Description

Don't bother looking at this one if you think the path to generating high returns lies in finding undiscovered micro caps.  However, if you don't mind making money by buying a large cap - whose superior economics lay in plain sight - at approximately 7X earnings, enter Wells Fargo & Company (WFC).

WFC is the second largest bank in the United States by deposits and it provides an array of financial services to consumers and businesses with the emphasis on traditional banking.  The company possesses an important cost advantage stemming from its best-in-class distribution model and it also has a track record of doing the right thing on the asset side of the balance sheet regardless of what the rest of the industry is doing.  As a result WFC has the economics which are superior to those of any large bank in the United States, which make its stock a steal at the current price.  More specifically:

 - WFC's superb distribution system enables the company to have the lowest cost of funding in the industry, which, in turn, enables WFC to grow market share while generating excellent returns on assets without taking on undue risks.  For example, in the most recent quarter WFC's cost of deposits amounted to just 0.5%, the best such ratio among the company's peers, whose cost of deposits amounted to 1.3% on average.  This enabled WFC over the past 10 years to produce revenue growth of approximately 11% vs. the industry average of 4%, while generating ROAs of 1.5% vs. the industry average of 1%.

- Solid financial condition, as WFC boasts an AA- financial strength rating from Standard & Poor's, the highest such ratings of all large banking institutions in the United States.  In addition, WFC boasts industry-leading historical loan loss coverage ratio of approximately 5X, further underscoring the bank's superior ability to withstand adverse economic conditions.

- Outstanding management team, which has significantly increased the value of the business over time by using WFC low-cost advantage to gain market share without taking on above-average risks.  For example, the company's long-term loan losses have been in line with industry averages (1% of total loans), whereas the company's loan losses during the past turmoil-stricken year have been significantly better than industry averages.

- Solid long-term growth potential, as evidenced by a large size of WFC's end markets, which are populated with financial institutions whose business models are less efficient than that of WFC.

- Dirt-cheap valuation, as WFC stock is selling for approximately 7X LFY normalized earnings. 

If this is enough to peek your interest please read on further for a more detailed overview.

THE BUSINESS AND ITS COMPETITIVE ADVANTAGES

Despite what happened over the past couple of years to a large number of American financial institutions, banking is not a bad business - as long as you keep it simple and "boring."  After all, how can a business where you take in deposits at X% and lend them out to credit-worthy customers at X%+Y% not be a good one?  Nevertheless, the key is a bank's ability to obtain stable low-cost funding, as this paves the way to market share gains coupled with above-average profitability.  And it is precisely this main advantage that sets WFC apart from its peers, as the company has the lowest cost of funding among large banks.  Naturally, the low cost producer in any industry wins out big over time at the expense of less efficient rivals, and this is exactly WFC has been doing.  More specifically, WFC's broad distribution system and relationship-based customer focus create a reputation for convenience, which leads to over 70% of WFC's customers having their primary banking relationship firmly lodged with the company.  As a result, WFC boasts a large amount of "core" deposits (checking/savings/market rate) - which are the cheapest and the most stable form of funding - thus establishing the company as the low-cost leader in the banking industry.  For example, core deposits comprise over 75% of WFC's deposit base, compared to the industry average of less than 60%.  Furthermore, due to its reputation for convenience WFC can afford to be at the low end of the industry range with respect to deposit rates, which further lowers its funding costs vs. peers.  Thus, WFC has the lowest cost of deposits among its peers at about 50 bps vs. the industry average of over 130 bps.  And this, in turn, enables WFC to earn NIMs circa 4.5% vs. 3% industry average and ROAs circa 1.5% vs. 1% industry average, without having to take undue risks on the asset side of the balance sheet.  Importantly, WFC's low-cost advantage is not likely to be replicated by its competitors, which ensures the bank's returns on capital should remain at above average levels in the future.  While it would be very hard for a rival to build out a distribution network comparable to WFC's due to considerable cost involved, it would be nearly impossible for him to replicate the brand name that WFC has in most of its markets.  Most consumers and businesses choose their primary banking destination based on the reputation and convenience, as opposed to pricing, and since WFC boasts #1 position (in deposits) in most of its markets, it would be nearly impossible for the incumbent to dislodge the leader.  Indeed, you will be hard-pressed to find a bank which saw its leading deposit position within a market deteriorate absent managerial error.  (And this is not something likely to happen at WFC - I will expand on this in the management review section.)

