Unlike most companies, Wells Fargo (NYSE:WFC) stock hasn’t rebounded much since the market crashed in March. With Wells Fargo stock at $25 now, it’s up only modestly above its multi-year low of $22, which it reached in May. And, thanks to the latest negative news, the shares are likely to remain volatile in coming days.
Specifically, on June 25, the Federal Reserve published new guidelines which will affect the nation’s too-big-to-fail banks. As a result of these changes, Wells Fargo said on June 29 that it expects to have to trim its dividend.
Tighter Capital Restrictions
The Fed’s new policy will stop banks from buying back their own stock for the immediate future. But most big banks, including Wells Fargo, had already suspended their share buybacks previously.
However, the Fed also inserted language about a dividend cap that may force some banks to cut their payouts. Under the new rule, banks’ dividends cannot exceed their average net income over the preceding four quarters, unless the Fed makes a specific exception.
Analyzing the Dividend Cut
It’s still unclear what the maximum permitted dividend for Wells Fargo will be under the Fed’s new cap. However, CEO Charlie Scharf said that:
“There remains great uncertainty in the path of the economic recovery and though it’s difficult to accurately predict the ultimate impact on our credit portfolio, our economic assumptions have changed significantly since last quarter. Accordingly, we expect our second quarter results will include an increase in the allowance for credit losses substantially higher than the increase in the first quarter.”
The higher credit allowances will result in the bank’s earnings taking a hit. By putting aside money for future loan losses, Wells is taking the pain up front while giving itself flexibility to offset future coronavirus-induced loan losses. Typically, when the economy recovers, as it did starting in 2010, banks are able to recapture many of these loan loss allowances, driving higher earnings in subsequent years.
In other words, by bracing itself for the worst now, Wells Fargo is making the prudent decision. It’s also taking preemptive measures to avoid any issues with the Federal Reserve by trimming its dividend. While this is unfortunate for shareholders in the short-run, it puts the bank on firm footing to make a quick recovery once the economy starts to pick up.
The Dividend Going Forward
As of this writing, Wells Fargo hasn’t announced precisely what its new dividend will be. Instead, the company said that it will announce the new payout level on July 14, in conjunction with the release of its Q2 earnings.
If Wells cuts its dividend in half, its new payout would be around $1 per share annually and its annual dividend yield would be roughly 4%. The bank’s earnings should easily cover that dividend unless the economy totally comes apart at the seams.
The Verdict on Wells Fargo Stock
Wells Fargo’s temporary Federal Reserve-induced dividend cut doesn’t meaningfully change the long-term appeal of its stock. The company was earning more than $4 per share in recent years and bought back nearly 20% of its outstanding stock. As a result, it should generate almost $5 of annual EPS in a normal economy. That means the shares are only trading at five times the bank’s normalized earnings. It gets better; I think Wells’ EPS can ultimately reach $6-$7 going forward as legal costs tied to the misdeeds of past management disappear.
Also, for a bit of perspective, consider that Wells Fargo last cut its dividend in the spring of 2009. At that point, its shares were trading around $15 and it slashed its dividend to 5 cents per quarter to conserve cash. Since then, the shares soared as much as 400%, and management increased the dividend tenfold from its 2009 bottom.. In other words, the last dividend cut didn’t destroy Wells Fargo stock; actually, it marked a fantastic buying opportunity.
Given that the current economic mess isn’t as bad for banks as the financial crisis was, Wells Fargo should enjoy a similar recovery after the current downturn is over. The bank has plenty of capital, and it’s aggressively taking steps to cope with the current economic downturn. Like in 2009, its profitability and dividend should quickly return to normal levels — or increase further — during the next economic rebound. As a result, its shares are a compelling buy at their current prices.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek. At the time of this writing, he owned Wells Fargo stock.