(WFC) Wells Fargo Performs As Expected

Wells Fargo & Company (WFC) has achieved the tenth consecutive quarter of growth in earnings per share by reporting earnings of 82 cents per share in second quarter 2012. Results improved from earnings per share of 75 cents in the prior quarter and 70 cents in the year-ago quarter and were in line with the Zacks Consensus Estimate.

Second quarter net income applicable to common stock came in at $4.4 billion, up 9.5% sequentially and 18.1% year over year.

Results at Wells Fargo benefited from improvements in mortgage banking as well as credit quality. The company experienced record quarterly mortgage applications and increases in lending to consumers and businesses. It also reported $400 million in reserve release (pre-tax), attributable to improved portfolio performance.

The quarter’s revenue came in at $21.3 billion, which was also on par with the Zacks Consensus Estimate. Though revenue slipped 1.6% sequentially, it advanced 4.4% year over year.

Furthermore, segment-wise, on a sequential basis, Wholesale Banking reported 1.4% growth in revenues while Community Banking and Wealth, Brokerage and Retirement segments reported drops of 2.5% and 3.0%, respectively.

Performance in Detail

Wells Fargo’s net interest income for the quarter came in at $11.0 billion, up 1.4% sequentially. Net interest margin remained flat sequentially at 3.91%. Though balance sheet re-pricing in the present low interest rate environment put pressure on net interest margin, it was mitigated by increased variable income, including purchased credit-impaired (PCI) loan resolution income.

Non-interest income at Wells Fargo came in at $10.3 billion, down 4.6% from the prior quarter. Lower market sensitive revenue, including a decline in trading gains associated with the deferred compensation plan investments primarily led to the decrease in net interest income. However, the fall was partially mitigated by higher deposit service charges, trust and investment fees, card fees and mortgage banking revenue.

As of June 30, 2012, total loans were $ 775.2 billion, up 1.1% sequentially. Commercial loans acquired in the quarter from WestLB’s subscription finance loan portfolio as well as BNP Paribas SA’s North American energy lending business contributed to this increase. However, it was partially offset by continued run-off in the non-strategic/liquidating portfolio. Average core deposits were $880.6 billion, up 5% (annualized) from the prior quarter.

However, non-interest expense at Wells Fargo was $12.4 billion, down 4.6% from the prior quarter. Lower employee benefits expense, including lesser deferred compensation expense, and reduced merger integration costs contributed to this decline in expenses. The decrease was partially offset by increased revenue-based incentive compensation and higher severance expense. Efficiency ratio improved to 58.2% from 60.1% in the prior quarter and 61.2% in the year-ago quarter.

Notably, for continued momentum in revenue opportunities this quarter, including a record number of mortgage applications, the company currently projects its fourth quarter 2012 expenses to be above its prior target of $11.25 billion. However, for the rest of the quarters in 2012, non-interest expense is anticipated to fall from the second-quarter levels.

Credit Quality

Wells Fargo saw an improvement in its credit quality trends in the quarter. It experienced reductions in net losses, nonperforming assets, nonaccrual loans, as well as loans 90 days or more past, due and still accruing.

Wells Fargo’s allowance for credit losses, including the allowance for unfunded commitments, totalled $18.6 billion as of June 30, 2012, down from $19.1 billion as of March 31, 2012.

Net charge-offs were $2.2 billion, or 1.15% (annualized) of average loans in the reported quarter, down from the prior quarter net charge-offs of $2.4 billion (1.25%). Provision for credit losses fell 9.8% sequentially and 2.1% year over year to $1.8 billion in the reported quarter. Nonperforming assets dropped to $24.9 billion in the quarter from $26.6 billion in the prior quarter.

For the rest of 2012, the company anticipates improvement in the credit quality trends but at a modest rate, provided the economy does not deteriorate substantially. Moreover, future reserve releases are also projected for the remaining quarters of the year.

Capital Position

Wells Fargo maintained a solid capital position. The company purchased 53 million shares of common stock in the quarter. Moreover, it went for an additional estimated 11 million shares through a forward repurchase transaction which is expected to be settled in the third quarter of 2012. It also redeemed $1.8 billion of trust preferred securities, with an average coupon of 6.31%, on June 15, 2012.

As a result, Wells Fargo’s Tier 1 common equity under Basel I increased $2.2 billion to $101.7 billion, with Tier 1 common equity ratio of 10.08% under Basel I as of June 30, 2012. Moreover, its estimated Tier 1 common equity ratio was 7.78% under the latest Basel III capital proposals.

The Tier 1 leverage ratio was 9.25% as of June 30, 2012, down from 9.35% as of March 31, 2012. Tier 1 capital ratio was 11.68% as of June 30, 2012 compared with 11.78% as of March 31, 2012. Book value per share improved to $26.06 from $25.45 in the prior quarter and $23.84 in the prior-year quarter.

Our Viewpoint

We believe that over the long term, investors should not be disappointed with their investments in Wells Fargo given its diverse geographic and business mix which enable it to sustain consistent earnings growth. Going forward, we believe that strategic acquisitions will help expand Wells Fargo’s business and improve its profitability.

In fact, Wells Fargo’s growth plans have historically included a large number of acquisitions, Wachovia being the largest addition in December 2008. Recently, in an effort to boost its subscription finance business, Wells Fargo has agreed to buy WestLB’s $6 billion subscription finance portfolio.

Wells Fargo is capitalizing on the deleveraging activities of the European banks. In February, Wells Fargo agreed to acquire the North American energy lending business of BNP Paribas with nearly $9.5 billion of loan commitments and approximately $3.9 billion in loans outstanding. The acquisition was closed in April 2012. Moreover, in 2011, Wells Fargo also made loan portfolio purchases from Bank of Ireland (IRE) and Allied Irish Banks (AIBYY).

We believe that long-term investors who can absorb the risks related to economy and regulations can expect decent growth in Wells Fargo’s earnings in the future. Solid capital levels, expense management as well as improved credit quality will also support its profit figures. Its stress test clearance and subsequent dividend hike as well as plan to increase share buybacks in 2012 also boost investors’ confidence.

Yet, we believe the top-line headwinds would persist, given the protracted economic recovery. Plus, a low interest rate environment would keep its margins under pressure. Wells Fargo’s unrelenting legacy mortgage issues also remain a concern. With the thrust of new banking regulations, there will be pressure on fees and loan growth could remain feeble.

Wells Fargo currently retains a Zacks #3 Rank, which translates into a short-term Buy rating. Considering the fundamentals, we also maintain a Neutral recommendation on the stock. Reflecting an upbeat sentiment post the release of the company’s results, the stock is trading at a premium.

Concurrent with Wells Fargo, JPMorgan Chase & Company (JPM) also kicked off the earnings season for the banking sector by reporting today. JPMorgan reported earnings per share of $1.21 compared with $1.27 in the year-ago quarter. Notably, its results included $4.4 billion in its Chief Investment Office’s synthetic credit portfolio.

All eyes are set on the next week when a host of the Wall Street big shots report their second quarter results. Among them, Citigroup Inc. (C) will report on July 16, while Goldman Sachs Group Inc. (GS) will report on July 17 and Bank of America Corporation (BAC) on July 18.

Read the full analyst report on “WFC”
Read the full analyst report on “AIBYY”
Read the full analyst report on “JPM”
Read the full analyst report on “C”
Read the full analyst report on “GS”
Read the full analyst report on “BAC”
Read the full analyst report on “IRE”
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