Pat Dorsey: Hi. I am Pat Dorsey, director of equity research at Morningstar. I've been addressing some big picture topics in the videos recently: profit margins across the economy, trends for the broader economy coming out of earnings season. So I thought it will be a little bit fun to change things up this week and just talk about a stock that I happen to like and that I happen to own, Wells Fargo. And there's two reasons I like Wells Fargo, and I own Wells Fargo, and they are pretty simple: cheap deposits and cross selling.
First of all, Wells Fargo is able to basically source money cheaper than just about any another large bank in the United States. Their cost of funds in the second quarter was about 77 basis points, which they then turned around and lent out at about 5.1%. So basically, their cost of funds was under 1%, it turned around and lent that out of 5%--and that's pretty good.
For comparison, Bank of America's cost of funds was about 1.3%, much higher than Wells Fargo's 0.77%, and they were only able to lend it out at 4%, so that's a much smaller, what we call, net interest margin or spread on the difference between what the bank sources of funds at and what it is able to loan the money out at, because that is essentially how bank makes money. They take it in from one area, pay a little bit of interest rate for it and then lend it out at a higher rate.
So cheap deposits are sort of the number-one reason why I like Wells Fargo, because at the end of day, banking is unfortunately a commodity business, and in a commodity business, it is the low cost producer that wins, and in many ways, Wells Fargo is a low cost producer in banking, certainly among the largest banks.Read Full Transcript
Secondly, cross selling. Wells Fargo has always been a master at cross selling. They've done a much better job than most other large banks at convincing their customers to not just have a checking account there, but to have a checking account and a mortgage and a credit card and a number of other products. Their average number of products per Wells Fargo customer is about six, which is pretty high for a bank. And what this means is that first of all, they tend to get lots and lots of revenue per customer and a lot of this is fee revenue, which is of course not credit-sensitive and tends to be very higher margin, but also it means those customers are a bit more sticky, because if you got your credit card and your mortgage and your checking account and maybe your securities portfolio at a bank, you are much less likely to move to a different bank that if you just happen to have a CD or a savings account there.
What's really benefiting Wells Fargo right now is it has been able to kind of work this cross selling magic, if you want to call it, and sort of wonderful sales culture that the bank has, on the Wachovia customers it had acquired, when it bought out Wachovia in late 2008 during the depths of the credit crunch. Basically Wachovia customers only had about 4.2, 4.3 products per customer, and so Wells has been basically training a lot of the Wachovia reps in how they get that up, and that's enabled them to post respectable loan growth in an environment where most banks frankly are having trouble making loans, because the demand for credit, as we've discussed many times, is simply structurally lower in the U.S. economy now than it has been in the past.
Wells trades for about $24 and change right now with a book value of about $21 and change. So you're only paying about 10%, 15% premium over book value for a bank that we think should be able to do 15% to 16% return on equity over the cycle, which is a very, very cheap price.
Back of the envelop, we think Wells can do between $4 and $5 in earnings power, which is pretty cheap on a $24-and-change stock. The worst case scenario for Wells really is that the U.S. goes in sort of a long-term deflationary environment, because if that really does become the outcome for the U.S. economy, sort of a Japan-like scenario over the next decade, even being able to cross sell these Wachovia customers on new products is not going to offset the deflationary pressure on loan demand.
But that said, I think buying the stock at just about book value, you're reasonably well protected on the downside, especially since that book value should grow pretty nicely over time. All-in-all, sounds like a reasonably good deal to me.
I am Pat Dorsey and thanks for watching.