Regional Banks – WFC: Rising Net Interest Margin Will Lift 2015 EPS Estimates

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

September 16, 2013

Regional Banks – WFC: Rising Net Interest Margin Will Lift 2015 EPS Estimates

  • We expect WFC to generate 2015 EPS of $4.40 versus consensus of $4.25 as the net interest margin expands from 3.4% for Q2 to 3.7% for 2015. With forward rates for 6-month Libor in mid-2015 at 1.6% versus 0.4% today, and an expected 50 basis point steepening of the curve out to 3-year swaps, WFC will gain more value from its deposit franchise and have improved reinvestment opportunities.
    • Despite positive management comments, we do not assume further improvement in credit, or expense leverage versus asset growth.
    • Given slowing mortgage originations, we expect non-interest income to remain flat through 2013 and increase less than 2% in 2014 before growing in line with earning asset growth of 5% in 2015.
  • Our 2015 EPS estimate is supported by flat reserves in 2015 (given WFC presently appears over-reserved) and by stock buyback of $6 billion and $7.5 billion in 2014 and 2015 respectively, for a total payout ratio in the high 50’s.
    • WFC guides to ROA of 1.3-1.6%, ROE of 12-15%, and a payout ratio of 50-65%. This guidance is consistent with higher leverage and, in particular, with an equity/assets ratio of 10.8% versus 11.4% today. This means our stock buyback forecast does not preclude further dividend increases and, if the dividend is not increased, could prove conservative.
  • We believe higher margins and capital returns, along with over-reserving, will create rising earnings estimates for regional banks in general. WFC is our favored play because its margins have been particularly suppressed by balance-sheet flows (strong deposit growth and weak loan growth) which will normalize with interest rates and the economy.

Overview

Over the last 60 days, 2015 EPS estimates for WFC have remained relatively stable at around $4.25 despite a meaningful change in the interest rate environment: for mid-2015, the forward rate for 6-month Libor is up 40 basis points to 1.6% at the same time that the forward yield curve has steepened slightly (with the spread between the 3-year swap rate and 6-month Libor increasing 10 basis points).

We believe this rate environment will lift the net interest margin at WFC by 30 basis points from 3.4% in Q2 2013 to 3.7% in 2015, equal to the result reported in 2012. Each 10 basis point increase in the net interest margin raises 2015 EPS by 17 cents, and our 2015 EPS estimate is $4.40. The estimate does not make aggressive assumptions for other elements of the income statement (see Exhibit 1). In particular, it assumes:

  • no decline in credit losses from current levels (despite positive commentary from management on the benefit to credit of a strengthening housing market);
  • no improvement in loan growth from the 3-4% of 2013;
  • no expense leverage relative to asset growth;
  • fee yields (i.e. non-interest income as a proportion of earning assets) decline 10 basis points in 2014 with less mortgage refinance activity, and stabilize into 2015.

Exhibit 1: WFC Model for 2015 EPS

Beyond the net interest margin, however, both reserve dynamics and stock buyback lift 2015 EPS. The reserve dynamics are driven by positive credit trends as articulated by CFO Tim Sloan: “home price have increased affordability and affordability remains very attractive. We’re seeing improvements throughout the economy, including job creation, lower household debt, and increasing consumer confidence, and these positive economic trends are clearly benefitting our credit results.” Below, we provide more detail on our reserve and buyback assumptions:

  • Reserves: WFC appears meaningfully over-reserved with the reserve coverage ratio (i.e. reserves over net credit losses) at 3.3x and expected to fall to 3.1x by year-end given guidance for a reserve-release of at least $500 million in Q3. Even this, however, is higher than at any other time over the last decade including in 2008 when the ratio was 2.7x. As a result, we expect a further small reserve release in 2014 and reserves to be approximately flat, despite loan growth, in 2015.
  • Stock Buyback: CFO Sloan has said WFC expects to achieve its target Tier 1 capital ratio of 9% (including a buffer of 100 basis points to allow for expected reductions in unrealized securities gains as rates rise) in the next couple of quarters provided there is no significant backup in rates. At that point, excess capital is available for stock buyback and we expect WFC to significantly increase the buyback amount in 2014 to 2015. Our specific forecast is for $6 billion buyback in 2014 and $7.5 billion in 2015 with corresponding total payout ratios in the high 50’s versus the maximum guidance level of 65%.

Risk

A risk to our forecast is that loan growth is stronger than we forecast. For example, if loan growth comes in at 5% over the next two years, then our 2015 EPS estimate falls to $4.35 from $4.40 because of the need to establish reserves up-front while profits accrue over time. Indeed, our assumption for low loan growth pushes the return on assets in 2015 to the high-end of WFC guidance for 1.3-1.6%. Guidance included an ROE range of 12-15% and payout ratio of 50-65% which implies leverage could increase so that the equity/assets ratio falls to 10.7% from 11.5% in 2015 in our model. In turn, this suggests stock buyback could exceed our forecast; if the dividend is not raised, a maximum payout ratio of 65% corresponds to stock buyback of $8 billion and $9 billion in 2014 and 2015 respectively lifting 2015 EPS to $4.45.

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