Wells Fargo Might Cut Its Dividend More Than 70% - Which Could Be A Good Thing

Summary

• The bank anticipates second quarter results to include an increase in the allowance for credit losses substantially higher than the increase in the first quarter.
• Under the Federal Reserve's new rule: banks’ dividends cannot exceed their average net income over the preceding four quarters.
• A larger second quarter provision will directly result in lower earnings - thus a smaller future dividend.

Background

Unlike smaller regional banks, and most other money center banks, Wells Fargo (WFC) stock hasn’t bounced off the March lows of the recent market crash. In fact, it really hasn’t gone anywhere. The stock, currently at $25 and change, is up only just modestly above its multi-year low of $22, which it reached in May. Thanks to the latest negative news, results from the Federal Reserve Board’s stress tests, the shares are likely to remain volatile until some of the fog of uncertainty is lifted during its 2Q20 earnings results on July 14th. 

Most Recent Blow

On June 25, the Federal Reserve published two new guidelines pertaining to both share repurchases and dividend payment. The easier to comprehend policy is the prevention of banks from buying back their own stock for the immediate future. Most big banks, including Wells Fargo, had already suspended their share buybacks previously – meaning this does not really matter too much in near-term.

The more complicated policy is the language about a dividend cap that may force some banks to cut their payouts. Under the new rule, banks’ dividends cannot exceed their average net income over the preceding four quarters, unless the Fed makes a specific exception. While there was no specific example as to what an exception might be, something along the lines of pure accounting mechanics seems palatable. An example of this would be a “goodwill impairment” because they do impact regulatory capital ratios. I would venture to suspect that most anything else would not be granted an exception. 

Addressing the Issue

While there is a lack of clarity on the permitted dividend under the Fed’s new guidelines, CEO Charlie Scharf recently addressed the topic and issued a press release that stated:

“The company expects its common stock dividend in third quarter 2020 will be reduced from the current level of $0.51 per share. The company expects that the level of the third quarter dividend will be announced when it releases second quarter financial results.”

While a statement like that would most certainly put dividend oriented stock into somewhat of a holding pattern until the catalyst-event clears, I found the more meaningful statement from the press release to have been overlooked by investors.

“We expect our second quarter results will include an increase in the allowance for credit losses substantially higher than the increase in the first quarter.”

A larger provision will directly result in a hit to earnings. However, by putting aside money for future loan losses, the company is taking the pain up front while giving itself flexibility to offset future COVID-induced loan losses. That said, the most apparent victim is the shareholder depending on the near-term dividend.

In the Fed's stress test, it found that hypothetical loan losses of $47.4 billion over nine quarters would drive Wells Fargo's common equity Tier 1 ratio down 2 percentage points to a minimum of 9.1% under a severely adverse scenario. While trimming the dividend is an unwelcome turn of events for yield focused shareholders in the short-run, it puts the bank on better footing to make a quick recovery or to better whether an extremely harsh storm.

Possible Dividend Going Forward 

Based in part on consensus earnings forecasts, coupled with the assumption of a static share count through the end of 2021 – I am projecting that Wells Fargo would be able to pay a dividend of no more than $0.39 per share in the third quarter (based on 2Q20 results) and no more than $0.15 in 1Q21 (based on 4Q20 results) assuming the Fed keeps the same restriction in place.

Source - SEC Filings, S&P Global Consensus Estimates 

Because of regulatory actions and Federal Reserve oversight on capital allocation, large banks like WFC are only allowed to change their dividend after Fed approval. Historically, this is done just once per year, and because of this extra hoop to jump through, one should anticipate the lowest level as the new dividend base - $0.15 per share for the foreseeable future. This drop from $0.51 would calculate to over a 70% decrease in dividend.

Biggest Takeaway

For a bit of perspective, the last time the bank cut its dividend was in early 2009. Shares were trading at around $15 and the newly cut dividend shook out to just $0.05 per share. Excluding the looming cut that is about to happen, the most recent dividend was $0.51 – a more than 1,000% increase over the past 11 years. Most importantly, at the time of the cut in 2009, it marked one of the lowest share prices in the economic cycle. Shareholders were rewarded handsomely if they purchased shares despite the negative sentiment. In other words, the last time the dividend was dramatically cut it didn’t destroy overly the stock; actually, it marked a fantastic buying opportunity.

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