3 Key Trends to Watch for Wells Fargo

By Trefis Team,

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Wells Fargo ( WFC ) was one of the banks to emerge the strongest after the financial crisis. As capital markets improve, we foresee Wells benefiting from its expanded presence in many markets relative to peers like Bank of America ( BAC ), Goldman Sachs ( GS ), JPMorgan Chase ( JPM ), Citigroup ( C ) and UBS (UBS). Below we look at the key factors to watch in the coming months that support our $33.81 price estimate , which is around 10% ahead of the market price.

1. Rising Rates Will Lift Net Interest Income

As a result of the economic recession, the U.S. government decreased the prime loan interest rate from high levels of around 8.25% in 2006-2007 to 3.25% in 2010. As the economic conditions remain uncertain, the prime rate is expected to remain low through 2011.

However, as interest rates rise slowly back to historical levels beyond 2011 with improvement in economic environment, Wells Fargo's interest income will be positively impacted.

2. High Core Deposits and Low Cost of Funding

While an increase in prime loan rates will likely impact both interest income as well as interest expense for Wells Fargo, the fact that Wells Fargo derives the majority of its funding from low cost core deposits will help the firm restrain its interest expense even as interest rates increase and thus boost its net interest margins. Wells Fargo has to pay lower interest rates on its core deposits as compared to long term debt and short term borrowings. Also Wells Fargo's average cost of deposits at 0.35% was the lowest in the industry and half of the peer average of 0.70% in 2010 making its cost of funding the lowest in the industry.

Wells Fargo's net interest margin (interest earned on earning assets minus interest paid on funding sources as a percentage of interest earning assets) of 4.86% (10 year average 2001-2010) has been significantly higher than the peer group average of 3.39% in the banking industry. The peer group includes banks like Citigroup, JPMorgan Chase, Bank of America, etc. The high net interest margins at Wells Fargo have, in large part, been attributed to its large low cost average core deposits (which include non-interest-bearing deposits, interest-bearing checking, savings certificates, market rate and other savings, and certain foreign deposits).

In Q4'10, nearly 67% of Wells Fargo's funding comes from deposits which again is way higher than peer average of only 49%. In 2009, nearly 93% of Wells Fargo's total average loans were funded from its average core deposits.

As such while we forecast the net interest yield on home mortgage loans to remain constant going forward (see rationales), a gain of 1% in net interest yield over our forecast period driven by the above factors could result in an upside of 5% to our $33.81 Trefis price estimate for Wells Fargo's stock. The upside will be even more pronounced if the increase in net yield occurs across Wells Fargo's different loan segments and asset classes.

3. Expanded Customer Base

Wells Fargo's cross-sell, meaning number of products sold to a banking customer, has risen historically. The cross-sell increased from 4.8 in 2005 to nearly 6 in 2009 for the old Wells Fargo (or 5.47 from combined Wells Fargo and Wachovia). In 2010 cross-sell further increased to 5.70.

A direct positive correlation exists between cross-sell and revenues for banks. As such while the cross-sell for Wells Fargo's wholesale and retail banking increased at annualized rate of ~6%, Wells Fargo's revenues increased at an annualized rate of ~9% (excluding the increase in revenue due to Wachovia acquisition). As the industry recovers and following the Wachovia acquisition, we believe there are fresh cross-selling opportunities for Well Fargo that will help support revenue growth.

You can drag the trend lines above to see the impact of various scenarios of home mortgage loans' net interest yield and outstanding loans on Wells Fargo's stock.

See our complete analysis of Wells Fargo .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Investing Ideas , Stocks , US Markets
Referenced Stocks: BAC , C , GS , JPM , WFC

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