2023-10-23 14:41:22 ET
Summary
- Wells Fargo reported strong earnings growth in Q3'23, exceeding earnings estimates on both the top and bottom line.
- The bank's deposit base has been declining due to cash-sorting behavior, resulting in a loss of deposits across its business segments in Q3.
- While net interest income has increased $1.0B Y/Y, the rise in credit provisions is concerning and could indicate weaker balance sheet and loan quality.
- Commercial real estate also appears to be headed for more trouble, given the rise in non-accrual CRE loans in the third quarter.
- I am taking a more cautious attitude and I am changing my rating to hold.
Wells Fargo ( WFC ) continued to perform well in the third-quarter and the Wall Street bank topped both revenue and earnings estimates on strong Y/Y net interest income gains. While the earnings report ( Source ) showed strong earnings growth year over year, the rise in credit provisions is troubling. There are also potential problems on the horizon relating to the commercial real estate market which may result in weakening balance sheet quality. Despite the presence of a 10% discount to book value, I am now no longer rating Wells Fargo as a buy, but as a hold!
Previous rating and expectations
I rated Wells Fargo a strong buy after the second-quarter earnings sheet was released, chiefly because of its low valuation and increasing capital returns: 9.8x FWD P/E, 17% Dividend Raise, 3% Yield . The Wall Street bank at the time just raised its dividend by 17% and was an attractive long term capital return play, in my opinion. Since my last coverage on the bank, Wells Fargo's share price has declined 14%, unfortunately. Obviously, Wells Fargo has not met my return expectations so far and I certainly did not expect a widening of the BV discount. I still believe that the dividend is well-supported by earnings and worth holding, but the decline in balance sheet quality came unexpected. Given the increase in credit provisions and declining balance sheet quality, I am changing my rating from strong buy to hold.
Wells Fargo reports solid earnings growth in Q3’23, beats estimates
Wells Fargo topped earnings estimates on both the top and the bottom line for the third-quarter: the Wall Street bank earned $1.48 per-share in Q3’23 on revenues of $20.86B. Adjusted earnings and revenues came in $0.22 per-share and $808M better than expected.
Source: Seeking Alpha
The bank reported total third-quarter earnings of $5.77B, showing 61% year over year growth driven chiefly by higher net interest income. While the bank achieved solid earnings growth, the trends in credit provisions and charge-offs are concerning to me.
Source: Wells Fargo
Wells Fargo’s deposit situation, continual cash-sorting behavior
The reboot of inflation in the third-quarter indicated to me that investors and savers were to continue to engage in cash-sorting behavior, meaning savers withdrew money from their low-yielding bank balances and invested it into higher-yielding money market funds.
Wells Fargo, like most of the bank sector, has been a victim of this cash-sorting behavior for quite a while and it resulted in a dwindling deposit base in Q3'23. At the end of the third-quarter, Wells Fargo had average deposits of $1.34T on its balance sheet, meaning the bank lost about $7.1B in deposits just in the last quarter. Excluding corporate deposits, Wells Fargo lost a massive $36.3B in deposits across its business segments in the third-quarter.
Source: Wells Fargo
Net interest income
Like Bank of America ( BAC ) -- which also showed considerable earnings strength in Q3 -- Wells Fargo benefits from a rising-rate world in the sense that it can charge higher rates for its loan products. In the third-quarter, Wells Fargo generated $13.11B in net interest income... which was a solid $1.0B more than in the year ago quarter. Since the Federal Reserve has cut back on rate increases in the last several months, the force of the tailwind for NII growth has moderated. However, I expect a reboot of Wells Fargo’s net interest income growth as inflation growth in Q3'23 sets the Federal Reserve up for new rate increases going forward.
Source: Wells Fargo
Credit provision trend remains a headwind for Wells Fargo and for its valuation
While Wells Fargo’s Q3’23 earnings release was solid overall, there are some things that weren’t as good. One thing that I am a bit more concerned about now than before is that the bank’s balance sheet quality is showing signs of weakness. As an example, while net interest income increased Y/Y, the bank’s provision for credit losses remained high at $1.2B. Compared to the year-earlier quarter, provisions therefore increased 53%. The rise in credit provisions indicates weaker balance sheet and loan quality and a recession would undoubtedly make the provision situation for Wells Fargo and other Wall Street banks worse.
Loan charge-offs went up $86 million in the third-quarter... and the increase was largely driven by the consumer business. With interest rates being abnormally high right now, growing credit provisions and charge-offs are a trend that investors unfortunately must expect to continue going forward… especially if the Federal Reserve raises interest rates a couple more times.
Source: Wells Fargo
Commercial real estate headed for trouble
I am also starting to get more concerned about commercial real estate and the potential consequences of further defaults: Wells Fargo's non-accrual loans in commercial real estate totaled $3.9B at the end of the September-quarter, showing a massive increase of $1.4B quarter over quarter. According to Wells Fargo, the increase was driven by a $1.3B increase in CRE office non-accrual loans. High interest costs and falling commercial real estate valuations ( Source ) are reasons for increasing headwinds in the commercial property sector, especially in the office market. Continual rate increases will likely add pressure on the commercial real estate market and potentially lead to higher default rates (and higher non-accrual loans for Wells Fargo).
Source: Wells Fargo
Wells Fargo’s valuation vs. Bank of America
Wells Fargo is trading again at a discount to book value… as is Bank of America. Wells Fargo is currently valued at 0.9X book value although the bank managed to trade at a 1-year average P/B ratio of 1.0X... meaning Wells Fargo, on average, was valued at book value in the last year. Bank of America is trading at a 19% discount to book value. In the long term I can see WFC trade at book value, but given the FY 2023 credit/charge-off trends, I am a bit more cautious.
Risks with Wells Fargo
The biggest risk is a decline in Wells Fargo's balance sheet quality if more loans, especially in the commercial real estate category, fail. Wells Fargo faces, in the medium term, also the possibility of declining net interest income as the Federal Reserve will sooner or later lower its key interest level. From an investment and earnings perspective, I am most worried about declining loan quality and higher credit provisions, especially with regard to the commercial real estate market right now.
Final thoughts
Wells Fargo submitted a robust third-quarter earnings sheet earlier this month, but little cracks are showing with respect to credit quality and provisions for credit losses… both of which indicate potential problems brewing on Wells Fargo’s balance sheet. Although Wells Fargo posted strong year over year earnings growth in Q3’23, driven by net interest income gains, the increase in credit provisions especially makes me a bit uneasy. If the trend continues to escalate and credit provisions/non-accrual CRE loans grow, I expect growing headwinds to Wells Fargo's valuation as well!
For further details see:
Wells Fargo Q3: Risks Are Growing (Rating Downgrade)