Friday, March 11, 2011

Wells Fargo to Devote 30% of Earnings to Dividend

In this article on Well Fargo (WFC), their CEO John Stumpf said the bank plans to use 30 percent of its earnings to fund a dividend and initiate a buyback.

According to the quarterly banking report released in February by the FDIC the banking industry has returned to significant profitability (though still far below normalized). Industry profits were $ 21.7 billion in the 4th quarter compared to $ 1.8 billion the previous year.

Banks Recovering but Need to Lend More: FDIC

The next step is more lending.

As long as 1) the yield curve doesn't get too flat and 2) balance sheets keep improving then increases in loan growth should follow and result in a decent profit cycle for the banks (especially the stronger ones).

In early 2010, Buffett commented on Wells Fargo's revenue potential and its ability to absorb losses on CNBC.

Even as the stock was being crushed during the chaos of the financial crisis Buffett remained consistent on Wells Fargo and kept buying.

In contrast, during the heat of the crisis on January 21st, 2009, FBR lowered their price target on Wells Fargo from $ 20 to $ 12.

The stock hit a low that day of $ 13.74/share and these days is selling at ~$ 32/share.

Only 18 months later, on July 22, 2010, did FBR then change its rating on WFC to "Outperform" and set a price target of $ 31/share.

Obviously, a company like Wells Fargo just does not have its intrinsic value change from $ 12/share to $ 31/share in an 18 month stretch. Seems like a bit too much focus on possible price action instead of trying to judge what a business is approximately worth intrinsically and likely to grow in worth over time.

I still consider Well Fargo to be worth quite a bit more than $32/share. For new purchases of the stock, I'd want a slightly larger margin of safety than what current market prices provide. The bank has a great capacity to grow in value over time in my view (emphasis here on growth in intrinsic value not necessarily the short to intermediate term stock price). This game of setting price targets or trying to guess what price some stock will trade at next week, month, or even 2 years from now makes little sense to me.

I happen to think that Wells Fargo has close to $ 20 billion of normalized earning power (+ or - a few billion...no false precision needed here). With a current market value of $ 168 billion (5.26 billion shares outstanding x $ 32/share) it sells for slightly more than 8x earnings.

"Our inability to pinpoint a number doesn't bother us: We would rather be approximately right than precisely wrong." - Warren Buffett in the 2010 Berkshire Hathaway Shareholder Letter

By normalized earnings I mean what Wells Fargo is likely to earn on average over a complete business cycle (use of peak earnings during boom times can easily result in the overestimation of value, while use of trough earnings during a recession can result in the opposite mistake).

Naturally, depending on the assumptions being used there will be disagreement on the normalized earning power of Wells Fargo going forward. Still, I doubt someone could come up with earnings that explains a $ 12/share value.

At the $ 12/share FBR price target, including the dilution that happened, Wells Fargo would have a market value of ~$ 67 billion (5.6 billion shares outstanding x $ 12/share). If you buy anything close to my estimate of $ 20 billion in earnings power that means Wells Fargo would have a price to earnings multiple just over 3x at that $ 12/share price.

To be fair, the unknown back then was how much dilution would occur (dilution that Buffett thought was unnecessary but nevertheless happened). Hindsight did prove Buffett to be right and the assumptions in the stress tests did underestimate the strength of Wells Fargo. Hey, no system is ever going to be perfectly fair. Still, the amount of dilution that would have to happen to justify a $ 12/share value does not seem plausible.

Back to dividends.

Something like Bank of America (BAC) will likely need to wait a while before increasing its dividend payouts.

Wells Fargo and J.P. Morgan (JPM) should get approval sooner than later.

Adam

Long position in BAC, WFC, and JPM
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