Wells Fargo Looks Undervalued Ahead Of Earnings Acceleration

For now, the market is not pricing banks like the earnings growth leaders they will likely prove to be in 2023. Higher rates and operating leverage should drive bank earnings up strongly (high teens year-over-year growth on a per share basis) next year, but the large caps are still trading around 10x '23 earnings, about 250bp below the typical forward multiple.

Wells Fargo (NYSE:WFC) is no exception, and I do believe the shares are priced for an attractive double-digit annualized return at today's price. That said, investors shouldn't be lulled into thinking this is a risk-free opportunity. While I do like Wells Fargo's leverage to "Main Street banking" (and its lack of exposure to capital markets), whether the Fed can bring inflation to heel without pushing the economy into recession remains to be seen, and Wells Fargo is likely to see more pressure on its funding costs as the cycle goes on.

 

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Wells Fargo Looks Undervalued Ahead Of Earnings Acceleration

Asset Sensitivity, Loan Growth, And Operating Leverage Feeding Improving Sentiment For Wells Fargo

 

I've been bullish on Wells Fargo (WFC) for a while, mainly on the basis of the significant operating leverage within the business once rates and loan growth move meaningfully higher. Moreover, while the well-known regulatory issues continue to linger (including the growth-limiting asset cap), the company is making progress resolving these issues and should be able to generate mid-teens ROTCEs a little further down the line, to say nothing of significant capital returns in the short term.

These shares have risen about 17% since my last update, outperforming a healthy big bank peer group. I currently see more upside in JPMorgan (JPM) given the post-guidance drop on worries about higher expenses and in the ongoing restructuring at Citigroup (C), but I don't think the high single-digit annualized returns I expect from Wells Fargo are bad, and I do see room for beat-and-raise quarters over the next two years that could drive more upside.

 

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Asset Sensitivity, Loan Growth, And Operating Leverage Feeding Improving Sentiment For Wells Fargo

Wells Fargo Marking Time Before Regulatory-Driven Growth Re-Acceleration

 

To whatever extent quarterly performance matters for large banks, it matters even less for Wells Fargo (WFC), as the key gating factor on this large bank’s growth is the company’s regulator-imposed asset cap. Once that cap is lifted, Wells Fargo is likely to enjoy a period of elevated growth as the business resets from around 9.5% to 10% ROTCEs to a level closer to the mid-teens.

I’ve been bullish on Wells Fargo for a while now, and that call has been working in 2021, as the shares have handily outpaced the larger bank index, and individual peers like Bank of America (BAC), Citi (C), JPMorgan (JPM), PNC (PNC), and U.S. Bancorp (USB) by 25% or more. That performance has shrunk the undervaluation I saw here, but the total return potential still more or less on par with larger banks, though Wells Fargo really needs to get out from under the asset cap to reach its mid-term targets.

 

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Wells Fargo Marking Time Before Regulatory-Driven Growth Re-Acceleration

Wells Fargo Offers Near-Term Rate Leverage And Long-Term Turnaround Potential

 

I’ve been bullish on Wells Fargo (NYSE:WFC) for a while – less on the basis of thinking it’s great and more on the basis of thinking “it’s not that bad” – and over the last six months this call has finally started to work. A shift toward “risk on” banks leveraged to the post-pandemic recovery has certainly helped, particularly with Wells Fargo’s well-above-average asset sensitivity, as has some increased confidence on management’s restructuring/turnaround plan and progress toward resolving the asset cap that has constrained the business for some time.

As one of the three banks in the U.S. with double-digit deposit share, Wells Fargo has a real chance of becoming one of the long-term winners as smaller “run of the mill” regional and community banks are squeezed out over time. Moreover, a streamlined bank more focused on higher-return opportunities in consumer and commercial banking has a better chance of recovering to mid-teens returns on tangible common equity over the next three to five years.

Given where things stand today, the investment argument for Wells Fargo is more complicated. I think investors who want an underappreciated story could do better with Citigroup (NYSE:C) or Truist (NYSE:TFC) among the larger banks now, and I think JPMorgan (NYSE:JPM) remains an appealing longer-term hold as well (with Bank of America (NYSE:BAC) moderately less attractive). Still, I do see annualized total return potential still in the high single-digits, which is still above the long-term norms of the sector, and there is still upside potential from the turnaround/restructuring efforts.

