WFC: Wells Fargo: Not Good Enough

Wells Fargo (WFC) has several structural problems that are affecting its performance, which justifies its discounted valuation and a re-rating of its shares may take some time to happen.

Major Hurdles

I’ve been bearish on Wells Fargo for the past three years, during a period in which the bank was clearly a laggard compared to other large U.S. banks both from an earnings perspective and share price return, with much of the underperformance coming in the last year.

As Wells Fargo is a retail-oriented bank, it relies more on revenues from interest rates, while its presence in corporate and investment banking is relatively small. This business profile made Wells Fargo more impacted by the Covid-19, but there are also fundamental issues that may continue to impact the bank’s performance in the near future.

Wells Fargo is one of the largest U.S. banks with close to $2 trillion in assets and around $1.4 trillion in customer deposits. The bank was the top deposit gatherer in the U.S., but its business has suffered in recent years following the disclosure of its sales practices in 2016 and, currently, JPMorgan (JPM) and Bank of America (BAC) have higher customer deposits in their balance sheets than Wells Fargo.

This is important because Wells Fargo’s business model is based on deep customer relationships and its strong brand, something that seems to have clearly deteriorated in the past few years. Indeed, during 2020 deposits have increased markedly for all large U.S. banks, with Wells Fargo being the laggard among this group.

On average, deposits increased by 28% year-on-year (yoy) for the other five large U.S. banks, while Wells Fargo’s deposit base was up by only 6.2%. This shows that Wells Fargo has had some difficulties in attracting new money, which has been one of its main competitive advantages compared to peers in the past. This clearly shows that Wells Fargo has lost to some extent its economic moat compared to its closest peers in recent years, which does not bode well for its earnings power in the near future.

Source: Wells Fargo.

As can be seen in the previous graph, due to the low interest rate environment, the average deposit cost was only 5 basis points (bps) at the end of 2020. Therefore, in the short-term the bank’s weakness in gathering deposits is not a big issue, but this may change a rising rate environment.

This may happen because customers are clearly more reluctant to make deposits at Wells Fargo, which means that in the future it should have to pay more than peers to attract new deposits, being an important headwind for its net interest margin (NIM). Additionally, competition is increasing from smaller players and new offers, such as Goldman Sachs (GS) from its Marcus online banking service.

In 2020, Wells Fargo’s NIM dropped to only 2.35%, the lowest point that I could see in the bank’s historical figures. This was a drop of 47 bps in one year, justified by a steeper decline in asset yields than on funding costs and a lower loan book.

Source: Wells Fargo

Given that I expect Wells Fargo to benefit less from rising rates in the future due to higher deposit beta than in the past, I don’t expect its NIM to recover to 2.80-2.90% in the coming years. Indeed, the bank even expects net interest income (NII) to be down in 2021, thus NIM is not going to recover in the next few quarters.

Source: Wells Fargo

Beyond margin headwinds, another big issue for the bank is the asset cap. Wells Fargo is assuming to continue to operate under the Fed’s asset cap in 2021, limiting its total assets to less than $2 trillion.

This was close to the level of the bank’s total assets at the end of 2016, which means that for the past five years Wells Fargo has not been allowed to grow its business. While Wells Fargo’s assets have been stuck at the same level for several years, its competitors continued to grow their size measured by total assets, making Wells Fargo less competitive.

For instance, JPMorgan’s assets amounted to $2.5 trillion at the end of 2016 and were almost $3.4 trillion at the end of 2020. This represents a compounded annual growth rate (CAGR) of 8.3% during this period, while Wells Fargo’s assets grow at only 0.3% CAGR during the same period. This has been another headwind for earnings growth at Wells Fargo and an asset cap removal is clearly key for the bank to improve its earnings power in the medium-term.

Another thing that fails to impress me is the bank’s strategy to concentrate its operations in banking operations. Wells Fargo has agreed recently with two private equity firms to sell its asset management unit, which has around $600 billion in assets under management. The price was somewhat low compared to recent deals in the asset management sector, but is justified by the bank’s strategy to focus its business on the core units.

