Fargo (NYSE: WFC), following the completion of its purchase of Wachovia, is now the fourth-largest U.S. bank by assets, with the largest branch network (Reuters, 2009). The company was founded in 1852 by Henry Wells and William Fargo as both a banking concern and a delivery concern (the forerunner of an armored car business). The bank opened in San Francisco during that city’s gold rush. At one point, they ran the western leg of the Pony Express. The company spread across the West on the basis of their transport business, first by stagecoach and later by railroad. By the early 1900s their offices were increasingly shifting towards the banking business (Wells Fargo History.com, 2009).
In 1918 the Federal government took over the express business and left the company as a bank only. The years following World War Two were the prime expansion years, with Wells Fargo able to grow rapidly from its strong market position in northern California. It introduced credit card service, and continued with a steady stream of mergers. The company did not begin to make acquisitions outside of California in earnest until the 1990s. Wells Fargo has stuck to its banking roots the entire time, focusing on the retail segment. After the Wachovia purchase, the company has a national presence and has extended into Canada as well through Wells Fargo Financial. In retail banking, they operate in 39 states.
3) Wells Fargo purchased Wachovia as of January 1, 2009. The deal was announced in October, 2008. Wachovia had held a significant amount of bad mortgage debt and was forced into finding a buyer by federal regulators. Wachovia had courted Citibank, but that bank’s bid was smaller than the one that Wells Fargo put in. The Wells Fargo bid came in at $12.7 billion.
The major consideration in this merger for Wells Fargo was whether or not it had properly assessed the risks in Wachovia’s assets. A significant portion of Wachovia’s toxic assets had come from its purchase in 2006 of Golden West Financial. Corp. Wells Fargo believes it will have to write down $71.4 billion of Wachovia’s $482.4 billion loan portfolio. The deal makes Wells Fargo the #4 retail bank in the U.S. based on assets (Reuters, 2009).
In other news, Wells Fargo raised $8.6 billion in capital through an issue of common stock this month. The government had mandated that Wells Fargo and several other banks much increase their capital in the wake of the government’s “stress test.” The banks were ordered to raise the capital, or risk having the federal government take out ownership stakes. This would give the government a degree of control over the banks that the bank managers would find uncomfortable. There would be changes, for example, at the senior management level. As a consequence, Wells Fargo was one of the first banks to raise the additional capital that was mandated (Fineman, 2009).
They raised the capital through a share issues, selling 392 million shares at $22 per share, giving them $8.6 billion in cash. Wells Fargo’s current position is relatively weak. They are facing losses for the next two years of $86.1 billion. Shares in Wells Fargo have declined 16% so far this year and the company was forced to cut its dividend by 85%. The federal government informed Wells Fargo that it needed to raise a total of $13.7 billion. After the issue, prices of Wells Fargo shares closed up 14% to $28.18.
4) Profitability ratios measure the degree to which the company converts its revenues into profits. The higher the ratio, the more of the banks’ revenues it retains after all expenses are calculated. In the banking industry, the gross margin is not calculated. From MSN Moneycentral, the pre-tax margin at Wells Fargo is 9.3. This compares with the industry average of 10.7. Competitor Bank of America has a pre-tax margin of 8.8. Wells Fargo’s performance with respect to pre-tax margin is therefore reasonable compared with its rival, and still within the context of the industry as a whole. Indeed, the five-year average pre-tax margin at Wells Fargo is 27.7% compared with an industry average of 27% and Bank of America’s 32.1%. We can see therefore that the major banks tend to vary in a range around the industry average. Wells Fargo outperforms the industry slightly over the medium-term but there will be year-over-year variability.
