Is Wells Fargo Still A Good Dividend Investment With Increased Regulation?

Published July 6th, 2016 by Eli Inkrot

Wells Fargo (WFC) is one of just 34 blue-chip dividend stocks in the  S&P 500 businesses with:

• 100+ Year operating history (164 years in Wells Fargo’s case)
• 3%+ Dividend yield (3.3% yield for Wells Fargo)

The company has been very successful both over the long-run, and in more recent history.

Here’s a fun stat: San Francisco-based Wells Fargo (WFC) is one of only two companies in the U.S., and the only bank, to earn over $5 billion for 14 consecutive quarters.

Granted that timeframe is a bit “cherry-picked” to favor Wells, but it illustrates a point that many casual observers might have missed: despite the environment, many of the largest banking institutions are pumping out gobs of profits.

Here’s a look at the consistency of Wells as compared to some of its large name peers:

Source: Wells Fargo, Financial Overview

Wells Fargo’s Business In Focus

The reason for this consistency relates back to a number of items. For one thing, Wells Fargo is an exceptionally large bank with assets nearing $2 trillion, nearly 270,000 team members, 8,800 physical locations, 13,000 ATM’s and a market capitalization well north of $200 billion. In other words, one bad loan or industry isn’t going to shake up the profitability picture for this company.

Second, you have a very deep-rooted customer base, as Wells has been able to cross-sell products to the tune of an average of six accounts per client. Once you put together a savings account, checking account, mortgage, investment account, maybe a car loan or your kid’s college account all at one place, it becomes less and less likely that you’re just going to pack up your financial baggage and move across the street.

Here’s a look at Wells Fargo’s income generation as it relates to “typical” banking practices against “non-typical” profit makers:

Source: Wells Fargo, Financial Overview

Roughly half of the business is tied to what you would consider “traditional” lending / interest income, while the other half is tied to noninterest income. Here’s how that “unconventional” income is divvied up:

Source: Wells Fargo, Financial Overview

Wells Fargo isn’t just a bank. It’s also an advisory, wealth management, credit card, insurance and investment banking firm. Obviously these things go hand-in-hand, but it stands that the company’s profit base is well diversified across a broad range of financial offerings.

Competitive Advantage & Total Returns

Here’s how the company describes its competitive advantage in a few bullet points:

Source: Wells Fargo, Financial Overview

Not that this is a perfect indicator of success, but we can see this unfold in a couple of ways. As mentioned above, it’s lead to exceptional and consistent profits for the bank in the recent years. Moreover, the returns generated for shareholders have been impressive as well:

Source: Wells Fargo, Financial Overview

The last column – 10 years’ worth of performance results – seems especially impressive. Despite the worst financial crisis you or I have ever seen. Despite a dividend cut from $0.34 a quarter down to $0.05 in 2009. Wells Fargo has still provided more than solid results over the years.

If that doesn’t make you want to seek out quality and a long-term mindset in the investing world, I’m not sure what would.

Before we get to today, let’s take a look at how the business and investment has performed using a few more numbers:

Note that the numbers are slightly skewed from what was detailed above as a result of timing. I’d like to focus on a few numbers just to give you a feel for what has transpired in the last decade.

In 2005 Wells Fargo was earning $7.7 billion and paying out $3.5 billion or so in dividends; indicating a payout ratio of about 45%. The average market capitalization that year would have been around $100 billion, representing an earnings multiple near 13.

Last year Wells Fargo earned $21.6 billion and paid out $7.5 billion or so in dividends; resulting in a payout ratio of about 35%. Today’s market capitalization is around $235 billion, equating to an earnings multiple of about 11 times.

The current dividend yield is more or less comparable to where it was a decade ago, but the company is generating substantially more profits (three times) and yet has a lower payout ratio and valuation. Granted a good bit of shareholder dilution took place during the recession, but it follows that these comparisons are done on a per share basis.  Which brings us to today…

Current Events & Regulatory Burden

The big news recently has been the Federal Reserve “stress tests” and determining how much capital banks can deploy. Wells Fargo announced that the Fed did not object to its plan, but has been a bit cryptic with regard to the exact specifics.

