- Wells Fargo's results were impacted by weak mortgage originations, as expected.
- A recovery of the mortgage origination business and solid economic developments could spur further growth.
- But how appealing is the current valuation actually? Valuations look attractive on earnings and dividends, yet the price-to-book is increasing during the good times.
Wells Fargo (NYSE:WFC) reported a solid set of second quarter results in what is a difficult operating environment for banks these days.
The mortgage origination activities create a drag on current earnings, offset by growth in other areas and effective risk management. While I applaud management for the solid results, I wonder what will drive incremental growth going forwards.
In that light, the current risk-reward trade-off is not that appealing in my eyes, as the premium to book values is growing. This results in some ¨air¨ in the valuation in case the economy faces an unexpected slowdown.
Second Quarter Highlights
Wells Fargo reported second quarter revenues of $21.07 billion, down 1.5% compared to last year, but up 2.1% compared to the first quarter. Revenues came in ahead of consensus estimates at $20.8 billion.
The bank posted net earnings attributable to shareholders of $5.42 billion, up 2.9% compared to last year, but down by 3.2% compared to the first quarter. On a diluted basis, earnings came in at $1.01 per share, up three pennies compared to last year. Earnings were in-line with consensus estimates.
Looking Into The Performance
CEO John Stumpf was pleased with the solid results, as he stresses the benefits from the diversified business model and focus on the long-term needs of customers. Strong credit quality, driven by the housing market and risk discipline, have fueled results.
Interest income was up by $176 million to $10.8 billion, driven by growth in commercial and consumer loans. Interest income was also aided by the fact that the second quarter included one more business day. Net interest margins on the balances outstanding fell by 5 basis points to 3.15%, driven by the high deposit growth.
Non-interest revenues rose by $0.3 billion to $10.3 billion driven by mortgage banking, investment fees, deposit service charges and card fees. A noticeable strong performance was displayed by the trust and investment fee business, which posted a $197 million increase in revenues towards $3.6 billion. Investment banking fees showed strength as well, while the mortgage business experienced much anticipated weakness. Non-interest income fell by 38% to $1.72 billion in this business.
Non-interest expenses rose a bit to $12.2 billion, with the efficiency ratio coming in at 57.9% of sales, in-line with the company's 55%-59% targeted ratio. Note that net earnings were impacted to a large degree by higher tax rates, with the effective tax rate of 33.4% coming in 5.5% higher than the first quarter. First quarter tax rates were lowered thanks to a $423 million tax benefit.
A Look At The Balance Sheet
The company ended the quarter with $1.59 trillion in assets, up 3% on a sequential basis and up 11% per annum. Total loans rose by $2.5 billion on a sequential basis to $828.9 billion, which does not seem a lot. Yet note that Wells transferred $9.7 billion in government guaranteed student loans during the quarter. Adjusting for this growth approached 6% per annum.
Credit quality remained good, with the reported $717 million in losses down 38% compared to the year before. This means that charge-offs were only 0.35% of average loan balances. Total non-performing assets fell from $19.6 billion last year to $18.1 billion over the past quarter.
Yet the real growth in the balance sheet resulted from a 9% annual increase in deposits which rose towards $1.1 trillion. This provides the firm with a very cheap cost of funding, with average rates paid on deposits totaling just 10 basis points per annum.
Total common equity Tier 1 capital was $134.8 billion under the Basel III approach. Based on this general approach, the ratio came in at 11.3% of risk-weighted assets. Under the advanced approach of Basel III, the Tier 1 ratio came in at 10.1%.
Valuation Of The Bank
Wells Fargo had a fine quarter, with capital ratios being solid while book value continues to increase. Reported book value of $31.18 per share was up significantly from $28.26 last year. As a matter of fact, reported underlying growth in the asset base was solid as the bank remains focused on keeping its cost base low, slashing 4% of its workforce over the past year.
On a trailing basis, Wells Fargo has generated sales of $83.1 billion on which it earned $22.6 billion. At $51.50 per share, equity in the business is valued at around $270 billion. This values the bank's equity at roughly 3.2 times sales, 12 times earnings and 1.65 times common equity.
Returning Excess Cash
Investors are very pleased with the bank's performance, growth, risk management and lack of involvement in scandals which have impacted many other banks, notably investment banks.
Given the adequate capital, Wells has resorted to please investors, announcing a 17% dividend hike over the past quarter. The $0.35 quarterly payout now yields 2.7% to current investors. On top of that come share repurchases, with the 39.4 million shares being repurchased during the second quarter implying another effective 3% return of cash to investors.
Of course, investors like the prospects of these strong payouts amidst this low interest rate environment, combined with operational growth. As such, shares have already risen 13% so far in 2014 alone.
Over the past decade, Wells Fargo has increased its operations significantly. Between 2004 and 2013, the bank has grown revenues from roughly $30 billion to almost $84 billion, growing revenues at around 11%-12% per annum.
Earnings have grown at a similar pace, or even slightly faster clip as well during the period. It is important to realize that the outstanding share base increased by little over 50% during this time period. This was of course the result of the acquisition of Wachovia back in 2008.
So what to think about the bank now, with shares trading at all-time highs? It is clear that the bank has great management and risk management, allowing the firm to stay out of major troubles during the recession. Of course, a further strengthening of the U.S. economy and recovery of mortgage originations could be triggers going forward. Note however that low interest rates are no longer having a major effect, with Wells only paying an average of 10 basis points on its deposit book.
Loan losses are very low as well, and while they could continue to inch down a bit, this will no longer be major driver behind year-on-year earnings growth. As such, only general economic growth and a recovery of the housing market could fuel incremental growth in my opinion, of course combined with continued cash returns to investors. As such, shares offer appeal at the current valuation amidst a moderate price-earnings ratio and high payouts.
This makes returns solid for as long as the good times last. Shares trade significantly above its book value, while of course the bank remains cyclically exposed if the economy witnesses a slowdown or renewed correction.
As such, I don't see compelling reasons for investors to take profits at current levels, yet I don't necessarily believe that current levels represent a great entry level for long-term investors.