Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
It's been 16 months now since a far-reaching scandal rocked Wells Fargo's (NYSE:WFC) stock, revealing how the bank opened millions of deposit and credit card accounts on behalf of customers -- but without their authorization or knowledge.
Since then, other misdeeds have been alleged. Wells Fargo has lost one CEO, reshuffled its board of directors, paid tens of millions of dollars to settle lawsuits, and seen new customer acquisitions plummet. You can find all the gory details in this summary prepared by my Foolish colleague John Maxfield last year.
And yet, the bad news passed, time marched on, and Wells Fargo stock has marched higher -- up 40% since the stock hit its low point in September 2016. What's more, one analyst believes Wells Fargo stock could be poised to march even higher in 2018.
Upgrading Wells Fargo
Characterizing what little bad news still dribbling out of Wells Fargo as mere "unfortunate distraction" from a bigger growth story, NYC-based investment firm Sandler O'Neill announced today it is upgrading Wells Fargo stock to buy and assigning the shares a new price target of $73. Relative to the stock's current $62 share price, that implies a nearly 18% profit over the next year for new buyers. Combined with Wells Fargo's market-beating 2.5% dividend yield, that works out to more than a 20% anticipated profit over the next 12 months.
All's well at Wells, and it's getting even better
What has Sandler O'Neill feeling so optimistic about Wells Fargo stock? As the analyst argues in a note covered by StreetInsider.com (requires subscription) this morning, there are several reasons to expect Wells Fargo to outperform in 2018.
For one thing, Sandler O'Neill highlights Wells' ongoing efforts to cut costs from its business, and improve profits. Even before news of the scandal broke, the analyst points out, Wells Fargo was performing poorly, with revenue growth anemic and profit margins falling. From a recent high of 40.9% in 2014, Wells' earnings before taxes profit margin fell to 36.6% over the past 12 months, according to data from S&P Global Market Intelligence. Net profit margins over the same period have declined from 27.8% to 24.9%.
But Wells is "still in the early innings" of an effort to cut $2 billion in annual costs from its business, according to Sandler O'Neill -- savings that should show up in the company's earnings this year. The analyst expects Wells Fargo to then embark upon another $2 billion worth of cost reductions in 2019. If implemented in full, the combined $4 billion in cost-cutting should be more than enough to boost profit margins and move the needle on Wells Fargo's bottom line, where net income last year was just under $22 billion.
Delivering on dividends
With more profits to work with, Sandler O'Neill also expects Wells Fargo to meaningfully improve its dividend payout -- which at 2.5%, is already a full 0.5 percentage point above what "most regional banks" pay. Sandler predicts we could see Wells Fargo hike its dividend by about one-fifth before the year is out -- from $0.39 to $0.46 per share, per quarter.
This would push Wells Fargo's dividend yield up to nearly 3%.
The most important thing: Valuing Wells Fargo
With Wells Fargo stock priced at 14.5 times trailing earnings, and pegged for a 7.7% long-term growth rate by analysts surveyed by S&P Global, Sandler O'Neill argues the stock is priced at a large discount "to other large regionals covered by this analyst." But here's what's so curious about that pronouncement:
Wells Fargo isn't really a regional bank at all, but rather a large megabank like Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM), and Bank of America (NYSE:BAC). Since the financial crisis of 2008, Wells has most often been discussed in the context of these three megabank peers -- not compared to regional banks -- and for good reason. According to data collected by Bankrate.com, Wells Fargo is one of the four biggest banks in America. Indeed, with $1.95 billion in total assets, it's the third-largest bank in America, ranking above Citigroup, and not far behind Bank of America and JPMorgan.
Why is this important to investors? Simply put, because when compared to its actual peers (as opposed to smaller regional banks), Wells Fargo doesn't actually look like as big of a bargain as Sandler O'Neill describes. Wells Fargo's 14.5 price-to-earnings (P/E) ratio may be cheaper than Bank of America's 15.4 P/E, but it's more expensive than JPMorgan Chase at 14 times earnings, and much more expensive than Citigroup at 12.6 times earnings.
Similarly, growth-wise, analysts have Wells Fargo pegged for 7.7% long-term earnings growth, which is faster than the 5% growth expected out of JPMorgan -- but slower than the 8.6% growth rate posited for Citigroup, and the 14.2% rate of growth predicted for Bank of America.
Long story short? Wells Fargo has had a good long run, gaining 40% from its post-scandal nadir. Today's price of 14.5 times earnings, however, doesn't look objectively attractive in light of 7.7% growth projections. It's even less attractive relative to Wells Fargo's peer megabanks -- which may be why Sandler O'Neill felt compelled to compare Wells Fargo to regional banks to make its case that this stock is a buy.