WFC – Expect Growth in Risk Assets to Limit Capital Leverage
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
October 19th, 2015
Re: WFC – Expect Growth in Risk Assets to Limit Capital Leverage
- Negative revisions of 2017 EPS at WFC will continue as analysts re-assess the embedded assumptions for operating and capital leverage. In particular, with no further scope for balance-sheet optimization, risk-weighted assets will grow more in-line with loans than over the last few years and limit the annual net payout ratio to 60% or less (versus the guidance range of 50-65%) by offsetting the benefit that arises as no further deleveraging is needed. As a result, we see the capital leverage implicit in 2017 estimates for a 2%+ reduction in the average stock count as unachievable.
- Deleveraging: WFC has increased the CET1 ratio, fully phased-in, to 10.7% from 10.4% at end-2014. Along with OCI losses, this is limiting the net payout ratio for FY2015 to <60% and it would have been lower had balance-sheet optimization not held RWA growth of 2% below loan growth of 7%. With optimization having run its course, the driver of capital-build shifts from deleveraging to RWA growth so that, again along with OCI losses and allowing for some preferred issuance, the net payout ratio will remain below 60%.
- We are a nickel+ below 2017 EPS consensus of $4.81 assuming in-line revenue growth of 6%, expense growth of 3.5% (so that operating leverage reduces the efficiency ratio from the current 58% to the low-end of management’s guidance range of 55-59%) and RWA-growth of 6% versus loan-growth at 7%. And there is more downside than upside risk to our estimate:
- Beyond non-conservative assumptions for operating and RWA leverage, the downside risk is on credit. Even assuming no meaningful deterioration in loss-performance and a reserve ratio at or about current levels, credit expenses increase ~50% in each of the next two years.
- The upside risk is on revenue but, with non-interest revenue unlikely to grow much more than 2%, consensus is already assuming a 10bps increase in net interest margin (from the GAAP level of 2.9% in 2015) in each of the next two years. This is achievable, even in the “lower-for-longer” rate environment envisaged by management, as the loan-to-deposit ratio rises (with deposit growth falling to 5% or less), but upside requires an earlier rate lift-off.
- Given negative EPS revisions, along with the ROA remaining at the low-end of management’s guidance range of 1.3-1.6% and no meaningful improvement in ROE from the current 13% towards the high-end of the 12-15% guidance range, we do not expect WFC to re-rate from the current 2.2x tangible book value of $23.5/share; this limits near-run upside to ~$5 being a couple of turns on the expected $2.3/share walk-forward increase in tangible book value through end-2016. We prefer C and BAC (see table below).
Consensus is calling for WFC to generate EPS growth of 7-8% in 2016 and 2017 on revenue growth of 6%. While the revenue is achievable even in a “lower-for-longer” rate environment envisaged by management, as a rising loan-to-deposit ratio lifts net interest margins and compensates for low growth in non-interest revenues, the implied operating and capital leverage look challenging. The reason is that, even with no meaningful deterioration in loss-experience, credit expenses will grow ~50% as the loan-loss allowance reverses from release-to-build in 2016 and then accumulates with continued loan growth in 2017. The result is a 2017 EPS-shortfall, albeit of only a nickel+ on consensus of $4.81 (see “EPS – $ SSR” in Exhibit 1), even if the efficiency ratio falls to the low-end of management’s guidance range of 55-59%. Given it currently stands at 58%, this would require significant operating leverage with expense growth held to 3.5% or below.
Exhibit 1: WFC P&L
Source: Company Reports, Capital IQ Estimates, SSR Analysis
Beyond lowballing preferred flows, consensus bridges the gap through capital leverage with average diluted shares falling over 2% in 2017. However, this requires a net payout ratio above the high-end of management’s guidance range of 50-65% along with increased leverage of the risk balance sheet (reducing the CET1 ratio, fully-phased, to 10.6% by end-2017 from 10.75% expected at end-2015). A key driver is increased growth in risk-weighted assets or RWA towards that of loan growth (forecast at 7%) from the 2% of 2015; the reason is that the scope limiting RWA growth through balance-sheet optimization has largely run its course. In assuming 6% growth in RWA we assume some ongoing optimization benefit but maintain the CET1 ratio at or about current levels. After allowing for OCI losses of $2bn along with some preferred issuance, these assumptions generate a net buyback in 2017 of just under $6bn reducing the end-of-period share count by 2% (see Exhibit 2) and the average share count by 1.1% versus consensus of 2.2%.
Exhibit 2: WFC Leverage and Payout
Source: Company Reports, Capital IQ Estimates, SSR Analysis
In summary, we expect negative revisions of 2017 EPS, which have fallen from $5.10 a year ago to the current $4.81, to continue. Along with ROA remaining at the low-end of management’s guidance range of 1.3-1.6% and no improvement in ROE from the current 13% towards the high-end of management’s guidance range of 12-15%, we do not expect WFC to re-rate from the current 2.2x tangible book value of $23.5/share; this limits near-run upside to ~$5 being a couple of turns on the expected $2.3/share increase in tangible book value through end-2016.
Note on Q3 Results
A feature of the earnings model at Wells Fargo is the use of the balance-sheet to stabilize reported results. For example, in the third quarter, there was a $2bn positive swing in other comprehensive income as the back-up in rates from the prior quarter reversed creating gains, rather than losses, in the securities portfolio. For context, this swing represents one-third of the $6bn net income for the quarter. And yet, the company delivered in-line results with a net payout ratio of 60%, right in the guidance lane of 55-65%.
This was accomplished through harvesting securities gains which came in $400mm higher than the quarterly run-rate for the first-half. The effect is to suppress the payout ratio (since realized gains flow through the earnings denominator) and allow the firm to absorb energy-related losses both as negative marks of $54mm on energy-sector investments (accounted for as other-than-temporary-impairment or OTTI) and an unspecified increase in reserves for energy-sector loans. The securities gains create stiffer compares for non-interest revenue which we model as increasing at 2% in 2016 and 2017 (versus less than 0.5% in 2015).
While card fees are growing nicely at 8-10% as WFC increases penetration of household accounts, they represent less than 10% of non-interest revenue (see Exhibit 3); over two-thirds of non-interest income, excluding trading and securities gains, is from three categories that, between them, we expect to limit growth: deposit service charges, trust and investment fees, and mortgage banking.
Exhibit 3: WFC Non-Interest Income
©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein. The views and other information provided are subject to change without notice. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, C, BAC, WFC, and GS.