Wells Fargo’s 6.2% Preferreds: An Oasis In The Desert

Summary:

• Wells Fargo has taken its share of hits over the years.
• It has paid out more than $11 billion to compensate customers for various harms they suffered at the bank’s hands.
• The bank’s reputation leads some to be wary of it.
• Nevertheless, the bank is profitable enough to pay the dividend on its 6.2%-yield preferred shares in perpetuity.
• In this article, I make the case that Wells’ preferred shares are more enticing than its common stock.

Wells Fargo (NYSE:WFC) is one of the most hated bank stocks in America. Having been fined more than $11 billion for consumer protection offences over the last decade, it has something of a shady reputation. In the 2010s, the bank was accused of “forcing” customers into products they didn’t want. The bank did not directly order employees to do this, but it encouraged high pressure sales tactics that incentivized the behavior.

As a result of its many fines and legal settlements, Wells Fargo got quite cheap in the 2010s. It remains comparatively cheap today, trading at:

• 11.75 times earnings.

• 2.7 times sales.

• 1.23 times book value.

• 4.98 times cash flow.

After months of relative strength, many banks are now pricier than they were last year. For example, Bank of America (BAC) trades at 12 times earnings and JPMorgan (JPM) does as well. The valuation gap here is not massive, although the asset-based valuation gap does become pretty big if you make some adjustments. JPMorgan trades at 1.87 times book value. BAC trades at 1.11 times book value if you go by reported amounts. BAC’s book value multiple would seem to be lower than WFC’s multiple, but remember that Bank of America has more than $98 billion in unrealized losses on its books. If you write those bonds down to fair value then book value ($291.6 billion) shrinks to $193.6 billion. The bank has 7.9 billion shares outstanding, so book value per share shrinks to 24.5 after the adjustment, and the price/book ratio rises to 1.51. WFC does not have that much in the way of unrealized losses, so its “adjusted” price/book ratio is lower than both BAC’s and JPM’s.

There is a case to be made for buying WFC on the basis of relative valuation. It’s cheaper than its peers, and the main headwind that investors have been concerned about (lawsuits) is mostly in the past. The company is profitable, is growing, and has a lot of high quality assets. Its stock is probably worth the investment at today’s prices. Indeed, I personally would be comfortable holding WFC stock.

Nevertheless, there is another security that is even more appealing than WFC equity at today’s prices:

The same company’s preferred stock. WFC’s “Series L” preferreds (WFC.PR.L) pay a high, fixed coupon, making them the easiest of WFC’s preferreds to understand. Some others have payouts that change in a year or two, while others have lower coupons. WFC.PR.L has high income potential and is relatively straightforward in structure, so it is a good preferred for those seeking an easy-to-understand income play.

WFC.PR.L sports a 6.2% dividend yield, are perpetual, and are convertible at $155. The conversion feature is somewhat academic because it isn’t worth exercising unless the preferred stock trades at $155 or higher. Although the series ‘L’ preferred share prospectus says that each preferred share can be converted into 32 common shares, a more up-to-date statement on WFC’s website says that the shares can be converted to just 6.3814 shares. This implies that a person converting WFC.PR.L for WFC today is paying $155 per share–a 169% premium to today’s price. Wells Fargo also has the option to convert your shares into WFC common shares, but the price has to exceed $203 for that to happen–WFC is nowhere near that level. Apart from the unlikely-to-be-exercised conversion option, WFC.PR.L is not callable by the issuer.

Why Wells Fargo Preferreds are Better Than the Equity

All stocks are theoretically valued based on the discounted value of their cash flows. There are many ways of measuring cash flows: free cash flow, operating cash flow, etc. In practical terms, the cash flow that matters is the cash you take out of the stock. For dividend stocks, this can be practically represented by the dividend payments.

Wells Fargo currently pays a dividend of $1.40 per share. Its stock price is $57.61, which means the dividend yield is 2.41%. That’s just over a third the yield that WFC.PR.L pays. WFC’s dividend would need to grow to $3.58 to match that on the same company’s preferred stock. That’s a mighty hefty amount of growth WFC will have to do for its common stock to match its preferred shares’ current yield. In order to get its dividend to $3.58 in five years, WFC would have to grow at 20.6% CAGR. The company’s actual five year CAGR dividend growth rate (18.56%) is not too far off that, although the ten year growth rate (1.18% CAGR) is a far cry from the target.

