WFC: The Bull Case by the Numbers
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
May 29, 2014
WFC: The Bull Case by the Numbers
- With WFC “at or near” its target capital model (bar some preferred issuance to meet liquidity requirements) and easing of two of the three margin headwinds (from the liquidity build and negative re-pricing of assets), the bank is well positioned to improve profitability and capital return. In particular, the rate back-up indicated by forward markets (with 6ML to 1.5% in mid-2015 from 0.3% today and 3YS to 2.4% from 0.9%) lifts the net interest margin by 10-30bps from today’s 3.2%.
- By 2015, we expect the third margin headwind to abate as growth in loans and deposits converges to 5-6% (vs. 4% and 9% respectively in 2014) so that the loan/deposit ratio will stabilizes at 74% (vs. 76% today and 90% in early 2011).
- Each 10bps increase in NIM is worth 20 cents on 2015 EPS (given earning assets of $1.5tn, a share count of 5.2bn, 32% tax rate, and no marginal cost).
- We do not believe the nickel raise in 2015 EPS consensus to $4.30 over the last 90 days is enough, and are publishing $4.45 largely on a $1bn revenue beat (vs. consensus of $88bn). Our key forecasts (NIM of 3.25% vs. 3.15% in 2014 and 3% growth in non-interest revenue as mortgage banking stabilizes) are not aggressive, and we use the low end of the 55-75% target range for net payout corresponding to a share count reduction of 80-90mm in each of the next two years. Risks:
- Credit: Our 2015 model has a $1.7bn swing in reserves (to a build of ~$500mm) as the net loss ratio stabilizes at today’s 0.4% and the reserve-to-loan ratio comes in 15bps and 5bps in 2014 and 2015 to end the year at 1.45%. The ratio is hard to forecast and EPS is sensitive: with loans of $900bn, each 5bps is worth 5-6 cents.
- OCI: Negative marks in a rate back-up on the $250bn investment portfolio (almost entirely AFS), beyond the $1.5bn assumed in 2015, can pinch the payout. WFC has raised its CET1 target to 10% from 9% in 2012 to build a buffer for this (as well as the Fed estimate for loan losses under CCAR stress) so the equity hit could be offset by an increase in leverage vs. our assumption that equity-to-assets is flat at today’s 11.2%.
- Efficiency: There is no cost associated with rising NIM so that efficiency improves; in 2015, we model a $5bn increase in revenue and $1bn increase in expenses (vs. declines of this or more in 2013 and 2014). The resulting positive operating leverage in 2015 (revenue up 6%, expenses up 3%) drives the efficiency ratio down to the low-end of the 55-59% guidance range vs. 58% today; however, management may choose to reinvest more than we expect.
- At $50 or 2.1x TBV/share of $24.2, WFC is trading in-line with our valuation regression given the tangible ROE of 18% (see Exhibit), and we see this as flat through 2015. However, there is upside beyond the $7 implied by accretion of tangible book value to $27.7/share at end-2015 (plus the 2.8% dividend yield). This is because rising margins over declining transactions costs will raise the ROE from the low- to high-end of the 12-15% guidance range (17%-20% on a tangible basis) for a re-rating to 2.3x TBV corresponding to a share price of $60-65.
- Net Interest Margin: The near-run stabilization of margins is largely due to balance-effects as deposit and loan growth converges so that there is reduced headwind from a mix-shift to the liquidity and investment portfolios. While this improves ROA, it does not materially lift ROE because these portfolios attract little capital. However, in 2015 and beyond, the margin driver shifts to positive re-pricing of the balance sheet, and this does lift the ROE. In 2015, the effect is masked by a swing from reserve-release to reserve-build but it will come through in the out-years. Even allowing for a tougher regulatory and competitive environment, there is a great deal of headroom; over the last 15 years, WFC’s average NIM is 4.7% vs. 3.2% today.
- Transaction Costs: From 2011 to 2013, WFC reduced its cost-to-serve by 14% per transaction. We expect this to accelerate as customers shift to digital channels (both mobile and self-serve in-store) leading to reconfiguration of the branch network for increased capacity at lower cost (e.g. branches that are one-third of today’s typical 3,000 square feet and run at 40% of the operating cost). Our note of April 23rd, “Mobile Banking Will Increase Scale Economies”, addresses the theme; the impact for WFC is that we expect the guidance range of 55-59% for efficiency to be revised down, and 1.3-1.6% for the ROA to be revised up, at the next biennial Investor Day.
Exhibit: TBV Regression for Bank Valuation
We expect WFC to grow revenues at 6% in 2015 (vs. flat in 2014) delivering $89bn vs. consensus of $88bn and driven by an 10 basis point increase in (tax-equivalent) net interest margin to 3.25% along with a 3% increase in non-interest income as mortgage banking stabilizes – see Exhibit 1. While there is a credit offset as reserves swing from a 2014 release of $1.2bn to a 2015 build of ~$450mm, we still expect a 15 cent beat vs. EPS consensus of $4.30. Appendix A1 provides the full earnings model.
