Next week, Wells Fargo (WFC +0.20%) kicks off earnings season for the nation's biggest banks; here are four things investors should watch for when it does so on July 14th.
1. Earnings
Wells Fargo emerged from the financial crisis as one of the biggest and most profitable banks in America.
- It earned $23 billion over the last 12 months, beating even JPMorgan Chase, the nation's biggest bank by assets.
- Its quarterly earnings per share have increased on a year-over-year basis in 18 out of the last 19 quarters.
- And over the last four quarters, it's generated a 14% return on equity. This not only exceeds the typical bank's cost of capital, it's also leaps and bounds better than Wells Fargo's too-big-to-fail peers -- JPMorgan Chase, Bank of America, and Citigroup -- which earned between 3.8% and 10.7% on their equity over the same period.
Given this, the story line for Wells Fargo's quarterly results typically revolves around whether the California-based bank grew its earnings per share on a year-over-year basis. To have done so in the second quarter, it will have needed to earn more than $5.7 billion, or $1.01 per diluted share.
2. Lending margins
Although growing its quarterly earnings per share is the ideal outcome, investors needn't be dismayed if Wells Fargo comes up short for the second quarter in a row. I say that because it's suffering through unusually low lending margins.
One of the main ways banks make money is to borrow at low short-term interest rates from depositors and other institutional investors and invest the proceeds into higher-yielding assets, such as loans and government securities. In banking lexicon, this is known as interest rate arbitrage.
The profitability of this activity is dictated by the lending margin -- that is, the difference between what a bank pays to borrow money and what it yields from interest-earning assets. For an asset-sensitive bank like Wells Fargo, the key to maximizing the lending margin is higher short-term interest rates, as the majority of the bank's loans on the asset side of its balance sheet are indexed to the federal funds rate or the London Interbank Offered Rate.
Analysts look at a bank's net interest margin to gauge this, which is calculated by dividing a lender's net interest income by its earning assets.
The problem for Wells Fargo is that persistently low short-term interest rates have compressed its (and other banks') net interest margin, which, in turn, weighs on profitability. With the Federal Reserve hinting that it won't increase rates this year, investors should expect this trend to continue.
3. Trend in expenses
One of the reasons Wells Fargo's first-quarter earnings per share didn't grow compared to the year-ago period was because its expenses increased at a faster rate than its revenue. Higher regulatory and compliance costs pushed its operating expenses up 4.7% in the first three months of the year to $12.51 billion, from $11.95 billion in the first quarter of 2014.
The key metric in this regard is the efficiency ratio, which is the percent of a bank's net revenue consumed by operating costs. In my opinion, this is the single most important metric one should use when picking bank stocks. You typically want to see a ratio in the 50% to 60% range; that leaves enough revenue to pay taxes and set aside for future loan losses without sacrificing a double-digit return on equity.
In the first quarter, Wells Fargo's efficiency ratio was 58.8%. This falls at the higher end of the bank's 55% to 59% target range. While it'd be nice to see this figure begin migrating lower, investors shouldn't be surprised, or concerned, if that doesn't happen just yet.
CFO John Shrewsberry explained why on the company's first-quarter conference call:
Now is the time when there are big demands in information security and compliance and risk management, and so if we're finding dollars on the efficiency side of the ledger, we're reinvesting them either in products and services for our customers or in becoming best-in-class across all risk management aspects. So that's probably going to keep us here at the higher end of the range, unless we have a breakout in some revenue category or we have an increase in rates, which is fine.
4. Mortgage origination volume
Among Wells Fargo's 90-plus operating units, none is more important than its mortgage-banking division. Following its 2008 acquisition of Wachovia, as well as Bank of America's retreat from residential lending since the financial crisis, Wells Fargo has acquired a commanding share of the domestic market for home loans.
Last year, Wells Fargo originated $175 billion worth of mortgages. This was markedly less than its record $524 billion in 2012 -- the majority of which refinanced existing mortgages -- but it nevertheless handily exceeded the $78 billion in originations from runner-up JPMorgan Chase in 2014.
There isn't a target number investors should watch for in this regard. The objective is rather to simply see how Wells Fargo's mortgage originations are trending. And given that we're in the middle of the homebuying season, you'll want to watch its purchase-money originations to get a sense for the ongoing progress of the housing recovery. You'll be able to find this data on the second-to-last page of Wells Fargo's earnings release, which can be accessed here.
