So, I bought a bank. I know...I know. I said I wouldn't. Then again, that was a year or two ago, when I couldn't understand what the hell these guys were doing to make money. CDOs. Sub-prime mortgages. I would try to read the annual reports, and they would make my head spin.
Fortunately, the days of "creative" investing is over...for now. I have full faith that Wall Street will ensnare the markets in another mess in the next ten or twenty years. Still, banks will eventually return to "normal" for at least a while. (That is, of course, once they get through this "panic" mode.)
In a "normal" environment, banks aren't all that difficult to understand. The lend money; the sell investments and financial products; they make money on interest rate spreads. With blood pouring through the streets in the banking sector, much of it for good reason, we'll look at Wells Fargo and Wachovia, separate and together.
Grab a cup of coffee. This is a long one, Then again, we're expanding our sphere which ain't light reading.
Wells Fargo, from 1994 through 2008
An analysis of Wells Fargo starts in 1994 — the earliest date we can get annual reports from the SEC's IDEA Database (formerly EDGAR). I'll spare you the historical details prior to 1999. Needless to say, Wells Fargo was a very strong bank. Its merger with Norwest in the late 1990s turned the company into a giant.
Of course, the merger wasn't without growing pains. In the first few years after the merger, Wells Fargo would take $500 to $800 million hits to earnings based on non-cash amortization charges, as well as non-recurring (or short-lived) restructuring charges and integration charges (like software purchases to bring the two entities onto one computer system, advertising to keep customers well-informed during the transition, etc.)
From 1999 through 2002, Wells Fargo would report aggregate net income of roughly $16.8 billion. Its actual cash earnings were closer to $20.1 billion during that time, generating nearly 20% cash returns on equity.
From 1999 through 2007, cash earnings grew from $4.9 billion to roughly $9.4 billion a year. In addition, Wells Fargo periodically repurchased shares, increasing the intrinsic value per share as the company grew.
We'll get into the actual valuation after we explore the businesses at length. For now, as you can see on the chart below, let's just say that Mr. Market did a pretty decent job of valuing Wells Fargo for most of 2000 through 2007. For the moment, ignore the 2008 section of the graph. We'll look at that as we pick apart today's valuation of the combined Wells Fargo/Wachovia entity.
Wachovia, from 1999 through 2007
Wachovia's earnings were much more sporadic than those of Wells Fargo in the early 2000s. Like Wells Fargo, however, Wachovia had a ton of non-cash charges and non-recurring charges that should be accounted for in calculating intrinsic value. Remember: It's the accountant's job to record the business; it's our job to evaluate it. In that light, we need to figure out what Wachovia would have earned had it not taken those special charges.
Don't get me wrong: Those charges are real. Still, because they were non-recurring or short-lived, and because we're looking into the future, we need to figure out what Wachovia would look like after it's done taking those charges.
Once again, Mr. Market did a good job of pricing a business. Wachovia generally traded right around its intrinsic value, with very little margin of safety, from 1999 through 2007. (Keep in mind that I calculate intrinsic value for each year as though I were an investor evaluating the business at that time, and not backwards looking with today's information.)
Rather than saying Wachovia's business took a small beating early in the 2000s, I'd look at it this way: Wachovia's business was too profitable in the late 1990s. The dot-com bubble paved the way for massive trading commissions, lots of investment activity, and unsustainable profits. When that bubble burst, Wachovia had some restructuring to do to get back to "normalcy."
Part of that return to normalcy was taking more than $5 billion in restructuring and goodwill charges from 2000 through 2002. When that was done, Wachovia returned to a more "normal" state of business, generating $4 to $5 billion in cash flow — cash flow that would increase to $7.5 billion in 2007.
The Combined Companies
Together, Wells Fargo and Wachovia would have been one heck of a team from 1999 through 2007, generating $8 billion in cash flow in the early part of the 2000s, and growing that to $17 billion a year by the end of 2007.
Their cash return on equity would have been around 15% during that time. Of course, that number is suspect because of the inflated asset values of the late 2000s — values that increased their combined shareholder equity to $124 billion.
Also suspect is the cash flow, some of which was derived from mortgages, mortgage-related investments, and other bubble-type "assets" that have since lost value or appeal. So, our job as investors is to figure out the value of this combined entity and to assess, with a degree of certainty, the future cash flow that this business will generate.
Planning for Losses
In 2007, the combined entity — Wells Fargo and Wachovia (we'll call it "Wellsovia" for our purposes here) — generated $17.3 billion in excess cash, and that's after setting aside $7.2 billion in credit reserves.
On a bank's financial statements, you'll usually find a line that shows the "provision for loan losses" or "provision for credit losses." This is a non-cash charge to earnings based on what the bank expects to lose on its loan portfolio; so, it reduces earnings. Though it's technically a "non-cash" charge, we don't add it to the cash flow of the business because these are losses that are likely to materialize, in which case the charge becomes "real."
