Wells Fargo Clawing Its Way Back

Wells Fargo (WFC) has shown that it can self-inflict wounds on a level that��s hard to match among the largest U.S. banks. While Wells Fargo is well and truly hated by quite a few people now (including investors), management has been working to rebuild the bank on multiple levels, including employee compensation/incentives, training, compliance, and customer relations. Rebuilding the brand and reputation is going to take a lot longer, and the bank still has serious regulatory headwinds, but the underlying operations haven��t been damaged all that badly.

Wells Fargo looks undervalued, but then so do others like Citigroup (C) and U.S. Bancorp (USB) (both with their own issues/challenges), as well as JPMorgan (JPM) and PNC (PNC). I won��t make a forceful argument that Wells Fargo is a must-own at today��s price, but the long-term potential total returns look pretty interesting and this remains a massive national platform with a very strong retail deposit base.

Feeling Less Stress From The Feds

Wells Fargo is likely going to be operating under the asset cap it agreed to as part of a consent decree earlier this year until at least mid-2019, but that doesn��t mean the bank��s regulators are necessarily stepping on the bank��s throat. Wells Fargo not only passed its stress test, but the company got approval for a substantial increase in its capital returns to shareholders �� seeing as how compliance issues are part of the process, I would argue that this can be seen as at least partial affirmation by the regulators that Wells Fargo is making progress with its compliance remediation issues.

Wells Fargo is likely going to pay out more than 100% of its earnings in buybacks and dividends this year. Not only did the bank get approval for a large year-over-year increase in its buyback authorization, but at $24.5 billion, Wells Fargo��s buyback authorization is quite a bit larger than peers like JPMorgan ($20.7 billion) and Bank of America (BAC) ($20.6 billion). Keep in mind that with the asset cap in place, there are limits to how much Wells Fargo can grow, so I wouldn��t exactly get used to this level of capital return, but it is a positive development all the same.

I��d also note the company��s decision to sell 52 branches to Flagstar (FBC) for a 7% deposit premium. Regulators could have stopped this transaction dead if they��d wanted to, and instead Wells Fargo is being allowed to profitably dispose of branches it didn��t really need or want anyway.

Improving Trends, But Wells Fargo Is Hamstrung

It was just as well that Wells Fargo had lackluster loan and deposit growth in the first quarter (loans down 2% on an end-of-period basis), while JPMorgan and PNC saw 4% loan growth and U.S. Bancorp saw 2% - with the cap in place, significant growth will create some balance sheet management challenges for Wells Fargo management.

Even so, there are positive underlying trends for the bank. Wells Fargo never lost as many customers or employees as many seemed to expect when the scandals were erupting. Customer growth/attrition bottomed out around the third quarter of 2017 and the bank has gone back to seeing growth in its retail and small business customer numbers.

There are also improving underlying trends in the banking sector as a whole. Fed data shows a 5% year-over-year growth rate for loans in the second quarter, with 1.4% sequential growth. Both CRE and C&I categories grew about 5% in the quarter, and card loans were up an eye-popping 9%. Deposit growth didn��t quite keep up (up 3.5% yoy), but that��s not so surprising. While smaller banks are seeing stronger growth, the large bank subdivision isn��t doing bad at all, with loan growth of more than 2% (despite a year-over-year decline in CRE lending) and deposit growth of about 3%.

I find it interesting that large banks are outperforming on deposit growth. That could put a little more pressure on smaller bank balance sheets, as these banks often have higher loan/deposit ratios and will need to pay more to fund the loan growth they��re seeing in areas like CRE lending. Along these lines, I��d also note that Wells Fargo��s deposit betas have remained pretty healthy on both an absolute and relative basis, with a cumulative beta below 30% since this rate cycle began.

The Opportunity

Wells Fargo made a pretty good case during its May Investor Day for improving returns on equity in the coming years, as the bank intends to close or sell almost 20% of its branches, while continue to leverage IT investments to reduce costs and attract/retain customers. With that, management is targeting some meaningful expense reductions �� more than 7% from 2017 to 2020. Although credit costs should increase (the bank is at around half of management��s estimate for full-cycle charge-off ratios), management has been shifting the loan composition toward a less risky mix (lower auto, lower pick-a-pay, lower junior lien mortgages).

At this point, a prolonged period of regulatory headwinds is probably the biggest company-specific risk facing Wells Fargo. While the asset cap could be lifted in mid-2019, other banks (including M&T Bank (MTB) and U.S. Bancorp) have seen regulatory/compliance issues drag on longer than expected and a prolonged cap on balance sheet growth would certainly make it harder for the bank to generate earnings growth.

My basic outlook for Wells Fargo remains basically unchanged, though, as I expect long-term growth in the mid-single digits. That supports a healthy return today and a fair value around $60, as does the near-term outlook for ROTE (ROTE and P/TBV tend to be pretty closely correlated).

The Bottom Line

I��m sure I��ll hear from readers proclaiming that Wells Fargo��s management team should all be in jail and how they��d never even consider owning the shares. So be it �� buy and hold whatever it is you��re comfortable with, and if Wells Fargo��s actions are unforgivable to you, I certainly won��t second-guess your decision. For the rest, though, I think the valuation on Wells Fargo is interesting enough to consider, though it��s not so special that there aren��t other options in the big-bank space that look almost as good (if not better).

Disclosure: I am/we are long JPM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.