4 Things To Watch When Wells Fargo Reports Earnings On Friday

Wells Fargo is expected to report $1.01 of earnings per share on $22.06 billion in revenue. From an earnings perspective, Wells Fargo has been extremely stable, coming in at just over $1 EPS for the past three years. Revenue has steadily increased over that same period, and Wells Fargo is expected to have grown about 1% this quarter as well.

Without doubt, the big focus this quarter will be on the fraud committed by thousands of Wells Fargo employees over the past five years. By Chairman and CEO John G. Stumpf's own admission, Wells Fargo employees created over 2 million illegal WFC consumer accounts in order to meet extremely aggressive corporate sales expectations. Over the same five year period, Wells Fargo fired approximately 1,000 employees per year, or more than 5,300 employees involved in the ongoing fraud. Yet until the media broke the story last month, cheating appears to have continued within the company's rank and file, according to some reports since 2005—well before the 'official' version of the ethics scandal broke.

Obviously, this is problematic in a variety of ways. Reputation is a critical business asset. Loss of reputation—especially for an institution whose core business involves holding and protecting customer funds on a daily basis—can be catastrophic. WFC was once considered one of the US's most respected financial institutions, though that's no longer necessarily the case. Still, a mass exodus from Wells Fargo is not expected, since customers hurt by the fraud have likely already left at this point.

Personal relationships are another key building block in this line of business. Until recently it was easy enough for management to blame a few bad apples in order to appease customers who were satisfied overall. But now that the story has been widely covered, and new details of the extent and range of the fraud keep leaking out, would you open a new account at Wells Fargo? We believe that potential new customers will at least be wary of an ongoing relationship with the bank and suspicious of its practices for at least a few more of quarters.

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Then of course, there's the big question of management. At least five full years of ongoing fraud, 2 million fraudulent accounts opened, 5,300 employees fired, and no one at the top took any action to stop these practices once and for all?

This mishandling of the situation by the bank's management is either borderline criminal or grossly incompetent. Either way, it reflects very poorly on top executives. And even though Wells Fargo announced just a few weeks ago that they would claw back CEO Stumpf's compensation of $41 million, along with forcing Carrie Tolstedt, the head of the bank's community banking division—from which the scandal emanated—to surrender $19 million worth of stock grants, it's difficult to understand why this ethical 'lapse' was allowed to continue for so long.

Tolstedt has left the bank, and just this past Monday, WFC announced a reorganization of its top rank executives, "solidifying the leadership structure beneath Timothy J. Sloan" the current president and COO of the bank who was once the head of its wholesale banking division, a unit that was not involved in the current scandal. Just yesterday, Stumpf announced he was leaving the bank, effective immediately.

Putting the fraud aside for a moment, Wells Fargo is considered to be one of this country's strongest banks, and is generally considered a safe investment. With revenues of over 20 billion, which have increased steadily during the past eight quarters (indeed they've been on an upward trajectory for well over a decade), the bank keeps on growing. During the past quarter, net interest income grew by $66 million while the net interest margin dropped another four basis points. Net interest margins fell in every one of the past five quarters, yet interest income grew. Over the past year, Wells Fargo provided another $67 million in loans, giving it an all-time-high $969 billion dollars in net loans assets. Which means that overall, Wells Fargo has not yet reached its full growth potential. Put simply, despite current economic conditions and ongoing low interest rates, Wells Fargo is still strong.

It's difficult to talk about Wells Fargo without mentioning Warren Buffet. According to CNBC's Berkshire Hathaway (NYSE:BRKa) it's 13% of the Oracle of Omaha's vaunted portfolio, valued at around $22 billion dollars. It's Buffet's largest financial sector stake, by far.

In July he requested approval from the Federal Reserve, asking for permission to enlarge his position in the company beyond the government's 10% threshold, as regulations require. On September 21st, Buffett said that he will not comment on the bank's current situation, claiming "it will lead down too many paths." One has to wonder if Buffett was aware of the unethical activities at WFC.

Nevertheless, the burning question is, what will Buffett decide to do? Any move by Buffet to divest even the smallest portion of his stake would lead to a major selloff of the stock, and for good reason. However, Buffett is not one to give up easily, nor to be influenced by short-term turbulence. It's likely that Buffett will ride out the storm. But that's not a given at this stage.

Conclusion

Is Wells Fargo a good and profitable business? Yes. Even in the current, slow-growth economic environment.

And, for savvy investors, a positive by-product of its recent negative publicity is that it's priced at a very attractive entry point. Wells Fargo is currently trading at around $45 (as of yesterday's close) with a price-to-book ratio of 1.312, the lowest ratio for the bank since February 2013. Its price-to-earnings ratio, 11, hasn't been this low since October 2013.

Even under the current cloud of scandal the bank is far bigger, wealthier, and stronger than it was three years ago. We believe the wildcard is Buffet, since any single word or move he might make could have terrifying consequences for WFC shareholders. Right now, we think Wells Fargo is a long term buy when judged by almost every parameter, but keep an eye on the Oracle of Omaha.

Written By: Investing.com