Is Wells Fargo Earnings Power Sustainable?

Is Wells Fargo Earnings Power Sustainable?

December 16, 2009
by Shane Parrish

Shane Parrish gives a qualified yes to this banking giant.

Here’s how to answer that: Yes, but not 100% certain. 
 
Wells Fargo has the best competitive position among retail banks. They have the number one position in U.S. banking stores, small business lending, mortgage originators, agricultural lending, and middle market commercial banking, and the number two position in banking deposits, debit cards, retail brokerage, bank-branded mutual funds and they are currently number four in wealth management.  
 
Wells Fargo also has some of the most competent managers in banking. Unlike Sandy Weill who passed the Citicorp baton to ass-kisser Chuck Prince over Jamie Dimon (for all of the wrong reasons), Richard Kovacevich, the former CEO, chose the strongest candidate to succeed him in John Stumpf.
 
Industries can be boiled down into a few key variables. For banking, one is the net interest margin, the difference between income generated from lending money and interest paid for borrowing money. Wells Fargo has the highest net interest margin in banking at 4.36%, ahead of PNC 3.76%, U.S. Bancorp at 3.67%, JPMorgan Chase at 3.1%, Citigroup at 2.93% and Bank of America at 2.61%. These basis point differences translate into huge advantages. 
 
The company’s net current interest margin might appear high where the industry average for the last 15 years is around 2.75-3.5%. Wells Fargo, however, is not your average bank. Its franchise (competitive position) gives it a competitive advantage. Whatever the average net interest margin spread for the industry is going forward, we can expect Wells Fargo to have an advantage over its peers. This difference, while small, compounded over many years is enormously powerful.
 
This doesn’t fully answer the real question about earnings power. Wells Fargo is on pace to generate $40 billion in pre-tax, pre-provision, earnings this year. This is only three times the current market cap of the company! Under normal conditions—not today—we can expect the company to incur $12-15 billion in losses leaving pre-tax income around $25-28 billion. This implies taxable income of around  $16-18 billion. This puts Wells Fargo stock at a P/E around 6-7 times normal earnings.
 
I expect that as the net interest margin spread comes down in the future, Wells Fargo will make up the difference with cost savings and growth. After the Wachovia acquisition Wells Fargo has a national footprint. Better yet, you have some of the best managers in banking running the show. So while I'm not 100% certain they can pull in $25-28 billion a year in pre-tax income, it does seem very likely.

Shane Parrish is the founder of the NoiseFreeInvesting.com investing blog, and is a friend of CGI.