Wells Fargo Beats Expectations, Yet Warning Signs Arise

Earnings season for the banking sector stocks is typically a reliable indicator, a window perhaps, into the state of economic affairs and how the industry that "does" money is positioned as the banks reflect their future outlooks in their operations and financials. In the case of Citigroup C and JP Morgan Chase & Co JPM, the focus seems to be on making sure there is enough liquidity to go around amid the recent liquidity crises and even flat-out collapses in regional banks, with a further decline in revenues from investment banking businesses.

A common theme around investment and commercial bank hybrids is the accelerated revenue derived from the consumer sector. More credit card lines are currently outstanding, and loan areas like mortgages push interest income at these institutions.

Wells Fargo & Company WFC has joined the financial sector party, beating revenue expectations and signaling similar developments as its peers. However, the good news did not come alone this time, as changing cash balances and increasing expenses deprived the stock of rallying on the news like other banks did.

The Good, The Bad, The Ugly

Wells Fargo reported higher than expected net interest income (NII) in the first quarter of 2023 of USD 13.3 billion translating to an increase of 45% from the previous year. The revenue increase can be attributed to the variety of sources under which the bank operates, such as consumer banking and lending, commercial banking, corporate and investment banking, and wealth and investment management. 

While consumer banking and lending delivered 9% revenue growth overall, the bulk of the push came from small business banking seeing a 28% increase in revenue stemming from higher interest rates on small business loans and lines of credit. Personal credit card revenue increased by 3% as overall balances increased for the bank, an industry trend, as it seems. What lagged for the consumer banking and lending business was the home lending and auto loan space, bringing revenue declines of 42% and 12%, respectively.

The declines are not bank-specific, as consumers may have postponed a possible home purchase amid rising mortgage interest rates and inflation fears. Auto loans decreased as the supply chain for new vehicles tightened in the past year, causing the used-vehicle market to become unaffordable for many consumers.

For the commercial banking and corporate investment banking segments, it was nothing but good news for the bank. Revenues increased by 42% in commercial banking, driven by higher balances and interest rates on middle-market banking activity and asset-backed lending.

For the corporate and investment banking business, Wells Fargo saw a 41% revenue bump attributed to, once again, higher balances and interest rates though this time, treasury management had a fair share of the action; trading activity amid market volatility delivered 53% revenue growth within this business as a cherry on top for investors. 

Wealth and investment management was the only business that reported a revenue decline, still only 2%. Despite a 31% increase in net interest income for the business, the 2% overall revenue decline is attributed to a 32% decline in overall deposits, driving a subsequent 11% contraction in non-interest revenue when customers chose to place their funds in higher-yielding alternatives.

Loan Level Data, Rising Expenses

An 8% decline in firmwide deposits has caused the bank's loan-to-deposit ratio (typically within 65-70% for a bank) to increase from 60% in 2020 to a high of 69% in the first quarter of 2023, which stands higher relative to competitors like Citigroup and Bank of America BAC which both carry a loan-to-deposit ratio below 50%.

A higher loan-to-deposit ratio not only places a ceiling on the potential interest income that the bank can generate on loans (a lower ratio can effectively allow banks to generate more loans) but also places some pressure on the leverage the balance sheet is carrying. 

The bank has added USD 643 million to its provision war chest dedicated to loans that could turn south; this can be a potential sign of a negative future outlook on the assets currently held in the bank's balance sheet. Moreover, net charge-offs increased by 17% year-on-year to a 0.26% net loan charge-off ratio, up from just 0.14% a year ago. The increase in provisions, alongside evidence of increased net charge-offs, is enough to cause Wells Fargo stock to decline by nearly a percentage point in today's trading session despite an overall expectations beat. 

Expenses for the quarter totaled USD 13.7 billion, slightly higher than the figures analysts were expecting to see from the report. The cost increase brought the bank's total efficiency ratio to 66% in the quarter. An efficiency ratio, computed as non-interest expenses divided by interest and non-interest income, can be taken as a measure of profitability where a smaller percentage equates to a more profitable banking operation.

The article "Wells Fargo Beats Expectations, Yet Warning Signs Arise" first appeared on MarketBeat.