Wells Fargo – Best In Class

WFC front

Like many of the banks, Wells Fargo (NYSE:WFC) has sold off in 2016. The stock is down about 10% YTD and down nearly 20% from its 52 week high set back in July 2015. It seems that the risks that have caused the sell off in the banks don’t really apply to Wells Fargo. However, the stock has been crushed anyway. This might be a unique buying opportunity for investors.

Wells Fargo is a financial services and bank holding company. The company’s segments are community banking, wholesale banking, and wealth and brokerage and retirement. The company’s community banking segment offers financial products and services for consumers and small businesses, including checking and savings accounts, credit and debit cards, and auto, student and small business lending. The community banking segment’s products include investment, insurance and trust services, and mortgage and home equity loans. The community banking segment’s products and business segments include middle market commercial and institutional banking, corporate banking and commercial real estate, among others. The company’s wholesale banking segment provides a range of financial solutions to businesses across the United States and around the world.

Operating Environment


Wells Fargo is often compared to its peers Citigroup Inc. (NYSE:C), Bank of America (NYSE:BAC), and JPMorgan Chase & Co. (JPM). However, one major difference sets WFC apart from these three; its operating environment. 97% of Wells Fargo’s revenues come from the U.S. This is very different from Citigroup where only half of their revenues come from the U.S. The big banks have been sold off in 2016 due in part to the fears of slowing global growth and negative interest rates overseas. However, these issues do not have an effect on U.S centric banks like Wells. The economic data in the U.S has actually been decent. The dramatic decrease in gas prices has allowed consumers to spend their savings elsewhere. The U.S. consumer continues to spend at a modest pace. The other reason the banks have been sold in recent weeks pertains to investors fears about the exposure they have to non-performing energy loans. Wells Fargo has been on top of this issue for more than a year now and they added some commentary about the issue in the Q4 2014 earnings call. Essentially, the company believes that the drop in oil prices will be a net positive for Wells Fargo. Yes, a net positive. Only 2% of their total loans are exposed to the energy sector. In addition, the company cited that the U.S is a net importer of oil. The decrease in gas prices has proven to be a tailwind for their auto and mortgage loan portfolios which have both grown 8% YoY.

Wells has taken a different approach than its peers in the current operating environment. The company has positioned its self to be successful in the current interest rate environment. They have done this by adding duration to their balance sheet which will allow them to continue to grow net interest income even if the rate environment continues to be challenging. Its peers have not positioned themselves in the same way. In the current interest rate environment, I expect Wells to outperform its peers.

Consistent Growth In Deposits


U.S. Commercial bank total deposit growth has grown every single year since 1934. Not a single down year. Since 1934, deposits held by U.S. Commercial banks have grown 7.3% per year. Wells Fargo has easily outperformed this growth in the last twenty years. See chart below.

New WFC Deposit

Since 2000 Wells Fargo has stolen market share of deposits from the other banks every year. In 2015, they overtook BAC in total deposits. WFC will now have more deposits than any other big bank in the U.S. See chart below.

WFC graph

Growing deposits faster than any other bank has been and continues to be a tailwind for Wells. Deposit growth allows the bank to grow average earning assets. The growth in average earning assets fuels the growth in net interest income despite the difficult current interest rate environment.

Operating Efficiency 


Wells Fargo’s efficiency ratios are very impressive and have been for several years. The company regularly outperforms its peers on this metric. Many analysts have had a difficult time using this ratio to compare the banks because of the regulatory penalties paid by many of the big banks after the financial crisis. Today, the majority of these penalties are behind the big banks which makes for more of an apples to apples comparison.

WFC efficiency

It should be noted that WFC is in the middle of a multi year initiative to invest in data security and mobile banking. The company is aware of the growing risks of cyber crime and is making investments to curtail the risk. The company also continues to invest in mobile banking which has shown double digit growth for the past six quarters. It is very impressive that the company continues to have stronger operating efficiency ratios than its competitors while having these additional investments. Wells expects to operate within the 55-59% operating efficiency range during all of 2016. I think this is achievable even with the current interest rate environment and the additional investments.

Financial Overview


WFC val 2

Summary

Wells Fargo trades at a very reasonable valuation. Many analysts point out the fact that it’s one of the only big banks that doesn’t trade at a discount to book value. I would argue that book value isn’t always accurate for two reasons. First, even if there is an active market from which market prices are extracted, markets can make mistakes and these mistakes will then be embedded in the book value. For example, the book values of mortgage-backed securities at banks in early 2008 reflected the market prices of these securities at time. It was only when the market prices collapsed that we woke up to the realization that the book values of financial service firms overstated their true values. Second, in many cases, assets are marked to market, based not upon an observable market price, but upon models used by an appraiser; in fact, the firm that holds the securities often assesses their value for accounting purposes. Not surprisingly, there is a tendency to overstate values and a lag in recognizing changes in those values.

Management has done a terrific job positioning the company to be successful in a difficult environment. The net interest margin and efficiency ratio are best in class. These are of course a little bit easier to obtain with nearly all of WFC business being in the U.S. The other big banks are are weaker on both of these metrics due to their presence overseas.

Valuation


WFC new val

The stock is currently trading at 11.1x trailing earnings of $4.21. This compares to the stock’s long term average of 13x. If the stock were to trade at its long term average it would trade around $55 which is just below my conservative estimate. With the company continuing to grow their deposits and stealing market share away from other banks, I would argue that it demands a premium to the long term average.

