Wells Fargo & Company — Q3 2016 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2016. Amounts are U.S. dollars; financial figures are rounded to billions unless stated otherwise.
Business context
Wells Fargo is a diversified U.S. financial services company. Its three reportable segments are Community Banking, Wholesale Banking, and Wealth and Investment Management. Results include acquisitions of GE Capital businesses during 2016; the final international phase closed October 1, 2016.
Financial performance and condition
| Metric | Q3 2016 | Prior-year comparison |
|---|---|---|
| Revenue | $22.3 billion | Up 2% |
| Net interest income, GAAP | $12.0 billion | Up from $11.5 billion |
| Net interest margin | 2.82% | Down from 2.96% |
| Wells Fargo net income | $5.6 billion | Down 3% from $5.8 billion |
| Diluted EPS | $1.03 | Down from $1.05 |
| Noninterest expense | $13.3 billion | Up 7% |
| Efficiency ratio | 59.4% | Up from 56.7% |
| Provision for credit losses | $805 million | Up from $703 million |
For the first nine months, revenue rose 3% to $66.7 billion, while net income declined 4% to $16.7 billion and diluted EPS fell 3% to $3.03. Provision for credit losses increased to $3.0 billion from $1.6 billion. Annualized Q3 ROA was 1.17% versus 1.32% a year earlier; ROE was 11.60% versus 12.62%.
- Loans and deposits: Period-end loans were $961.3 billion, up 6% year over year; deposits were $1.276 trillion, up 6%. Average loans grew 7% and average deposits 5% year over year.
- Credit: Q3 net charge-offs were $805 million, or 0.33% of average loans, versus $703 million and 0.31% a year earlier. Oil and gas portfolio losses drove much of the commercial deterioration. Nonperforming assets were $12.0 billion, or 1.25% of loans, down from the prior quarter.
- Reserves: Allowance for credit losses was $12.7 billion, or 1.32% of loans, versus 1.39% a year earlier; coverage was 4.0 times annualized Q3 net charge-offs.
- Liquidity and funding: Unencumbered primary liquidity was $411.3 billion at quarter-end. Long-term debt was $254.8 billion and short-term borrowings $124.7 billion. The fully phased-in supplementary leverage ratio was 7.7%; fully phased-in standardized CET1 was 10.71%.
- Cash flow: For the nine months, operating cash flow was negative $4.5 billion, investing cash flow negative $109.2 billion, and financing cash flow positive $113.9 billion. Cash and due from banks increased $176 million to $19.3 billion.
- Shareholder returns: The company returned $3.2 billion through common dividends and net repurchases in Q3; the declared dividend was $0.38 per share. It repurchased 38.3 million shares in the quarter.
Material changes versus prior periods
- Net interest income increased, supported by loan and securities growth and GE Capital acquisitions, but net interest margin compressed amid low rates, deposit growth, and higher long-term debt.
- Expenses rose, including personnel, GE Capital-related operating leases, professional and contract services, deposit assessments, and litigation-related operating losses. Management said the efficiency ratio was expected to remain elevated.
- Q3 segment net income was $3.2 billion in Community Banking, $2.0 billion in Wholesale Banking, and $677 million in Wealth and Investment Management. Community Banking earnings fell 9% year over year; Wholesale Banking rose 6% and WIM rose 12%.
- Investment securities reached $390.8 billion, up 13% year over year. Growth in commercial loans included $26.5 billion of GE Capital loans and capital leases acquired during the first nine months.
- For the nine months, revenue growth was more than offset at the net-income level by higher credit-loss provision and higher expenses. Prior-year nine-month results also included a $359 million discrete tax benefit.
Outlook, commentary, risks, and unusual items
- Sales-practices matters: The company announced $185 million of settlements with the CFPB, OCC, and Los Angeles City Attorney, plus $5 million for customer remediation; these amounts were accrued by June 30. An independent review identified about 2.1 million potentially unauthorized consumer and small-business accounts, including 623,000 credit-card accounts. The company reported refunding $2.6 million of fees and expanding its review to 2009–2010. Government inquiries and private lawsuits continue; the ultimate financial and business impact is uncertain.
- Senior leadership changed: John Stumpf retired and Tim Sloan became CEO; Stephen Sanger became Chairman. Carrie Tolstedt left and Mary Mack took over Community Banking. The two former executives forfeited unvested awards, and neither was to receive a 2016 bonus. Retail product sales goals were eliminated effective October 1, 2016.
- The high end of reasonably possible litigation losses above accrued probable losses was approximately $1.7 billion. The company said it could not determine whether the ultimate resolution of sales-practices or mortgage investigations would materially affect consolidated financial condition.
- After regulators found the 2015 resolution plan not credible or insufficient for orderly resolution, Wells Fargo submitted a remediation plan on September 30; regulatory feedback had not yet been received. Further deficiencies could lead to restrictions on capital, liquidity, growth, or activities, or potential divestitures.
- Fitch and S&P affirmed ratings in October but changed their outlooks from stable to negative, citing uncertainty around the sales-practices matter.
- Management said the company was positioned to benefit from higher interest rates, while acknowledging risks to net interest income and mortgage-related earnings. No specific earnings or revenue guidance is provided in the filing text.
- Hurricane Matthew’s October impact was still being assessed, particularly for consumer real estate, commercial real estate, and auto loans. The filing also cites oil and gas credit deterioration, low interest rates, litigation and regulatory costs, cybersecurity, and funding and market risks.
- Unusual items included $381 million of pretax gain from the crop-insurance business sale and $290 million from the health-benefit-services sale in the first half. A Q3 reassessment of Pick-a-Pay PCI cash flows reduced expected weighted-average life from 11.5 to 7.6 years and lowered accretable yield by $4.1 billion.
Important facts for investors to verify
- Progress, costs, customer remediation, legal exposure, and regulatory consequences of the sales-practices investigations; distinguish amounts accrued from possible additional losses.
- Whether expense growth and the elevated efficiency ratio persist, and whether acquired GE Capital businesses deliver expected returns.
- Commercial credit trends, especially oil and gas nonaccruals, charge-offs, criticized loans, and allowance adequacy.
- Net interest margin sensitivity to interest rates, deposit pricing, funding costs, and balance-sheet growth.
- Regulatory feedback on the resolution-plan submission and any effect on capital distributions, growth, or operations.
- Cash-flow movements and liquidity measures, considering the scale of securities, lending, and financing activity in a bank.
- Changes to the Community Banking cross-sell methodology: the reported metric was 6.25 products per household versus 6.33 a year earlier, but definitions changed and the metric was not adjusted for potentially unauthorized accounts.
- Potential hurricane-related credit effects and the negative rating outlooks announced after quarter-end.