All Aboard the Pony Express

11/16/2010 10:49 am EST


Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Jaime Peters are banking on Wells Fargo’s cheap deposits and rapid cost-cutting.

With the purchase of Wachovia, Wells Fargo (NYSE: WFC) has become a nationwide bank and was catapulted into the top tier of US banks. The bank has $1.2 trillion in assets and 6,600 offices across the nation.

Though it only has a narrow moat, this company is on the wide-moat borderline. [Morningstar uses the term of a wide or narrow moat to describe a company’s sustainable competitive advantage—Editor.] It appears to have emerged from the crisis stronger than before.

Wells Fargo has a simple but effective strategy: Build deep customer relationships and keep a close eye on credit quality. Superior execution of this sound strategy has created industry-leading returns year after year. The company doubled its size through the purchase of Wachovia, [but] we are more excited about the strong long-term return potential at this nationwide bank.

An ability to attract low-cost deposits, which allows a bank to borrow more cheaply than the government, is the typical source of a bank’s moat. Wells is one of the best banks in this regard, with an average net interest margin of 4.9% from 2003 to 2008.

The addition of Wachovia has hit the net interest margin—which was 4.38% in the second quarter of 2010—but even this lower net interest margin easily outstrips its peers’. A whopping 21% of its deposits are non-interest-bearing, helped by the ability to gather escrow deposits from its mortgage business.

We believe the main driver for Wells Fargo’s deposit growth is its customer-service model. The company sells “packages” of products rather than trying to just gather checking accounts. Knowing that the more products customers have with a bank, the longer the customers stay and the more profitable the products are, Wells sets a goal of eight products per customer.

Our biggest concern remains credit quality. Mortgages, credit cards, and construction loans were the source of most loan losses in 2008 and 2009. However, commercial loans are also hitting the company hard. Total loan losses were 2.33% of loans in the second quarter of 2010, down from the first quarter. As long as the economy continues to stabilize or improve, we believe that credit losses have peaked and will continue to improve from here.

Wells has used the crisis to improve its operations, cutting back on bonuses and achieving new scale efficiencies with the acquisition of Wachovia. This reduced its efficiency ratio [comparing expenses with revenue—Editor] from an average of 59% from 2003 to 2007 to 54% in 2009. We expect the company will give back some of its efficiency gains and trend toward 57% in the long run as it reinstates larger bonuses and meets the cost burden of additional regulatory reform, but it will still be relatively better off than before the crisis.

Our fair value estimate is $39 per share, and [the stock closed below $28 Monday—Editor].

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