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This is Part 4 of a series of articles discussing the returns on common stock and TARP warrants for a few financial institutions relative to the institution's book value. Part 1, on AIG, is located here and Part 2, on Bank of America, is located here and Part 3, on Citi is located here.

Wells Fargo (NYSE:WFC) received roughly $25 billion during the 2008 financial crisis from the government to help keep the bank operating. In return for this capital infusion, the government was given long term warrants in the company. These warrants are now publicly traded.

Also during the financial crisis, Wells bought Wachovia for roughly $12.7 billion. This acquisition helped Wells become even larger and gave it a larger deposit base and share of the mortgage origination market. The bank now originates roughly 33% all mortgages nationally (Source).

As a result of their huge share of the mortgage market, the bank greatly benefited last year as a result of a slight uptick in the housing market and the rush to refinance mortgages. During the most recent quarter, the bank maintained a net interest margin of 3.56% (Source). This is higher than the average for all banks, of 3.39% (Source). This means that not only does Wells have the largest individual share of the mortgage market, but they make more from originating each loan than other banks do. Wells Fargo is also a favorite of Warren Buffett, who owns roughly 8% of the outstanding shares.

The Wells Fargo warrants are less liquid than most other TARP warrants because the company purchased 63% of the warrants when the government sold their stake (Source). This relative lack of liquidity should not impact retail trading in the instrument during normal trading, but could have a significant impact if the shares must be bought or sold outside of normal trading hours or during a panic. Investors should be aware of this fact and avoid market orders at all times.

On the downside, continued low net interest margins, relative to historical levels, continue to crimp earnings. The Fed has promised to keep these rates low for a long time, so the company needs to continue to perform well in this environment, with little room for error. A downside of the company's reputation as 'best of breed' is that they have set a high bar for performance so they will need to continue to beat expectations to justify the high price. Lastly, they have already reduced costs and now could lose some of their investor base as investors shift to banks that are able to cut costs and streamline operations which would help them beat expectations. Wells Fargo has already done this so they face a negative mean reversion.

In the table below, I list the relevant information about the warrants, the current stock price, the current stated book value (from the latest quarterly report), and two scenarios for warrant and stock returns based on price relative to future book value. I assume book value grows at 3.5% per year from current levels. This is a low growth rate to keep the analysis conservative.

Unlike the other three institutions I've performed this analysis on thus far, I think a valuation of 1.6x book value in 2018 is too low. The bank already commands a higher than average valuation, and I expect the valuation gap to continue into the future. For a bank as well run as Wells Fargo, a valuation of around 2x book value seems more reasonable (Source). The bank is currently trading at roughly 1.3x book value.

 Wells Fargo Warrant (WFC.WS)Wells Fargo Common Stock (returns calculated until warrant exp.)
Warrant Strike Price$34.01--
Warrant Price$10.30--
Warrant Exp. Date10/28/2018--
Time until expiration (years)5.79--
Current Stock Price$35.10$35.10
Current Book Value per Share$27.64$27.64
Price if stock trades at 1x BV which grows at 3.5% per year till expiration$0.00$33.73
Historical P/B Ratio2.02.0
Price if stock trades at historical P/B & growth in BV of 3.5% per year$33.45$67.46
Return if stock at BV-100%-4%
Return if stock at historic P/B, 2.0x225%92%

These Wells warrants, like other TARP warrants, have dividend protection. As the quarterly divided rises above $0.34, the strike price of the warrants are adjusted down by any amount over the threshold. In the analysis above, I neglected any impact dividends may have on returns.

The dividend threshold was set on all TARP warrants at the current dividend at the time the banks received aid.

To account for dividends in the return calculations, some additional assumptions must be made. The bank currently pays a dividend of $0.88 per year. For further analysis, I assume the bank gets approval to increase their yearly 2013 dividend to $1.20. Last year, the bank was able to raise their quarterly dividend from $0.12 to $0.22, so an increase this year from $0.22 to $0.30 is reasonable. From there, I assume the dividend is increased at 5% per year based on a reasonable earnings growth rate and constant payout ratio.

Given those assumptions, the quarterly dividend rises above the warrant adjustment threshold in 2015. A total of $7.78 in dividends is paid out between now and the third dividend of 2018. Also, the warrant strike price is adjusted down by a total of $0.26.

The table below presents the returns for the stock and warrants with dividends included.

Returns with Dividends as Calculated Above
 Wells Fargo Warrant (WFC.WS)Wells Fargo Common Stock (returns calculated until warrant exp.)
Total Dividend Paid (through 2018 Q3)$7.78$7.78
New Warrant Strike Price$33.75--
Price if stock trades at 1x BV which grows at 3.5% per year till expiration$0.00$33.73
Historical P/B Ratio2.02.0
Price if stock trades at historical P/B & growth in BV of 3.5% per year$33.70$67.46
Return if stock at BV (including dividends for common stock)-100%18%
Return if stock at historic P/B, 2.0x (including dividends for common stock)227%114%

On a return to 2.0x book value, a reasonable expectation given the nearly 6 year time horizon, the warrants return 227%, or 22% annually. Over the same time period, the stock returns 114%, or 12% annually including dividends. As you can see from the table above though, the warrants will face significant losses if the stock doesn't trade well above book value at expiration.

These warrants have such a high return because they appear to be pricing in the company losing their higher than average valuation. The CAGR is more in line with other TARP warrants if you assume a lower ending valuation of the company, closer to 1.6x book that I used for Bank of America and Citi.

If you are positive on Wells Fargo going forward and believe they can maintain the premium they demand amongst other banks, the warrants will have a significantly higher return than the common stock. If the company looses their premium though, the warrant returns will be lower than expected (or possibly negative). Keep in mind that the majority of the warrant value is time value which is subject to decay.

The common stock is a more conservative way to gain exposure to the company. Also, even if the dividend is slower to reach the warrant adjustment threshold than I calculate, the stock will still benefit from the cash returned to shareholders.

For new purchases in the stock, I would hold off for a few days. This is a short term call based on the reaction to their earnings report. The stock will probably continue to drift down for another few days. The 50 day SMA is around $33.50 so if it gets down there, that looks like a good entry point. To start building a position. Hold off on buying the rest of the position until the market corrects.

Source: Wells Fargo Stock And Warrant Returns Relative To Book Value