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By Clinton Holmes

Full disclosure, as you read this article, we are not saying this is the only reason Buffett buys Wells Fargo (WFC), but one of many.

Earlier this year I introduced an article called, "A Method for Investors to Identify Companies with Competitive Advantages" that, as the title describes, provides investors with a method for identifying companies with a competitive advantage. The technique, which was adapted from the book, "Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage" is one of the ways Black Coral Research, Inc. measures a company's long-term economics, which was first described by Buffett in Berkshire Hathaway's (BRK.A) (BRK.B) 2007 annual shareholder letter.

Today, we share our analysis of Wells Fargo's financial statements using the method described. Our conclusion is that Wells Fargo has a durable competitive advantage that gives it the favorable long-term economics Buffett seeks in his investments for Berkshire.

Please note, the method does not indicate what the competitive advantage is, it will only indicate whether there is or is not a competitive advantage working in favor of Wells Fargo.

The Income Sheet

There are seven metrics within the income sheet that are looked at when performing the Buffett durable competitive advantage analysis:

  1. Gross margin trend
  2. The ratio of SG&A to gross profit
  3. The ratio of R&D expense to gross profit
  4. The ratio of depreciation, depletion and amortization expense to gross profit
  5. Interest expense relative to operating income (EBIT)
  6. Net margin trend
  7. Earnings trend

In the case of Wells Fargo, the gross margin trend and interest expense relative to operating income are not relevant because WFC is a bank, which reduces the list of metrics to five. Additionally, revenue will replace gross profit in this analysis because gross profit is just revenue less cost of goods sold (CoGS) and in the case of a bank, its CoGS is zero.

Ratio SG&A to Revenue

Selling, General & Administrative (SG&A) represents all the expenses indirectly and directly related to selling a product or delivering a service. This includes things such as advertising, management salary, legal fees, payroll costs, travel fees, etc.

A company with a competitive advantage will typically meet two criteria:

  1. The ratio of SG&A to revenue will be less than 50%. While the percentage can be higher if the other expenses are in check, generally anything more than 50% means the company is in a highly competitive industry where they have to invest heavily in advertising in order to stay relevant.
  2. SG&A is consistent. Companies with competitive advantages have more flexibility to control expenses, which will be reflected in the consistency of the percentage.

Over the past 10 years, the SG&A expense for Wells Fargo has consistently been between 28-36% of revenue.

WFC SG&A Expense (% of Annual Revenues) data by YCharts

While there is a clear gyration caused by the 2008 recession, the graph otherwise indicates that Wells Fargo meets both of the above criteria, unlike some of its biggest competitors Bank of America (BAC), JPMorgan (JPM), and Citigroup (C).

WFC SG&A Expense (% of Annual Revenues) data by YCharts

Ratio of Research & Development to Revenue

Like most banks, Wells Fargo does not have any research and development expense. This helps indicate it has a competitive advantage because it means WFC does not have to invest in new technology to continue to generate revenue.

Ratio of Depreciation, Depletion and Amortization to Revenue

Putting it simply, the lower this ratio the better. Buffett really doesn't like to see anything higher than 15%. Anything above than that means the company is in an industry where the company needs to continually invest in capital to stay competitive.

Over the last decade, Wells Fargo's depreciation has been on a steady trend downwards.

(click to enlarge)

While just on the cusp of failing the 15% criteria in 2003, today Wells Fargo is just below a healthy 4%.

Net Margin and Earnings

Net margin and earnings tend to be well correlated. In fact, if they aren't, it is probably prudent to dig deeper into the financial statements to understand what is going on.

In determining if Wells Fargo has a durable competitive advantage, we are looking for net margins that are in excess of 20% and earnings that are consistently trending upward with no losses.

WFC Net Income (% of Annual Revenues) data by YCharts

Obviously the 2008 recession had a heavy impact on earnings and net margin; however, we think Wells Fargo meets the criteria for net margin and earnings because:

  1. Net margin and earnings are in harmony. Both net margin and earnings were rising pre-2008, both fell in 2008, and both have been rising steeply since 2008.
  2. Net margin is greater than 20%. This puts Wells Fargo's net margin back at pre-2008 levels.
  3. Earnings never went negative. Despite a near melt down of the entire financial industry, earnings remained positive in 2008.
  4. Clear upward earnings trend. Over the past decade, earnings are up about 80%.

