A decent set of numbers

The major investment banks' second quarter performance suffered from the lacklustre trading environment that prevailed through the period. Wells Fargo's business is not so exposed to the vagaries of Wall Street, given that it has a significantly smaller trading operation. The bank's performance is therefore in many ways a better indicator of the health of the US recovery.

Wells Fargo enjoyed a reasonably robust second quarter, delivering earnings in excess of $3 billion for only the fourth time in its history. More importantly with regards to the recovery, the bank is beginning to see growth in its loan portfolios.

An element of weakness from the likes of JP Morgan and Citigroup was the absence of loan growth. The availability of credit is essential to any modern economy and certainly a pre-requisite if the nascent US recovery is to sustain itself. We are therefore encouraged to see Wells Fargo report positive developments on this front in terms of increased demand.

Turning to the result itself, Wells Fargo achieved top line sales of $21.4 billion, representing a 5% decline from the same period last year. The bank's earnings came in ahead of expectations at $3.06 billion. While the bank's earnings were 3% lower than the same period last year, earnings were up 21% from the first quarter.

In keeping with most of the other banks, Wells' earnings benefited from a significant release from its loan-loss reserves, to the tune of $500 million. Releasing reserves is simply an accounting adjustment and does not reflect an operational improvement. It does however speak volumes as to the outlook for bad debts, which has clearly passed its peak.

Of Wells Fargo's three divisions the most significant is its Community Banking arm. The division provides banking services to retail customers, in addition to more than 2.5 million small businesses. The divisionÕs earnings expanded 21% from the opening three months of the year, to $1.8 billion.

Community Banking's consumer loans contracted overall, but there were positive indications in various areas. Mortgage applications for example increased 14% during the second quarter and the unclosed mortgage pipeline lifted 15% to $68 billion. Auto loans were also up 4% and student lending gained 1%.

The other big hitter for Wells is its Wholesale Banking division, which contributed $1.4 billion to group earnings. This represents 16.7% growth from the first quarter and 32% from the same period last year. Wholesale Banking also revealed some positives with regards to loan growth, with business lending up in the quarter.

The comparatively small Wealth, Brokerage and Retirement division (WBR) delivered 5% earnings growth from the same period last year. The growth was primarily a function of larger managed account asset values, which in turn delivered significant growth in fee revenue.

One of the key uncertainties hovering over US banks is the issue of regulatory reform. The various aspects of the reform bill are primarily targeted against trading activities, derivatives and private equity. Because Wells Fargo is not a significant player in these areas we would not expect the bank to be particularly impacted by the reform.

Additional capital requirements could be an issue, but Wells has always been very prudent in this regard, which at least limits any top up that may be required. The bank currently has tier 1 capital ratio of 10.4%, which is up from 9.8% as at June 30 2009. Moreover, given the necessity for credit growth rather than contraction, it is unlikely that the new regulations would force though aggressive increases to capital requirements.

Meanwhile, the Wachovia integration is proceeding satisfactorily towards its expected completion in 2011. The benefits of the deal are evident in the growth of cross-sell business that was one of the key motivations for the Wachovia deal in the first place. Indeed, the integration of Wachovia will provide Wells with a very strong foundation from which to drive its business forward through the years ahead.

Turning to the charts, the weekly chart shows that the recent uptrend that has been in effect since the March 2009 low has recently been broken. The price action has pulled back to test the $25 support level having broken below both the 50 and 200 day moving averages. The weekly MACD has also given a bearish signal and has since crossed the zero signal line which confirms the trend direction as downward.

Moving on to the daily chart of WFC we can see that the 50 day moving average has just crossed below the 200 day moving average forming a bearish signal known as a “death cross”. These moving averages are likely to provide some resistance. The $25 support level has held up on a few occasions now. The daily RSI has turned higher from oversold territory which also adds to our conviction that the $25 level will hold for now. Ideally we need to see a break back above the 50 and 200 day MAs and resistance around the $30 mark. This would develop an upside target of $34.25.

Wells Fargo will remain held in the Fat Prophets Portfolio.