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Adding to a Financial After Its Report

The stock has pulled back on a revenue disappointment, but we like the long-term story.
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-- Buying 100 shares of Wells Fargo (WFC) at about $40.32.

Wells Fargo (WFC) reported earnings this morning that beat consensus by $0.02 at $0.99 per share. Revenue fell 3.5% year over year to $20.48 billion and was roughly in line with the $20.9 billion estimate.

On the positive side, credit improved, released reserves were $900 million, and expenses fell 1.5% quarter over quarter. On the negative side, net interest margin fell 8 basis points quarter over quarter, worse than the low- single-digit rate expectation, mortgage originations fell 29% year over year, and loan growth grew at just 2.5%.

Investors are disappointed in the lack of top-line growth, and shares are down 1.5%. As we indicated in the JPMorgan (JPM) quarterly review, financial companies that have a broader set of revenue drivers (capital markets, investment banking, M&A) will likely fare better in the near term to offset the weakness in mortgage originations. JPMorgan and Morgan Stanley (MS) remain our preferred ways to play the bank recovery. We like what Wells Fargo is doing in terms of expenses and credit improvement, but we reduced the size of the position over the last month (locking in our gains) on the mortgage headwinds and flatter yield curve -- the two things that Wells has significant exposure to.

Shares are down 4.8% since we sold and are now down 10.5% from their highs, and a lot of this mortgage-related news is now reflected in the shares. For the long term, the eventual yield curve steepening and the company's adjustment of its cost structure in mortgages (this is just a matter of time) and overall expense leverage keep us interested in the name, especially as the stock gets cheaper and the valuation more attractive. After you have received this Alert, we'll add 100 shares at about $40.32.

Third-quarter net income rose 13% to $5.6 billion year over year and 1% quarter over quarter, earnings, at a record of $0.99, also increased 13% year over year and 1% quarter over quarter, and revenue fell 3.5% to $20.5 billion. The revenue decline was due to the weaker-than-expected mortgage results and to a lesser extent lower trust and investment fees.

Net interest income of $10.95 billion was basically in line with expectation but was affected by the weaker-than- expected net interest margin of 3.38%, which fell 8 basis points quarter over quarter on higher deposit balances. Again, analysts were expecting a decline of around 4 basis points, and this highlights the challenges, given the flattening yield curve environment, something that is likely to change into 2014 as the economy improves and steepens the yield curve. Non-interest income of $9.73 billion was slightly below plan on weakness in mortgages and asset management. Again, this was expected, and it is the reason behind the 10.5% decline in shares from recent highs.

Mortgage banking income fell $1.2 billion to $1.6 billion, compared with the expectation of $2.2 billion. Originations fell 29% year over year, and since the pipeline at the end of the quarter is down 44% to $35 billion (from $63 billion in the second quarter), the soft production will likely continue in the fourth quarter. Asset-management fees fell to $3.28 billion and were down from $3.49 billion quarter over quarter and below the $3.4 billion expectation. Return on assets rose 8 basis points year over year to 1.53% but was down 2 basis points quarter over quarter, and return on equity of 14.07% increased 69 basis points year over year and 5 basis points quarter over quarter.

Credit improved, as net charge-offs of 48 basis points fell 73 basis points year over year and 10 basis points quarter over quarter. Expenses fell 1.5% quarter over quarter to $12.1 billion on lower commissions and incentive compensation, but the efficiency ratio increased 200 basis points year over year and 177 basis points quarter over quarter to 59.1% -- it is now at the high end of the company's goal of 55%-59%. Capital levels were strong at 9.54% under Basel III, and this compares favorably with the 8.6% level last quarter. The company bought back more shares than expected, at 51 million.

After our trade, we will own 1,500 shares of WFC, or 2.0% of the portfolio.

Regards,

Jim Cramer, Stephanie Link, and TheStreet Research Team

DISCLOSURE: At the time of publication, Action Alerts PLUSwas long WFC, JPM and MS.