Exhibit 1 – WFC: Return to Revenue Growth in 2015
The shift in earnings dynamics to revenue growth from reserve-release improves quality and operating leverage, particularly since there are no expenses associated with rising net interest margins, and we expect the efficiency ratio in 2015 to fall from 58% currently to the low-end of the guidance range of 55-59%; this will still allow for non-interest expenses to grow 3% vs. declines of 2-3% in 2013 and 2014. In the out years, we expect positive operating leverage to be sustainable as the net interest margin continues to normalize with the rate environment (the 15-year average margin for WFC is 4.7% – see Exhibit 2) and as the cost-to-serve declines with customer migration to digital channels (discussed in a note of April 23rd titled “Mobile Banking will Increase Scale Economies”).
Exhibit 2 – WFC: Net Interest Margin History
The forecast increase in net interest margin arises as the balance sheet re-prices in a more favorable rate environment and as headwinds abate from balance mix-shifts:
- Re-pricing: WFC has indicated that the negative re-pricing associated with the decline in rates since the financial crisis is now largely complete. Going forward, the implied curve is indicating a meaningful improvement in rates with 6-month Libor at 1.5% by mid-2015 (vs. 0.3% today) and 3-year swaps at 2.4% (vs. 0.9% today). As discussed in a note of March 6th, titled “The Dynamics of Net Interest Margins at Selected US Banks”, we believe there is a disconnection with the pricing of bank stocks, particularly WFC which will see assets re-price faster than liabilities to a greater extent than other banks given its relatively rate-insensitive deposits. For example, as shown in Exhibit 3, the liquidity portfolio now represents 15% of earning assets (vs. just 5% two years ago) and generates a yield of only 0.3%; re-pricing to 1.5% in 2015 will add nearly 0.2% to the aggregate net interest margin.
- Balance Mix-Shift: Deposits are currently growing at 9% vs. 3-4% for loans compressing margins as the excess are deployed into the low-yielding liquidity portfolio. The headwind will abate in 2014 as WFC has now met regulatory liquidity targets and will deploy more deposits to the relatively higher yielding investment portfolio, and cease to be meaningful in 2015 as loan and deposit rates converge to 5-6%. Loan growth will converge up as legacy portfolios complete their run-off, and deposit growth will converge down as consumers respond to higher short rates by shifting funds from bank deposit accounts to money-market savings accounts.
Exhibit 3 – WFC: Growth in Liquidity Portfolio will flatten in 2015
Rising Net Payout Ratio
WFC has been buying back stock at reasonable rate with share repurchases of near $4bn in 2012 and $5.4bn in 2013, but the benefit has been largely offset by stock issuance. For example, in 2013, WFC sold $2.7bn of Treasury stock, converted preferred stock into $1bn of common shares, and incurred $725mm of stock-incentive compensation expense; net of these and other items, share repurchases were only $1.1bn.
On Tuesday last week, WFC guided to a net payout ratio of 55-75% and we find the low-end of this range consistent with maintaining the current accounting leverage (i.e. an equity-to-assets ratio of 11.2%) over the next two years given consensus EPS estimates, 5-6% growth in the balance sheet, and a $1.5bn hit to equity in 2015 (zero in 2014) through other comprehensive income as rising long rates reduce the fair value of AFS debt securities. As shown in Exhibit 4, these assumptions correspond to a net buyback of $5bn in each of 2014 and 2015 so that the share count falls 3.3% to 5,087mm by end-2015.
Exhibit 4 – WFC: Expect Net Buyback of $5bn in each of 2014 and 2015
Note: To the (typically not meaningful) extent the declared dividend is credited to paid-in capital rather than cash, the dividend payout is overstated and net buyback understated. In 2013, the error is 4 basis points with the declared common dividend of $6,169mm being split $6,086 paid to shareholders and $83mm credited to capital.
Our more complete WFC model is included in the Appendix: Earnings and Profitability (A1); Balance Sheet and Payout (A2); and Earning Assets and Net Interest Margin (A3).
A1: WFC – Earnings and Profitability
A2: WFC – Balance Sheet and Payout
A3: WFC – Earning Assets and Net Interest Margin
- 6ML is 6-Month Libor and 3YS is 3-Year Swaps
- We are arguing not for a return to the 15-year average but that the rate back-up indicated by the 2015 forward curve is the early stage of renormalization. For example, the forward rate for the 10-year Treasury is 3% while 5% would be more normal.
- The “earning liquidity portfolio” comprises fed funds sold, “repo” securities purchased under resale agreements, and other short-term investments.
- Run-off amounted to $13.7bn in 2013 reducing loan growth by 1.7%.
- We recognize that regulatory, rather than accounting, capital (and particularly the CCAR stress-tests on the leverage ratio) are the binding constraint on the return of capital to shareholders but nonetheless do not expect WFC to need to reduce accounting leverage.