Wells Fargo's Revenue Remains Under Pressure in the Third Quarter

 Wells Fargo (WFC) reported net income available to common shareholders of $3.8 billion, or $0.72 per diluted share, for the third quarter of 2011. Net revenue came in slightly lower than our expectations, primarily due to a drop in market-related line items, including trading gains, commissions, and asset-based fees. We see the shortfall in these often volatile sources of income as temporary, and our fair value estimate remains unchanged.

More concerning, however, is the continued narrowing of net interest margin--down to 3.84% from 4.25% during the last four quarters. Our valuation incorporates a modest (around 30 basis points) increase in NIM from current levels during our five-year forecast. While our medium uncertainty rating and the resulting margin of safety protect against a substantial shortfall in net interest income, the low interest rate environment appears likely to pressure results for the foreseeable future. On the other hand, the company managed to grow its loan book by more than $8 billion during the quarter, driven primarily by strength in commercial and industrial lending. In our view, this indicates a reasonably healthy level of loan demand (and also supports our thesis that commercially focused banks will experience more growth in the near term), increasing our confidence that net interest margin eventually will rebound. We see the more than $800 million year-over-year and quarter-over-quarter declines in trading revenue and the $158 million decline in trust and investment fees during the quarter as temporary effects of a difficult quarter, and expect better results by 2012, if not the fourth quarter of this year.

Although revenue growth continues to be an issue across the banking sector, Wells appears to be making some progress reducing expenses. Noninterest expense fell by about $800 million during the quarter, and nearly $600 million from the third quarter of 2010, driven by lower employee benefits expense and a decline in other expenses. Our valuation incorporates a slight decline in expenses in 2012, consistent with the results reported in the third quarter. We therefore will be watching the expense lines carefully in the fourth quarter to determine if the reductions are indeed permanent.

Finally, Wells Fargo's capital position is acceptable, in our view. The company estimates that its Tier 1 common equity ratio under Basel III would have been 7.41% as of Sept. 30, 2011. The company repurchased 22 million shares in the third quarter, and another 6 million in a forward repurchase transaction that will settle in the final quarter of the year. We're pleased to see Wells Fargo repurchasing its undervalued stock, and would greet further buybacks with enthusiasm, though with more than 5 billion shares outstanding, it would take a considerable program to move the needle on our fair value estimate.

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