Tuesday morning, Wells Fargo (WFC) reported strong results that suggest shares continue to have upside (press release available here). The company earned $1.00 vs. analyst consensus of $0.98, and revenue was also strong at $20.7 billion. Wells Fargo continues to drive efficiency in its business with non-interest expense down $800 million year over year. These cuts have helped to maintain strong profit margins in a mixed trading environment. Over the past year, shares have rallied about 30%, and while I don't expect gains to be that robust in 2014, shares do remain at a discount to fair value.
Wells Fargo is one of the nation's largest lender and has leading market share in mortgages. For the company to grow earnings, it is critical that the company continues to boost its lending activity. Year over year, loans are up a strong $26 billion to $826 billion. However, WFC's mortgage dominance could be a bit of drag in the first half of 2014. The company generated significant fee revenue from refinancing mortgages. As rates have risen, this refinancing activity has plummeted.
Mortgage origination in the quarter was $50 billion, significantly off from $80 billion a year ago. This decline in origination has been offset partially by growing "gain on sale margins" from securitization, which was up 35bp to 1.77%. With rates higher, mortgage volume in the first half of the year will trail 2014, and the Fed taper will likely cut gain on sales. As such, first half fee revenue should be weak due to refinancing declines, though a strong housing market should help to temper the decline.
While this may seem like bad news, it really isn't. In the long run, banks want to see interest rates rise as they make far more money from interest income than origination fees. 2013's refinancing pace was unsustainable, and low rates have kept net interest margin depressed. 2014 and 2015 should be fantastic years for net interest margins. With a decent economy, loan demand (especially for autos and home purchases, not refinances) should remain relatively strong. In other words, Wells Fargo will be adding higher yielding loans to its portfolio, which will increase its average interest rate earned.
At the same time, the Federal Reserve is planning on keeping the overnight rate below 0.25% into mid-2015. This rate is a major driver of deposit interest rates. As this rate will remain low, Wells Fargo will continue to have very low interest expense. We are in a steepening environment with the Fed letting the long end of the curve rise while short end stays near 0%. In this environment, net interest margins should climb, which is extremely accretive for bank earnings.
In 2013, Wells Fargo had a 3.39% net interest margin, but with the long end higher, I expect 2014 to be close to 2012's results when the company's NIM was 3.76%. A NIM in the 3.70-3.76% range is a reasonable expectation that will greatly improve the company's earnings and offset a decline in refinance volumes. This higher net interest income will add about $4 billion to pre-tax profits while mortgage fees should drop $1.5-2 billion. On the whole, these two factors will lead to a jump of $2-$2.5 billion in pre-tax profits. As a whole, they will drive EPS higher by $0.30-$0.35. At the current pace of loan growth, I would then expect about a 10% rise in earnings per share to roughly $4.30 in 2014.
Investors should also recognize that Wells Fargo is exceptionally well capitalized with a Tier 1 Common Equity of 10.82%. The company's Common Equity Tier 1 under Basel III is 9.78%. As such, the company will be able to return a significant amount of capital to shareholders again this year. All told, Wells Fargo could return $18.5-$20 billion to shareholders while maintaining the same capital ratio. I expect a similar sized dividend hike to $0.35 per quarter, which would leave $10-$12 billion for a share repurchase. We should get a clearer picture of capital returns in the next two months as the Fed reviews and approves the plans.
Now, some investors might be concerned that shares trade at a roughly 50% premium to book value, which stood at $29.48 at the end of the quarter. I actually believe shares deserve a slightly higher valuation. Return on assets was 1.47% last quarter and 1.51% in the full year while return on equity was 13.81% in the last quarter compared to 13.87% in the full year. With strong net interest margins, I expect similar or slightly higher returns in 2014. When a stock trades at book value, ROE will be investors' long run return.
Historically, equities have returned around 8%. This means that a bank that is generating a 13.5-14% return on equity should trade at a 70% premium to book value. If investors applied that premium to Wells Fargo, fair value is between $49 and $51, or about 10% upside. Importantly, I am expecting $4.30 in earnings in 2014, and even at $50, shares have a modest multiple of 11.6x. At $45, shares don't reflect the company's strong return on equity and trade at a very cheap 10.5x forward earnings. With strong net interest margins and high operating efficiency, Wells Fargo is still a buy at current levels.