Updated: WFC Is Still Undervalued
The six main points regarding WFC:
1) Diversified and stable revenue stream.
2) Comparatively low funding cost.
3) High RoA.
4) Comparatively low leverage.
5) Conservatively managed.
6) Revenue growth.
1) Diversified and Stable Revenue Stream:[/b]WFC puts big emphasis on cross-selling its various products and thereby increasing their overall stickiness. The thinking is that the more products a client has with a bank, the more cumbersome and inconvenient and hence unlikely it is that he or she will switch to another bank. Wells Fargo’s cross-selling has grown from 4.6 products per household in 2004 to 6.05 products per household in 2012.
Cross-selling products is very important as it not only creates a sort of moat for a bank but also enables it to collect more fees related to the various products which diversifies its revenue stream and makes it less dependent on interest rates. The makeup of non-interest income is also very important – WFC has only a small portion of net gains from trading, large account and service fees (which are very stable, “high quality” earnings), and a strong mortgage banking business (which is set to expand). Currently, about 50% of WFC’s revenue is non-interest revenue ($43.2 billion net interest income vs. $42.9 billion non-interest income).
[b]2) Comparatively low funding cost:
WFC has very low funding costs and high deposits to total liabilities (meaning it has high quality funding). Deposits are the best kind of funding source as they are extremely low cost and very sticky, and WFC’s strategic focus on cross-selling enables it to keep its customers even though it is offering the lowest interest rates as compared to competitors. This gives WFC a sort of pricing power in a commodity market (every bank offers basically the same checking and savings accounts, loans, etc.).
In 2012, WFC’s funding cost was about 39% lower than that of JPMorgan (JPM) which had the next lowest funding cost within the group, yet it had a 9% deposit growth, so the low rates don’t seem to be deterring depositors. WFC has beaten every of these five major competitors in terms of their funding cost in all but one of the last 14 years.
3 and 4) High RoA and Comparatively Low Leverage
WFC has consistently had a far higher ROA than its competitors (in large part due to its lower funding costs) and can reasonably earn around 1.4% to 1.5% (ROA) in a normalized environment – looking at 2012, that’s 50% higher than JPM which has the next highest ROA within the group. WFC is also by far less leveraged than most of its competitors as can be seen at its leverage ratio.
5) Conservatively managed
WFC has historically mostly steered clear of industry hypes and asset bubbles (e.g. late 1980s and early 1990s highly leveraged transactions, 2003 to 2007 interest only or negative amortizing loans and CDS frenzy). WFC had far lower net charge-offs post-2008 than its competitors despite purchasing Wachovia which had lots of bad loans mainly due to its Pick-a-Pay loan portfolio (the name says it all). WFC emerged out of the 2007 to 2008 bubble burst far stronger than it was before as the Wachovia transaction added a lot of value. Based on WFC’s normalized return on deposits which can (conservatively) be pegged at about 1.8% to 1.9% (for the year ended Dec. 31, 2012, it was at 1.87%), the Wachovia transaction added between $7.67 billion to $8.1 billion in earning power wherefore WFC snapped up Wachovia at a price of only about 3.5 to 3.7 times normalized earnings (for a total price of $23.1 billion plus $5 billion in integration costs) and thereby grew its deposits by $426.2 billion to $781.4 billion (120% growth). Despite its size (WFC represents about 9.5% of U.S. deposits), WFC still managed to grow its deposits by 8.5% in 2011 and 9% in 2012 which is incredibly high.
6) Interest rate risk and growth:
WFC has a natural hedge against interest rate fluctuations as it is the largest U.S. mortgage originator. The 2012 10-K provides a breakdown of selected loans ($348.8 billion out of WFC’s roughly $800 billion portfolio) of which 89% of one-to-five-year loans and 75% of five or more year loans are variable rate. These loans will fluctuate with interest rates while WFC can further counteract the pressure of increasing funding costs by keeping new loans (or MBS), originated at higher interest rates, on its books.
In preparation for the rebound of the mortgage market as well as other investment opportunities in a higher yield environment, WFC has about $160 billion in cash and liquid short-term investments on hand which represents 11.9% of its assets (the second highest percentage in over 15 years). WFC also grew its home loan origination business in the past few years while its competitors, such as Bank of America (BAC), scaled back, which puts it in a great position for the rebounding mortgage market (mortgage applications in 2012 were $736 billion versus $537 billion in 2011 – a 37% increase).
Free Cash Flow and Valuation:
*The 2008 cap-ex was calculated as an average of the cap-ex in years 2004-2007 since the increase in 2008 increase in PPE was mostly due to the 2008 Wachovia acquisition which does not represent regular maintenance expenditure
**FCF = N/I + provision – net charge offs + depreciation – capex + stock comp + tax benefit – actual comp expense – pension cost + other
***Other = Wachovia merger integration costs
**** Actual comp. expense = intrinsic value of stock options exercised
*****pension cost = change in underfunded status of pension plan
******FCF margin = FCF/ revenue
WFC currently trades at around an 11.5 times P/ FCF multiple, implying an 8.7% equity yield. Based on 2012’s FCF growth of 30%, which saw the beginning of a rebound in the mortgage market (mortgage banking sparked most of the FCF growth as it increased by about $3.8 billion*) but still features a historically low NIM, there is substantial FCF growth ahead of WFC once the mortgage market thrives again and WFC starts to deploy some of the $160 billion in dry powder it has amassed at higher rates.
A 12% to 14% ROI (pretax) (div's + share price appreciation. Assuming no multiple expansion) going forward is a reasonable assumption based on WFC’s 8.7% equity yield and a continued about 3% to 5% FCF growth as the housing market expands and interest rates normalize (WFC’s NIM is at an all-time low, while interest rate expansion will initially put further pressure on the NIM as funding sources adjust faster, it should over time rebound to more normal levels in the 4% to 6% range as it has been over the 40 years pre-2008).
Conclusion:Wells Fargo is a very strong bank which by far outperforms its largest competitors in the most important areas. It has a strong, diversified non-interest revenue stream and low funding costs, both of which explain its high return on assets even in this low-yield environment. WFC has a very low leverage multiple and is a bank that focuses on the core business of a retail bank, that is, deposit taking and loan origination.
At a P/FCF of 11.45 times and a P/B multiple of only 1.24 times (2 times would be more in line with historical values), WFC is still a cheap buy and has a lot of upside potential over the long-run when net interest margins normalize and the housing market fully recovers.
*This $3.8 billion increase is despite of a near $1.9 billion mortgage repurchase liability (provision), of which $1.7 billion was a belated bolster for "low-quality" MBS sold pre-2008. This provision will fall off drastically over the near future as the allowance for pre-2008 MBS has been established and the MRL for 2012 and 2011 loans was only about $0.1 billion to $0.2 billion (far higher quality loans require only a small provision), therefore freeing approximately an additional $1.5 billion in income in the future.