Article Thesis
Wells Fargo (WFC) will report its third-quarter earnings results on October 14. We will take a quick look at what investors can expect from those quarterly results, and we will also try to examine what the future could hold for Wells Fargo. The bank has current problems, but eventually, it should get back to solid levels of profitability. Over a time span of a couple of years, holding shares of Wells Fargo could generate ample total returns.
Source: imgflip.com
It looks like Buffett may have broken his own rule when it comes to Wells Fargo, as Berkshire Hathaway (BRK.A) (BRK.B) has sold its huge stake in Wells Fargo at the lows. Instead of selling shares in the $60s in early 2018, when the accounting scandal was already well-known, Berkshire Hathaway held onto shares while they were expensive, and sold them in 2020, when they were trading in the $20s. In retrospect, that does not seem like great timing and adherence to Buffett’s own rule.
Wells Fargo’s Performance In H1 2020
None of the large banks had an especially strong H1, and neither did Wells Fargo. Pressure on net interest margins, stemming from interest rates at record lows, combined with high provisions for credit losses, are the reasons why profitability at Wells Fargo and its peers was well below the levels seen during the last couple of years.
Wells Fargo generated earnings per share of just $0.19 during H1, driven by a net loss during the second quarter, which offset most of the profits from Q1. To make things worse, big banks were also hit by a mandatory pause on stock repurchases, even though the timing for buybacks would have been great during H1, when share prices were well below the levels seen during recent years. On top of that, most banks also traded below book value at least for parts of the year, which would have resulted in buybacks being accretive to book value per share. In Wells Fargo’s case, the bank was also forced to cut its dividend substantially. This naturally made income investors quite unhappy, which explains why shares have underperformed the broad market since then.
We can summarize that H1 2020 was not at all a great time for Wells Fargo, and it wasn’t great for the stock’s owners either. Year-to-date, shares are down 53%, not including dividends.
Wells Fargo’s Q3
On the other hand, however, it looks like things may be looking better going forward. Coronavirus cases in the US have peaked and are now below the levels seen earlier this year, and so far, the recovery from the virus-induced recession looks decidedly V-shaped:
Data by YCharts
At the beginning of this crisis, some analysts worried that the recovery from this crisis may drag on for a very long time. But so far, it looks like the recovery is on strong footing, which surely is, at least partially, due to the massive amounts of stimulus spending and quantitative easing by the government and the Fed, respectively. US GDP has recovered nicely from the low that was hit in March, and so have job openings, which are almost at pre-crisis levels again. The US unemployment rate is still way above pre-crisis levels but has dropped from the double-digits to less than 8% already, showcasing a lot of improvement over the last couple of months. Last but not least, thanks to massive stimulus spending, US disposable personal income is actually higher than it was before the crisis. High disposable income levels bode well for consumer spending in the foreseeable future, but also for the ability of households to meet their financial obligations – pay their mortgages, their credit card debt, and so on.
All in all, it seems clear that this crisis has impacted the economy to a large degree, but things seem to be improving, and we could be looking at a very V-shaped recovery if things continue like they have over the last couple of months.
This is good news for basically everyone, and it also is a positive for bank stocks such as Wells Fargo. A quick recovery would mean that default rates on its loans would likely not spike to a very high level, which may lessen the need to increase provisions for credit losses by a lot. At the same time, solid consumer spending (possible thanks to high disposable incomes) and a healthy housing market mean that the bank’s profit centers are not threatened to a large degree.
Data by YCharts
Taking a closer look at the US housing market, we see that both average and median house prices are up this year, despite the crisis. On top of that, sales activity has hit a new high in September, which shows that the market is very active. Unlike during the subprime crisis, the housing market is thus not a reason to worry, but rather a source of strength in this crisis – which is a positive for the major banks.
