Wells Fargo Helped By Provisioning, But A Bit More Patience Required

To date, my coverage of Wells Fargo ( WFC) has been a channel of a Michael O'Higgins "Dogs of the Dow” approach. O'Higgins suggested that big blue-chip firms have more time to address any problems that might be affecting their stock prices due to their size. If the problem was solved , it would be a good idea to reinvest higher than average dividends yields.

Wells Fargo doesn’t meet that bill, not for the small reason that its dividend was shredded! The San-Francisco bank was a beloved of the dividend community when Seeking Alpha began. Despite its woes there is still a good business. It is not a problem that needs to be fixed, even though it takes longer than expected. (I assume most readers are familiar with the bank's problems so I won’t repeat them. For those who don't know , you can find a brief overview .

Let me be clear, Wells has not done well since its debut here in 2020. Although it has lag JPMorgan as well as Bank of America among mega-caps, the stock has barely beaten Citigroup over that period. The total return on cumulative dividend cash is about negative 3.5%, with approximately a dollar forty per share. It's not great, though COVID is a major culprit. It has performed well since I doubled its efforts in Q2 2020.

Provisioning Boosting Results

The stimulus measures have clearly helped to ensure that credit quality has remained strong during the downturn. This was evident when I covered Wells in the first quarter. Let's recap: The bank entered the downturn with a loan loss allowance of approximately $9.5b. This is roughly 100bps more than total loans. The bank then put aside $14.1b to cover bad debt. This is an increase of $2.7b from 2019. Its loan loss allowance now stands at 200bps. This impacted 2020 annual profit which, at 41C/per share, fell by 90% compared to pre-COVID levels.

Now, the reverse is happening. Wells and other industry members are now releasing previously built-up reserves through the income statements. In Q2, the bank released $1.6b more than it had previously, with net charges clocking in at $523m compared to $579m in the previous quarter. It also had a $9.5b provision cost, with $1.1b net charge-offs. However, the lower provisioning is a huge boost to the bottom line. FY21Q2 net income to common rose $1.5b to $5.7b, bringing the total provisioning down to $9.5b. This resulted in a return of tangible common equity (ROTCE), of 16%.

Core operations are looking a little less mixed. The net interest income ("NII") was $8.8b. This is 11% less YoY due to lower interest rates, shrinking loans books, and higher deposits. Margins were also affected by lower interest rates. The Q2 decline in loans to $854.7b was 2%, and deposits increased 3% to $1.4t. Q2's net interest margin was 2.02%, down from 2.05% in Q1 and 2.25% last year. Private equity and venture capital investments gains saw a significant increase in non-interest income this quarter. This made FY21Q2 numbers appear better than they actually were due to lower provisioning.

A Mixed Bag Still, But Optimism Wins Out

It's likely to remain a mixed bag, but I remain optimistic for the medium-term. There are a few possible pitfalls in the bad. First, the economy could experience a decline in credit quality as the stimulus measures wind down. This would expose it to the "truer COVID" hit. This is something I am not worried about, but it is worth keeping an eye on. The Fed's feared asset cap is still in place, which is threatening growth prospects. The third is the poor operating environment, due to low interest rates. In FY21Q2, the yield on $1.7t of interest earnings assets decreased to 223bps, which was another 10bps lower sequentially. A corporate tax increase might be on the horizon. I believe expectations are moderated here. However, I'm not an expert on Washington politics. Given the potential impact, it's probably best to be cautious.

It all boils down to what the value of the good is. Wells can do a lot via cost cutting. This was previously a problem due to legal and regulatory problems as well as restructuring costs. Non-interest expenses have dropped 8% YoY and by 5% QoQ, to $13.3b for FY21Q2. Pre-COVID, annual non-interest expenses ran in the $58b-range. It looks like there is slow progress. If it achieves its annual goal of $50b, then the numbers look very positive in terms of trickle down to earnings.

That last sentence sums it all. Wells Fargo shares trade below $45 per share. This is approximately 1.3x tangible value and an average price-earnings ratio ("PE") between 11-12x. The bank will eventually be able to earn a decent double-digit ROTCE in normalized conditions. Although it might have to raise rates and so forth to reach its 15% target, there is still upside to the current value even at lower levels. Wells Fargo stock is still cheap in an environment that makes it difficult to find a bargain.