Wells Fargo (NYSE: WFC) The scandal and its impact

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1 Wells Fargo (NYSE: WFC) The scandal and its impact Highlights Recent Results: WFC has a trailing 12-month basic EPS of $4.08 in the latest filing, down from $4.20 YoY. Third quarter ROE dropped 8.25% YoY from 12.21% to 11.21%, while ROA declined 12.01% YoY from 1.37% to 1.21%. Efficiency ratio increased to 59.42%, the highest since the first quarter of 2012, indicating management s deficiency with noninterest expenses. We expect a mixed result performance of EPS and ROE in midst of the expected interest rate margin improvement due to the potential Fed rate hike at the end of What s New: WFC is working through a difficult business environment after the exposure of its unauthorized account opening scandal. Multiple cities and states, including Chicago, Massachusetts, Illinois, and California, have decided to suspend their business and bond underwriting deals with WFC. We expect there will be a huge drop in account openings, credit card applications, as well as mortgage lending, resulting in shrinkage in WFC s lending abilities, hence, lowering earning potential. Operations: In recent years, WFC has kept a low net charge-offs ratio and provision for loan losses due to a well-managed risk appetite. The declining nonaccrual mortgage loans in both consumer and commercial portions also indicates a reviving housing market in the U.S., which may lead WFC to outpace its peers due to its position as the largest mortgage lender. While the macroeconomic outlook seems favorable, the microeconomic performance is contingent on whether customers will regain their confidence and trust the brand again. The negative coverage surrounding Wells Fargo certainly isn t the first of its kind, but is worrisome nonetheless. Under the current uncertainty, we target a base case scenario price at $47.00, with a range of $34.00 to $51.00, for the next 12 months. Hoyt Lui, MFin Leo Liu Hoyt.Lui@queensu.ca Liu.Liu@queensu.ca HOYT (4698) Paul Quick Hannah Wang Paul.Quick@queensu.ca Sicong.Wang@queensu.ca Key Statistics* GICS Sector Sub-Industry Financial Diversified Banks Stock Overview Price as at 10/19/16 $ mo Target Price $ wk Price Range $ Beta 0.82 Market Cap $228.36B Shares O/S 5.05B Inst. Ownership 82.14% Profitability & Yield ROE 11.83% ROA 1.20% Profit Margin 25.28% Diluted EPS (ttm) $4.05 Payout Ratio 36.58% Dividend per Share $1.515 Dividend Yield 3.35% Valuation Price/Earnings (ttm) Price/Sales (ttm) 2.45 Price/Book (mrq) 1.27 PEG Ratio (5-yr exp) 1.47 *data retrieved from Bloomberg Terminal 2016 Queen s MFin Portfolio Management Group 1 of 15

2 Price Performance Forecast Exhibit 1. WFC Outlook Scenarios. Target price: $47 Outlook: With a downside price of $34, base price of $47, and an upside price of $51, we project WFC trending down. WFC s risk management is on par with its peers. Total loans are growing steadily. We expect loans will grow at a slower rate than before, due to the impact of the account opening scandal. Price Target: $47 Bull Case: $51 Base Case: $47 Bear Case: $34 Blend of valuation methodologies: P/E and P/TBV (tangible book value) ratios, dividend discount and residual income models Investment securities, loans held for sale, and mortgage held for sale improves more rapidly than our base case. Valuation based on 2015 P/E, 2016E P/E and 2017E P/E Loan growth rate slows down, deposits decline. Valuation based on 2015 P/E, 2016E and 2017E P/E valuations WFC is not able to generate sufficient long-term return to its shareholders. Valuation based on 2015 and 2016E P/TBV, dividend discount and residual income models Our HOLD rating based on 4 key expectations: - Loan lending capacity: The recent account opening scandal leads to a pullback of deposits, which limits the bank s loan lending abilities, thus, limiting its interest-earning assets - Loan charge-offs: U.S. economy will continue to revive and WFC s net loan charge-offs will keep its nonaccrual loans low - Earnings: ROE is not able to boost back to the previous high level in the current low interest rate environment - Capital management: Efficiency ratios and other capital and leverage ratios continue to perform on par with its peers 2016 Queen s MFin Portfolio Management Group 2 of 15

