Raising Our Fair Value for Wells Fargo Slightly, Net Interest Income Likely To Develop Favorably

Strategist

Eric Compton

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Wells Fargo remains in the middle of a multiyear rebuild. The bank is still under an asset cap imposed by the Federal Reserve and we don't see this restriction coming off in 2023. Wells Fargo has years of expense savings related projects ahead of it as the bank attempts to get its efficiency ratio back under 60%. We also see a multiyear journey of repositioning and investing in the firm's existing franchises, including growing its middle market investment banking wallet share, investing in the cards franchise, and revitalizing a wealth segment that has lost advisors for years. These tasks take on increased importance for a bank that has been on defense for years after its fake accounts scandal broke in late 2016. 

We're already starting to see glimpses of the transition to offense from defense with the launch of multiple new card products, advisors not declining for the first time in years in fourth-quarter 2022, and the $2.2 billion of incremental internal investments in 2023 (a step up from the $1.7 billion goal from 2022). Even so, while the bank is making progress, we expect a multiyear journey remains.

Despite the bank's issues, Wells Fargo remains one of the top deposit gatherers in the U.S., with the third most deposits in the country behind JPMorgan Chase and Bank of America. Wells Fargo has one of the largest branch footprints in the U.S., excels in the middle-market commercial space, and has a large advisory network. We believe this scale and the bank's existing mix of franchises should provide the right foundation to eventually build out a decently performing bank. Wells Fargo may not reach the types of returns and efficiency that peers like JPMorgan and Bank of America have achieved, but we expect Wells Fargo to remain larger than any other regional bank and stay competitive as such. We're also gaining confidence that CEO Charlie Scharf is guiding the bank in a new and positive direction.

For now, the bank needs to consistently hit the expense targets it is laying out (the bank achieved this in 2021 and 2022), and keep making progress with regulators. We're hoping for the asset cap removal by the end of 2024, but this remains highly uncertain.

Business Strategy & Outlook

We believe Wells Fargo possesses a wide moat based on cost advantages and switching costs that are consistent with our bank moat framework. Wells Fargo is one of the largest U.S.-based banks by assets and has leading share and operations in many of the key areas in which it competes. It has one of the largest retail branch networks in the U.S. and is one of the leading deposit gatherers in the country. Wells Fargo is also one of the largest U.S. issuers of credit and debit cards (with particular strength in debit), has one of the leading commercial banking franchises (with particular strength in the middle market), has a leading consumer franchise with products across roughly 70 million consumers and small businesses, and also has significant wealth management operations with its advisory unit. Further, Wells Fargo has the lowest global systemically important bank surcharge among the big four, giving it a further structural return advantage from having to hold relatively less capital. Given the bank’s higher capital levels since the crisis, the increasing importance of scale and scope with changes in technology, and robust fee income, we believe Wells Fargo will consistently earn returns that exceed its 9% cost of equity through the cycle, and we see the bank having a structural scale advantage compared with other regional banks.

While the fake accounts scandal and ensuing regulatory costs have certainly harmed Wells Fargo's returns on equity, the fact that the bank has still been able to outearn its assigned 9% cost of equity in almost every year since 2016 points again to the reality of how hard it is to truly destroy the bank's franchises to the point where they become cost of capital entities or worse. While we don't expects Wells' returns to be as strong as some of its other wide-moat peers, we nonetheless have enough confidence in the bank's ability to outearn its cost of capital over the next two decades, that we believe a wide moat is still appropriate.

We argue that bank moats are derived primarily from two sources: cost advantages and switching costs. We see cost advantages as stemming from three primary factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting, with regulatory costs being a final factor that must also be considered. Within the operating efficiency bucket, we also see room for economies of scope leading to a cost advantage via lower relative customer acquisition costs. This factor applies primarily to the banks with the largest distributional scale and the largest breadth of products.

Wells Fargo fared better than many of its peers during the great financial crisis. The bank had actively steered away from the most risky mortgage products, and its business model was much less heavily reliant on capital markets and trading activities. The bank’s largest exposures came from the 2008 acquisition of Wachovia. Even so, despite the acquisition of a troubled Wachovia and the bank’s higher concentration in consumer lending and real estate in general, Wells performed exceptionally, outperforming peers during the period. Overall, we are encouraged by the bank’s history of above-average underwriting and risk-taking ability and believe the underwriting culture has probably remained positive since the crisis, despite the bank's other operational issues. 

Wells Fargo’s operating efficiency has generally been close to or better than peers in most years, however this has admittedly changed given extra expenses associated with the bank's regulatory issues. Recently, legal accruals, remediation charges, and the need to build out a much more robust internal controls system have weighed on the bank's expense base, but we anticipate the bank will eventually work through these issues and will return to an operating position that won't put it at a disadvantage that would erode its moat. Further, we think scale will matter more and more over time, given the new phase of banking we are entering, where technological changes are occurring faster and are more impactful than ever before and can be deployed across singular, integrated platforms. Therefore, we see only more advantages for the largest banks when it comes to operating efficiency in the future. With Wells Fargo’s tech budget of over $9 billion per year, the bank will be able to maintain higher levels of investment while maintaining similar levels of efficiency. The bank is admittedly quite sensitive to rates, and therefore the rate cycle will play a role in its efficiency, but through the cycle we see good enough efficiency for the bank, although it will take years to see what a reborn Wells Fargo is capable of on this front.

Wells Fargo’s overall deposit market share is attractive, with some of the highest market share and market coverage among all U.S. banks. As a result, the bank has the third highest deposit share in the U.S., with the fourth largest player being roughly 40% the size of Wells. On a cost advantage basis, we view the bank’s deposit base as having a likely chance of being advantaged in the future, based on historical performance, although we acknowledge the bank's historical advantage here has decreased over time. 

