|Shares Out. (in M):||0||P/E|
|Market Cap (in $M):||98,000||P/FCF|
|Net Debt (in $M):||0||EBIT||0||0|
Wells Fargo represents an opportunity to take advantage of a company that will likely be able to profit from its position as one of the “last big banks standing.” In fact, some evidence indicates that this is already taking place, as WFC continues to make high-quality home loans while at the same time taking advantage of low-interest loans from the government to do so.
At the same time, I believe the market has seriously overpriced the future volatility of WFC, providing the investor with a mechanism for unlevered returns in the range of 30 percent.
To take advantage of this opportunity, an investor can either buy WFC shares at the market and sell an at-the-money call option out to Jan 2010, or equivalently simply sell a put option out to Jan 2010, provided that the investor sets aside the money to purchase the stock should that put be exercised. I will analyze the covered-call case, as it is simpler.
At current prices, a share of WFC will cost $29.48 (though it moved lower in the after-hours, possibly offering a better deal at the start of the new year – it may move still lower because of the expected close of the Wachovia deal). Selling a call struck at $30 out to Jan 2010 nets the investor about $7.00. Assuming WFC continues to pay its dividend throughout 2009 (a reasonably safe assumption in my view), the investor will also receive $1.36 in dividends, bringing the total cash-in to $8.36 across 2009.
Assuming that WFC ends 2009 at or above $30 per share, the investor will then take home $8.36 for every $22.48 invested (because the $7 is received immediately, I do not consider it as part of the return computation). This represents an annual return of 31 percent, far above what I would consider a standard “goal” return on a value investment.
Obviously, the key consideration in this investment is the risk associated with a significant depreciation in WFC across 2009, so I will devote the remainder of this writeup to that question.
From a valuation perspective, should WFC’s stock be trading below $30 at the end of 2009, the investor who purchased the covered call investment here would be holding stock with a cash cost of $21.12 per share (assuming you incorporate both the option premium and the dividend into the purchase price). At that point, assuming no change in the dividend rate, the investor will be receiving annual dividends of 6.4 percent.
And, without putting too much emphasis on book-value in an environment where the value of assets is deeply uncertain, the investor will hold WFC at a market cap of $70.2B versus a book value of about $47B as of the end of September 2008. Or, from a projected earnings perspective, using conservative earnings projections of around $2.25 per share, the investment has a P/E of around 9.4.
I believe the most likely case is
that WFC’s stock is near or above the current levels, meaning that the investor
will walk away with the dividend and the option premium, representing more than
a 30 percent annual return. Worst case scenario is that the investor winds up
owning the stock at a $21.12 price, which is around 60 percent of what