Wells Fargo TARP Warrants Are Cheap, Low-Risk Leverage

By: SumZero Staff | Published: April 04, 2013 | Be the First to Comment

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Wells Fargo TARP warrants present a cheap way of leveraging onto Wells Fargo value being unlocked. The TARP warrants are the warrants the treasury forced Wells to sell during 2010. The TARP warrants strike price is $34.01 but their long duration (October 2018) and unique financial features presents an attractive opportunity to enjoy Wells Fargo's robustness and growth.

Warrants are currently priced $12 per warrant, which means that they are about $3 "in the money". I'll keep the WFC pitch short as many of us already know this grade A company, and later focus on the value proposition of the warrants.

Wells is currently undervalued and the market does not value Wells' earnings power. Here's why:

1. Earnings per share will increase in the near future because of less and less intangibles amortizations. