation improves significantly.

Valuation

Banks

Trailing P/E

Forward P/E

Wells Fargo

11.49

10.54

JPMorgan

8.66

8.48

Citigroup

15.93

9.07

All three bank's trailing P/E is less than its forward P/E. Wells Fargo's forward price-to-earnings, or P/E, of 10.54, is less than its trailing P/E of 11.49. This indicates that its earnings are expected to increase next year. Also, its P/E is more than the industry's P/E of 9.7, which should give investors confidence in company's future earnings. Wells Fargo's EPS is expected to increase to $3.84 next year, a 14% year over year increase. Wells Fargo is undervalued in comparison to its closest competitor, Citigroup, which has a P/E of 15.93. At such a low valuation, Wells Fargo should be included in an investor's portfolio.

Conclusion

The U.S. banking industry is undergoing a change, with many banks diversifying their business segments and regions to reduce their dependency on U.S. markets. Wells Fargo is also looking towards Asia in its asset management and retirement services for expansion. With the help of its partnership with American Express, it will also grow its credit card segment. The rise in interest rates will further boost its NIM, which has been declining for years. With bright prospects ahead, a discounted P/E in comparison of Citigroup, and EPS growth, this stock is unlikely to disappoint investors in the future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Wells Fargo: Still Cheaper For An Entry?