Wells Fargo May Prove Warren Buffett Right Again

TheStreet.com

Updated to reflect additional analyst comments and updated share prices

NEW YORK (TheStreet) -- When Wells Fargo WFC reports first-quarter earnings later in April it may resolve a lingering question about Warren Buffett's bank investing strategy: Has the "Oracle of Omaha" put his money behind America's most profitable bank?

Expectations are for Wells Fargo to possibly unseat JPMorgan Chase JPM as the most profitable U.S. bank by year end and solidify Buffett's next bank investing coup .

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Going into first quarter earnings, investors are expecting big results out of Wells Fargo, after its record fourth quarter earnings outperformed rivals. The San Francisco-based bank saw its earnings grow nearly 30% in 2011, significantly beating the sub-10% earnings growth of competitors like JPMorgan and Citigroup C , while Bank of America BAC swung from a 2010 loss to a moderate profit.

Wells Fargo is expected to earn $3.9 billion in first quarter profit on $20.3 billion in revenue, according to consensus estimates compiled by Bloomberg. For 2012, the nation's fourth largest bank by assets is expected to post a record $17.5 billion profit on $81.3 billion in revenue, which would put it in contest with the $18.5 billion in profit that JPMorgan is expected to earn.

While the profit gap with JPMorgan is expected to narrow next year, don't count Wells Fargo out in 2012. Momentum is on its side.

Wells Fargo shareholders, led by Buffett and his 7.28% share stake, have benefitted from the bank's faster growth expectations. In the past 12 months, Wells Fargo is the only "big four" bank to post share price gains, even after a 2012 financial sector share rally that's added over 20% to the KBW Bank Index KBE . Since this time last year, Wells Fargo shares are up over 7%, while JPMorgan is just in the red and Citigroup and Bank of America continue to show deep losses from a 40%-plus 2011 share crash.

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After stress tests results were reported by the Federal Reserve earlier in March, Wells Fargo led one of the most ambitious capital return and buyback programs, boosting its dividend by 83% and adding billions in share buybacks.

Starting in 2012, Buffett and other Wells Fargo investors could see a an annual rate of return near 18% driven by the company's improving profitability, according to Marty Mosby of Guggenheim Partners

While Wells Fargo shares trade at $34 -- below 2007 highs -- the company's earnings per share of $2.82 in 2011 eclipsed a previous pre-crisis high of $2.38. After a 2008 acquisition of Wachovia doubled the bank's revenue and earnings, Wells Fargo is expected to see continued growth. "Earnings levers could add almost $3 in earnings power to 2007 earnings per share of $2.38, more than double the level of earnings when the stock price peaked at around $37," notes Mosby in a Friday report. He rates shares a "buy," with a price target of $43.

In first quarter earnings, Wells Fargo is expected to show a strong combination of revenue growth and cost reductions, which could keep quarterly profits near record levels. Of the largest U.S. lenders, Wells Fargo also has the largest portion of its revenue tilted to the U.S. housing and mortgage market, which could recover with the broader economy in 2012.

"We see the bank benefiting from a recovery in the US economy and housing market," writes Richard Staite of Atlantic Equities in a March 23 note raising his price target on shares to $40 from $38, while maintaining an "outperform" rating.

As home inventories fall, signaling an increasing demand for sales that could lift prices and overall activity in housing-related businesses like mortgage lending and origination, Wells Fargo may also benefit from government programs like the Home Affordable Refinance Program- dubbed HARP 2.0.

The program could add a revenue tailwind for banks levered to mortgage origination. On Thursday, Jefferies analyst Brian Foran upgraded Wells Fargo to "buy," while downgrading US Bancorp USB and PNC Financial PNC to "neutral" on the expected impact of the program.

For Wells Fargo, the government fostered refinancing program could drive up to 10% earnings per share upside in 2012, as it continues to manage expenses, according to Foran. "The key downfall to bank cost cutting historically is revenues start falling six to nine months into the program. Given the HARP tailwind, these banks will have much more flexibility to execute on efficiencies without making revenue harming decisions," writes Foran.

Costs could also be a tailwind for Wells Fargo. First quarter earnings will be the first since Wells Fargo's acquisition of Wachovia that won't include merger integration costs. Now the bank is set to see the full benefit of the crisis-time deal. "Following the Wachovia merger its scale and coast to coast distribution network give it increased competitive advantages over smaller banks that will find it hard to compete," notes Staite of Atlantic Equities.

Meanwhile, an improving economy and housing market could lead to a continued drop in the banks' credit losses and non-performing assets, which could benefit profitability and capital returns. "We see Wells Fargo expanding market share, cutting costs and benefiting from a further decline in credit costs driving return on tangible equity to over 18%," adds Staite.

After the first quarter, Wells Fargo may also see an increase in its net interest margin on a boost in loans, a reduction in trust preferred securities and higher long term interest rates, according to Deutsche Bank analyst Matt O'Connor, who expects second quarter expenses to "come down a lot."

To be seen is whether Wells Fargo's lending businesses will outperform peers who also have investment banking operations. On one hand, Wells Fargo is also less exposed to volatile investment banking fee revenue, which is expected to continue to fall throughout the sector in the first quarter and in 2012, according to a March note by Morgan Stanley analyst Betsy Graseck. As a result, the bank isn't facing one of the lingering risks for banks -- a potential ratings downgrade by Moody's -- as it reassess the risk of capital markets oriented businesses.

Still, a strong debt trading environment augurs well for JPMorgan's first quarter earnings as it rules over Wall Street, signaling that Wells Fargo will face stiff competition in 2012. Citigroup analyst Keith Horowitz highlighted JPMorgan and Goldman Sachs GS as top picks headed into quarterly earnings because of their trading orient in a Thursday note. "Overall the tale of the 1Q appears to have been a "risk-on" rally across markets from equities to credit to mortgages," notes Horowitz.

Even though Wells Fargo commands a significant premium its competitors, the company's shares are expected to continue to rise, as some analysts cut their outlooks on competitors like Bank of America.

Evercore Partners analyst Andrew Marquardt cut his rating on Bank of America shares earlier in March, matching other analyst moves. Still Marquardt kept his "overweight" rating on Wells Fargo shares and price target of $39 a share, though it is the only bank of the "big four" with a price-to-earnings ratio above 10. Overall, analysts polled by Bloomberg give Wells Fargo a price target o $35.81, on 27 "buy" recommendations to go with 10 "holds" and a sell.

Going into first quarter earnings, Wells Fargo's continued outperformance and faster than industry-average growth may help Warren Buffett to a new a new bank-investing feat, as Berkshire Hathaway's portfolio continues to be repositioned for an economic recovery.

For more on bank earnings, see why earnings failure is not an option for Citigroup. See why Warren Buffet can rest as John Paulson digs in for more on competing bank investing strategies.

-- Written by Antoine Gara in New York

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