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Wells Fargo Offers Near-Term Rate Leverage And Long-Term Turnaround Potential

Wells Fargo Continues To Languish Under Its Consent Order

As Wells Fargo (WFC) closes the books on another year to forget, and the fifth year in a row where the shares underperformed its comp group, it’s fair to wonder just how long it’s going to take for this bank to turn around. The consent decree (and the related asset cap) has clearly damaged the business, leading to noticeable share loss in the corporate lending business, and the expense structure is out of whack in comparison to its peer group, but it may well prove challenging to meaningfully cut expenses without undermining revenue generation even more in the short term.

While I said that Wells Fargo wasn’t “my favorite name” back in May of 2020, I nevertheless underestimated some of the challenges that the bank would still be facing heading into 2021 and overestimated the extent to which sentiment would shift more towards the recovery prospects (which it has for many of Wells Fargo’s peers). Trading below tangible book, there’s more upside here than with most other large banks now, but there are valid reasons for that discount and I still can’t call this a favored name, even though I do believe the appreciation potential is better than average.

 

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Wells Fargo Continues To Languish Under Its Consent Order

Wells Fargo's Credit Challenges Are Manageable, But Slow The Recovery Story

Wells Fargo (WFC) had enough challenges on its plate already, most of which were due to its own past actions, and the Covid-19 outbreak and recession certainly won’t help the situation. While I see no meaningful threat to Wells Fargo’s capital from the coming increase in bad debts, nor much threat to its ability to return capital to shareholders, it will push out meaningful improvements in pre-provision profit growth.

Wells Fargo has looked undervalued for a while, and today is no exception. While some investors may believe that the company’s retail banking scandals have permanently impaired the bank’s competitiveness, I see little evidence of that and this Covid-19 outbreak may well accelerate digital banking adoption – putting large banks like Bank of America (BAC), JPMorgan (JPM), and Wells Fargo even further ahead of smaller banks. Investors are still spoiled for choice among undervalued banks, and Wells Fargo isn’t my favorite, but the valuation is nevertheless appealing for long-term investors.

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Wells Fargo's Credit Challenges Are Manageable, But Slow The Recovery Story

Wells Fargo's Results Show The Amount Of Work Left To Be Done

In quarter that has so far seen earnings reports that I’d characterize as okay-to-good, Wells Fargo (WFC) once again stands out for the wrong reasons. Not only was there barely any positive news of significance in the quarterly results, I’m not sure investors will be patient with a turnaround process that is going to take years – particularly with management indicating that it was going to take most of 2020 for the new CEO just to complete his review of the business.

Of course it’s more important for Wells Fargo’s turnaround to be done right as opposed to right now, but as I said, Wall Street is not a forgiving or patient place, and 2020 results are likely to be weak. Low single-digit earnings growth can still support a fair value in the mid-$50’s, but it’s tough to reconcile above-average long-term potential with considerable short-term challenges.

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Wells Fargo's Results Show The Amount Of Work Left To Be Done

Lackluster Results At Wells Fargo, But Likely Past The Bottom In Sentiment

Wells Fargo (WFC) has been a frustrating stock for a little while now, as not only has the company been posting lackluster results (due in part, but not totally to a consent decree), but there has been ongoing uncertainty as the board searched for a new CEO. Sentiment seems to have bottomed out after second quarter results, though, with the shares up about 10% since then and outperforming the likes of Bank of America (BAC), Citi (C), JPMorgan (JPM), PNC (PNC), and U.S. Bancorp (USB).

With a new CEO in place and a lot of things that need doing, I expect a lot of activity from Wells Fargo over the next 6 to 18 months, including management changes, business restructuring, and philosophical/business priority shifts. Exactly what new CEO Charlie Scharf has in mind is unknown, but I continue to argue that Wells Fargo will be starting this restructuring from a position of strength with respect to its consumer and commercial lending franchises.

Wells Fargo shares still look undervalued, even though I expect core earnings in 2023 will be slightly lower than they were in 2018. For the longer term, I expect basically the same low single-digit growth I expect from most large banks, and I do see some potential for upside. All in all, Wells Fargo isn’t at a can’t miss price (particularly compared to quality names like JPMorgan that still have some upside), but a successful turnaround could easily support a higher price.

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Lackluster Results At Wells Fargo, But Likely Past The Bottom In Sentiment

It's Harder To Defend Wells Fargo Absent Meaningful Progress

It was never reasonable to assume the Wells Fargo (WFC) was going to fix itself quickly, but not unlike Citigroup (C), these shares have suffered as the management has failed to make the hoped-for progress in areas like operating cost reductions. Add in an ongoing regulatory/legal headwind, an ongoing CEO search, weak lending, and the prospect of more intense spread compression, and it’s harder to stay positive in the absence of better progress on operating efficiency.

