Dividend Pressure at Wachovia Bank?

Can any doubt remain that Wachovia’s (WB) top-of-market acquisition of Golden West was a stinker? Its acquired California exposure and worse-than-expected residential mortgage credit performance are serious enough. Golden West’s “pristine” mortgage portfolio losses are already running well in excess of early 1990s peak losses. But CDO and SIV missteps and poor capital markets risk controls have weighed heavily on financial performance and add, too, to management’s credibility deficit. And could last August’s 14% common dividend increase been more ill-timed or advised?

Let’s recap the Golden West transaction:

• The 15% premium, $24.3 billion deal generated $13.8 billion in intangibles and another half billion dollars in restructuring charges.
• 2.8 times tangible book and 16.6 times trailing earnings.
• 36% core deposit premium.

Sound expensive? You bet. Stated another way, Wachovia paid a remarkable $85.3 million for each of Golden West’s less-than-stellar branches (even Vernon never paid that much to open a new branch), buying its mainly high-cost CD deposits at a staggering premium. At the time, Wachovia’s CEO Ken Thompson promised a “low-risk” transaction, an acceleration of long-term growth, cash EPS accretion in the second year, and an IRR of 17%. But the purchase pulled tangible equity levels to less than 4.5% of assets, and the “achievable” assumptions always seemed a stretch at best. Most investors ran the other way, taking the stock down more than 42%, from $60 at announcement to less than $35 in recent days. Market capitalization fell 32% despite a 19% increase in outstanding shares.

Meanwhile, capital markets and loan losses stretched Wachovia's balance sheet. In the past six weeks, the company went to the preferred equity market twice, with a $2.3 billion preferred infusion on December 20 and a larger $3.5 billion piece this past week. Both pay 8% dividends, and each incrementally dilutes common EPS. It seems reasonable to ask whether still more is required. As it is, the combined $5.8 billion will not lift tangible equity ratios to 5%. Street EPS estimates are trending down.

If mortgage or capital markets losses do not surprise, the preferred infusions may be sufficient to allow the company to defend the common dividend, but why has the company chosen to raise capital via the most expensive of available alternatives? With a year-end tangible equity ratio of 4.3%, no doubt Wachovia needed the capital, but until late last year, it had no preferred stock in its capital accounts. As it is, the annual preferred dividends will sum to about $460 million, diluting common EPS by 23 cents. And by implication, the common dividend, which yields an extraordinary 7.4%, appears at risk, despite management’s assurances to the contrary. In 2008, Wachovia will use about $4.9 billion in capital to pay its common dividend, up from $4.6 billion and $3.6 billion in 2007 and 2006, respectively.

The Golden West acquisition was anything but low-risk. It permanently lowered Wachovia’s earnings multiple and destroyed shareholder value. And salting the company’s equity with expensive preferred, when a common dividend cut was more financially responsible, will likely destroy still more.