How profitable was Wells Fargo in 2006, and how did returns compare to prior years?

Net income reached a record $8.5 billion in 2006, up 11% from $7.7 billion in 2005. Diluted EPS was $2.49, up from $2.25. Return on average assets was 1.75% (vs. 1.72% in 2005), and return on average equity was 19.65% (vs. 19.59%). Earnings per share compound growth over the prior 20 years was 14% annually, according to management.

Is Wells Fargo's credit quality deteriorating?

Partially. Net charge-offs actually declined to 0.73% of average loans from 0.77%, and the allowance for credit losses stands at $3.96 billion. However, nonaccrual loans rose to $1.67 billion from $1.34 billion, and total nonperforming assets climbed to $2.42 billion from $1.53 billion, driven largely by foreclosed assets (including $322 million of GNMA-related foreclosed real estate under new reporting rules). Auto loan losses also rose $160 million due to collection capacity issues. The allowance ratio fell to 1.24% from 1.31%, which management attributed to a shift toward consumer loans with shorter loss emergence periods.

What drove the Home Mortgage decline, and how much did it matter?

Home Mortgage revenue fell $704 million, or 15%, to $4.2 billion. Management attributed the decline to the company's sales of adjustable-rate mortgages and the rate environment. The company also adopted FAS 156 in 2006, which changed how mortgage servicing rights are measured, creating volatility in mortgage banking income (MSR valuation changes reduced results by $154 million net of hedging). Revenue outside Home Mortgage grew 12%, so the company's overall growth was not dependent on this segment.

How is Wells Fargo returning capital to shareholders?

In 2006 the company paid $3.6 billion in common dividends (declared $1.08 per share, up 8%), repurchased 59 million shares, and issued $2.1 billion of common stock under employee and dividend reinvestment plans. The Board authorized an additional 50 million shares for repurchase in June 2006, and 62 million shares remained under authorization at year-end. Management noted that the company generally does not announce repurchases in advance, and that the timing and amount depend on capital needs, stock price and legal considerations.

What are the main risks to the investment thesis disclosed in this filing?

The filing highlights several risks: an economic slowdown that could reduce loan demand and increase credit losses; rising or flattening yield curves that could compress net interest margin (currently 4.83%, down from 4.86%); volatility in mortgage servicing rights value and mortgage banking revenue as interest rates change; reliance on cross-selling to grow revenue; venture capital gains that can be volatile; auto loan credit problems; and regulatory and legislative change, including challenges to the OCC's authority over national banks. The company also relies on dividends from its bank subsidiaries, which are subject to legal limits.

WFC 10-K FY2006 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 1, 2007. Cited figures are marked; the original filing is the authoritative source.

Wells Fargo's 2006 10-K (filed March 1, 2007) reports a year of record results: revenue rose 8% to a record $35.7 billion^a, net income grew 11% to a record $8.5 billion, and diluted EPS reached $2.49 (after the August 2006 two-for-one stock split).

Return on average equity was 19.65% and return on assets 1.75%. Growth was broad-based across the company's three segments (Community Banking, Wholesale Banking, Wells Fargo Financial), with Wholesale Banking net income up 17% to a record $2.09 billion^b and Wells Fargo Financial up 111%. Home Mortgage revenue fell 15% to $4.2 billion, reflecting the company's ARM sales and a weaker mortgage environment.

Credit quality showed some pressure beneath the headline numbers. Net charge-offs were 0.73% of average loans (down from 0.77% in 2005), but nonaccrual loans rose to $1.67 billion^c from $1.34 billion, and total nonperforming assets reached $2.42 billion (0.76% of loans). Auto loan losses rose $160 million due to collection constraints during the integration of prime and non-prime auto businesses.

The allowance for credit losses covered 1.24% of total loans, down from 1.31%, and the company released $50 million^d of Hurricane Katrina reserves. Balance sheet strength was a clear positive. Total assets were $482 billion, deposits $310 billion, and stockholders' equity $46 billion (equity-to-assets of 9.52%, up from 8.44%).

