On Second Thought, Wells Fargo Had a Horrible Third Quarter
When I learned on Friday that Wells Fargo had reported its 15th consecutive quarter of earnings-per-share growth, I can't say I was surprised. The California-based lender is one of the best in the business and has exploited its dominance of the mortgage market to more than double its net income over the last seven years.
After digging deeper into the numbers over the weekend, however, I realized that my initial impression had been wrong. Indeed, far from reaffirming my opinion of its performance, I've since come to conclude that Wells Fargo's third quarter was a downright disappointment.
To be fair, Wells' headline numbers were impressive. For the three months ended September 30, it earned $5.6 billion, or $0.99 per diluted share of common stock. These figures are 1% better than last quarter and a staggering 13% over the same period last year.
But that's where the good news both begins and ends.
Its revenue provides a case in point. Even though Wells Fargo's earnings did increase, its top line actually declined -- and not by a small margin. Revenue at the bank fell by 4% compared to the previous quarter and by 3% relative to the third quarter of 2012.
The culprit wasn't just a single outlying event. In the first case, although its net interest income did improve, that was only because its cost of funds dropped. That is to say, Wells Fargo didn't generate more revenue from its asset portfolio; it simply reduced its interest expense.
In the second case, its noninterest income dropped precipitously. While the executives at Wells Fargo -- and every other bank for that matter -- go to great lengths to praise the company's diversification -- CEO John Stumpf likes to refer to the "85 to 90 horses that pull this coach along" -- the reality is that it's heavily dependent on mortgages to maintain its record level of profitability.
Look halfway down its income statement, and you'll see what I mean. Excluding mortgage-banking income, its noninterest income grew by $378 million, or 4.9%, compared to last year. But throw mortgage banking back into the picture, and you get an entirely different outcome. It alone declined by $1.2 billion, leaving overall noninterest income down by $821 million, or 7.8%, year over year.
To add insult to injury, its expenses barely budged, dropping by only $10 million over the last 12 months. In the whole scheme of things, that rounds down to a whopping improvement of 0%.
With all of this in mind, you'd be excused for wondering exactly how Wells Fargo earnings actually grew.
The answer lies in the bank's provision for credit losses. In the third quarter of last year, Wells Fargo recorded $1.6 billion in provisions. Fast-forward to last quarter, and its provision expense dropped to a mere $75 million.
The point being, every last penny of its earnings growth was attributable to a reduction in credit provisions. Not revenue expansion. Not expense reduction. Not anything you would consider "organic" to the profit-generating process.
So, does this mean you should sell Wells Fargo's stock? No, far from it. At the end of the day, the mortgage giant is still at the top of its industry and will make money hand over fist as the economic recovery picks up steam.
What it does mean, however, is that you should prepare yourself for a less impressive showing in the fourth quarter. With provisions already cut to the bone, Wells Fargo will be hard-pressed to continue its record streak of quarterly earnings growth unless either demand for loans picks up or some other miraculous thing happens to prove me wrong -- which, let's be honest, is always a possibility.
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The article On Second Thought, Wells Fargo Had a Horrible Third Quarter originally appeared on Fool.com.John Maxfield has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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