Although Wells Fargo & Co (NYSE:WFC)’s outlook remains constructive, particularly expense leverage tied to the company’s efficiency initiative and legacy servicing/mortgage-related costs, earnings growth is clearly moderating into ’14. The slowing momentum is only exacerbated by the stubbornly low rate environment and normalizing mortgage banking revenues. With the shares trading at 10.2x ’14 EPS meaningful multiple expansion from current levels is unlikely says a new report from Todd L. Hagerman of Sterne Agee. Full details below.
- We are downgrading the shares of Wells Fargo & Co (NYSE:WFC) to Neutral from Buy on valuation given expectations for more modest earnings growth. Our price target of $42 remains unchanged and implies 10.5x our 2014E of $4.00 and 1.5x our 2014E TBV. We are fine-tuning our 2Q13 estimate to account for slightly lower loan loss provision, although our ’13 and ’14 estimates remain unchanged at $3.65 and $4.00, respectively.
- High performance company deserving of a premium multiple, but limited upside given expectations for more modest earnings growth into ’14. With Wells Fargo & Co (NYSE:WFC) shares trading at 10.2x forward EPS and 1.8x TBV, we see limited upside from current levels, even with a modestly higher earnings multiple or earnings growth. To be sure, the company’s top-tier profitability metrics (an estimated +16% ROTCE and 1.34% ROAA in 2013E), balanced revenue stream, and relatively benign risk profile are deserving of a premium valuation. However, accounting for modest EPS upside relative to current expectations and additional multiple expansion only yields a low/mid $40 intrinsic value in our view. While we consider Wells Fargo a high-quality, core holding for investors (company continues to redeploy 50-60% of earnings via dividends and share repurchases), meaningful outperformance of Wells Fargo shares at this juncture seems unlikely.
- Outlook broadly better than peers, but we see the shares now as largely fairly valued. Our $4.00 2014E EPS implies roughly +5% earning asset growth, which ranks at the top of our large-cap bank coverage. With ongoing momentum in the wholesale bank (select portfolio acquisitions, organic loan growth, and increasing market share), the spread income outlook remains steady, despite expectations for further margin compression. And we continue to forecast modest top-line growth and efficiency gains (55% in ’14, or the low end of Wells Fargo & Co (NYSE:WFC)’s 55-59% target) despite normalizing mortgage revenue. To rationalize material upside to the current price target, we would need to muster earnings in excess of $4.75/share (see Figure 7), which would again place Wells Fargo at the very top of its 1.3%-1.6% ROAA guidance, which we envision the company achieving by 2015 at the earliest.
Wells Fargo: Key Investment Points
Although Wells Fargo & Co (NYSE:WFC)’s outlook remains constructive, particularly ongoing credit leverage as well as expense levers tied to the company’s efficiency initiative and legacy servicing/mortgage related costs, earnings growth is clearly slowing into ’14. The slowing momentum is only exacerbated by the stubbornly low rate environment and normalizing mortgage banking revenues. To be sure, we expect to see ongoing momentum in the wholesale bank (select portfolio acquisitions, organic loan growth, and increasing market share) and identified expense leverage through Wells Fargo’s efficiency initiative (Project Compass) and lower accruals attached to legacy servicing/mortgage related matters.
However, our optimistic earnings sensitivity analysis surrounding our existing conservative pre-provision profit forecast for ’14 (refer to Figure 7), notably better-than-expected mortgage revenues, lower provisions, accelerated decline of legacy mortgage-related costs and lower variable expenses tied to production volumes suggest potential EPS leverage of about 25-30% in 2014. However, this scenario would again place Wells Fargo & Co (NYSE:WFC) at the very top of its 1.3%-1.6% ROAA guidance and well below its targeted efficiency range of 55-59%, which we envision Wells Fargo achieving by 2015 at the earliest.
