This business model attracts fee income which is in high demand these days as it doesn’t entail taking on balance sheet risk. Wells Fargo also has the lowest deposit costs of their peers allowing them to generate the highest net interest margins in the industry. According to Morningstar between 2003 to 2008 WFC averaged a net interest margin of 4.9% which is by far and away the highest in the industry. Even better, 21% of WFC’s deposits are non-interest bearing which is emblematic of the significant emphasis on the sales process within the branches.
Now, fee income and high net interest margins are great, but loose underwriting can kill a bank of any size. It is here where Wells has really differentiated themselves by writing vanilla mortgages, and avoiding the CDO’s and SIV’s. Most of Wells Fargo’s loan losses have come off of their home equity lines of credit (Heloc) and their closed end second mortgages (CES). These losses were very difficult to avoid, but due to the strength of the Wells Fargo business, model and due to their stringent underwriting WFC has remained profitable throughout the crisis.
During the financial crisis WFC bought Wachovia in a transaction that doubled the size of the company. Because Wachovia was somewhat of a distressed seller, WFC was able to acquire it at a bargain price which significantly reduced the risks on the transaction caused by Wachovia’s more lax underwriting. The only real problem with the acquisition was that due to the increased regulatory oversight, WFC was forced to raise equity at prices significantly below the intrinsic value of the company. Wachovia is a strong strategic fit for Wells because they have a large footprint in the Southeast where Wells was historically week. Wachovia also owns a strong securities division which has bolstered Wells Fargo’s retirement and investment offerings. We believe that Wells Fargo’s superb management and sales staff should be able to get a lot more out of Wachovia, and the scale of the new enterprise should provide ample opportunity for cost cutting.
From a valuation perspective Wells Fargo is very cheap when you look at the earnings power of the enterprise. As loan losses decline and new loan demand increases we expect Wells Fargo to come close to their historical 18% return on equity. If they can do that we peg their 2012 earnings power to be between $3.5-$4 a share. If you put a 10 price/earnings multiple on EPS of $3.5 you are looking at a stock worth approximately $35. This would be a very low valuation for Wells and we believe they should be able to grow EPS by about 10-12% a year from there for the next 3-5 years.
We are recommending selling the WFC $27 put for August which is actually in the money. The reason for this is that if the put expires worthless which we think is a reasonably good probability we can collect a fabulous 64% annualized return on our investment. Being that we are not day traders we have no ability to forecast what an individual stock will do the next few days, or weeks even, so when we set this trade we are completely satisfied taking the stock. That enables us to reap the benefits of owning the stock at a significant discount to intrinsic value.
Primary Risk Factors
A double dip recession would slow earnings growth. The biggest risk is onerous government regulation forcing WFC to raise capital in a real short time period.
Disclosure: Long WFC, short puts, short calls