Wells Fargo: Taking Its Medicine

by The Compound Investor

Wells Fargo (WFC) reported 2Q20 financial results earlier this week. The stock has hardly budged an inch since I called it incredibly cheap back in early-May. If you want to see how crazy things have gotten this year then check out a chart of Wells versus electric car maker Tesla. The former was worth roughly 2.75x the latter at the start of the year. That relationship has now completely reversed. 

Anyway, back to the bank’s 2Q20 results. It’s fair to say that the headline numbers look quite grim. The company posted a net loss of circa $2,440m in the quarter, some $8,000m lower than the $6,200m profit it made in 2Q19. That came on the back of a $9,500m provision expense for bad debt, with net charge-offs clocking in at $1,100m. That tells you the big story – the bank is taking its medicine and setting aside a heck of a lot of money for potential credit losses.

The situation is not helped by the fact that interest rates are at rock bottom levels. Net interest income fell to $9,880m, around 20% lower than the year-ago figure. Non-interest expense also rose in the quarter, further squeezing profit. Oh, and just to make matters worse, the bank also slashed its dividend by 80%. I think that just about sums up most of the bad news. On the plus side, the bank remains well capitalized with its CET1 ratio 190 basis points above the 9% minimum.

A Cheery Consensus

Observing the travails of Wells Fargo reminds me of the now well-known headline from a 1970s Forbes piece by Warren Buffett. Buffett’s Berkshire Hathaway does, of course, own a big chunk of Wells stock:

You pay a very high price in the stock market for a cheery consensus.

Just about everything that could have gone wrong here, has. The bank is still dealing with the fallout from its account fraud scandal, details of which don’t need to be rehashed. The COVID-19 economic depression, plus the combination of low interest rates and bloated expenses, makes for an almost perfect storm.

In spite of the above, now arguably represents the best opportunity to buy Wells Fargo stock in a decade. The fact that banks are cyclical is not new, yet I still see many dozens of comments arguing that Wells stock is still untouchable. Unless these folks think the stock has much further to fall, or indeed go totally under, this doesn’t make much sense to me.

On that note, I find it hard to see it dropping all that much further. The shares closed the week at $24.95 per share, which represents around 65% of its book value. That is a massive discount to peers such as JPMorgan.

Outlook

The bank wants to cut $10,000m from its annual expense bill, a step it sees as necessary in order to bring it into line with peers. No surprises there given how bloated its costs had become. Indeed, Wells bringing its efficiency ratio back into line has formed a part of the bullish case for some time now, and an extra $10,000m running down to the pre-tax income line is no small change.

I say that because Wells stock currently trades at just 6x its FY19 net income per share. Granted, much has happened since then, but things still look very cheap down the line. My screen shows that analysts think Wells will make just $8,800m in FY21 net income. As low as that is, it corresponds to $2.15 per share and hence a valuation of just 11x forward earnings. That’s not bad even when viewed in isolation, never mind as part of the bigger picture.

Looking further ahead, what happens if the bank removes $10,000m in annual costs while simultaneously returning to a semi-normal economy? I don’t think it a stretch to talk about earnings in the $5 per share area, even leaving aside tailwinds from the resumption of stock buybacks and dividends. On that basis, I think the stock could easily double within the next two to three years.

Note

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