Wells Fargo spread income growth and further margin compression remain risks. Adjusted for the shortened day count in 1Q13, spread income was flat ($10.7B) as average earning assets increased 2% sequentially. While absolute net interest income was adversely impacted by two fewer days in the quarter, the net interest margin fell 8bps to 3.48%, marking an aggregate decline of about 43bps from the year-ago period. The decline in margin was attributable to about 2bps of asset yield pressure (balance sheet re-pricing), 3bps to strong deposit inflows resulting in higher liquidity balances, and 2bps of lower variable income (lower PCI accretable yield).
Wells Fargo PCI accretable yield benefited interest income by $447mm or modestly lower than 4Q12 results ($513mm). While the margin is expected to remain under pressure in the near/medium term, management expects absolute net interest income will increase in 2013. However, we expect flat spread income due to a modestly larger balance sheet, including some commercial loan growth. We look for a margin of about 3.35%-3.40% for the full-year 2013 (versus 3.48% in 1Q13), or down about 35-40 bps year over year.
Similarly, we look for additional compression of about 5bps in 2014, which should result in positive spread growth of 2-3%. Currently, we would expect pre-provision profits to fall about 2-3% in 2013 as mortgage banking continues to normalize, in conjunction with relatively flat net interest income, although we remain relatively conservative on the expense side for now (down ~2-3% in 2013).
Mortgage banking expected to normalize over the course of the year. Core fee revenues fell 6% sequentially in 1Q13 and were relatively flat from the year-ago period due primarily to a decline in market-sensitive revenues, including mortgage banking. We would note that mortgage banking was trending at unsustainably high levels in 2H12, and the quarterly decrease was effectively within expectations, down roughly 9% to $2.8B. While still respectable, origination activity (10% tied to HARP) and flow sale gains associated with origination/sales were down in the quarter, which registered $2.5B vs. $2.8B in 4Q12.
Origination activity tailed off somewhat, as total originations of $109B were down from 4Q12 ($125B) and the mortgage pipeline of $74B declined from $81B in the prior quarter. Despite the modest slowdown in the quarter, origination volumes are expected to remain relatively healthy, given improving housing values, seasonal benefits (spring buying season) and ongoing refinance opportunities. However, because so much of the current volume is driven by refinance activity, revenues will likely further slow in the coming quarters as purchase volumes likely struggle to offset the expected volume decline in refinance activity.
Gain on sale margins will likely compress throughout 2013. On an annual basis over the past four years, GOS margins have edged as high as 2.3% and as low as 1.6%, which is the outlook for 2Q13—in other words, unpredictable. In 1Q13, gain on sale margins were surprisingly flat at 2.56%. The outsized range for 2Q13 is essentially tied to the company’s ultimate decision to retain conforming fixed-rate mortgage production on its balance sheet ($3.4B in 1Q13 vs. $9.7B in 4Q12). However, the company has suggested that it would likely not retain additional mortgage production going forward. Net hedge results were also down in 1Q13 to $129mm vs. $220mm in 4Q12.
Additionally, Wells Fargo mortgage revenues were also negatively impacted by $250mm for additions to the mortgage repurchase reserve as well as by $58mm for certain servicing and foreclosure costs. Total mortgage repurchase reserve additions were $309mm or an 18% decrease from 4Q12 ($379mm). However, the quarterly provision again represented a net reserve build, as total repurchase reserves climbed to $2.3B (from $2.2B). The number of total third-party loan claims (mostly GSE related to 2006-2008 vintages) did fall slightly in the quarter to $1.8B (vs. $4.3B at 2Q10 peak). Requests on the private side remain negligible and declined as well with over 50% of exposure void of traditional repurchase risk (largely held on Wells Fargo’s balance sheet).
During May, primary secondary spreads or the spread between mortgage rates and various cost of funds indices are little changed, although we note some tightening thus far in June. In addition, it is important to look at what is going on in the current, this week/daily market. On Thursday (06/13/13) Wells Fargo & Co (NYSE:WFC) was quoting a 4.125% rate on a 30-year fixed -rate conventional mortgage and Quicken a 3.99% rate. These are ~22 and 9bps, respectively, above the FMAC survey rate from 06/6/13 and suggest a likely reversion to spreads consistent with (or only modestly lower than) what we saw in 1Q13. Conversely, JP Morgan Chase (JPM, $54.17, Buy) was quoting a 3.875% rate, or 2bps below the survey rate.