Wells Fargo Bank, N.A. was upgraded to AAA by S&P in February 2007, making it the only U.S. bank rated AAA by both S&P and Moody's. Management also returned capital through $3.6 billion in dividends and 59 million repurchased shares, with 62 million shares remaining under authorization.

02—Key points

Key Highlights

Record 2006 net income of $8.5 billion (up 11%) and record diluted EPS of $2.49 (up 11%), with ROE of 19.65% and ROA of 1.75%.
Record revenue of $35.7 billion (up 8%), with net interest income up 8% to $19.95 billion and noninterest income up 9% to $15.7 billion.
Wells Fargo Bank, N.A. upgraded to AAA by S&P in February 2007; it is the only U.S. bank rated AAA by both Moody's and S&P.
Net charge-offs improved to 0.73% of average loans, but nonaccrual loans rose 25% to $1.67 billion and nonperforming assets reached $2.42 billion (0.76% of loans).
Home Mortgage revenue fell 15% to $4.2 billion, offset by strong growth elsewhere: card fees up 20%, trust and investment fees up 12%, and gains on equity investments up 44%.
Capital position strengthened: Tier 1 RBC ratio of 8.95%, total RBC of 12.50%, and equity-to-assets of 9.52%, with all covered banks rated well capitalized.
Noninterest expense rose 9% to $20.7 billion as the company added 4,497 sales and service team members and opened 109 new regional banking stores.

03—Questions

Frequently Asked Questions

How profitable was Wells Fargo in 2006, and how did returns compare to prior years?
Net income reached a record $8.5 billion in 2006, up 11% from $7.7 billion in 2005. Diluted EPS was $2.49, up from $2.25. Return on average assets was 1.75% (vs. 1.72% in 2005), and return on average equity was 19.65% (vs. 19.59%). Earnings per share compound growth over the prior 20 years was 14% annually, according to management.
Is Wells Fargo's credit quality deteriorating?
Partially. Net charge-offs actually declined to 0.73% of average loans from 0.77%, and the allowance for credit losses stands at $3.96 billion. However, nonaccrual loans rose to $1.67 billion from $1.34 billion, and total nonperforming assets climbed to $2.42 billion from $1.53 billion, driven largely by foreclosed assets (including $322 million of GNMA-related foreclosed real estate under new reporting rules). Auto loan losses also rose $160 million due to collection capacity issues. The allowance ratio fell to 1.24% from 1.31%, which management attributed to a shift toward consumer loans with shorter loss emergence periods.
What drove the Home Mortgage decline, and how much did it matter?
Home Mortgage revenue fell $704 million, or 15%, to $4.2 billion. Management attributed the decline to the company's sales of adjustable-rate mortgages and the rate environment. The company also adopted FAS 156 in 2006, which changed how mortgage servicing rights are measured, creating volatility in mortgage banking income (MSR valuation changes reduced results by $154 million net of hedging). Revenue outside Home Mortgage grew 12%, so the company's overall growth was not dependent on this segment.
How is Wells Fargo returning capital to shareholders?
In 2006 the company paid $3.6 billion in common dividends (declared $1.08 per share, up 8%), repurchased 59 million shares, and issued $2.1 billion of common stock under employee and dividend reinvestment plans. The Board authorized an additional 50 million shares for repurchase in June 2006, and 62 million shares remained under authorization at year-end. Management noted that the company generally does not announce repurchases in advance, and that the timing and amount depend on capital needs, stock price and legal considerations.
What are the main risks to the investment thesis disclosed in this filing?
The filing highlights several risks: an economic slowdown that could reduce loan demand and increase credit losses; rising or flattening yield curves that could compress net interest margin (currently 4.83%, down from 4.86%); volatility in mortgage servicing rights value and mortgage banking revenue as interest rates change; reliance on cross-selling to grow revenue; venture capital gains that can be volatile; auto loan credit problems; and regulatory and legislative change, including challenges to the OCC's authority over national banks. The company also relies on dividends from its bank subsidiaries, which are subject to legal limits.

04—Continue

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