Wells Fargo Earnings Review

In a week when coal miner Peabody Energy filed for bankruptcy and rival bank JPMorgan Chase & Co. increased its provision for credit losses by 46% largely because of pressure on its energy, metals and mining clients, investors' focus was naturally on Wells Fargo's energy portfolio. Let's take a look at how credit loss provisions hit income at Wells Fargo, and the other key takeaways from the first-quarter report.

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Wells Fargo: Still a Well Positioned Directional Play on the Economy

Analyzing the prospects for banking stocks like Wells Fargo  $WFC  isn't really as hard as many people think.

The fortunes of the banking sector tend to follow the direction of its underlying assets, which, in turn, tend to follow the economy. If you are bullish on America, then you should be bullish on Wells Fargo.

Wells Fargo reports results
The bank's fourth-quarter diluted earnings per share increased 10%, but as always with banking stocks, the devil is in the detail. Essentially, Wells Fargo has done very well growing its net interest income over the course of the year, despite its net interest margin, or NIM, falling. The NIM is the difference between its interest income and what it pays out to its lenders, all over interest-earnings assets.

Source: Company presentations.

This was no small feat considering that core deposits (including retail deposits) have gone up significantly more than it managed to increase its loan book.

Source: Company presentations.

It's somewhat of an anomaly to view a rising deposit base as a problem, because raising deposits is what banks are supposed to do! Indeed, in traditional recoveries, deposit growth is highly sought-after because it gives banks greater ability to extend their loan books. However, this recovery has been relatively anemic, and loan demand has been slow to take off. In short, Wells Fargo needs a more positive environment for loan demand, but the good news is, it has the deposit base to benefit should this happen.

So, how has Wells Fargo been generating income growth?
Given the dramatic decline in the NIM, Foolish readers might be wondering just how the bank has increased its overall net income? The answer is that credit quality has improved so much that its provisions for credit loss have declined massively.

In other words, Wells Fargo set aside nearly $1.5 billion less in the most recent quarter compared to a year ago.

Not all good newsThe mortgage refinancing market had been very strong leading into 2013, and Wells Fargo had previously positioned itself to benefit. However, with rates rising this year, the refinancing market has slowed, and Wells Fargo has been inordinately hit. In the words of its CFO, Tim Sloan, on the recent conference call:

Our market share, over the last couple of years was disproportionately high, primarily because the biggest driver for origination volume until the last couple of quarters was refinances, and the reason for that, again to remind everybody, is that we are the largest servicer and the quality of our servicing book was the highest in the industry. 

Indeed, Foolish investors can see the effect of the refinancing slowdown when looking at Wells Fargo's non-interest income. Note how the reduction in mortgage banking income has reduced non-interest income.

Source: Company presentations.

Putting the pieces together for Wells Fargo
In a typical economic recovery, an increase in credit quality is usually followed by an increase in loan demand, and then the NIM starts expanding while interest rates rise at the same time. However, this has been anything but a normal recovery.

In short, Wells Fargo needs to see a pick-up in loan growth in 2014. History suggests this will happen, and given its exposure to housing, and its growing deposit base, Wells Fargo is ideally placed to benefit.

On the other hand, should the economy stagnate, it can't really boost its net income via reduction in credit loss provisions. Moreover, a slow economy implies sluggish loan demand growth. The NIM would probably decline even further in this scenario.

The bottom line
In a sense, the stock remains a key barometer of where you think the economy is headed. Moreover, Wells Fargo gives you specific exposure to the U.S. and to housing, two of the more positive aspects of the global economy.

All told, investors everywhere can discuss this stock to death, but it still remains a cyclical play on the economy. If you think the U.S. housing market will continue to recover and increase loan demand with it, then Wells Fargo is ideally placed to benefit, and the metrics discussed above will all get better.

Which Stocks to Buy if Interest Rates go up

Equity investors can be guilty of ignoring the repercussions of bond-market movements, but Foolish investors might not want to be so complacent. Year to date, 10-year Treasury rates have gone up significantly, and even though it's a less than 1% move, it represents a near 50% increase in the rate. The economic impact has already been felt in some ways, and it's time to look at which stocks could benefit if rates rise further.

Rates on the move
Here's how the benchmark 10-year U.S. Treasury yield has moved this year:

Source: Yahoo! Finance.

Clearly, rates have moved up recently. In addition, its noticeable how low they still are when compared to previous years. So, which stocks can outperform if they move up?

Rates up + economy up = time to buy financials
Financials will benefit in this scenario because an improving economy will bring increased loan demand, while rising rates should increase net interest margins for the financials.

For example, although Wells Fargo  recently reported record quarterly net income, its net interest margin has been declining for more than a year now.

Source: Company presentations.

An improving housing market, however, will aid its mortgage loan origination business, and increased interest rates should help it issue loans and mortgages at higher rates than it has in the last year or so.

A similar dynamic applies to a lender like Capital One Financial . Wells Fargo and Capital One have been challenged over the last few years because of weak loan demand. In addition, it has been trying to replace loans issued at previously higher rates. The result is that income has come under pressure. However, there are some positive signs. Capital One is known for being a conservative lender, so it's a good sign when its management says this on a conference call:

New originations are growing, and we're seeing more opportunity to increase credit lines for existing customers, which should improve the trajectory of both the loan growth and purchase volume growth over time.