In Figure 2, we analyze HARP gain on sale for the industry from three perspectives: 1) no change in origination rate, 2) a 50 bps increase in mortgage origination rate, and 3) a higher mortgage rate, but a loss of all pay-up premium. Our sense is with the combination of higher rates on new mortgages and relatively flat premiums on HARP pools, compression tied to gain on sale will likely be modest relative to the last few quarters.
Lower legacy mortgage-related costs and efficiency initiatives for Wells Fargo will continue to at least partially offset sluggish top-line growth. In 1Q13, operating expenses slipped 3% from the year-ago period, but increased a modest 1% sequentially, adjusted for the 4Q12 IFR settlement. Operating expenses are expected to decline in 2Q13, largely reflecting lower employee benefit expense and further declines in environmental-related costs. However, the pace of decline in these costs has lagged somewhat that of its peers. These costs aggregated $3.9B in 2012, and in 1Q13 these costs declined approximately $230mm sequentially to roughly $550mm. On average, these costs have trended more toward $600-$700mm/quarter, ex. litigation-related accruals. Legal-related expenses aggregated $2B in 2012 and the quarterly accrual tied to professional services declined $209mm from the previous quarter.
Going forward, these costs for Wells Fargo should continue to trend lower considering a large part of the outstanding litigation tied to the GSEs/AGs has been settled and ongoing improvements in housing should further reduce the aforementioned costs. Over time, Wells Fargo & Co (NYSE:WFC)’s goal is to further improve the operating efficiency of the company (target range of 55-59%), which compares to our estimate of roughly 55% in 2014, which might prove a bit aggressive, particularly given the residual litigation risk.
Credit quality improvement will likely continue to outpace expectations following the severity of the financial downturn, suggesting that the magnitude and duration of credit leverage in the industry are likely far greater than current expectations. Total NPAs of $22.8B represented a 7% sequential quarter decrease in 1Q13, representing 2.85% (adj.) of total loans/OREO vs. 3.05% in 4Q12. The decline in problem assets was fairly broad based in both commercial and consumer, including HELOC credit which declined 7% to $2.7B.
Additionally, early stage consumer delinquencies improved to 1.53% from 1.79% in 4Q12. Net charge-offs of $1.4B declined from $2.0B in 4Q12, and provisions of $1.2B were $200mm lower than net charge-offs (compared to a $250mm reserve release in 4Q12) with reserve coverage trending lower to 2.16% from 2.19%. However, expectations are that reserve release will remain steady in the coming quarters as credit quality continues to improve and loan growth remains slow. Nonetheless, reserve release has only represented about ~5% of earnings; thus the potential leverage is not significant at this stage of the cycle for Wells Fargo & Co (NYSE:WFC).
Capital levels provide ongoing flexibility. The company’s tangible common equity ratio increased to 8.20% from 8.04% in 1Q13, while the Tier 1 Common ratio improved 26bps to 10.38% on a sequential quarter basis. The estimated pro-forma impact of Basel III implies roughly a 199bp impact to the Tier 1 Common ratio to about 8.39% in 1Q13. The company continues to indicate comfort with evolving required capital levels and the continued share repurchase underscores the company’s strong capital position. The company purchased 16.6mm shares in 1Q13 and is authorized to increase its repurchase activity through 1Q14 vs. its 2Q12-1Q13 buyback of 128mm shares (pursuant to its 2013 Capital Plan).
Additionally, the company raised its quarterly dividend to $0.30/share (a 20% increase from the current
$0.25/share). Our current estimates currently imply roughly 80-85mm shares repurchased through the remainder of 2013, which represents a combined 40-45% capital payout ratio.