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Wells Fargo's a Buy Ahead of Earnings

Richard Saintvilus

NEW YORK ( TheStreet) -- Shares of Wells Fargo closed down 1.5% to $42.07 on Wednesday following the bank's downgrade by analyst Scott Siefers of Sandler O'Neil. Seifers, who now has a hold rating on the stock, cited Wells Fargo's valuation as being higher when compared to its peers.

However, from my vantage point I believe Wells Fargo's price-to-earnings ratio, which is two points higher than JPMorgan Chase , is deserved. But this is not the first time Wells Fargo has created doubt among analysts. There were plenty of questions when the bank reported fiscal first-quarter earnings results in April.

The Street wasn't pleased with management's inability to grow the bank's usually strong mortgage lending business. The stock dropped 5% in the days that followed. I didn't disagree that a 13% sequential drop in loan originations was disturbing. But I also didn't think it was time to panic either.

Given Wells Fargo's excellent track record of execution and solid leverage, I was already looking forward to the second quarter. I said: "With better improvement, these shares should reach $45 sometime in the second half of the year."

Since that article, the stock has been up by as much as 15%. Wells Fargo will report second-quarter earnings on Friday. With shares now trading at less than 10% away from my year-end target of $45, I don't see a reason to change course, especially given the bank's much improved growth prospects on the likelihood of higher interest rates.

Although the financial sector has done well in terms of stock performance, overall operational performance has been pretty lethargic in terms of actual growth. This was evident not only in Wells Fargo's first-quarter performance but the results from Bank of America and Citigroup yielded similar lackluster outcomes.

For Wells Fargo, however, given the 2% year-over-year decline in expenses, it was clear that management placed an emphasis on cost cutting. I've said it before: Investors shouldn't discount the level of difficulty there is in reducing expenses amid a highly competitive banking market. I believe Siefers is overlooking this fact.

In that regard, I don't believe Wells Fargo's second-quarter results will disappoint on Friday. Analysts are looking for earnings of 93 cents per share on revenue of $21.2 billion, which represents 12% year-over-year earnings growth and a slight decline (40 basis points) in revenue. I think Wells will surprise the Street with a beat on revenue.

The market seems too heavily focused on the bank's mortgage business. Granted, there were some struggles last quarter. But management has been working to diversify Wells Fargo's capabilities. The Street, including Siefers, has quickly forgotten how strong Wells Fargo is in areas like small business lending and auto loans.

Let's not also forget that during last quarter's conference call, management addressed strategic areas such as raising loan balances. The bank said it wanted to double its loan volume to (roughly) $50 billion, while expanding its credit card business. The logic behind that strategy was to help boost revenue and other operational deficits, while the mortgage business and interest rates rebound.

With both housing and interest rates on the rise, it certainly looks as if it was a worthwhile gamble by management. Accordingly, I also expect Wells Fargo to have a much better showing in net interest margin, which was down 33 basis points in the first quarter -- leading to a 3% year-over-year decline in net interest income.

I'm not by any means suggesting this will be a slam-dunk quarter for Wells Fargo, but there is significantly more upside potential here for the stock than there are risks.

While speaking at the Sanford C. Bernstein Strategic Decisions Conference a couple of months ago, Wells Fargo CEO John Stumpf made some very interesting comments about the bank's ability to grow in a low-interest-rate environment:

"Even though the private sector is deleveraging while the public sector is leveraging, we still think we can get more than our share of the loans. Last year, we grew loans by $50 billion. The net was $35 billion because we still have a liquidating portfolio that's exiting.

"So, as we think about -- if it's low rates for longer, we still believe in that environment we can grow net interest income, but also recognize over half our revenue come from noninterest income, which is a huge advantage for us, fees for services."

Basically, management is saying that even though competition from JPMorgan Chase and Bank of America has increased, Wells Fargo has plenty of firepower to return value to shareholders. I believe that regardless of the interest rate environment, (which is trending positively, by the way) Wells Fargo is poised to outperform and grow earnings. So $45 per share remains the target.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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