Wells Fargo: Bears vs. bulls
A pleasant surprise in earnings guidance has the stock jumping, but is it just a false alarm for financial recovery?
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| The Bear: Frederick Cannon of Keefe, Bruyette & Woods |
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| The Bull: Dick Bove of Rochdale Securities |
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NEW YORK (Fortune) -- Wells Fargo thrilled investors earlier in April when the bank said its first-quarter profit would be double Wall Street's expectations as home-loan demand surged with low interest rates. Shares jumped 32% that day and optimists wondered if the news marked an end to the banking industry's slump.
The stock has backed off half its gains since then, as some analysts question the strength of those preliminary results. Bears believe Wells Fargo's anticipated $3 billion profit, comes mostly from merger accounting after its year-end acquisition of Wachovia, as well as a benefit from state laws that prevented foreclosures.
But bulls counter that Wells Fargo (WFC, Fortune 500) is reaping new business from customers refinancing at low interest rates as government intervention helps stabilize the housing market.
We asked two top analysts ahead of Well's Fargo's first-quarter results due out Wednesday if the stock is a buy or sell.
"It's important to recognize we have very limited information on Wells Fargo until they release earnings this week. So we're taking a bit of a leap here.
"But the good preliminary earnings news had more to do with merger accounting and foreclosure moratoriums than underlying trends.
The $3.3 billion in announced net charge offs in the first quarter was low relative to what we might have expected. There were a couple of reasons for that: One is the way the merger accounting worked with Wachovia. The loans in Wachovia's portfolio that were delinquent as of the end of the year were put aside and were no longer counted as delinquent. Therefore, the losses on those loans no longer need to be charged off.
"Essentially, you take Wachovia's $480 billion of loans and the ones delinquent at end of year - $96 billion - are lifted out, marked down to market levels and no longer are accounted for as problem loans.
"So within the first quarter's 90 days, you're not going to see much in the way of charge offs on those loans. We think there will be lost content on the other $380 billion, but it's not going to happen this quarter.
"That's some of the nuance of merger accounting that I didn't fully appreciate it until we got the numbers from Wells.
"In addition, the fact that you had a California moratorium on foreclosures or notices of default has postponed some losses at Wells Fargo. We did see a significant dip in notices of default in the fall and winter months as a result of new laws in California. But since then, there's been a reacceleration of those.
"Also, Wells said it would incur lower-than-expected expenses, which is surprising because it initially said it was going to take a $10 billion merger charge.
"To date it has only taken $77 million in merger charges, and in the first quarter it doesn't appear that it took a merger charge. That's going to be an expense it will have to deal with.
"Our view is that the positive first quarter earnings results can't be sustained with future merger expenses and rising charge-offs.
"We downgraded shares to 'underperform' and have a $12 target."
"I've accepted the point of view that if a loan is not in default, it's worth what it says it's worth. And that means I think the markdowns are excessive in the sector.
"Wells Fargo has been taking some fairly sizable write-offs. In the fourth quarter, it took an extreme write-off - $37 billion - so that this year it could build its reserves and keep a relatively low loan-loss provision. If it's right, then its provision is not going to go up dramatically this year, despite the fact that foreclosures are likely to increase.
"I think [Cannon's] right about foreclosures. Not only are you seeing defaults rise because the forgiveness period is over, but you're going to see them rise with this whole stress test environment. But are they going to rise to an extent that they will impact Wells Fargo's earnings so negatively that the company will not be able to maintain earnings somewhere in the 50-cent-per-share level? I don't think so.
"If it's correct to argue that foreclosures are going to expand dramatically, you're not going to see it until October in Wells Fargo's number. But I'm not sure you're going to see it then either, because the government is committed to buying $3 billion to $5 billion of mortgages a day. There has to be an impact in the housing market from these issues.
"And the most important factor is that real incomes are rising and you still have 153 million people working. At some point all of those metrics come together and you get a stabilization of the housing market.
"I'm not going to tell you that in the next six years you will see an improvement in housing prices of any magnitude, but it strikes me that we're pretty close to the bottom if we're not already there.
"Simply, I think Wells Fargo can earn its way out of its capital dilemma. We have a $25 target price." 
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