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Wells Fargo and Wachovia Together

February 13, 2009 | About:

Joe Ponzio

So, I bought a bank. I know...I know. I said I wouldn't. Then again, that was a year or two ago, when I couldn't understand what the hell these guys were doing to make money. CDOs. Sub-prime mortgages. I would try to read the annual reports, and they would make my head spin.

Fortunately, the days of "creative" investing is over...for now. I have full faith that Wall Street will ensnare the markets in another mess in the next ten or twenty years. Still, banks will eventually return to "normal" for at least a while. (That is, of course, once they get through this "panic" mode.)

In a "normal" environment, banks aren't all that difficult to understand. The lend money; the sell investments and financial products; they make money on interest rate spreads. With blood pouring through the streets in the banking sector, much of it for good reason, we'll look at Wells Fargo and Wachovia, separate and together.

Grab a cup of coffee. This is a long one, broken down into two parts, each one being ridiculously long. Then again, we're expanding our sphere which ain't light reading.

Wells Fargo, from 1994 through 2008

An analysis of Wells Fargo starts in 1994 — the earliest date we can get annual reports from the SEC's IDEA Database (formerly EDGAR). I'll spare you the historical details prior to 1999. Needless to say, Wells Fargo was a very strong bank. Its merger with Norwest in the late 1990s turned the company into a giant.

Of course, the merger wasn't without growing pains. In the first few years after the merger, Wells Fargo would take $500 to $800 million hits to earnings based on non-cash amortization charges, as well as non-recurring (or short-lived) restructuring charges and integration charges (like software purchases to bring the two entities onto one computer system, advertising to keep customers well-informed during the transition, etc.)

From 1999 through 2002, Wells Fargo would report aggregate net income of roughly $16.8 billion. Its actual cash earnings were closer to $20.1 billion during that time, generating nearly 20% cash returns on equity.

From 1999 through 2007, cash earnings grew from $4.9 billion to roughly $9.4 billion a year. In addition, Wells Fargo periodically repurchased shares, increasing the intrinsic value per share as the company grew.

We'll get into the actual valuation after we explore the businesses at length. For now, as you can see on the chart below, let's just say that Mr. Market did a pretty decent job of valuing Wells Fargo for most of 2000 through 2007. For the moment, ignore the 2008 section of the graph. We'll look at that as we pick apart today's valuation of the combined Wells Fargo/Wachovia entity.

Wachovia, from 1999 through 2007

Wachovia's earnings were much more sporadic than those of Wells Fargo in the early 2000s. Like Wells Fargo, however, Wachovia had a ton of non-cash charges and non-recurring charges that should be accounted for in calculating intrinsic value. Remember: It's the accountant's job to record the business; it's our job to evaluate it. In that light, we need to figure out what Wachovia would have earned had it not taken those special charges.

Don't get me wrong: Those charges are real. Still, because they were non-recurring or short-lived, and because we're looking into the future, we need to figure out what Wachovia would look like after it's done taking those charges.

Once again, Mr. Market did a good job of pricing a business. Wachovia generally traded right around its intrinsic value, with very little margin of safety, from 1999 through 2007. (Keep in mind that I calculate intrinsic value for each year as though I were an investor evaluating the business at that time, and not backwards looking with today's information.)

Rather than saying Wachovia's business took a small beating early in the 2000s, I'd look at it this way: Wachovia's business was too profitable in the late 1990s. The dot-com bubble paved the way for massive trading commissions, lots of investment activity, and unsustainable profits. When that bubble burst, Wachovia had some restructuring to do to get back to "normalcy."

Part of that return to normalcy was taking more than $5 billion in restructuring and goodwill charges from 2000 through 2002. When that was done, Wachovia returned to a more "normal" state of business, generating $4 to $5 billion in cash flow — cash flow that would increase to $7.5 billion in 2007.

The Combined Companies

Together, Wells Fargo and Wachovia would have been one heck of a team from 1999 through 2007, generating $8 billion in cash flow in the early part of the 2000s, and growing that to $17 billion a year by the end of 2007.

Their cash return on equity would have been around 15% during that time. Of course, that number is suspect because of the inflated asset values of the late 2000s — values that increased their combined shareholder equity to $124 billion.

Also suspect is the cash flow, some of which was derived from mortgages, mortgage-related investments, and other bubble-type "assets" that have since lost value or appeal. So, our job as investors is to figure out the value of this combined entity and to assess, with a degree of certainty, the future cash flow that this business will generate.

Planning for Losses

In 2007, the combined entity — Wells Fargo and Wachovia (we'll call it "Wellsovia" for our purposes here) — generated $17.3 billion in excess cash, and that's after setting aside $7.2 billion in credit reserves.

On a bank's financial statements, you'll usually find a line that shows the "provision for loan losses" or "provision for credit losses." This is a non-cash charge to earnings based on what the bank expects to lose on its loan portfolio; so, it reduces earnings. Though it's technically a "non-cash" charge, we don't add it to the cash flow of the business because these are losses that are likely to materialize, in which case the charge becomes "real."

In this next post, we'll begin our quarterly journey through 2008 to see if we think Wellsovia will survive this mess and return to a state of "normalcy."

Joe Ponzio

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