Wells Fargo (WFC) reported first-quarter results last Thursday. I’m far from an expert on banks, but the valuation seems reasonable at current levels. The purpose of this article is to share some thoughts on Wells Fargo – and to hopefully push readers with more experience than myself to share some of their thoughts. If all goes well, I’ll do the same for JPMorgan (JPM) in a few weeks.
The first number that catches my attention is $1.3 trillion: that’s how much Wells Fargo had in deposits at the end of the first quarter (up 7% from the prior-year period). The company has nearly 24 million consumer checking customers and does business with one in three U.S. households. Wells Fargo is the industry leader in retail deposit market share in the United States; based on the data I’ve seen, Wells Fargo’s retail deposit share is roughly 10%.
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- WFC 15-Year Financial Data
- The intrinsic value of WFC
- Peter Lynch Chart of WFC
The cost for that $1.3 trillion in the first quarter was only 17 basis points (0.17%). Those deposits are the primary source of low-cost funding that the bank uses to support $964 billion in (average) loans. The average yield on those loans in the first quarter was 4.26% (annualized).
The yield on the company’s loans (and other investment securities held by Wells) less the cost of deposits (and other funding sources like long-term debt) is known as the net interest margin (NIM). Wells Fargo’s NIM in the first quarter was 2.87%. The low interest rate environment has put significant pressure on Wells Fargo’s – and other banks' – NIM. In addition, there’s been a shift in the balance between loans and investment securities (as an example, “Federal Funds Sold, Securities Under Resale Agreements and Other Short-Term Investment” increased from ~6% of earning assets in 2010 to ~17% of earning assets in 2016; this shift accounted for nearly 50 basis points of NIM compression). While that second change will continue putting pressure on NIM, it also lowers the overall risk profile of the assets held on Wells Fargo’s balance sheet.
Here's why that matters. In 2010, the NIM was 4.26%. By 2016, the NIM had fallen to 2.86%. The difference – 140 basis points – may seem small. Against $1.7 trillion in earning assets in the first quarter, we can see that those basis points start to add up: the difference between 4.26% and 2.86% is nearly $24 billion a year in net interest income for Wells Fargo (that’s not a typo).
As interest rates rise, the NIM should start to tick higher (my understanding is that we’ll see a lag as deposit costs reset more quickly than the longer-term loans on the books). Regardless of the timing, we can see that a higher NIM has significant potential to boost earnings at Wells Fargo.
The other noteworthy item is operating expenses. In the first quarter, Wells Fargo’s efficiency ratio – a measure of noninterest expenses divided by revenues – was north of 62%. This is a full five percentage points higher than the company’s target of 55% to 59% (the efficiency ratio was at the high end of this range from 2012 through 2015). As management noted on the first-quarter conference call, this outcome is unacceptable. At the same time, they were clear that this probably will not change in the coming quarters (“currently expect the efficiency ratio to remain elevated”). Just as with the NIM, the numbers add up: against $52 billion in 2016 noninterest expense, each percentage point improvement in the efficiency ratio is worth half a billion dollars (pretax).
Outside of the opportunities discussed above, Wells Fargo will earn somewhere around $4 per share in 2017, valuing the business at less than 13x earnings (that includes the expense for amortization of core deposits, an accounting charge that does not reflect economic reality). The company has had a net payout ratio of 60% to 70% over the past few years (current dividend yield is 3.0%) with the remainder retained to support mid- to high single-digit deposit and loan growth. These have been the drivers of long-term book value per share and earnings per share growth of 7% to 8% per year. If you attribute value to the items discussed above, you can make a pretty compelling case for Wells Fargo at $52 per share (at least relative to the market).
“I don’t think it impacts the future of Wells Fargo. As a matter of fact, they’ll be better for it. The nice thing about doing something dumb is you probably won’t do it again.”
It looks like some key insiders agree with that conclusion. CEO Tim Sloan recently bought 39,000 shares on the open market, valued at roughly $2 million. Chairman Stephen Sanger did the same, buying $3 million worth of stock.
Personally, there’s one major issue that concerns me. When I pull up the quarterly release or annual report for Wells Fargo or J.P. Morgan (especially JPM), something is immediately clear: these banks have many moving parts. Becoming intimately familiar with the disparate components of the business (and the accounting) is very difficult. I’m of the opinion that these banks could easily report just about any headline EPS number (within reason) without detection by outsiders if they truly wanted to. Said differently, if you’re going to invest in one of these banks, you better be damn sure that they have the right people in charge and the right culture. There needs to be a focus on the long term with accounting that clearly errs on the side of conservatism. For me, this is the biggest hurdle when considering an investment in a bank like Wells Fargo or J.P. Morgan.
That’s probably a good stopping point for now. I look forward to hearing your thoughts.
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About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.