Wells Fargo's Valuation And Earnings Can Still Climb Higher

| About: Wells Fargo (WFC)

While a rising tide lifts all boats, some vessels are much better suited for handling the inevitable storms. While Wells Fargo (NYSE:WFC) and the other large banks might look weathered and worn out after the Financial Crisis, investors can still benefit from increasing their exposure to one of the most undervalued areas of the market. The big banks have fortress balance sheets, more conservative lending practices and enhanced market share. These characteristics combined with relatively low valuations and likely enhanced capital distributions, Wells Fargo and the other large banks some of the best opportunities for investors to obtain double-digit per annum investment returns over the next five years.

The analyst community in general, and most market pundits, have been unequivocally wrong in their assessments of the large banks. There have been some exceptions ,such as Dick Bove and Bruce Berkowitz, but the list of those that were overwhelmingly bearish when valuations were most attractive is far too long to even attempt to list. Clearly, the tides have turned and the banking sector has been one of the strongest in terms of appreciation performance over the last two years. This appreciation has certainly reduced the absolute future return expectations for the sector but from a relative basis, the large banks still offer a compelling risk-reward. The highest quality banks such as Wells Fargo and J.P. Morgan (NYSE:JPM) trade at fair price, with upside as earnings, dividends and valuations improve. The improving banks such as Bank or America (NYSE:BAC) and Citigroup (NYSE:C) offer substantial upside, as the stocks still trade at considerable discounts to book value and earnings growth will likely be considerably higher from a lower base.

It is amazing to think that we are now in excess of 5 years past the peak of the Financial Crisis and there is still pervasive negativity and lawsuits stemming from those issues. This witch hunt and blame game has been a tremendous boon to attorneys but have likely had a negative impact on the overall economy, as concerns over litigation risk clearly increase costs for credit. The latest negativity surrounds the decline in mortgage origination and refinancing due to increase in interest rates. There is no doubt that mortgage banking has slowed, but the long-term trends, which impact business value are still strong due to still low absolute interest rates and strong demand for housing. The big banks are vastly underrated in terms of the diversification of their businesses, which allows them to overcome short-term headwinds in individual business segments. Wells Fargo for instance, has seen solid loan growth outside of mortgages in recent quarters, and its Trust and Wealth Management businesses continue to enhance their respective earnings power. This attitude to not being able to see the forest through trees is a microcosm of short-termism by most market participants and analysts, and it allows for a time-arbitrage for long-term investors that are interested in acquiring stakes in businesses at discounts to intrinsic value.

Wells Fargo deserves to trade at a premium multiple relative to the industry due to the quality and sustainability of its earnings power and returns on assets. Ingrained in Wells Fargo's culture is its cross-selling platform, which generate lower risk fee-based revenues and maximizes profitability per customer. The big banks already dominate the U.S. so the easiest way to increase revenue per customer is to sell additional services to existing customers, as opposed to marketing for new customers. This cultural strength was proven in the successful integration of Wachovia, where average cross-sell and revenue per customer improved markedly. In the 4th quarter, Well Fargo's retail banking cross-sell grew to 6.16 products per household. Wholesale banking and wealth, brokerage and retirement cross-sell improved to 7.1 and 10.42 products, respectively.

On January 14th, Wells Fargo reported very impressive 4th quarter earnings and full year 2013 results. For the full year, net income of $21.9 billion was up 16% from 2012, on revenue of $83.8 billion, which was down from $86.1 billion in the year ago period. Diluted earnings per share were $3.89 for 2013, up 16% from 2012. Wells Fargo did what many banks are only hoping to achieve in attaining a 1.51% return on assets, which was up 10 basis points YoY. The company's return on equity was 13.87% for the year, which was up 92 basis points from the year ago period. Despite the increased capital requirements and regulatory scrutiny, Wells Fargo was able to return a whopping $11.4 billion to shareholders through dividends and share buybacks. I view these results as being pretty indicative of Wells Fargo's normalized earnings power with $4-5 billion plus or minus in better or worse economic environments, respectively.

For the 4th quarter, net income of $5.6 billion was up 10% from the 4th quarter of 2012 on revenue of $20.7 billion, which was down from $21.9 billion YoY. Diluted earnings per share of $1.00 were up 10% from the 4th quarter of 2012, while non-interest expenses of $12.1 billion were down $811MM YoY. The bank's efficiency ratio of 58.5% reflected 30 basis points of improvement. The company's ROA of 1.47% was up 1 basis point and the ROE of 13.81% was up 46 basis points. While many analysts choose to focus on the declining mortgage environment, hiding in plain sight is the fact that Wells Fargo experienced strong loan growth of $26.2 billion from the 4th quarter of 2012 to $825.8 billion. Importantly, the core loan portfolio was up $39.9 billion from the same time last year. Total average core checking and savings deposits were up $50.7 billion, reflecting the continued increase in market share of the large banks.

Unsurprisingly, Wells Fargo's credit picture continues to improve with net charge-offs of $963MM, down $1.1 billion from the same time last year. Credit metrics likely have another year of improvement coming this year, which will of course be more mild than the last two years, but we are close to peak credit conditions; although expenses can certainly still come down significantly. Nonperforming assets were down $4.9 billion YoY and Wells Fargo was able to release $600MM from reserves due to improved credit performance and economic conditions. Wells Fargo's capital position remains outstanding with a Tier 1 common equity ratio under Basel I of 10.82% as of 12-31-13, and a Common Equity Tier 1 ratio under Basel III using the advanced approach, of 9.78%. The company finally has been able to decrease its share count by about 16.6MM from the 3rd quarter of 2013 after buying back 30MM shares in the 4th quarter. Total average deposits in the 4th quarter were $1.1 trillion, up 9% from a year ago, and had an average deposit cost of just 11 basis points. Clearly, these are high class liabilities that ultimately will lead to significantly more earnings power as net interest margins expand.

As of 12-31-13, Wells Fargo had 5.2572 billion shares outstanding so at a recent price of $45.42, the company has a market capitalization of roughly $238.8 billion. Book value stood at $29.48 per share, so the bank trades about 1.54 times book. That seems about fairly priced for a business that can earn 1.5% on assets but as earnings grow, buyers at current prices could still see 8-10% per annum appreciation even in if the multiple doesn't expand. However, don't be shocked if the multiple does expand to 2 times book value, as market participants price in the rock solid financial position and lower risk profile that the increased capital requirements provide at the cost of lower returns on equity. The utility example is an apt one in many respects and it is not uncommon for utilities to trade in excess of two times book value. I believe that Wells Fargo is every bit as safe as a utility with more attractive earnings power, but I wouldn't say the same thing for all banks.

For those that might be skeptical about the overall market or that aren't as comfortable buying the stock after its strong rise, it might not be a bad idea to look at selling long-term put options. Currently, the January 2016 $45 puts are going for about $5.80 per contract. This equates to about a 14.7% target return on the maximum risk of $3,920. On an annualized basis, the target return would only be about 7.4% assuming you hold the option till expiration and the stock is above $45, but if the stock rallies more quickly, there is an excellent chance at exiting at a higher annualized rate of return. If the stock is below $45 at expiration, then you would own Wells Fargo at a breakeven of $39.20, which is about 10 times normalized earnings. I see this as a lower risk way of accumulating a position in Wells this late in the game for those so inclined.

Disclosure: I am long WFC, C, BAC, JPM, . 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.