Overall, we believe the bank’s key advantage come from its scale in certain fixed-cost, fixed-platform businesses, as well as the breadth of products it can offer to clients. This contributes to economies of scale and scope and creates switching costs for customers as they use the bank for more and more products. The bank has consistently been one of the top issuers of debit cards and is also in the top 10 for credit card balances in the U.S. The card space is a highly competitive space and has consolidated over time, but it's still a good and profitable business if you can establish a footprint, and while Wells Fargo certainly isn't one of the most dominant players here, it has managed to establish a footprint nonetheless. The same trend of increased competition, increased digitalization, and the need to bring a full suite of products to the market place is also occurring for other consumer-based, mass-market products. Payments and other technology investments bleed over into the corporate payments space, where Wells’ treasury and payments management platform has helped the bank maintain excellent share in the commercial market, particularly with middle-market business clients. As a result, when we think about the long term and which banks will be able to put together the most complete consumer and commercial banking platforms, we think Wells Fargo will be one.

While all of these segments are strong on their own, we believe there are advantages to combining them under one banking roof. While the cross-selling strategy was poorly implemented in the past, we don’t believe the overall idea of being able to expand a customer base with more products per customer is fundamentally flawed. The key is healthy implementation and execution. With that in mind, on the consumer side Wells Fargo is able to cross-sell multiple products, providing advantaged pricing to key customer segments, and spread the overall costs of customer acquisition across more revenue streams. On the commercial side, similar dynamics apply; the bank is able to offer a complete package with national scale that few can compete with, while sending out armies of bankers to existing and new markets in an effort to win new business and maintain local relationships. In Wells Fargo's wealth management operations, while scale isn’t necessarily a huge advantage, we do believe these segments can help contribute to economies of scope. The bank is able to be a one-stop shop, offering investing and advisory capabilities along with more traditional banking services to the same client base. Many of these seemingly separate capabilities have natural overlap, such as advising clients on selling their business and then helping them manage the large wealth inflow. A final point relates to the switching costs created and the advantages that come from lowering customer acquisition costs. In banking, where many of the products are commodified to a large degree, getting potential clients into your banking platform (where it helps to have more products in more places) and then keeping them there (where more products equals higher switching costs) matters a lot, and we see Wells Fargo being able to pull this off.

Finally, the largest banks will be able to spend the most on technology and will have access to unique data on the largest client bases, and Wells Fargo is no exception. We believe Wells' ability for higher investment in tech platforms that can scale, as well as its access to customer data on millions of households, should bolster the bank’s advantages over the longer run.

From a systemic standpoint, we believe the U.S. banking system has improved over the last decade, as capital levels supporting the banking system are at all-time highs. Further, regulation has become considerably stronger in the past several years. The U.S. banking market is quite fragmented, and Wells Fargo must compete with a variety of regional and community banks as well as large money center institutions, although this fragmentation has gradually decreased since the 1990s. While we view the banking sector as intensely competitive, the largest banks by asset size have generally been able to earn higher returns on equity for the last several decades and still do so today. Our outlook is generally positive from a macroeconomic and political standpoint for the U.S. banking system, as the U.S. is still the world's leading democracy, has increased GDP at a steady pace for years, and maintains the world's reserve currency, all of which contribute to banking stability.

Wells Fargo is large enough to be considered a global systemically important bank, although the bank has the lowest GSIB surcharge of the big four, at 1.5%, which supports the view that Wells Fargo should have some of the lowest regulatory requirements and costs among the big four (recent scandals and fallout excluded). The bank is also large enough to be subject to the Federal Reserve's annual stress tests, as well as a host of other regulatory requirements, and we don’t see any massive regulatory relief coming for the large money center banks. The stringent capital requirements that the largest banks are held to give us some reassurance that these banks will be able to weather the next economic downturn.

Wide

Economic Moat

Wells Fargo

Wells Fargo & Co. is a diversified, community-based financial services company. It is engaged in the provision of banking, insurance, investments, mortgage products and services, and consumer and commercial finance. It operates through the following segments: Consumer Banking and Lending, Commercial Banking, Corporate and Investment Banking, and Wealth & Investment Management. The Consumer Banking and Lending segment offers consumer and small business banking, home lending, credit cards, auto, and personal lending. The Commercial Banking segment offers banking and credit products across multiple industry sectors and municipalities, secured lending and lease products, and treasury management. The Corporate and Investment Banking segment offers corporate banking, investment banking, treasury management, commercial real estate lending and servicing, equity and fixed income solutions, as well as sales, trading, and research capabilities. The Wealth & Investment Management segment provides personalized wealth management, brokerage, financial planning, lending, private banking, trust and fiduciary products and services to affluent, high-net worth and ultra-high-net worth clients. The company was founded by Henry Wells and William G. Fargo on March 18, 1852 and is headquartered in San Francisco, CA.

Earnings data Q3 2023

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Wachovia Corporation, a financial holding company, provides commercial and retail banking services, and other financial services. Wachovia was a diversified financial services company based in Charlotte, North Carolina.   Before its acquisition by Wells Fargo in 2008, Wachovia was the fourth-largest bank holding company in the United States based on total assets. Wachovia provided a broad range of banking, asset management, wealth management, and corporate and investment banking products and services. At its height, it was one of the largest providers of financial services in the United States, operating financial centers in 21 states and Washington, D.C., with locations from Connecticut to Florida and west to California.

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