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Wells Fargo Investor Payoff Requires Warren Buffett-Like Patience

NEW YORK ( TheStreet) -- Wells Fargo's (WFC - Get Report) largest shareholder -- Warren Buffett -- has seen his investment in the bank recover to pre-crisis levels on steady gains posted by the nation's top mortgage lender.

Investors should take note of that fact in the wake of the bank's record fourth-quarter profit, which raised some near-term earnings questions.

Generally, today's earnings show why Wells Fargo remains a best-in-class bank that has earned Buffett's long term investing imprimatur. All three of Wells Fargo's businesses, community banking, wholesale banking and wealth management grew profits from quarter-ago and year-ago levels.

Those looking for a short-term trade, however, might have been disappointed. Expect Wells Fargo's fundamental growth to be at the head of the banking sector in 2013, even if near-term headwinds prove a concern to some.

Wells Fargo reported better than expected revenue of $21.9 billion and profitability of $5.1 billion, signaling that the bank's steady share performance remains on track heading into 2013.

Meanwhile, the bank's 20% 2012 earnings per share growth reflected impressive momentum and a strengthening position in the recovering U.S. housing market. Wells Fargo is also increasingly returning capital to investors, boosting buybacks by a total of 48 million shares. An increase of Tier 1 capital to 10.12% of risk assets augurs well for Wells Fargo, as it prepares for Federal Reserve mandated stress tests.

On an earnings call with analysts, Wells Fargo chief financial officer Tim Sloan said the bank submitted a capital plan to the Fed that potentially increases its quarterly dividend.

Still, worse than expected interest-based earnings margins and the prospect a refinancing boom wears off cloud Wells Fargo's short-term share performance in the New Year.

Wells Fargo reported its net interest margin -- the difference between what it earns on loans and what it pays to fund them -- fell a greater than expected 10 basis points. The bank's mortgage pipeline, meanwhile, fell 16% to $81 billion in the quarter, while home loan origination and applications fell from quarter-ago levels, signaling some slowing in the housing market.

On the positive side, core loans grew $47.7 billion and the bank's improving loan quality drove a $250 million reserve release.

Jefferies analyst Ken Usdin wrote in a note to clients that the mortgage banking declines came in less than forecast, while steady loan and deposit growth were strong points to Wells Fargo's earnings.

Marty Mosby, a large-cap banking analyst with Guggenheim Partners, said in an interview prior to earnings that any reported net interest margin decline of less than five basis points and loan growth sequentially from the third quarter would be taken positively by investors.

Wells Fargo impressed on one of those fronts, while a greater than expected NIM decline meant overall interest-earnings for the bank fell $249 million to $10.6 billion.

The earnings provide investors crucial insight into trends driving Wells Fargo's profitability and growth given the bank's top footing in the housing market, healthy balance sheet and industry leading dividend payout.

Investors and banking sector analysts are watching interest margins and loan growth as a key proxy for the impact of a third round of Federal Reserveeasing announced in September and insight into the strength of the housing market.

A stabilization of Wells Fargo's interest margins after a 25 basis point drop in the third quarter would have removed the bank's biggest near term earnings risk, freeing investors to focus on positive longer-term trends, according to Mosby.

"The market right now is discounting Wells Fargo's earnings power because they think it is going to be lost because of significant compression of net interest margin," said Mosby.

Investors may need to wait another quarter for interest margins to bottom, and for Wells Fargo's strong fundamental qualities to overshadow short-term headwinds.

Mosby argues that if uncertainties such as interest-earnings and the sustainability of loan demand dissipate, Wells Fargo could outperform the banking sector in 2013, as it has in years past. The analyst notes that while Wells Fargo has doubled earnings since the financial crisis, investors have given it little credit.

Wells Fargo shares currently stand roughly in-line with pre-crisis levels seen in 2007.

"[This] could be the year where they get a revaluation," said Mosby, who calculates the bank might be able to boost its dividend to the 3% range, far ahead of large cap banking peers such as JPMorgan Chase (JPM - Get Report), Bank of America (BAC - Get Report) and Citigroup (C).

Bill Smead, chief investment officer of Smead Capital Management, expects Wells Fargo's exposure to a long-term housing pickup to more than offset Fed interest rate policies. "We happen to think a company like Wells Fargo might make more money in the rebound on the value in foreclosed homes than what they will lose on a decline in their interest rate spreads," said Smead, in an interview prior to earnings.

Smead's analysis was borne out in record quarterly earnings.

A $1.6 billion increase in non-interest income, driven by the write up of legacy assets, and flat net interest income on better than expected loan and deposit growth drove overall earnings, even if margins suffered slightly.

"That will wash out in the long run, which is why you want to increase market share," said Smead of Wells Fargo's increasing presence in the mortgage market and in community banking.

Wells Fargo's deposits grew to $928 billion in the fourth quarter, a 7% increase from year-ago levels. Those deposits, however, cut at Wells Fargo's net interest margin by 5 basis points, according to the bank. In a rising rate environment, Smead said he expected the margin pressure to reverse.
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