Wachovia Beats Estimates, but Gains Raise Eyebrows Among Investors

Third-quarter earnings rise to $1.27 a share, but three analysts think the nonrecurring gains inflated the figure.
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Wachovia

(WB) - Get Report

, long known for its solid operating results and pristine credit quality, reported third-quarter earnings Wednesday that dinged its reputation.

The main issue: a $17.5 million gain that was included in operating revenue, which totaled $973 million. Winston-Salem, N.C.-based Wachovia said $7 million of the gain was attributable to a branch sale and the rest to a credit card securitization. But three analysts say those gains shouldn't have counted in operating income, which Wall Street watches in determining whether earnings growth hits targets.

In trading Wednesday, Wachovia slipped 1 5/16, or 1.6%, to 79 7/8. Its earnings were released before the market opened.

For its third quarter, Wachovia reported that operating earnings, which excluded merger-related costs, rose 11% to $260.9 million, or $1.27 a share, from $235.2 million, or $1.13 a share, in the year-earlier period. Analysts expected that Wachovia would earn $1.26 per share in the most-recent quarter, according to

First Call/Thomson Financial

. Generally speaking, operating earnings omit nonrecurring gains or losses. Without the gains, the analysts say, earnings would have missed estimates by as much as 4 cents a share.

Bob McCoy, Wachovia's finance chief, says the gains weren't done to "create income" and "they were not timed for earnings purposes."

But George Bicher, an analyst at

Deutsche Banc Alex. Brown

, wonders whether the securitization gain should've been included in operating results. "We are slightly uncomfortable with the fact that a credit card securitization was part of reported results," Bicher wrote in a research note to clients Wednesday. (Deutsche Banc hasn't performed recent underwriting for Wachovia.)

And since they represented a one-time gain that wasn't part of Wachovia's core operations, the branch sale proceeds also almost certainly shouldn't have been in the operating numbers, say Marni Pont O'Doherty, an analyst at

Keefe Bruyette & Woods

, and Adam Levy, a financial institutions analyst at

Invesco

funds. (Keefe has performed recent underwriting for Wachovia. Invesco doesn't hold Wachovia.)

McCoy says booking the branch sale proceeds made sense because the bank was essentially selling deposits that would have contributed to operating revenue had they been kept.

As for the credit-card securitization, McCoy says it was included because it was a "funding mechanism" designed to bring in revenue. And he adds that the gain on the credit-card securitization will have to be amortized, which subtracts from income, over the next 20 months, starting this month.

Pont O'Doherty estimates that without the branch sale, earnings per share would have been just under 2 cents lower: "If that's the case, then the quarter would have been below expectations."

And without the $10.5 million securtization gain, which came on a sale of $500 million in credit card receivables in late September, earnings per share could have been another 3 cents lower, putting them at $1.22 per share.

"Because it's Wachovia, these

gains do raise eyebrows," says Levy at Invesco.

Levy also was disappointed with credit-quality numbers. True, in the third quarter, nonperforming assets didn't register the 37% leap that took place between the year's first and second quarters. But Levy points out that nonperforming assets didn't fall, as he would've liked. They edged up to $238.3 million in the third quarter from $234.8 million in the second quarter.

Wachovia has traditionally traded at a premium to the market because of its reputation for strict credit standards. At Wednesday's close, it's trading at 16 times forecast 1999 earnings, compared with 14.3 times for the

KBW Bank Index

.

"Wachovia shouldn't command a premium anymore," Levy says.

McCoy says Wachovia still has good asset-quality indicators and remains extremely vigilant, adding that the recent jump in nonperforming assets was a sign that the bank is prepared to move quickly to recognize non-accrual loans. Wachovia's nonperforming assets were equivalent to 0.5% of total loans and foreclosed property at the end of the third quarter. In the second quarter, that ratio was 0.48%, vs. the southeastern regional average of 0.6%, according to

Merrill Lynch

.

Pont O'Doherty at Keefe also was unimpressed with loan growth in the third quarter. Outstanding commercial, retail and foreign loans were all down in the quarter compared with second-quarter levels.

McCoy says the declines were "by design." The drop in retail loans was due in part to the change in credit card receivables, he explains. The fall in commercial loans -- to $16.2 billion in the third quarter from $16.9 billion in the second -- was the result of Wachovia's decision to cut back on syndicated lending because pricing in that sector has become unattractive, McCoy adds.