-Seven Year Dividend Growth Rate: Negative
-Current Dividend Yield: 2.81%
-Credit Rating: AA- / A2 / A+ (high)
Wells Fargo appears fair in the low-to-mid $40′s, and is set to offer a substantially higher dividend over the next few years.
OverviewWells Fargo & Co (WFC) is one of the largest four banks in the United States, with its specific ranking depending on the metric used. As of June 2013, Wells Fargo is the largest mortgage originator in the country, the largest consumer lender, the largest auto lender, the second largest holder of deposits and issuer of debit cards, and one of the largest retailer brokerages and wealth managers. The bank has over 9,000 locations, more than 12,000 ATMs, and over 22 million online customers.
The bank in its current form was a result of several mergers and acquisitions, with the most recent major one being Wachovia in 2008 as the financial crisis was leading to the failure of that bank, which dramatically increased the size of Wells Fargo. Within two or three years, all Wachovia locations were converted into Wells Fargo locations, to reunify and strengthen the brand. The brand of Wells Fargo itself stretches back to 1852 when it was founded as a bank in California.
As far as diversification is concerned, the loan portfolio is 55% consumer, 40% commercial, and 5% foreign. Almost exactly half of the revenue for the company comes in the form of net interest income, while the other half consists of noninterest income. The noninterest income is extremely diverse, with 30% coming from advising/investment fees, 26% coming from mortgage fees, 11% coming from deposit service fees, 7% from card fees, 5% from trading gains, 4% from insurance, and 17% from other fees and other noninterest income.
(Chart Source: DividendMonk.com)
The revenue chart is included primarily to show the relative size of the Wachovia acquisition during the financial crisis, which resulted in a doubling of the total company size. Of course, Wells Fargo had to issue quite a number of shares of company stock in order to fund this acquisition, and grew their existing number of outstanding shares by over 50% for that expansion.
EPS and Dividends
(Chart Source: DividendMonk.com)
EPS grew at an average rate of about 5.9% per year over the past seven years, although the financial crisis resulted in a major period uncertainty and reduction, followed by a rebound. Analysts currently have an average expectation of about 10% EPS growth for 2013 followed by 5% growth for the next year. These estimates are of course subject to change for a company as large and dynamic was Wells Fargo in that upcoming period.
Book value per share increased at a rate of about 12.5% per year over this period.
The dividend had a more negative period than EPS, having ended at a lower point than it started during this period. A major dividend cut was done to preserve as much cash as possible during the crisis, and the dividend has rebounded at a very quick growth rate as the company has regained profitability. In 2013, the company has boosted its dividend back up close to where it was cut, with one or two more dividend increases being required to hit a new high point in dividends per share. The dividend payout ratio from earnings for the most recent quarter was about 30%.
Investment ThesisWells Fargo tends to be managed well in comparison to large peers in several metrics. For 2013 so far, Wells Fargo generated a higher revenue/asset ratio, a higher return on assets, a higher return on equity, and a higher deposit/liability ratio than its three large U.S. peers JPM, BAC, and C. The company also reported a lower combined delinquency/foreclosure rate on its mortgage portfolio than its three peers, and a lower net charge-off %.
The stand-out aspect of Wells Fargo is its focus on cross-selling. As one of the nation’s largest banks, management consistently focuses on expanding the number of services that each customer uses. From depositing, to getting a mortgage, to getting an auto loan or commercial loan, to accessing their investment advisory services, to other financial services, Wells Fargo is the best cross-seller in the industry, which is what drives its high revenue/asset ratio. The “economic moat” of a bank has always been its high switching costs, meaning the difficulty and hassle of actually changing banks. For Wells Fargo, the more services that the average customer uses, the higher the switching costs are.
