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Wells Fargo & Company

Ngoi Se Chai

Business description:
Wells Fargo is a bank holding company registered in the United States (U.S.). It involves in providing diversified
financial services including banking, insurance, investment, investment banking, retail banking, mortgage banking,
brokerage and consumer finance mainly in the U.S. It acquired Wachovia Corporation in a transaction valued at
$12.5 billion to Wachovia shareholders on 31 December 2008.

There is no doubt that bank stocks are among the hardest to analyse. Nevertheless, it is still worth to give it a try
given the extreme decline in the share prices of most bank stocks as well as the fact that banking is a utility, we
needed it as if we couldn't live without electricity.

Short history of U.S. banking industry:
Banking crises have developed many times throughout history. Prominent examples include the bank run that
occurred during the Great Depression which led to the formation of FDIC; the U.S. Saving and loans crisis n the
1980s and early 1990s, and the subprime mortgage crisis in 2007 to 2009. Nevertheless, the banking industry
consolidated and grew larger each time.

It is believed that in order to come out from the current subprime crisis, the banking industry will need to take the
following three steps:
1st Stop denial and write off bad loans and mortgages on-balance sheet as well as off-balance sheet.
2nd Deleveraging - It would be a prolonged and difficult period for most banks.
3rd Rebuilding its capital base.

Methodology:
Isolated analysis and evaluation of an individual security is impractical. While this report will focus its discussion on
Wells Fargo, its financial performance and situation are compared with a group of four other major U.S. banks..
When interpreting financial ratio, it is most informative to look at a period which cover a complete business cycle. A
seven-year period (2002 to 2008) is used as it covers the period after the Dot-Com bubble (the rise of sub-prime
mortgage loans) to the end of sub-prime mortgage era

The key determinants of a successful bank are Return on assets (ROA), Net interest margin (NIM) and
Underwriting practices, and Wells Fargo has performed brilliantly in all three.

Business model and moat:

1. 'Cross-selling' was their major strategy, Wells Fargo had the highest cross-selling ratio of 5 products per
customers in 2008. Another important strategy was to grow by acquisition.
2. Wells Fargo had a NIM of 4.90% in 4Q08 and an average of 4.97% in the past seven years, which was the
highest among its peer. NIM could act as a cushion for bad loan as high NIM could provide high margin of
safety against losses from bad loans.
3. Wells Fargo had a huge core deposit base. Average core deposit had been growing at a CAGR of 9.95% over
the past seven years, excluding the substantial amount of core deposit it gained from Wachovia acquisition.
Ratio of core deposits to earning assets was over 60% in 2008.
4. An average 1.67% ROA between the period from 2002-2007 was at or near top of its industry.
Underwriting practice:

1. This was the most important factor determining the fate of a bank as a highly leveraged financial institution.
A loose underwriting practice could easily wipe out 100% of the bank's equity in a crisis.
2. Wells Fargo didn't not participate to any significant degree in CDOs, SIVs to hold assets off balance sheet,
the underwriting of highly leveraged loans and the subprime mess. As a result, they lost between 2 and 4
percent in mortgage origination market share from 2004 to 2006.
3. Almost all banks stated that they had followed sound underwriting practices but the fact was that many of
them didn't. Wells Fargo's management had shown that they had the culture and discipline to reject new
business which were under-priced.
Economics of the business:

1. At the end of 2008, 41% of Wells Fargo's total loan outstanding was residential real estate mortgages and
this represented both opportunities and risks.
2. Banking is a utility. Despite the cake had been shrinking, Wells Fargo had managed to win a bigger slice of
the cake. Since mid-2007, Wells Fargo had been able to grow its market share while many of its competitors
were struggling.
3. According to MBA forecast, roughly 4.7 million houses would change hand in 2009 and Wells Fargo had an
estimated 14% share in the mortgage origination market in 2008 (not including Anchovy).
4. Pre-tax & pre-provision earnings had been growing at a CAGR of 11% from 2002 to 2008.

Major risks:

1. The quality of assets acquired from Wachovia even though significant purchase accounting adjustments had
been made.
2. Despite their past success in managing acquisition, we would always have some surprises when integrating
two large institutions and the synergy expected might not be realized.
3. Both Tier 1 capital ratio and Tangible common equity ratios were 7.84% and 2.86% respectively at end of
2008. Wells Fargo might be forced by U.S. Treasury to issue a lot common stock at a very low price under
certain circumstances even though they might not need to to it.
4. Unemployment rates in the United States might surge well beyond 10% in 2009 and would lead to higher
bankruptcy overall. Given the size of Wells Fargo, this might result in higher than expected bad loans and an
increased in the foreclosed assets being held in the bank’s book.

