Tuesday, January 17, 2012

Wells Fargo Reports 4Q and Full Year 2011 Net Income

Almost all bank stocks did poorly during the crisis.

Most of the stocks, yes. Yet, at least in some cases, the best in the banking business came out the crisis just fine.

Telling the strong from the weak at the height of the crisis wasn't easy but, now that some time has passed, it's become more clear where the quality was and is.

Some of the best banks are intrinsically more valuable now per share than before the crisis occurred. Short of another financial crisis, the better ones are in a solid position to continue building on that value.

Wells Fargo (WFC) seems a good example. The bank just reported 4th quarter and full year net income.

From the earnings release:

Wells Fargo & Company (NYSE:  WFC) reported record net income of $4.1 billion, or $0.73 per diluted common share, for fourth quarter 2011, compared with $3.4 billion, or $0.61 per share, for fourth quarter 2010, and $4.1 billion, or $0.72 per share, for third quarter 2011. Full year 2011 Wells Fargo net income was $15.9 billion, or $2.82 per share, up 28 percent from 2010.

"I'm extremely pleased with Wells Fargo's performance in 2011 – including strong deposit and loan growth,  record cross-sell and record earnings," said Chairman and CEO John Stumpf. "We achieved these results while completing the conversion of Wachovia's retail banking stores – the largest such conversion in banking  history – and now all of our 6,239 retail banking stores are on a single platform serving customers coast to coast. At the time of the merger, we said the integration of Wachovia would take three years and we are right on track."

Wells Fargo certainly made their fair share of mistakes during the crisis but, compared to most peers, they've come through it just fine to say the very least.

In what is still a very challenging bank environment, Wells Fargo is now already earning more per share than it ever did pre-crisis.

That may or may not seem like a huge deal but, in contrast, other less well run banks are still having a tough time earning even a fraction (if they're even still around) of what they earned pre-crisis.

Citigroup (C) is as good an example of this as any. The bank may be getting its house in order now, but that doesn't change what it looks like from a long-term equity investors point of view.

At its pre-crisis peak, Citigroup earned more than $ 48/share (apples to apples accounting for the 10-1 reverse stock split) but earned less than $ 4/share during all of 2011 (as just reported).

Even when things begin to fully normalize for Citigroup, the amount of wealth destruction for shareholders has been extensive. Much of that value destruction, of course, is due to extreme share dilution and the need to sell off valuable assets to clean up the balance sheet. As a result, as far as the common stock goes, it is a shadow of its former self.

Not so at Well Fargo, the bank is intrinsically more valuable absolutely and, most importantly for an investor, on a per share basis. There is also plenty of reasons to think they'll compound that value at a higher than average rate for a bank going forward.

In its peak earnings year prior to the crisis, Wells Fargo earned $ 2.47/share.

For the just reported 2011 full year, the bank earned $ 2.82/share (Wells share dilution during the crisis was more than offset by increases to earning power).

So, at a time when Citigroup still can't even earn 1/10th per share of what it did pre-crisis, Wells Fargo is already earning more than its best pre-crisis year (earnings are expected to be higher in 2012...we'll see).

In what is still a rough environment for any bank, Wells Fargo has figured out a way to earn more than it ever did previously while building a healthy balance sheet (and also absorbing the not-so-healthy and very large Wachovia).

When a more healthy economic expansion begins to kick in, the deposit and loan growth should lead to much more earning power and eventually more capital being returned to shareholders.

In addition, compared to peers, Wells is less complex and requires a much smaller balance sheet to produce a similar amount of net income.* Unlike the other large banks, Wells Fargo never really focused on investment banking and its many pitfalls. Not a small advantage. The result is a cleaner model focused primarily on commercial banking. The bank has a substantial advantage over most peers in terms of net interest margin. If sustainable, in combination with their credit culture and other qualities, should lead to higher than average return on equity (ROE) over time (for a bank, a sometimes useful if imperfect proxy for investor returns given the limits of accounting) and, ultimately, superior long-term investor returns (increases to intrinsic value).

When it comes to banks, investors should tread carefully with what looks like a "bargain". The better bank stocks sometimes look relatively expensive compared to book value** and/or earnings per share, but that's often because the best are capable of increasing intrinsic value at a higher rate.
(Wells Fargo has been very cheap, at times, for several years but that's no longer the case as of today. It's selling at slightly more than 10x earnings. Expensive? No, but not cheap either. Many banks sell at a far lower earnings multiple or discount to book value but watch out for those that are cheap and, well, worth it.)