3 1) Loan Lending Capacity Exhibit 2. We expect a drop in the account service charges and card fees as a percentage of noninterest income To settle the unauthorized opening of more than two million accounts, WFC paid $185 million and fired 5,300 employees. 1 More worrying than the fines paid is information released by WFC detailing some of their growth metrics for the last month of the quarter: customer visits to branches have declined 10%, credit card applications have fallen by 20%, and chequing account openings have fallen by 25%. 2 These trends are critical to the sustained performance of Wells Fargo. In recent years, deposit account service charges and card fees have been rising as total amounts, and as a percentage of the bank s noninterest income. We expect the fees charged in these two categories will drop in the next four quarters to normalize from the fraudulent account openings. The scandal facing WFC have led to severe repercussions with some of its business partners. Ohio said it would ban state business with WFC for a year. California has barred WFC from underwriting state debt, handling its banking transactions, and will not add to its investments in WFC securities for at least a year. They have also replaced the bank on two municipal bond deals totalling $527 million. 3 Illinois suspended $30 billion in investment activity from WFC. Massachusetts has removed WFC from handling the underwriting of state debt and the city of Chicago also has severed ties with WFC for one year, freezing the bank out of any work with the city and, again, including bond underwriting. The Chicago Treasurer plans to divest $25 million the city has invested with WFC (of the city s $7 billion investment portfolio). 4 As large cities and states decided to remove their business with WFC, we expect the bank will experience operational challenges within the short-tomedium term. The loan lending capacity would be limited in the following year, as shown in Exhibit Queen s MFin Portfolio Management Group 3 of 15

4 Exhibit 3. Declining loan growth particularly in the U.S. commercial and consumer segments Exhibit 4. We expect WFC s commercial loans will not grow as rapidly as before Total consumer loans are hovering around $440 to $460 billions for the past 3 years, while commercial loans grew much more rapidly, at around 10% per year. Exhibit 4 shows the most recent 6 quarters in commercial and consumer loans. However, as the account opening scandal hurts WFC s reputation, we expect some short-term fall on loan lending will happen to the bank, resulting in an average of 0.09% decline of total loan for the next 4 quarters. Exhibit 3 above shows our forecasted total loans for WFC. Exhibit 5. Decreasing commercial and consumer nonaccrual loans Under a prolonged low-rate environment, net interest margin (NIM) is constrained, interest income is lower as loan assets increase more slowly than liabilities. While Wells Fargo is the biggest mortgage lender in the U.S., the loss in NIM is partially offset by less nonaccrual commercial and consumer mortgage loans due to the improving housing market, decreasing from $17.7 billion in 2012 to $9.8 billion in As shown in Exhibit 5, declining nonaccrual debt is a positive sign for both residential housing markets and WFC. However, the increasing commercial default rate, which is largely attributable to losses in oil and gas portfolios, is also a concern Queen s MFin Portfolio Management Group 4 of 15

5 Exhibit 6. Oil and gas deterioration leads to increasing net charge-offs in 2015 Low oil prices have had an impact on WFC that is not insignificant. In 2015, $844 million in loans to the oil and gas sector were moved into the nonaccrual category, which is more than the sum of all the other sectors combined [$545 million]. Oil and gas deterioration led to increasing net charge-offs in the bank s Commercial and Industrial Portfolio. Persistent low oil price is expected to worsen the total loan portfolio for the company and lead to extra chargeoffs, which puts pressure on bank assets and profitability. Exhibit 7. UK, Canada and Eurozone play a huge part in WFC foreign loans Although WFC operates mainly in the U.S., it is involved with foreign loans and is exposed to country risk exposure; the top 30 countries comprised 8.8% of its total loans in The top three foreign countries contributing to Wells Fargo s foreign risk exposure are the U.K., Canada, and the Eurozone. While Brexit was officially announced on June , the new regulations on both private and public sectors are still yet to be outlined and implemented Queen s MFin Portfolio Management Group 5 of 15