Capital One expects its domestic card-loan growth to turn positive "sometime around the second half of next year."

Rival lender Discover Financial Services   is a somewhat more aggressive lender, and it managed to grow its credit card loans by 4% in its third quarter even while its credit card charge-off rate hit a record low of 2%.

Moreover, its management described the market as being a "very benign credit environment. We don't see any situation where there is any type of a meaningful deterioration in credit in the near-term horizon at all."

Although not a financial, Automatic Data Processing , or ADP, holds large amounts of its payroll clients' funds on its books, from which it earns interest income.

ADP is interesting because its employer services and professional employer organization, or PEO, services are obviously geared to the economy. In addition, the company is achieving margin expansion as its revenue grows. In fact, in its third quarter, employer services (69% of revenue) grew earnings by 15%, and PEO (18% of revenue) did so by 12%. The main reason its total pre-tax earnings only grew around 7% was because lower interest rates took its interest income down by $17.6 million, to $89.2 million. Given higher rates and an improving economy, ADP has plenty of upside.

In a similar vein, payroll specialist Paychex  (NASDAQ: PAYX  )  also holds significant amounts of customers cash on its books. You can see how the cycle works in the following graph.

Source: Company presentations.

As the economy improves, more small business want use Paychex's payroll services. Consequently, the amount of funds held goes up. Meanwhile, interest rates tend to go up, so the amount earned from customer funds goes up. In fact, it went up to around 8% of total revenue in 2007. If the same thing happens over the next few years, Paychex could see a revenue boost from this effect.

The bottom line
Foolish investors need not fear rising rates because they're usually a sign of a stronger economy. With a relatively benign inflation environment, the stocks discussed above have upside. The financial media often frets about higher rates, but Foolish investors can prepare for them and invest accordingly.

Wells Fargo is Still Good Value Despite Rising Rates

Earnings season is in full flow now, and it’s the turn of banking heavyweights such as Wells Fargo (NYSE: WFC) and JPMorgan Chase (NYSE: JPM) to give their numbers and commentary on the economy. As ever, investors will focus on the housing market’s effect on banking stocks' prospects, and what it means to the wider economy. Frankly, I think the housing market is the key to future movements in their share prices. Moreover, as long as the banks are saying good things about housing, investors can feel confident about the U.S. economy.

Don’t get fooled by randomness

It’s important not to get caught up in the minute detail of looking at the banks. In truth they are still cyclical businesses. The banks make money when the economy is trading in the direction of the core assets (mortgages, loans, etc) on their loan book.

Therefore, if you want to buy banking stocks, you will need to focus on how the economy affects the quality of their loan books. If housing and the economy are doing well, then their credit quality (loan delinquencies, charge off rates) will get better, loan loss provisions will reduce, and demand for loans will go up. Ultimately higher rates should be a positive to their earnings in the long term. In turn, all of these metrics affect the valuation of the company.

My point here is that it's the direction of the core assets, rather than looking at a snapshot of their earnings right now, that counts in terms of making a decision to buy the stocks.

The big question over the banks…

The key issue is how the banks might deal with a rising rate environment. The markets have been keen to price in higher rates ever since Ben Bernanke implied that the Federal Reserve would begin tapering bond-market purchases. So where does this leave the banks? Will rising rates choke off loan demand, or will the housing market continue to recover despite them?  Naturally, if the latter occurs, the banks will see increased loan demand and banking profitability.

The issue can be seen by looking at Wells Fargo’s net income and its net interest margin (NIM). Interest income (roughly half of income) is more important to follow than non-interest income, because it is more variable.

The market has been fretting over this issue in 2013 as economic growth (therefore loan demand growth) has been moderate, while interest rates remain low (reduced interest rate income) and deposit growth has grown strongly (consumers continuing to deleverage).

Meanwhile, financial services companies such as Capital One Financial (NYSE: COF) have been experiencing run-off. This is where existing loans are paid off and not replaced by new loans due to weak demand. Indeed, Capital One expects run-off to be $12 billion in 2013 and a further $8.5 billion in 2014.

Furthermore, JPMorgan’s CEO, Jamie Dimon, discussed the possibility for a “dramatic reduction” in the bank’s mortgage profits if rising rates slowed demand for home loans. The issue is highly relevant because Wells Fargo and JPMorgan are the two biggest mortgage lenders in the U.S. Moreover, as the housing market is a key determinant for the ‘wealth effect’, the banks can expect demand for other forms of credit (auto loans, credit card, etc) to be indirectly tied to it.

The two reasons why the banks will do well

The first cause for optimism is that the increase in deposit growth created by consumer de-leveraging is building a powerful asset base from which the banks can lend. For example, here is how Wells Fargo’s average core deposits have increased recently:

In addition, its tier 1 capital ratio (a common measure of a bank’s capital adequacy) has been rising. This indicates an increased capacity to lend.

The second reason is that the wealth effect from housing is real. Here is a graph of data from the Federal Reserve that demonstrates how U.S. households and nonprofit organizations have seen real restate wealth and their net worth improve in recent years:

Furthermore, gains in employment and slow-but-steady economic growth are creating a favorable environment for growth in loan demand. If these conditions persist, then the banks should be able to deal with a rising rate environment. Indeed, historically speaking, a rising rate environment means that banks will make more money.

The bottom line

In conclusion, investors should stay positive on the financial services sector as long as the underlying fundamentals are moving in a favorable direction. The debate about the effects of rising rates on the economy will go on and on. There will be tomes of spilled ink discussing the NIM, run-off, Basel III and other esoteric concepts that ordinary investors find hard to grasp.

However, Bernanke has made it clear that tapering the purchases of bonds –therefore lowering interest rates– is contingent upon a stronger economy. Either the Federal Reserve will try to lower rates in the future (given a slowing economy), or the economy will get better (implying more loan demand). In any case, the banks are being supported in their activities and, unless the economy is heading towards another recession, investors should look to hold some banking stocks in their portfolio.

Is Capital One Financial A Buy?

Textbooks will tell you that economies work in concert with some kind of ideal and consistent. Unfortunately, it never quite works out like that. In the financial sector in particular we have seen some unusual developments in recent years.

On a historical basis the sector looks cheap, with many of the leading companies trading at below book value; however, we are living in uncertain times and the credit cycle is not the same as it once was. So do the financial companies present good value right now?

It’s different this time

These are some of the most famous last words in investing. They induce investors into making assumptions that they build into stocks, which then promptly disappoint them. In the case of the financials we are seeing ongoing weak consumer demand for loans; however, I think it would be a mistake to assume that it really is different this time. At some point--as long as the economy keeps improving--consumer demand for loans will increase. History suggests that when employment and incomes increases then loan growth will follow.

With this said it is worth reflecting on how slow the recovery has been. Employment gains have been on a par with previous recoveries, but nothing near enough to recompense for jobs lost in the recession. Moreover, we have come through a few years of consumers deleveraging, and such behavior can become habitual.  Meanwhile, the Federal Reserve is doing anything it can to throw liquidity into the economy. Interest rates are low and financials are facing declining net interest margins as they struggle to replace higher rate loans that are maturing. A veritable mix of pluses and minuses.

How this plays out in the Industry

We can see these issues playing out in the metrics of the lenders. For example, here is Discover Financial Services' (NYSE: DFS) net charge off rate and delinquency rates for its US credit loans.

Clearly asset quality has improved in a rather dramatic way since the last recession, and it is notably lower than before.

While asset quality has improved across the board, low interest rates have created net interest margin (NIM) difficulties. For example, here is a look at Wells Fargo’s NIM numbers.

In the case of Wells Fargo It has seen significant increases in deposits, which created pressure on its NIM while new mortgage origination hasn’t been as strong as many might have hoped. 

In a sense the whole industry is positioned in a similar manner. Asset quality is improving, but consumer demand remains weak and many loans are maturing, leading to significant amounts of runoff and capital appreciation.

Enter Capital One Financial

Within financials the stocks that I like are Wells Fargo (on the basis of its exposure to the US housing market and conservative approach), Goldman Sachs  because it still trades below book value and offers significant upside from exposure to more M&A activity this year, and Capital One Financial .

Here are the price to book numbers for the stocks discussed in this post.

GS Price / Book Value data by YCharts

Discover’s evaluation reflects its more aggressive approach to lending, while Goldman Sachs remains subject to regulatory risk. Nonetheless I think Goldman is good value. I’m not the biggest fan of this company and the way that successive administrations have catered to its interests, but I’m willing to bet that these trends will continue and regulatory fears will ease. As for Discover, investors have to ask themselves if it is chasing too much business.

Good Value?

Evaluations are attractive, but these stocks will not have such good value if lending doesn’t come back. My point is that if the economy continues to improve then at some point loan demand will surely return. However if it doesn’t (or if the same weak environment ensues) then I would rather be invested in a financial with a traditionally conservative approach to lending. In this regard I think Capital One is a good option.

Drilling down into the details of Capital One’s latest numbers it’s clear that it expects run-off to continue this year and the next.  It plans for $12bn in 2013 and then a further $8.5 billion in 2014. So while its credit performance is good, consumer demand is still weak. It would be understandable if its management then decided to chase growth in areas like auto loans (which grew $800 million); however its auto loan originations declined by $500 million in the quarter as they refused to chase low quality loans.

In essence Capital One is a more conservative lender that still gives exposure to the upside of an improving economy. The fact that areas like auto loans have offered growth to lenders hasn’t caused Capital One to create potential areas of weakness in its loan book which could then threaten the company’s ability to lend in future.

Moreover, it is planning to use its capital appreciation to reward investors with buybacks and is already in talks with regulators about this.

The bottom line

Capital One offers a solid way to get exposure to the financial sector without too much risk. I think investors should take this into consideration rather than just looking for broad-based financial exposure.

Its evaluation is not expensive on a price to book basis, and a dividend yield north of 2% plus the prospects of further capital returns to shareholders offers upside prospects if the economy continues to grow.