The other key measure of profitability is the net margin. This reflects not only the bank’s ability to drive profit after operating expenses, but its ability to manage its tax burden. Last year, Wells Fargo had a net margin of 7.2%; Bank of America had a net margin of 7.7%. The industry average last year was 9.7%. This shows that both of these major banks suffered tougher years than the industry as a whole last year. The five-year average net margin for Wells Fargo is 18.8%. For Bank of America this is 22%. The industry average five-year net margin is 19.7%. This shows that Wells Fargo was not only less profitable last year than Bank of America and the industry but has also been less profitable over the medium-term. The company’s ability to control its tax burden is inferior to that of the industry and major competitor Bank of America. It should be noted, however, that for the company to have been profitable at all last year is a testament to its conservative culture. Wells Fargo had little exposure to toxic assets. After purchasing Wachovia, however, Wells Fargo acquired a substantial amount of toxic assets and is expected to suffer significant writedowns on these assets and receive assistance from TARP.
5) The asset utilization ratios indicate the company’s ability to generate profits from its asset base. In the banking industry, firms first compete to acquire assets (deposits) and then they compete to generate income from those assets (loans). To some extent, the revenue that can be generated from assets is dictated by the Federal Reserve, which sets basic interest rates and reserve requirements. However, the bank’s cost structure and the type of investments they make with their assets will also dictate their asset utilization.
As such, the traditional asset utilization ratios — receivables turnover, asset turnover and inventory turnover — are worthless in the banking industry and are not calculated. Return on assets, however, is calculated, because it reflects directly the bank’s ability to generate profits from its assets. At Wells Fargo, last year’s return on assets was 0.4%. For Bank of America, it was 0.3%. The industry average is 0.4%. This indicates that Wells Fargo’s asset utilization was on par with the industry while Bank of America underperformed.
The five-year average return on assets for Wells Fargo is 1.2%, versus 1.0% at Bank of America. The industry’s five-year average is 0.9%. This indicates that both of these firms historically outperform the industry. Wells Fargo in particular outperforms the industry by a third, indicating dramatically superior performance to most of the other major banks. Bank of America roughly performs in line with industry averages, give or take a percentage point on either side.
6) The banking industry does not view liquidity in the same way that other industries do. The standard liquidity ratios — current ratio, quick ratio and cash ratio — measure the ability of firms to cover their short-term obligations. At banks, liquidity is guided by reserve requirements as set out by the Federal Reserve. Banks are compelled to hold a portion of their deposits in order to maintain liquidity. Additionally, the federal government provides a measure of liquidity to the banks through the Federal Deposit Insurance Corporation (FDIC), which guarantees depositor’s balances up to $100,000. There is also the Temporary Liquidity Guarantee Program (TLGP), of which Wells Fargo is a member. Thus, bank liquidity is a tricky thing to measure and the three standard liquidity metrics are not normally used.
Discussions of liquidity at banks refer primarily to the role as financial intermediaries. The banks are used by the Federal Reserve to create liquidity in the financial system. Banks manage their own liquidity on a constant basis, by lending to one another or with the Federal Reserve banks. Banks take into consideration the structure of their liabilities. The recent equity issue was a response to government demands that Wells Fargo improve its capital. The company has long been prepared to use debt issues where needed to improve liquidity (2008 Wells Fargo Annual Report, p.72), but this time more financing was required. Provided that Wells Fargo raises the required capital, their liquidity needs will be considered met by federal regulators.
Bank of America is in a similar position. They are preparing to sell 1.25 billion shares of common stock in order to meet federally-mandated liquidity requirements (Fineman, 2009).
7) As with liquidity, debt utilization is a difficult issue to assess with banks. As asset at a bank is a mortgage or loan; a liability is a deposit. The way banks work is that they require liabilities in order to generate assets. The liabilities are subject to reserve requirements, however. This means that the bank cannot have more financial assets than it has liabilities. So debt utilization is an entirely different animal in the banking industry than it is in conventional industries.
