Most of my articles will be focused on the fundamentals of a company, and I will be trying to determine whether or not it is undervalued. Rather than focus on Wells Fargo's (NYSE:WFC) operating results though, here I want to focus more on qualitative aspects. After all, we are not talking about a competitive and operating issue as much as an ethics and company culture issue.
With a competitive issue, the investor may ask themselves: "Has this company lost its core competitive advantage for the long-term, or is it simply struggling due to temporary and cyclical factors?"
With an ethical issue, however, a more appropriate question would be: "Is this event an isolated incident, or was this something more widespread and rooted in the culture of the company?"
The reason this question is important has to do with the time value of money. If a company faces a one-off business event or isolated unethical incident that causes a brief drop in earnings, the value of the stock is not likely to be seriously affected. That's why when a security suffers a significant price drop as a result of one of these isolated events, they are often good buying opportunities.
When the issue is more serious and the recovery in reputation and earnings may take longer, then the value is going to take a bigger hit. Even though the price has dropped, it may not necessarily be a good buying opportunity.
Recently, Forbes put out an article in its October 4, 2016 issue detailing Andrew Witty's eight-year tenure and GSK's "turnaround" stemming from unethical business practices that included bribing doctors to promote their drugs. Now you can read it yourself, but to me, it seems like Witty has done a pretty good job as a CEO. The problem is this:
You have a CEO who has done a pretty solid job given the situation he was dealt with, but even with that the stock has had a tough stretch relative to its peers. I think that this quote from the article provides a pretty good explanation as to why: "While Witty was trying to make up for lost sales from patent expirations, he was busy with another task: trying to get past the ethical messes that had gotten GlaxoSmithKline in trouble before he took over."
So yes, patent expirations were a big problem for GSK during this period, but this is part of business in the pharmaceutical industry.
When the company's reputation is harmed, you can no longer just focus on money going forward (that attitude is probably what got you there in the first place). Part of the time, money, and effort go to rebuilding the company's culture and image. One of the things the article mentions that Witty does was change the way sales reps are incentivized, as he acknowledged the traditional way "incentivized them to push the ethical and legal envelope."
Does that sound familiar? The last point I would like to make on GSK is the recovery it took since their performance in 2007. In 2006 and 2007, GSK earned $9.92 B and $10.43 B respectively. Earnings did not fully recover to that level until 2015, when it earned $12.791 B (Source: S&P Capital IQ reports through Fidelity).
I'm not saying the ethical issues were the reason why GSK struggled during this time period. What I am saying is that the ethical issues made it harder for the company to focus on what matters: Continue replacing any lost sales from patent expirations and then hopefully add on top of that. Due to this long earnings recovery, the stock wasn't necessarily a good investment when Witty took over in May 2008.
WFC has a different situation than GSK did, and I'm not saying it will be as serious and as difficult to recover from. I am not as familiar with the GSK scandal and timeline, but after reading the article in Forbes, I realized it helps communicate my point. If the business recovery will be prolonged and not brief, buying on the price drop may not be the best thing to do.
The problem is obviously determining the seriousness of the situation without seeing the future results. With the recent events regarding Wells Fargo, let's think like a doctor to try and figure out if this is one of those scandals that will linger with the company for a long time, or if its reputation will carry on largely intact.
Thinking Like a Doctor
Now let's say you are a doctor who has a patient with cancer. Why do you think it is that you hear it is important to catch cancer early? The reason is because the earlier you catch it, the less chance it has to spread. If you can contain cancer to its original source and identify that singular source, chances are your prognosis is pretty good.
Now on the contrary, let's say you don't catch it early. This gives it the chance to spread to areas other than its original source. The problem is now that even though you may catch it, it can no longer be traced to a single, identifiable source.
We should all be able to see that the latter scenario is probably going to have not only a worse prognosis, but the recovery would probably be a much slower and longer process. Now let's shift to business, because I think the same concepts apply.
When scandals come up where there is an isolated incident at a company (i.e. the example of a rogue employee acting unethically), it is usually possible to pinpoint the source of a problem. You can point the finger at an employee, a branch, or even a specific point in time when there was an unethical act.
But what about when the unethical acts have been going on for a while, many employees are involved, and it has got to the point where it has affected the culture of the company? Now the solution isn't so simple. Let's keep these extremes in mind to judge the seriousness of the Wells Fargo situation.
The Facts and Analysis
First, I used a New York Times article for some details regarding the recent findings. Wells Fargo paid a total of $185 million in fines related to fraudulent account openings and applications for credit cards. Of this amount, $100 million was paid to the CFPB, the largest penalty of this type the agency has issued.
The practices date back to 2011, and at least 5.3K employees have been fired related to this issue. In total, about 1.5 million bank accounts were opened and 565K credit cards were applied for without authorization. The bank has 40 million retail customers.
I think we can use 3 questions to try and judge how serious this issue is. How long has it been going on, how many employees are involved, and how high up does it go? Part of the problem for Wells here is that this has been evidently going on for quite a while.
After all, opening up 1.5 million bank accounts doesn't happen in a short period of time. However, it has not been thought to have been going on for an extremely long time (say, a decade or more), and this is important because a big positive for Wells' reputation was the way it navigated the financial crisis. This is still the bank that survived it in as good of shape as any large bank in the U.S.
