In times of market turmoil it is usually the strongest companies in a given industry that are able to capitalize on consolidation and retrenchment. Wells Fargo & Co (WFC) has built itself into one of the most profitable banking franchises in the world through masterfully executed acquisitions, and a corporate structure that emphasizes lower risk profitability. By avoiding businesses which are impossible to manage such as large scale credit default swaps, Wells has benefited from gaining both investors and regulators confidence in the company's financial strength. Despite exceptional operational performance, Wells Fargo trades at a large discount to intrinsic value due to sector and macroeconomic concerns.
After the 1998 merger of equals between Wells Fargo and Norwest, the company moved forward with a corporate culture emphasizing the maximization of fee revenue. Fee revenue isn't tied directly to net interest margins, nor does it require the company to necessarily take credit risk, making it a lower risk source of income. Key to this revenue source are Wells Fargo's cross-selling initiatives, which attempt to deepen customer relationships, and increase the switching costs cementing long-term client relationships. An example of Wells Fargo's cross-selling would be a customer establishing a mortgage through Wells, and then being sold a credit card and certificate of deposit. This works just as well on the corporate side, but while every bank has a game plan to cross-sell, Wells Fargo is successful because the strategy is ingrained into the corporate culture, just as much as Wal-Mart Stores Inc. (WMT) is focused on being the low cost retailer for example. Non-interest income represents about 50% of Wells Fargo's income, and foreign loans represent a mere 5% of total loans insulating the company from the European crisis.
In 2008 when financial markets were reeling to a degree not seen since the Great Depression, Wells Fargo doubled in size through the acquisition of Wachovia. This acquisition was a transformational one for the company because it broadened the bank's reach across the country, and by implementing Wells Fargo's best practices to Wachovia, the company was able to increase the overall earnings power of the company dramatically. "Fresh start" accounting reduced the risk of the acquisition right off the bat, and Wells Fargo's cross-selling initiatives have boosted the combined company's average cross-sell rate to 5.98 products per household as of the 1st quarter of 2012. The East Coast branches that were inherited from the acquisition lag the West Coast branches by about 86 basis points, meaning there is still plenty of room for improvement moving forward. While most acquisitive company's post tremendous synergies and cost reductions via Powerpoint, Wells Fargo has actually delivered results on schedule and under budget. Management that delivers on its promises and has astute capital allocation ability is worth a premium in any investment environment.
Since the acquisition Wells Fargo has had nine consecutive quarters of EPS growth. This consistent growth is emblematic of the company's business model which has benefited from improving credit trends and increased market share in core businesses such as mortgages. On June 12th Bloomberg had an article discussing Wells Fargo's implicit goal of attaining 40% market share as long as it can be achieved without sacrificing underwriting standards. It is important to note that Wells Fargo survived the ultimate housing collapse in 2008-2011. While such a high market share might be scary to the pessimists on the housing recovery, I believe that lower asset values, lower loan to value ratios, and higher margins make now the time to strike in the mortgage market. By the time other banks start cracking away at that market share which is inevitable in my estimation, asset values will be higher and most likely underwriting standards will have slipped.
Wells Fargo has developed the lowest cost deposit franchise in the industry. Its $900 billion of low-cost deposit funding, accounts for 80% of the company's liabilities. Most banks that have had death experiences such as Lehman Brothers, were reliant on short-term funding sources like commercial paper or brokered deposits. This deposit base has enabled Wells Fargo to post dramatically higher net interest margins than its largest competitors over the last several years, and the advantage is only likely to expand due to the perception of less risk in Wells Fargo's business model, which has lowered its relative cost of capital in comparison to the other Big 3 of Citigroup Inc. (C), JPMorgan Chase & Co (JPM), and Bank of America Corp (BAC).
Wells Fargo's financial strength and demonstrated earnings power allowed the company to pass the Federal Reserve's stress tests with flying colors, opening the door for share buybacks and dividends. I'd like to see the company more aggressive on its buyback plan at current prices. The company has purchased $3.9 billion of North American energy loans from BNP Paribas S.A. (BNP), and $3.3 billion in loans backed by U.S. commercial real estate from the Irish Bank Resolution Corp. More deals are likely to come as European banks deleverage, and these cherry-picked transactions should enable Wells Fargo to grow assets and earnings despite modest loan demand.
