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Margaret Moran
Margaret Moran
Articles (348) 

Wells Fargo: Transforming From a Value Buy to a Value Trap

The embattled bank major seeks to sell its asset management business as troubles mount

October 23, 2020 | About:

Wells Fargo & Co. (NYSE:WFC) is preparing to sell its asset management business for around $3 billion as it struggles to make ends meet during the economic recession sparked by the Covid-19 pandemic. According to Reuters sources, the bank has been in talks with potential buyers, though no deal has been reached yet.

The sale will likely be made in preparation for an expected tsunami of losses from bad loans. In the second quarter, the bank booked a $2 billion loss as it set aside reserves for bad loans, and in the third quarter, it reported net income of around $2 billion compared to $4 billion a year ago, which it mainly attributed to customer remediation and restructuring expenses.

Wells Fargo has been struggling ever since its fake accounts scandal in 2016, but due to its status as one of the largest U.S. banks, many investors still considered it to be under the "too big to fail" umbrella, making it attractive as a value buy. However, now that the bank is not only facing an asset cap, but is also considering downsizing of its own accord, could this value buy have already become a value trap?

Recent earnings results

For the third quarter, Wells Fargo reported revenue of $18.9 billion, down from $22 billion in the prior-year quarter. Net interest income dropped 19% to $9.4 billion, while non-interest income declined 8% to $9.5 million. Average deposits increased 8% to $1.4 trillion, while average loans were down 2% to $931.7 billion.

The bank kept its allowance for loan losses at $20.5 billion, the same as the second quarter but still representing a higher percentage of assets than most other U.S. bank majors. The liquidity coverage ratio stood at a 134%, which is above the regulatory minimum of 100%.

CEO Charlie Scharf had the following to say:

"Our third quarter results reflect the impact of aggressive monetary and fiscal stimulus on the US economy. Strong mortgage banking fees, higher equity markets, and declining sequential charge-offs positively impacted our results, while historically low interest rates reduced our net interest income and our expenses continued to remain elevated. We continue to provide support for our customers having helped more than 3.2 million consumers and small businesses by deferring payments and waiving fees."

The Wealth and Investment Management segment, which consists of wealth management, investment and retirement products and asset management, reported revenue of $3.794 billion altogether, a sharp drop from $5.141 billion in the prior-year quarter. Client assets under the asset management business ended the quarter up 21% from the prior year to $607 billion, while wealth management assets remained flat at $229 billion.

Selling the asset management business

Wells Fargo's asset management business manages approximately $578 billion, and analysts expect that it could fetch a price tag of around $3 billion. The bank clarified that the sale would not include its other wealth management operations.

Since its liquidity coverage ratio is already at 134%, why would Wells Fargo need to divest a portion of its business? A few potential reasons come to mind, primarily long-term restructuring plans and the expectation of large loan losses from the economic recession.

Scharf has indicated that one of the ways he wants to transform the company after joining as CEO last year is to cut costs to the tune of $10 billion annually, so divesting an entire business segment seems a natural step in that direction.

Additionally, Wells Fargo stands in a difficult position amidst the massive business lending efforts undertaken by the U.S. government in order to lower the number of bankruptcies and job losses from the recession. Like the other bank majors, Wells Fargo participated in the government loan programs, but unlike competitors, it was forbidden from earning anything on the good loans, effectively creating zero upside and unlimited downside. This additional restriction was in penalty for the fake accounts scandal back in 2016.

Thus, it stands to reason that Wells Fargo will face higher loan losses than other banks. The decision to downsize seems like it could be a reflection of these issues, which spells trouble for the bank's long-term prospects.

Valuation

As of Oct. 23, Wells Fargo's stock price stands at $23.28 after a decline of 56% year to date and 54% over the past 12 months. The GuruFocus Value Chart rates it as a potential value trap; the price is so cheap that it carries a high chance of being an indication of permanent damage in the underlying company.

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While value investing often involves investing in cheap stocks that are undergoing temporary issues, it seems like Wells Fargo's issues are becoming more permanent as it seeks to cut costs, even at the expense of getting rid of a segment that none of the other major U.S. banks are offloading. This is also a point that management seems increasingly resigned to. While Wells Fargo will likely continue to serve customers and generate profits for many decades to come, that alone doesn't make it an attractive investment.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.

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Rating: 4.3/5 (6 votes)

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Comments

Praveen Chawla
Praveen Chawla premium member - 1 month ago

Good article. The question is: Are we at the point of "maximum pessimism"?

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