What Wells Fargo’s TARP Payback Means for Investors
Raise your right hand and repeat after me: “I will not get caught up in the banking hype.”
Now say it again. This time like you mean it.
Three banks — Citigroup (NYSE: C), Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC) — have recently agreed to pay back the billions they took from the federal government as part of the Troubled Asset Relief Program (TARP). (Other major financial institutions, notably J.P. Morgan Chase (NYSE: JPM) and Goldman Sachs (NYSE: GS), have already repaid their TARP funds.)
Wells, in fact, sold $10.4 billion worth of stock at $25 a share this morning to help it raise the cash necessary to pay off Uncle Sam, which had lent the bank $25 billion. Its shares rose modestly on the news, to $25.70.
Deutsche Bank upgraded Wells’ shares, to “buy” from “hold,” and Keefe Bruyette Woods raised Wells to “outperform.” Deutsche Bank set its price target at $36, some 40% above today’s price.
#-ad_banner-#And that’s where the wheels may have come off the stagecoach.
Paying back TARP money is seen, nearly universally, as a good thing. I certainly think so. No investor should want the federal government owning banks or making decisions that executives or board members should make on behalf of shareholders. A little regulation goes a long way: The adage suggests an ounce of prevention is sufficient, and the federal government’s oversight of TARP banks was too heavy by half.
That, alas, might really be a political discussion, which isn’t going to make anyone but Bill O’Reilly any money. So let’s get down to brass tacks: Is Wells Fargo a good buy? Is a $36 price target even remotely reasonable for these shares?
Wells has had a remarkable year. For the nine months ended Sept. 31, that is, the fevt three quarters, Wells has earned a net profit of $9.5 billion, already far and away more than the previous five years. But — and this is a crucial but — Wells still has $23 billion in bad loans on its books and only $10 billion in its loan reserve. The 2010 consensus earnings estimate for the bank, according to Bloomberg, is $1.77, less than 2009’s estimated $2.28, which was Wells’ worst performance since 2005.
Wells Fargo is typically worth 14 times earnings, though it’s trading at 11.4 times earnings today. Multiplying 11.4 times the 2010 estimate of $1.77 implies a fair-value year-end 2010 price of $20.18 at the bank’s current valuation and $24.78 if investors decide the bank is worth 14 times earnings. Either way, there’s no upside.
For Deutsche Bank’s $36 price target to come true, Wells Fargo either needs to return to normal valuation of 14 times earnings and post annual EPS of $2.57 per share, fully +45% above estimates, or it has to maintain its current valuation and blow the estimates out of the water with EPS of $3.15 a share. I don’t see that as likely.
And income investors should be especially wary: Wells will need to siphon off much of its cash earnings in the coming quarters and years to cover those $23.2 billion in bad loans. Some of those bad debts, $13.3 billion, are partially guaranteed by the government, but even if Uncle Sam picks up the tab for half, Wells still needs to come up with $16.6 billion in cash just to make up for the ill-fated loans it has already made.
Even giving Wells the benefit of the doubt, covering those losses will devour two full years’ worth of profits. But that would leave the loss reserve at zero, which no bank can do. Ensuring loss provisions are at adequate levels — currently at 3.2% industry-wide, or $11.2 billion of Wells loan portfolio — could easily mean devoting another two years of earnings to the kitty. That’s particularly worrisome for income investors, as loan-loss provisions and dividends can only be paid for with cash, cash that is in very limited supply at Wells.
It’s undoubtedly good that Wells, B of A and Citi have paid back their TARP funds. But let’s be clear: The federal government wasn’t and isn’t the only thing on these banks’ backs. They may be shed of some bad assets, but cleaning up the aftermath of the financial tsunami will take more time and more money, and, in the meantime, investors should consider looking elsewhere for opportunities.