Wells Fargo: Man Overboard?
They say generals are always fighting the last war, but it is equally true of investors. This month banks were sold indiscriminately as memories of 2008 resurfaced. Banks we part of the problem during the last downturn. This time, they will be part of the solution. A strong showing through this cycle could even be a catalyst to a higher valuation on the other side.
Wells Fargo was hit harder than many banks, falling 47% from the market’s February 19 high to its low on March 23rd. Michael Mauboussin calls this the “Man Overboard Moment” and suggests it is a good time to revisit assumptions. We agree, and decided to take the opportunity to write up our thesis.
Wells Fargo’s fake accounts scandal has made their financial statements messy. On trailing basis, Wells earned $4.89 in 2019. At $30 per share, Wells’ trailing P/E ratio is just 6.1. Normally, we’d expect Wells’ to fetch a 10x pre-tax multiple (12-13x after-tax). If that were true, Wells’ stock would double, even if the business didn’t grow.
However, we care about Wells’ earnings power, not their trailing earnings. To estimate Wells’ normalized earnings power we need to make assumptions in three areas:
1. Expenses
2. Credit Costs
3. Interest Rates
Since 2017 Wells’ expenses have been elevated. Wells’ efficiency ratio (non-interest expenses / net revenue) averaged 55.4% for the years 2014 through 2016 and jumped to 66.5% for 2017 through 2019. For context Bank of America’s is 60% and JPMorgan’s is 57%. Expenses are elevated due to litigation costs, catch-up investments in compliance, and fines. Over time we expect Wells’ efficiency ratio to trend lower towards its pre-scandal average. This will take many years.
The good news is that online banking is a tailwind for efficiency. Banks are closing branches and leveraging their apps, which reduces overhead.
We think Wells can get back to a 60% efficiency ratio in a handful of years. That would be a big improvement over the present, but a ways off Wells’ best years.
While Wells is under-earning due to elevated expenses, it is over-earning due to historically low credit costs. Provisions for loan losses averaged just 0.24% of loans the past three years. Credit is cyclical and will deteriorate into the bottom of the cycle. Wells’ average provision the last twenty years was 0.75% of loans. Provisions peaked at 1.05% in 2001 and again at 2.77% in 2009. We assume a 0.75% provision to normalize Wells’ earnings across the cycle.
Normalizing Wells’ exposure to interest rates is trickiest. It’s overly simplistic to say that higher rates benefit banks and that lower rates hurt.. Wells has made a profit every year back to 1972, which is the earliest I have data available. Wells made money in the panics of 1974, 1987, 1990, 2001, and even 2008 and 2009. They made money in 1980 when the prime rate hit 20.30% and they made money in 2010 when Fed Funds hit zero and the prime rate hit 3.25%.
Banking is a spread business: borrow short and lend long. Banks care more about the spread between short-term and long-term rates than their absolute value. Wells benefits most when long rates are significantly higher than short rates.
That said, the Fed’s move to slash rates back to zero will hurt Wells in the short term. Lower rates could reduce earnings by $3 billion (~12%) for one or two years.
The longer term picture is cloudier. In a “lower for longer” scenario Wells should be able to increase account fees and reposition some asset to recoup earnings.
After normalizing Well’s efficiently ratio to 60% and provision for credit losses to 0.75%, plus some smaller, one-off adjustments, we think Wells can earn $5.20 per share. This would be a 12.9% return on equity and 15.5% return on tangible equity. This squares with Wells’ historical record. Since 1972 Wells has averaged around a 15% ROE. Recent results have been weaker due to lower interest rates.
Today the stock trades for just 5.8x normalized earnings at $30 per share. We think it is worth about 10x pre-tax or 12-13x after-tax, which would be $68 per share — double its present quotation.
If we discount Wells’ normalized earnings to account for lower rates, they drop to $4.65, putting it at 6.5x and a 14% return on tangible equity. It is still a bargain in this scenario.
Wells’ currently pays out about half of its earnings as a dividend and yields 7.0%. Additionally, Wells authorized (and the Fed approved) a $23.1 billion buyback last June which was to be completed by this July.
Unfortunately, all of the big banks collectively announced that they would pause their buybacks in the wake of the coronavirus pandemic. Buybacks are scheduled to resume after Q2, but could be delayed further.
Wells has about $28 billion of excess capital on its balance sheet. Today this is an important buffer against an uncertain world.
To explain how much capital this is, Wells’ provision for credit losses peaked at 2.77% in 2009. The same provision today would amount to $26.7 billion — less than Wells’ excess capital and equal to one year of normalized pre-tax earnings. Even if the present situation turns into a 2008-like scenario Wells will survive and bounce back quickly.
Wells’ earnings may be ugly the remainder of the year as provisions for credit losses increase. But we are concerned with Wells’ long-term normalized earnings power, which appears as strong as ever.
The key to Wells’ earnings power are its deposits. There’s a saying: “A banks assets are its liabilities and its liabilities are its assets.” Charlie Munger says something similar: ”The liabilities are always 100% good. It’s the assets you have to worry about.”
Wells has $1.3 trillion of deposits which cost it 0.67%. Deposits are 135% of loans and 73% of earning assets.
It’s not particularly difficult to make money when people give you $1.3 trillion dollars for only 0.67%. This removes an incentive for management to reach for yield or lower underwriting standards. So long as Wells’ deposit franchise remains intact, earnings power will remain strong.
The chart below gives some perspective on Wells’ ability to collect deposits over the decades.
Over the past 45 years Wells grew deposits at an 11.5% rate. That’s an astounding record. Recent growth has slowed, partially due Wells’ size and partially due to Wells’ scandals. Over the past five years Wells grew deposits 2.5% per year. This is slower than peers Bank of America (+5.0%) and JPMorgan (+6.2%), but still acceptable. Deposit costs are higher than Bank of America by 10 basis points, which is not a disaster.
Deposits actually decreased in 2018 but mostly recovered in 2019. Wells offered promotional pricing in 2019 to speed the recovery. This partially explains why deposit costs rose 44 basis points year over year.
From my view, Wells’ deposit franchise remains intact. 2018 will mostly like prove to be a one-off event. Wells’ shouldn’t need to consistently pay premium rates to attract deposits. If it did, that would be a problem. I don’t expect Wells’ deposit growth to revert back to historical rates, but I’d hope it could close the gap with its peers.
Regardless, so long as Wells’ merely maintains its existing deposits, makes solid loans, and buys back shares, the stock will perform admirably. Today the stock is priced like it is going out of business, which doesn’t make sense given Wells’ strong capital position. We think that in several years buying Wells’ at $30 will look very smart. Wells’ new CEO Charles Scharf evidently agrees: Scharf paid $5 million for 173,000 shares on March 13th. His average price was $28.69.
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