Wells Fargo (WFC 1.35%) recently reported second-quarter earnings that didn't live up to investors' already modest expectations.
In this clip from Industry Focus: Financials, host Michael Douglass and Fool.com contributor Matt Frankel give an overview of the bank's second-quarter results and what they mean for investors.
A full transcript follows the video.
This video was recorded on July 16, 2018.
Michael Douglass: Let's start by talking about, arguably, the loser of the bunch. Folks who have been listening to Industry Focus for a while know that's going to be Wells Fargo.
Matt Frankel: Yeah. This shouldn't come as too much of a surprise to anybody. First of all, Wells Fargo is not allowed to grow right now. They have a big Federal Reserve penalty hanging over them, and it's indefinite in time frame, that says they're not allowed to get any bigger than how big their assets were at the end of 2017. While some of the other banks saw really impressive loan growth, deposit growth, which we'll get to in a minute, we didn't see any of that with Wells Fargo, understandably so. In fact, they're scaling back a little bit to make sure they don't violate the Federal Reserve's penalty and grow. Deposits were down 2% from last year. Loans were down 1%.
This is really troubling to investors, because this is arguably the best time for bank growth in the past two decades. Going a little deeper, Wells Fargo historically has been the most profitable of the Big Four banks. Now, they're No. 3 in terms of return on assets and return on equity. Efficiency, they are the absolute worst with a 65% efficiency ratio. That means they spent $0.65 to generate every dollar of revenue. None of the other three got over 60% in that category.
Douglass: Let's unpack that a little bit. A reminder for folks -- the efficiency ratio is essentially, you want a lower number. Generally speaking, you want under 60% where possible, but always lower. So, something at 65%, particularly Wells Fargo, which has historically been so good, is a very bad sign.
Also, let's talk about the elephant in the room here for a minute: tax reform. Tax reform has been a big benefit to the big banks. We'll talk more about that with each of them. With Wells Fargo, return on equity and return on assets got worse year over year. That's an incredibly bad sign, given that tax reform freed up all kinds of extra cash that they would have otherwise had to pay up to the government.
Frankel: To be fair, they had about a $500 million charge that reduced earnings in the second quarter, but it wasn't nearly enough to depress profitability that much.
The other thing with Wells Fargo, there is some good news. It's mainly because their price is so low. First of all, they finally saw some interest margin expansion. They've been lagging the other three since interest rates started to rise. Everyone else's profit margins started to rise a little bit along with it. We finally started seeing that with Wells Fargo this quarter.
The other thing is, because their share price has underperformed the banking sector so much, it's actually a really good deal when it comes to buying back shares. Wells Fargo just got approved from the Federal Reserve for a massive buyback over the next year. They're actually set to buy back about 9% of their outstanding shares at the end of the year. Even if they're not allowed to grow, 9% is actually a pretty decent return for a big bank to give back to investors in one year.
Douglass: Yeah. Not surprisingly, Wells Fargo is continuing to struggle. We have covered, fairly exhaustively, most of the brand and operational issues at this massive bank over the past couple of years. I think the key question to investors moving forward, thinking about not this year or this quarter but next year, two years from now, ten years from now, is whether right now represents a trough, at which point, the stock is a great buy; or if this represents a new normal because they've cut out of some of that aggressive cross-selling culture because it led to all of that cheating that got them in so much trouble in the first place.
For me, that's very much an open question. That's why I'm very firmly on the sidelines with Wells Fargo and intend to remain that way. That may mean that I miss out, personally, on a great turnaround story one day. For me, I'm OK with that, because I think there's so much execution risk that I would rather deploy my money elsewhere.
Frankel: I think there's a lot of long-term potential in the banking industry elsewhere that doesn't involve the same kind of wait-and-see mentality.