As always, you've got to pay an appropriate discount to value. For most banks, the analysis of what it's worth should start with balance sheet health and net interest margin performance but credit and selling culture, complexity, compensation systems, and attitudes toward accounting practices are crucial. Having a simpler business model and a management team that prioritizes balance sheet health over short-term income statement performance likely wins in the long run. All these characteristics contribute to the robustness of the franchise and help an investor gauge, though never precisely, how rapidly intrinsic value is likely to increase over multiple business cycles.***
(It's how these many different moving parts play out in combination over time that determines returns...not just one or two of these things.)

Evidence of sustainable and high return on equity (book value) relative to peers is a useful if insufficient measure.

Paying a reasonable multiple of normalized earnings always makes sense to protect, at least somewhat, against the unforeseen and unforeseeable.

Still, in the long run, if you don't gauge things like culture and the effectiveness of compensation systems reasonably well, the rest likely won't matter much.

Also worth consideration: Is the the culture, practices, and competitive advantages that produced prior results still mostly in place?

It is one thing for a bank like Wells Fargo to temporarily have reduced earning capacity per share as it absorbs credit losses. With even the best bank that kind of goes with the territory. For shareholders, the key thing is that those earnings are substantially restored (and then eventually begin climbing again) after the worst of a credit cycle passes.

It's a whole different ballgame, as is the case with Citigroup, to have so much earning power per share (and, of course, intrinsic value) permanently destroyed. Some of the wealth destruction comes down to dilution and asset sales but there is another disadvantage: It's a lower return business than Wells. Even when things begin to more fully normalize Citigroup will continue to be a shadow of itself on a per share basis.

In general, I can think of easier ways to produce solid long-term risk-adjusted returns other than investing in financials. Wells Fargo may be "less complex" than other large banks but that's not really saying much. Any large bank, including Wells Fargo, is not at all simple and ends up being a bigger leap than most other investments.

There's more room for error with businesses in other sectors.

It's worth remembering that during the worst of the financial crisis, very few distinctions were being made between quality financial institutions and those that behaved the worst. The downward price action was awful for just about all of them and that action always has the potential to become self-fulfilling, at least to some extent, under times of stress.

The situation is very different for a business like Coca-Cola (KO). The beverage company doesn't much depend on the kindness of the capital markets to fund itself.

The difference in possible outcomes is night and day.

A long track record of producing returns and protecting wealth, especially through difficult periods, is one way to begin judging the quality of any financial institution. The benefit of the recent financial crisis is it provided a good real world stress test. No bank came through 2008-9 without real financial pain though it is much more clear now who avoided the excesses.

That should count for a lot, and inform any analysis, but will always be insufficient.

Adam

Long WFC

* Example: J.P. Morgan (JPM) has ~$ 2.3 trillion in assets compared to $ 1.3 trillion for Wells Fargo yet earned only $ 17.6 billion compared $ 15 billion. So almost $ 1 trillion more in assets (73% more than Wells) produced just $ 2.6 billion more in earnings (17% more than Wells) for common shareholders. One way to look at it is this: JPMorgan is on the hook -- in an economic downturn -- for the losses associated with a relatively large chunk of additional assets (~$ 1 trillion and the associated risks of potential loss/other liabilities) but produces a relatively small ($ 2.6 billion) amount of incremental earnings with those assets.
** Book value is a sometimes useful, but mostly limited proxy for real business worth given the limits of accounting. Intrinsic value (itself a necessarily imperfect measure that, using the John Burr Williams definition, is primarily the present value of future cash flows) can be much higher or lower than book value. A bank that has higher sustainable net interest income, noninterest income, similar expense levels as a percent of revenue, and fewer credit losses over a complete business cycle is naturally worth more intrinsically. The return it will generate on that book equity (more importantly, the economic returns) will be superior resulting in more intrinsic value creation over time. The opposite, of course, is also true.
*** Things like balance sheet strength, net interest margin, return on equity, and other quantifiable measures are not difficult to understand. These things, of course, matter but only up to a point. Yet, a culture that chooses balance sheet strength over short-run income statement performance, with conservative accounting practices, and smart credit standard are harder to see in an SEC filing but those characteristics often determine durability. Those who have compensation systems that reward short-run outcomes will inevitably lead to a gaming of the system. It's best to view bank performance over a full business cycle or even longer. None of this is exactly easy to judge.
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