Wells Fargo a buy despite weaker Q4

by Levi Folk | January 18, 2008

U.S. financial stocks have been decimated since August, 2007, when troubles in the credit markets began. What started as a correction in the U.S. housing market has spread to securities underpinned by pools of U.S. mortgages. U.S. investment banks have been hit particularly hard after announcing billions of dollars in writedowns due to losses on these securities. Despite the broad losses, more fallout is likely for the sector. Yet bottom fishers mucking through all this detritus may wish to consider Wells Fargo (WFC/NYSE) as a potential diamond in the rough.

The San Francisco-based bank on Wednesday reported fourth-quarter earnings of US$1.4-billion (US41¢ a share) from US$2.2-billion (US64¢), its lowest quarterly earnings in six years. Still, it managed to avoid the big losses at other banks, and chief financial officer Howard Atkins said it is finding “significantly more opportunities” for acquisitions, portfolio purchases and loan and asset purchases than at any time in the past five years. Moody’s Investors Service said the bank is well positioned to weather the economic storm that’s brewing. It gives Wells Fargo a “AAA” rating for depositors, a potential lure to customers shaken by recent bad news in the banking sector.

To put the Wells Fargo story in context, the third quarter of last fiscal year was an unmitigated disaster for most U.S. investment banks. Profits at U.S. banks fell 24.7% in the third quarter of 2007, versus the same quarter in 2006, according to research from U.K.-based Smithers and Co. Citigroup posted a writedown upward of US$18.1-billion for the fourth quarter of 2007, after roughly US$5.9-billion in writedowns in the previous quarter. The question now turns to one of value and whether these stocks are viable investments over the long term.

The answer at this point is not in favour of these stocks, for several reasons including: continued deterioration in the U.S. housing sector; further losses and writedowns on these mortgage-backed securities; and perhaps even a permanent impairment to the business model of these companies going forward.

U.S. banks have not made adequate provisions for losses based on the current “coverage ratio” — the ratio of reserves to “non-current” loans, which are those with interest unpaid for 90 days. According to U.S. Banks: Poor Value and Poor Prospects, a recent report by Smithers and Co., the ratio is at its lowest level since the third quarter of 1993.

The long-term return on equity (ROE) for U.S. banks is a modest 6% to 7% versus ROEs that have hovered in the mid-to-high teens in recent years. And a return to average ROEs seems likely given the permanent impairment to many lines of business these investment banks have pursued.

The originate-and-distribute model of repackaging mortgages into collateralized debt obligations (CDO) is not viable going forward for several reasons, including a lack of buyers in the current market and a failure by these investment banks to successfully move these securities off their balance sheets when the market turned against them in August.

However, Wells Fargo, a diversified U.S. retail bank with more than 6,000 individual retail stores, stands out in the recent storm for its strong franchise and low exposure to crisis. The bank has set aside US$1.4-billion in special reserves out of a portfolio of high-risk loans, valued at US$11.9-billion, to come out of fourth-quarter earnings. Despite the losses on these dubious loans, Wells Fargo is has one of the best franchises in U.S. banking according to two trusted sources: former Trimark Fund manager Tye Bousada and Punk Ziegel financial analyst Dick Bove.

According to Bove, Wells Fargo is “best positioned” to capitalize on the return to an “originate-and-hold” business model from the former model of “originate and distribute.” A return to traditional banking businesses is clearly a positive for the bank. It may suffer a compression in ROE going forward, since it has been pursuing low-margin growth business in recent quarters to offset weakness elsewhere, but the steeper yield curve will offset some of this ROE compression.

Most important, Wells Fargo is relatively cheap. It has had a near 30% share price decline since October, 2007. Bousada says this is the cheapest it has been in a decade, based on price-to-book value. After the fourth-quarter earnings release, analyst Lori Appelbaum of Goldman Saks reiterated her buy rating on the stock, with a target price of US$34, adding the shares yield 4.5%.