If you have been keeping up with the financial news over the past few years, it is likely you’ve seen plenty of negative headlines about Wells Fargo. You may have heard their name thrown around in political discussions. Lately, Wells has become the poster child for corporate wrongdoings and big bank greed. This is because of a scandal uncovered in 2016 where employees of the bank were found to have opened fake accounts on behalf of customers in order to hit quotas and receive fat paychecks for doing so. These accounts did not cause severe financial issues for any individuals, but generated small fees for a lot of customers that should not have been charged. People have not forgotten the history of wrongdoings of the big banks and Wells has not been spared any mercy, thus creating serious headline risk for the company.
Throughout the past few years, Wells has had executive turnover and is now on its third CEO (who is only interim CEO) since prior to the scandal. In addition, the Federal Reserve has placed an asset cap on the bank and is not allowing them to grow until they meet strict compliance and internal control demands. Their progress in meeting those demands has been disappointing to this point and there is no timetable for the cap removal.
Financially, Wells is doing ok but is not as profitable as they were prior to the bumpy ride they’ve been on. The low interest rate environment continues to pressure interest income in the banking industry as a whole. Wells also has to deal with their own costs which have ballooned over the last couple years due to the large legal and personnel costs needed to navigate their way through an operational risk management transformation. From 2013-2015 prior to the scandal, the bank’s efficiency ratio, which measures non-interest expenses to revenue, was just above 58%. It is now up to 65%. Like golf, lower is better.
It is safe to say there is now legitimate pessimism surrounding the company which was once the golden standard in the financial sector and is a longtime favorite of legendary investors. I see this as an opportunity, as the bank’s core advantages remain intact and its wounds can gradually be healed. And not often has the business been available to buy as cheap as it is now.
The Business
Wells Fargo’s brand and products are very well entrenched in the American economy. The bank serves 1 in 3 households in the U.S. Through its well diversified segments, it offers a full suite of products from mortgages to student loans to credit cards to wealth management services. Wells’s revenues are essentially split; a little over half comes from interest income and the rest from other fee generating products. This somewhat insulates profits from temporary variations in interest rates or declines in other fee businesses, such as mortgage originations. The bank focuses more on traditional banking – taking in deposits and lending them out – and less on trading and investment banking, which fluctuate with the capital markets.
There are advantages that come with doing business with 1 in 3 households in the country. One is the stickiness of the relationships. Most of Wells’s customers have several products with the bank, like a checking account, credit card, student loan, investment account, and a mortgage, making it difficult and a serious hassle to switch banks. Because of this stickiness and a well distributed physical presence, Wells gets consistent access to $766 billion of low-cost retail deposits, a top figure in the industry that powers attractive returns without taking undue risks. The stickiness of these deposits is evidenced, very importantly, by the fact that customers have not fled the bank following the account opening scandal. Community banking deposits at the time of the scandal hitting the news (September 2016) were $708 billion. Today they are 8% higher. These cheap deposits are a large portion of funding for the bank’s assets and give it a cost advantage over rivals that have to use more expensive forms of funding for their assets.
Another advantage Wells Fargo has comes from scale and its ability to cross sell products. It is a lot cheaper to sell a product to an existing customer than to a new customer. The bank’s former CEO, Richard Kovacevich, explained this in a 2011 interview:
“The cost of selling an incremental product to an existing customer is about 10% of the cost of selling that same product to a new customer. Isn’t that intuitive and obvious? You don’t open up a new account. You don’t advertise. You don’t take other risks.
Because the margin is so high, you can actually give some of that margin back to the customer. You can say to the customer: ‘If you bring over your Treasury management product, your business or personal insurance, your credit card, your 401(k) or whatever, I’m going to give you a better deal than the competitor who is selling you only one product because of the 10% cost versus that 100% cost.'”
Because Wells already has a massive customer base it can sell them new products at prices much cheaper than what they would pay for a similar service at another institution. This also creates a virtuous cycle in which Wells Fargo’s customers, and their valuable low-cost deposits, become further entrenched at the bank as it continues to grow the average products used per household, a measure I think of as the glue that keeps their finances stuck at the bank. The bank’s deposit market share has grown at a steady clip the past several decades and now sits at 11%. While it’s unreasonable to expect them to repeat the impressive growth of the past, once the asset cap is lifted they can still take market share going forward as one of the most efficient operators in a consolidating industry.
Historically, Wells has operated with a very prudent underwriting culture. They avoided the devastating financial risks leading up to last decade’s real estate bust which allowed them to opportunistically acquire Wachovia and grow market share at attractive returns while less disciplined competitors were playing defense. Their conservative risk-taking history allows them to have the lowest capital reserve surcharge of the big four banks that are considered global systemically important banks. This allows Wells to generate profits with less capital than peers, enhancing returns for shareholders in the process. There is no reason to believe that underwriting standards have wavered in relation to the account opening scandal as credit metrics are healthy (loan charge-off rate of 0.30% and low subprime FICO score exposure) and management is de-risking the balance sheet to manage the asset cap.