The second advantage that WFC has - and it is almost as important as the first one - is the company's underwriting philosophy.  More specifically, WFC is at all times firmly committed to old-fashioned conservative lending principles in contrast to most of its peers who periodically tend to chase short-term profits by going up the risk curve.  For example, in recent years - unlike virtually all of its peers - WFC stayed away from the toxic stuff, such as option ARMs, "covenant-lite" leveraged loans, CDOs, and SIVs, highlighting managerial commitment to doing things the right way regardless of what the rest of the industry is doing.  As a result, while WFC's long-term loan loss rates of 1% are in line with industry averages, the bank's legacy loan book losses over the past two turmoil-stricken years were well below 2% vs. 2.5% industry average.  (WFC's loan losses including Wachovia acquisition would have been about 2%.  Some may argue that Wachovia should be included for the purposes of assessing WFC's underwriting track record.  I'd argue otherwise- after all, if Buffett is taking over portfolio management from a dart-throwing monkey, blending the track records of the two aforementioned individuals wouldn't do much good in terms of establishing as to how good Buffett is.)  It is this conservative lending philosophy, which is ingrained in WFC's organizational DNA that serves as one the company's significant competitive advantages.  It would be hard for the company's competition to replicate this advantage, for the reasons of institutional imperative.  It is highly unlikely that an organization that has been permeated for decades with - to borrow from Chuck Prince - the "dance while the music is playing" mentality would, all of a sudden, decide to permanently change its strides.  (Bankers might get more conservative in the short-term given how badly they got burned in the past couple of years.  But old habits die hard, if at all - once the sun shining you can be sure that most bankers will be back to being their normal selves, as evidenced by what the fact that each of the banking crises of the past was in due time followed by another one.)  I realize that this replication barrier may, at first, appear to be hard to assess compared to replication barriers such as brand names and distribution systems in, say, a toothpaste or a candy bar business.  Nevertheless, I believe that the "institutional imperative" replication barrier is a very real and a very significant one, as I am not aware of any sizeable of banking companies who successfully switched from the "dance while the music is playing" to the "remain disciplined at all times" modus operandi, despite the clear economic benefit of the latter.  In a way, this is similar to value investing - the superior economics of value investing have been known for decades, yet the overall percentage of those who practice this trade hasn't really increased over time.

In addition to WFC's aforesaid advantages, the bank has another competitive edge, which is its solid financial condition.  WFC enjoys Standard and Poor's rating of AA-, the highest such rating of all large United States banking institutions.  In addition, WFC boasts a historical average loan loss coverage ratio of approximately 5X (or just over 2X based on recent figures reflecting the highest losses in the past 20-year period), which is the best such ratio among large banks.  This superior ability to withstand loan losses further underscores WFC's financial stability.  The solid financial condition should enable WFC, over the long-term, to pick up a substantial amount of business, as the bank's less efficient competitors are held back due to their poor capital positions.

(A quick note regarding WFC's Tier 1 common ratio is appropriate here, as this topic received much press over the past few months.  The argument is being made that since Tier 1 common ratio of WFC is among the lowest in the industry the company's financial condition is less than solid.  There are a couple of things to keep in mind with respect to that notion: (1) If WFC chose not to be extremely conservative with Wachovia write-downs - and it was substantially more conservative most of its peers - the company's Tier 1 common ratio would have been close to that of its peers; (2) Given WFC industry-leading loan loss coverage ratio there is a much smaller chance that the company's loan losses will eat into its capital as is the case with its peers.)

WFC's low-cost producer advantage should help the company grow its business over time while maintaining industry-leading ROEs.  As WFC's share of US deposits strands at just 11%, there is still room for the company to grow market share at the expense of undercapitalized competitors with inefficient cost structures.  Further, WFC is working on expanding the breadth of its offerings complimentary to its core lending business which should further enhance the company's growth potential.  For example, while the average U.S. consumer uses 16 financial products, legacy WFC has a cross-sell ratio of just 5.9 products-per-household and Wachovia has a cross-sell ratio of just 4.7 products-per-household.  If WFC broadens its offering to 8 products-per-household, which they think can be done within the next few years, this will result in a significant additional revenue gain over that time period on product intros alone.  All in all, while mid-teens growth is probably the thing of the past for WFC now that the company is so much bigger than it was just 10 years ago, the growth drivers outlined above should still enable WFC to expand over the long term at rates well in excess of industry average of 3-5%.  It is worth mentioning that WFC should benefit from tough economic conditions, such as the ones that are currently present.  The reason is that during tough economic times less efficient and more aggressive banking institutions often go bust or are forced to shrink, which should present opportunities to WFC to increase its underlying business value at an above-average pace.