6 2) Loan Charge-Offs Exhibit 8. We expect a reduction in the total commercial loan charge-offs in the following quarters As mentioned above, the oil and gas deterioration played a big part in WFC s nonaccrual loan. The increase in loan charge-offs in 1Q16, 2Q16 and 3Q16 is mainly contributed by the commercial and industrial category, and a large proportion of it is from the gas and oil sector. We expect oil price has been bottomed and will rise gradually, which will lead to a reduction in the total commercial loan charge-offs for WFC. Exhibit 9. We expect net loan charge-offs will remain high but decrease over time We expect WFC s net loan charge-offs will remain high in the next 2 quarters, but will decrease over time as we believe the U.S. housing sector continues to strengthen, and nonperforming loans lower in the financial statements. Exhibit 10. We expect net charge-offs ratio will hover around 0.08% to 0.09% Net charge-offs (NCO) ratio, calculated by net charge-offs over total loans, hovers around 0.08% to 0.09%. We expect total consumer loan charge-offs will decrease, resulting in a slight drop of NCO ratio for the next 4 quarters Queen s MFin Portfolio Management Group 6 of 15

7 Exhibit 11. Total commercial loan charge-offs and net loan charge-offs showing uptrend in the past 7 quarters 2016 Queen s MFin Portfolio Management Group 7 of 15

8 3) Earnings Exhibit 12. Net Interest Margin (NIM) has been decreasing over the past 4 years and is expected to revive in 2017 if Fed raises interest rate at the end of 2016 WFC, like many US-based banks, is feeling the pinch. The persistently low interest rate environment continues to pressure lending margins. On Jun 23, 2016, U.K. s referendum vote to leave the European Union will probably keep the interest rates low for the near future. We expect it will keep the global interest rate low for an extended period of time despite the Fed s projected US rate increase at the end of this year. If the Fed does raise interest rates this year, we expect WFC s NIM to improve gradually by Exhibit 13. We expect the quarterly NIM will be at its bottom in 2016 and start to rebound in 2017 As shown in Exhibit 13, the decrease in quarterly NIM slows down in We forecast NIM will maintain at the same level around 2.86% and slightly go up in 2017 if the Fed raises interest rates at the end of Exhibit 14. We expect efficiency ratio to be hovering around 58.5% for the next 4 quarters WFC s efficiency ratio jumped to 59.42% in 3Q16, the highest since 1Q12. We expect WFC will hover around 58.5% in the following 4 quarters as both net interest income and noninterest expense drop proportionally Queen s MFin Portfolio Management Group 8 of 15

9 Exhibit 15. WFC is earning sound profit compared to its peers *Data obtained from Bloomberg Terminal on Oct 19, 2016 Exhibit 15 indicates that WFC shows stronger profitability strength over its peers. With an outperforming NIM and 5- year average ROE and an on-par profit margin and efficiency ratio, we expect WFC will continue to provide reasonable return to its investors compared to its peers, given its customers won t be deterred from the scandal. Exhibit 16. Profit margin and ROE is expected to bounce back in the following quarters As dissected by the DuPont Analysis, leverage ratio is expected to decrease as loan lending is limited, resulting in the shrinkage of the growth rate of the total assets relative to that of the total equity. However, if Fed raises interest rates at the end of this year, we expect profit margin to improve in 4Q16, mainly contributed by the interest rate spread, leading to the increase in ROE. We also see a healthy asset turnover in the following quarters. Exhibit 17. Net income is expected to increase as the spread between interest income and interest expense widen We expect WFC will experience a high net income next quarter, mostly contributed by a higher interest income and a lower interest expense as shown in Exhibit 20. We forecast a decrease in short-term borrowings and long-term debt along with the Fed rate hike, which might lead to a drop in interest expense. Although projecting a decrease in service charges on deposit accounts and card fees under noninterest expense, as shown in Exhibit 21, we still see net income increase in the following quarters Queen s MFin Portfolio Management Group 9 of 15

10 Exhibit 18. We expect basic EPS will increase in 2017 Basic EPS has been increasing since 2013, but we project that trend to reverse slightly in This change will be driven by the recent scandal in the community banking segment and the resulting fallout. If interest rate is raised by the Fed, we expect to see a higher profitability for the bank, which leads to a rise in EPS in Exhibit 19. WFC has outperforming P/E and PEG ratios to its peers *Data obtained from Bloomberg Terminal on Oct 19, 2016 Exhibit 19 shows the relative valuation of WFC and its peers. The P/E and PEG ratios indicate WFC is relatively undervalued, while P/B ratio indicates WFC is relatively overvalued. Exhibit 20. Increasing average interest-earning assets leads to an increase in net interest income 2016 Queen s MFin Portfolio Management Group 10 of 15

11 Exhibit 21. We expect a drop in the service charges on deposit accounts and card fees under total noninterest income, which would adversely affect the net income earned by the bank 2016 Queen s MFin Portfolio Management Group 11 of 15