Therefore, typical debt utilization ratios are of little relevance. Interest coverage is tied to liquidity, and is therefore not measured for banks. The debt-to-equity ratio is measured, however. For Wells Fargo, this is 3.01. For Bank of America it is 3.97. The industry average is 3.28. The significance of this metric in the banking business is that the higher the ratio, the riskier the business. Another measure is the leverage ratio. This is at Wells Fargo 12.0, versus 9.7 at Bank of America and 14.7 overall. Thus, both of these companies are less highly leveraged than the industry as a whole. Wells Fargo has a lower debt-to-equity ratio indicating lower risk than Bank of America.
8) The DuPont number is used to provide a more in-depth analysis of the return on equity figure. The ROE is broken down into the operating leverage, asset use efficiency and the equity multiplier. The idea as that ROE changes can be understood as being a function of these three items and that it is important to know the relative contribution levels of each of these three. Because of the lack of asset turnover figures, however, the traditional DuPont analysis cannot be used in the banking industry. There is, however, a version of the DuPont that is used for banks. This formula is:
ROA = Asset Utilization — Expense Ratio — (taxes/average total assets)
Where asset utilization is the revenues divided by average total assets and the expense ratio is the total operating expense divided by the average total assets.
Using figures obtained from MSN Moneycentral, this figure for Wells Fargo is 0.3. For Bank of America it is 0.4. The Bank DuPont distills returns into cost management and revenue management. We can see that Wells Fargo has a lower figure than its ROA while Bank of America has a higher figure than its ROA. For Wells Fargo, their tax management is weaker, as they paid more tax and less income. This offset the benefits of their asset utilization. Both firms had similar expense ratios. Thus, Wells Fargo uses its assets less efficiently and has weaker tax management than does Bank of America.
9) The degree of operating leverage is the degree to which income changes as a result of a change in sales. Based on figures from MSN Moneycentral, the operating leverage at Wells Fargo is 18.2 and the operating leverage at Bank of America is 14.1. This indicates that Wells Fargo exhibits a steeper reaction to income loss than does Bank of America.
The degree of financial leverage at Wells Fargo is 97.94%, indicating a strong correlation between the decline in EBIT and the decline in EPS. A financial leverage of less than 100% indicates that the firm’s earnings are somewhat insulated from declines in EBIT, such that EPS does not decline or increase as quickly as EBIT. The degree of financial leverage at Bank of America is 105%, indicating that its EPS declines or increases more quickly than its EBIT. For Bank of America shareholders, their earnings declined more sharply than the company’s earnings last year.
The degree of combined leverage for Wells Fargo is 18.2, whereas the degree of combined leverage for Bank of America is 14.1. These figures are unusual for the year 2008, given how sharply earnings decreased. Both the figures in financial leverage are based on figures net of expenses. Both banks suffered relatively minor declines in top line earnings but posted steep net profit declines as a result of writedowns on their toxic assets. This has skewed the figures for last year, such that the combined leverage score is almost entirely dictated by the operating leverage score.
Part II. 10) Both banks are highly leveraged. Therefore, the cost of capital is heavily weighted to the cost of debt. Within this, it is unreasonable to take debt at banks as being entirely bonds. Banks are, of course, financed by deposits, which are debt. At Wells Fargo, 64.5% of debt is deposits, thus 59.6% of the firm’s capital structure is deposits. Given that, they must be included in the cost of capital. The cost of debt at banks is dictated in part by the prevailing interest rates that must be paid to depositors and the cost of debt that the bank pays to other banks. The latter is determined primarily by liquidity. To determine the cost of debt at a bank we must consider both of these debt forms. The interest expense is isolated on the balance sheet in terms of both interest on deposits and interest on borrowings. This can be evaluated against total deposits and total short-term and long-term borrowings. Thus, at Wells Fargo the cost of debt is 0.84%. This seems unusually low for any business until you isolate the deposit interest, which is 0.57%. Debt is weighted at Wells Fargo of 92.4%; equity at 7.6%.
