Wells Fargo: Where Is The Upside?

Summary

• Some investors believe that Wells Fargo can increase earnings due to higher interest rates, lower corporate taxes and cost-cutting initiatives.
• This seems to be already priced-in and further upside to current expectations seem difficult to emerge.
• Wells Fargo doesn’t seem to have much upside and is presently a sell.

I’ve recently analyzed Wells Fargo (NYSE:WFC) and rated it a sell, due to concerns about low growth prospects and a relatively high valuation. I’ve received some pushback on this call, as readers seem to think that Wells Fargo can increase earnings in the next few years, supported by higher interest rates, a lower corporate tax and expense reductions.

The first two factors are outside of the bank’s management control and are positive tailwinds for all banks, while cost-cutting is where the bank can beat current expectations. In this article, I analyze these three bullish arguments in more detail, as the negative issues like litigation and the asset cap are usually accepted as valid arguments for a bear case.

Interest Rates

Theoretically, higher interest rates are good for banks because asset margins tend to increase more rapidly than liabilities margins, leading to higher overall business margins assuming a stable balance sheet.

This means that net interest margin [NIM] is expected to expand in a rising interest rate environment, like the one experienced in the U.S. over the past couple of years.

However, interest rate sensitivity is not the same for all banks, depending on the asset and funding structure. For instance, banks with higher funding coming from non-interest bearing deposits should see NIM expanding faster than banks with more reliance on wholesale funding or interest-bearing deposits.

Over the past few quarters, Wells Fargo has reported slightly lower loans outstanding ($951 billion in 1Q18 vs.$963.6 billion in 1Q17), but average loan yields have increased, from 4.26% in 1Q17 to 4.50% in the most recent quarter. This is positive for Wells Fargo’s top-line, as it receives higher income from loans outstanding.

_{Source: Wells Fargo.}

On the other hand, average deposits have been quite stable near $1.3 trillion, but the average cost of deposits has doubled in the past year, from 0.17% to 0.34%. About 28% of Wells Fargo’s deposits are noninterest-bearing and I expect this weight to decline in the coming quarters, as customers become more demanding on deposit rates due to higher interest rates and competition from other banks.

_{Source: Wells Fargo.}

Taking into account this background, it is no surprise that despite higher interest rates, Wells Fargo has reported both slightly lower net interest income and net interest margin over the past few quarters. This shows that Wells Fargo has not benefited much from higher interest rates, despite its guidance of net asset sensitivity of 5-15 basis points (bps) for a 100 bps parallel shift in the yield curve.

_{Source: Wells Fargo.}

Banking is a spread business and higher interest rates are feeding through both the asset and liabilities sides of the balance sheet, leading to a relatively stable NIM in the past few quarters. Additionally, the yield curve is becoming more flat (short-term rates are rising faster than long-term rates), which is negative for banks.

Another way the bank could have higher NIM is through loan growth, but Wells Fargo is restricted due to the asset cap. Not surprisingly, this NIM dynamic is not expected to change in the near future, as current consensus estimates don’t expect much higher revenues or NIM in the next four quarters. Therefore, higher interest rates don’t seem to be particularly bullish for Wells Fargo.

_{Source: Bloomberg.}

Corporate Taxes

Lower corporate taxes are a positive factor for earnings growth and this was visible in the first quarter earnings for most banks. Wells Fargo was no exception and this was a key reason why its net income increased in the first quarter of 2018.

The bank’s income before income tax expense amounted to $7.5 billion, a decline of 4.5% from the previous year. Note that this does not include the $1 billion settlement announced more recently and should not be taken into account to analyze the impact of lower corporate taxes, as it is a one-off cost and does not affect the bank’s future earnings.

Its income tax expense in the quarter was $1.37 billion, a decline of 36% from the same quarter of 2017, or a lower tax expense of about $760 million. Its effective tax rate was 18.3% in the past quarter, while in 1Q17 it was 27.1%.

This was the main reason why Wells Fargo’s reported net income (before preferred stock dividends) increased by 5.4%, to $5.94 billion. Thus, without the benefit of lower taxes, Wells Fargo would have reported lower earnings in the past quarter, compared to 1Q17.

Lower income tax expense will boost earnings in 2018, but going forward it should be neutral to earnings assuming that taxes will remain unchanged thereafter. I think this is well understood by inve stors and is not a driver of further upside for Wells Fargo because the profitability boost from lower taxes is a one-time gain.

Expenses

Regarding expenses, this is the only are a where the bank may beat expectations because it does not depend on external factors. Wells Fargo’s efficiency ratio is quite poor compared to its closest peers, given that it has been consistently above 60% over the past few quarters.

_{Source: Wells Fargo.}

In the past quarter, its efficiency ratio was close to 65%, a much higher level than JP Morgan (JPM) which had an efficiency ratio of 58% or Bank of America (BAC) at 62%. This means that Wells Fargo seems to have room for further cost cutting and may improve its profitability in the next few years.

Indeed, Wells Fargo has a cost-cutting program ongoing aiming at improving efficiency, targeting $4 billion in gross cost savings by end-2019. However, half of these expense reductions are expected to be reinvested in the business, thus its net savings should be around $2 billion.

Its guidance is for 2018 annual expenses to be in the range of $53.5-54.5 billion, including cost-cutting initiatives, while it expects additional $2 billion savings by the end of 2019, to be fully reflected in its bottom-line.

However, in the past quarter, the bank increased noninterest expense by 3% compared to 1Q17, to more than $14 billion. As seen below, the main expense lines (salaries and commission and incentive compensation) reported year-on-year growth of 2% in 1Q18, not boding well for the bank’s cost-cutting program.

_{Source: Wells Fargo.}

Wells Fargo is targeting expense reductions from several initiatives, such as optimization of processes and the close of 250+ branches in 2018. Given that Wells Fargo is a large bank, it may be possible to reduce expenses by improving its operational efficiency, but so far there isn’t much evidence of that.

Looking at current consensus estimates, it seems that sell-side analysts are also skeptical about the success of Wells Fargo’s expense reduction efforts, given that noninterest expenses are expected to be at the top of its guided range in 2018 and be close to $53 billion, both in 2019 and 2020.

_{Source: Wells Fargo.}

This means that analysts’ currently don’t that Wells Fargo’s will be able to achieve its target of $2 billion annual net savings by 2019, which doesn’t seem odd taking into account the expense growth reported in the first quarter of 2018.

Therefore, Wells Fargo needs to explain better how it intends to achieve expense reductions and improve efficiency at its investor day next week. However, I doubt that it will increase its target of $2 billion net savings and this doesn’t seem to be a factor that provide much upside in the short-term.

Conclusion

Wells Fargo’s growth prospects are relatively muted due to the asset cap and low sensitivity to higher interest rates, while cost cutting seems to be the only area where it can provide some upside to current expectations.

Despite this, Wells Fargo is trading at 1.42x book value, not particularly cheap for its profitability level. Its return on equity, a key measure of profitability within the banking sector, is expected to be between 12-13% in the next three years.

Using a variation of the Gordon Growth Model to value banks and assuming this ROE range, I see a deserved price-to-book value valuation between 1.25-1.38x. This implies a fair value between $46-51 per share, or a downside potential between 3% and 12%, thus Wells Fargo remains a sell.

Analyst’s Disclosure: I am/we are short WFC. 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.