Very recently, I published an article why banks could be a good long-term investment and I also explained my reasoning why I avoided banks so far. One of the six banks I used as example to illustrate my points was Wells Fargo & Company (WFC) and this first article is dedicated to the bank, that has been one of Buffett’s favorites for a very long time.
Wells Fargo is especially interesting as it seems cheap after a steep decline and steep declines often create the illusion of a bargain, which doesn’t always have to be true. In the following article, I will look at the dividend and the risks, the company might be facing. Additionally, I will try to put the underperformance of Wells Fargo in the last few years in context and try to answer the question, if Wells Fargo could be a good long-term investment before I finally present my strongest argument, why I think Wells Fargo could be very close to a major buying opportunity. But we will start with a short business description and presentation of second quarter results.
On Tuesday, July 14, Wells Fargo reported second quarter results and while nobody expected positive results, the numbers for Wells Fargo were particularly bad – especially compared to its peers. Wells Fargo reported a net loss of $2.4 billion, resulting in a loss of $0.66 per share. Revenue could increase 0.6% compared to the first quarter of 2020, but declined 17.4% compared to the same quarter last year. The biggest drag on the bottom line was $9.5 billion in provision for credit losses bringing up this amount to $13.5 billion for the first half of 2020. While non-interest income declined about 16% compared to the same quarter last year, interest income declined 31% for the same timeframe.
(Source: Wells Fargo Investor Presentation)
When looking closer at the different sectors, the Community Banking segment had to report a loss of $331 million (mostly due to provision for credit losses of $3,378 million) in the second quarter. Net interest income declined 19% compared to the same quarter last year and non-interest income declined 35%. While Community Banking is offering financial products and services for consumers and small businesses and is being responsible for more than 50% of Wells Fargo’s revenue, Wholesale Banking, which is providing solutions to business and financial institutions is responsible for only 1/3 of revenue, but has a much higher margin and is generating more than half of the profits (at least in past quarters). In the second quarter of 2020, the segment had to report a loss of $2,143 million (mostly due to provision for credit losses of $6,028 million). Net interest income declined 14% compared to the same quarter last year, while noninterest income could increase 6%. The third and smallest segment is Wealth and Investment Management, which reported a net income of $180 million in the second quarter and was the only segment that was profitable.
Not only were second quarter results especially bad, Wells Fargo was clearly underperforming other major banks in the last few years and several numbers are indicating, that the company is in trouble. For example, when looking at the stock price, Wells Fargo underperformed in a drastic way compared to many other banking stocks in the last few months.
But not only the stock underperformed. We can look at several measures of profitability and Wells Fargo seems to underperform its peers in almost every way. The net income margin is only 9.19% while other banks are still reporting net income margins between 25% and 30%. The return on equity is also much lower – while Wells Fargo has a RoE of only 3% right now, the other banks are still in the double digits (or at least very close). Wells Fargo is also generating a lower revenue per employee than the other banks.
(Source: Seeking Alpha)
Or when looking at the reported second quarter results for other big banks, Wells Fargo was also a huge disappointment. Most other banks – like Bank of America (BAC), Goldman Sachs (GS) or U.S. Bancorp (USB) – could beat earnings and revenue expectations and JPMorgan Chase (JPM), Goldman Sachs and U.S. Bancorp could all report positive earnings and revenue growth.
Putting in Context
However, I think we have to put the second quarter results and the weak performance in the last few years in context. We start by looking at the stock price and Wells Fargo has a long and successful history and it is not surprising, the bank is one of Warren Buffett’s all-time favorites. When looking at the performance over several decades, Wells Fargo clearly outperformed US rivals like JPMorgan Chase or the Bank of America and was running head to head with U.S. Bancorp.
We can also look at the performance and profitability metrics for the last decade and not only the most recent numbers. One of the most important numbers is return on equity and when looking at Wells Fargo (red line) compared to some competitors, we see that Wells Fargo clearly outperformed banks like JPMorgan Chase or the Bank of America and that the performance came close to The Toronto-Dominion Bank (TD). Only towards the end of the decade, the performance of Wells Fargo got worse.
(Source: Author’s work based on numbers from Morningstar)
When looking at the net income margin, Wells Fargo once again outperformed the two US competitors and performed almost in line with the two Canadian banks. And once again we see, that the underperformance did not occur before 2016.
(Source: Author’s work based on numbers from Morningstar)
And when looking at the second quarter results, there are some aspects we need to point out. Wells Fargo’s top and bottom line was affected by many aspects like the fact, that Wells Fargo did not (or: could not) keep the profits from the processed PPP loans – unlike other banks like JPMorgan and Citigroup (C). Banks like Goldman Sachs or JPMorgan Chase could also profit from the trading business segments, which had a huge positive effect on second quarter results. And finally, $9.5 billion of provision expense for credit losses during the second quarter is much higher than the provisions for credit losses other banks reported – despite a higher amount of outstanding loans for other banks. As Jonathan Weber argued in his article, we can assume that Wells Fargo is very cautious, which should be seen as good sign in this volatile times.
Wells Fargo was for decades one of the best-run banks in the country and a high RoE as well as a revenue CAGR of 11.69% and a net income CAGR of 14.11% since 1980 underline this statement. But since the account fraud scandal in 2016, Wells Fargo seems to be in trouble and is facing additional expenses. Wells Fargo was also not able to cut costs like many of its competitors, which resulted in the lower net income margin and lower return on equity.
Economic Moat in Danger?
As I argued in my last article, banks usually have a wide economic moat, which is based on switching costs and cost advantages – and at least until 2016, this was very well the case for Wells Fargo. Not only did Wells Fargo outperform the overall market, it also outperformed most of its peers in an impressive manner, which is a strong hint for an economic moat. But the decisive question it comes down to, is the following: Does Wells Fargo still have its wide economic moat or has the moat been damaged by the account scandal in 2016?
When looking at some numbers, we can clearly show an underperformance of Wells Fargo since 2016. Not only did return on equity and the net income margin decline since 2016 (see above), when looking at loans, deposits or assets under management, we also see a trend reversal in 2016. Assets under management more or less stagnated over the last few years, but as this depends also on current asset prices, it makes more sense to look at loans and deposits. While loans increased 5.6% in 2016 and 6.3% in 2015, the amount is more or less stable since 2016 (it actually declined from $968 billion to $962 billion). The picture for deposits is a little better, but more or less similar. In 2016, deposits increased 6.8% and in 2015, the increase was 4.7%, but since 2016, deposits increased on average only 0.42% annually.
But Wells Fargo was struggling not only with fines it had to pay, but also with the FED decision in 2018, that Wells Fargo is not allowed to grow beyond $1.95 trillion in assets until it improves governance and controls. And although the FED temporarily altered the growth restriction in April 2020, so that Wells Fargo can participate in the Small Business Administration’s Paycheck Protection Program, this is a huge challenge for Wells Fargo as it is restricting its abilities to grow in a low interest rate environment.
It might certainly take some time (maybe several years) before Wells Fargo can return to its pre-2016 levels of performance, but I assume it is possible. In late 2019, Charles Scharf was appointed as new CEO and hopefully he can turn the ship around. If the FED will abolish its restrictions and the company is able to cut billions in expenses (as Scharf promised), Wells Fargo might be able to grow again – even if not at a similar pace as before. And hopefully customers will trust Wells Fargo again.
And even if we assume, that Wells Fargo’s moat is not in danger, the company is still facing risks and as I already mentioned in my last article, this section is the most difficult for me. I simply don’t know enough about banks and the banking sector to assess the risks in a proper manner. This is also the reason I avoided banks for a long time and I have to rely on what others are saying. We can for example look at the results of the FED stress test, that projected a minimum common equity tier 1 ratio for Wells Fargo would be 9.1 in a severely adverse scenario. Wells Fargo is therefore close to the mean of the 33 firms tested and certainly not the safest bank, but also not the worst. Wells Fargo ended the second quarter with a CET1 ratio of 10.9%, which is 1.9%, or $23.7B, above the regulatory minimum. That should give investors a sense of security given the substantial loan loss reserves already taken and the halting of stock buybacks, along with a reduced dividend payout.
(Source: Wells Fargo Investor Presentation)
According to its latest reports, the allowance for credit losses for loans is 2.19% of total loans. Especially for credit cards, the ACL as % of loans is high – currently 10.49%. In total, Wells Fargo is currently expecting that about $20.5 billion in losses are likely and to prepare, Wells Fargo added $9.5 billion in provision expenses for credit losses in the second quarter alone.
As for many other banks, dividends play an important role and banking stocks are usually interesting for dividend investors due to the high dividend yields (often resulting from rather high payout ratios) and annual dividend increases (if we exclude the Financial Crisis). But Wells Fargo was the first major bank to announce a dividend cut and similar to the Financial Crisis, the cut was pretty steep. Last Tuesday, Wells Fargo announced it will cut the dividend from $0.51 to only $0.10 quarterly. Last time, it took until 2014 before the dividend was higher again than before the cut.
(Source: Author’s own work based on numbers from Wells Fargo)
Right now, Wells Fargo has a dividend yield of only 1.6%, but if we assume this crisis to be similar as the Financial Crisis, we can expect huge dividend increases in the years to come (maybe starting in 2021 or 2022).
