Wells Fargo Record Earnings Loom, but Growth Stays Tied to Economy

Updated to reflect opening share prices and Smead Capital comment

NEW YORK ( TheStreet) -- Wells Fargo ( WFC) may post a 15th consecutive quarter of earnings-per-share growth, surpassing consensus expectations of a slight decline, as investors in the bank await signs of rising economic growth in the U.S.

Such a scenario indicates that Wells Fargo still has room to improve its bottom line and drive overall EPS growth, even in an economic environment where expectations of job creation, gross domestic product growth and activity in the housing market have fallen sharply in recent months.

After a few quarters of strong mortgage origination revenue, Wells Fargo is poised to see a significant decline in activity as a mid-quarter surge in mortgage rates put some home-buyers and those seeking to refinance their loans on the sidelines. Meanwhile, downward trends to the labor market and mixed data on GDP growth indicate that the bank is still operating in a weak economic environment that is depressing small business formation, consumer loans and housing activity.

Consensus Wall Street forecasts compiled by Bloomberg indicate that Wells Fargo will report revenue of $21 billion, a drop sequentially and from year-ago levels. Those forecasts also indicate Wells Fargo may see its earnings fall sequentially, after the bank reported a record 98-cents a share in diluted second quarter EPS.

While consensus may indicate a poor quarter for Wells Fargo, some expect the bank to continue its bottom line earnings growth as credit quality improvements, rising net interest income and higher mortgage servicing revenue offset expectations of declining housing market activity.

"We do think that Wells Faro can continue to show sequential growth in their earnings per share," Marty Mosby, a large-cap banking analyst with Guggenheim Securities, said in a Wednesday telephone interview.

Mosby forecast Wells Fargo's mortgage origination activity will drop substantially from second-quarter levels, but that it will be offset by expense reductions and other parts of the bank's business such as its credit quality.

Wells Fargo will also continue to buy mortgage securities, in an effort to deploy the bank's excess liquidity into yield-earnings assets, according to Mosby.

Whether or not Wells Fargo can find a way to grow its EPS will certainly be the headline coming out of the bank's third quarter results, due at 8 a.m. ET on Friday.

"We expect that Wells Fargo will put together another good quarter," Tony Scherrer, Director of Research and Co-Portfolio Manager at Smead Capital, said in a telephone interview.

Wells Fargo continues to grow its market share in key banking functions such as mortgage lending, wealth management and consumer deposits. As a result, many expect that the bank will show strong earnings leverage to consistent economic growth in the U.S.

"We still have years ahead for Wells Fargo to capitalize on a trend in home starts," Scherrer said of the bank's about share of the U.S. mortgage market and current below-trend home starts figures. Even with mortgage originations poised to fall about 30% from the second quarter, Wells Fargo remains at an advantageous position. "The secular trend is far more important than a single quarter," Scherrer added.

Wells Fargo shares were rising over 1% to 41.39% in early Thursday trading. Shares have gained nearly 20% year-to-date, excluding dividends, outperforming the S&P 500.

For now, investors are yet to realize those expectations, given weak macro-economic data in the U.S., particularly the second half of 2013.

"We are kind of in a boring growth period," Mosby, the Guggenheim Securities analyst said. Still, current economic trends do reflect continued recovery from the Great Recession, a scenario that augurs well for Wells Fargo's overall credit fundamentals.

Eventually, large cap banks will need a better economic backdrop to justify rising valuations across the sector. Some analysts are beginning to question whether a weak post-crisis recovery will strengthen anytime soon.

Speaking about a multi-year recovery in banking sector bellwethers such as Wells Fargo, Christopher Mutascio, an analyst with Keefe, Bruyette & Woods wrote that "it feels like the historical progression of catalysts for the banks of 1) improving credit quality giving way to increased loan growth and then 2) an improving economy resulting in higher short-term rates and NIM expansion has broken down -- at least for the time being."

Mutascio expects Wells Fargo to beat consensus this quarter and report $1 a share in third quarter EPS. Still the analyst also expects poor overall operating trends. "While our EPS estimate is higher than consensus, we think the company's core operating EPS could come in weaker than its reported EPS as the company pulls some levers to offset weak core mortgage banking results," Mutascio wrote in an October earnings preview.

Wells Fargo could use $20 billion in securities purchases to drive higher net interest income, while reporting improved mortgage servicing income and lower operating expenses. " If significant loan loss reserve releases are needed to offset the decrease in mortgage production income, then the reaction may not be as positive as investors may view such an offset as only temporary," the analyst wrote.

An earnings miss could represent an opportunity for investors who are confident in Wells Fargo's overall position. It could also present an opportunity for those who haven't lost their confidence in wider U.S. economic fundamentals.

"Unfortunately, it seems to us that the fate of the bank stocks (in terms of positive catalysts) is now tied directly to the macro-economic environment. A breakout of the GDP malaise could allow for further multiple expansion and outperformance. Conversely, it is hard for us to envision further outperformance at these levels if economic growth remains sluggish," Mutascio wrote.

In the wake of Wells Fargo's second-quarter earnings, TheStreet highlighted the importance of economic conditions to the bank's earnings outlook. Those trends haven't and aren't expected to improve in the second half of 2013.

Nevertheless, few investors are likely to take Wells Fargo's third-quarter earnings results as a reason to change their outlook on the bank's shares. Wells Fargo remains well positioned for durable growth. The question is when that will come.

-- Written by Antoine Gara in New York

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