WFC - Wells Fargo: Solid Balance Sheet But Limited Margins Are Concerning

2023-03-21 10:51:08 ET

Summary

• Wells Fargo & Company remains a well-capitalized and strong bank, but margins are relatively modest.
• This is not too encouraging from a profitability point of view, as the company can only raise deposit rates in a limited manner without jeopardizing profitability.
• Wells Fargo will benefit from its large status, but earnings headwinds rightfully scare investors after a lackluster performance in recent years.

As the turmoil in the (regional) banking sector persists, shares of Wells Fargo & Company ( WFC ) have lost ground as well, trading near the 52-week lows. Shares of the bank have been struggling for years as the once beloved bank faced scrutiny amidst the opening of fake accounts, with fees payable by its clients, and it never recovered the same status as before. Shares of the bank peaked around the $50-$60 mark between 2014 and 2019, but even in the aftermath of the pandemic, it did not see those levels again.

2022 - A Base

Over the past year, Wells Fargo has seen a rough year, with full year revenues down 6% to nearly $74 billion, although that the composition of revenues changed dramatically with net interest income rising sharply, more than offset by declines in non-interest income to the tune of around a third. As the company took a $1.5 billion credit loss provision, which provided a more than $4 billion benefit to the 2021 results, net earnings fell from $21 billion and change to $13 billion, with earnings reported at $3.14 per share. Even without this volatile component (the loss provisions) income would have been down a bit.

The company has seen a decline in the asset base, with total assets down from $1.94 trillion in 2021 to $1.88 trillion in 2022. The deposit base fell 6% to $1.38 trillion over the twelve-month period, while the loan book rose 8% to $948 billion. The quarterly interest expense rose to $4.4 billion in the fourth quarter, trending at nearly $18 billion a year, indicating that the company starts to pay considerable amounts to fund the banks, to depositors and other financiers.

These interest payments include interest on debt securities as well, as average deposit rates trend at 70 basis points, up from 23 basis points in the third quarter. Despite this rate, the company saw quite significant outflows, totaling $90 billion over the past year. This is noteworthy as the operating profits of the bank of around $14 billion leave just a percent gap to hike deposit interest rates, without turning into loss making territory.

These outflows are concerning, as the company has resorted to some short and long-term borrowings to shore up its finances. This is not too comforting as liquidity has come down a bit, although that total cash and equivalents of $159 billion remain formidable, even if down a third on the year before.

Worrying is that the business has nearly $500 billion in debt securities, of which nearly $300 billion are held-to-maturity and trade at cost. The annual report revealed that the bank has net unrealized losses to the tune of $50 billion on available-for-sale and held-to-maturity instruments by year end 2022, as these are substantial in relation to the $182 billion equity base of the business. This is still manageable as the bank has plenty of liquidity, although higher interest rates through the first quarter might make these losses greater, albeit that interest rates have recently taken a leg lower here following the turmoil in the sector.

The Problem With Banks (In General)

The discussion above highlights some of the problems which some banks face. The financial system ended the pandemic period being very rich on deposits as consumer received large similar checks, but had troubles to spend this money.

Amidst a very aggressive rate hiking cycle over the past year, banks were slow to raise rates and hence have seen deposit outflows as the risk-free alternatives (short-term T-Bills) were paying much more compelling yields. This created a tough combination as banks which have not seen enough liquidity, as a result of long-term assets being held or those who have seen heavy deposit outflows, have been forced to sell long-term assets. These have fallen substantially in value following the long duration of the instruments.

For Wells Fargo, the deposit situation is quite solid, in the sense that it has a relative large portion of these deposit base falling under the insurance limit of $250k set by the FDIC, and now the implicit backing of the government for amounts in excess of this. Moreover, large banks have generally been beneficiaries of deposit inflows from smaller regional banks, but the extent of this is not known in the case of Wells Fargo.

The problem which I have with the bank is that the company has just about one percent room to hike rates on deposits before the bank itself goes into lossmaking territory. This creates a relative earnings disadvantage versus other banks, as this makes me cautious. This comes as the efficiency of the bank is lagging a bit compared to the peers.

Concluding Remarks

The reality is that the capital base of Wells Fargo & Company looks quite solid, and while unrealized losses are large in relation to the equity base, they are not so large in relation to some other banks. The bigger issue which I have with the bank is the limited profitability of the bank here, as Wells Fargo & Company can only raise deposit rates by a percent without incurring losses. After all, a $14 billion operating profit number is relatively modest in relation to $1.4 trillion in deposits.

Moreover, the large nature of the business makes that the bank is forced to contribute to the First Republic Bank ( FRC ) assistance as well, with Wells Fargo contributing $5 billion in deposits. Somewhat noteworthy is that the company announced a mixed shelf offering to the tune of $9.5 billion by mid-March, a precautionary measure, but not one taken by all big banks.

The reality is that I feel comfortable with Wells Fargo & Company from a credit point of view, but the weaker earnings power is concerning, certainly as competition for deposits is on the increase, as higher deposit rates mean that earnings power of the banking sector at large, and in this case certainly Wells Fargo, should see significant pressure. Hence, the current sell-off is not automatically appealing, as the sector at large will see more limited earnings power and perhaps tougher regulations as well.

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