I do think Wells Fargo will get itself sorted out eventually, and the core of the business is still strong – it is still one of the largest branch banks in the country, the #1 or #2 deposit-holder in about half of the country, one of the largest CRE lenders, the largest asset-backed lender, and a leader in consumer areas like auto and mortgage, with room to grow in areas like card and payments. The problem is how long it takes to get ROEs moving toward the mid-teens and generate real profit growth. The valuation here is hard to ignore, but this is going to be a frustrating hold until a new CEO is in place, and even then there will be risks tied to whatever restructuring plan that person puts into place.

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It's Harder To Defend Wells Fargo Absent Meaningful Progress

Quality, Value, And A Little Bit Of Growth - Bank Of America Seems To Offer Quite A Bit

There are some exceptions, of course, but investors who want to invest in U.S. banks today have to make some choices and trade-offs between quality, value, and growth. JPMorgan (JPM) has quality and growth, but not as much value. U.S. Bancorp (USB) has quality and maybe more growth potential than believed, but also not much value. Citi (C) and Wells Fargo (WFC) may offer more value, but quality is certainly an issue with both franchises.

And that brings me to Bank of America (BAC). Bank of America has the scale (#2 overall in deposits and assets) to keep up with the likes of JPMorgan and Wells Fargo in IT investments and drive operating scale, but it also done quite well with expenses and deposit costs without overly compromising loan growth. I don’t wish to position or suggest Bank of America as a scintillating growth story, because it’s not, but management continues to invest in growth opportunities like digital banking and opening branches in new strategic markets, and I believe Bank of America can beat the average large bank in pre-provision profit growth over the next three to five years.

All that, and a stock I think should trade closer to the mid-$30’s.

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Quality, Value, And A Little Bit Of Growth - Bank Of America Seems To Offer Quite A Bit

With More Earnings Reports In Hand, Wells Fargo Looking Even Worse

Expectations have been relatively low for Wells Fargo (WFC) ever since the asset cap was put into place, but this large bank has nevertheless managed to disappoint, with the shares underperforming banking indices by about 12% over the last six months and 10% over the last three months. With a sizable number of Wells Fargo’s peers now having reported their first quarter earnings, a look back at Wells Fargo does not look so good for this struggling bank.

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With More Earnings Reports In Hand, Wells Fargo Looking Even Worse

BB&T Basically On Track Ahead Of Its Game-Changing Merger

Despite the significant long-term potential benefits of BB&T’s (BBT) merger of equals with SunTrust (STI), the market is still generally against M&A in the banking sector, and BB&T shares have lagged regional bank indices a bit since the deal announcement (about 300bp of underperformance). I continue to believe this is a strong merger, though, and I think BB&T shares remain one of the more interesting values among banks in its weight class.

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BB&T Basically On Track Ahead Of Its Game-Changing Merger

U.S. Bancorp Doing Fine And Ready To Start Making Some Moves

As one of the best banks out there in terms of quality, U.S. Bancorp (USB) tends to be better as a “safe haven” or a long-term holding. When bank stocks were falling apart in late 2018, U.S. Bancorp held up a little better, but the shares have also lagged peers since the start of this year as banks have largely kept pace with the S&P 500.

I expect that it is going to be harder for banks to grow going forward, as I think net interest margins are peaking and credit costs are likely to head higher from here. Loan growth is healthy now, but I do still have some concerns about the overall economy. With that backdrop, I think organic growth drivers are going to be more important, and with U.S. Bancorp now free of its consent orders, it has more options to drive growth through organic expansion and branch rationalization. U.S. Bancorp isn’t particularly cheap now, but it’s definitely a name to watch for relative underperformance.

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U.S. Bancorp Doing Fine And Ready To Start Making Some Moves

Citigroup Making Slow Progress, Which Is Still Better Than What's Priced In

Being somewhat bullish on Citigroup (C), mostly in the “it’s really not that bad” sense, has felt a little lonely at times, but the shares do seem to have started reflecting a bit of the slow progress that has been underway here. The shares outperformed banking peers over the past year by more than 5% and by a similar amount over the last three months and management has reiterated its target for a return on tangible common equity of more than 13% by the end of 2020.

If we’re only talking about quality, I wouldn’t recommend Citi over JPMorgan (JPM), U.S. Bancorp (USB), PNC (PNC), or BB&T (BBT) (and that list could probably go on a while…). But factoring in the substantial apparent discount to value, and Citi looks like an interesting risk/reward proposition, particularly as the bank’s non-US banking exposure could help offset some of the cycle risk in the U.S. banking sector.

