Description

There are currently a number of factors, positive and negative, obscuring Wells Fargo’s normalized earnings potential.  Adjusted for all of these factors, including adjusting for a higher credit loss environment, WFC trades at ~9x normalized earnings for a ~16% ROTCE business (mid-cycle) with decent long-term growth prospects and very little risk of disruption.  That seems absurdly cheap in an environment with 30-year treasuries yielding 2.7%.

Below I’ll describe the adjustments that I make to 2018 earnings to arrive at “normalized” earnings per share. 

Excess Capital

WFC currently has a CET1 ratio of 11.9% compared to its target of 10%.  Management expects the target to end up between 10.25% and 10.5% after implementing CECL, a new accounting standard that requires financial institutions to book expected credit losses over the life of a loan up front.  

Using 10.375% as a target CET1 ratio, WFC has $19.5B of excess capital.  The company returned $32.6B to shareholders under its 2018 Capital Return Plan, about $10B more than it earned.  At that pace, all of the excess capital will be returned to shareholders over the next two years.  In calculating “normalized” earnings per share, I assume this is all returned in the form of buybacks at a 15% premium to the current price to account for appreciation over the next couple years.  

Bloated Expense Structure

Expenses totaled $56.1B in 2018, resulting in a 65% efficiency ratio.  But the 2018 number includes $2.5B of costs related to all of the scandals over and above the normal $600MM/yr budget for those types of operating losses.  Adjusting those out gets us to $53.6B of “core” expenses.  That number includes $769MM of core deposit amortization which is a non-cash charge that won't appear in the financials going forward.  It also includes ~$300MM of FDIC surcharges which are no longer being charged beginning in 2019.  Adjusting both of those out gets us to $52.5B, which is the mid-point of 2019 expense guidance.  Tim Sloan guided to $50-51B in 2020 (before he was terminated) which I believe is very conservative based on the amount of labor WFC is carrying. 

WFC has $1.26T of deposits and $1.88T of assets compared to BAC with $1.38T of deposits and $2.38T of assets.  Yet, WFC has 55,000 more employees and ~1,300 more branches.  There is no reason why WFC needs so many more employees and branches to serve a 7% smaller deposit base.  The median WFC employee earns $65,191/year. If WFC reduced its headcount to match BAC’s, it would save $3.6B.  Note: (1) This figure is gross wages only and does not include benefits or taxes paid by WFC, and (2) JPM has even fewer U.S.-based employees, 170,000, serving a $1.2T deposit base.

Therefore, adding it all together, I believe there is a clear path to $49-50B of operating expenses in the next few years, down from $56.1B in 2018.  As a gut check, that would put WFC at a 55-56% efficiency ratio which is just below BAC & JPM today.  That makes sense given the fact that JPM & BAC are more complicated businesses with much larger investment banking segments.  Until recent years, WFC typically had a lower efficiency ratio than BAC & JPM.  I assume $49.5B of operating expenses in my "normalized" earnings estimate.

Favorable Credit Environment

Current earnings benefit from the very low level of credit losses running through the income statement.  In 2018, provisions expense was only $1.75B, or 0.19% of average loans outstanding, well below a mid-cycle level.  Management estimates that mid-cycle provisions would be 60-70bps.  At 65bps, that would be $6.15B, or $4.4B more than currently expensed.  I reduce earnings by this amount to account for a “normal” credit environment.

Misc. Revenue Adjustments

I reduce 2018 revenue by $2.6B to adjust for some unusual gains on sales and asset, primarily the Pick-a-Pay loan sales and the sale of Wells Fargo Shareowner Services.

Normalized Earnings & Fair Value

Adding it all up, I get to $5.19/share in “normalized” earnings potential, or just under 9x earnings at the current price. 

Note, this deducts $1.10/share for normalizing the credit environment to a mid-cycle level; so critiques that banks deserve a low multiple of earnings at this point in the cycle have already been addressed by reducing the earnings to reflect that.  

WFC should be able to grow revenue with nominal GDP over time while distributing ~75% of its earnings.  Assuming 10% discount rate (very high for such a stable business in an environment with 30yr treasuries yielding 2.7%), 4% growth (assumes no operating leverage, a very conservative assumption given digital banking trends) and 75% of earnings are distributable, implies a fair multiple on this business of 13x earnings or $67.5/share, a 48% premium to the current price. 

A Note on The Asset Cap – It’s Manageable

The asset cap is $1.95T, leaving room to grow assets by 4.3% assuming half the excess capital is returned this year.  And because of the significant amount of excess capital, WFC had in the past taken on some high-cost non-operational commercial deposits that generate a very low NIM (70-75bps) and low ROE.  At year-end 2017 there were $200 billion of deposits in this category.  There is likely still around $150 billion of this type on the balance sheet that can be shed to make room to serve growth in the more profitable retail segments of the business.  

The glass half full view of the asset cap is that going forward, it’s much less likely that there will be skeletons in the closet at WFC than at BAC or JPM, who have not been under two years of intense regulatory scrutiny.  

Catalyst

(1)  Asset cap lifted.

(2)  New CEO hired who pursues aggressive cost cutting.

(3)  Return of excess capital.