In 2008, Wells Fargo (WFC) nearly doubled in size with the completion of its purchase of Wachovia. This deal transformed Wells Fargo from a super-regional bank with a focus west of the Mississippi to the fourth largest bank in the U.S. with over $1 trillion of assets. Wells Fargo's new balance sheet along with Wachovia's larger capital market division gave Wells Fargo the heft to begin to compete with the New York money-center banks. Since the merger, Wells Fargo's strategy has been to build on its strong credit underwriting legacy as it takes advantage of the disarray affecting competitors like Bank of America (BAC) and Citigroup (C). The integration of Wachovia is essentially over and Wells Fargo is well positioned to capture increased market share when U.S. and global growth returns to historical norms.
Wells Fargo divides its business into three operating divisions: Community Banking, Wholesale Banking and Wealth Management. Community Banking, which encompasses most of Wells Fargo's mortgage and retail banking assets, generated approximately $9 billion of net income in 2011. Wholesale Banking, which is lending and other services to business, generated slightly over $7 billion. Wealth Management is based around the assets of the former A.G. Edwards, which Wachovia acquired shortly before Wells Fargo purchased Wachovia, and the division generated close to $1.3 billion in net income during 2011.
Wells Fargo is well balanced between interest income and non-interest income with the 2011 split at 48% and 52%, respectively, when post provision interest income is used. The ratio has moved slightly toward interest income since 2009, but this is due primarily to larger gains on the securities portfolio in 2009 that distorted the 2009 non-interest income.
Determining a bank's ability to absorb losses remains a difficult task for both regulators and equity analysts. A large amount of common equity is the best protection against losses, but reduces equity returns. Regulators continue to wrestle with the appropriate amount of equity to require, and the forthcoming Basel III rules will require a minimum.
7% Tier 1 Common Equity to Total Risk-Weighted Assets: Wells Fargo will likely be required to maintain a higher ratio due to its importance to the economy, but will have time to phase this increase in. Wells Fargo appears to be making excellent progress on building its capital with its Tier 1 Common to Risk Weighted Assets estimated under Basel III to be 7.50% at December 31, 2011 and 7.81% at March 31, 2012. Among large U.S. based banks, only Citibank and Bank of America likely had capital ratios below 7% at 12/31/11 although they did not break their estimates out in 2011 company 10-K filings.
Net Interest Margin, or the spread between what Wells Fargo pays in interest versus what it earns, was 3.94% for 2011 versus 4.26% for 2010. The low interest environment along with tightening spreads on lending products continue to pressure margins and is likely to continue through at least the first half of 2013.
Fee income was severely impacted by the Durbin Amendment, which limited the amount that card issuers can charge merchants. Commonly called swipe or interchange fees, the amendment went into effect in October 2011 and reduced Wells Fargo's fee income by $365 million in Q4 2011 versus Q4 2010. Wells Fargo estimates it will cost the bank approximately $1 billion in revenue per year, but the company believes that roughly $500 may be recouped by changing its fee structures and product mixes.
It is hard to argue with Wells Fargo's success in navigating the financial crisis and subsequent recession. Of the big four commercial banks, only JP Morgan Chase (JPM) may have fared better during the recession. Wells Fargo's acquisition of Wachovia before the major storm on too big to fail allowed it to create a national banking giant. Due to caps on the national share of deposits it is unlikely that Wells Fargo will be acquisitive in the near future, and given its trillion dollar balance sheet it is likely will attempt to take commercial lending and capital market business from weaker competitors.
Opportunities and Competition
Wells Fargo is continuing to increase its capital markets business with the recently announced purchase of Merlin Securities. This increased push will increase its competition against Goldman Sachs (GS) and Morgan Stanley (MS).
Capital market businesses like prime brokerage do not necessarily have to be risk increasing enterprises, however these activities are closely related to investment banking and securities underwriting. Wells Fargo has leveraged Wachovia's larger securities business to gain market share and fee income. Both investment banking and securities underwriting are generally talent driven businesses that carry significantly higher compensation costs than traditional commercial banking. The history of commercial banking successfully competing in investment banking and securities underwriting is a mixed bag at best.
Many of the commercial banks that have tried it in the past have either paid too much for talent or accepted excessive risk to win business that ultimately wiped out any economic profits that the new venture had generated. It is not clear to me whether Wells Fargo's frugal Main Street culture will succeed on Wall Street or end up destroying shareholder value. Wells Fargo's wholesale bank includes both its corporate and commercial banking operations. Within banking the distinction is not always clear, but generally speaking corporate banking is for clients with more than $500 million in revenue and commercial banking is centered more on the middle market. Wells Fargo competes against the largest commercial and investment banks in the world for corporate banking work and faces equally fierce competition in the middle market space.
Many of the regional banks escaped the tumult of the financial crisis relatively unscathed, have large capital positions available and are actively looking for borrowers. Two of Wells Fargo's strongest competitors in the middle market are US Bancorp (USB) and BB&T (BBT). US Bancorp, through its subsidiary, US Bank, competes primarily from Ohio to the West Coast. It has limited exposure to the Southeastern United States and is aggressively growing both deposits and loans. BB&T is a North Carolina based lender that has approximately $175 billion in assets and is primarily focused on the Southeast, where it is successfully competing against other weaker regional banks like Suntrust (STI) and Synovus (SNV).
Prior to the collapse of Lehman Brothers well run commercial banks routinely traded for more than four times the common equity (less intangible assets). Since 2008, Wells Fargo has traded at each year-end for less than two times. The lack of clarity on when interest margins will improve, Dodd-Frank and weak economic growth do not justify a multiple greater than 2.25 times, and at a 2.25 times multiple Wells Fargo is worth approximately $43 a share.
Wells Fargo's dividend is truncated due to the Federal Reserve and the need to build capital to meet Basel III requirements. Although it is likely Wells Fargo's payout ratio will gradually return to historical levels, there is no guarantee. I believe based solely on the dividend stream and stock buyback investors can justify a value of approximately $34 a share, which I consider to be the lower limit for Wells Fargo's share value.
The risk associated with Wells Fargo is fairly high as seen in the wide valuation range. Wells Fargo originates over 33% of all the mortgages issued. In addition to issuing mortgages (which are often sold to investors), Wells Fargo handles the collection of payments. This servicing business is highly sensitive to interest rates. Mortgage origination and servicing are supposed to be natural hedges to one another, but this relationship can fail in times of market stress. Additionally, the increased regulation and continuing litigation create operational and reputation risks. Wells Fargo's increasing exposure to securities underwriting and capital market activities increases the potential risk to equity investors as well as increased operating costs which may not be fully covered by increased revenue. Lastly, poor economic growth or even recession could cause credit losses to escalate requiring large provisions to loan loss reserves and corresponding decreases to earnings.
I believe Wells Fargo is one of the best managed large banks in the United States. The stock has rebounded from its lows following the collapse of Lehman Brothers to trade recently near $34 a share. My valuation for Wells Fargo ranges from a low of $34 to a high of $43 a share. This equates to a mid-point valuation of $38.50 a share. Given the risks associated with Wells Fargo, I am assigning a 25% margin of safety from the mid-point. This provides a target entry point of $29 per share for an investor with a five-year horizon. The IRR after dividends would be approximately 9.50%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.