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.