The Bull Case for Wells Fargo

Commercial Real Estate Funding System

Commercial Real Estate Financing

Get Instant Access

There is much to admire about Wells Fargo. By all accounts it has a great management team and a very strong franchise that will likely become even stronger with the acquisition of Wachovia, which gives it a coast-to-coast presence and propels it to the top, or near the top, of U.S. banks. The combined company is number one in bank branches (6,610), small business lending, middle market commercial lending, agriculture lending, commercial real estate lending and brokerage, and bank-owned insurance brokerage (number five worldwide). It 's also number two in banking deposits in the United States (11.2 percent, a hair behind Bank of America, which has 11.3 percent), mortgage originations and servicing, retail brokerage, and debit cards.

Wells Fargo 's pre-Wachovia business was highly profitable, earning $19.6 billion pretax in 2008 before provisions for loan losses (which were enormous—net income was only $2.9 billion; peak net income was $8.4 billion in 2006). Figure 13.1 shows the dramatic growth over the six years between 2003 and 2008.

Wells Fargo 's robust earnings were primarily driven by the company 's net interest margin, which in 2008 vastly exceeded the margins of its three largest competitors, as shown in Figure 13.2 .

-

2004

2005

2006

2007

2008

2003

2004

2005

2006

2007

2008

Figure 13.1 Wells Fargo Pretax, Preprovision Earnings, 2003-2008

Source: Wells Fargo Q4 2008 financial results presentation, January 28, 2009, p. 10.

Citigroup

JPMorgan Chase

Wells Fargo

Bank of America

Citigroup

JPMorgan Chase

Figure 13.2 Net Interest Margin of the Four Largest U.S. Banks, 2008

Source: Wells Fargo Q4 2008 financial results presentation, January 28, 2009, p. 15.

Wells Fargo not only had higher margins, but was also growing its revenues and pretax, preprovision earnings faster than its peers, as shown in Table 13.1.

Table 13.1 Growth in Pretax, Preprovision Earnings and Revenue

Pretax, Preprovision Earnings Growth

Revenue Growth

2008

5 Years

2008

Wells Fargo

17.4%

11.3%%

6.1%%

JPMorgan, Citigroup, BofA

-60.5%

-60.4%

-16.7%%

Top 9 peers

-47.9%%

-41.7%%

-2.1%%

Source: Wells Fargo Q4 2008 financial results presentation, January 28, 2009.

Source: Wells Fargo Q4 2008 financial results presentation, January 28, 2009.

Turning to Wachovia, Figure 13.3 shows its pretax, preprovision earnings for the past six years, which are approximately 60 percent of Wells Fargo 's.

The combined earnings power of the two companies is enormous. We estimate that with interest spreads at record levels currently, the pretax, preprovision income of the original Wells Fargo will rise slightly to between $20 billion and $22 billion in 2009, plus we add $10 billion to $12 billion from Wachovia, so that's $30 billion to $34 billion. On top of this, Wells Fargo estimates $5 billion in cost savings and synergies, so let's assume savings of $4 billion to $6 billion, for a grand total of

2003

2004

2005

2006

2007

Q1-2 08

Figure 13.3 Wachovia Pretax, Preprovision Earnings, 2003 to Mid-2008

Source: Wachovia 10-K 2007 and 10-Q, Q3 2008.

2003

2004

2005

2006

2007

Q1-2 08

Figure 13.3 Wachovia Pretax, Preprovision Earnings, 2003 to Mid-2008

Source: Wachovia 10-K 2007 and 10-Q, Q3 2008.

$34 billion to $40 billion in normalized pretax, preprovision earnings (it may take a little while to realize the cost savings). This is consistent with what Warren Buffett estimated when he was interviewed by CNBC on March 9, 2009: "I would expect $40 billion a year preprovision income."

Buffett added: "And under normal conditions, I would expect maybe $ 10—$ 12 billion a year of losses." That's 25 to 30 percent of $40 billion, so applying the same percentage to $34 billion, that's $8.5 billion to $10.2 billion in losses, leaving pretax income of between $23.8 billion and $25.5 billion. Now subtract 33 percent for taxes and divide by 4.2 billion shares, and the result is earnings per share (EPS) of between $3.78 and $4.05. The same calculations at $40 billion of pretax, preprovision income, minus $ 10-$ 12 billion of losses, result in EPS of $4.44 to $4.76. Any way you cut it, that's a lot of earnings for a stock that closed on March 12, 2009, at $13.95.

