(Published by Bob Ciura on May 24)
Bank stocks have been on fire since the election. Wells Fargo & Co. (WFC, Financial), one of the biggest banks in the U.S., is up 18% since Nov. 8.
There has been a remarkable shift in investor sentiment in just the past six months.
For most of 2016, Wells Fargo investors faced the unfolding fake accounts scandal, tightening regulations and weak growth stemming from low interest rates.
But in the aftermath of the election, things are looking up for Wells Fargo shareholders.
One of the company’s biggest investors is Warren Buffett (Trades, Portfolio), chairman and CEO of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial).
Berkshire owns 479.7 million shares of Wells Fargo, worth approximately $26.70 billion.
Investor hopes are buoyed by the prospect of a much friendlier regulatory environment and a compelling growth catalyst in the form of rising interest rates.
Wells Fargo is a classic Buffett stock and has a positive outlook going forward.
Business overview
Founded in 1852, Wells Fargo is the nation’s third-largest bank by assets.
This is a more difficult period for the bank than usual due to the company’s fake accounts scandal. Wells Fargo incurred a $185 million fine because it opened millions of accounts for its customers without their consent.
It eventually cost then-CEO John Stumpf his job, and cast a cloud of uncertainty over the company for most of 2016. While Wells Fargo’s full-year revenue increased 2.6%, its earnings per share declined 3.2% to $3.99.
The results deteriorated as the year progressed. Earnings per share declined 7% in the fourth quarter.
Source: 4Q Earnings Presentation, page 8
The good news is Wells Fargo’s financial performance held up well. The company remained highly profitable in 2016, which is a testament to its competitive advantages.
This allowed the company to continue investing in the business and buying back stock, which helped keep earnings afloat.
Conditions have remained stable to start 2017. Revenue dipped 0.9% in the first quarter, but EPS rose 1% due to cost cuts and share repurchases.
The company benefited from growth in average loans and deposits, which increased 3.9% and 6.5% year over year.
Going forward, Wells Fargo has plenty of promising growth catalysts.
Growth prospects
Wells Fargo has several growth catalysts to look forward to. First and foremost, it should benefit from higher interest rates.
On March 15, the Federal Reserve raised interest rates for the third time since the financial crisis ended. The central bank is expected to raise rates a total of three times in 2017.
This will be a major boost to Wells Fargo. As the largest mortgage originator in the U.S., higher interest rates will increase its net interest margin, which is the spread between interest earned on loans versus interest paid on deposits.
In addition, the company is undergoing a major cost-cutting program. It expects to cut expenses by $2 billion annually by year-end 2018.
Source: 2017 Investor Day Presentation, page 26
Management is targeting several areas of the business for cost reduction, including compensation, marketing, third-party expenses, infrastructure, travel and more.
Another growth catalyst is an improving loan portfolio. Wells Fargo’s allowance for credit losses as a percentage of total loans was 1.28% last quarter, down from 1.34% in the same quarter last year.
Lastly, Wells Fargo’s bottom line could benefit from a more favorable regulatory climate.
The Trump administration has expressed a desire to cut financial regulations, such as Dodd-Frank, in an effort to spur economic growth.
Valuation and expected returns
Despite Wells Fargo’s impressive rally over the past six months, the stock is still cheap.
Wells Fargo trades for a price-earnings ratio of 13.3 based on trailing EPS over the past year. It is much cheaper than the S&P 500 Index, which has an average price-earnings ratio of 26.
As a result, Wells Fargo shares appear to be undervalued. An expanding price-earnings ratio would yield a significant return.
Investors could become more comfortable with Wells Fargo’s position given the company’s long track record of steady profitability.
Source: 2017 Investor Day Presentation, page 2
Wells Fargo remains a high-quality business, which could warrant a higher valuation multiple once the negative news fades into memory.
For example, if Wells Fargo’s price-earnings ratio expands to 15, it would represent a return of approximately 13%.
Plus, Wells Fargo is likely to grow EPS moving forward given its many growth catalysts.
Wells Fargo’s future returns will be based on earnings growth and dividends. A potential breakdown of future returns is as follows:
- 4% to 6% earnings growth
- 2.8% dividend yield
The company could reach mid-single-digit earnings growth based on a combination of revenue growth, cost cuts and share repurchases. Including the 2.8% dividend yield, total annualized returns could reach a range of approximately 7% to 9% per year.
Dividend analysis
Not only is Wells Fargo stock potentially undervalued, it is also an attractive stock for income.
Even though the current environment is challenging, Wells Fargo’s capital levels are strong, which enable its shareholder capital returns.
Source: 2017 Investor Day Presentation, page 29
Wells Fargo currently pays a dividend of $1.52 per share, which yields 2.8% based on its share price.
This is a higher dividend yield than the market average. The S&P 500 Index has an average yield of just 2%. As a result, Wells Fargo stock provides 40% more income than the average stock in the S&P 500.
Additionally, there could be potential for Wells Fargo to raise its dividend down the line.
To be sure, there is a good chance the company will keep its dividend steady for 2017 as it works to recover from the fake accounts scandal.
But thanks to the company’s highly profitable business model and multiple growth catalysts, Wells Fargo could return to dividend growth in 2018 and beyond.
Based on the company’s 2016 EPS, the stock has a payout ratio of just 38%. This is a fairly modest payout ratio, which leaves room for dividend increases going forward.
Final thoughts
Buffett famously looks for companies he can buy and hold over the long term. There is perhaps no company in the financial sector that epitomizes this more than Wells Fargo.
Throughout Wells Fargo’s 165-year history, it has navigated all sorts of challenging economic periods, including two world wars, the Great Depression and the 2008-2009 financial crisis.
Wells Fargo has come back from difficult situations before, and it will again. The company remains highly profitable with a firm growth outlook.
The stock is cheap with an attractive dividend yield.
Disclosure: I am not long any of the stocks mentioned in this article.
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