For the full year of 2011 Wells Fargo reported net income of $15.9 billion, which was up 28% from 2010's $12.3 billion. This equated to diluted earnings per share of $2.82, therefore at a current price of $30.78 WFC is trading at just under 11 times earnings. With a book value of $25.06 Wells Fargo is one of the few large banks that are trading above book value making it expensive on a relative basis. Wells Fargo achieved these record earnings in a lackluster U.S. economy with housing still serving as more of a headwind than anything else. The company achieved a return on assets of 1.25% and a return on equity of 11.93% for the full year. These numbers are the envy of any large bank not named U.S. Bancorp, and when you factor in the impact of low interest rates decreasing its net interest margin, future earnings power looks bright. Pre-tax, pre-provision profit actually dropped to $31.55 billion from almost $35 billion in 2010 at total revenue declined due to lack of loan demand, and the decline in NIM.
In a stronger 1st quarter of 2012 Wells Fargo was able to generate pre-tax, pre-provision profits of $8.6 billion despite a higher cost structure, which will almost assuredly decline over the remainder of 2012 as legal and integration costs decrease. Capital levels are growing at a double digit annual pace with a Tier 1 common equity ratio under Basel I of 9.95%, and an estimated Tier 1 common equity ratio under Basel III of 7.81%. Wells Fargo pays $0.22 cents a share as a dividend per quarter, which has been increased dramatically, and with the bank's business model and focus on American growth, there should be ample opportunities to continue to accelerate the return of capital to shareholder over the next several years.
As mentioned before Wells is relatively expensive, but I'd argue on an absolute basis the company is exceptionally cheap. Wells Fargo could generate $40-$45 billion of pre-tax, pre-provision earnings per annum over the next 3-5 years. Expenses are expected to decline sequentially starting with about $500-$700MM MM in Q2 2012, therefore Wells Fargo's efficiency ratio should trend lower than the 61% in 2012, and 58% in Q1. This would put normalized net income in a stronger credit cycle at $18-$22 billion, which on the higher end is only reflective of a 15% ROE on current equity. I'd expect the top line to grow slightly faster than the overall U.S. economy, but with increased operating leverage and share buybacks I believe WFC could grow earnings by 7-10% per annum moving forward. This means that even if the multiple doesn't expand over the next 7 years you could see both a double in price, and an annual yield between 3-5%. If Wells Fargo's multiple does expand to 12-13 times earnings the mathematics become much more explosive, but the key is that I believe that market participants are overpricing risk given Wells Fargo's business model. The absolute disconnect between future earnings and the stock price isn't as dramatic as it would be if Wells Fargo's peers were trading at levels that had any association whatsoever with business values, but that is certainly not the case currently. If one looks at the relative value of WFC versus a Procter & Gamble Co. (PG) or an MLP for example, the disconnect between business value and price becomes more apparent.
To increase the cash flow yield on buying Wells Fargo, I'd recommend executing what we call a "hybrid trade." This means we suggest selling the January 13 $30 puts for $3.00, buying the stock for $30.78, and selling the January 13 $35 calls for $1.40. Assuming you bought 100 shares and sold one of each option, and you hold on to your positions till expiration which we'd recommend doing, there are only three possibilities of what could happen.
1) If the stock closes above $35 at expiration you will make $422 from the stock appreciating, plus $140 from the call, and you'd keep the $300 from the put. This equates to $862 on the maximum risk of $5,638 resulting in a 15% return in 220 days.
2) If the stock closes above $30 but below $35, you'll keep your $440 profit on the options which is 8% of the maximum risk, plus or minus any upside or downside on the stock from $30.78.
3) Lastly your "worst case" scenario is that if the stock closes below $30 at expiration, you'll be exercised and will end up owning 200 shares at a breakeven price of $28.19 per share. While this might reduce your short term profits, this result generally creates the most outsized profits over time through the benefit of the stock rebounding.
In addition you received the dividend on the stock which is $.22 a quarter or 2.9% at the current price.