Wells Fargo Deepens Its Funding Moat

Interest rates continued to weigh on  Wells Fargo's (WFC) results in the third quarter, even as net interest income rose to $10.9 billion from $10.8 billion thanks to higher deposit and loan balances. Low-cost core deposits--the key source of Wells Fargo's narrow moat--grew at an 8% annualized rate during the quarter, an indication that the company's competitive advantage continues to grow. Yields continue to pressure results, though, and net interest margin was 3.06% during the quarter, down from 3.39% in the third quarter of 2013 and 4.79% five years ago. We're still reluctant to incorporate a rebound of similar magnitude, as the timing and extent of rate increases are difficult to predict. Our current valuation forecast incorporates net interest income growth averaging 5% annually over our five-year forecast period, stemming from both loan growth and an increase in net interest margin. However, current futures data from CME Group implies a 43% probability that the target fed funds rate will not exceed 0.25% by September 2015, supporting our cautious outlook. We don't expect to alter our $50 fair value estimate.

While Wells Fargo is poised to benefit from rising interest rates in years to come, part of this benefit is likely to be offset by rising credit losses. The bank charged off only 0.32% of loans in the third quarter, well below our long-term forecast of 0.55%. We note that the bank experienced recoveries in both its commercial real estate and construction lines of business and charged off less than 3% of credit card loans, results we believe are not sustainable.

Finally, management confirmed that an increasing regulatory burden is likely to continue weighing on costs. Salaries and incentive compensation both reached their highest levels in five quarters--offset by declining employee benefits--and litigation accruals and outside professional costs again ticked up, consistent with our thesis and forecasts.

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