What about the people involved? Here, we can see another problem for Wells. No matter what the CEO says, it is hard to believe that 5.3K is a few bad apples. This shows the unethical behavior had spread through the company to at least some extent. Furthermore, the community banking division involved is the company's largest source of profit. It contributed just under 60% of profits in 2015.
Source: Wells Fargo 2015 Annual Report
Now, on the flip side, we need to keep in mind that the company employs over 250K people in total, so 5K doesn't seem like as big a number from this perspective.
The last thing, and perhaps the most indicative of how much the problem became rooted in the company culture, is how high up there was knowledge of this issue. We now know that executives knew of this issue, but we don't know yet if they knew the scale of the problem. Zoren Philip Musngi recently put out a good article on WFC with some employee reviews from glassdoor.com.
If you look at each and every one listed, the cons always list the intense culture of selling products to customers (in some cases whether they needed them or not). One of the reviews actually clearly stated that the company culture incentivized employees to act unethically in order to get promoted. But let's give the management the benefit of the doubt and say they didn't know about the fraudulent account openings of this scale.
Even if they didn't know though, they either knew or should have known about the pressure possibly incentivizing employees to act unethically at the company. When you read through the employee reviews, the scariest thing was that this problem was right there staring the company and management in the face.
So they cannot be completely innocent. Recently, a class-action lawsuit has been filed against Wells by former employees. This is something to keep an eye on because it has the potential to have both a significantly negative financial and reputational impact.
Everyone has their opinions, but I've seen scandals handled much better than this. I don't think it is a wise strategy to place an inordinate amount of blame on the employees when this was clearly somewhat in the culture of the company. Is it reasonable to think that the 5.3K employees were the only problem here?
I'm not saying they weren't a problem, but what about the managers who knew about the problem and obviously didn't take it seriously enough? What about the pressure and culture of Wells that went too far to at least somewhat incentivize this behavior?
Then there are the questions going forward. How does that impact Wells' ability to attract talent in the future? And while many have pointed to the fact that current customers are unlikely to switch banks, what about attracting prospective customers?
Source: American Banker (The chart indicates the percentage of customers of each of the 10 biggest banks who say they're frustrated that their bank is trying to sell them "products they don't need or want.")
When I go through the facts of this situation, it is clear to me what the right thing to do is: nothing. For those who think this is a buying opportunity, I would urge you to think about these things. Maybe not in the same way I did, but think about the impact this has on WFC's competitive advantage in the long run.
I think we have all at some point or another made the comment that we would like company XYZ if it dropped by say 10 or 20%. "It's just a little too high for me right now." I know I've done this. Some people will have limit orders to buy once it hits a certain price.
But I think this is a reminder to think about what we really mean when we say "I would like it at this price." What we really mean is that we would like its price or valuation to come down without having the long-term health of the company impacted. Who wouldn't love a company they are following to drop 25% for no business reason? Sometimes, though, drops in stock price actually do correspond to a drop in value. In cases like these, the stock isn't necessarily any cheaper because it dropped.
On the other hand, those screaming sell should also take a step back. While hopefully you can agree WFC's value has dropped, we can also see that its price has dropped. It has significantly underperformed bank stocks this year, and especially as of late.
Source: Google Finance
This is 2016 YTD performance. Wells Fargo is the light blue line, and the KBW Nasdaq Bank Index is the green line. The rest are US Bancorp (NYSE:USB), JPMorgan Chase (NYSE:JPM), and Bank of America (NYSE:BAC).
Going back to the impacts of the recent events, it is hard to believe that these will be detrimental to the company. These were unethical actions taken by some of its employees, but did the company reap huge benefits over the years because of this? We will see on that, but I'm pretty sure the answer is no.
I think they said they have refunded the fines charged on these authorized amounts and it came out to around $2.6M. Again, unethical and immoral? Yes. But it's not like because of this Wells was able to be successful all these years and make it through the financial crisis in such solid shape.
No matter how strong a brand name is, no company is immune from unethical behavior. I think Warren Buffett said it best when he said "We [Berkshire Hathaway] now employ more than 330,000 people and the chances of that number getting through the day without any bad behavior occurring is nil." To read more on how Warren talks about the way to handle situations like these, here is the link.
At some point down the road, every company is going to face an issue like this. Everything goes back to finding these things early before they become widespread problems. Unfortunately, for Wells, this seems like it is a pretty serious problem. It does not however seem detrimental.
This is the company that has consistently earned higher returns on assets, equity, and capital than its peers. It has carried its premium valuation for a reason. With respect to its large bank peers (JPM, BAC, C), WFC had the least in fines of any stemming from the financial crisis.
Here is a link to a very good article that has three charts to demonstrate WFC's ability to outperform its peers from a business, shareholder, and risk perspective. This has been a historically excellent business, but it is now facing a problem where the culture that has driven it to success (cross-selling and fee income) has gone to an extreme. It has dropped in both price and value. Whether you hold shares or not, I think doing nothing will serve you best going forward.
There are other good companies out there that earn high returns on capital and outperform their peers (and probably in industries with a lot less regulations than banks), and I will attempt to write about them going forward.
Keep in mind that behind all of this news, Wells Fargo is in an industry where regulations seem to increase by the day. Looking forward, don't be surprised if it becomes harder for even the best banks to continue to outperform. Don't think that some of this pressure that crept into Wells Fargo's culture wasn't a result of the tougher business environment facing banks.
That still doesn't make what it did right. But we can begin to come full circle by realizing that the ethical and cultural issues of today may be driven by the business and operating issues of tomorrow.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.