DISCUSSION OF POTENTIAL BALANCE SHEET RISKS

WFC faces two significant potential balance sheet risks, which, although not critical in my opinion, are worth reviewing: 

The first risk relates to WFC's book of loans the company acquired from Wachovia, as the latter was known for aggressive lending and penchant for exotic loan instruments.  However, reviewing the numbers suggests that there aren't likely to be any sizable downsize surprises stemming from the Wachovia loan book.  At closing WFC wrote down approximately 9% of Wachovia's loans, with most of the write-downs relating to the high-risk portion of Wachovia's loan book.  At the same time, industry averages with respect to delinquent loans indicate that a loan mix similar to that of pre-acquisition Wachovia (~22% option ARMs/subprime + 78% prime) saw losses peak at approximately 6% in 3Q2009.  Therefore, it appears that WFC was rather conservative in its loan loss estimates on the Wachovia's loan portfolio and that it is unlikely that loan losses in that portfolio will overshoot the estimate producing a negative surprise.  Nevertheless, even in an unlikely event it were to happen, the overall effect on WFC's business would be rather immaterial.  For example, even if Wachovia's loan book produces the losses twice the industry average of comparable loan types - i.e. 12% vs. 6%, which is a very significant difference - WFC's income will still be enough to comfortably cover the shortfall within less than a year.

Another potential risk is that the government may force WFC to raise additional capital if it deems current capital too low thereby diluting existing shareholders.  Currently, after raising approximately $10.5 billion to repay TARP WFC Tier 1 common ratio stands at about 6.3%, which is above the 6% threshold defining a well-capitalized institution according to current regulations.  Nonetheless, there is a chance that in light of what happened to the banking industry over the past couple of years the government may increase the threshold, and the "whisper number" is 8%.  While WFC is currently below 8% with respect to its Tier 1 common, even if the higher capital requirement is enacted it is not likely to result in dilution for WFC shareholders.  The reason is that WFC's superb profitability enables the company to generate enough capital internally so as to add over 2% per year to its Tier 1 common ratio even at the current elevated level of loan losses.  At this pace WFC should be able to comfortably meet the new requirement, if enacted, within less than a year, thus minimizing the risk of government-mandated capital raise and resultant dilution. 

MANAGEMENT AND OTHER INSIDERS

WFC has a highly qualified and reputable management team at helm.  The company's CEO John Stumpf has been with the company since 1982 and during his tenure he has been an inspirational leader and architect behind WFC's low-cost banking business model.  Under the watch of tight-knit group of WFC executives, which included John Stumpf and Chairman Dick Kovacevich, the bank since 1986 has grown revenues at 13%, net income at 20%, and EPS at 15% pace, thus significantly outperforming all of the company's large-cap peers.  Despite leading performance executive compensation at WFC is below average, while the officers have a significant amount of equity tied up in the bank's stock.  The top five executive officers own approximately $900 million worth of WFC stock, including $150 million for the CEO and $400 for the Chairman.  Management performance compensation is tied to long-term profitability, growth rates, financial condition, and shareholder return, thus further aligning the interests of management with those of the shareholders.  Historically management has followed a generous dividend policy, while also repurchasing shares when they were selling below fair value.  In the past couple of years WFC effectively suspended both dividends and buybacks, as the company had to rebuild capital in accordance with the government's requirements.  Nevertheless, once WFC brings its capital above the level that government wants to see, which should happen within the next year, the company should be back to paying a sizeable dividend and making share repurchases.

In addition to management the ranks of significant long-term shareholders in WFC include Warren Buffett, who is the largest shareholder with an approximately 7% stake.  Buffett has been on the company's shareholder roster for a very long time, understands banking business very well, and thus serves as an important safeguard of the company's conservative culture against the Wall Street pressure.

VALUATION

Since banking business is highly cyclical owing to the lumpy nature of loan losses which tend to stay low during the strong economy and increase during recessionary periods, reported earnings in any given year may be far off from the sustainable "intrinsic" earnings.  Therefore, to calculate a sustainable earnings number you have to normalize current earnings based on certain assumptions regarding the firm's long-term loan losses.  Based on my set of assumptions, WFC trades at 7.2X LFY multiple of "normalized" earnings, which indicates that the stock is significantly undervalued.

Obviously, the earnings estimate on which the above multiple is based is only as good as the assumptions made with respect to loan loss provisions, which are the most volatile component of the normalized earnings estimate.  I am assuming that WFC will be able to maintain loan loss provisions at approximately 1% of average loans over the long-term.  This number approximates the average loan loss ratio that the company has experienced over the past 15-year period, which includes both strong economy periods and weak economy periods, and, therefore, makes the historical ratio a good baseline for estimating future long-term results.  As all the past elements of the disciplined lending culture are still present in the WFC organization, it is reasonable to assume that long-term future loan loss provision percentage will approximate the one observed in the past.

Here is a back-of-the-envelope calculation that details the main inputs of the normalized earnings number:

2009E

Pre-tax pre-provision income....................$40.0 billion

Loan loss provision (normalized)...............$8.0 billion

Pre-tax income.......................................$32.0 billion

Net income (35% tax is assumed).............$20.8 billion

Dividends applicable to preferreds...............$0.8 billion

NORMALIZED NET EARNINGS.....................$20.0 billion

Market cap @28 = $144 billion (includes TARP repayment equity raise).

Catalyst

- Sheer cheapness of the stock that trades at a significant discount to its intrinsic value.