My near-term view of the Banking and Finance sector remains dim. I am not excited about this sector in the near term. Nevertheless, my investment portfolio rarely abandons any sector completely. For me, reasonable diversification is always in style.
Previously, my banking "horse" had been Citigroup Inc (C); whereas I held an under-weighted shareholding, largely as a speculative turnaround play. However, after reviewing both Citi and Wells Fargo (WFC) 4Q earnings reports / webcasts, I made the decision to scale out of Citi and into Wells Fargo. Furthermore, my plan is to move from CitiGroup common shares into Wells Fargo warrants. Please find my analysis and rationale below.
Citigroup: the Good, the Bad, and the Ugly
My initial reaction to Citi's earnings report and webcast could be summed up in one word: ABYSMAL. I had to reread the transcript and double-check the financial statements / presentation materials to re-calibrate a more cold-eyed view of the state of the business.
This exercise improved my reaction from "abysmal" to simply "miserable."
Citi missed badly on both EPS and revenue, despite analysts significantly lowering the bar on both benchmarks within the last month. The Investment Banking branch tanked, though it should be pointed out that an historically weak fourth quarter was compounded by the global uncertainty around the EU debt crisis.
Of particular note was poor expense management. Despite the business shrinkage, expenses continued to climb. Management made 2012 promises to reduce overhead, but even if it hits its markers, I'm not sure it's enough.
Notable was the fourth-quarter Loan Loss Reserve (LLR) release of $1.47 billion. This was a bit higher than Street projections. Subtracting this figure from reported Net Income of $1.17 billion, the net-net goes negative. The bank would have booked a loss without the LLR release.
The financial statements remain opaque, riddled with myriad "special items."
One telling number was management's determination that Net Tangible Book Value is $49.81 per share. Yet the shares trade at approximately $29 a share. Seems like a great bargain, right? Evidently, many investors are less than convinced the figures are tight. I'm one of them.
Return-on-Assets and Return-on-Equity are poor. I calculated them as 0.6 percent and 6.3 percent, respectively. The RoA figure is especially weak.
Cumulative to the negative column is Moody's recent report that listed Citi as the financial institution with the most exposure to the GIIPS (Greece, Ireland, Italy, Portugal and Spain). A slide found in the appendix of the earnings presentation outlined the magnitude of the exposure.
To be fair, Citi's retail banking loan book showed year-over-year growth of nearly 15 percent. The company's plan to increase the global footprint demonstrated solid growth in Asia, and Latin America. Net Credit Losses (NCLs) continued a gradual downward trend. The Net Interest Margin appears to have bottomed and may have started a reversal, albeit from very depressed levels.
The balance sheet (at least according to Citi accounts) is on the mend. Citi Holdings (the "bad bank") continues to unwind itself by divesting weak or non-core assets.
Bottom Line: Citigroup remains in the doldrums. It's understood the company is sprawling, complicated and maligned. Sure, it takes time to fix. However, this earnings report generates serious doubts as to the the progress and timing of that fix. Indeed, I challenge anyone to tell me they really understand the financials. CEO Vic Pandit is running out of time to straighten out the business. The stock could end up bouncing around the bottom for awhile.
That said, the go-forward downside for equity owners may be limited. The stock has all kinds of bad news stewed into it. Loan activity is up, the balance sheet looks OK, and future loan losses continue to decline. Despite the hiccups, Citi is executing its strategy to become a truly global bank; eclipsing the footprint of other major U.S. banking counterparts.
On balance, my view is to begin to scale out.
Wells Fargo: An Earnings Report with a Different Drumbeat
The Wells Fargo webcast left me with cautious optimism.
No question Wells' management is experienced and sound. Its business model is to be a premier "traditional" banking institution. Ninety-eight percent of the business is U. S. based. It has little direct exposure to Europe. The business is much more "Main Street" than "Wall Street."
No question, one could listen to the webcast, read the financial metrics / reports, then say, "Yeah, I get it."
