Wells Fargo investors need Buffett-like patience
The nation's top mortgage lender reported record quarterly profits, but interest margins remain under pressure.
Wells Fargo's (WFC) largest shareholder -- Warren Buffett -- has seen his investment in the bank recover to pre-crisis levels on steady gains posted by the nation's top mortgage lender.
Investors should take note of that fact in the wake of the bank's record fourth-quarter profit, which raised some near-term earnings questions.
Generally, the earnings show why Wells Fargo remains a best-in-class bank that has earned Buffett's long-term investing imprimatur.
All three of Wells Fargo's businesses, community banking, wholesale banking and wealth management grew profits from quarter-ago and year-ago levels.
Those looking for a short-term trade, however, might have been disappointed. Expect Wells Fargo's fundamental growth to be at the head of the banking sector in 2013, even if near-term headwinds prove a concern to some.
Wells Fargo reported better-than-expected revenue of $21.9 billion and profitability of $5.1 billion, signaling that the bank's steady share performance remains on track heading into 2013.
Meanwhile, the bank's 20% 2012 earnings per share growth reflected impressive momentum and a strengthening position in the recovering U.S. housing market. Wells Fargo is also increasingly returning capital to investors, boosting buybacks by a total of 48 million shares. An increase of Tier 1 capital to 10.12% of risk assets augurs well for Wells Fargo, as it prepares for Federal Reserve mandated stress tests.
Still, worse-than-expected interest-based earnings margins and the prospect a refinancing boom wears off cloud Wells Fargo's short-term share performance in the New Year.
Wells Fargo reported its net interest margin -- the difference between what it earns on loans and what it pays to fund them -- fell a greater than expected 10 basis points. The bank's mortgage pipeline, meanwhile, fell 16% to $81 billion in the quarter, while home loan origination and applications fell from quarter-ago levels, signaling some slowing in the housing market.
On the positive side, core loans grew $47.7 billion and the bank's improving loan quality drove a $250 million reserve release.
Jefferies analyst Ken Usdin wrote in a note to clients that the mortgage banking declines came in less than forecast, while steady loan and deposit growth were strong points to earnings.
Marty Mosby, a large-cap banking analyst with Guggenheim Partners, said in an interview prior to earnings that any reported net interest margin decline of less than 5 basis points and loan growth sequentially from the third quarter would be taken positively by investors.
Wells Fargo impressed on one of those fronts, while a greater than expected NIM decline meant overall interest-earnings for the bank fell $249 million to $10.6 billion.
The earnings provide investors crucial insight into trends driving Wells Fargo's profitability and growth given the bank's top footing in the housing market, healthy balance sheet and industry leading dividend payout.
Investors and banking sector analysts are watching interest margins and loan growth as a key proxy for the impact of a third round of Federal Reserve easing announced in September and insight into the strength of the housing market.
A stabilization of Wells Fargo's interest margins after a 25 basis point drop in the third quarter would have removed the bank's biggest near term earnings risk freeing investors to focus on positive longer-term trends, according to Mosby.
"The market right now is discounting Wells Fargo's earnings power because they think it is going to be lost because of significant compression of net interest margin," said Mosby.
Investors may need to wait another quarter for interest margins to bottom, and for Wells Fargo's strong fundamental qualities to overshadow short-term headwinds.
Mosby argues that if uncertainties such as interest-earnings and the sustainability of loan demand dissipate, Wells Fargo could outperform the banking sector in 2013, as it has in years past. The analyst notes that while Wells Fargo has doubled earnings since the financial crisis, investors have given it little credit.
Wells Fargo shares currently stand roughly in-line with pre-crisis levels seen in 2007.
"[This] could be the year where they get a revaluation," said Mosby, who calculates the bank might be able to boost its dividend to the 3% range, far ahead of large cap banking peers like JPMorgan Chase (JPM), Bank of America (BAC) and Citigroup (C).
Bill Smead, the chief investment officer of Smead Capital Management, expects Wells Fargo's exposure to a long-term housing pickup to more than offset Fed interest rate policies. "We happen to think a company like Wells Fargo might make more money in the rebound on the value in foreclosed homes than what they will lose on a decline in their interest rate spreads," said Smead, in an interview prior to earnings.
Smead's analysis was borne out in record quarterly earnings.
A $1.6 billion increase in non-interest income, driven by the write up of legacy assets, and modest increase in net interest income on better than expected loan and deposit growth drove overall earnings, even if margins suffered slightly.
"That will wash out in the long run, which is why you want to increase market share," said Smead of Wells Fargo's increasing presence in the mortgage market and community banking.
Wells Fargo's deposits grew to $928 billion in the fourth quarter, a 7% increase from year-ago levels. Those deposits, however, cut at Wells Fargo's net interest margin by 5 basis points, according to the bank. In a rising rate environment, Smead said he expected the margin pressure to reverse.
Smead, who also owns JPMorgan and Bank of America shares, said Wells Fargo's risk reward relationship compares favorably to large cap banking peers in a normal economy.
In addition to a careful eye on interest margins and loan growth, Stifel Nicolaus analyst Christopher Mutascio said the bank's efficiency ratio and reserve releases are an important investor issue. Recently, Wells Fargo abandoned an expense target of $11.25 billion for a ratio of between 55% to 59% of overall revenue as a result of surging housing market and refinancing activity.
Mutascio expected that after reserve releases fell through 2012, the quarterly releases could stabilize at between $150 million and $200 million through 2013 and 2014.
Releases of $250 million beat estimates, while Wells Fargo's efficiency ratio, excluding one-time items, fell sharply to 54%. "We put the core operating efficiency ratio at 54%... This is a positive," wrote Mutascio, in a note assessing earnings.
Given Wells Fargo's above industry average stock and earnings performance in recent years, some Wall Street analysts recently saw reason to downgrade their outlook for the bank, citing value at competitors Bank of America and Citigroup.
Betsy Graseck, a banking analyst with Morgan Stanley downgraded Wells Fargo from 'Outperform' in late December, citing "less ability to improve [its] best-in-class expense ratio and already high loan growth."
Such near-term earnings and valuation concerns relative to lenders like Bank of America and Citigroup, who remain far below pre-crisis levels, aren't likely to phase Wells Fargo's largest investor Warren Buffett.
"Nine years from now I would think that Bank of America as well as Wells Fargo (WFC) and probably the other major banks will be worth considerably more money than they are now," said Buffett in a Thursday interview on Bloomberg TV.
That perspective might serve Wells Fargo and banking sector investors, in the wake of Friday's earnings.
In the fourth quarter, Wells Fargo recorded took a $644 million charge for a Monday foreclosure settlement agreed with the Federal Reserve and Office of Comptroller of Currency (OCC), which has the bank committing a total cash payment of $766 million and a further $1.2 billion for already provisioned for foreclosure prevention.
Here's a look from TheStreet at why Wells Fargo's earnings troubles were hidden in plain sight ahead of the Friday report.
More from TheStreet.com
Remember those two Buzzards sitting on a tree limb...Discussing "Patience my Azz." ??
And today WFC is downgraded ??
Go for it Warren....You will make out anyway or someway ?
I know I should maybe have some in Banks.?..But for the time being, I'll settle for REITS.
The last time into banks...We didn't get hurt, but weren't in during the fall to grace....Lucky.
Well,maybe we broke even on PNC ?? But, the others were okay and made us a return.
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