Wells Fargo & Co. did a lot of things a public company is supposed to do at earnings time report a flashy profit gain and appear to exceed an ambitious capital plan, to name two but it just wasn't enough to silence the alarm bells from a larger-than-expected deterioration in credit quality.
The guarded reaction of analysts and investors not only speaks volumes about the complexities of a banking giant like Wells Fargo, it underscores how in this earnings season, deep scrutiny of credit-quality statistics has supplanted routine measures such as earnings per share.
Besides a double-digit jump in the bottom line, the $1.3 trillion-asset Wells reported solid revenue growth not only from mortgage banking but across many of its business lines as well as margin expansion from core deposit growth. It also said it could fulfill its capital-raising plan without another stock offering.
However, chargeoffs and nonperformers rose more than expected, in both legacy Wells commercial real estate and consumer loan portfolios, and from option adjustable-rate mortgages inherited from its Wachovia Corp. acquisition last year.
Wells' credit quality is still better than many banks', and early delinquencies in some portfolios showed signs of slowing. But the unexpected deterioration overall concerned many analysts and drove Wells' stock down 3.6% Wednesday, to $24.45 per share.
Howard Atkins, Wells' chief financial officer, said credit issues will likely not abate for some time.
"Until the economy comes back, credit losses will remain elevated, but we hope they'll be a bit more moderated given the actions we've taken," Atkins said in an interview.
In particular, Wells has been aggressive in working through problems with commercial real estate borrowers, writing down much of the losses on Wachovia mortgage loans through purchase accounting, and lowering its risk in some consumer portfolios such as indirect auto lending, Atkins said.
Still, observers focused on the fact that chargeoffs unexpectedly rose 35% from the first quarter, to $4.39 billion, and nonperforming assets rose 45%, to $18.3 billion.
Adam Barkstrom, an analyst at Sterne, Agee & Leach Inc., said Wells has more exposure to consumers relative to other banking companies, which may not bode well if the economic recovery drags out.
"With unemployment continuing to go up, it's going to be a tough road for them," Barkstrom said. "Additionally, the option-ARM portfolio they acquired from Wachovia I don't think we've fully seen that played out, either."
Paul Miller, an analyst at Friedman, Billings, Ramsey & Co. Inc., wrote in a note Wednesday that given the big increase in chargeoffs and nonperformers, Wells is underprovisioning for future losses, because it built reserves by only about $700 million in the second quarter.
"Unless Wells' net chargeoffs stabilize over the next few quarters, Wells will have to start materially increasing its provision expense, which will put pressure on earnings and valuations," Miller wrote.
Not all analysts were bearish on Wells' credit deterioration, however. Anthony Polini at Raymond James & Associates said he was encouraged that nonperformers were increasing at a slower rate than in previous quarters, and that they were still a relatively low percentage of total loans (2.23% at June 30).
Additionally, better-than-expected revenue growth from a number of business lines, including mortgage banking, and from margin expansion (14 basis points from the first quarter, to 4.3%), should help Wells better absorb higher credit costs down the road, said Joe Morford, an analyst at Royal Bank of Canada's RBC Capital Markets.
Revenue rose 28% from the first quarter, to $22.5 billion, including $3 billion from mortgage activities, of which $1 billion came from a write-up of mortgage servicing rights net of hedge results.
Overall, Wells' net income rose 47% from a year earlier, to $2.58 billion, or 57 cents a share, after paying preferred dividends. Subtracting several one-time items, including a $565 million FDIC special assessment and merger-related and restructuring expenses from the Wachovia acquisition, Wells easily beat the average analyst estimate of 34 cents.
The San Francisco company also posted pretax, pre-provision net revenue of $9.8 billion, and said that it has now generated $14.2 billion toward addressing its $13.7 billion capital shortfall, as per the government's stress test results in May. The company raised $8.6 billion from a common stock offering in May, and the $5.6 billion balance came both from second-quarter revenue and other internal sources of capital, including realization of tax assets, Atkins said.
Though analysts were not sure whether regulators would agree with Wells' assertion that it had met the capital shortfall a quarter early, Atkins said it was "undisputed that we raised $14.2 billion."
Bottom line: both Atkins and analysts were confident that Wells would not need to raise additional capital.
Atkins also said the company had not set a timetable for repaying the $25 billion in capital it received from the Troubled Asset Relief Program.
Wells generated $2.2 billion in revenue from mortgage activities on $129 billion of mortgage originations.
Analysts said that Wells' mortgage banking activities, particularly refinancings, might taper off in the second half of the year as interest rates rise. Atkins agreed, saying it does depend to a certain extent on the movement of interest rates.
The second quarter was one of the company's best production quarters ever, and "as long as interest rates remain relatively low, this level of activity will continue for a reasonable period of time," Atkins said.
But even if mortgage activity subsides, the company is continuing to post strong revenue growth in about half of its business lines, Atkins said.
"Wells is a revenue machine we have always had very strong revenues, irrespective of the cycle," Atkins said.
Moreover, a good part of its revenue growth in the second quarter was margin expansion stemming from strong core deposit growth, he said.
Average consumer checking and savings deposits increased 20% from the first quarter on an annual basis, to $613.3 billion.
"We have a much higher percentage of core deposits in the form of checking and savings accounts than any other bank in the country, which accounts for our wide margin," Atkins said.
