Wells Fargo & Co (NYSE: WFC) shareholders were caught completely off guard by the extent of the company’s fraudulent behavior related to its recent $185 million settlement, and now Wells Fargo CEO John Stumpf is getting taken to the woodshed by Senator Elizabeth Warren and others on the Senate Banking Committee.
In case you’ve been living under a rock, Wells Fargo must pay $185 million in settlements to quell the damage done by Wells Fargo’s “widespread illegal practice” of signing customers up for phony accounts to meet sales quotas.
Senator Warren is calling for Stumpf to take responsibility and resign. “It’s gutless leadership,” Warren said.
WFC stock is down 8.5% since the beginning of September, and there is likely more downside in the near term.
What’s $185M to WFC Stock?
First of all, WFC should have no problem managing the $185 million settlement itself. WFC generated $22.9 billion in income in 2015. However, the actual cost related to the fraud charges will be much higher.
This was not simply a case of one rogue banker taking advantage of customers. Wells Fargo reportedly opened 85,000 fraudulent accounts. That’s not a bad apple; that’s a rotten orchard. WFC now has to completely re-think its sales strategy. It has already dropped its sales quotas for bankers and put a temporary hold on cross-selling financial products. But if WFC has been up to anything else sketchy in recent years, regulators will now be searching extra hard to dig it up.
WFC investors shouldn’t be surprised if the Federal Reserve is particularly tough on WFC next year during its CCAR. After all, the stress tests, the CCAR and even the creation of the Consumer Financial Protection Bureau were all intended to prevent this type of dubious behavior within the banking industry.
This week, UBS analyst Brennan Hawken said that he believes the combination of the costs associated with a shifting business strategy and intensifying regulatory scrutiny will knock 10 cents off of Wells Fargo’s 2017 per-share earnings.
A Blow to the Reputation of Wells Fargo
The cost to Wells Fargo’s business is one thing, but it’s hard to put a price on reputation. Justified or not, Wells Fargo had gained a reputation as the “good one” among the biggest U.S. banks.
WFC mostly avoided the headlines that plagued Bank of America Corp (NYSE:BAC), Citigroup Inc (NYSE:C) and other big banks following the financial crisis of 2008. Sure, WFC had its fair share of mortgage-related settlements, but its focus on deposits and loans, rather than trading revenue, earned WFC a reputation as a high-quality traditional banking pure-play. WFC was considered the safe bet among the big banks because it delivered dependable and reliable earnings. Or so we thought.
This PR nightmare is certainly not flying under the radar. In the wake of the scandal, social media sentiment toward Wells Fargo has plummeted from 24% positive and 31% negative to 3% positive and 74% negative.
Breaking Up Is Hard to Do
Personally, I find it extremely unlikely that the government will break up the big banks. The logistics of the process seem like a nightmare. But Wells Fargo has certainly provided some fresh fuel for those calling for breakups.
Activist investor Bart Naylor believes that a breakup could be good news for WFC shareholders. This week Naylor filed a shareholder resolution calling on WFC to investigate “whether the divestiture of all non-core banking segments would enhance shareholder value.”
In the meantime, general breakup-related fears and uncertainty are likely to continue to weigh on WFC stock.
Better Options Than WFC Stock
Banks have struggled to grow profits and share prices in the modern low-rate, high-regulation banking world. However, the majority of economists now expect the Fed will get back on track raising interest rates by the end of the year.
Bank stocks as a whole are poised for a cyclical upswing as soon as their net interest margins get some relief from rising interest rates. With the stock market at an all-time high, bank stocks are one of the few groups in the market that still look cheap. However, some bank stocks are cheaper than others.
Incredibly, BAC and Citigroup still trade at only about 0.6x book value. WFC stock, on the other hand, trades at about 1.3x book value. This premium may have been justified when investors thought WFC was the only bank playing by the rules. Now BAC and C look like the better value plays.
At a forward price-earnings of only 11.0, WFC stock will probably be fine in the long-term, assuming the company can avoid any more negative headlines. The downside for WFC stock from the fraud settlement, however, is likely not fully realized just yet.
In the near-term, there are better value buys out there in the risky banking sector.
As of this writing, Wayne Duggan was long C stock.