As far as future growth is concerned, the company reports that it has consistently grown the EPS every quarter for the past 14 quarters. Most of this growth has been due to fees, not net interest income. The company expects a more normalized interest rate environment will boost its net income to increase the company’s overall earning power. Although re-branding is fully finished, company is still integrating the large Wachovia acquisition into itself, meaning that Wells Fargo’s cross-selling strategies are likely not fully saturated for former Wachovia customers; the company can still squeeze more revenue out of that acquisition by bringing those average customers up to its company-wide average customer service usage.
The Buffett Effect
For value investors that do take notice of the statements or moves by billionaire investor Warren Buffett, CEO and Chairman of Berkshire Hathaway, his view of Wells Fargo couldn’t be more glowing.
During 2009 Buffett stated, “If I had to put all of my net worth into stock, that would be the stock,” referring to Wells Fargo back when it was under $9/share and trading at a discount to his fair value, and it has handily beaten the S&P 500. Of course, with proper diversification, nobody should do such a thing, whether it’s trading at $9 or today’s price.
That being said, Wells Fargo now is the largest stock holding of Berkshire Hathaway’s portfolio, having displaced The Coca Cola Company for the top spot. Wells Fargo alone accounts for about 20% of the stock portfolio, and despite the large stake, he was buying more shares in the mid-$30′s as recent as the latest reported quarter. Both the stock price and EPS have inched up since then; still at a fairly similar valuation.
RisksIn some ways, Wells Fargo is not an ideal dividend payer. While the dividend yield is currently reasonable with strong dividend growth, this is rebounding from the dividend cut in 2009 following the financial crisis. Investors that were expecting a solid dividend income stream from WFC stock’s 4.5% dividend yield going into 2009 would have been disappointed by an 85% cut to its dividend. In July 2013, we’re still about one or two dividend increases away from seeing Wells Fargo get back to its high point of $0.34 per share per quarter in dividends at the beginning of 2009.
Although Wells Fargo held up better than its large peers, it did take an emergency loan from the U.S. federal government as part of the government’s response to the financial crisis, which the company paid back.
As Wells Fargo is tied to the pulse of the country, risks are diverse. The size and diversity of the company should buffer it from any one threat, but major macroeconomic declines will hurt the company should they occur. Economic problems related to higher unemployment rates can lead to mortgage delinquencies and a decline in new mortgage applications, and during recessions some businesses will reduce their commercial borrowing needs. Economic risks also can lead to regulatory changes that can affect profitability at major banks.
Wells Fargo, like all banks, maintains a fluctuating net interest ratio on the difference between its borrowing and lending costs, which is partially outside of the company’s control (other than maintaining a lean cost structure) and is responsible for half of the company’s revenue. The company is reliant on staying competitive with its fees and cross-selling strategies in order to reliably produce the other half of their revenue.
Conclusion and ValuationWells Fargo has not proven itself to be a reliable dividend payer, having had to dramatically cut its dividend during the financial crisis, but out of its peers, Wells Fargo is in better shape based on several metrics. There are several smaller banks that dividend investors may be interested in, and Canadian banks are also available options, but as far as the largest U.S. banks go, Wells Fargo and JPMorgan Chase are the only two that pay yields higher than the S&P 500 average.
The dividend payout ratio in 2007, before the dividend cut, was around 50%, compared to only about 30% currently. The dividend is growing more quickly than EPS as the bank has stabilized and increased its payout ratio from very low levels after the crisis. If the stock had a 50% dividend payout ratio today, based on its most recent quarterly EPS figure of $0.98, it would be $0.49/quarter, or $1.96/year, which based on the current stock price, would be about a 4.5% yield. If the dividend continues to expand into earnings to come closer to its previous payout ratio, we can expect either a higher yielding stock, or more likely, a moderately higher yield stock that has increased in share price.
According to the Gordon Discount Model, using a 10% discount rate (target rate of return), Wells Fargo requires a long-term dividend and EPS growth rate of a bit over 7% per year on average in order to make the current price of $43-$44 fair. It will depend on a few factors, but I expect to see substantial dividend increases over the next couple of years, leading into a more relaxed pace of growth.
Full Disclosure: As of this writing, I have no position in WFC.