Wells Fargo Helped By Provisioning, But A Bit More Patience Required

by The Compound Investor

My coverage of Wells Fargo (WFC) to date has basically been to channel a kind of Michael O’Higgins “Dogs of the Dow” approach. O’Higgins hypothesized that, thanks to their size, big blue chip firms often have a bit more breathing space to sort out any issues that may be plaguing their stock prices. In the meantime, reinvesting larger than average dividends yields (which is of course what you get when share prices decline) would work out nicely if those firms did go on to sort out their problems.

Wells Fargo doesn’t exactly fit that bill of course, and for the not-so-small reason that its dividend has been shredded! But the San-Francisco based bank was a darling of the dividend community when I first started reading Seeking Alpha, and despite its woes, there exists a good business buried down there somewhere. Or put another way, its problems are not existential, even if they are taking longer than expected to clean up. (I imagine most readers know the bank’s problems well so I won’t go over them again. Those who are unfamiliar can read a quick overview here.)

I’ll hold my hands up, Wells hasn’t done great since it first appeared here at the start of 2020. The stock has lagged mega-cap peers JPMorgan and Bank of America, though it has marginally bested Citigroup in that time. Including about a dollar forty per share in cumulative dividend cash, total returns are roughly negative 3.5% since first coverage. Not great, though COVID takes a lot of the blame. At least it has done nicely since I doubled down on it back in Q2 2020.

Provisioning Boosting Results

Credit quality has obviously held up extremely well during this downturn thanks to the stimulus measures. That much was clear when I last covered Wells back in the first quarter. Just to recap some numbers, the bank entered the downturn with its loan loss allowance standing at around $9.5b, or circa 100bps relative to total loans. It then set aside $14.1b for bad debt, up from $2.7b in 2019, bringing its loan loss allowance to 200bps. That weighed on 2020 annual profit, which at 41¢ per share fell around 90% versus pre-COVID levels.

The reverse is now happening as Wells and the wider industry release previously built up reserves through the income statement. The bank released another $1.6b in Q2, with net charge-offs clocking in at $379m versus $523m in the prior quarter. The same quarter last year saw it book a whopping $9.5b provision charge, including around $1.1b in net charge-offs. Anyway, lower provisioning means a big boost to the bottom line, with FY21Q2 net income to the common up $1.5b sequentially to $5.7b. That was good for a return on tangible common equity (ROTCE) of ~16%.

The bad (or rather, less good) news is that core operations look a bit more mixed. Net interest income (“NII”) clocked in at $8.8b, down 11% YoY as lower interest rates, a shrinking loan book and elevated deposits weigh on margins. Loans fell another 2% QoQ to $854.7b, while deposits rose 3% to $1.4t over the same period. The net interest margin came in at 2.02% in Q2, down from 2.25% a year ago and 2.05% in Q1. Non-interest income did see a big boost this quarter, though, mainly from private equity and venture capital investment gains. As with lower provisioning, that made its FY21Q2 numbers look better than they were.

A Mixed Bag Still, But Optimism Wins Out

Looking ahead, it’s probably still a mixed bag here, though I remain optimistic over the medium-term. In terms of the bad, a few potential pitfalls stand out. Firstly, credit quality may slump as stimulus measures wear off, thus exposing the economy to the “truer” COVID hit. I’m not really worried about this but maybe something to keep an eye on. The second is the dreaded asset cap from the Fed is still here, crimping growth prospects. Thirdly, the operating environment isn’t great, what with the low interest rates and all. The yield on the bank’s $1.7t in interest earnings assets fell to 223bps in FY21Q2, down another 10bps sequentially. Finally, a corporate tax hike might be coming. I think expectations have moderated here, though I’m no expert on the details of Washington politics! Probably best to err on the side of caution given the potential outsized impact here.

In terms of the good, well, it basically boils down to the valuation. Wells can do a lot of heavy lifting via cost cutting, which had become bloated due to regulatory & legal woes, as well as restructuring charges. Now, non-interest expenses fell 8% YoY and 5% QoQ to $13.3b in FY21Q2. Annual non-interest expenses were running in the $58b range pre-COVID, so it looks like slow progress is being made. And if it can eventually make good on its circa $50b annual target, then the math looks very good in terms of trickle-down to earnings.

I think that last bit just about sums it up. Wells Fargo stock still trades below $45 a share, equal to around 1.3x tangible book value and a price-earnings ratio (“PE”) of around 11-12x. At some point the bank will sort itself out to the extent it earns a decent double-digit ROTCE in a normalized environment. It might need rate hikes and so on to hit its 15% target, but there’s still upside to the current valuation even at lower levels of profitability. In an environment where getting a bargain isn’t easy, Wells Fargo stock still strikes me as cheap.


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