Wells is currently trading at a book value of 1.42x. The company’s price to book ratio has been climbing with the growth in deposits and loans over the last few years. The average price to book ratio over 2014 and 2015 was 1.66x. The recent selloff in the banks has swept WFC with it. If Wells Fargo were to trade at 1.66x book value again it would trade at $62.78 which is in line with my median value estimate. I think it is just a matter of time before it trades back at this P/B ratio.

Conclusion


Wells Fargo is a terrific business and management has done a phenomenal job positioning them to be successful in a difficult environment. The company has had very solid growth in deposits and loans for a extended period of time. I expect this trend to continue as the company remains focused on providing a great customer experience. I think this selloff may have created a unique buying opportunity for investors.

Disclosure


Long WFC

 

 

 

What Does Buffett See In Phillips 66?

PSX gas station

Warren Buffett has accumulated a $5.8 billion position in Phillips 66 (NYSE:PSX). His $5.8B position equates into an approximate 14% ownership of the company. Phillips 66 is an energy manufacturing and logistics company with midstream, chemicals, refining and marketing and specialties businesses. The Chemical segment manufactures and markets petrochemicals and plastics. The Chemicals segment consists of its 50% equity investment in Chevron Phillips Chemical Company LLC (CPChem). The refining segment buys, sells and refines crude oil and other feedstocks into petroleum products (such as gasolines, distillates and aviation fuels) at 14 refineries, mainly in the United States and Europe. The Marketing and Specialties segment purchases for resale and markets refined petroleum products (such as gasolines, distillates and aviation fuels), mainly in the United States and Europe.66 Segments

Phillips 66 owns 69% of Phillips 66 Partners LP (NYSE:PSXP), a midstream MLP. PSXP will be driver of future growth in the midstream and chemical segments. This partnership contributes most of the midstream earnings growth to Phillips 66 today. The other part of the midstream business is DCP Midstream which is a 50-50 JV with Spectra Energy (NYSE:SE). This JV is expected to contribute $500 million in EBITDA by 2018.

Segment Breakdown


The two largest segments of the company are the refining and marketing segments. These two account for about 97% of total revenues and about 65% of net income.

PSX Segments

The majority of the earnings historically have come from the refining segment. However, major investments are being made in the midstream and chemical segments. I would think that investors would welcome the diversification. The refining business is incredibly cyclical and investors saw that play out in 2015. The 3:2:1 crack spread (three barrels of crude oil producing two barrels of gasoline and one barrel of diesel) was very strong in the first three quarters of 2015 but substantially decreased in Q4. The sharp decrease in crack spreads has a big impact on margins and therefore overall earnings. The enhanced diversification of assets with make Phillips 66 unlike any other refining company.

Financial Overview


PSX valuation

Summary

The refining business is known for having very small margins. In addition, these margins can swing based on the 3:2:1 crack spread. Due to the low margin environment that refiners operate in, all of them trade at low P/E ratios (average of 11X).

Returning Cash to Shareholders

PSX has a terrific track record of returning cash to shareholders. They have bought back about 16% of the outstanding shares in the last three years and continue to buy more. The company yields 2.85% and management continues to boost the dividend. In the last three years, the dividend has grown at a 34% CAGR. See chart below.PSX Distributions

CapEx

PSX spent a substantial amount of money in 2015 on growth capital projects in its midstream segment. The company poured about $3.0B into midstream projects which mostly went into building pipelines. In 2016, it is expected that they will spend an additional $1.3B in its midstream projects. Other midstream competitors are having to cut capex spending due to the difficult operating environment caused by low oil prices. Investing heavily in new projects now might give PSX a competitive advantage since current companies in the space are having financial difficulties. PSX has cash flow being generated from the refining segment and they are able to deploy capital into growth segments. The midstream segment could be very important to investors going forward because a lot of the revenues will be fee based. Fee based revenues will stabilize overall revenue and offset the large swings in refining margins caused by fluctuating crack spreads.

PSX is also allocating capital into their chemical segment. The drivers in this segment are CPChem and Phillips 66 Partners LP. CPChem is a chemical company created by a 50-50 JV with Chevron (NYSE:CVX). It is expected to add $1.5B in EBITDA by 2018. Phillips 66 Partners is a small company but it is growing fast. In Q1 2015 they made a $1.1B acquisition that will add $115 million in EBITDA next year. These two companies allow PSX to have exposure in natural gas liquid (NGL) pipelines. This exposure will increase the amount of fee based income which will allow for stable cash flows.

Valuation


PSX val 2

Based on the trailing twelve months earnings of $8.57, the stock is currently trading at 9.1x earnings, compared to the stock’s long term average of 10.5. If the stock was trading at 10.5x earnings it would trade at about $85 which is about 5% above my estimate of $80.49.

The stock is currently trading at a book value of 1.8x versus the historical book value of 1.85x. If the company were to trade at its historical book value, the per-share value would be $80.24 which is in line with my estimate.

Conclusion


It is not completely clear what Warren Buffett is seeing in PSX. Investors are speculating as to whether Buffett has been buying Phillips 66 to hedge his investment in Suncor Energy (NYSE:SU). Suncor Energy is much more exposed to the energy sector but I don’t think PSX is a hedge.

Phillips 66 is in my “too hard” pile. I simply don’t understand all of the different segments they are involved in well enough to have an edge. PSX might be building a moat of diversified assets and maybe that is why Buffett likes it. I don’t have enough wisdom to know what a great moat would like. I do know that there are not any other refiners that will have an array of assets similar to PSX but I don’t know if this will give them a competitive advantage going forward.

Disclosure


No positions in my personal portfolio at the time of this writing.