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Citigroup Making Slow Progress, Which Is Still Better Than What's Priced In

JPMorgan Back On Track As One Of America's Best Banks

Investors are still generally skeptical about the earnings growth prospects for banks at this point in the cycle, and JPMorgan's (JPM) rare miss for the fourth quarter didn't help. I wasn't that concerned about the miss at the time, and with first quarter results coming in ahead of expectations despite somewhat weak lending, I'm still not all that concerned about JPMorgan's performance and prospects. While a broader slowdown in the U.S. economy would, of course, create new headwinds, and I do believe the bank sector is past the peak in terms of metrics like credit quality, these shares still look undervalued and have appeal as a longer-term core holding.

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JPMorgan Back On Track As One Of America's Best Banks

The Strong Look To Get Stronger As JPMorgan Continues To Target Growth

Already one of the best-run companies I follow, JPMorgan Chase (JPM) has shown an uncanny ability to leverage its strengths and maintain a steady pace of process improvement while looking for new growth opportunities. There wasn’t much that was all that new in JPMorgan’s Investor Day presentations (nor in the 10-K), but when you’re already executing very well on a very good plan, there’s not much reason to change.

JPMorgan's shares remain undervalued in my view, even though I believe banks are no longer in the best part of their respective cycle. With a high-quality business that still has meaningful long-term growth opportunities, I still regard this as a core holding and I think the upside potential still leaves it as a name to consider for new investment.

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The Strong Look To Get Stronger As JPMorgan Continues To Target Growth

South State Bank Still Grinding Through Some Repositioning

“Ground and pound” may be effective, even necessary, as a strategy, but it’s not a lot of fun to watch, and I believe the sluggish near-term results (and expectations) for South State Bank (SSB) continue to explain this bank’s relative underperformance to broader bank indices, as well as regional peers/rivals like BB&T (BBT), Bank of America (BAC), First Citizens (FCNCA), SunTrust (STI), and Wells Fargo (WFC). Although loan growth has perked up a bit and deposit costs remain low, real earnings acceleration is probably more of a 2H’19 event and the shares aren’t comparatively all that cheap now.

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South State Bank Still Grinding Through Some Repositioning

Quality Not Helping PNC Financial Much, As Growth Concerns Mount

I expressed some concerns with PNC Financial’s (PNC) position vis a vis near-term growth prospects last quarter, and those concerns really haven’t gone away. I think this is a very well-run bank and a solid candidate for a long-term position, but the lackluster results (highlighted by weak loan and revenue growth) have led to relative underperformance compared to other large banks like BB&T (BBT), Bank of America (BAC), Wells Fargo (WFC), U.S. Bancorp (USB), and J.P. Morgan (JPM).

Not much has really changed in my basic view of PNC Financial. I do see some risks to the company’s middle-market lending business and its “thin branch” digital banking expansion, but I think those risks are more than adequately reflected in the share price. Likewise, while I don’t dismiss the risk of weaker economic conditions over the next two or three years, just low single-digit adjusted earnings growth is enough to drive an appealing long-term return from here.

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Quality Not Helping PNC Financial Much, As Growth Concerns Mount

Comerica Has Thawed A Bit, But Expectations Are Still Modest

I don’t really evaluate or recommend stocks on a short-term return basis, but I won’t pretend that it hasn’t been nice to see Comerica (CMA) jump over 10% (beating underlying regional bank indices by about 5%) since my December update when I flagged expectations/sentiment as unusually low. Better still, it looks like expectations are still quite modest even after this stock and this sector have both rebounded from their December lows.

I’m still troubled by Comerica’s relatively weak loan growth, though it looks as though that may accelerate in 2019. Likewise, Comerica’s guidance for mid-single-digit net interest income growth could prove conservative as it includes no further rate hikes. I’d certainly recommend keeping an eye on loan growth, credit quality, and spread leverage here, but even just low single-digit long-term growth should be able to support a fair value more than 10% above today’s level.

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Comerica Has Thawed A Bit, But Expectations Are Still Modest

Wells Fargo Remains Undervalued But Ongoing Regulatory Challenges Pressure Growth

Shackled to “muddle through” performance as long as a regulator-imposed asset cap remains in place, Wells Fargo (WFC) is indeed muddling through. Not much is going for the bank in terms of loan growth or fee income right now, but investors can at least look forward to more substantial capital returns in the near term. Wells Fargo still maintains one of the largest retail banking franchises in the country, and a strong middle-market lending operation as well, but the combination of increasing competitive pressure and economic headwinds is likely to hamper growth. Even so, the valuation is past “undemanding” and these shares do look cheap even considering the issues in place at this bank.

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Wells Fargo Remains Undervalued But Ongoing Regulatory Challenges Pressure Growth