Alex Cho
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Wells Fargo a Riskier Bank Than the Rest?

UBS released a sell rating on Wells Fargo this past week. I know right, huge for a major investment bank to downgrade a company to “sell.” But the underlying logic behind why UBS is citing concerns about Wells Fargo is due to the credit quality of the portfolio, the risk of heightened costs due to borrowing costs increasing following the full implementation long-term debt requirements by the FASB, limited net interest margin upside, shrinking fee income pool and limited expense leverage.

Here’s what UBS stated in their report:

WFC is overweight C&I in its loan book, so the migration of credit stress beyond energy would represent a bigger risk for WFC than peers. WFC's energy portfolio appears more biased to risky loans than we had expected, and their prior credit performance is consistent with, but not superior to peers (as their reputation would suggest). In the consumer portfolio, WFC is a leading auto lender and our analysis suggests this portfolio is riskier than most of its large bank competitors. Valuation: Initiating with a $45 price target Our $45 price target represents 11x our 2017 EPS estimate of $4.10. We believe WFC should trade between the regional banks and money centers on a P/E basis, as we believe that is reflective of the reality of WFC's prospects for earnings growth and regulatory burden.

For the most part, Wells Fargo’s efficiency metrics was driven by their ability to reduce loan loss reserves and avoid litigation post the financial crisis. However, Wells Fargo’s ability to drive fee based income is under risk, as their wealth management business could be met with higher regulatory requirements following recent regulation that was proposed by the Department of Labor.

The new DOL proposal will implement a fiduciary standard for both broker dealers and investment advisors. The new standard will likely require more disclosures to wealth management clients, and will require advisors to act on behalf of the client despite the incentive to generate some portfolio turnover to generate brokerage fees on behalf of clients.

In other words, there’s not enough information on the DOL proposal to determine the exact outcome it will have on WFC’s business model, but when taking into consideration the added oversight over advisors who also act as brokers, the extra regulatory burden diminishes the cross-synergies of its banking/brokerage model. Furthermore, the compliance cost is expected to increase for Wells Fargo, which is why the company’s valuation seems a little stretched when compared to regional banks.

Source: UBS

It’s also worth noting that there’s some expectation risk for the upcoming quarters, as the analyst consensus have revised Wells Fargo’s revenue/earnings figures less significantly when compared to peers. Since expectations for sales/earnings are high relative to peers, the company’s valuation could be significantly impaired following a series of earnings report misses. Furthermore, when taking into consideration slower fee income growth, and ongoing loan portfolio concerns due to exposure to lower credit quality mortgages there’s a lot more downside risk than what other analysts are modeling. Wells Fargo’s loan loss reserves could tick higher assuming loan delinquencies worsen.

Of course, I’m hesitant to say that this will occur in the near term, but it’s also worth noting that lower credit quality will eventually result in higher loan losses. Therefore, Wells Fargo’s current operating metrics doesn’t seem that sustainable. Also, the company’s efforts to reduce expenses may have hit an upper ceiling as the business is heavily geared towards regional lending. The company’s efficiency ratio is lowest among money center, super regional and regional banks. Therefore, the bank’s added size is what’s limiting the bank ability to generate similar profitability to smaller banks as a result of higher regulatory capital requirements. In a nutshell, WFC’s ability to drive improvements on SG&A spend is limited, and may reach a point where the incremental operating profit gets offset by higher loan losses down the road.

The arguments weighing against Wells Fargo seem fairly practical. While, I don’t agree with UBS on its outlook of loan growth despite declining refinance activity, it’s the combination of lending risk, limitations to fee income growth, and low likelihood of margin recapture that make Wells Fargo less compelling when compared to some of the other banks.