Intrinsic Value Calculation
It is difficult to calculate an intrinsic value or determine a fair value for Wells Fargo, but we can try a few different ways to estimate. A first approach is to use simple valuation multiples. In the last five years, Wells Fargo was trading on average with a PE ratio of 12.34. If we are a little more cautious and assume a PE ratio of 11 in the near-term future and assume that Wells Fargo will reach 2019 EPS in 2022 again, the share price would be $44.55 in 2022. Analysts are estimating on average an EPS of $3.52 for 2022, which would lead to a share price of $38.72. And if Wells Fargo should return on the path of growth again and the outlook for the banking sector might be more optimistic in a few years from now, a higher multiple might also be realistic (maybe 14 or 15), which would lead to a much higher share price.
Another way to determine an intrinsic value is by using a discount cash flow analysis. For this calculation, we need to make some assumptions what a realistic free cash flow could be in the years to come. But the fact, that most banks have a wildly fluctuating free cash flow makes it difficult to derive assumptions from past numbers. The average free cash flow over the last ten years was $24,261 million and assuming that over one decade, extremes will balance out over time, this might be a realistic number we can use for calculations. But to be a little more cautious, we rather use the net income of 2019, which was $19,549 million.
In a first conservative estimate, we assume $0 free cash flow for 2020 and 2021 and for 2022 we assume a return to pre-crisis levels and assume $19.5 billion in free cash flow. For the following years we assume, that Wells Fargo will not be able to grow again and free cash flow will stay at that level. This leads to an intrinsic value of $39.27 for Wells Fargo and would make the stock extremely undervalued. However, there are some additional points worth to consider:
- Assuming $0 for two years in a row is not unrealistic and could happen in a steep recession, but it could also turn out better.
- Even in the last decade, which was the most difficult decade for banks in a long time, Wells Fargo could still grow its net income with a CAGR of 5.23% and when also including share buybacks, earnings per share grew with a CAGR of 8.75%. And even when assuming that the next few years will be difficult, 0% growth for the next decade is rather unrealistic for a wide moat company.
- And when assuming that banks might perform better over the next few decades due to increasing interest rates – as we argued in our last article – 0% growth for perpetuity seems also rather unrealistic.
It seems to be difficult to make good estimates for the intrinsic value of Wells Fargo and the intrinsic value could be much higher as all the estimates we used in the calculation seem to be extremely unrealistic because they are way too cautious. But even when calculating with very moderate estimates, Wells Fargo seems to be undervalued at this point.
Aside from these fundamental aspects, that make it sometimes a little bit difficult to decide whether one should be bullish or bearish about Wells Fargo, there is one final aspect that is making me rather bullish: the chart of Wells Fargo. The stock did not only sell off in a pretty steep fashion, but the stock is also very close to an extremely important support level. And the combination of being in an oversold state (monthly chart) and being supported by several indicators and support levels has to be seen as a rather bullish sign.
First of all, we have the 23% Fibonacci retracement of the last upward wave, which started in 2009, at $21.44. Additionally, at $22.75, we have the lows of 2010 and 2011, that should provide additional support for the stock. The stock is also hitting a declining trendline (orange line), which is connecting the highs of 2007, 2010 and 2011. And finally, we have an upward trendline (red line), which is connecting the lows from the early 80s (not visible in the chart) and the lows during the Financial Crisis. This trendline has to be seen as an extremely strong support level.
When considering, that an oversold stock is hitting these strong support levels, a bounce seems likely and I consider it rather implausible for the stock to drop below $20 at this point.
(Source: Author’s own work created with Traderfox)
But – as always – these are only probabilities and while I would assign the above-presented scenario a high probability, I consider a different turnout to be possible as well. We also have to point out, that banks usually decline pretty steep in times of crisis. In the past, it was not uncommon that bank stocks sold off 60% or 70% (sometimes even more) and compared to that, the decline so far was rather moderate for most banks.
Determining if Wells Fargo is a long-term buy is a difficult question. On the one hand, Wells Fargo seems to be really cheap and the wide economic moat, which the business still has in my opinion should protect the company from competitors and leading to high levels of defensibility to withstand threats to its business model. However, the low multiples the market is assigning Wells Fargo right now, the stagnating revenue over the last decade and especially the poor performance in the last few years is a red flag. And it is often difficult to decide, if we really have an extremely discounted stock and the market just got it wrong or if market participants actually know more than the individual investor and there actually is a reason for this low valuation.
With the information I have, I must assume that Wells Fargo is a buy at this point – or at least at the strong support level around $22.50, but I can’t shake the bad feeling that there might be something wrong with Wells Fargo. And at this point, I haven’t decided if I might buy Wells Fargo or rather another banking stock – as there seem to be many undervalued banks, that could be a great long-term investment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Originally published on Seeking Alpha