Justin Sullivan
Wells Fargo (NYSE:WFC) finally got it right with the hiring of Charlie Scharf who is rightfully laser-focused on resolving regulatory issues, reducing the cost structure, and improving businesses where Wells Fargo doesn’t swing its own weight, such as credit cards and private banking. Wells was one of the finest banks in the country for years, positing returns on equity that were the envy of the industry, but the cross-selling culture eventually caught up to it, and it has been a struggle. Progress has been stymied by the Covid-19 lockdowns and now another likely recession, but the long-term picture looks bright. Long-term investors should accumulate shares on weakness.
While Mr. Market seems quite myopic on a likely recession, very little credit is being given to banks benefitting from higher interest rates, which is becoming increasingly apparent this earnings season. Wells Fargo has had an asset cap restriction, so it has been extremely judicious in how it has used its balance sheet, so credit really should not be a problem for them. With its large retail deposit base, more modest deposit betas should allow Wells to make the most of these interest rate hikes bolstering net interest income. Fee revenue is under pressure with weaker capital markets, decimated mortgage origination, and pressure on fees such as overdrafts. However, rapidly growing net interest income solves a lot of those problems, and Wells Fargo is one of the few banks actively reducing its normalized expense run rate.
One of Scharf’s areas of focus has been credit cards, where Wells Fargo has lagged behind peers offering more attractive rewards programs. I’ve been a Wells Fargo customer for 22 years and have many credit cards, but I’ve never used Wells, which is pretty crazy to think of. The situation is changing, and the company launched its fourth new credit card offering in the past year, Wells Fargo Autograph. Momentum is growing, as new consumer credit card accounts are up over 60% from a year ago. This new card will provide three times points across top categories and is the first of several rewards-based cards being introduced. The company is also in the midst of rolling out Wells Fargo Premier, which provides differentiated products and experienced focused on strengthening and growing affluent client relationships. The idea is to offer one set of products and services that are tailored to the needs of these customers throughout Wells Fargo’s various individual businesses. Scharf’s experience at JP Morgan also augurs well for the Investment Bank where Wells could potentially increase in size a bit. I think Wells Fargo was a bit spoiled before they got into trouble, and they neglected some of these opportunities, because they were already doing so well, but times have changed and now they are too.
On July 15th, Wells Fargo reported $3.1B of net income, or $.74 per share, which included a $576MM impairment on equity securities, mostly in its venture capital business due to the bear market. One year ago, Wells Fargo recorded $2.7B of gains on equity securities during a strong market, so those earnings are volatile. Wells increased its allowance for credit losses by $235MM due to loan growth, following six consecutive decreases in the allowance, including $1.1B in Q1 and $1.6B a year ago. Wells Fargo’s credit quality is truly exceptional with a charge-off ratio of only 15 basis points, hovering near historical lows. Commercial credit was even better with only 2 basis points of net charge-offs in Q2, which included net recoveries from the commercial real estate portfolio. Non-performing assets decreased by 13% to $878MM, as consumers continue to make payments after Covid-related accommodations. Pre-tax pre-provision profit of $4.145B was up from $3.722B in Q1, but down from $6.929B at the same time last year.
Average loans grew by 8% YoY and 3% sequentially, while period-end loans grew by 11% YoY. Average loan yields grew by 19 basis points YoY and 27bps sequentially, due to higher rates. Average deposits grew by 1% YoY, or $10B, led by growth in consumer banking and lending. Average deposit costs increased by only one basis point from Q1, but the company expects deposit betas to accelerate as rates continue to rise, and customers seek higher-yielding investments. Net interest income of $10.198B grew by 16% YoY, or $1.4B. Sequentially, NII grew by 11%, or $977MM due to higher rates, as NIM expanded to 2.39% from 2.03% a year ago. Management increased its NII growth estimates to a whopping 20% from 2021, which was up from a mid-teen’s projection as of Q1.
Noninterest income of $6.83B, had a much more challenging quarter being down 40% YoY, as higher rates crimped mortgage banking, and the market took a toll on investments. Home lending revenue declined by 53%YoY and 35% sequentially. Credit card revenue was up 7% and auto revenue was up 5%. Personal lending was up 7% from a year ago, largely due to higher loan balances. As discussed earlier, credit cards is a business where Wells Fargo has underperformed in years past, but management is adding rewards cards and is making an emphasis to increase its penetration. I’m very optimistic that it can be a powerful revenue growth engine for the company long-term. Debit card spending increased by 3% YoY, while credit card point-of-sale purchase volume was up 28% YoY, led by fuel, travel, and entertainment. Middle market banking revenue increased by 27% YoY, due to higher rates and loan balances. Asset-based lending and leasing revenue grew by 8%. In the Corporate and Investment Bank, revenue increased by 4%, helped by treasury management, while IB fees declined on less market activity. The company also took a $107MM write-down on unfunded leverage finance commitments, as spreads widened substantially. Market revenue grew by 11% YoY on higher FX and commodities trading.
Noninterest expense declined by 3% from a year ago, as divestitures came out of the run rate, and through expansive efficiency initiatives. Operating losses increased by $273MM YoY, driven by a litigation expense. Wells Fargo is still dealing with customer remediation matters stemming from many years ago, which can be hard to project the outcome of. Wells Fargo still expects full year 2022 expenses to be roughly $51.5B, as lower revenue-related expense offset higher operating losses. Normalized costs have been dropping substantially, which is impressive in this inflationary environment where mid-to-high single digit increases are common. Management indicated that it expects costs to drop again next year as well, which should continue to help the bottom line. When you consider that Wells Fargo will likely have a run rate of roughly $50B in annual net interest income coming out of this year, you can get a feeling for the underlying earnings power that of the company.
WFC ended Q2 with a CET1 ratio of 10.3%, down about 20 basis points from Q1 due to declines in the AOCI resulting from interest rates along with dividend payments, largely offset by earnings. The company did not buy back any stock in the 2nd quarter, which I find a bit disappointing given the selloff in shares and the strong capital position. Based on the recent federal stress test, WFC’s SCB is expected to be 3.2%, which would increase the regulatory minimum plus buffers by 10 basis points to 9.2%. The bank’s tangible book and book value per share ended the quarter at $34.66 and $41.72, respectively. Wells Fargo has reduced its diluted average common shares outstanding by 8% YoY to 3.819B. Wells Fargo has an allowance for credit losses for loans of $12.884B, which is 1.37% of total loans. The company has already been overweighting pessimistic economic scenarios in formulating its reserves, so it would take significant deterioration to see major increases in provisioning akin to 2020 for example. Non-performing assets decreased by 13% from Q1, so credit is not showing any signs of stress at this juncture, and Wells has fared well in both of the last two recessions due to conservative underwriting and its footprint.
At a recent price of $41.13 (after a 6% gain after earnings), Wells trades right around book value per share of $41.72, and at 1.19x tangible book value. The company expects to achieve a sustainable 10% ROTCE, and then ramp up to 15% over time. After a strong stress test, Wells Fargo is increasing its dividend to $.30 per quarter, which puts the current dividend yield at 2.9%. It appears that management is going to be conservative about stock buybacks in the near-term, but it does have capacity to do so opportunistically, which is nice given the volatility that we are seeing. I think Wells Fargo should trade around $50 per share given the quality of its earnings, and upside potential as Scharf’s transformation continues to make progress. I don’t see credit really being an issue, meanwhile the company is highly levered to benefit from these rate increases. It isn’t the cheapest bank relative to intrinsic value, but it is a good long-term buy and should be accumulated on dips.
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