The cost of equity at Wells Fargo can be calculated by using the capital asset pricing model. The risk free rate is considered to be the 3-month Treasury bond rate. According to Bloomberg, the yield on this is currently 0.15%. The beta for Wells Fargo is 1.3. The market return is taken to be 8.9%, based on the compounded annual gain in the S&P 500 from 1965-2008 (Buffett, 2008). This gives us a CAPM of Ra = 0.15 + (1.3)(8.9-.15) = 11.525%
Thus, the WACC for Wells Fargo is as follows:
(11.525)(.076)+(0.84)(.924) = 0.87 + 0.77 = 1.66%
For Bank of America, the cost of debt is higher, at 2.5%. This is because Bank of America’s capital structure is less heavily weighted to deposits than Wells Fargo’s structure. At Bank of America, deposits account for just 48.5% of the capital structure. Thus, the cost of debt is more heavily slanted towards bond issues at Bank of America, dramatically increasing this cost. Debt accounts for 90.2% of the capital structure.
The cost of equity is related to the measures above, but reflecting the beta of Bank of America. This beta is 2.39, which indicates severe volatility. Because volatility equates to risk, Bank of America’s equity commands a high cost. The cost of equity is 21.06%. This volatility can help explain the high cost of debt relative to Wells Fargo as well.
The weighted-average cost of capital for Bank of America, given these figures, is 4.32%. The high degree of volatility at Bank of America is indicative of a bank where deposits play a lower role in the capital structure. It has resulted in Bank of America having a much higher cost of capital that Wells Fargo.
Indeed, when the corporate bond yields on these two firms are analyzed, this difference in risk is born out. An August 2010 maturity for Wells Fargo has a YTM of .559%; for Bank of America this is 1.945%. Wells Fargo debt is rated AA by Fitch; Bank of America debt is rated A by Fitch.
11) Based on the betas of Wells Fargo and Bank of America, one would expect that the latter would be the far more volatile of the two. Bank of America’s 2.39 beta is indicative of a highly volatile firm, while Wells Fargo is much more stable at 1.39. As two of the nation’s largest banks, they would be expected to move in much the same direction at the same time. The volatility means that Bank of America’s movements should be much more intense in nature, but that they should show the same basic pattern as the movements at Wells Fargo.
What we see is that for the first eight months of the two-year study period (5/07 through 12/07) that the two banks did trade almost in lockstep. Through the end of September, both stocks were rangebound, ending up pretty much where they began. Over the course of the autumn that year, a steep decline begins and both banks finish the year between 15-20% off of their positions on May 1st. Bank of America stock was down further, but there is little indication of the strong volatility suggested by the beta.
In 2008 both banks drop further then begin a swift recovery. Contrary to what might be expected, Wells Fargo has the more intense recovery and more volatile stock price. Bank of America stock pulls slightly higher for a couple of days but this success is short-lived. After April 1st, 2008 the volatility difference between the two stocks becomes more evident. Both banks gradually begin to decline, heading for seasonal lows in mid-July. The difference is that the declines for Bank of America were far more intense during this period. By mid-July, Wells Fargo was down over 40% for the past 15 months, while Bank of America was down over 60%, highlighting the volatility. For the remainder of the summer, the banks traded gradually upward. As with the previous uptrend, Bank of America had a flatter slope than did Wells Fargo, indicating strong volatility going down but less strong volatility going up. Wells Fargo by mid-September had turned positive from its May 1, 2007 position. Bank of America, on the other hand, was still down 40% at this point.
The fall of 2008 marked similar roller coaster rides for the stock price of both companies. Wells Fargo, as predicted, did not experience as intense a drop as did Bank of America. It could be characterized as Wells Fargo dropping and Bank of America plummeting. By the time the year was over, Wells Fargo was down 20% and Bank of America was down 70%.
