Premium Multiples Being Drained from Wells Fargo

Includes: WFC, XLF
by: ContraHour

The premium earnings and book value multiples that Wells Fargo (NYSE:WFC) has enjoyed for the past decade are being drained from Wells Fargo. Wells Fargo's stock has always traded at approximately a 20% premium to the banking group because of its higher than average earnings growth, higher returns on equity, and low level of non-performing assets.

However, that premium multiple relative to the group is beginning to erode in a phenomenon known as "multiple compression." Wells Fargo has underperformed the other bank stocks since the beginning of the year. Wells is down 37% vs 23% for the group since December 31st.

click to enlarge images

WFC Comparable Returns Since Jan 1st

Source: Bloomberg

Several events in the past two weeks account for investors deciding that the premium multiple was no longer worth paying for Wells Fargo. First, the company has a very low tangible common equity-to-assets ratio after the Wachovia deal. My estimate is about 2.6% - 2.7% vs the average bank of around 5.0% - 6.0%. This raises the probability that Wells will be tapping the TARP II for a second time to consummate the Wachovia deal. Even though most refer to this as a bailout (i.e. free money) tapping the TARP is anything but free because the government's preferred shares sit higher in the capital structure than the common shareholders. In addition, the TARP II money seems to be coming with many more onerous terms from Hank Paulson and company including reducing or limiting dividend growth. This makes the common stock much less attractive.

Second, Bank of America (NYSE:BAC) increased the loss ratio of the Merrill subprime CDOs to over 30%. This is higher than the "worst-case" 20% loss ratio Wachovia had assumed in some of its subprime mortgage portfolio. Most likely, loss estimates will be going up significantly for the bad loans at Wachovia. Increasing loss estimates will require additional capital. It's hard to see how the combined Wells Fargo/Wachovia can be considered a premiere institution given the rising level of losses and need for additional capital.

Third, the sentiment toward bank managements has soured significantly since Ken Lewis was exposed as a liar regarding the Merrill Lynch merger. Wells' CEO John Stumpf and CFO Harold Atkins have, on numerous occasions, touted Wells' strong capital ratios and outperforming mortgage portfolio.

However, after the Bank of America announcement, investor skepticism is high. Wells Fargo has been magically impervious to the California real estate collapse despite it being their home market. Many short sellers believe that Wells is simply taking their time recognizing losses in their mortgage portfolio rather than taking their medicine as the losses occur. Management is delaying taking the losses under their accrual accounting basis rather than taking mark-to-market losses like the investment banks. And who knows how many troubled loans Wells Fargo will "discover" now that it has consummated the merger with Wachovia? John Stumpf might yet turn out to be the next Ken Lewis.

The premium multiple is being drained out of Wells Fargo as investors anticipate increased government investment because of these issues. Yet some of the premium still exists. The following charts show that even relative to other high quality banking companies, Wells still trades at a high multiple. As late as December, Wells traded over 4.0x tangible book value and over 2.0x stated book value. This was a significant premium to the other national banks, which traded around 1.5x tangible book value and 0.9x stated book value. Impaired companies such as Citigroup (NYSE:C) and Bank of America currently trade around 0.3x stated book value.

WFC Book Relative To Industry

Source: Baseline

If the consensus view becomes that Wells Fargo is no longer a premiere institution, then the premium multiple could disappear all together. This indicates to me that Wells could see further downside from these levels. At 0.9x book value, which is the current median multiple of the banking group, Wells Fargo stock would be trading at approximately $12 - $13.

The rapid decline in Wells Fargo shares will also have a negative effect on the broader market. Wells Fargo is one of the most widely held financial stocks by insitutional investors. Every fund looking to maintain some financial exposure has been hiding in Wells Fargo. The 37% decline in this "safe" stock will weigh on the performance of most every large cap mutual fund. Even Warren Buffett has taken a $4 billion hit on the stock in the past two weeks.

A list of the top 25 fund holders is a who's who of large cap stock managers who are now underperforming their indexes.

WFC Institutional Holders

The decline in Wells Fargo stock is certainly weighing on its holders but could also have negative implications for the future performance of the market as a whole. If the once impervious Wells Fargo turns out to be worse than expected, the confidence in the overall securities markets will erode further. And that could lead to further multiple compression for the entire market.