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Summary

  • The dividend level after the approval of the capital plan will go above the pre-dividend cut levels.
  • There is a substantial cushion in the cash flows and earnings to support the future growth in dividends.
  • The share buyback plan along with the continued growth in earnings should take the stock price higher.

We previously wrote about Wells Fargo (NYSE:WFC) about a month ago and analyzed the dividends and the growth prospects of the company. Since then, the Federal Reserve has come out with the results of the stress test and allowed a number of banks to increase the dividends and buy back shares. Wells Fargo also cleared the stress test and the bank was allowed to go ahead with its capital plan. Wells Fargo was one of the very few banks that did not have to alter its capital plans as the Federal Reserve agreed that the bank's capital plan will not impact the minimum capital adequacy required by the Federal Reserve.

Another Look at the Dividends

After the financial meltdown of 2008, banks had to cut dividends. Wells Fargo was no exception and the bank cut its quarterly dividend from $0.34 per share to $0.05. The dividend cut came in the second quarter of 2009 and the dividends remained unchanged till the second quarter of 2011. Federal Reserve conducted regular stress tests after the credit crunch in order to ensure the stability of the banks as well as the financial system of the country. Wells Fargo increased its dividend from $0.05 per share to $0.12 in the first quarter of 2011, an increase of about 140%. The bank paid the dividend for the first quarter in two installments. However, the dividend still remained substantially lower than the pre-dividend cut levels. The next major increase came in the next year when the bank increased the dividend to $0.22 per share and then $0.30 in the following year. So, the dividend growth has been strong for the bank even after the financial meltdown.

After the approval of the capital plan, the bank has decided to increase the quarterly dividend by 17%, which will take the divided to $0.35 per share. At these levels, the quarterly dividend is now above the pre-dividend cut levels. The stock is currently yielding about 2.9% based on the increased dividend. The increased dividend will be paid in the second quarter of the current year.

Let's now take a look at the payout ratio. According to our previous calculations, the payout ratio based on earnings stood at 27%, and keeping in mind the 12% average growth in earnings and the 17% growth in quarterly dividends; we expect the payout ratio to jump up slightly from the previous levels. However, it should still remain extremely manageable. As the CapEx is usually not major factor for the banks; it is safe to compare the cash dividends with the cash flows from operations. Cash flows from operations have shown average annual growth of about 107% -- however, it should also be kept in mind that operating cash flows were abnormally down during 2011 ($13.6 billion compared to $28.6 billion at the end of 2009). Five year average annual growth of about 20% is a better measure, in my opinion. The growth in cash flows is commensurate with the growth in the dividends, which should allow the bank to continue growth in dividends in the future.

Share Repurchase Plan

In addition to the dividend increase, the bank was also allowed to buy back 350 million shares of the common stock during the quarter. If we take the current price, the bank will spend about $17.5 billion in share repurchases during the current year - the share repurchases amounted to $5.3 billion during the last year. In total, the bank will return about $25 billion to the share holders during the current year.

Impact on Valuation

The share repurchase plan and the increase in dividends will certainly have a positive impact on the stock price, and the market's belief in the ability of the bank will be further enhanced. The capital review plan is a qualitative measure of the Federal Reserve that takes into account the future earnings and cash flows ability of the bank, in simple words, the review process looks at the business strength of the bank. On the other hand, the initial phase of the stress test looks at the quantitative aspects under different economic scenarios. The no objection approval of the bank's capital plan shows that the Federal Reserve believes Wells Fargo can continue its solid growth and the plan will not impact its capital.

How are the Peers Doing?

Federal Reserve also allowed some other major players in the sector to increase the dividends and share repurchase plans. Bank of America (NYSE:BAC) increased its quarterly dividend from $0.01 per share to $0.05, increasing it by 400%. Other major players such as JPMorgan (NYSE:JPM) and Morgan Stanley (NYSE:MS) also announced an increase in dividends. JPMorgan increased its quarterly dividend from $0.38 per share to $0.40; the stock currently yields 2.6%. Furthermore, the bank will buy back shares worth $6.5 billion. Morgan Stanley also announced to double its quarterly dividend from $0.05 per share to $0.10 and also decided to buy back shares worth $1 billion. The only major plan to not receive approval for the capital plan was Citigroup (NYSE:C). Clearly, Wells Fargo has the biggest capital plan among its peers and the bank will be the returning the highest amount to shareholders.

Conclusion

We believe Wells Fargo is the best dividend pick in the sector. The bank is growing dividend at an impressive rate - the cushion in the cash flows and earnings is more than enough to support the future growth in dividends, and most importantly, the continued growth in earnings will continue to grow the cash flows of the bank. We believe Wells Fargo will perform exceptionally well during the current year as the overall conditions in the banking sector becoming better. We see considerable upside potential and a solid income opportunity in this stock.

Source: Is Wells Fargo The Best Dividend Stock In The Banking Sector?