Thesis of the article
Wells Fargo (WFC) reported second-quarter results that were significantly worse than expected. To top it off, the banking giant also announced that its dividend would be reduced by 80% in the future. A dividend cut was expected later this year, but it was not clear that this would happen during July, and most analysts did not expect such a sharp cut.
What does this mean for shareholders? Is the bank in major trouble? For very long-term oriented investors, Wells Fargo might deserve a closer look here, I think, as future prospects aren’t too bad.
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Wells Fargo Second Trimester: How Bad Was It?
Wells Fargo reported its second quarter earnings results on Tuesday morning, announcing that it lost $ 0.66 a share during the quarter. This compares very unfavorably with results published by peers such as JPMorgan (JPM) and Citigroup (C), which easily beat estimates.
What was Wells Fargo’s much weaker performance ratio compared to other major banks? There are a couple of factors that played an important role. Let’s take a closer look.
First, Wells Fargo does not have a commercial business that is comparable in size to JPMorgan’s. This was an obstacle for Wells Fargo as volatility in the financial markets resulted in an excellent trading environment. This allowed JPMorgan to report one of the best quarters in the business unit, which greatly helped to beat the estimates. Wells Fargo, on the other hand, without a similarly sized business unit, was unable to benefit from volatility in financial markets to the same degree. To some extent, Wells Fargo’s weaker performance may be explained by differences in the respective business model, as Wells Fargo’s more loan-focused approach was not worth it during these volatile times.
Another factor that plays a role in Wells Fargo’s weak profitability was that the company did not benefit from PPP loans to the same degree as other banks. Wells Fargo processed loans just like its peers, but unlike JPMorgan and Citi, Wells Fargo did not maintain earnings. A couple of days ago, Wells Fargo was reported to donate the $ 400 million in PPP-related earnings it had generated during the quarter. Based on a stock count of ~ 4.1 billion, this donation only affected earnings per share by $ 0.10 for the quarter.
However, the most important factor for the weak bottom line was Wells Fargo’s decision regarding its loan loss provisions. The company reported provisions for credit losses of $ 9.5 billion during the second quarter, while JPMorgan added $ 8.8 billion and Citigroup added $ 5.6 billion to its provisions, respectively.
Data by YCharts
This occurs despite the fact that Wells Fargo has the smallest asset base among these three banks. Wells Fargo, therefore, was more conservative with his provisions compared to his peers. Wells Fargo has a fairly large exposure to California, where Wells Fargo is the second largest lender. California has seen its infection count increase dramatically in the past two weeks, and recent setbacks from some reopening moves could damage the state’s economy to an above-average degree. Wells Fargo’s above-average provisions can be partially explained by this exposure, but this alone cannot possibly explain why Wells Fargo puts more money into provisions than JPMorgan, which has a much larger asset base and also a base of Larger loans ($ 1.0 trillion for JPM versus $ 970 billion for Wells Fargo).
Therefore, it appears that Wells Fargo’s supplies during the second quarter were on the high end compared to what its peers did, and it seems logical that this above-average provisioning is not going on endlessly. In fact, it seems more likely that provisions will drop to a level that is in line with that of Wells Fargo pairs in the future. A smaller supply in the coming quarters will result in higher profitability, everything else the same.
Things should improve, and the valuation is very low
From now on, I think things are looking better for Wells Fargo. The economic context is improving, as most of the blockades have ended, while the housing, employment, etc. markets are trending up again. At the same time, thanks to Wells Fargo’s huge supply accumulation in Q2, supplies during H2 will likely be much lower. Combined with improvements in the economy, this could generate significantly better results during the rest of the year, compared to the second quarter. The dividend is down now, and there will be no further cut in the future, so it looks like things can / will improve in the future. So if Q2 was probably the depression for Wells Fargo, does this make your stock a buy? It depends. Investors who want a well-run bank with good results and few headwinds can favor JPMorgan or Bank of America (BAC) over Wells Fargo, and that surely wouldn’t be a bad choice.
But for those who are investing with a multi-year horizon and want the best value, Wells Fargo could be a good option.
Data by YCharts
Wells Fargo is trading at the lowest price to reserve multiples among its peers, being valued at just 61% of book value. To some extent, this is justified due to its below average return on equity. But it should be noted that, coming out of the financial crisis, Wells Fargo was actually the best in terms of ROE:
Data by YCharts
Wells Fargo has been one of the best-managed banks in the country for a long time, and its leading ROE was the result of that. Its profitability problems, and correspondingly lower ROE, only emerged in recent years, mainly due to additional expenses to clear up its accounting scandal. I think the bank may be able to leave this scandal behind at some point in the future, and once the asset cap is raised, Wells Fargo should be able to grow its business once again. Once that happens, profitability should improve and ROE should return to more “normal” levels. If that happens over the next five years, it wouldn’t be surprising to see Wells Fargo’s valuation expand substantially, with its price / book ratio possibly rising above 1 once again. For someone who buys now, around 0.6 times the book value, therefore there is great potential for growth in the years to come, although profits are of course not guaranteed.
Data by YCharts
Analysts forecast EPS of $ 3.70 in 2022, with a long-term EPS growth rate of 8% on top of that. If this estimate is close to what Wells Fargo can actually earn, there could be a significant advantage even within 2-3 years. Put a multiple of winnings 10 times higher than the earnings of $ 3.70, and Wells Fargo shares could change hands for $ 37 in two years. This, of course, compares favorably to the current share price at the low $ 20.
To carry out
Is Wells Fargo a risk-free investment? It is not, and there are lower-risk picks in the industry for sure. Does the dividend cut hurt? It does, of course, as investors now make a return of less than 2%. But is Wells Fargo doomed? We think the answer is no: the company had a very bad Q2, but things look better in the future.
In a couple of years, once the pandemic and accounting scandal have passed, Wells Fargo could return to pre-crisis profitability levels, and those who shop here would be content with considerable returns in that scenario. To long-term oriented investors, Wells Fargo seems to deserve a closer look at the current vaulted valuation.
One last word
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Divulge: I am / we are long WFC, C, BAC, JPM. I wrote this article myself and express my own opinions. I receive no compensation for it (other than Seeking Alpha). I have no business relationship with any company whose shares are mentioned in this article.
