Wells Fargo's earnings quality and its reliance on one-time gains

Wells Fargo (NYSE: WFC) has consistently met or beaten analysts' earnings estimates each quarter, making the bank well-known for its earnings consistency. Investors should look to the quality of those earnings and how the bank generates them. While it does have a profitable core banking stream, the bank tends to rely on one-time gains it garners from selling assets and securities. These one-time gains have largely been responsible for the bank's earnings for the last 12 quarters. These gains have also led to a valuation that may be inflated and that is higher than that of other big bank competitors.

For the second quarter, Wells Fargo reported earnings per share of $1.01, which matched the estimate of analysts but which fell short of expectations. This also led to the share price falling to $48 per share, a drop of -2 percent.

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WFC was the only large bank that did not meet its investors' expectations. An analyst from Barclay's (NYSE:BCS) calculated that 14 percent of WFC's earnings were comprised of noncore and special factors, leading many analysts to question the true quality of the bank's earnings.

Seizing cars of U.S. soldiers: Probe

Wells Fargo is reportedly under Department of Justice and regulatory investigations for allegedly violating the Servicemembers Civil Relief Act by repossessing vehicles that were owned by military service personnel. The law requires that banks seek and obtain court orders before repossessing military members' vehicles when the members are delinquent on their payments. The bank has branch locations on eight military bases and says it prides itself on making obtaining automobile loans easier for servicemembers. After the 2008 housing crisis, Wells Fargo paid $28 million in settlement funds for improperly foreclosing on the homes of active-duty military personnel in violation of the law. In May 2016, WFC reported it had $61 billion in delinquent auto loans of which $55 million were 90 days or more past due.

The effect of the poor interest rate market

The current interest rate market appears to be poor for banks as interest rates are likely not to rise for some time. Banks like WFC rely on earnings from interest for half or more of their revenues. Interest earned on loans and fixed-income securities is lower than the yield would be if the interest rates were higher, hurting the banks' overall profits. Wells Fargo has $951 billion of loans. In comparison to six years ago when interest rates were higher, today's interest rates equate to the bank earning $8 billion less than if the rates were as high as before. Wells Fargo is working to combat this issue by growing its loan and securities portfolios. In the second quarter, the bank reported a year-over-year loan portfolio growth of $80 billion and a year-over-year securities portfolio growth of $18.5 billion, allowing its net income to rise.

Comparison with JPMorgan

By contrast, JPMorgan (NYSE: JPM) reported a blockbuster second quarter with its earnings rising 24 percent over those of the first quarter. This beat analysts' expectations. JPM reported earnings per share of $1.55, far exceeding the analysts' estimates of $1.43 per share. The bank was able to increase its lending by 23 percent during the quarter despite the forecasts that Brexit would result in lowered sales. JPM also reported $25.2 billion in revenue for the second quarter, meaning it is the only big bank that is currently on track to make more than $100 million in revenue for 2016.

Conclusion: JPM a better choice

While Wells Fargo has consistently reported earnings that meet or beat analysts' estimates, the quality of those earnings should give investors pause. The fact that the bank is also under investigation for violating the Servicemembers' Civil Relief Act may end up having a negative impact on its business and valuation, as well due to falling investor confidence. The interest rate market looks as if it will continue to be poor for banks, and WFC has taken some steps to combat this negative impact. By contrast, JPMorgan far exceeded the analysts' expectations and reported enough in revenues that it might pass the $100 million mark for the year. When comparing the two, we recommend that investors who are interested in the financial sector choose JPMorgan over Wells Fargo.