Wells Fargo Earnings: Rising Profits, Rising Pressure (Update 2)

Updated from 12:34 a.m ET to include fund manager comments and additional data throughout.

NEW YORK ( TheStreet) -- Wells Fargo ( WFC) on Friday reported its thirteenth straight rise in quarterly profits, exceeding expectations that the nation's top mortgage lender would see its profit fall on a slowing in refinancing activity.

Although Wells Fargo's rising profits may give some like the Warren Buffett's Berkshire Hathaway ( BRK.A) -- the bank's largest shareholder -- continued confidence that its business model is diversified and closely aligned with a recovering U.S. housing market, the bank's earnings nevertheless highlight many long-standing concerns.

Fundamental strength at Wells Fargo is underscored by the bank's record $5.2 billion quarterly profit and a string of rising earnings that surpasses competitors such as JPMorgan ( JPM), Citigroup ( C) and Bank of America ( BAC), highlighting the consistency of the bank's business model.

Those record earnings, however, don't put to rest concerns among analysts and investors regarding falling interest margins and the sustainability of earnings derived from mortgage refinancing.

As such, Wells Fargo may stand as the most prominent example of the challenges the banking industry faces in the low-interest rate environment created by the Federal Reserve.

The San Francisco-based lender reported better-than-expected earnings of $5.2 billion, on revenue of $21.3 billion, generally beating estimates of $4.75 billion and $21.5 billion respectively.

Adjusted first-quarter earnings of 92 cents a share beat the consensus estimate of 88 cents, according to analyst forecasts compiled by Bloomberg.

Wells Fargo shares fell less than 1% to $37.21 in Friday trading.

Bill Smead, head of investment manager Smead Capital, said a Friday drop in Wells Fargo's shares indicated the financial sector may have been overbought headed into first-quarter earnings.

While Smead said his fund is fully invested in financials and isn't buying Wells Fargo shares at this time, he remains optimistic the bank will continue to benefit from a rising economy and the prospect of dividend increases in 2013.

Investors mystified by Wells Fargo's consistent earnings growth to new records, and its relative share price underperformance over the past 12 months, need not look beyond a financial metric called net interest margin and a decline in mortgage banking income.

The bank's net interest margin -- the spread between the average yield on loans and investments and the average cost for deposits and borrowings -- fell 8 basis points to the lowest level in about eight years.

Chief financial officer Tim Sloan said on an earnings call that three basis points in the margin decline came from deposit inflows, while the rest of declines came from lower variable income and a re-pricing of loans on the bank's balance sheet.

Net interest income makes up roughly 50% of Wells Fargo's revenue. As higher yielding assets such as those picked up as part of the company's 2008 acquisition of Wachovia run off the bank's balance sheet, they are being replaced by assets carrying a much lower yield, pressuring overall margins.

Marty Mosby, a large cap banking analyst with Guggenheim Securities, said in an April interview prior to earnings that net interest margin declines of three-to-four basis points would signal a stabilization for Wells Fargo. Instead, margins fell more than expected to eight year lows of 3.48%.

Overall, the margin decline and a near 9% drop in mortgage banking revenue are the reason the shares traded off in the wake of record earnings.

Prior to earnings, Mosby said an earnings beat would hinge on flat mortgage banking earnings, were the bank to increase new home loans and end a program to hold some originations on the balance sheet. Wells Fargo, however, retained $3.4 billion in mortgage loans, forgoing approximately $112 million in revenue.

Evercore Partners analyst Andrew Marquardt forecast a 4 basis point NIM drop, and foresaw a 7% drop in mortgage revenue vs. declines in excess of 10% at other large cap banks such as JPMorgan.

Morgan Stanley analyst Betsy Graseck said in a client note that Wells Fargo's gain-on-sale margins could augur well for the earnings of SunTrust Bank ( STI), while below-expectation trust asset growth could indicate headwinds for Bank of New York Mellon ( BK), Northern Trust ( NRT) and State Street ( STT).

Wells Fargo also will have less room to grow earnings from one-off items such as reserve releases and falling net-charge-offs, given near-record low levels reported on Friday.

Improvements to Wells Fargo's balance sheet, however, may have run their course in providing savings to bottom-line earnings.

Net charge-offs of $1.4 billion represented about a 40% drop from year-ago levels as the rate fell to a post-crisis low of 0.72%. The bank released $200 million in reserves and reported non-performing assets of $22.9 billion, an over 13% drop from the first quarter of 2012.

Still, an efficiency ratio of 58.3%, at the high end of recent projections, indicates one area of the bank's bottom line that could improve significantly in coming quarters.

A 14th straight quarter of earnings growth will hinge on fundamental improvements across Wells Fargo's businesses that could finally dispel prominent concerns among investors, even if the bank's performance remains among the best in the U.S. financial sector.

"Quarterly earnings and EPS increased at double-digit rates compared with first quarter 2012, while loans and deposits demonstrated continued growth in a challenging economic environment. In addition, expenses continued to decline as we improved efficiency across the franchise, and returns on assets and equity increased and remained among the highest in our industry," John Stumpf, Wells Fargo chief executive said in a statement.

As a ballast in the global financial sector, Wells Fargo's interest margins are also being pressured by continued deposit growth as savers seek only the strongest banks. Total core deposits of $926 billion reflected a $55.4 billion inflow of depositor money in the quarter.

In that sense, Wells Fargo has suffered from its own success over the past two quarters.

On an earnings conference call, Wells Fargo highlighted consistent market share gains in deposits and mortgage originations as an obvious positive. The bank expects to cross-sell a bevy of financial products to incoming customers, creating new growth prospects.

With market share gains across mortgages, deposits and some capital market activities, there is a real prospect for pressures that cast a pall over Wells Fargo's 13th quarter of earnings growth on Friday to turn to a benefit in coming quarters.

"While the quality of the beat will be contested, we believe estimates should hold up given that credit is already much better than our existing model," Ken Usdin, a Jefferies analyst wrote in reaction to Friday's earnings announcement.

For more on Wells Fargo's earnings expectations, see why a streak of rising earnings poses a hidden opportunity for investors.

Also see why Moody's says Wells Fargo's burgeoning buyout business is a risk to the bank's sterling credit rating.

Buffett Buyback Math Key to Post Stress Test Bank Earnings

-- Written by Antoine Gara in New York

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