Wells Fargo stock was recently hammered because of the obviously hostile departure of its esteemed CFO, Howard Atkins under mysterious circumstances.
I believe and have posted a theory that there was significant hostility between John Stumpf, the recently heightened CEO and Atkins, who didn’t get the promotion. A heated argument between these guys is the obvious explanation, especially now that time has elapsed and no other reason has surfaced.
I’m still highly curious as to what issue or issues was the linchpin that led to his stealthy and obviously hostile departure. I have a theory…one that if correct, will prove to be an enormously positive tailwind for the stock. I believe that Atkins left because he was causing under-reporting of earnings and Stumpf got tired of having artificially degraded earnings during his short tenure, which reflected poorly on his performance….they fought?
Mind you, this understatement of earnings was perfectly legal so long as he had a legitimate reason for doing so. That legitimate reason was tax savings. (Cynics could argue that he also had an illicit reason: Depress the stock price to acquire cheap options…I’m not amongst those cynics.)
What evidence do I have that earnings have been minimized? Here are the premises:
1) Huge 4Q charitable contribution. The single most obvious reason is that Wells frontloaded 3 years of charitable trust contributions to the tune of $400 million dollars in 4Q of 2010. Starting 1Q of 2011 this expense disappears.
2) Overstated tech expense? Next there is an extra $300 million of “tech, communications and equipment” expense in 4Q of 2010. (See Morningstar’s last 5Q’s of income statement. http://quote.morningstar.com/stock/s.aspx?t=wfc). This is over and above the greatly heightened $500 million quarterly expense of the last few Qs. Wells spent more than $10,000 per employee on this expense in the last year…that’s a lot of PCs. I think Wells frontloaded this 2011 expense into 2010.
3) Unrecognized securities gains. Wells has consistently sold and realized losses on securities held for sale and deferred the gains on winners. Unrecognized (untaxed) gains now tally $8.3 billion .
4) Undervalued Mortgage Servicing Rights. Wells services about $1.8 trillion of home mortgages. Over time a significant balance sheet asset valuation ($13 billion) has been placed on the mortgage servicing rights (“MSRs”). Traditionally during a low interest rate environment the value of the rights increases because the likelihood of loan pre-payments falls. On the contrary of late, Wells has been dramatically reducing the value of its MSRs over 2010 and late 09. It now values them at .72% of the pool of serviced loans, by far the lowest valuation in the industry. The effect of this highly conservative valuation is to lower current period earnings on mortgage originations and save taxes….hmmm. If Wells increased the value of the pool by 30 basis points to a more historic number for Wells (and the industry) it would have earned an extra $5 billion pre-tax over the last 2 years.(Note: Under Basel III capital requirements Wells doesn’t get capital credit for the MSRs over a ceiling anyway…another incentive to reduce the value?)
5) Excessive loan loss and repurchase reserves? While I have no direct evidence of this, my guess is that Wells has been “over-reserving” for losses. Why? To minimize taxes.
I believe Atkins, like most great CFOs was a tax saving zealot. I believe Stumpf is not quite such a zealot and wanted perhaps a little less single-minded mission. One piece of this puzzle is Wells new (and perhaps belated) emphasis on expense reduction. In fact that may have been “the” argument between the two. Well’s expenses are presently bloated perhaps for good reason, perhaps not. In any event, Stumpf has said expenses will drop. I believe a lot…and of course, taxes will increase. (fine by me, if income increases)
The tax-saving angle is especially prescient in 2010. With all the talk about lowering corporate tax rates, the benefit of deferring tax liability is greatly heightened. Why not defer income to a time when tax rates are reduced by 33%?
How will reversal of earnings headwinds to tailwinds effect forward earnings? Here is a tally:
Pre-tax forward savings per quarter:
- Charitable contributions--$400 million/Q savings - immediately
- Tech-Communications expense--$400 million/Q by 4Q of 2011?
- Unrecognized gains start being realized $300 million/Q by 4/Q?
- Discontinue under-valuing MSR’s = $500 million/Q?
- Loan losses to .7% of loans (2002-2005 levels) = $1.5 bil./Q
- Wachovia integration reduction (less the tech expense savings above) $300 million/Q?
- TRUP (preferred stock dividends) eliminated $182 million/Q in 2Q of 1011?
- Long-term debt reduced---$150 million/Q by 3Q of 2011
- Repurchases of mortgages reduced $250 million/Q by 4Q 2011
- 30,000 mortgage employees eliminated saving $350 million/Q in 1Q of 2012
Lower Corporate Tax Rate?
Share Count Reduction?
There may be some new headwinds as yet to be disclosed, but by my calculation $4. 33 Billion/Quarter of expense headwinds will disappear by 1Q 2012. At the current 33% tax rate and share count, we’re talking about a per share earnings increase of $.56/Q by 1Q 2012 without considering any revenue growth? Add these and Wells earn rate easily beats $5/share annually in 2012.
No wonder Atkins wanted to minimize taxable income?... No wonder the big boys are buying boatloads of Wells Fargo?
Disclosure: I am long WFC.