Wells Fargo Will Fly Higher In 2013 On High Credit Quality, Low Risk

 |  About: Wells Fargo & Co. (WFC), Includes: BAC, C, JPM
by: Ry Frank

In mid-April, Wells Fargo (WFC) reported its first-quarter results and the stock declined about 3.5%. I believe this is a good opportunity to buy Wells Fargo for several reasons. First, the bank passed the Fed test and it has an almost 8% Tier one common equity ratio, well above the 4.5% threshold under Basel III. Second, Wells Fargo started paying a $0.22 quarterly dividend for a yield of 2.7%. For comparison, of the other three banks of the big four banks, only JPMorgan Chase's (JPM) yield of 2.7% is comparable to Wells Fargo's. The other two, Citigroup (C) and Bank of America (BAC), are paying only token dividends for annual yields of 0.1%, and 0.4%, respectively. Third, Wells Fargo's mortgage banking segment is the strongest among the big four banks and it is showing success in cross-selling products to its retail customers.

Finally, the investment banking division reported a number of improvements, which investors largely overlooked. There were some negatives such as decreases in commercial and industrial loans, net interest margin, and in consumer debt. In my opinion these should not prevent an investor from committing to Wells Fargo. With 2012 earnings per share estimated at $3.25, Wells Fargo is trading at an attractive price-to-earnings ratio of around 10. This low valuation should provide ample room for the stock to appreciate once the economy returns to a more normal state. Until then, the 2.7% dividend yield is much better than the interest rate that Wells Fargo pays its own customers.

Wells Fargo has a relatively low international risk and its exposure is mostly to the domestic market. Its annualized net charge-off rate was 1.25% in the first quarter, which is the lowest since 2007, and net charge-offs declined $245 million from the prior quarter. Due to its improvements in credit quality, I view Wells Fargo as a more stable company, which is well-managed and has sufficient risk controls. As such, Wells Fargo should trade at a premium to the market's price-to-earnings ratio of about 15. Its current valuation is about 30% below the market average. Over time, I believe that Wells Fargo will revert to its average price-to-earnings ratio of 15 to 16.

As mentioned earlier, Wells Fargo is paying $0.88 per share in annual dividends. This is less than 30% of its estimated earnings in 2012 and well below the recommended payout of 70% by the Federal Reserve. The higher dividend payment should lower the volatility of the stock price and provide a floor in case of a sudden economic deterioration. In addition, Wells Fargo is less dependent on investment banking and overseas operations, which are usually a lot more volatile. While a dividend alone should not be a reason to invest, in the case of Wells Fargo shares, this should be considered a major catalyst.

After the recent Wachovia acquisition, Wells Fargo is the largest retail mortgage lender and servicer in the country with a mortgage portfolio of over $1.8 trillion and mortgage origination in the first three months of 2012 of $129 billion. Importantly, it had a household cross-sell ratio of 5.98 products per household in February, 2012. For comparison, JP Morgan mortgage origination in the first quarter amounted to $61.8 billion and its mortgage servicing portfolio has $884.2 billion but is at par in cross-selling.

According to Thompson Reuters deals intelligence tables (free registration required) Wells Fargo global investment banking standings improved in a number of areas: global loans book-runners (from 9th to 7th), mandated arrangers (from 11th to 7th), municipal book-runners (5th from 8th), global debt (16th from 19th ), global mortgage backed securities (7th from 14th). Only global equity registered a decrease (14th from 11th). Wells Fargo will continue to play an even larger role in the debt capital markets as consumers start to reevaluate their long-term bond funds, which I expect to underperform in an inflationary environment with stable and rising interest rates. It does not come as a surprise when Wells Fargo reported its quarterly earnings in mid-April that revenue from wholesale banking increased by 11% compared with the first quarter of 2011 or to $6,033 million. Its net income was up even better at 14.3% or up to $1,868 million. For comparison, JPMorgan investment banking revenue decreased to $7,321 million in the quarter, compared with the last year's first-quarter revenue of $8,233, a drop of 11%.

There were some disappointments in Wells Fargo's first-quarter earnings release. Its net interest margin, the difference between the interest it lends at and the interest it pays to depositors, was 3.91% compared with 4.05% in the first quarter of last year. This was still better than JPMorgan Chase's deposit margin of 2.68%. Another weaker-than-expected area was the wealth, brokerage and retirement segment. I expect this area to rebound and continue to improve as demand for investment advice continues to be robust. Wells Fargo has a top-quality wealth management and retirement network. I estimate that this segment, which contributes less than 10% of the company's net income, to grow to mid-teen digits by 2015. Finally, its non-interest expenses in the quarter increased to $13 billion from $12.5 billion the quarter before, mostly due to seasonal personnel expenses. The company expects its expenses to go down $500-$700 million in the second quarter.

In conclusion, the stock market often provides us with windows of opportunities to buy stocks below their intrinsic values and I believe that it provided such an opportunity after Wells Fargo stock declined over 3% on the day it reported its Q1 2012 results. Wells Fargo is well-managed bank. Its stock, at current valuation levels, is an attractive investment compared with peers. The shares should provide investors with lower volatility than those of other banks, which rely more on the volatile equity and international markets, like JPMorgan Chase and Citigroup, and also banks with lower asset quality portfolios like Bank of America. Thus, I think it is safe to say that among the big four banks, Wells Fargo offers the most compelling investment opportunity following the financial crisis of 2008.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.