Risk, Reward Balance Wells Fargo

We have reaffirmed our Neutral Recommendation on Wells Fargo & Co. ( WFC - Analyst Report ) based on its fundamentals and recent acquisitions.

Wells Fargo’s first quarter 2012 earnings of 75 cents per share were 2 cents ahead of the Zacks Consensus Estimate. Results improved both sequentially and year over year, primarily driven by a higher top line, attributable to solid mortgage banking and market sensitive revenues. It also reported $400 million (pre-tax) reserve release, driven by improved portfolio performance. However, an increase in operating expenses was on the downside.

At Wells Fargo’s annual investor day event held recently, management announced its return on assets target of 1.3% to 1.6% and 12% to 15% return on equity, subject to economic and regulatory environment. This is likely to support a shareholder payout ratio of about 50% to 65%.

Notably, Wells Fargo’s average return on assets between the first quarter of 2009 and 2012 is 1.12% and average return on equity for the same period is 10.97%. We believe its solid fundamentals would help it in achieving its target over time.

Moreover, with a strong capability to generate organic capital, Wells Fargo is well positioned for future attractive acquisition opportunities. In fact, its growth plans have historically included a large number of acquisitions, Wachovia being the largest addition in December 2008.

Moreover, since 2011, the company has completed six transactions which include both loan portfolio purchases as well as business unit acquisitions. Notable among these were the purchases of BNP Paribas North American Energy Lending, Burdale Financial Holdings Limited from Bank of Ireland Group ( IRE ) and EverKey Global Partners. These deals were completed in 2012. Wells Fargo also made loan portfolio purchases from Irish Bank Resolution Corp., Bank of Ireland and Allied Irish Bank in 2011.

Additionally, the company has agreed to buy San Francisco and New York City-based Merlin Securities LLC, and the deals are pending at this moment. The company plans to expand its operations in international markets and augment its asset management business.

Wells Fargo has come out of the financial crisis well and posted nine consecutive quarters of growth in earnings per share. Going forward, we believe that with a diverse geographic and business mix as well as opportunistic acquisitions, the company is well poised to augment its top line. Its stress test clearance, subsequent dividend hike and plan to increase share buybacks in 2012 also give a fillip to investors’ confidence.

Yet we believe the top-line headwinds will persist, given the protracted economic recovery. Plus, a low interest rate environment would keep its margins under pressure. Regulatory concerns and the company’s unrelenting legacy mortgage issues remain as overhangs.

As a result, we believe that the risk, reward profile for Wells Fargo is currently balanced and therefore reiterate the Neutral recommendation on the stock.

Wells Fargo currently retains a Zacks #3 Rank, which translates into a short-term Hold rating.