12 4) Capital Management Exhibit 22. WFC is on par with its peers regarding its efficiency, tier 1 capital and tier 1 leverage ratios By comparing to its peers, WFC has an average D/E ratio, tier 1 capital ratio and tier 1 leverage ratio, showing favorable positioning. *Data obtained from Bloomberg Terminal on Oct 19, 2016 Exhibit 23. We expect WFC s capital management will drop in 2016 but rebound in 2017 We expect all of the capital management ratios will suffer from a slight drop in 2016 as we forecast the total risk-weighted assets and the adjusted average assets outpacing tier 1 common equity, tier 1 capital and total qualifying capital. Fast tracked to 2017, we expect interest-earning assets to decrease, leading to the decrease in total risk-weighted assets. The ratios, as shown in Exhibit 23, will be rebounded subsequently, which lessen the bank s capital risk management Queen s MFin Portfolio Management Group 12 of 15

13 Valuation Our price target of $47 and bull case of $51 are based on 2015, 2016E and 2017E P/E valuation, whereas our bear case of $36 is based on 2015 and 2016E P/TBV, dividend discount and residual income valuations. Discounted 2015, 2016E and 2017E P/E valuation: We find the range of the P/E multiple from WFC s peers, then we multiply the findings by WFC s EPS to get the range of the value. Discounted 2015 and 2016E P/TBV valuation: We find the range of the P/TBV multiple from WFC s peers, then we multiply the findings by WFC s TBVPS to get the range of the value. Dividend discount model (DDM): We calculate a base case share valuation of $37.64 when applying the DDM. We use a levered beta of 1.09, a risk-free rate, which is the 10-year U.S. treasury yield curve, of 1.80%, and an equity risk premium of 8% to get the cost of equity of 10.52%. Then we use the terminal P/TBV multiple between 1.0x and 1.8x with the cost of equity between 8.5% and 12.5% to find the price range. Residual income model: We calculate a base case share valuation of $34.84 when applying the residual income valuation. Same as DDM, we use a levered beta of 1.09, a risk-free rate, which is the 10-year U.S. treasury yield curve, of 1.80%, and an equity risk premium of 8% to get the cost of equity of 10.52%. Then we use the long-term return on common equity between 8.5% and 12.5% with the cost of equity between 8.5% and 12.5% to find the price range. Exhibit 24. WFC football field based on relative valuation, dividend discount and residual income models 2016 Queen s MFin Portfolio Management Group 13 of 15

14 Exhibit 25. WFC s summary and key ratios for 5-year projection 2016 Queen s MFin Portfolio Management Group 14 of 15

15 Disclosures About Queen s MFin Portfolio Management Group Queen s Master of Finance Portfolio Management Group (PMG) seeks to invest a portion of the Queen s endowment. We aim to reinvest our investment proceeds to benefit the Queen s MFin program and PMG. Furthermore, a large part of the program is relevant to investment management and we believe PMG offers an excellent platform for transition to real-life application. The purpose of our fund is to not only bridge the gap between the classroom and practical application, but we also seek to cultivate investment intuition and entrepreneurial instincts in our members while refining leadership and collaboration skills as well. The fund is directed by students and recent graduates in its entirety. While our long-term investments follow a value-oriented selection process, we may also employ a macro-tactical framework to capitalize on short-term opportunities. Our Annual Investment Outlook helps provide direction for the latter approach, whereas the former is driven partly via fundamental analysis, sector-specific focus and the Annual Investment Outlook. Queen s MFin Portfolio Management Group Disclaimer Queen s MFin PMG is an independent investment research student-run organization. Queen s MFin PMG is not a registered broker dealer and does not have investment banking operations. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this report constitutes individual investment, legal or tax advice. Queen s MFin PMG shall accept no liability for any loss arising from the use of this report, nor shall Queen s MFin PMG treat all recipients of this report as customers simply by virtue of their receipt of this material. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as an indication or guarantee of future performance. Queen s MFin PMG executives, analysts, and/or members may from time to time have long or short positions in, act as principal in, and buy or sell, the securities or derivatives, if any, referred to in this research. The information contained in this research report is produced and copyrighted by Queen s MFin PMG. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of Queen s MFin PMG Queen s MFin Portfolio Management Group 15 of 15