The first quarter of 2009 is off to a good start according to CFO Howard Atkins, who made some bullish comments in a press release on March 6, 2009: "Our strong operating results for the first two months of 2009 have been driven by continued growth in lending, deposits and mortgage volumes. Mortgage originations for the first two months alone were $59 billion, exceeding in two months the exceptionally strong fourth quarter of 2008, and mortgage applications were $107 billion."1

Regarding its balance sheet, in the same press release Wells Fargo announced that it was cutting its dividend by 85 percent, which will save the company $5 billion annually—a very smart move. In another smart move, Wells Fargo was aggressive in booking impairments and taking write-downs in Wachovia 's portfolio, as shown in Table 13.2 .

Table 13.2 Credit Impairments and Write-Downs Taken by Wells Fargo on

Wachovia

Portfolio

Credit Impaired Credit

Loan Balance (Bn) Write-Down (Bn)

Credit

Pick-a-Pay mortgages (option ARMs)

Other consumer loans

Commercial real estate

Other commercial loans

Other

Total

Source: Wells Fargo Q4 2008 financial results presentation, January 28, 2009.

In the March 6 press release, Atkins summarized why Wells Fargo believes that its capital position is strong:2

Our capital position, adjusted for risk, is near the top of our peer group. At December 31, 2008, stockholders' equity was $99 billion with Tier 1 Capital at 7.84 percent—30 percent above the 6 percent regulatory minimum for well-capitalized banks. Our tangible common equity was $36 billion, 2.86 percent of tangible assets and 3.32 percent of regulatory risk-weighted assets. These ratios are after significantly reducing the risk in the Wachovia loan and securities portfolios, about half of the combined balance sheet of the new Wells Fargo. By immediately writing down loans and securities at Wachovia through purchase accounting adjustments at close, we have already significantly reduced the risk of loss to tangible common equity. Since these losses have already been recognized, our future earnings will be higher and therefore tangible common equity can now grow faster. Adjusted for the fact that we already accounted for these future losses, our tangible common equity as a percent of regulatory risk-weighted assets would have been 5.2 percent at December 31, 2008.

Buffett certainly thinks Wells Fargo is attractive, but worries about what the government might do. Here 's what he said during the March 9 CNBC interview:

Warren Buffett: . . . Our stocks we plan to hold a very long time. . . . Overall I like to buy them with the idea of owning forever. And the quotes don 't make much difference.

Now, if I looked at the performance of Wells Fargo ... in a couple years—and management doesn' t have anything to do with what I'm saying here—I would expect $40 billion a year preprovision income. And under normal conditions I would expect maybe $10 to $12 billion a year of losses. I mean, you lose money in banking; you just try not to lose too much.

So, you know, you get to very interesting figures. I mean, the spreads are enormous on what they' re doing. They' re getting the money at bargain rates. So if there were no quote on Wells Fargo and I just owned it like I own my farm, I would look at the way the business is developing, and I would say, you know, "These are a couple of tough years for losses in the banking business, but you expect a couple tough years every now and then," and that the earning power is . . . going to be greater by far than it's ever been when you get all through with it.

The only worry in that is the government will force you to sell shares at some terribly low price. And I hope they 're wise enough not to do that. That's what's spooking the banking market to a big extent. Becky Quick, CNBC: You worry about that, too. Warren Buffett: Yeah, sure.

Becky Quick: That's why you 'd like some clarity out of Washington on what they 're planning to do. . . . Warren Buffett: I think clarity is a good thing for the whole country. . . . Any issue to do with people 's money, clarity's important. People want to be clear about their money. But I would say that . . . Wells Fargo, their prospects three years out are better than ever.

To summarize, Buffett loves the stock, it's trading at 3 to 4 times normalized earnings, and the company has taken large write-downs for Wachovia, so why isn' t every investor buying it? The answer lies in the balance sheet, in particular a minimal amount of equity, which may yet put Wells Fargo in the same dire position as Citigroup.

Was this article helpful?

0 0
Secrets of the Credit Industry

Secrets of the Credit Industry

Legal strategies that credit bureaus, creditors and debt collectors do not want you to know! How to use consumer credit protection laws, without hiring a lawyer, and without going to court! At some point in your life, either you, or someone you know will need this information.

Get My Free Ebook


Post a comment