I’ve been bullish on Wells Fargo (WFC) for a while, mainly on the basis of the significant operating leverage within the business once rates and loan growth move meaningfully higher. Moreover, while the well-known regulatory issues continue to linger (including the growth-limiting asset cap), the company is making progress resolving these issues and should be able to generate mid-teens ROTCEs a little further down the line, to say nothing of significant capital returns in the short term.
These shares have risen about 17% since my last update, outperforming a healthy big bank peer group. I currently see more upside in JPMorgan (JPM) given the post-guidance drop on worries about higher expenses and in the ongoing restructuring at Citigroup (C), but I don’t think the high single-digit annualized returns I expect from Wells Fargo are bad, and I do see room for beat-and-raise quarters over the next two years that could drive more upside.
Emerging Momentum, But Q4 Wasn’t Quite As Strong As It May Seem
There were definitely some meaningful positives in Wells Fargo’s fourth quarter, including 4% sequential net interest income growth and both net interest margin improvement and earning asset growth, but I would argue the results weren’t quite as good as they first appeared.
The 4% qoq growth in net interest income was a clean beat, contributing about $0.05/share of upside to Street expectations. Fee-based income is more complicated, as gains on sale from debt and equity investments inflated the numbers. It’s typical to adjust these out, but for some reason, most sell-side analysts didn’t do that this time. Core fee-based income, excluding those gains, contracted 5% qoq, missing modestly, and leading to a core revenue contraction of 2% compared to the third quarter.
Expenses declined modestly (down 1% qoq) and were a bit higher than expected. Pre-provision revenue jumped 26% qoq if you include those gains on sale, but on an adjusted basis, pre-provision profits declined 6% and just barely beat expectations.
Tangible book value per share rose more than 2% qoq, and the company ended with a CET 1 ratio of 11.4%, so capital isn’t an issue.
Revenue Growth Is Coming… And Apparently So Is Operating Leverage
As the economy shifts to a tightening cycle, Wells Fargo is in a good position to generate revenue growth in the coming years.
First, loan growth is already starting to pick up, with end-of-period loans up 4% qoq on an adjusted (ex-PPP) basis, with over 8% growth in the C&I lending business. CRE lending growth was also better than average, and consumer lending saw good growth in auto (up 5% qoq) and cards (up 7% qoq), offset by a little weakness in residential mortgages.
Management’s guidance for low-to-mid single-digit loan growth in 2022 certainly wasn’t on the high end of what other banks have guided for, but adjusted growth should be better and I see room for upside here given Wells Fargo’s broad footprint and solid presence in areas like asset-backed lending and CRE (an area where other banks have retreated). Middle-market lending will be an area to watch, particularly with so many banks (including peers like Bank of America (BAC), JPMorgan, and PNC (PNC)) investing for growth in this space.
Augmenting the loan growth is Wells Fargo’s above-average asset sensitivity (meaning Wells Fargo’s net interest income goes up more for a given increase in rates). On a reported basis, Wells Fargo is at the top of the list when it comes to asset sensitivity among large banks. While I think the real sensitivity will end up being lower, Wells Fargo is still on the “more sensitive” side of the curve, giving the company good leverage to higher rates.
And speaking of leverage, operating leverage is another key contributor to above-average growth potential in the coming years. Management guided to a year-over-year decline in spending for FY’22 and indicated that FY’23 expenses should be down as well. That’s a marked contrast from JPMorgan’s substantially higher expense growth guidance, as well as higher guides from other banks on increased costs/wage inflation.
I think there are a few factors working for Wells Fargo here. First, as outlined by management in prior communications with investors (sell-side meetings, et al), Wells Fargo didn’t have the same existential worries coming out of the last crisis and never went through the same degree of cost-cutting, leaving more for management to trim now. Secondly, expenses tied to compliance issues should start to scale down, giving the company the opportunity to reinvest in areas like IT while still reducing over total expenses.
That said, I’m very curious to see how the spending/investment decisions play out across the space over the next five years and beyond. JPMorgan is arguing that they’re “investing” in future growth, and so I’ll be curious to see whether banks like Wells Fargo ultimately feel like they have to catch up to maintain/regain share (assuming JPMorgan’s decisions do in fact lead to share gains).
There’s still no clarity on the removal of the asset cap and the resolution of the ongoing regulatory issues at Wells Fargo, but the Street seems to have shifted to a viewpoint where management has these issues in hand, progress is being made, and the bank “will get there when they get there”. I could see some sentiment risk here if there were regulatory disclosures/warnings suggesting delays or dissatisfaction on the part of regulators with Wells Fargo’s remedies, but it doesn’t seem like the Street is overly concerned about the timing of this anymore.
Looking at how Wells Fargo has emerged from the downturn and how it’s positioned for the next cycle, I’m more bullish on the bank’s earning potential during this tightening cycle. This is a rate-sensitive lender with large deposit share and large lending share in a wide range of lending categories, giving it good exposure to loan demand growth, and better-than-expected operating leverage potential over the next few years. With that, my long-term core earnings growth rate moves from the mid-2%s to the mid-3%s and more on par with other large banks.
The Bottom Line
I could argue for a fair value in the low $60s on a 12x-12.5x ’23 P/E, and discounted core earnings support a long-term annualized total return in the high-single digits. With the shares having outperformed, the forward return potential still looks more on par with its high-quality large peers rather than superior, but I do see better beat-and-raise potential here over the next couple of years, and this is still a bank worth owning at this point in the cycle.