- WFC Quarterly update to a fantastic well managed over capitalized business.
- A look into normalized WFC earnings adjusted and quarterly changes to the business.
- Why I own some and why I am still a buyer at these prices.
It has been 6 years since I first researched Wells Fargo. What caught my curiosity then? Was it Warren Buffett's large investment in it? Was it the outstanding industry leading metrics it was posting? Was it just luck?
Why am I still following it?
I am still following it because it is a fantastic company that I have a sizeable position in. It is currently my 3rd largest position. In my opinion it is still in the buy-zone of the price to value spectrum.
How long will I hold it? How will I decide when to sell? When will I buy more?
I think the SeekingAlpha world probably has a pretty good understanding of some of the main facts surrounding Wells Fargo, but let's make sure we are all on the same page:
· WFC survived the credit crisis unscathed. When another large historic bank, Wachovia, failed, Wells Fargo picked it up on the cheap. This roughly doubled the size of Wells Fargo deposits and loans and gave them a few more business lines, although they did have to absorb the losses from Wachovia's bad loans (and a few of their own although those paled in comparison). This acquisition was an extremely profitable decision.
· If you bought one share of Wells Fargo in 1980 you spent about $1.07. If you kept that share until today and reinvested your dividends, it would be worth about $75.00, for a compound annual growth rate of about 14%.
· The base salaries of the management team of Wells Fargo are actually quite low; if the company does fantastic over the years the management team share in those rewards. This is a very fair proposition for shareholders which is not usually taken to this extent at most other companies.
· Wells Fargo has one of the best deposit franchises in the banking world.
· Wells Fargo has a diversified stream of non-interest earning streams that allow them to easily weather any difficulties in the loans and deposits side of their business.
I am going to be an analyst writer for a day for Wells Fargo. I am going to try to give you the quarterly details I would want to know if you didn't let me analyze the company for myself.
First, let's start with a summary of the key metrics for Wells Fargo:
Stock Price: 48.93 per share
Diluted Common Shares Outstanding: 5353 Million = 5.353 Billion (Undiluted shares outstanding = 5266 Million = 5.266 Billion - or within 2% so let's use the more conservative Diluted number. When some of those extra options are exercised they will bring in some cash for the company but it will be small in numbers we are talking about so let's assume it is negligible)
Market Capitalization: 48.93 x 5.353 = 277 Billion (the cost to buy all shares of the business)
Tangible Stockholders Equity: 175.6 Billion - 17.2 Billion (preferred stock) - 25.6 Billion (goodwill) = 132.8 Billion
Total Earnings Assets: 1364 Billion
Total Loans: 826 Billion
Total Investment Securities: 270 Billion
Total Federal Funds Sold (Equivalent to short term investments/cash): 213 Billion
These three don't perfectly add up to total earning assets because there are some other assets that are not as significant. These three are shown to demonstrate the investment breakdown at Wells Fargo.
Total Deposits: 1053 Billion (1094 Billion total - 41 Billion certificates of deposit, only counting the very low interest rate deposits)
Long Term Debt: 154 Billion (1.62% yield - EXTREMELY inexpensive)
Short Term Borrowings: 54.5 Billion (0.09% yield - words alone cannot describe how cheap this is)
In fact, let's make this liability side of the balance sheet even simpler to analyze. The 1.36 Trillion dollars Wells Fargo has "borrowed" from depositors/long term debt/short term debt costs them an annual interest rate of 0.29%. Despite having this much deposits, they are still growing deposits faster than the industry as a whole. If that doesn't tell you what the world thinks of Wells Fargo creditworthiness, I don't know of any other single fact that could change your mind. If you were still unconvinced I would ask to look at what other companies typically pay to use other people's money to earn money for themselves.
Now let's turn our minds to what this all means for profit for us, the shareholders. We will do this by adjusting the reported Net Income for nonrecurring items and for items that are not really income or expenses but accounting forces them to be reported this way.
Q1 2014 Unadjusted Net Income Applicable to Common Stock: 5.61 Billion
In order to get a more normalized earnings number, we need to take out items included in the net income figure that cannot be banked on in normal conditions.
MINUS Tax Benefit in the Quarter (non-recurring): 0.42 Billion
MINUS Reserve Release in the Quarter: 0.50 Billion
PLUS Core Deposit and Other Intangibles Amortization (non-cash expense that actually doesn't cost the company money but is included as an "expense" on the income statement): 0.34 Billion
MINUS Net Gains from equity investments: 0.85 Billion
At quarter end they had 3.46 Billion in marketable equity securities. If they had a much larger amount of marketable securities (15B+) we might normalize and consider some recurring income over a multi-year period and average it out. Since it is a small in comparison we will be conservative and assume this is negligible.
PLUS Net taxes on gains from equity investments (if the gains aren't recurring at this rate, the related taxes aren't recurring at this rate either): 0.85 Billion x 0.3 = 0.26 Billion (assuming 30% tax rate)
This gives us 5.61 - 0.42 - 0.50 + 0.34 - 0.85 + 0.26 = 4.44 Billion
There are 365/4 = 91.7 days in a "true" quarter. When normalizing earnings you want to normalize for the number of days too. There are actually 90 days in the first quarter, but let's adjust it to a "true quarter."
4.44 Billion x 91.7/90 = 4.52 Billion
This is less than the headline number. We are trying to be conservative. In all likelihood there will be further reserve releases in the coming years as long as the economy does not dramatically dip. Wells Fargo will probably still have equity gains in the future (they may or may not be as high as this quarter). They may find ways to pay less taxes. On the other hand, they may earn less income in the mortgage servicing business as new regulations look like they will make keeping those on bank balance sheets more of an onerous capital burden. There are a lot of other factors at work, which is why we will not base our valuation on a single quarter. However, it is always instructive to delve deeper into the drivers of the results in order to look into what this could mean for the future of the company.
