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Wells Fargo, U.S. Bank, and a Look at Commercial Banking

Matthew Frankel, The Motley Fool

Industry Focus: Financials edition host Michael Douglass and Fool.com contributor Matt Frankel take a deep dive into the two largest commercial banks in the United States, Wells Fargo (NYSE: WFC) and U.S. Bancorp (NYSE: USB). Here's what investors need to know about commercial banking and how to evaluate these two bank stocks.

A full transcript follows the video.

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This video was recorded on Feb. 2, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, February 12th, and we're talking about investing in commercial banks. I'm your host, Michael Douglass, and I'm joined as per usual by Matt Frankel. Now, before we get started and get into the nitty-gritty, this is part three of our three-part series on big American banks. Part one was our December 11th episode breaking down the investment banks, Goldman Sachs and Morgan Stanley. Part two was our January 29th episode breaking down universal banks, Bank of America (NYSE: BAC), Citigroup (NYSE: C) and JPMorgan. Now we're in part three, commercial banks, that's Wells Fargo and U.S. Bancorp. We'll be running these banks through the same framework that we did the first two sets. Anand Chokkavelu, fool.com's managing editor, wrote a great piece, I really call it my banking Bible, back in 2014. It's his best attempt at a framework for how to understand a bank stock. It's a great accompaniment to this episode, because we'll be following that framework throughout. Shoot me an email at industryfocus@fool.com if you need the link, if you don't have it, because I think it really helps tie everything we're talking through together. 

With that in mind, let's go ahead and get started. What is a commercial bank, and how was it different from, say, a universal bank or an investment bank?

Matt Frankel: A commercial bank is one that looks like what you normally think of as a bank. A bank's primary business focus is to take in deposits from customers and make loans to other customers and profit from the spread in between those. Commercial banks also engage in some other activities, such as wealth management. Some have insurance operations like, they'll partner with an insurance company and sell it to their customers, safe deposit boxes, credit card businesses, things of that nature. But, in general, they avoid investment banking activities such as M&A advising, trading, underwriting, things like that. They're more of what you would consider a traditional savings and loan bank.

Douglass: Exactly. I think that's a critical thing. When you think about banking, probably, and if you haven't seen The Big Short, you're probably thinking about banks a lot like U.S. Bank and Wells Fargo. Let's start with part one of the framework, which is, how do the banks make money, and what do they actually do?

Frankel: Both Wells Fargo and U.S. Bank have, like I said, one basic activity, which is to loan money and take deposits. That split between what's known as community banking, which is, when you open a checking account, you're part of the community banking system, which refers to banking products and services that they sell to individual customers -- loans, deposit accounts, credit cards. There's also wholesale banking, which is the business banking line of it, business checking accounts, governmental banking products. And both of these are also engaged in wealth management businesses. Commercial banks don't quite put the emphasis on wealth management that the investment banks or the universal banks tend to, but it's still a big part of their business. Wells Fargo Advisors is a pretty big division, it brought in over $4 billion in revenue last quarter. So, these banks do have substantial wealth management businesses in addition to what you would normally think of as a community bank.

Douglass: And you can see this by looking at their balance sheet. Assets, Wells Fargo, about $1.94 trillion. U.S. Bank, $462 billion. Loans make up about half of Wells Fargo's assets, and closer to two-thirds of U.S. Bancorp's. Most of the rest is securities, which is tied up in all of the wealth management activity. One other thing that's important to note is assets vs. deposits. Wells Fargo, again, about $1.94 trillion in assets, about $1.3 trillion in deposits. U.S. Bank, it's $462 billion and $347 billion. So, in both cases, most of their assets are covered by deposits, and they actually have deposit exceeding their loans. That means they're still taking on some debt, but they are a lot more heavily covered than you tend to see on, for example, the investment banking side.

Frankel: Right. Investment banking, you'll see, they have a lot more securities on their balance sheet generally, in their trading divisions. Neither Wells Fargo nor U.S. Bank has a significant trading desk. That's why you see the mix shift toward mostly deposits, definitely well over half in both cases. And loans being well-covered by those deposits. They're not financing their loans with debt. Like I said, the traditional business of taking in money and trying to loan all that money out.

Douglass: Right. The other thing that really highlights that is when you look at their income statement, you look at the metrics of net interest income and non-interest income. Net interest income is, again, that money that they're making from those loans. And non-interest income is everything else. In both cases, net interest income makes up a clear majority of their total net revenue. That's, again, a sign that these are both fairly traditional banks.

