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Morningstar | Expenses To Remain Elevated for Wells Over the Medium Term, Rate Pressures Also in Focus

Wide-moat Wells Fargo reported OK second-quarter results, and there were a mix of positives and negatives. The bank guided toward the lower end of its previous net interest income range of negative 2% to negative 5% growth given the worsening interest rate environment. Fortunately, this includes the possibility of one to two rate cuts, depending on timing, therefore we don’t think it will get much worse for 2019. The bank also highlighted that it expects to come in at the higher end of their expense guidance for 2019 given the challenges around the increased need to continually invest in risk- and compliance-related items. Management also admitted that, while they aren’t providing 2020 guidance just yet, 2020 expenses could come in even with 2019, which is a bit worse than the original guidance from investor day. Our biggest take away from all of this is that the bank is still very much in the middle of its restructuring and with its efforts with regulators, and it does not appear to us that the bank is in the final innings here just yet. After making several adjustments to our projections, including accounting for three rate cuts through 2020, we are lowering our fair value estimate to $59 per share from $60.

We’ll remind investors, Wells is still in the process of finding its next CEO, the asset cap will be staying on until 2020 at a minimum, and the bank is having to spend more and more on regulatory and compliance spending. This contributes to our conviction that the bank still has a lot of work to do, with potentially years of additional work still outstanding. Meanwhile, the bank’s main competitors are reaching newfound levels of operational strength and profitability, putting them decidedly on offense while Wells remains on defense. In the meantime, Wells should have enough fire power to repurchase roughly 10%-11% of share outstanding, depending on share price movements over the next 12 months.

On the positive side, operating losses were only $247 million, essentially even with results from the first quarter. The bank’s return on tangible equity was 15.8%, the best result since before the sales issue surfaced. This was largely helped by the one-time gain of $721 million on the sale of $1.9 billion in Pick-a-Pay loans. Normalizing for this, the return on tangible equity was closer to 14.1%, which is still not a bad result, especially considering that Wells likely has an elevated expense base given its current situation and will eventually be able to roll off some of the initial expenses involved with all of the internal build ups the bank is completing. A 14% return on tangible is still better than full year results for the past three years. Regardless, there are only $1.1B in PCI Pick-a-Pay loans remaining, so this lever is running out.

Deposit balances were up slightly for Wells compared with first quarter of 2019, up 0.5%, with a small amount of growth within community banking. Average loans were essentially flat year over year, although there are many moving parts behind this. Average commercial and industrial loans were up a decent 3.6% year over year, while the bank continues to stay cautious within CRE. Mortgage originations picked up, up 6% year over year, credit card balances were up 6%, and auto loans, after a period of runoff, are beginning to grow again. Credit costs remained fairly steady, with the net charge-off rate coming in at 0.28%, and provisioning coming in at $503 million.