For contrast, consider the net margins of WFC's competition:

WFC Net Income (% of Annual Revenues) data by YCharts

Both Bank of America and Citigroup have gaps in the chart due to earnings losses. JPMorgan is the only competitor who appears to potentially have a durable competitive advantage of its own.

The Balance Sheet

The balance sheet is analyzed to determine how Wells Fargo is funding future growth. Companies with a durable competitive advantage tend to fund growth from existing operations rather than raising capital by issuing bonds or shares.

Below are the three metrics we used to analyze the balance sheet of Wells Fargo. These are a bit different than what was shared in my original article, because the balance sheet for a bank is very different than a product or service company; however, the principle remains the same.

  1. A low ratio of short to long term debt
  2. Ratio of liabilities to stockholder equity plus treasury stock
  3. Amount of preferred stock
  4. Retained earnings trend

Ratio of Short to Long Term Debt

For financial institutions, this ratio is critical. A low ratio indicates the financial institution is growing in a sustainable way by borrowing and lending money for the long term. A high ratio means the institution is growing by borrowing money short term, when rates tend to be lower, to lend at a higher rate over a longer term. This works, but is not sustainable. As soon as the short term financing stops, the system breaks, just ask Bear Sterns.

In the case of Wells Fargo, the amount of short term debt has fluctuated between 40% and 50% of long term debt over the last decade. This indicates the ratio is well balanced and that growth is not being funded by manipulation of short term interest rates.

WFC Current Portion of Debt (Annual) data by YCharts

In contrast, consider the graph for Bank of America over the last decade.

BAC Current Portion of Debt (Annual) data by YCharts

On the positive side, it looks like BAC learned its lesson.

Ratio of Liabilities to Stockholder Equity plus Treasury Stock

Another way institutions can fund growth is through bond or stock offerings. Companies with a durable competitive advantage grow through earnings; therefore, the ratio should be low. For product or service companies, the maximum ratio liabilities to stockholder equity plus treasury stock is 0.8. Anything lower than that and the company is most likely using earnings from a competitive advantage to grow the company.

With banks, it is a little different. Part of the banking business model is to carry a large amount of debt. As such, when we analyzed Wells Fargo, we revised the criteria based on Buffett's advice to a ratio of 10 or less.

Prior to 2008, Wells Fargo flirted with the ratio limit of 10, but never exceeded it until 2008.

(click to enlarge)

The ratio dropped below 10 again in 2009 and has trended downward ever since. Over the past twelve months, the ratio was 8.15, well below the ratio limit of 10. Overall, the graph indicates that WFC's growth is not being funded with new debt offerings.

Amount of Preferred Stock

Preferred stock is the most expensive form of equity offerings. While a small amount is fine, a considerable amount is an indicator that the company does not have a competitive advantage.

Wells Fargo had very little preferred stock prior to 2008.

WFC Preferred Stock (Annual) data by YCharts

In 2008, Wells Fargo had to issue roughly $32B in preferred shares to survive the financial crisis. WFC has since reduced the amount by almost 60% to $12.9B. While a large number, the cost to the company is small. According to the 2013 Annual Report, Wells Fargo paid approximately $900M, or 5% of its 2012 net income, of preferred dividends.

Retained Earnings

This is the most important metric on the balance sheet for determining if a company has a competitive advantage. Companies growing their retained earnings more than 7% yoy are more than likely operating with a durable competitive advantage.

Wells Fargo has grown its retained earnings significantly over the past decade, increasing from $26B in 2004 to $78B in 2012.

WFC Retained Earnings (Annual) data by YCharts

Over the course of the past decade, WFC has grown retained earnings at an average growth rate of 12.7%.

WFC Retained Earnings (Annual YoY Growth) data by YCharts

The Statement of Cash Flows

The only item in the statement of cash flows that Buffett recommends analyzing is the ratio of capital expenditures to net income. The theory is that the higher the ratio, the more the company has to invest in order to stay competitive, and therefore does not have a competitive advantage.

Wells Fargo does not have any capital expenditures.

Conclusion:

Wells Fargo is a long time favorite of Warren Buffett. Using the technique adapted from the book, "Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage" with a few modifications to the criteria to better suit a bank, we are able to conclude that Wells Fargo has a durable competitive advantage. This durable competitive advantage produces the favorable long term economics that Buffett looks for in his investments.

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Source: One Reason Buffett Buys Wells Fargo: Competitive Advantage

Additional disclosure: I have no positions in JPM, but may investigate further following this analysis.