Wells Fargo Has Dug Itself Into A Hole, But It Won't Be There Forever

| About: Wells Fargo (WFC)

Summary

Wells Fargo delivered middle-of-the-road performance for the fourth quarter, with comparatively good loan growth.

The bank's management will be dealing with the fallout of its fraudulent account scandal for some time, but the long-term ramifications likely won't cripple the bank's ability to generate ROE.

Wells Fargo looks slightly undervalued on the basis of 5% long-term earnings growth, but investors have to accept the possibility of headline risk and weaker results in the interim.

Sooner or later, Wells Fargo (NYSE:WFC) will move beyond its current set of problems (many of which are/were self-inflicted) and get back to the business of generating attractive returns from an exceptional retail banking franchise. The problem with "sooner or later", though, is that later can sometimes be a lot later, and there's a not-so-fine line between investing with a long-term focus on living in denial.

Certainly there are a lot of things going against Wells Fargo right now, but the bank is not falling apart and the new administration's policies are likely to be good for banks and could be particularly good for a more "regulatory-challenged" bank like Wells Fargo. These shares actually look slightly undervalued on the basis of mid single-digit long-term earnings growth, but of course there is the risk that these recent problems cause greater long-term problems than I assume.

"Good Enough" Will Do For Now

Wells Fargo didn't blow anybody away with its reported results, but its core pre-provision profit performance came in sandwiched between weaker sequential results from large money center banks like Citi (NYSE:C) and Bank of America (NYSE:BAC) and better results from smaller super-regional banks like PNC (NYSE:PNC) and U.S. Bancorp (NYSE:USB). Net interest income was actually pretty strong, up 4% sequentially against a peer average of around 1%, with a better net interest margin and above-average earning asset growth. Core fee income was not strong on an absolute basis (down 5% sequentially), but again sandwiched between worse results from the Bank of America/Citigroup side of the comp growth and better results from companies like U.S. Bancorp and PNC.

Loan growth was actually pretty good compared to its peers, with period-end balances up about 1% after excluding the deconsolidation of some sold loans. Wells Fargo was actually one of the better performers among the larger banks in terms of C&I and CRE loan growth, with good growth in cards and leasing as well. Credit is more of a non-factor to me at this point for most banks, but Wells Fargo continues to drive its above-average NPA ratio lower, though its reserve level is still a little lower than I'd like.

More Than The Normal Set Of Problems

The elephant in the room for Wells Fargo is the ongoing fallout from the company's fraudulent sales practices. Over 2 million accounts were opened without the account holder's permission (including 1.5 million checking accounts), and over 5,000 employees have been fired for opening these accounts - an action they took to meet what have since proven to be aggressive (if not unrealistic) cross-selling performance targets.

While "only" about 115,000 of those fraudulent accounts saw Wells Fargo charge a fee, there has been and will continue to be a lot of negative fallout. Wells Fargo has already announced close to $200 million in settlements with the CFPB and OCC, but I would assume more will be on the way (at least based upon what we saw with the housing/mortgage debacle). The scandal cost former CEO Stumpf his job (though he was allowed to retire) and the bank has had to fundamentally restructure its marketing approach for the retail banking business.

There have been other business repercussions as well. Consumer checking account openings have been diving - down 44% yoy in October, down 41% in November, and down 40% in December, though I suppose the "good news" is that the December figure was up 2% sequentially. Wells Fargo also saw the OCC revoke some provisions of the early settlement agreement (including expedited approvals for changes to its business plan and/or personnel), the Basel Committee increase its SIFI buffer by a half-point, and Prudential (NYSE:PRU) has suspended the sale of MyTerm policies through Wells Fargo over allegations of similar aggressive sales practices for these term insurance policies. I'd also note that the SEC's own investigation of this issue (relating to disclosures) could entangle the new CEO Tim Sloan as well.

While the retail sales issue is the hottest fire burning under Wells Fargo today, it's not the only one. There is also an ongoing issue with the company's "living will", and it is the only remaining major U.S. bank without a plan deemed satisfactory by the regulators. Until this is resolved, Wells Fargo won't be allowed to expand outside the U.S. or buy a non-bank business and it could conceivably lead to forced downsizing or divestiture of businesses if it continued on.

Also, even more recently, the Seattle City Council Finance Committee just voted today (February 1) to take its money (around $3 billion) out of Wells Fargo and find a more "socially responsible" bank to manage the money. This action was prompted not by the retail scandal, but by the company's participation as a lender to Dakota Access pipeline project. While things like this happen from time to time with many large banks, it's another straw on the back of a camel that already has a lot to carry.

Some Upside

The new administration in Washington could a catalyst for better things for Wells Fargo in the coming years. A more accommodating regulatory environment sounds at least superficially like a good thing for a company that has gotten itself into hot water with regulators. More broadly, though, rolling back the regulations that have been issued for the banking industry since the credit crisis could create opportunities for higher revenue, lower expenses, and lower capital requirements. With that, there is also at least the possibility that valuations could claw back some of the erosion seen since the crisis.

There are some other drivers to consider. Infrastructure stimulus and stronger economic growth in the U.S. would both likely be good for loan demand, and would also help reflation and higher spreads. Also on the subject of spreads, banks so far have seen lower than expected deposit betas since the December rate hike. There are no guarantees that that will persist, but if it does it means more leverage to higher rates for banks like Wells Fargo.

The Opportunity

I do think the retail banking scandal will weigh on Wells Fargo, but I don't think it's going to break the company. I still believe that ROE can climb toward the mid-teens over time, supporting adjusted earnings growth in the neighborhood of 5%. That, in turn, supports a fair value in the mid-$50's with a half-point penalty to the discount rate for the next few years to reflect the heightened regulatory risk and the risk of further erosion in the retail business.

The Bottom Line

Given the big run in bank stocks since the election, it is not so surprising that cheap-looking bank stocks have issues. I'm not trying to make excuses for what Wells Fargo did - it was wrong and they deserve to get fined for it - but I don't expect that it will cripple a bank capable of generating mid-teens ROE and ROTCEs in the high teens to low 20%'s. Investors need to be comfortable with the risk that things will get worse from here and that the recovery process could stretch out over a while (not to mention the risk that the optimism over the policies of the new administration evaporates if/when the actual bills/policies disappoint), but the valuation does look interesting for long-term investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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