Investment Thesis
It is my belief that the core sustainable advantages of Wells Fargo’s business listed above are still intact. The bank is dealing with largely temporary issues that have its profits and investor sentiment in the gutter. There are five areas I’ve identified where upside potential could be meaningful or risk reduced:
- Management is improving the bank’s asset quality by selling riskier assets to stay under the asset cap. This should result in stronger performance during an economic downturn and allow for attractive capital deployment opportunities when the asset cap is lifted. In addition, this is currently reducing the average yields earned by the bank and compressing their net interest income margin. Wells Fargo’s net interest margin was lower in 2018 than it was in 2015, even though interest rates bottomed in 2015. I think this and the next point are causes of an under-earning asset portfolio that won’t remain over the long term.
- Another source of margin compression is the persisting unfavorable interest rate environment for banks. A 200 basis point increase in interest rates would increase Wells Fargo’s income by over 10% from current levels. I don’t know where rates will go, but a reversion to the mean would suggest upward.
- Yet one more source of margin compression is the bloated non-interest expenses I discussed earlier. I think this is our most likely and largest source of upside potential. The bank has already made progress on this front compared to last year. If management can get the efficiency ratio to the upper 50%’s range of their past, that would increase net income by around 15-20%. A removal of the asset cap will be needed to get most of this benefit by scaling fixed costs, however Wells is reducing its branch count now and enacting some personnel cuts that should continue the positive trend in this area. NOTE: An interesting point here is the fact that Wells Fargo has 26.5% more employees and 35% more branches than Bank of America even though they serve only 6% more customers, have only 9.9% more retail consumer deposits and 5.75% less in total deposits, and 20.1% less assets than BAC. In other words, I think Wells is pretty fat right now. Once a permanent CEO is in place, I think his/her first priority will be efficiency, and it seems there is enough opportunity here to generate significant operating leverage like Bank of America has demonstrated in years past.
- Wells has a fortress balance sheet right now. Not just the improving asset quality that I referred to before, but a capital reserve ratio of 11.9% currently is well above regulatory requirements and the bank’s 10% target. Getting to 10% with no growth would release $24 billion back to shareholders, which is 11.7% of the current market cap. That’s a full year of attractive return just in excess capital. Share buybacks and dividends have been massive recently and should continue to be hefty for 2-3 more years, providing a boost to earnings per share.
- I believe the probability of any negative surprises related to internal controls, customer service, or operational risk to be greatly diminished at this time as regulators and politicians have been watching the company like a hawk for several years now. Any other missteps would have likely been uncovered already. Also, everyone at the firm should be on their best behavior to move on from recent mistakes as fast as possible (and to not find themselves on the front page of the Wall Street Journal or as one of Elizabeth Warren’s campaign talking points).
Valuation
Wells Fargo’s market cap is $205 billion and they generated $22.4 billion of earnings in 2018. That’s a 10.9% yield on the price. But because Wells has excess capital that is likely to be returned in the next few years, I find it reasonable to subtract that $24 billion from the current price to find the net. That would leave Wells selling for $181 billion, bringing us to a 12.4% yield on last year’s earnings.
For one of the least changing, profitable businesses around that is so important to our global financial system that the government won’t allow it to fail, I think that’s a pretty good deal considering the low-to-mid-single digit yields on most investments today. Once the asset cap is lifted, management will attempt to get costs in line with the bank’s past as the focus will shift from satisfying regulators to operating lean. If they succeed at reclaiming their margin profile, that would bring earnings to roughly $27 billion. We also need to adjust for full cycle credit charge-offs, as management has provided an estimate for normalized charge-offs that is about double the current levels. This would reduce earnings by $2 billion to ~$25 billion, a 13.8% yield on our net price.
If that outlook is too rosy for you, assume earnings remain flat in the next five years. Wells could return $136 billion if it paid out all earnings each year and the excess capital to shareholders. That’s two-thirds of the current price returned in the first five years, a staggering amount when compared to alternative investments. If you value the business on a discounted cash flow basis, the valuation is front loaded with capital return which makes it much more certain of a valuation than one in which uncertain growth in future cash flow is extrapolated far into the future. This certainty, combined with a business as stable as Wells Fargo, is very valuable for an investor looking to make a confident, sizable investment. I believe risk of loss is very low.
A lot of the capital will be deployed through share buybacks, which will increase per-share value and do so rapidly if any upside materializes. It is quite possible that Wells will decrease its shares outstanding by around 25% in the next three years depending on the share price and timing of the asset cap removal. A 25% reduction in shares combined with $25 billion in earnings (based on a margin profile that I believe they can attain due to reasons listed above) would be $7.39 of earnings per share. The stock sells for about $45 now. That’d be a 16.4% yield on cost. How long it may take to execute on a cost reduction program is hard to tell, however value is being created now with a 4% dividend yield, tons of buybacks, and low risk of capital loss. If no earnings growth materializes we are still left with a 12.4% yield on the net price. In a business as durable as Wells Fargo, I’ll take that any day.
As the asset cap is lifted, Wells will be able to begin reinvesting in its core business again which generates attractive returns on capital in the mid-teens. This will compound value over time and likely cause the market to apply a higher multiple on the earnings and book value to adjust for the rate of increase in intrinsic value. Right now the stock is at just a 1.17 premium to book value, a discount to its historic multiple and another safety net against severe capital loss.
Catalysts
- Tons of buybacks
- Positive Federal Reserve stress test and capital plan results in next two weeks
- Permanent CEO put in place
- Asset cap removal
- A more hawkish Fed
Disclosure: I hold a position in WFC stock.
Bryce Dooley
BD Capital 