However, this will increase even more the bank’s revenues reliance on interest rates, which together with its margin constraints doesn’t bode well for earnings growth in the near future. In 2020, NII accounted for 57% of Wells Fargo’s total revenues and with the sale of the asset management unit, which generates mainly non-interest income, the weight of NII is expected to increase in total revenues.

Recent Earnings

Regarding its most recent financial performance, Wells Fargo has been somewhat a laggard in recent quarters, due to its business profile that is much more focused on retail and commercial banking rather than capital markets activities.

Indeed, Wells Fargo has limited operations in investment banking, being therefore more exposed to consumer banking and overall economic activity than other large U.S. banks. This was clearly shown during 2020, with its peers being able to offset weaker results in their consumer banking units by better than expected results from investment banking. Taking this background into account, Wells Fargo reported the weakest financial trends in 2020 among large U.S. banks, being more hit by the Covid-19 than its closest peers.

On the top-line, Wells Fargo’s total revenues amounted to $70.3 billion in 2020, a decline of 12.4% yoy. This drop was mainly justified by lower interest rates, which had a negative impact on the bank’s NII and NIM like I have shown previously.

On the cost side the bank has been able to reduce its expenses, but in the past year Wells Fargo was again impacted by restructuring and litigation costs of close to $3.7 billion. Therefore, its total operating costs only declined by 0.9% yoy to $57.6 billion. This means that the bank had negative jaws in 2020 (revenue growth – cost growth), leading to a steep increase in the efficiency ratio (a higher ratio is bad).

Indeed, Wells Fargo’s efficiency ratio was 82% in the past year, compared to 72.5% in 2019. Even without considering extraordinary costs, the bank’s efficiency ratio was 77%, still a very poor level. This is the worst efficiency among large U.S. banks and way higher than JPMorgan, which had an efficiency ratio of 58% in the past year. Taking this backdrop into account, cost reductions are clearly key for earnings growth at Wells Fargo, with the bank expecting only a slight reduction in 2021 to around $53 billion.

Source: Wells Fargo

In the medium-term, the bank talks about several efficiency initiatives that can lead to gross savings of $8 billion, but assuming constant revenues and that net savings should be lower because the bank needs to invest in digitalization and technology, its efficiency ratio is not expected drop below 70% in the next 2-3 years.

Another factor that impacted markedly the bank’s earnings in 2020 was the increase in provisions due to the Covid-19, a trend similar to the whole banking sector. For the full year, provisions amounted to $17.5 billion compared to $5.5 billion in the previous year, showing a conservative approach by the bank in the first two quarters of 2020. In the last quarter the bank had a small amount of provision reversals, which may continue in 2021 if economic activity and asset quality remain robust.

Source: Wells Fargo

Taking into account the drop in revenues and much higher provisions, it’s no surprise that Wells Fargo’s bottom-line dropped to only $3.3 billion in 2020, a decline of 83% yoy. Its return on equity (ROE) ratio was only 1%, a level that was even lower than what the bank achieved in 2008.

Regarding its capitalization, Wells Fargo’s capital ratio was 11.6% at the end of 2020 and its leverage ratio was above 8%, thus the bank seems to be well capitalized and I don’t see any issues here, which means that the bank will continue to return capital to shareholders if the Fed allows it.

Conclusion

Wells Fargo has been a laggard and 2021 doesn’t seem to be a turning point for the bank, as margin pressure should continue and cost reductions aren’t ambitious enough. The recent increase in interest rates is something positive for the sector as a whole, but is not enough to change Wells Fargo’s fundamentals that much.

However, these weak prospects seem to be reflected in the bank’s share price, considering that Wells Fargo is trading at 0.93x book value compared to 1.30x for the U.S. banking sector. This discount is justified and I don’t expect a re-rating this year, thus I will continue to stay away from Wells Fargo for the time being.