Last month, we wrote about the opportunity found in Wells Fargo (WFC). We believe that an investor can get high-quality growth and income from buying the stock at a discount to intrinsic value that exists mainly due to concerns over the banking industry as a whole, vs. anything Wells Fargo has done.
On Friday, July 13, Wells Fargo came out with very strong earnings despite a gloomy macroeconomic environment. Diluted EPS of $0.82 and net income of $4.6 billion were up 38% and 35%, respectively, on an annualized basis from the prior quarter. Pre-tax pre-provision profit (PTPP) was $8.9 billion, up 12% from the prior quarter despite revenue being $21.3 billion vs. the prior quarter's $21.6 billion. Wells Fargo continued to make progress in improving its operating leverage via lowering the company's expense structure by approximately $600 million, and we believe there is still a lot of room for improvement in this area. This helped the efficiency ratio improve to 58.2% from 60.1% in the first quarter, and the company believes that 55% is achievable over time.
Return on assets improved to 1.41% and return on equity rose to 12.86%, up 10 and 72 basis points, respectively, from the prior quarter. Most banks would be ecstatic to post these types of returns in a robust economic environment considering the current regulatory headwinds, but Wells Fargo is leading the pack and picking up market share while competitors retrench.
The European deleveraging process has allowed strong banks such as Wells Fargo to acquire attractive loan portfolios at a time when credit demand has been lackluster. During the quarter, the company completed the acquisitions of BNP Paribas' (BNPQY.PK) North American energy lending business with nearly $9.4 billion of loan commitments, and WestLB's subscription finance loan portfolio with $3.7 billion in loans outstanding. These acquisitions helped Wells Fargo grow its total loan balance to $775.2 billion at June 30, 2012, up from $766.5 billion at March 31, 2012. Total average core checking and savings deposits were up $12.5 billion from the prior quarter as the bank continues to keep its funding costs exceptionally low, which is imperative due to the terrible squeeze it is facing with net interest margins due to the low interest rate environment. Wells Fargo prudently redeemed $1.8 billion of trust preferred securities with an average coupon of 6.31% on June 15, 2012, and this assisted the company is keeping its net interest margin flat at 3.91% from the first quarter.
Wells Fargo continued to improve its capital position with Tier 1 common equity under Basel I increasing $2.2 billion to $101.7, for a ratio of 10.08%. The company estimates that its Tier 1 common equity ratio under the latest Basel III capital proposals is a healthy 7.78%. Wells Fargo continued with its strong capital allocation principles, purchasing 53 million shares in the second quarter and 11 million shares through a forward repurchase transaction expected to settle in third quarter 2012. We view these buybacks as very attractive due to the discount to intrinsic value that Wells Fargo is currently trading at, and the company's $0.22 per share quarterly dividend offers a nice balance between the two.
While the macroeconomic environment may be difficult, credit conditions have rarely been better for most banks, particularly Wells Fargo. Net charge-offs were $2.2 billion, a decline of $195 million from the prior quarter, and the net charge-off rate of 1.15% is the lowest since the third quarter of 2007. Non-performing assets were down $1.8 billion from the prior quarter to $24.9 billion, and the pre-tax reserve release was $400 million. Many analysts are underestimating the impact of an improving housing market on the banks, which are perhaps the most leveraged to benefit as prices stabilize and mortgage demand accelerates. In Q2 2012 Wells Fargo had record mortgage applications, and the company leverages its cross-selling business culture through increases in lending to both consumers and businesses. The retail bank actually reached a cross-sell milestone of 6.00 products per household for the combined company, up from 5.82. Because the more established West Coast branches average 6.37 products per client, compared to 5.52 in the former Wachovia east coast branches, there is still ample room for improvement for the overall company.
One problem that doesn't seem to want to go away for Wells Fargo and the other banks are costs due to mortgage loan repurchase losses, particularly from the GSE's. WFC provided $669 million for these costs in the second quarter, which was up from $430 million in the first quarter. It will take time to work through these repurchases issues, but fortunately Wells Fargo is able to tackle them with its core businesses operating like gangbusters. We expected Wells Fargo to continue to acquire more foreign loan portfolios when attractive opportunities arise to try and compensate for low interest rates. The company is well on its way to having in excess of $20 billion in normalized earnings power in a historically low interest rate environment, and investors can be confident that the company will do everything it can to squeeze out more efficiencies along the way. If the U.S. economy actually enters a true growth stage inclusive of decreasing unemployment, Wells Fargo could move materially higher.
Disclosure: I am long WFC.