What we do know is that the dividend is apt to remain at its current level or increase, while Wells Fargo expects to pay out 55% to 75% of its profits in the form of dividends and share repurchases. Here’s what that has looked like over the past three years:

Source: Wells Fargo, Financial Overview

You can see that for 2014 and 2015 the company’s goal was just barely met. Moreover, instead of Wells Fargo paying out 40% to 50% of its profits in the form of dividends as had been the norm prior the financial crisis, now the company is only returning 35% or so in cash payments.

This brings up an important counterpoint. A lot of investors or potential investors have bemoaned the idea of greater regulation in the banking industry, citing higher capital requirements stymieing potential growth. Greater capital requirements equal less leverage equals more difficult growth.

This notion could very well come to fruition. In fact, it’s much more than a notion as you can see this trend already taking place:

Source: Wells Fargo, Financial Overview

In just the last couple of years, Wells Fargo has reduced its expectation for both return on equity and return on assets – both key factors for banking success. Indeed, as compared to marks closer to 19% ROE and 1.6% ROA in 2005, today’s numbers certainly do not appear as attractive.

However, I think it’s important to make a number of observations. For one thing, lower margins certainly do not necessitate that growth is over. Even with returns on equity dropping from 19% down to 11%, Wells Fargo is still generating three times the amount of profits that it was 10 years ago.

Furthermore, the increased capital requirements may not be as bad as they first appear. For starters, the greater requirements are making Wells and other large institutions safer; or at least that’s the idea. So less growth potential, but also less blow up potential as well. It’s a trade-off.

Future Prospects

For the prospective investor, the slower potential growth has led to lower valuations and well above average dividend yields. Moreover, as we saw above, dividends are being limited. This means that a greater portion of shareholder returns will be derived from share buybacks. So you have more funds and a lower valuation, leading to more effective share repurchase programs.

Finally, increased regulation could very well slow growth, but the potential of eventually higher interest rates may be a future tailwind. Expressed differently, slow growth with a solid dividend, valuation and share repurchase program isn’t the worst of news, and the calls for this slow growth scenario could actually be a bit premature.

Let’s see how this could apply to a Wells Fargo investment over the next half decade. Ideally I like to keep a longer-term mindset, but for the purposes of a prospective investment opportunity five years ought to offer a reasonable view.

Last year Wells Fargo earned $21.6 billion. With 5.1 billion common shares outstanding, that equates to an earnings-per-share number over $4.

Analysts are presently anticipating high single-digit growth for the company over the intermediate-term. This can come from loan or product growth, potentially higher rates and the now more effective share repurchase program.

Just to give you a sense of the program, if Wells Fargo were to earn the same amount for the next five years and spend 30% of those profits on retiring shares, the company would be repurchasing over $30 billion worth. Per share profits could be perhaps 15% higher as a result of that avenue alone. Granted the share repurchases may not be as effective as they first appear, but it still stands that Wells has the opportunity to reduce its share count in a meaningful way during the coming years.

For the sake of illustration, let’s suppose that Wells Fargo is able to grow earnings by 6% annually. That would lead to a future earnings-per-share number around $5.50 after five years. The company’s average historical multiple has been in the 13 to 16 range, but it’s been closer to 12 or 13 since the recession. Let’s use 12 as a baseline. This would indicate a future price of about $66.

In addition, we can think about the potential dividend payments. Should these payouts grow in-line with earnings you’d anticipate collecting $9 or so in dividends over the next half decade. That works out to an even expected value of $75 during the next half decade, prior to thinking about reinvestment. (And remember this is merely a baseline.)

What makes this interesting is the current share price of Wells Fargo. If shares were trading hands around $75, you likely would not be interested. However, that’s not the value proposition that is being offered today. Instead, shares are trading hands around $46. At this level, using the above assumption, you come to a total expected gain of over 10% per annum.

At ~$46 per share, Wells Fargo looks like a bargain.  Investors looking for exposure to the banking sector should consider Wells Fargo at current prices.  It doesn’t hurt that the stock is also one of Warren Buffett’s largest holdings – and one of his highest yielding holdings as well.

Naturally something much better or worse could occur in practice, but that’s how I’d begin to think about an investment in Wells Fargo. A lot of people are concerned with regulation and uncertainty.

With regard to the cloudy future, that’s always going to be the case. With regard to regulation, future growth may indeed slow but you have a number of factors still working in your favor.

Namely, a reasonable valuation coupled with a solid and well-covered dividend to go along with a now more effective share repurchase program.