I have recently been very critical of Wells Fargo (WFC 0.68%) because I believe the company did a poor job projecting loan losses in the second quarter, which left investors and most analysts surprised when the bank reported a $2.4 billion loss. But just because you don't like the way a company went about something doesn't mean that company lacks value. While it will be a long road to recovery, I still see Wells Fargo, one of the largest banks in the U.S., having serious value in the long term.
The asset cap
After Wells Fargo was found to have opened roughly 2 million fraudulent bank and credit card accounts, the Federal Reserve put it under an asset cap in 2018, limiting the bank to roughly $1.95 trillion in assets. This asset cap has been a nightmare for Wells Fargo, especially with the low-rate environment that saw interest rates quickly scoot back to zero in March.
One primary way that you can measure how banks make money is through the net interest margin (NIM), which is the difference between what banks pay for deposits and what they earn on loans. In a low-rate environment, because the NIM is generally smaller (although low rates also bring down deposit costs, which can help), banks lend more to offset the smaller spreads. This is normally doable because consumers want to take advantage of paying less interest. But Wells Fargo is right up against its asset cap, meaning it really won't be able to lend in the volume it needs to. The bank's NIM dropped 33 basis points (0.33%) between the first and second quarter, while the bank's net interest income dropped about $1.4 billion in that same time period.
As long as the asset cap is still in place and rates are zero -- which could be a while -- it's presumably going to be hard for Wells Fargo to generate sufficient revenue, especially if it keeps having to set aside cash to cover potential loan losses. The asset cap has now been in place for more than two years, and management hasn't been able to provide any concrete time frame for when it will be removed.
But the good news in all of this is that most investors see the asset cap as one of the main barriers blocking the company from getting back to its performance before the scandal. Once the cap is removed, the stock should see a significant bump.
The other good news for investors is that Wells Fargo CEO Charlie Scharf announced on the company's recent earnings call that it plans to cut $10 billion in annual expenses. This will improve the bank's efficiency ratio, currently a whopping 81.6% (efficiency ratio measures a bank's expenses as a percentage of its revenue, so lower is better).
This could be harder than expected. While Wells Fargo has room to reduce expenses through job cuts, which are certainly coming, and branch consolidation and closures, the bank will need to maintain or possibly spend more on the regulatory side of things because of the asset cap. Bank executives have also acknowledged they need to invest heavily in technology as well.
Scharf, who was brought in to clean up Wells Fargo, is a good man for the job, having spent years in the earlier part of his career working with JPMorgan Chase CEO Jamie Dimon, who first made a name for himself as a cost cutter. Scharf already appears to be making progress on this front and is taking a classic page from Dimon's playbook, vowing to cut spending on outside consultants, which the bank spends $1 billion to $1.5 billion on annually, according to the Financial Times.
How long is the horizon?
The bad news is that no one really has an idea about the time frame for the asset cap. The other bad news is that Scharf, on the company's recent earnings call, wasn't exactly clear if overall expenses would be down in 2021. So Wells Fargo is certainly a long-term play.
But at Friday's close, Wells Fargo was trading at $25.07 per share, or a little more than a 20% discount to tangible book value. That's after significantly cutting its dividend and dealing with a lot of pain, including the pandemic, rates falling to zero, and dismal earnings results. So at this point, it seems like a lot of the struggles are already priced in.
The stock was trading at more than $47 per share in late February before the coronavirus really started to hammer the market (a 39% premium to tangible book value), so there should be some shorter-term recovery and upward movement as the economy rebounds and we get closer to a vaccine for COVID-19.