Wells Fargo's ( WFC)
earnings report was a tale of two cities -- the one management portrays and the one investors and analysts see. Wells' stock took a nose-dive after the results, falling as much as 7.6% at one point on Wednesday, and closed down another 19 cents at $24.26 on Thursday, despite a broad market rally. Investors seemed to be focused on Wells' troubling credit trends and relatively weak capital coverage, rather than its booming bottom line and revenue, which topped even the most bullish forecast. CFO Howard Atkins explained away a sharp increase in non-performing assets largely as a technicality related to their categorization after the Wachovia acquisition. Both Atkins and Chief Credit Officer Mike Loughlin said that Wells' efforts to modify loans and write down bad debt have reduced risk, leading to moderation in loan-loss growth and early-stage delinquencies. "Not all NPAs result in a loss," Atkins said. However, many of them certainly do -- and have -- throughout the economic crisis, making such assurances ring hollow. And because Wells has raised relatively little capital, it seems the company is less prepared to handle potential losses than competitors. For instance, while Wells noted that its capital ratios increased "significantly" last quarter, at least one key metric is still far below peers. Its ratio of Tier 1 common equity to risk-weighted assets stood at 4.49% at June 30, compared with Bank of America's ( BAC) 6.9%, and JPMorgan Chase's ( JPM) 7.7%. Citigroup ( C) only reported its Tier 1 ratio, which was 12.7%, also far above Wells Fargo's 9.8%.
"Wells now has the lowest capital levels of the 'four horsemen,'" FBR's Paul Miller said in a note Thursday. The analyst reiterated an underperform rating, citing higher credit costs and lack of adequate capital to repay bailout funds any time soon. Goldman Sachs analyst Richard Ramsden notes that Wells may have to raise additional funds to repay the government's $25 billion preferred stake, and extinguish related warrants. Wells has been opposed to capital moves that would further dilute shareholders, and toed the line when mentioning the TARP repayment on its prerecorded earnings call. Atkins reiterated that management would like to do so as soon as possible, in a "shareholder-friendly" manner. But he and CEO John Stumpf also boasted of strong pre-provision revenue, which topped not just the Federal Reserve's stress test estimates, but its internal projections as well. And, as pledged, Wells boosted Tier 1 capital levels by $500 million above the $13.7 billion the Fed required, with a healthy portion coming from earnings. The strategy was deemed risky by many, but Wells delivered on that promise, as well as many others, as doubts continue to bubble up about Wachovia's bad loans or Wells' overall ability to weather the economic storm. Sandler O'Neill analyst R. Scott Siefers attributed Wells' stock slump on Wednesday to "a case of 'buy on the rumor, sell on the news,' in that we believe most investors expected
Wells to report a very strong quarter." Indeed, Wells shares rallied more than 10% in the two weeks or so ahead of its earnings report, closing at $25.35 on Tuesday. But the question of future performance will rely on whether or not investors maintain confidence in the firm's braggadocio -- whether or not it is warranted.
In a recent New Yorker article titled "Cocksure," social commentator Malcolm Gladwell examines the relationship between Wall Street's confidence in a company, and its ability to survive. Gladwell notes that Bear Stearns had a capital cushion of more than $17 billion up to the point when it nearly collapsed and had to be rescued in a government-assisted sale to JPMorgan. As rumors spread about its health, customers withdrew funds and lenders stopped lending. Eventually, the rumors became actual problems that crippled the firm. The author points out that the more CEO Jimmy Cayne insisted that Bear Stearns was fine, the less people believed him, because his statements were undercut by a transforming reality. "If you were a Wall Street CEO, there were two potential lessons to be drawn from the collapse of Bear Stearns," says Gladwell. "The first was that Jimmy Cayne was overconfident. The second was that Jimmy Cayne wasn't confident enough." Another way to look at it is that it's not just about confidence, but about timing. While investors were clearly troubled by loan losses and capital concerns, Atkins and Stumpf spent a lot of time in prepared remarks discussing Wells Fargo's earnings power, and the concept of "cross-selling" to get customers interested in new financial products. "Our very strong growth in revenue, deposits and net income this quarter and the first half of this year demonstrates again that the combined Wells Fargo-Wachovia has significant power to generate capital internally," Stumpf said in a statement.
The problem is, no one doubts that Wells' ability to expand offerings across the combined franchise. Nor are they worried that the firm won't be able to earn money on those products. They're worried that losses not yet accounted for will cause large enough craters in the balance sheet to consume those profits. FBR analyst Paul Miller estimated that Wells' allowance for loan losses covers about 5.4 quarters' worth of charge-offs, vs. 6.9 quarters during the last period. "Unless
Wells Fargo's net charge-offs stabilize over the next few quarters," says Miller, " Wells Fargo will have to start materially increasing its provision expense, which will put pressure on earnings and valuations."