'Stress' test:

Wells Fargo and Wachovia had a combined pre-tax pre-provision earning of roughly $30B in 2007 and 2008
excluding certain non-recurring items. In addition, they also had $21B in allowance and these provided a cushion of
$51B. Total loan outstanding was $865B, $56.7B of which had been written down by 40% through purchase
accounting adjustments. If 10 % of the remaining $808B loans (not only mortgage loan) were further hit by the
crisis, and these produced losses (including foregone interest) averaging 40% of principal, the company would
roughly break even.

Valuation:

Historically, Wells Fargo had earned an average 1.5-1.7% ROA while Wachovia had earned a lower 1.1-1.34%
ROA. Although it was believed that Wells Fargo's management had the capability to raise the ROA of Wachovia, a
1.4% ROA was used in estimating earning power.

Given $1.3 trillion of total asset and 1.4% ROA, Wells Fargo were expected to earn an average $18.2 billion in the
next few years after the market recovery. A 10% earning yield would give rise to a market capitalization of $182
billion, which translated into $42 per share. Another valuation method would be to base on pre-tax and pre-provision
earnings of $30B plus a year and it will produce a similar valuation at $40 per share. Take the stock price of roughly
$12 per share on 27th February 2009, the valuation suggests there is a 70% margin of safety.

This is not a recommendation to buy or sell Wells Fargo or any other stocks. This write-up is just a by-product of my research and
analysis project submitted to the Oxford Brookes University. You may email me at sephirothngoi@gmail.com if you need a more
detailed analysis.
APPENDIX
Extracts from Financial Statements
Wells Fargo 2008 2007 2006 2005 2004 2003 2002 Average CAGR
(dollars in million, except per share data)
Net interest income 25,143 20,974 19,951 18,504 17,150 16,007 14,482 18,887 9.63%
Non-interest income 16,754 18,416 15,740 14,445 12,909 12,382 10,767 14,488 7.65%
Total Revenue 41,897 39,390 35,691 32,949 30,059 28,389 25,249 33,375 8.81%

Non-interest expense 22,661 22,824 20,837 19,018 17,573 17,190 14,711 19,259 7.47%
Pre-tax Pre-provision earn 19,236 16,566 14,854 13,931 12,486 11,199 10,262 14,076 11.04%
Net income 2,655 8,057 8,420 7,671 7,014 6,202 5,710 6,533 -11.98%
Preferred stock dividends -286 - - - - - - - -
No. of shares outstanding
-for EPS calculation) 3,378 3,297 3,377 3,355 3,389 3,396 3,372 - -
No of shares outstanding
-on 2009 fully diluted basis 4,229 4,229 4,229 4,229 4,229 4,229 4,229 4,229
Efficiency ratio* 54.09% 57.94% 58.38% 57.72% 58.46% 60.55% 58.26% 57.92% -
Earning per share (EPS) 0.70 2.44 2.49 2.29 2.07 1.83 1.69 - -
EPS (adj. to 2009 basis) 0.56 1.91 1.99 1.81 1.66 1.47 1.35 1.54 NM
Dividend per share 1.30 1.18 1.08 1.00 0.93 0.75 0.55 - -
dividend payout 186% 49% 43% 44% 45% 41% 35% 42.73% -
(not including assets of Wachovia)
Equity at year-end 68,272 47,628 45,814 40,660 37,866 34,469 30,319 43,575 14.49%
Total assets year-end 604,396 575,442 481,996 481,741 427,849 387,798 349,197 472,631 9.57%

Wachovia 2008 2007 2006
(dollars in million, except per share data)

Net income before tax (after Minority interest) -49,035 8,773 11,470
Adjustments:
Minority interest 32 571 414
Non-recurring items -Goodwill impairment 24,846 - -
-Market disruption related losses* 8,213 3,051 -
Provision for credit losses 22,431 2,261 434

Pre-tax and Pre-provision earnings 6,487 14,656 12,318

Wells Fargo 2008 2007 2006

Pre-tax and Pre-provision earnings 19,236 16,566 14,854

Total pre-tax pre-provision earnings 25,723 31,222 27,172
(*The amount for 4Q08 was assumed to be same as 3Q08.)

Earning Yield 2008 2007 2006 2005 2004 2003 2002 Average
(2002-2007)
Wells Fargo 2.13% 8.09% 7.01% 7.28% 6.66% 6.20% 7.23% 7.08%
Bank of America 3.98% 8.12% 8.73% 8.88% 8.00% 9.04% 8.74% 8.58%
Wachovia* -83.16% 8.70% 8.29% 8.08% 7.36% 6.89% 7.19% 7.75%
Citigroup -83.31% 2.48% 7.88% 9.97% 6.89% 7.19% 8.50% 7.15%
JP Morgan Chase 4.47% 10.33% 8.61% 6.12% 4.08% 9.04% 3.38% 6.93%
*up to Q3 2008