Wells Fargo (WFC) recently indicated that it was mulling a plan to buy into the insurance sales business. Presumably, this will complement Wells Fargo's mortgage, car financing and credit card businesses and could entail Wells Fargo buying established businesses from other financial institutions or tying-up with European banks that have more experience in this business.
Known as Bancassurance, or the practice of selling insurance products through banking channels, this business had been taken up over the years by a number of large European banks such as HSBC (HBC), Credit Suisse (CS) and Deutsche Bank (DB). Recently, however, HSBC divested some of its insurance units while Credit Suisse sold its insurance unit, Winterthur, to French Insurer AXA (OTC:AXAHY) last year.
Of the major American banks, only Citigroup (C) has a meaningful Bancassurance business - but this operates mostly outside the United States.
Considering that HSBC and Credit Suisse are abandoning the business, one has to wonder why Wells Fargo thinks it can make a go of it. Assuming Wells Fargo is able to make a business out of Bancassurance, how much can it reasonably expect a Bancassurance unit to add to its bottom line?
To illustrate, HSBC sold its own general insurance business for just $914 million in March, implying that it possibly added between $30 and 45$ million per year to HSBC's profits. That much revenue wouldn't do much for Wells Fargo's business in the near-term - it's equivalent to less than 1% of what it earned from Mortgage Banking in 2011.
Whatever the case, it underlines the fact that while Wells Fargo enjoyed strong first quarter profits on the back of strong refinancing activity, the mortgage market remains in the doldrums with home prices still a long ways off from their peaks.
That said, Wells Fargo can reasonably expect refinancing activity to remain buoyant for the next few quarters - at least - since the U.S. Federal Reserve has continuously reiterated its preference for keeping interest rates essentially at zero until late 2014.
What's more, despite the fact Wells Fargo controls about a third of the mortgage market, it has not experienced a derivatives blow-up of the kind that has plagued other banks like JPMorgan Chase (JPM). That alone sets it apart from the rest of the large U.S. banks.
Wells Fargo's prudent management of such risks is evident in the fact that even though its Basel 1 Tier 1 Common Equity ratio at the end of the 1st Quarter was a shade below 10%, it passed the Federal Reserve's February Stress tests and was allowed to raise its dividend to 22 cents per share (n.b. its Basel 3 Tier 1 ratio was 7.8%, which is above the 7% requirement).
Contrast that with Citigroup, which was not allowed by the Federal Reserve to increase its shareholder payouts despite having a Tier 1 Common Equity rate of close to 12% at the end of 2011 because doing so would have meant it falling below the required Tier 1 ratio. Consequently, it can be inferred that Wells Fargo's balance sheet does not contain the sorts of volatile assets that would cause it to take outsized losses during periods of systemic financial distress.
As a brief tangent related to this and Wells Fargo's insurance plans: Were it to enter the insurance business, it would not be able to include the assets of any of its insurance subsidiaries for purposes of calculating its capital adequacy. Thus, at least for purposes of calculating its Tier 1 Common Equity - and therefore its ability to pass a Stress Test - an investment in an insurance unit would represent something of a capital drain.
Wells Fargo's Card Business should also continue to benefit from the recovery of the U.S. Economy, with charge-offs at much lower rates and growth in the segment expected to be in the 35% range. This was already reflected in Wells Fargo's 1st Quarter results, when its charge-offs fell by $245 million. The more impressive figure related to that was its 1.25% annualized charge-off rate. Given that the U.S. economy continues to expand and the jobless rate has fallen, I expect Wells Fargo to continue seeing good results from its card business.
Meanwhile, although it's expected that the economic recovery will result in higher spending and therefore lower levels of savings, Wells Fargo has actually been on the right side of it - its deposits grew by $3.9 billion. This probably has something to do with Wells Fargo's reputation as a relative safe-haven among American banks.
Clearly, Wells Fargo has been able to make strides even amidst the very difficult banking environment in the U.S. To me, the most impressive statistic is that it's been able to raise its quarterly income for each of the past seven quarters.
How does Wells Fargo stack-up against the rest of the banks? Not too shabbily, actually.
For one thing, its revenues are growing at a 15% pace while its earnings-per-share (EPS) are growing by 13% -- contrast that with the rest of the banking industry where revenues have been essentially flat (up 2%) while EPS actually contracted by 16%. What this tells me is the same thing that its Tier 1 Common Equity ratio tells me: Wells Fargo has avoided the mirage of making money by trading in derivatives; or at least that it hasn't made many bad trades.
Wells Fargo's shares aren't even expensive: with a Price-Earnings (P/E) ratio of 11x, they're actually a bit below the banking industry's 12.5x. What's more, investors are compensated for holding onto its shares with a dividend yield of 2.7% - 28% higher than the S&P 500's 2.1%. Of course, that yield might seem paltry compared to the average bank dividend yield of over 11% -- but that number if bloated by the fact that several banks wanted to make large payouts after years of losses.
In that sense, you could say that Wells Fargo has wisely chosen to retain cash in its profitable operations rather than gratifying its shareholders in the short term by paying outsized dividends.
While I don't agree with Wells Fargo's Bancassurance aspirations - it's a largely untested business model in the U.S. that hasn't really produced exceptional returns for the banks that introduced it in Europe - it does show that its management is exploring other less-risky avenues to boost its profits rather than rolling the dice with credit default swaps.
Given this, while I am lukewarm to the U.S Banking Industry because of the potential for fallout from Europe, I believe that Wells Fargo should be the exception. Moreover, I think that other investors will see it the same way I do and expect Wells Fargo's stock to rise by 70% in the next 15 months.