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Is Wells Fargo Toast?

- By Joseph L Shaefer

Has Wells Fargo gone from being "the best thing since sliced bread" to "toast?"

Wells Fargo & Co. (WFC) did some incredibly stupid things that came to light last fall. A bank that was a key contributor to the opening of the West and a proponent of fair business practices, and the least-fined major bank coming out of the banking fiasco of the recent recession, screwed up.


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Under its now-fired Chairman and CEO John Stumpf and his overzealous prot?g? Carrie Tolstedt, Wells Fargo employees were encouraged to open and rewarded for creating 2 million phony bank accounts. Wells has been fined $185 million -- so far -- for these transgressions. It has, however, "clawed back" incentive pay and bonuses - so far -- of $69 million from Stumpf and $63 million from Tolstedt. Leaving aside the question of why the bank believes it had to pay so much money for individuals fomenting such malfeasance that $132 million is considered only a partial payback, they are at least mitigating some of those fines.

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More importantly, Wells still has a retail franchise with more branches than any other U.S. bank. This is quite the competitive advantage. As commercial and individual customers seek to borrow before future rate increases, Wells Fargo has deep pockets that are well replenished by its many depositors nationwide. Barring another Great Recession, I believe interest rates will increase steadily in the next one to two years, which in turn will increase Wells Fargo's margins.

In addition, as the nation's largest mortgage originator, Wells will benefit as more millennials seek to buy homes and more individuals become re-employed.

Wells Fargo is the third-largest bank in the country and, until recently, employed the sharpest executives and managers. I believe this recent scandal was a one-off and the bank is now committed to restoring its customers' faith and moving forward with the strengths its size and geographic reach provide. This too shall pass.

At this price, the company enjoys an operating margin of 37% and a net margin of 25%, a retun on equity (ROE) of 10% and a return on assets (ROA) of a little more than 1%. It sells at 12.85 times earnings and pays a healthy dividend yield of just under 3%.

I began buying shares (this time) in one of my personal accounts at $54.75. I averaged down on Thursday after the revenue was reported for the first quarter as just a hair below the year-ago period and earnings just a hair above, buying at $51.75.

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I have chosen to go the relatively conservative route of buying the common shares. I have, however, also previously owned shares of the Wells Fargo troubled asset relief program (TARP) warrants and may again. For those of a more speculative bent, these might be appropriate. During the past month when the common fell 12%, the warrants plunged 30% in 30 days. That is the joy and the heartache of leverage.

The warrants (WFC.WS on BigCharts) are currently trading at $18.20. Their strike price is $34.01. That means there is a remarkably small premium to pay for this warrant (think of it as a call option that expires in October 2018.) Adding $34.01 and $18.20, we see that the premium is just 86 cents to control a share of Wellls Fargo from now until October of 2018 (34.01+18.20 = 52.21; 52.21-Thursday's close at 51.35 = 86 cents).

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The downside? If Wells Fargo closes in October 2018 at $34.01, a common shareholder has lost a good chunk of money. The warrant holder, on the other hand, has lost absolutely everything.

Of course, if the bank recovers just to $60, the common holder buying at $51.50 makes $8.50; the warrant holder is awarded $26 per warrant, or roughly the same dollar amount from $18 that the common shareholder makes spending nearly three times as much. A caveat: leverage cuts both ways. And you must be right on the direction of the stock and the timing. And - there are other adjustments that are too detailed to spin us around for this short article, but these performance adjustments could make the warrants even more worthwhile.

If you are spending mad money, I would personally rather spend it on a leveraged way to play a great company than an unleveraged way to buy a lesser company. In either case, however, let the buyer beware.

Disclosure: I am long WFC and may buy WFC.WS

(1) Do your due diligence! What's right for me may not be right for you.

(2) Past performance is no guarantee of future results. Rather an obvious statement, but most people look for past performance instead of a solid, rational approach they can agree with.

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This article first appeared on GuruFocus.