Wells Fargo (WFC) reported better-than-expected third-quarter results before the market opened Friday, bolstering shares and validating our bullish investment case for the lender. Total revenue rose by 2.5% year-on-year, to $19.5 billion, beating analysts’ expectations for $18.78 billion in revenue. Earnings-per-share of $1.30 (excluding a $2 billion, or $0.45 per share, headwind from accruals for litigation, customer remediation, and regulatory matters) exceeded estimates of $1.09 a share.

Key company metrics

Before digging into the various operating segments, let’s take a quick look at how some key overall metrics stacked up in the third quarter.

• Net interest income: $12.1 billion, up 18.6% quarter-over-quarter and 36% year-over-year, compared with the consensus estimate of $11.6 billion.

• Net interest margin: 2.83%, compared with 2.03% during the same period a year prior, and above the consensus estimate of a 2.68% 

• Non-interest income: $7.407 billion, ahead of expectations of $7.112 billion, but down 25% year-on-year.

• Non-interest expense: $14.327 billion, up 7.7% year-over-year and up 11% over last quarter, versus a $12.62 billion consensus estimate. That figure includes $1.7 billion in operating losses related to the bank’s legacy issues, without which total expenses would have declined due to efficiency initiatives.

• Return on average tangible common equity (ROTCE - measure of annualized earnings applicable to Wells Fargo common shareholders as a percentage of average tangible common equity): 9.6%, below analysts’ forecasts of 12.5%.

• Efficiency ratio (measure of efficiency that is calculated as total non-interest expenses divided by net revenues): 73%, up from 71% last year, above analysts’ expectations for 67.7%.

• Average loans: $945.5 billion, up 11% year-over-year and 2% from the second quarter, in line with analysts’ expectations. Period end loans increased for the fifth consecutive quarter.

• Average deposits: $1.4 trillion, down 3% year-over-year, in line with analysts’ forecasts.

• Tangible book value per share (TBVPS - measure of intrinsic liquidation value that removes intangibles such as goodwill): $34.27, down 4% year-on-year and down 1% from last quarter.

• Provisions for credit losses: $784 million, well ahead of analysts’ expectations for $572 million, and up from $580 million last quarter.

Segment results

Consumer Banking and Lending total third-quarter revenue was $9.27 billion, up 5% over last year and up 9% over last quarter. Consumer and small business banking (CSBB) revenue increased 29% year-over-year, primarily due to higher rates and deposit balances. Within consumer lending, home lending was down 52% from last year, while credit card revenue increased 8% over last year. Auto loan revenue was down 5% year-over-year and personal lending increased 9% from last year. 

Commercial Banking third-quarter revenue soared by 42% year-over-year, to $2.952 billion. Middle market banking revenue of $1.793 billion represented an increase of 54% over the same period last year, on the back of higher interest rates and loan balances. Asset-based lending and leasing revenue of $1.159 billion increased 27% year-over-year thanks to higher net gains from equity securities, higher loan balances, and higher revenues from renewable energy investments. Non-interest expenses increased 9% year-over-year, primarily due to higher operating costs and operating losses.

Corporate and Investment Banking third-quarter revenue climbed by 20% year-over-year, to $4.06 billion. Total banking revenues increased 28% year-over-year and 24% from last quarter, a result of higher interest rates. Investment banking fees were down year-over-year but increased from the second quarter. Commercial real estate revenue increased 29% year-over-year and 14% from the second quarter. Markets revenue was up 6% year-over-year and 4% from the second quarter. Non-interest expenses increased 6% year-over-year but were up only 3% from the second quarter, partially due to higher operating costs.

Wealth and Investment Management third-quarter revenue was $3.665 billion, up 1% year-over-year. Net interest income jumped 71% year-over-year and 19% from the second quarter, due to higher rates. Non-interest income, however, fell 14% year-over-year and 8% from the second quarter, a result of lower asset-based fees. Non-interest expenses fell 4% year-over-year due to lower revenue-related compensation and efficiency initiatives.

Fourth quarter and future outlook

We have stood behind Wells Fargo despite concerns over a potential recession because it’s the most interest-rate sensitive bank among its peers. We also have confidence in management’s ability to reduce expenses, unlike other banks struggling to keep costs down. That’s why we were pleased to see management provide an upside guide to both net interest income and expenses for the fourth quarter.

Wells Fargo now sees full-year net interest income 24% higher than in 2021, up from a previous estimate of 20% growth. The bank expects fourth-quarter net interest income to be approximately $12.9 billion, beating analysts’ estimates of $12.42 billion. Wells Fargo anticipates expenses to come in around $12.3 billion in the fourth quarter, below analysts’ forecasts for expenses of $12.5 billion. It’s important to note this outlook does not include any future operating losses related to historical obligations.

Looking ahead to 2023, management plans to provide a net interest income- and expense outlook for next year when it reports fourth-quarter results. The hope for the bulls is that 2023 net expenses will be lower than 2022 levels, excluding losses. But management reiterated Friday the importance of balancing investing in the business with cutting costs.

As expected, there was no formal update about when Wells Fargo management expects the Federal Reserve to lift its mandated asset cap, a punishment tied to the bank’s 2016 fake accounts scandal. We believe management is working tirelessly to resolve outstanding issues and that it’s a question of when, not if, the asset cap is lifted. At that point, Wells Fargo will be able to pursue higher returns on asset opportunities and grow its loan book, facilitating stronger earnings.

Capital returns

Wells Fargo did not repurchase any stock for the second quarter in a row, consistent with management’s commentary last month at a conference. This comes despite an authorization of $18 billion and the bank’s Common Equity Tier 1 (CET1) ratio of 10.3% being well above its regulatory minimum and buffers of 9.1%. The bank wants to be more “conservative on capital rather than less conservative” due to various economic uncertainties and the potential for big swings in its Accumulated Other Comprehensive Income (AOCI).

Bottom line 

A strong quarter for Wells Fargo played into our bullish thesis: Higher interest rates are having an outsized impact on the bank’s net interest income, while management’s operating efficiency initiatives have cut down on the expense base. The combination of these two factors should allow the bank to increase its earnings capacity in future quarters.

Meanwhile, its credit quality remains strong. On Friday, Wells Fargo management spoke positively about the health of the consumer, thanks to historically low delinquencies and higher payment rates across the bank’s portfolio.