Frankel: Yeah. Non-interest income includes things such as all the fees they're getting from those wealth management businesses. I mentioned that Wells Fargo's in particular is pretty big. Also, this includes things like safe deposit box rental, every time you get an overdraft fee on your bank account, the monthly checking account fees, which has become very prevalent in the banking industry, unfortunately, over the past few years. I remember, my checking account used to be free. I don't know about Michael's. These are the things that are in the non-interest income category. So, it may seem like a lot that Wells Fargo, although it's pretty much a traditional savings and loan, is generating almost $10 billion a quarter in non-interest income. It's actually pretty standard when you think of all the fees that banks charge for their services.

Douglass: Which you can think of as ancillary to those traditional banking activities. Again, an overdraft fee doesn't tell us that it's not a traditional savings and loans bank. So, yeah, part of the drawback of looking at any metric is you really have to understand the nuance. So, that's a good point to throw in there. 

OK, let's turn now to part two of the framework, which is, how expensive is the bank? Of course, there are a few different ways to approach that, but out preferred is price to tangible book value.

Frankel: Right. This is how much a bank trades for relative to the actual assets, excluding intangible items like good will that are on its balance sheet. Kind of the short way to say it is that U.S. Bancorp is expensive.

Douglass: [laughs] Yes, that would definitely be how to say it.

Frankel: They trade for a little over 3X tangible book, which is, if you've been following the first two parts of our series, is the highest of the seven banks we've discussed. Wells Fargo is right around 2X tangible book. It's interesting to note, though, that if you value these in the traditional way, price to earnings ratio, both are almost right around 16X earnings. And if you look at some of the other banks, they all trade between 15-17X earnings, despite the fact that their price to tangible book varies considerably, from Citigroup's just over 1X tangible book to U.S. Bank over 3X tangible book. That's a metric you want to look at to differentiate between all the banks, even though their price to earnings ratios may look about the same.

Douglass: And what's one of the interesting things to me about the price to earnings ratio here is, it tells us, in some ways, a different story. When you have a bank that's expensive from a book value perspective, but is, let's say cheap, or in line, at least, from a price to earnings perspective, that's usually a sign that you have a high return on equity. As a reminder, generally speaking with banks, you want to see return on equity of over 10%. Over 12% is awesome, but at least over 10%. And U.S. Bank's ROE is just under 14%. So, that's one of the reasons why, even though it's expensive from a book value perspective, it actually looks in line from a price-to-earnings perspective.

Frankel: Definitely. This is a return on equity that would be reasonably good for a bank without branches. That's almost unheard of for a branch-based bank, especially one that size. Just to give you the comparison, Wells Fargo's is 11.3%. And that's very good. Most of the other banks are right around 10% or even a little bit less. Return on assets is another one. You want to see about 1% return on assets. U.S. Bank is almost 1.4%. So, the quick way to say this is, you get what you pay for. You're paying a premium valuation for the bank, but you're getting a much higher quality banking institution. Not to say Wells Fargo is low-quality. U.S. Bank is just in a class by itself.

Douglass: Indeed. And I have to admit here that we have slipped into part three, which is, what is the bank's earnings power. But it was such a natural conversation that I couldn't resist. One of the other pieces to look at is efficiency ratio. You always want to see an efficiency ratio under 60% if possible. U.S. Bank clears that at 58.8%, and Wells Fargo doesn't, they're 66.2%. Now, there are some particular reasons for Wells Fargo's to be so high recently, we'll get to that in a bit. That's certainly something to keep an eye on. The other piece I'll throw out there is, net interest margin, almost 3.1% at U.S. Bank, which is a really, really good spread. And it's 2.9% at Wells Fargo, which is also a really good spread. Generally speaking, if you're seeing over 1.5%, I start getting pretty happy. To see them both at or near double that is a good spot to be, particularly because as interest rates continue to hopefully rise, knock on wood, there is a lot of opportunity for that interest margin to expand further.

Frankel: Yeah, definitely. To give you a comparison, Bank of America is about 2.25%, which we think is pretty good. If you have anything over 1.5%, it's nice. Another thing you want to watch for is margin expansion. Wells Fargo is a special case, we'll get to why in a minute.

Douglass: We'll just keep burying that lead.

