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Falling Rates and Legal Costs Weigh on Wells Fargo's Profits

By Matthew Frankel, CFP® - Oct 15, 2019 at 10:41AM

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Wells Fargo's earnings didn't quite live up to expectations, but there's more to the story.

Earnings season kicked off with a barrage of bank stock earnings, and Wells Fargo (WFC 2.08%) was among the first to report its third-quarter results. While the bank's revenue was certainly impressive, a significant decline in profitability is weighing on the stock.

Having said that, there's more to the story than just the top- and bottom-line figures. Here's a rundown of the bank's numbers, why profitability declined, and what investors should know about the bank's performance.

Strong revenue but weaker earnings

As far as the headline numbers go, Wells Fargo's third quarter was a mixed bag. Revenue of $22.0 billion handily exceeded estimates of $21.19 billion. On the bottom line, however, earnings of $1.07 per share came in $0.08 shy of expectations, and overall net income fell to $4.6 billion from $6.0 billion in the same quarter a year ago.

Exterior of a Wells Fargo branch.

Image source: Wells Fargo.

When a company generates more revenue than anticipated but still falls short on earnings, it means that there was a big drop in profitability. Of course, the headline numbers don't tell us why this was the case.

Digging a little deeper

To try to figure out why Wells Fargo's profitability wasn't quite up to par, let's take a closer look. There's a lot to unpack in the company's earnings report. Here are some of the most important takeaways.

Wells Fargo's net interest margin (NIM) was 2.66%, 28 basis points lower than it was a year ago and a fairly sharp decline from 2.82% in the second quarter. This isn't exactly a surprise, given the falling-rate environment of the third quarter, but it is one of the main drivers of falling profits. In fact, net interest income fell $947 million compared with the same quarter a year ago.

The bank also reported a $1.6 billion legal charge for the quarter, stemming from the numerous scandals of the past few years. This reduced earnings by $0.35 per share all by itself, which was partially offset by a $0.20-per-share gain from the sale of Wells Fargo's Institutional Retirement and Trust business.

Thanks to these items and a few others, Wells Fargo's return on equity (ROE) and return on assets (ROA) fell to 9% and 0.95%, respectively, well short of the 13.3% ROE and 1.31% ROA it produced in the second quarter.

With all of that in mind, it's important to point out that the report wasn't entirely negative. On the positive side of things, there are a few points investors should know:

  • Wells Fargo's deposits and loans grew by 2% and 1%, respectively. This doesn't sound like excellent growth, but given the economic uncertainty in the U.S. as well as the Federal Reserve's growth limitation on the bank, it is pretty strong.
  • Asset quality remains strong as well. Net charge-offs and nonaccrual loans are actually down year over year, although the bank is setting aside more money to cover any future losses.
  • Wells Fargo is buying back stock at an aggressive pace. The number of outstanding shares is down 9% from the end of the third quarter of last year, and with the current buyback authorization, this trend should continue into 2020.

The takeaway from Wells Fargo's third quarter

Falling interest rates hurt Wells Fargo's profitability in the third quarter, and the continued legal impact from the bank's scandals certainly didn't help either. The bank's business appears to be doing well, however, with a reasonable level of loan and deposit growth and strong asset quality.

As a final point, don't forget that Wells Fargo has been without a CEO for some time, but that is changing in the fourth quarter. New CEO Charles Scharf takes the helm on Monday, Oct. 21, so it'll be interesting to see how the transition plays out.

Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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