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

 

 

 

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