Thursday, January 16, 2014

Wells Fargo's 2013 Results

Here's a quick summary of Wells Fargo's (WFC) latest earnings:

Full year 2013
- Net income: $ 21.9 billion, up 16 percent from 2012
- Diluted earnings per share: $ 3.89, up 16 percent
- Revenue: $ 83.8 billion, down 3 percent
- Return on Equity (ROE): 13.87%, up 92 basis points
- Annualized net charge-offs as a % of average total loans were less than half than the previous year
- Average loans increased to $ 805.0 billion from 775.2 billion
- Average core deposits increased to 942.1 billion from 893.9 billion

Net interest margin continued to decline from 3.76% at year end 2012 compared to 3.39% at the end of 2013. In a vacuum that naturally is not be a good thing but, in the context of the current interest rate environment and relative to competitors, they continue to do just fine. Net interest margin remains a real relative advantage for Wells compared to other large banks which directly contributes to the bank's more than solid ROE.

One way to look at their performance overall since the financial crisis is that, despite that narrowing net interest margin and the year over year decline in revenue, they just earned $ 3.89 per share compared to $ 2.47 in their peak earnings year leading up to the financial crisis.

In contrast, some other large financial institutions are still earning only a fraction per share of what they earned prior to the crisis or, well, had a far worse fate.

I think it is fair to say that the decline in net interest margin is hardly surprising considering the current interest rate environment.

Any improvement to this environment could favorably impact net interest margin and, ultimately, Wells Fargo's overall earnings power. The good news for shareholders is the bank is doing just fine even if that does not occur anytime soon.

Of course, inevitably, the economic environment will erode some time down the road. When (not if) that time comes, what will matter is whether the bank is capable of handling it. That comes down to things like pre-tax pre-provision profit (PTPP)*, making quality loans, along with sufficient liquidity and capital.

The diluted average share count did decline in 4Q 2013 compared to 3Q 2013 due to buybacks (from 5,381.7 billion to 5,358.6 billion). We'll see if this continues. They did say in their news release that additional shares were bought back through a forward repurchase transaction that's expected to settle in 1Q 2014.

Net interest income after provision for credit losses increased to $ 40.5 billion from $ 36.0 billion, the biggest driver of the increase to earning in 2013. Net interest income was actually slightly down year over year but the reduction in provision for credit losses was substantial. This, more than anything else, was a key driver of the 2013 earnings increase.

Noninterest expense declined to $ 50.4 billion from $ 48.8 billion.

This also partly accounts for the increase to earnings.

On the other hand, noninterest income declined from $ 42.9 billion to $ 41.0 billion. This was the biggest hit to earnings and was driven by a decline in mortgage banking. It should be noted that 2012 was an elevated year for mortgage banking activity compared to 2011 and 2010. In fact, the noninterest income not related to mortgage banking were, in total, actually higher year over year.

With these 2013 earnings in mind, consider the following comments about Wells Fargo by Warren Buffett in the 2012 Berkshire Hathaway (BRKa) shareholder letter. In the letter, Buffett explains the "'non-real' amortization charge" that burdens Wells Fargo's earnings:**

2012 Berkshire Hathaway Annual Report

"...serious investors should understand the disparate nature of intangible assets: Some truly deplete over time while others never lose value. With software, for example, amortization charges are very real expenses. Charges against other intangibles such as the amortization of customer relationships, however, arise through purchase-accounting rules and are clearly not real expenses. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when calculating earnings – even though from an investor's viewpoint they could not be more different."

He later adds the following:

"A 'non-real' amortization charge at Wells Fargo, however, is not highlighted by the company and never, to my knowledge, has been noted in analyst reports. The earnings that Wells Fargo reports are heavily burdened by an 'amortization of core deposits' charge, the implication being that these deposits are disappearing at a fairly rapid clip. Yet core deposits regularly increase. The charge last year [2012] was about $1.5 billion. In no sense, except GAAP accounting, is this whopping charge an expense."

So there may be actually be more earnings power --  economically speaking, even if the accounting indicates otherwise -- at Wells Fargo than meets the eye.

In any case, what Wells Fargo does in any particular quarter -- or, for that matter, any particular year -- just is not that interesting. It may be for traders, it shouldn't be for long-term owners. Similarly, when and by how much interest rates will be up or down isn't something I'm going to try and figure out. Sometimes the environment will be favorable; sometimes it will not be.

What really counts -- since the environment inevitably oscillates between being more and less favorable -- is whether a banking franchise is likely to produce attractive relative and absolute results at less risk over the long haul. The focus is on whether the moat will remain wide (better yet, can it be widened?), smart management of risk, and the long run trend of normalized earning power.***

Banking is by its very nature a very leveraged institution (even if less so these days). The real question with any investment but especially leveraged institutions is whether it has been built to be resilient during times of severe -- especially if systemically destabilizing -- economic stress.

As some learned the hard way during the financial crisis, funding sources for leveraged institutions must remain stable; liquidity plentiful. A bank can look or even be profitable but that won't matter much if suddenly the balance sheet comes under real pressure.

The only thing worse than being forced to raise capital when prices are least favorable for owners, is seeing funds leave, en masse, and being unable to raise capital in a timely manner from other sources.

Quality management will do smart things during the good times that anticipates the not-so-good times.

Adam

Long position in BRKb and WFC established at much lower than recent prices. 

* Pre-tax pre-provision profit (PTPP) -- net interest income, noninterest income minus noninterest expense -- is the first line of defense for any bank against credit losses. Otherwise, those losses begin impacting the balance sheet (i.e. allowance for loan losses and/or shareholders' equity balance). PTPP is a useful measure of a bank's ability to generate sufficient capital to cover credit losses during the worst part of a full credit cycle. Morningstar provides an explanation here (page 3). Strong PTPP relative to assets (and equity) isn't just about the potential for greater returns. It's not just about the upside. To me, what is far more important is that strong core earnings provides greater capacity to absorb credit and other losses that will inevitably arise at some point during a credit cycle even for the highest quality bank. Knowing that pre-tax, pre-provision capacity to earn is strong reduces at least one form of risk (among many others). 

** see pages 12-13 of the letter.
*** Some might be tempted to trade around the environment based upon how more or less favorable it seems. Best of luck. I mean, no doubt there are exceptions who actually do this successfully, but an approach based upon the exception seems more than just a bit unwise to me.
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