Wells Fargo: Asset Sensitivity, Loan Growth, Operating Leverage Flow Improving Sentiment

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I was optimistic about Wells Fargo (NYSE: WFC) for a while, primarily based on the significant operating leverage within the business once rates and loan growth increase significantly. Moreover, while the well-known regulatory problems persist to linger (including the asset cap limiting growth) the company is making progress in addressing these issues and should be able to generate mid-teen ROTCE a bit further down the line, without talk about significant short-term capital returns.

These stocks are up about 17% since my last update, outperforming a peer group of healthy big banks. I currently see more benefits in JP Morgan (JPM) given the post-guidance decline due to concerns over rising spending and ongoing restructuring at Citigroup (C), but I don’t think the high single-digit annualized returns I expect from Wells Fargo are bad, and I see room for beat-and-bump quarters over the next two years that could lead to more upside.

Emerging momentum, but Q4 wasn’t as strong as it looks

There were certainly some significant positives in Wells Fargo’s fourth quarter, including sequential net interest income growth of 4% and both net interest margin improvement and asset growth, but I would say the results weren’t as good as they first appeared.

The 4% quarter-on-quarter growth in net interest income was a strong success, contributing about $0.05/share to Street’s expectations. Fee-based income is more complicated, as gains on the sale of debt and equity investments have inflated the numbers. It’s common to adjust them, but for some reason most sell-side analysts didn’t this time around. Base fee-based revenue, excluding these gains, contracted 5% quarter-on-quarter, missing slightly and causing base revenue to contract 2% from the third quarter.

Expenses decreased slightly (-1% q/q) and were slightly higher than expected. Pre-provision earnings jumped 26% quarter-on-quarter if you include those sales gains, but on an adjusted basis, pre-provision earnings were down 6% and barely beat expectations.

Tangible book value per share increased more than 2% year-over-year and the company ended with a CET 1 ratio of 11.4%, so capital is not an issue.

Revenue growth is coming…and apparently so is operating leverage

As the economy transitions into a tightening cycle, Wells Fargo is well positioned to generate revenue growth in the years ahead.

Firstly, loan growth is already starting to pick up, with end-of-period loans up 4% QoQ on an adjusted basis (excluding PPP), with over 8% growth in C&I loans. Growth in CRE loans was also above average, and consumer loans saw good growth in automobiles (+5% q/q) and cards (+7% q/q), offset by slight weakness in residential mortgages.

Management’s forecast for low to mid single digit loan growth in 2022 was definitely not in the high end of what other banks have been guiding, but adjusted growth should be better and I see room for improvement here given Wells Fargo’s large footprint and strong presence in areas such as asset-backed lending and CRE (an area where other banks have fallen back). Middle market lending will be an area to watch, especially with so many banks (including peers like Bank of America (BAC), JPMorgan and ANC (PNC)) investing for growth in this space.

Wells Fargo’s above-average asset sensitivity (meaning Wells Fargo’s net interest income increases more for a given rate increase) increases loan growth. On a reported basis, Wells Fargo tops the list for asset sensitivity among major banks. While I believe the actual sensitivity will end up being lower, Wells Fargo is still on the “more sensitive” side of the curve, giving the company good leverage for higher rates.

And speaking of leverage, operating leverage is another key contributor to above-average growth potential in the coming years. Management pointed to lower year-over-year expenses for FY22 and indicated that FY23 expenses are also expected to decline. This is in stark contrast to JPMorgan’s significantly higher expense growth forecasts, as well as other banks’ higher guidance on rising costs/wage inflation.

I think there are a few factors working for Wells Fargo here. First, as management has pointed out in previous communications with investors (sell-side meetings, etc.), Wells Fargo did not have the same existential worries coming out of the last crisis and never experienced the same degree of cost reduction, leaving more for management to cut now. Second, expenses related to compliance issues should begin to decline, giving the company the opportunity to reinvest in areas such as IT while reducing overall expenses.

That said, I’m very curious to see how spending/investment decisions play out across the space over the next five years and beyond. JPMorgan argues that they are “investing” in future growth, so I’ll be curious to see if banks like Wells Fargo ultimately feel like they need to catch up to maintain/regain their share (assuming the JPMorgan’s decisions actually lead to earnings sharing).

Perspectives

There is still no clarity on removing the asset cap and addressing ongoing regulatory issues at Wells Fargo, but the street seems to have moved to a view where management has these issues in hand, progress are done and the bank “will get there when they get there”. I could see some sentiment risk here if there were any regulatory disclosures/warnings suggesting delays or dissatisfaction on the part of regulators with the remedies from Wells Fargo, but it doesn’t seem like the street is too concerned about the timing of that anymore.

Looking at how Wells Fargo emerged from the recession and how it is positioned for the next cycle, I am more optimistic about the bank’s upside potential during this tightening cycle. It is a rate-sensitive lender with a large deposit share and large loan share across a wide range of loan categories, giving it good exposure to loan demand growth and potential better-than-expected operating leverage over the next few years. With that, my long-term core earnings growth rate goes from the mid-2% to the mid-3%+, on par with the other big banks.

The essential

I could argue for fair value in the low $60s on a 12x-12.5x ’23 P/E, and discounted basis earnings support a long-term annualized total return in the high numbers. With stocks having outperformed, the forward return potential still looks more on par with its larger, high-quality peers rather than above, but I see better beat and rally potential here over the next couple of years, and that’s still a bank worth owning at this point in the cycle.