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Wells Fargo: Navigating a Difficult Rate Environment

On Tuesday, Wells Fargo (NYSE:WFC) reported results for the third quarter of fiscal 2019.

For the quarter, revenues were flat at $22 billion. This reflects an increase in noninterest income to $10.4 billion, offset by an 8% decline in net interest income to $11.6 billion. Let's look at each of those buckets in closer detail.

On noninterest income, the year-over-year increase largely reflects the impact of "other" income (gain on the sale of the Institutional Retirement and Trust business) and net gains from the sale of equity securities. If we back those out (which seems appropriate given they are not core business results), noninterest income has declined low-single digits year-to-date, with the reduction primarily attributable to a double digit decline in mortgage banking.


The decline in net interest income reflects a sizable decline in the company's net interest margin (NIM) to 2.66%. As a reminder, the net interest margin measures what Wells Fargo earns on assets like loans and investment securities less the cost associated with deposits and other funding sources. Currently, Wells is feeling pressure on both fronts. On the asset side, the lower interest rate environment and the significant flattening of the yield curve over the past year is impacting asset yields (balance sheet repricing). As it relates to funding, Wells is facing pressure from a "retail banking deposit campaign pricing for new deposits" (promotional rates and offers in an attempt to win business). As noted on the call, we should see some relief on deposit costs in coming quarters.

Looking at the year to date results, interest income has increased 6% to $50.5 billion. At the same time, interest expense has increased 39% to $14.5 billion. The net result has been a 4% decline in net interest income to $36.0 billion (and -8% in the third quarter).

As noted on the conference call, this is not expected to improve in the near term: management now expects net interest income to decline by roughly 6% for the year. Off the 2018 result ($50.6 billion), that implies a reduction in 2019 of more than $3 billion. Assuming that all flows through the income statement, that's a roughly $0.70 hit to pre-tax earnings per share (EPS) - a material drawdown relative to current earnings of roughly $5 per share. Finally, based on the current forward curve, management thinks net interest income could decline again in 2020 (by low-to-mid single digits). This has been - and likely will be - a continued headwind for Wells Fargo.

While this is clearly having an impact on profitability, there's reason to believe it's having a positive impact on the customer experience: checking accounts and retail deposits are both growing (despite a roughly 5% year-over-year decline in the branch network), with customer loyalty and overall satisfaction reaching a three-year high in the quarter. As shown below, Wells Fargo's growth has trailed J.P. Morgan's (JPM) by a wide margin over the past three years. In the last six months, that gap has largely disappeared - with Wells actually growing faster than J.P. Morgan in the quarter.

The pressure on net interest income is being offset (on a per share basis) by outsized capital returns. In the third quarter, Wells Fargo repurchased $7.5 billion of stock, with the diluted share count falling 9% year-over-year. As noted on the call, that level of spending is expected to be roughly matched in the fourth quarter (65% of the gross repurchase spending authorized by the Federal Reserve will be utilized the back half of 2019). This is why long-term investors should cheer when the stock falls out of favor with Mr. Market. As shown below, the share count has started to fall quite precipitously.

Conclusion

With the stock at roughly 10x earnings and a dividend yield of 4%, I think the risk/reward looks attractive. In the long run, I believe there is upside optionality from a leaner cost structure (they lag peers by a wide margin, which gives them an "extraordinary efficiency opportunity"), a material benefit to net interest income if we ever return to a "normal" interest rate environment and outsized capital returns to shareholders (at a 10.5% CET1 ratio, there's still $14 billion in excess capital on the books). Personally, when I think about the headwinds the company is facing, I think most of them are levers that could potentially drive meaningful per share value over time. Risk in the eyes of market participants with a short time horizon may prove to be opportunity for the long-term investor.

I look forward to hearing what incoming CEO Charlie Scharf has planned to try and accelerate the company's turnaround and get the regulatory issues resolved.

Disclosure: Long WFC

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This article first appeared on GuruFocus.