Don't get me wrong. Wells Fargo is not riding a straight, clear highway. Nor does management say that it is. The Wachovia integration, while complete, has uncovered more warts than thought originally. It will take some work to clean up the debris. While the EPS and Revenue figures met Street expectations, they were nonetheless down double-digits from 2010. Loan losses have leveled off, but they are not dropping quickly. Wells Fargo is closely tied to the U.S. mortgage market, and the prognosis for that patient is not good, at least for the short term.
Wells Fargo's management did impress me with its optimism and simplicity of purpose. This can only be nuanced through listening to the conference call: "The Tone at the Top." Its business plan is straightforward and focused on clear operating metrics.
Loan activity was up 11 percent year over year. The Net Interest Margin has turned around. It's 3.89 percent, a very good figure. Deposits advanced strongly.
CEO John Stumpf was asked by analysts about returning capital to shareholders. He noted the bank "intends" to improve shareholder returns. It has submitted a plan. The bank is awaiting regulatory approval by March 15.
I noted that WFC has a RoA and RoE of 1.25 percent and 11.97 percent, respectively. I also paid attention to the fact that Wells Fargo management published these figures in the financial release. I had to calculate these numbers for Citi. They were not to be found in the presentation materials.
After reviewing the reports and webcast, I reflected upon Warren Buffett's advice to "invest in things you can understand." It may be noted that Mr. Buffett is Wells Fargo's largest shareholder.
Bottom Line: Wells Fargo is a well-run bank with a straightforward business model. It is executing on that model. The management team is experienced and backed by investor Warren Buffett. The U. S. banking / mortgage market is rugged, but Wells' team states it is up to the challenge.
On balance, I chose to scale in.
Wells Fargo Warrants
Under my initial premise that the Banking Sector is out-of-favor and will remain so for at least the near term, I reviewed various ways to invest in Wells Fargo equity: common stock, preferred stock, and warrants. Via the web, I researched an interesting way to invest in WFC longer term:
Wells Fargo Warrants, Expiration October 28, 2018.
These securities were created as part of TARP (Troubled Asset Relief Program) in 2008.
What is a Warrant?
A warrant is like a very long-term option. Options offer the holder the right, but not the obligation, to purchase a security at a certain price (the option strike price) within a certain time (the option duration). Ordinarily, options run for under a year. LEAPs typically run for two years.
The Wells Fargo warrants (WFCWS) were created to run for 10 years, 2008 to 2018.
In the case of WFCWS, the strike price is $34.01. This strike may be adjusted downward if the bank pays dividends greater than 34 cents a quarter. If so, the strike will be adjusted accordingly. Currently, WFC pays a dividend of 12 cents a quarter.
This thinly-traded paper is currently priced at little above $9 each. Since Wells' stock now trades just above $30 a share, the warrants are currently "out of the money."
Each warrant permits the owner to buy one share of common stock anytime between now and October 28, 2018. Alternatively, the owner may also buy or sell the warrant itself. They trade openly just like any other equity. However, the volumes are generally low, so the bid / ask spread can be wide.
The holder of the warrants, if held to expiration, must see the underlying common stock price reach $43 a share to "break even." Nevertheless, given the long expiration date, the pricing machinations of such securities are a bit more interesting than that. I'll permit readers to grind through their own scenarios.
The owner will not receive dividends (unless the warrant is exercised), but only needs to put up one-third of the capital versus purchasing a common share, thereby controlling triple the number of shares with the same outlay as a common equity owner.
My view is that the U.S. housing market and the banking industry will recover. Not today or tomorrow, but it will recover. Business changes, politicians change, regulations change. Seven years is an eternity within the investment domain.
Over the years, my experience leads me to believe the investment community tends to underestimate change and overestimate the status quo. When things are good, they will always be good. When they are bad, they will stay bad forever. Time heals many wounds and can be a patient investor's best friend.
There are times when a small investor can capitalize on these factors, and I think this could just be one of those times.
Disclosure: I am long C and WFCWS. The ticker symbol for Wells Fargo Warrants varies by listing agent.
