Wells Fargo Still Faces Uphill Battle

 Wells Fargo (WFC) reported net income of $5.2 billion, or $0.92 per share, for the first quarter of 2013. The results for this narrow-moat bank were in line with our expectations, and we do not intend to significantly alter our fair value estimate.

Loan demand appears to have weakened early in 2013. Wells Fargo's core commercial loan portfolio was flat during the quarter, while an increase in consumer loans was driven by retention of conforming mortgages, which cost the bank $112 million in mortgage production revenue. Net interest margin fell from 3.56% to 3.48% during the quarter, reflecting the impact of the continued low interest rate environment. Our fair value estimate incorporates a modest increase in net interest margin over our forecast period.

While loan demand and growth were weak, credit quality continued to improve. Nonperforming assets now make up only 1.6% of total assets. However, the benefits from reserve releases are likely to decline somewhat. We think Wells Fargo's allowance for loan losses is sufficient. Though it now covers only 73% of nonperforming assets, it also represents more than three years of charge-offs at the current rate. At any rate, quarters like this one--in which Wells provisioned $1.2 billion while charging off $1.4 billion--are more likely than large releases. 

Despite some continuing issues, we think Wells Fargo's competitive advantages are intact. Core deposits grew more than $51 billion over the past year, providing a low-cost source of funds for the company's operations, and just under half of the company's revenue came from sources other than interest income, demonstrating the effects of cross-selling, which could increase customer switching costs as well as boost pricing power. We think these factors are responsible for the company's 1.49% return on assets and 13.6% return on equity in the first quarter--very respectable figures in the current environment.

Wells Fargo did not make much progress on the expense front. Noninterest expenses totaled $12.4 billion during the quarter, and declines were due to the lack of unusual items like the Independent Foreclosure Review settlement, professional services related to regulatory consent orders, and charitable contributions. Although the company's efficiency ratio was an acceptable 58%, we think it may be tough for the bank to cut expenses much further. The company's previous goal of $11 billion per quarter in noninterest expenses was apparently much harder to achieve than management initially expected.

In the mortgage business, Wells Fargo originated $109 billion in loans during the quarter, down from $125 billion in the fourth quarter and $129 billion in the first quarter of 2012. Although gain on sale margins remained near peak levels, this is not likely to last much longer. The bank increased reserves for repurchase losses by $111 million, to $2.3 billion, and the original balance of outstanding claims stands at $1.79 billion. Although we believe problems stemming from precrisis mortgage lending are declining fast, at some point the benefits of low rates and high refinancing volume are likely to do so, as well.

If its internal estimates are accurate, Wells Fargo's Tier 1 common ratio under Basel III would now stand at 8.39%, in excess of the level the company is likely to require in coming years. The company's planned $0.30 quarterly dividend represents a 2.8% yield at our fair value estimate, but we think Wells Fargo's lower Basel III capital needs (compared with large peers), its simpler business model, and higher potential earnings power as measured by return on assets and return on equity could result in better-than-average dividend growth prospects. We believe these qualitative factors also warrant a slightly higher earnings multiple for Wells; this is reflected in the 10% cost of equity we use for the bank versus the 12% we apply to more complex institutions.

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