Frankel: Yeah, we'll kick the can down the road on that one. U.S. Bank, their margins have expanded by 10 basis points over the past year. So, you can see the effect of rising interest rates at work. Just, generally, the rates banks charge for loans, outpaces the rates they're paying for deposits. So, you'll see margins expand as interest rates, hopefully, like you said, knock on wood, continue to rise.

Douglass: Absolutely. And of course, this takes us to part four, which is, what risk is the bank taking on to achieve those earnings? To some extent, when you see a lot of growth and you see a lot of good metrics with a bank, one of the first questions you really have to ask is, what's the flip side of this? Have they really found a way to build a better mousetrap? Or is this a case of loaning out money too aggressively to people who may not be a good credit risk? So, think about it this way. If you're putting out a risky loan, chances are good you're putting it out for a good interest rate -- from the bank's perspective, of course not so much from the consumer's perspective -- because you're able to charge more for someone who's higher risk. The flip side of that is, when the tide goes out and the credit cycle turns and the economy goes bad, those tend to be loans that are going to default first, which is not so great from a bank earnings perspective. So that's something you really, really have to keep an eye on. Both Wells and U.S. Bank, their net charge-offs are pretty low. Wells' is at 0.31%, U.S. Bank's is at 0.46%. Of course, cautionary point here, everything tends to look good when the credit cycle is doing well. But they both did pretty well, even through the Great Recession, comparatively speaking.

Frankel: Yeah, both of these banks have historically been known for having top-notch asset portfolios. One thing you do want to keep an eye on, both have substantial credit card businesses, especially Wells Fargo. And these tend to be, like Michael just said, riskier loans, but banks are willing to make them because, what's the interest rate on your credit card? 20%? 22%?

Douglass: Something like that.

Frankel: That's why they're willing to do it. But, those are the loans that tend to turn first when the credit cycle gets bad. So, like you said, the numbers look great right now, they look great across the board. I can't think of a bank that has a high net charge-off ratio right now. But, keep an eye on these when the tide goes out. Wells especially looks great right now, but they have a gigantic credit card business, so keep an eye on it.

Douglass: Yeah. I think one of the other things to pay attention to as well is assets over equity. Basically what that tells us is how hard is the bank levering to achieve its earnings power. Usually, if you see around 10X, you're pretty happy. Wells and U.S. Bank are right between 10-11X. So, no really big concerns there, from my perspective, at least. So, that's how that looks.

Generally speaking, returns have looked pretty good, particularly when you adjust for risk, given that their asset portfolio has been historically good. But, there are other parts to this story, and I think it's worth us talking about them. But first, of course, let's talk about taxes, because that's the story of the day with all the big banks.

Frankel: Yeah. Taxes really made fourth quarter bank earnings a real chore to read. Some banks had a big net charge-off. Citigroup, for example, had to take over a $10 billion hit in the fourth quarter, whereas some banks had a tax benefit. Wells Fargo happened to be one of the few that had a big tax benefit. They carry deferred tax liabilities on their balance sheet. And now that the corporate tax rate is 21% as opposed to 35%, those are less of a liability. So, they got to take a nice little credit this quarter. So, ignoring 2017's tax rates, just because you can't really tell what's what, in 2016 and the years before that, Wells Fargo paid an average of a little over 31%. U.S. Bank's is closer to 27%. But, the new corporate tax rate should be a tremendous boost to them and most of the other banks. Wells Fargo said in their earnings report they expect to pay 19% in 2018. Now, the difference between 31% and 19% when you're talking about a company that's generating $20 billion or whatever it is of income a year, telling them they get to keep an extra 12% of that is a big deal.

Douglass: Yeah. It absolutely is. That's going to be a big plus for banks going forward, as well as, of course, as interest rates increase, as we've already discussed. Let's talk a little bit about Wells Fargo now. If you watch or read or hear the news, you're probably familiar with the Wells Fargo scandals, the fake account scandal in particular, where, basically, a lot of people were signed up for products that they didn't need and also didn't know they had by Wells Fargo staff who were trying to meet pretty aggressive sales quotas. That not only looked quite bad and resulted in fines and class action lawsuits and a lot of money paid out, but it's also meant that Wells Fargo has really shifted its culture, or at least is attempting to. They've gotten rid of the aggressive sales targets, and they're trying to figure out how to generate really strong profitability without the incentives that cause this kind of cheating. And frankly, that means the bank is kind of in a transitional year, probably a transitional few years, as it tries to figure that out. For me, that's definitely a big concern for the bank in the near term.

