Analysts brighten on Wells Fargo's path past consumer scandals

A little more than a year after CEO Charles Scharf took the helm, Wells Fargo & Co.'s post-consumer scandal trajectory appears to be clarifying and analyst sentiment on the company is improving.

In part, the shift reflects the belief that Wells Fargo's shares, trading at about 90% of tangible book value through December 2020, are attractively priced as the bank sector moves beyond the worst fears about the pandemic's impact on credit losses. But analysts also think the company has a credible path to tame expenses that helped drive its efficiency ratio to a dismal 80% in the third quarter.

The consensus does not anticipate that Wells Fargo will soon recover the position at the top of the Big Four U.S. banks it held before its toxic sales practices broke into full public view in 2016. In 2014 and 2015, Wells Fargo handily outdid JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. in terms of return on average assets, return on average equity and efficiency.

But consensus estimates project steady improvement in efficiency at Wells Fargo over the next two years, to about 70% in 2022. Consensus estimates also have Wells Fargo recovering from a fourth-place finish in terms of return on assets in 2020 to pull roughly alongside Citi in 2021 and 2022. Citi's own expenses have recently come under pressure because of a clash with regulators over risk controls.

Brian Kleinhanzl of Keefe Bruyette & Woods is one of several analysts who have upgraded their ratings on Wells Fargo to outperform in the past two months. "We do not see [Wells Fargo] returning to the historical premium that the company once traded at versus peers," Kleinhanzl wrote in a Dec. 14, 2020, note, with the bank's return profile lowered by changes it has been forced to make to reform its sales culture. "That said, we would expect [Wells Fargo's] valuation to migrate back toward the peer multiple" of about 1.4 times tangible book value as it reduces expenses and sheds excess capital," the analyst added.

Compass Point analyst David Rochester also expects Wells Fargo to gravitate toward tangible book, arguing that "there are multiple ways something can go right" for the bank, including a credible cost-cutting roadmap and a resumption of share buybacks. Wells Fargo's net interest income could remain under pressure in the near term, and "investors have grown somewhat fatigued with consistently worsening guidance over time," Rochester wrote in a note Dec. 1, 2020, but loan growth could reappear in 2021.

Scharf has promised that the bank will provide relatively precise guidance on 2021 expenses and revenues in January, though he said in December 2020 that the medium-term outlook remains clouded by economic uncertainty.

As for the changes in the bank's business line composition, Scharf hinted at something less than transformational. When he took the job, he said that Wells Fargo's existing franchises were "extraordinary," and a "good base to build from," though executives also said that "everything is on the table" in terms of possible exits and divestitures. In December 2020, Scharf said not to expect "dramatic surgery" as the bank continues to look at "pruning" in certain areas.

Wells Fargo did recently agree to sell a $10 billion student loan portfolio after telling borrowers in September 2020 that it had decided to exit the business, though the deal was small relative to the bank's $1.922 trillion balance sheet. Even the rumored sale of its fund management operation, with about $600 billion in assets under management, might involve about $1.5 billion of forgone investment management fees in the first nine months of 2020, compared with total noninterest income and net interest income of $53.92 billion at the bank over the same time.

Wells Fargo executed business exits of a roughly comparable scale over the two years preceding Scharf's arrival. For example, in 2019 the bank sold a commercial real estate brokerage and a retirement and trust business that together generated about $800 million in revenue that year.

In all of this, Wells Fargo is waiting for the Federal Reserve to lift an asset cap once the bank completes an operational overhaul to correct the problems that gave rise to a wide range of consumer abuses. The bank has said the cap has hurt revenue by forcing it to fight balance sheet expansion during the pandemic.

Scharf has not given a specific timetable, and analyst expectations vary. KBW's Kleinhanzl believes "the company will be able to start the release process late in 2021" but won't complete the exit until the first quarter of 2022. That is longer than Kleinhanzl previously anticipated, and he lowered his EPS estimates for 2021 and 2022 to reflect the continuation of balance sheet constraints, despite his overall favorable view on the stock.

Morgan Stanley analyst Betsy Graseck, who upgraded Wells Fargo to overweight in a Nov. 30, 2020, note, said her base case was that the cap would be lifted around the fourth quarter of 2021, opening the way to loan growth.

One concrete area where Wells Fargo might be able to reduce expenses is "operating losses," a category the bank uses to record routine fraud and theft costs, but has recently been driven by attempts to make customers whole for past injuries. Such "remediation" explained most of the $1.22 billion in operating losses in the third quarter of 2020, which represented 8% of total noninterest expense during the period.

In fact, operating losses have totaled $1.22 billion or more in four of the past five quarters, compared to the $150 million executives have given for an ordinary run rate. In other words, if Wells Fargo in fact had recognized $600 million of operating losses over the 12 months through the third quarter, its expenses would have been about $4.2 billion lower — or about 40% of the roughly $10 billion in cuts it has said it might need to catch up with peers.