Wells Fargo's Performance Justifies a Premium Price

 Wells Fargo (WFC) reported net income of $5.9 billion, or $1.05 per diluted share, for the first quarter of 2014, equivalent to an impressive 1.57% return on assets and a return on total equity exceeding 14%. The results were aided by $500 million reserve releases and a slight decrease in the tax rate. We expect Wells Fargo to continue recording exceptional performance compared to peers, and think the stock--now approximating our $48 fair value estimate--may still be interesting for certain investors due to its above-average earnings power and roughly 3% dividend yield.

Wells Fargo's expense reduction efforts are continuing to bear fruit. Its efficiency ratio was just under 58% during the first quarter, as the company cut both employee costs (reducing staff by 9,000) and expenses related to professional services. We think Wells Fargo can achieve an even better ratio of expenses to revenue as costs related to compliance with new regulatory regimes and legal issues decline over time, even if revenue growth is challenged. We think the bank’s relatively low-risk business model provides an advantage over peers in this area, as larger banks are likely to be adjusting their business models to new regulations for years to come.

Wells Fargo continued to build on its primary competitive advantage--its enormous base of low-cost deposits--and average balances grew by 9% year over year. The advantage remains muted in the current low-rate environment, but we think it will be an enormous benefit if interest rates rise and competition from online banks grows, as we foresee.

Finally, we are turning a more favorable eye toward Wells Fargo’s approach to capital return as it trades closer to our fair value estimate. With little incremental benefit to buybacks at fair value, we think an aggressive dividend policy makes sense--and Wells Fargo’s conservative business model should continue to give its capital plans a leg up over large peers in the eyes of regulators.

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