Justin Sullivan
For now, the market is not pricing banks like the earnings growth leaders they will likely prove to be in 2023. Higher rates and operating leverage should drive bank earnings up strongly (high teens year-over-year growth on a per share basis) next year, but the large caps are still trading around 10x ’23 earnings, about 250bp below the typical forward multiple.
Wells Fargo (NYSE:WFC) is no exception, and I do believe the shares are priced for an attractive double-digit annualized return at today’s price. That said, investors shouldn’t be lulled into thinking this is a risk-free opportunity. While I do like Wells Fargo’s leverage to “Main Street banking” (and its lack of exposure to capital markets), whether the Fed can bring inflation to heel without pushing the economy into recession remains to be seen, and Wells Fargo is likely to see more pressure on its funding costs as the cycle goes on.
Loan Demand Is Healthy, And Banks Will Get Pickier
Loan demand was strong in the second quarter, with overall loans up about 10% year-over-year across the sector, and particularly strong demand for C&I loans. Broadly speaking, Wells Fargo kept pace, though individual rivals like PNC (PNC), U.S. Bancorp (USB), Regions (RF), and Truist (TFC) did outperform in the C&I lending space.
So far, as per Fed data, demand has remained strong through the third quarter, with loan growth trending up about 10% yoy and 2% qoq, with C&I lending once again at the forefront. Card lending also remains quite strong (up 15% yoy and 3% qoq), and this was an area where Wells Fargo did a bit better than average in the second quarter.
At the same time, credit quality has continued to improve. Wells Fargo saw better-than-average improvements in its criticized loans in the second quarter, with criticized C&I loans down 29% yoy (and 6% qoq) and criticized CRE loans down 32% and 10%, respectively. As a percentage of total loans, criticized C&I loans are now 2.8% of total C&I loans, bringing Wells Fargo back into parity with the peer median. Criticized CRE loans are still a bit high (7.9% of the total versus 7%), but here too Wells Fargo is coming back in line with its peer group.
Given increasing funding pressures (which I’ll discuss more in a moment), I believe strong loan demand and improving credit quality is going to lead banks like Wells Fargo toward being more selective in their lending behavior. With the capital markets in much weaker shape and more pressure on deposit-gathering, I expect to see more favorable lending terms for banks, and I expect more “picking and choosing” among prospective borrowers, with banks like Wells, PNC, et al likely to favor those clients willing to establish/continue long-standing relationships.
On the flip side, investors should watch for the banks who use this as an opportunity to gain share. While I think the credit risks associated with more aggressive C&I lending will be manageable, aggressive lending as deposit betas rise will squeeze net interest margins and the Street has been pretty harsh on banks that can’t generate attractive operating leverage.
The Cost Of Doing Business Is Going Up
One of my “watch items” from bank stock articles back in February was the likelihood that deposit betas would end up exceeding what I thought were too-low expectations on the part of Street analysts and bank CEOs. So far, that prediction seems to be coming true as deposit betas are rising more quickly than expected and funding costs are heading higher.
Wells Fargo saw its average deposit balances decline 1% qoq in the second quarter, while end-of-period balances declined closer to 4%, both worse than the average for peer-group banks. Wells Fargo also saw its loan/deposit ratio move to 66% versus a peer-group average closer to 69%. Deposit costs were better-controlled than average (smaller increases), but the bank is starting to see higher costs emerging.
This is also evident in the asset sensitivities coming out of the second quarter as per 10-Q reports. Asset sensitivities are always tricky to compare, because you’re always going to be using “apples to oranges” comparisons unless you build your own models (and then you have the “garbage in, garbage out” risk), as banks use different assumptions for key drivers like deposit beta.
Even so, a clear trend coming out of the quarter was lower sensitivities across the board. Average sensitivity to a 100bp move for Wells Fargo’s peer group fell from over 3% to just over 2% from the first quarter, with Wells Fargo slipping from close to 8% to 4.5%. Wells and Bank of America (BAC) are still among the most asset-sensitive banks I follow, but that sensitivity is noticeably lower now and the leverage to future rate increases is lower now, as the banks are going to start feeling a pinch from higher funding costs.
I’d also note that Wells Fargo seems more restricted on its ability to drive operating leverage through cost containment. As I said in a prior article, Wells seemed to have a little more flexibility going into this year than many of its peers, but with inflation increasing the overall cost of doing business, management’s commentary suggests less “wiggle room” to offset quarter-to-quarter changes in remediation costs than the bank has enjoyed up until now.
The Outlook
Factors like rising deposit/funding costs and higher operating costs do mean that the rate of improvement for banks should shrink pretty significantly from here. That said, the benefits of higher rates, past operating expense reductions, and lower credit costs have yet to be fully realized, and that is what I expect will propel strong pre-provision profit (and EPS) growth for Wells Fargo in the second half of 2022 and into 2024.
I believe adjusted profit growth could exceed 25% in FY’23 and approach 10% in FY’24 provided the economy doesn’t tip over into recession, and I continue to expect solid low-to-mid single-digit core operating earnings growth over the longer term. While Wells Fargo is likely to stay on the sidelines a bit longer with respect to major capital returns, I do believe this pace of earnings growth can continue to fund significant returns of capital in the coming years.
A key debate/unknown with Wells Fargo is whether the bank can generate a sustained return on tangible equity of 15% or higher. Doing so would certainly support a more significant re-rating, but it’s not my base-case assumption today – I believe the bank will get comfortably into the 14%’s, but 15% seems a bit of a reach for now.
The Bottom Line
Between discounted core earnings and ROTE-driven P/TBV, I believe Wells Fargo remains undervalued today with a near-term fair value in the mid-to-high $50’s and a potential double-digit long-term total annualized return. I like Wells Fargo’s leverage to wider interest spreads, its huge operating footprint, and its leverage to healthy “Main Street banking”. With bank stock valuations at below-average levels despite above-average earnings growth potential in 2023, I think this is a stock worth considering.
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