On Tuesday, Wells Fargo & Co. (WFC, Financial) reported results for the second quarter of fiscal 2019.
For the quarter, revenues were flat at $26.1 billion. This reflects a mid-single digit increase in noninterest income, offset by a 3.5% decline in net interest income. Let’s take a closer look at each of those buckets.
On noninterest income, the year-over-year increase largely reflects the impact of “other” income (gain on the sale of Pick-a-Pay PCI loans) and net gains from the sale of equity securities. If we back out of each of these "one-time" sources and look at the year-to-date results, noninterest income declined 3% as a result of double-digit declines in mortgage banking and trust and investment fees.
The decrease in net interest income reflects an 11 basis point decline in the company’s net interest margin (NIM) to 2.82%. As a reminder, the net interest margin measures what Wells Fargo earns on assets like loans and investment securities less the cost associated with deposits and other sources of funding. The bank is feeling pressure on both sides of the coin, with the lower rate environment impacting asset yields while higher deposit pricing is leading to an increased cost of funding. In the quarter, the company’s interest income increased 6% to $17 billion. On the other hand, interest expense increased 41% to $4.9 billion (with the cost of deposits up 75% to $2.2 billion). The net result was a 3.5% decline in net interest income to $11.6 billion.
As noted on the call, this is not expected to improve in the short term: “Last quarter we said we expected NII to decline 2% to 5% this year… if the rate environment we are in today persists, we would expect to be near the low end of the range (-5%).”
Broadly speaking, there are signs of progress at Wells Fargo. For example, the company reported its seventh consecutive quarter of growth in primary consumer checking customers, with the pace of growth slightly accelerating from the prior period (adjusted for the sale of 52 branches to Flagstar in 2018). I’d also note this result occurred despite a 5% reduction in the number of retail bank branches over the past year, which reflects the company’s ability to retain clients (deposits) as their interaction with the bank shifts to digital channels. As shown below, Wells Fargo has done a good job over the past year of closing the growth gap between itself and a best-in-class peer in JPMorgan (JPM, Financial). Finally, the company continues to show strength in terms of credit quality, with net charge-offs (NCO's) holding steady at roughly 0.3% (annualized) of average loans.
With that said, the company still has a lot of work to do. As an example, Chief Financial Officer John Shrewsberry bluntly noted on the conference call that “our expenses are too high.” But that comment was quickly followed up with the admission that net expense reduction is unlikely to be material in the coming year. This is a large opportunity for the company – and as a result, the 2020 guidance was disappointing. For context, Wells Fargo’s efficiency ratio (noninterest expense as a percentage of total revenues) is in the low 60s. As Shrewsberry noted in a CNBC interview on Tuesday, that number should fall in the mid-to-high 50s over time (management previously guided to a long-term target of 55% to 59%). Hitting that target will require the bank to take out roughly $4 billion in run rate expenses. That would be material – but it sounds like this is at least two years out. I doubt Mr. Market will give the stock credit for this potential improvement until we start to see some results.
Capital returns continue to be a key part of the story. The diluted share count declined by more than 8% (year over year) in the second quarter to 4,495 million shares. Despite the significant reduction in the share count, the company’s CET1 ratio remained unchanged at 12% (the plan is to take that down to 10.25% to 10.50%). At $45 per share, the market cap is just north of $200 billion. The $23.1 billion of repurchases over the next year that the Federal Reserve has already approved is equal to 11% of Wells Fargo’s market cap. As noted on the conference call, repurchase spend will be weighted toward the front half of the period; as a result, if the stock price does not move, the share count will decline by another 7% over the next six months. This is having a meaningful impact on the per-share financial results of the business. The company also increased the quarterly dividend by 13% to $0.51 per share (quarterly). At $45, the dividend yield is roughly 4.5%.
Conclusion
The last few years have been difficult for Wells Fargo. The bank has worked to win back the trust of customers while simultaneously investing to meet the demands of regulators (and to ensure that internal controls around operational risk and compliance are up to par). These efforts are consuming much of management’s attention. At the same time, low interest rates and the flattening of the yield curve are not making life any easier.
The question a potential investor needs to answer is how those factors will develop over the coming years. Said differently, how you think about outsized expenses or net interest margin pressures is partially dependent on your time horizon. What is correctly viewed as a risk or headwind in the short term may end up being a long-term opportunity. As an example, if your objective was to trade in and out of this stock within the next 12 months, the 2020 expense guidance was a major negative for the bull case. On the other hand, if you’re planning on owning this business for the years and decades to come, it’s a lot less concerning. Personally, as I think about the headwinds that the company is currently facing, I think most of them look like levers that could potentially drive meaningful per-share value creation over time. Admittedly, I have been saying that for some time. (If you wait too long, the outcome may prove comparable to just being plain wrong.)
I think the risk-reward looks quite attractive at $45 per share. Assuming the business doesn’t shrink and the valuation is unchanged, we have a straightforward setup for double-digit returns from capital returns alone (includes a buffer to account for the fact that the 2019 payout ratio isn’t sustainable). But that assumes you’re comfortable owning a stock with no apparent catalyst that may continue treading water (or go down even more) in the short term. I’m fine with that.
The stock currently trades for 1.1 times book value and 1.3 times tangible book. The price-to-earnings multiple is roughly 10x. It’s hard for me to understand how this valuation makes sense for a business with a low-teens return on equity in a world where long-term Treasuries yield less than 3%.
Disclosure: Long Wells Fargo.
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