Thus far in 2009 we have seen the first significant divergence in stock performance between these two major banks. Wells Fargo dropped substantially to begin the year and the stock’s performance has been fairly volatile over the first four months. The movements have been more intense than those of Bank of America’s stock. For example, at the beginning of March an upward movement began. This has affected Wells Fargo far more than it has affected Bank of America. The end result is that as of May 1st, 2009 Wells Fargo was down around 45% and Bank of America was down over 80%, as the betas would have predicted.
One of the possible explanations for this is that investors may at this point view Bank of America’s situation as being so dire that the stock is valued only marginally. Changes to the firm’s stock price are not likely to demonstrate the traditional high degree of volatility until the firm’s long-term future is assured.
With respect to Wells Fargo, however, there is a stronger ongoing business. Plus, Wells Fargo’s exposure to toxic assets is a consequence of its acquisition of Wachovia — Wells itself had been conservative in its lending and had little subprime exposure as a result. Therefore, Wells Fargo’s situation is viewed as relatively normal, hence the normal volatility this year; Bank of America’s situation is not regarded as normal hence the abnormal stock price (lack of) movement.
12) The best way to approach the five-year growth rate for earnings is to take this past year’s earnings level, but apply to it a historical growth rate. If we include last year’s abysmal performance, it appears as though Wells Fargo has a negative earnings growth rate on average, which is simply not the case. The year 2008 was an aberration caused by a near-total meltdown of the financial system. This is an unusual circumstance unlikely to repeat itself any time soon. However, the use of current income levels is fair because a) this is the starting point and b) the company still has toxic assets on the books that will impair earnings in the coming years. The average growth rate is around 3.7%, so this is the rate we shall apply. The discount rate is the WACC, which for Wells Fargo we have calculated to be 1.66%.
This gives us a net present value of the next five years’ earnings of $14,095 million. This is, of course, based on a recovery of normal business conditions. To be more specific, the bank will neither lose the annualize 12.4% nor will it gain the 3.7% that has been tallied here. Analysts are predicting that Wells Fargo will lose money this year and next as it rids its books of the toxic Wachovia assets and begins to integrate that bank into its operations. After that, however, growth is expected to resume. In the case of Wells Fargo, that growth potential is high, given the expected benefits of absorbing Wachovia and the combined bank’s relatively strong financial position and standing in the market.
The price/earnings ratios for the past four quarters have varied quite a bit. At the end of Q2 2008, the price/earnings ratio was 10.8, which is a fairly low level. This can be attributed to the slow pace of growth at Wells Fargo at the time and the threat of the subprime crisis slowing down the credit markets and economy.
By the end of Q3 2008, the price/earnings ratio had gone up to 17.3. The stock price, which had been sliding, had increased significantly over that time period, whereas earnings had experienced a slight decrease. This divergence brought the price/earnings ratio to a level that is befitting a bank with some growth prospects.
The price/earnings ratio grew high at the end of Q4, however, when the trailing 12 months EPS dipped sharply due to heavy losses in that quarter. The losses of course had not yet been announced so the price/earnings ratio at the time was high at 38.5 as the market was unaware of the size of the writedowns that were going to be done at the end of the year. (The market knew that there would be writedowns because they were specific to the Wachovia deal).
By the end of Q1 2009, the market had accounted for the writedowns and the threat that ongoing business was also not going to be profitable. As a result, the stock price dropped substantially and the price/earnings ratio was brought into line at a reasonable 14.6.
We can see that over the course of the year, the price/earnings ratio began at a relative equilibrium point then moved out of that equilibrium but then the price dropped to reflect the new earnings outlook at Wells Fargo, which brought the price/earnings ratio back in line with equilibrium levels.
The expectations in the market right now are tempered by the fact that the earnings are expected to be suppressed for at least the next two years. There is something interest in Wells Fargo because they have strong long-term growth potential, but at present the market is generally nervous about banks. Wells Fargo is not as healthy as the market had thought at one time, and this has been reflected in the stock price and the market’s outlook towards the company.