Now let's discuss some major factors that are semi-predictable:
Cheap deposits are currently under utilized:
At the end of Q1 2013 Wells Fargo only owned 121 Billion of Federal Funds Sold, while at the end of this Quarter, they have 213 Billion of Federal Funds Sold. Wells Fargo at the end of Q1 2013 was even over capitalized so this means that they definitely have at least 100 Billion they would like to invest in loans due to their increasing deposit base. Wells Fargo will find a way to use this extra money in a more efficient earning way than it is currently. At their current overall loan interest rate of 4.29%, if they made loans instead of government securities yielding 0.27%, and you assume 0.5% of the loans go bad over time, and the extra profits are taxed at 35 % rate you get:
100 B x (0.0429-0.0027-0.005) * (1-0.35) = 2.3B extra profits per year. In one quarter this would make earnings increase by 0.6 Billion. I would not assume this would happen overnight and it just goes to show that even though they are gathering excess deposits they will use those very advantageously in their future.
Wells Fargo can easily grow loans without growing deposits at this point in time. In practice banks often have a loan to deposit ratio that is somewhere between 0.9 to 1.1 so there is even more room to grow loans than the 100 billion suggests. However, future deposit growth will also add dramatically more value to Wells Fargo. Normalized 4.52 Billion earned this quarter reflects the full expense of the deposits and them being underutilized, therefore this point will be a net positive to earnings. I will value them at a quarter of their potential value and will increase it in the future as they are utilized, which means an additional 0.15 Billion added to this quarter's normalized earnings. This brings us to 4.67 Billion.
Long Term Debt:
With banks, debt is a very different item than at most other companies. At banks, this money is lumped into the overall funding sources pool. The similarity to debt at companies in other industries is that the cheaper the debt is, the better.
At quarter end, Wells Fargo had 153.8 Billion dollars in debt. This may sound like a bad thing, until you find out their interest rate is 1.62%. The ironic thing is that they have enough deposits to fund their earning assets. This debt is very cheap long term capital that will surely be more profitable than it costs. Similar to the deposits to loans discussed in the previous point, this long term debt would allow them to fund an approximately equivalent amount of loans. If we use their current loan interest rate of 4.29% with 0.5% of loans going bad over time and extra profits taxed at 35%, this long term debt can effectively be providing 154 Billion x (0.0429 - 0.005 - 0.0162) x (1-0.35) = 3.34 Billion in excess profits compared to them not utilizing debt. However, right now, because most of this equivalent value of debt is currently invested in treasury bills and other short term investments, currently yielding approximately 0.29%, it is actually costing them 154 Billion x (0.0162 - 0.0029) x (1-0.35) = 2.0 Billion per year. This comes out to 0.5 Billion per quarter. So this debt is essentially providing a value of -2 Billion per year to 3.34 Billion per year and providing an excess safety capital net for its term. Wells Fargo will use this money bucket to make profitable loans in the future so my bet is on this debt undertaking to be 1 to 2 billion accretive to Wells Fargo's value per year from now until it is paid off. In the interim they will have the option of adding new long term debt or reducing the current long term debt as it suits their needs, which is a very big advantage indeed. This is similar to the excess deposit discussion above and I will value it at ¼ of 1 Billion per year, or an additional 0.06 Billion. This brings us to 4.73 Billion.
Mortgage Servicing Rights:
These are definitely a hot topic in the banking world right now. I won't pretend to be an expert on this category, but from what I see, Wells Fargo earned had 938 million in mortgage banking servicing income in the first quarter. This does not include the expenses associated with this income and Wells Fargo doesn't break those out individually. Lots of the banks are selling their mortgage servicing assets to non bank companies that specialize in this area. They are selling not because they cannot handle doing the work but because new regulations are making mortgage servicing rights more capital intensive to hold. It is difficult to come up with a good number for how much this will hurt or help profits. As a crude estimate, let's use Wells Fargo's efficiency ratio to guesstimate what type of earnings they might have achieved on the 938 million of mortgage servicing revenue this quarter. I would bet that this has a lower profit margin than other lines of business but let's be conservative and assume it is the same. With Wells Fargo efficiency ratio at 57.9 percent, this would give us a 42.1 percent pre-tax profit margin. Using a 35% tax rate with a 42.1% pre-tax profit margin gives: 938 million x 0.421 x (1-0.35) = 260 million in profit for the quarter. Since Wells Fargo will be selling these rights as opposed to servicing them themselves, and there are going to be lots of sellers, let's assume that they can only get half price compared to the margins they are currently earning, so once these regulations fully come into effect it could about 130 million per quarter in reduced profits. As you can tell this is much less scientific than other parts of this post but I do think it is approximately in the ballpark. This reduces profits by 0.13 Billion which brings us to 4.60 Billion.
Ironically, we are still quite close to our normalized number, and still not far off the accounting reported number. The factors do not nearly always cancel out as nicely as they seem to have today and it is very common to find a company is making far more or less than the accounting reported net income. There are a lot of other areas of Wells Fargo's business that have some variability and a few that have under and over performed this quarter. In the aggregate they seem close to a normal quarter which is why I haven't brought any more items up separately. This quarterly checkup says yes, Wells Fargo is well equipped for the future. It also says I won't be selling any of my shares anytime soon.