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Wells Fargo Beats on Lower Expenses

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Wells Fargo & Company (WFC - Free Report) has achieved the eleventh consecutive quarter of growth in earnings per share by reporting earnings of 88 cents per share in third quarter 2012. Results improved from earnings per share of 82 cents in the prior quarter and 72 cents in the year-ago quarter. Also, it beat the Zacks Consensus Estimate by a penny.

Third quarter net income applicable to common stock came in at $4.7 billion, up 6.8% sequentially and 23.7% year over year.

Results at Wells Fargo benefited from improvements in non-interest income as well as cost control measures. The company experienced decline in non-interest expenses reflecting positive operating leverage. It also reported $200 million in reserve release (pre-tax), attributable to improved portfolio performance.

The quarter’s revenue came in at $21.2 billion, lagging the Zacks Consensus Estimate of $21.4 billion. Though revenue slipped 0.5% sequentially, it advanced 8.2% year over year.

Furthermore, segment-wise, on a sequential basis, Wholesale Banking reported a 3.3% fall in revenues while Community Banking and Wealth, Brokerage and Retirement segments reported rise of 0.2% and 2.0%, respectively.

Performance in Detail

Wells Fargo’s net interest income for the quarter came in at $10.7 billion, down 2.7% sequentially. Net interest margin dipped 25 basis points sequentially to 3.66%. With the pressure of low interest rate environment, income and margin were affected by decreased variable income, including purchased credit-impaired (PCI) loan resolution income.

Non-interest income at Wells Fargo came in at $10.6 billion, up 2.9% from the prior quarter. Higher market sensitive revenue, including a rise in trading gains associated with the deferred compensation plan investments offset in employee benefits expense primarily led to the augmentation in non interest income. Moreover, the rise was supported by higher deposit service charges, trust and investment fees and card fees.
As of September 30, 2012, total loans were $ 782.6 billion, ascending 1.0% sequentially. Growth in auto, credit card, private student lending, and commercial and industrial (C&I) loan balances contributed to this increase. However, it was partially offset by continued reduction in the non-strategic/liquidating portfolio. Average core deposits were $895.4 billion, up 7% (annualized) from the prior quarter.

Non-interest expense at Wells Fargo was $12.1 billion, down 2.4% from the prior quarter. Lower operating losses, reduced insurance commissions, low severance expense, and third consecutive quarterly reduction in foreclosed asset expense led to the fall in total expenses.

These were partially mitigated by higher deferred compensation expense offset in non-interest income and elevated occupancy as well as advertising costs. Efficiency ratio improved to 57.1% from 58.2% in the prior quarter and 59.5% in the year-ago quarter.

Credit Quality

Wells Fargo reported mixed credit quality trends in the quarter, affected by the implementation of the Office of the Comptroller of the Currency (OCC) guidance, which demands write-down of performing consumer loans restructured in bankruptcy to collateral value.

Wells Fargo’s allowance for credit losses, including the allowance for unfunded commitments, totaled $17.8 billion as of September 30, 2012, waning from $18.6 billion as of June 30, 2012. Provision for credit losses fell 11.1% sequentially to $1.8 billion in the reported quarter.
However, net charge-offs were $2.4 billion, or 1.21% (annualized) of average loans in the reported quarter, up from the prior quarter net charge-offs of $2.2 billion (1.15%). Nonperforming assets surged to $25.3 billion in the quarter from $24.9 billion in the prior quarter.

Capital Position

Wells Fargo maintained a solid capital position. The company purchased 17 million shares of common stock in the quarter. Moreover, it opted for an additional estimated 9 million shares through a forward repurchase transaction, which is expected to be settled in the fourth quarter of 2012.

As a result, Wells Fargo’s Tier 1 common equity under Basel I increased $4.1 billion sequentially to $105.8 billion, with Tier 1 common equity ratio of 10.06% under Basel I as of September 30, 2012. Moreover, its estimated Tier 1 common equity ratio was 8.02% under the latest Basel III capital proposals.

The Tier 1 leverage ratio was 9.45% as of September 30, 2012, up from 9.25% as of June 30, 2012. Tier 1 capital ratio was 11.66% as of September 30, 2012 compared with 11.69% as of June 30, 2012. Book value per share improved to $27.10 from $26.06 in the prior quarter and $24.13 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 Wells Fargo expand its 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. Notably, in the first half of 2012, the company completed three acquisitions with combined total assets of $4.5 billion.

Further, on August 1, the company completed the acquisition of a prime brokerage and technology provider with assets of approximately $280 million. In addition, it is capitalizing on the deleveraging activities of European banks.

Also, it has announced consecutive dividend increases over the past three years with the latest hike of 83.3% being announced in March 2012.

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 expected improvement in credit quality though at a slower pace, will support its profit figures. Its stress test clearance and subsequent dividend hike as well as its strategy 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 Hold rating. Considering the fundamentals, we also maintain a Neutral recommendation on the stock.

Concurrent with Wells Fargo, JPMorgan Chase & Company (JPM - Free Report) also kicked off the earnings season for the banking sector by reporting today. JPMorgan reported earnings per share of $1.40, beating the Zacks Consensus Estimate of $1.20 as well as prior-year quarter’s earnings of $1.02 per share.

All eyes are set on the next week when a host of the Wall Street big shots will report their third quarter results. Among them, Citigroup Inc. (C - Free Report) will report on October 15, while The Goldman Sachs Group Inc. (GS - Free Report) will report on October 16 and Bank of America Corporation (BAC - Free Report) on October 17.

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