13) Wells Fargo has a strong business, and after the acquisition of Wachovia, the company has become the fourth-largest bank and the #1 in the mortgage business. The brand is one of the strongest and most recognizable in the banking business. The intangibles are definitely in Wells Fargo’s favor.
However, the banking business is depressed. Banks, including Wells Fargo have found themselves subject to considerable federal government scrutiny. The demand that banks raise capital to shore up their liquidity positions has only contributed to market trepidation about the future of banks. Wells Fargo has responded to the government’s request by selling stock, which it did. The stock on May 1st was priced just over $10. A week later the shares were issued at $22 per share and closed over $28. Clearly, a purchase on the 1st of May would have been far more prudent than a purchase at today’s levels just 2 1/2 weeks later.
I recommend to hold Wells Fargo stock. The company has strong fundamentals and intangibles, but there is little doubt that the bank is going to struggle for the foreseeable future. Not the least of their concerns are the toxic assets inherited from Wachovia. Getting those off the books and restructuring the organization to add such a major competitor will be a drain on Wells Fargo finances and profits for at least the next couple of years. Economic recovery — not on the horizon yet — will not alone bring about a return to profitability for the banking industry.
Wells Fargo therefore is a hold. Two weeks ago, at $10 and a multiple of 14, it was probably a buy, simply for the fact that the business is so strong that the long-term potential in the stock was strong. At this point, however, Wells Fargo may be trading at the high end of its potential until we see a full and proper economy recovery. Also, the company still must generate more capital in order to appease the government. If this comes in the form of another stock issue that could potentially have a dilutive effect on the stock’s price.
The hold recommendation is therefore a recommendation based on the balance between the relatively high current price, the strong long-term growth prospects and the dismal short-term growth prospects. This stock is a buy at lower multiples, but not a buy today. Under no circumstances, however, is a company with this much potential a sell.
Company overview and some financials from MSN Moneycentral. Retrieved May 15, 2009 from http://moneycentral.msn.com/companyreport?Symbol=WFC
2008 Wells Fargo Annual Report. Retrieved May 15, 2009 from http://moneycentral.msn.com/companyreport?Symbol=WFC
No author. (2009). Wells Fargo Completes Wachovia Purchase. Reuters. Retrieved May 15, 2009 from http://uk.reuters.com/article/marketsNewsUS/idUKN0133136720090101
Wells Fargo History website. Retrieved May 15, 2009 from http://www.wellsfargohistory.com/
Fineman, Josh. (2009). Wells Fargo, Morgan Stanley Take in $16.6 Billion. Bloomberg. Retrieved May 15, 2009 from http://www.bloomberg.com/apps/news?sid=azALSN8KLxMw&pid=20601103
Pinsent, Wayne. (no date). Decoding DuPont Analysis. Investopedia. Retrieved May 16, 2009 from http://www.investopedia.com/articles/fundamental-analysis/08/dupont-analysis.asp
DuPont Analysis, Bank Version retrieved May 16, 2009 from home.ust.hk/~davcook/BSIS.ppt
Treasury bond rates from Bloomberg. Retrieved May 16, 2009 from http://www.bloomberg.com/markets/rates/index.html
Buffett, Warren. (2008). Berkshire Hathaway Shareholder Letter. Retrieved May 16, 2009 from http://www.berkshirehathaway.com/letters/2008ltr.pdf
Appendix A – Financial Ratios
Bank of America
Gross margin n/a n/a
Return on Assets
Appendix B – DuPont Number
Average Total Assets
Total Operating Exp
Appendix C – Forms of Leverage
% change in income
% change in sales
% change EPS
% change EBIT
Appendix D – Cost of Capital
Cost of Debt
Weighting of Debt
Cost of Equity
Weighting of Equity
Appendix E — WFC vs. BAC (from MSN Moneycentral)
Appendix F – Growth Rate
Five year growth
Appendix G: P/E
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