It's the first quarter of 2008 and the proverbial you-know-what is hitting the fan. The credit crisis has begun; the recession has started; Bear Stearns will be a distant memory by the end of the quarter. Wellsovia sets aside $4.86 billion for credit losses this quarter, more than half of what it had set aside in the entire year 2007 if it were a combined entity.
Though Wellsovia — the soon-to-be-combined entity of Wells Fargo and Wachovia — reports just $980 million in earnings for the quarter, it generates roughly $1.5 billion in cash, when accounting for various non-cash charges like amortization of core deposits, restructuring charges, etc. If the company doesn't take the full $4.86 billion in credit hits, that amount will show up in earnings down the road; so, we make a note of it and move on.
2008: Wellsovia Q2
As the credit crisis and recession begin to grasp the economy and markets, Wachovia has some bad news for Mr. Market — it lost a staggering $9.8 billion in the second quarter. Will it survive the credit crisis as a stand-alone company? Mr. Market doesn't think so, and he sends Wachovia's price plummeting even further.
Part of Wachovia's loss is a $6 billion non-cash hit to goodwill. Even still, Wachovia chugs through nearly $5 billion of cash in the second quarter — not good for a company with just $47 billion in cash on the books at the end of the quarter.
At that rate, Wachovia will be out of cash in two and a half years, assuming things don't get worse.
Wellsovia fares much better than stand-alone Wachovia. Thanks to Wells Fargo, the combined entity would have burned through just $3 billion with nearly $70 billion of cash in the bank. And remember — Wellsovia put $8.5 billion aside for credit losses this quarter; so, it has taken a loss but has more than enough cash to cover it and keep going, and it has planned for tougher times ahead.
2008: Wellsovia Q3
Merrill who? Lehman who? Tougher times are here, and Wachovia "loses" $24 billion. Or does it? Of that $24 billion loss, $18.9 billion is "goodwill impairment." What does that mean? From Wachovia's Q3 2008 SEC filing:
The goodwill impairment analysis is a two-step test. The first step, used to identify potential impairment, involves comparing each reporting unit's fair value to its carrying value including goodwill. If the fair value of a reporting unit exceeds its carrying value, applicable goodwill is considered not to be impaired. If the carrying value exceeds fair value, there is an indication of impairment and the second step is performed to measure the amount of impairment.
The second step involves calculating an implied fair value of goodwill for each reporting unit for which the first step indicated impairment. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination, which is the excess of the fair value of the reporting unit, as determined in the first step, over the aggregate fair values of the individual assets, liabilities and identifiable intangibles as if the reporting unit was being acquired in a business combination.
If the implied fair value of goodwill exceeds the goodwill assigned to the reporting unit, there is no impairment. If the goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss recognized cannot exceed the amount of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted under applicable accounting standards.
Allow me to put that into Plain English: Wachovia carried its various business segments at a certain value on its balance sheet. When its stock price tanked, the "market value" of those businesses sank to prices well below the value carried on the balance sheet; so, Wachovia wrote off — or "impaired the goodwill of" — those segments to the tune of $18.9 billion.
No surprise there. Wachovia's market capitalization dropped $100 billion. It couldn't possibly carry its business segments at values higher than the price it would cost to purchase the entire business!
Wachovia also had roughly $800 million in other non-cash, temporary write-offs like restructuring charges and other amortization, and nearly $2 billion in securities losses — temporary losses in the sense that they should not be expected to be recurring during the remaining life of the company. (If they do, Wachovia should consider getting out of the investment business.)
As ugly as the quarter was for Wachovia, the combined Wellsovia would have done much better. After setting aside $9.1 billion for credit reserves, the combined company burned through just $600 million or so of cash. With $64 billion in cash at the end of the quarter, $600 million is but a drop in the bucket.
During the third quarter, Wells Fargo would also get $25 billion in TARP money, bringing the combined company's cash to roughly $89 billion.
2008: Wellsovia Q4
In this last quarter of 2008, Wells Fargo would complete its acquisition of Wachovia. Wells Fargo CEO John Stumpf allegedly says that he "loves" the acquisition. Why? Let's explore:
Wachovia was acquired in a stock-for-stock deal — no cash. Each share of Wachovia turned into 0.1991 shares of Wells Fargo. At the end of the third quarter of 2008 (Q4 reports haven't been filed yet), Wells Fargo had 3.321 billion shares outstanding and Wachovia had 2.136 billion shares out. So, Wells Fargo issued roughly 425 million shares — or 12.8% of its business — to acquire Wachovia for about $12 billion. In the first three quarters of 2008, Wachovia's operations burned through about $7 billion in cash — an alarming rate considering it started the year with just $33 billion in cash.
Without the merger, Wachovia alone might not have been around long enough to survive the credit crisis. Without the merger, Wells Fargo would probably have been just fine.