Frankel: It is. Their management openly acknowledges that they're not going to be able to sell eight different banking products to every customer anymore, and this could be a drag on earnings. They're also trying to be on their best behavior right now because of all the scandals, so they're really not being pushy on Wells Fargo customers. Walking into a bank branch, I get so many fewer sales pitches now that all this has happened. But, going forward, they're doing a good job of trying to compensate in other ways. They're trying to reduce expenses on an ongoing basis by $2 billion this year and another $2 billion next year. So, it's going to be a matter of whether that's enough to make up for what they're losing by getting rid of the aggressive sales practices. If they are successful at making up for it and maintaining their 11% return on equity and fantastic asset quality, they could look like a great turnaround story. But it's kind of a work in progress. Like you said, they're in a transitional period right now.

Douglass: And particularly when you consider that it's still trading at 2X tangible book, it's not particularly cheap by most metrics. So, it feels to me a little bit like some of that optimism still remains priced in, which is one of the reasons why I'm not a Wells Fargo shareholder. I will say, with U.S. Bank, in a lot of ways, it's just a really boring bank, and that's what makes it so beautiful, is just its constant, grinding success. Not enormous success. This isn't the next Google. But it's a company that consistently does pretty well pretty quietly, without a lot of headlines or a lot of scandal or a lot of trouble.

Frankel: It's worth mentioning, both of these are Warren Buffett banks. Buffett owns both of these in his portfolio because of precisely that, they're boring and do their job and deliver strong returns year after year without -- I mean, until this year, in Wells Fargo's case -- without much headline news. [laughs] Generally, like during the financial crisis, you didn't hear about Wells Fargo in a bad light. You heard about Citigroup and Bank of America and Goldman Sachs and the others. You didn't care about Wells Fargo or U.S. Bank in a bad way. So, that's what these banks are aiming to do, and maybe Wells Fargo will be that again. But for now, we'll see.

Douglass: Yeah. Certainly, between the two, I prefer U.S. Bank just because, unlike Wells, they haven't had some major recent tarnishing event, and I do believe that you get what you pay for in a lot of ways when you're looking at big banks. I would say, of the big banks, U.S. Bank is probably my favorite of the bunch, because in a lot of ways it's the most traditional and, I would say, in a lot of ways, the simplest. And I think that's a really positive thing. What are your thoughts, Matt?

Frankel: Of the two, I would say it's really tough to make a case against U.S. Bank at these prices. Yes, it's expensive, but the bank does everything they're supposed to do. They're growing nicely. There's no reason to worry about their asset quality, just, historically, looking back to the financial crisis. And they're just an-all around very well-run institution. I'm not saying I would buy it in my portfolio right now, but if I were to take one of the two, it would definitely be U.S. Bank.

Douglass: Agreed. I'll say, for what it's worth, and I've actually had some great email conversations with listeners about this -- if you ever want to talk banks, shoot us an email at industryfocus@fool.com, I love getting mail and I love talking to folks about this sort of thing -- I personally don't own any of the big banks outside of through index funds, and I don't plan to anytime soon. My belief is that they are so large, so well-covered, and so diversified that it's difficult to see, at least for me right now, with the catalysts that we know about and the valuations that we see, it's hard for me to see market-beating returns in the next several years. So, I'm allocating my capital differently. I tend toward smaller financial companies because I believe that a disproportionate share of the profits and the returns and all that good stuff that we investors love will come from the disruptors. That's definitely its own episode for its own time.

Frankel: Yeah, I can't argue with that logic.

Douglass: Right. Well, Matt and I are both temperamentally growth investors in a lot of ways. But, that said, of the big banks, your favorite is Bank of America, mine is U.S. Bancorp. I think it's hard to make a huge case against either of them right now. So, there's definitely a lot of reason to see good things happening in the coming years, if perhaps not market-beating things happening. But, that's its own long conversation.

Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at industryfocus@fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Mat Frankel, I'm Michael Douglass. Thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Matthew Frankel owns shares of Bank of America. Michael Douglass owns shares of Alphabet (C shares). The Motley Fool owns shares of and recommends Alphabet (A shares) and Alphabet (C shares). The Motley Fool has a disclosure policy.