The macro environment for Wells Fargo is thus not a dreadful one, but rather shows a clear improvement versus Q2, which is why Q3’s results will likely be significantly better than those that the bank reported for the second quarter. The analyst consensus estimate sees Wells Fargo reporting a net profit of $0.47 per share on the back of improving fundamentals, which would be a steep improvement versus Q2’s net loss. Net profits of around $0.50 per share would still be down by roughly half versus the previous year’s quarter, however. Since provisions for credit losses will likely remain well above 2019’s levels for Q3 and Q4 of this year, this deterioration in profitability versus the previous year is not a surprise. The sequential improvement, however, is an important factor for Wells Fargo’s stock going forward.
The Outlook Over The Next Couple Of Years
All in all, analysts are forecasting that Wells Fargo will earn about $1 per share this year, a steep decline versus the roughly $4 that the bank earned in 2019. Thanks to sequential improvements going forward, and due to the fact that another net loss like that from Q2 will likely be avoided, the outlook beyond 2020 is far better. Analysts are currently predicting net profits of $2.15 per share for fiscal 2021, and profits of $3.30 per share for fiscal 2022.
Eventually, once this crisis is behind us, and once Wells Fargo has fully processed the accounting scandal and its negative impact, the company may even get back to generating net profits of $4 or even more on a per-share basis. After all, even in 2019, when Wells Fargo was still feeling headwinds from the accounting scandal-related asset cap, the company generated net profits in excess of $4 per share.
For a profit estimate a couple of years from now, we can also look at book value and Wells Fargo’s ROE:
Data by YCharts
The bank averaged a return on equity of about 12% over the last decade, backing out the pandemic-hit H1 of 2020. When the company manages to get its ROE back to that level eventually, e.g. by 2025, it could generate quite attractive net profits. With a book value per share of $38, a return on equity of 12% would equate to earnings per share of $4.60 a couple of years from now, not factoring in any book value growth or buybacks between now and 2025. When we include the fact that book value should grow meaningfully over the next 4 years, and that buybacks will eventually be allowed again, Wells Fargo’s earnings per share by 2025 could be substantially higher than $4.60.
Valuation and Shareholder Return Potential
Valuations matter when deciding when to enter or exit a position, thus we have to look at how the market is currently treating the bank before we can decide if it is an opportune time to buy. In a lower-growth industry such as banking, a lot of a stock’s total return potential depends on shareholder returns (dividends and buybacks), as those can drive meaningful shareholder value. Comparing Wells Fargo to its peers on these counts looks like this:
Source: Stock Rover
Wells Fargo offered the largest shareholder yield over the last twelve months, although that will fall going forward, due to mandated buyback pauses (for all major US banks) and its dividend cut. Still, the very high trailing shareholder yield shows that the bank is capable of returning massive amounts of cash to its owners in a more normal environment. Shares also clearly are very inexpensive on a price to book and price to tangible book base, both versus peers and versus the historical valuation. Based on forward expected net profits, shares look a little more expensive than those of most peers, as analysts are not forecasting a full profit recovery by the end of 2021.
If Wells Fargo manages to leave the accounting scandal and the current crisis behind it eventually, and if earnings per share of $4+ are achieved by 2025, which is, I believe, not at all unrealistic, then there could be meaningful upside for Wells Fargo’s shares. Putting an 11 times earnings multiple on 2025’s EPS of $4.50, Wells Fargo’s shares could trade for ~$50 a couple of years from now. A share price target of $50 by the end of 2025 would equate to share price gains of roughly 100% over five years, or annual returns of 15%. Factoring in the dividend, even at its currently rather low yield, investors may see high-teens annual returns from Wells Fargo over the next couple of years.
Takeaway
Wells Fargo isn’t a sleep-well-at-night stock, as there are considerable headwinds in the near term. Eventually, the bank should be able to leave these issues behind it, however. If Wells Fargo manages to get profits back up to pre-crisis levels, its shares could provide very attractive total returns going forward, even if that process takes 3-5 years. In the near term, shares could remain very volatile, but eventually, buying shares now could pay off a lot. Valuations matter, and Wells Fargo at a historically low book value multiple seems like a value pick worthy of consideration.
One Last Word
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Disclosure: I am/we are long WFC, C, BAC, JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