When the 10-Q is filed with the SEC in the next few days, we'll get a better idea of how the two fared. What we do know is that Wellsovia has taken significant hits to earnings so that it could build a $21.7 billion credit loss reserve, revalue Wachovia's business segments, complete the merger, and proceed with integration and restructuring.
So, what does John Stumpf love about the merger? Much of the fourth quarter $13.7 billion loss experienced by the combined entity was an accounting and de-risking loss which included a number or non-recurring or short-lived charges. In addition, Wells Fargo picked up all of that cash on Wachovia's balance sheet — much more than the $12 billion acquisition price. So, Wachovia was essentially free.
What a Sweet Deal!
Think of it this way: A friend of yours comes to you with a problem. He's got $100,000 in credit card debt that he can't afford to pay. If he declares bankruptcy, he'll lose his house and his family will be out in the cold. He's got $80,000 in the bank. If he uses that to pay down his debt, he'll be able to afford the monthly payments but won't have any "emergency" reserve fund. If he doesn't use that money to pay down his debt, bankruptcy is probably his only option.
So, you cut a deal. You will assume his credit card debt so he and his family can move forward. For doing so, he'll give you $70,000 cash and $10,000 of his annual earnings for the rest of his life. (You already had $100,000 in cash, little debt, and strong earnings.)
Because he will have credit again (now that you've assumed his debt), he doesn't need the full $80 grand — he can survive with a much smaller amount. You take his $80,000 and pay down the majority of the debt. Then, you pay the remaining $20,000 balance out of your own cash.
For your $20,000 "investment," you just picked up a lifetime of earnings.
That's the Wachovia deal in a nutshell. Wells Fargo paid roughly $12 billion for a company that, under normal circumstances, should generate $5 to $7 billion a year in excess cash. All Wells Fargo needs to do is assume the remaining losses on the loan portfolio.
2012: Wellsovia (Now Wells Fargo again)
What will Wells Fargo look like in 2012? Let's assume, for a second, that the credit crisis is behind us in 2012. The economy is back on track and things are returning to normal, just like after all other bank, real estate, economic, market, war, government, and other debacles we've overcome in the past. I may be wrong on the timing; still, I am right on the outcome.
How do I know? Because if I'm wrong, your/our/the world's problems are much more severe than losing money in Wells Fargo stock. If everything goes to hell in a hand basket, the least of our problems is our portfolio. Whether you have $100 or $100 million, it will be worthless because our currency would be entirely worthless.
So, we act greedy when others are fearful and know that, at some point, things will return to normal.
Wells Fargo, formerly known on F Wall Street as Wellsovia, is generating about $13 billion a year in owner earnings — a combination of Wells Fargo's earning power and that of Wachovia, net of, say, a 5% cost savings resulting from the merger.
That would mean that Wells Fargo would be worth north of $125 billion, and perhaps as high as $170 billion. Now, I can't say for certain what it will be worth at that point as the future is not entirely clear. Then again, we don't have to pin our valuation down to the nth decimal. If we know that Wells Fargo will survive this mess (and it is in a great position to do so, barring the hand basket scenario) and if we can reasonably predict its future cash flows (using, for example, the cash flow of the combined entity from 2004), we can come up with a reasonable estimation of its intrinsic value.
What Can We Expect Over The Next Two Years?
Together with Wachovia, Wells Fargo has taken quite a bit of write-offs over the last year. That doesn't mean that they're done doing so. In the 1994 real estate recession in California, Wells Fargo had a ton of exposure to that market. From March 31, 1994 through September 30, 1995, the company's shareholder equity dropped 8.5% as it wrote off some $200 million in bad loans ("provisions for credit losses") — a hefty sum to a company that, as the time, was generating just $200 million a quarter in earnings.
Today's situation is worse.
At the end of 2007, the two companies would have had a combined equity of $124 billion. By the end of 2008, that equity was just $67,000. If it continues to build its provision for loan losses, that figure may continue to drop.
As it goes through its massive merger and restructuring, earnings will be unimpressive at best, and possibly horrendous, depending on the costs of the merger, its need to continue to beef up its credit loss reserves, and its need (or desire) to amortize intangibles, depreciate assets, and "de-risk" its balance sheet.
The costs of the merger will probably stick around for twelve to twenty four months, but we'll treat them as non-recurring costs to see the "normal" state of Wells Fargo's business. The length and depth of the deleveraging process is yet to be seen. What we do know is this: The new, bigger Wells Fargo ended the year with $128.1 billion in a combination of cash, short-term investments, and "trading assets" — investments recorded at market value (so, there shouldn't be any real surprises there).
With an $864.8 billion loan portfolio, of which $21 billion has already been written off through those provisions for credit losses, a hell of a lot would have to go wrong for Wells Fargo to fall off the face of the Earth.
Because its earning power is so strong, Wells Fargo will be able to suffer quite a beating for quite some time, and still emerge a strong company. And when things return to "normal," the stock market will likely pay a very high price for its cheery consensus on Wells Fargo.
And that's why I like Wells Fargo.