(Seeking Alpha) -- Wells Fargo is one of the largest banks in the U.S. in terms of loan and deposit portfolios and in terms of market cap. With assets of more than $1.9 trillion, loans of more than $950 billion and deposits of $1.3 trillion, Wells Fargo is a major player in the U.S banking sector.
During the past two years, the bank has been involved in various consumer fiascoes that partially damaged its previous spotless reputation. Investors have since been disappointed and shares have lingered despite significant improvements in important financial metrics such as net earnings growth, return on equity and efficiency ratios.
At the same time, the bank has been treating its shareholders exceptionally well, demonstrating the highest capital return story of all U.S banks. Investors have been skeptical, but now is the time to start listening again.
Improving Metrics
Wells Fargo has recently released its annual report for 2018. The numbers were encouraging and pointed to a broad improvement in many financial metrics.
In the fourth quarter of 2018, Wells Fargo generated net revenues in the amount of $21B, down $100 million compared to the same quarter last year. But the bank scored high on where it counts, the bottom line.
Earnings were $1.21 per share, up 5% compared to the same quarter last year, driven by favorability in taxes, efficiency gains and fewer shares outstanding.
Wells Fargo has done a wonderful job in cutting costs, which translated into much better efficiency ratios.
In the past quarter, the company recorded an adjusted efficiency ratio (rate of expenses from revenues) of 63.6%, compared to an efficiency ratio of 65% in the same quarter last year. In fact, Wells Fargo is becoming smaller and more efficient.
The bank has closed 300 branches across the U.S in the past year alone, which is part of a $4 billion efficiency plan to be implemented by the end of 2019. And it shows in the numbers.
The bank has recorded an impressive return on equity of 12.89% compared to only 12.4% back in December 2017, and compared to only 11.35 percent throughout 2017. That's a significant improvement.
A Wonderful Capital Return Story
The investment theme in Wells Fargo is not about revenue growth, but about consistent growth in earnings and cash flow.
That's why it is especially important to make sure the bank rewards its shareholders well. In fact, Wells Fargo is the #1 bank in the U.S banking system in terms of shareholder return which includes both dividend payouts and share repurchases.
In 2018, The bank has returned a staggering sum of $25.8 billion back to the hands of its shareholders. Specifically, the bank has spent $17.9 billion in repurchasing its shares over the past year, and has paid almost $8 billion in dividend payments.
This is in line with its shareholder return plan that was approved in July 2018, following the successful application of its CCAR tests.
Just to get things in perspective, Wells Fargo has been given a green light to increase the capital return to its shareholders by 70% (not a typo) year over year.
This is the most prominent capital return among U.S banks.
What The Market Is Missing
Investors have two main concerns regarding Wells Fargo. The first concern revolves around its damaged reputation, following several consumer scandals during the years 2016–2018.
The second concern revolves around the consent order that the bank has recently received from the Fed, putting a cap on its ability to increase its loan book.
Regarding the reputational damage, Wells Fargo has admitted to various consumer malpractices such as an unauthorized opening of more than 3.5 million accounts across its U.S branches.
These are strong claims against a bank which up until recently has been perceived as the "cleanest bank" in the U.S system, and one which has won the support and backing of legendary investor Warren Buffett.
These allegations should not be taken lightly, but they should be taken in the right context of matters.
You see, Wells Fargo has terminated the employment of various bank seniors as a result of this case. It has also altered its existing compensation scheme to its employees across its various branches.
In addition, it has paid a relatively negligible fine in the amount of $1 billion to the Fed in order to settle this matter.
Now, although some reputational damage has been done, I do not believe that this makes Wells Fargo "un-investable" as some investors claim.
Regarding the asset cap imposed by the Fed - yes, Wells is not allowed to grow its loan book above the level recorded on December 2017, but that's not game over for Wells Fargo.
You see, the investment theme in Wells is not based on revenue growth.
Instead, it is based on a massive capital return to shareholders, combined with an improving return on equity as a result of mobile penetration and closure of physical branches across the U.S.
In fact, Wells Fargo can fully implement its loan book practice without deviating from the Fed cap.
For example, over the past few quarters, Wells has been trimming its exposure to risky auto loans while increasing its exposure to classic consumer credit loans, and all that has been down within the predefined frame of the Fed asset cap.
In other words, Wells Fargo has been successfully growing its loan book, despite the asset cap, by trimming down its exposure to risky loans, which is a goal that management has set prior to the asset cap announcement.
Not less important than loan growth is the loan quality. In that aspect, Wells Fargo reigns supreme.
You see, non-accrual loans on the bank's balance sheet were a total of $6.5 billion at the end of 2018. That's a significant 15 percent reduction from the $7.7 billion of non-accrual loans recorded at the end of 2017.
Valuation Is A "BUY"
Due to the recent business turmoil regarding the bank's business practices, Wells Fargo is currently trading close to its lowest valuation over the past five years.
Specifically, the recent contraction in the multiple is especially enticing.
You can easily watch the gradual rise in revenues and earnings over the past five years (white and blue lines, respectively) versus the recent sharp decline in valuation – both in terms of book value ratio (green line) and in terms of price to earnings multiple (brown line).
I believe that this represents a very attractive entry point to a high-quality earnings compounder
Risks
There are two main risks in this investment – a business risk and a macro risk.
The business risk will materialize if Wells Fargo fails to increase its loan book over time, or successfully implements its efficiency plans.
The second risk will materialize if the U.S experiences a slowdown, which is likely to significantly increase the rate of its nonperforming loans.
My Bottom Line
Despite recent headwinds, Wells Fargo remains a high quality compounder in the U.S banking system. The bank has been successful in carrying out significant strategic cost-cutting plans while treating its shareholders very well. Current valuation presents a good entry point for years of compounding.