The good news is that WFC’s payout ratio is just 15%, so there is considerable room to raise the dividend even in the event of low to no earnings growth. Nevertheless, it’s hard to imagine WFC stock giving as good a return as the preferreds over a 1-2 year timeframe. The expectation is for $4.78 in diluted EPS in 2024, which is basically unchanged from 2023’s level. There is little reason for a 2.48% yielding stock to provide a capital gain when treasuries have more yield. So, I’d expect WFC to trade flat over the next 1-2 years while delivering 2.48% per year in dividends. The preferreds offer higher potential returns than this.

Additionally, WFC’s preferreds are well supported by the bank’s capital stack. Wells Fargo has a whopping $316 billion in cash and equivalents, $141 billion in tangible book value, and a 10.73% CET1 ratio, well above the regulatory requirement. The cash and equity are assets that WFC can use to pay dividends even if profitability stumbles, while the CET1 ratio implies that WFC can use the cash without angering regulators.

Finally, if you discount WFC.PR.L’s $75 coupon at the current 10 year treasury yield (4.2%), you get a $1,785 price target, which is 43.5% upside. With a 6% discount rate, you get a $1,250 price target, which is about 2.5% upside. It is a buy with treasury yields between 4.2% and 6.2%. Should yields go above 6.3%, WFC.PR.L will cease to be worth owning, as the fair value estimate goes below $1,219 at that discount rate.

WFC: Challenges to Earnings

One of the reasons why Wells Fargo’s preferred shares are preferable to its common shares is because they aren’t terribly affected by the company’s biggest risk factor: legal risk. The countless fines WFC has taken over the years speak to an aggressive culture in which sales volume is prioritized over soundness. Such a bank could be at risk of writing bad loans, or doing things that get it in trouble with regulators. WFC has taken over $11 billion in fines and legal settlements in just a decade. If the next decade looks similar then WFC will probably underperform its peers, like Bank of America and JPMorgan Chase.

WFC’s preferred shares aren’t affected by this risk factor as much as the common stock is. Despite the name, preferred shares (especially non-participating preferreds) are basically a kind of debt. As long as the company remains solvent, they will likely continue being paid. The kind of financial crisis that would cause preferred dividends to be cut doesn’t come around often. It’s also pretty rare for American banks to cut the dividends on their common stock, but it’s more common than them cutting dividends on preferred shares. It’s entirely possible for WFC’s dividend growth to stall out and for common stock bought today to not hit a 6.2% yield-on-cost.

It’s here that WFC’s ethical issues and its finances intersect. According to Seeking Alpha Quant, WFC does about $17 billion a year in earnings. The five year CAGR growth rate in earnings is a mere 2.45%. $17.98 billion compounded at 2.45% over five years is $20.29 billion, or growth of $2.313 billion. If Wells takes another $11 billion in fines over the next 10 years, and it’s spread out evenly over the 10 year period, then the fines will cause earnings to decline. We would not expect WFC’s dividends to increase in this scenario. WFC.PR.L, on the other hand, will likely keep paying its dividends, as these dividends are fixed and do not require an extremely high level of profitability to be maintained. They also don’t need to grow over time in order to have a high yield: they yield 6.2% already.

A final point is worth bearing in mind: Federal Reserve policy. The Fed is expected to cut rates this year. If it does so, then treasury yields might decline, which would make WFC.PR.L’s 6% yield look more appealing in comparison. That could trigger buying in WFC.PR.L that would drive the yield down. That would imply capital gains, which would be a boon to those who buy the stock today. WFC common stock could benefit from rate cuts too, although to a lesser extent. The effect of interest rate policy on bank earnings is ambiguous. On the one hand, higher rates on loans mean higher interest revenue; on the other hand, higher interest on deposits mean higher costs. When the yield curve is inverted, the expectation is for lower net interest margins. If the yield curve un-inverts while the Fed cuts, that will probably help WFC common stock, but this is a much more specific scenario than the one where rate cuts simply cause a capital gain in WFC.PR.L: for rate cuts to benefit the common stock, more “moving pieces” (cuts, un-inversion, low deposit interest) have to be in place.

Speaking of rates:

The Big Risk

The big risk to WFC.PR.L shareholders is the inverse of the scenario just discussed: rate hikes. Thanks to rising oil prices, inflation is running a little hotter than expected this year. Just this week, the Fed said that it found recent inflation data disappointing. If inflation goes from merely “disappointing” to dangerous, then we might see hikes. Treasury yields are already climbing on the expectation of fewer rate cuts than previously expected. If inflation data gets worse, then those yields might go higher still, and make WFC.PR.L look less appealing.

Nevertheless, the current expectation is for cuts rather than hikes. Inflation is coming in hotter than expected, but it’s nowhere near the double digit levels seen in mid-2022. On the whole, WFC.PR.L looks more attractive than treasuries.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

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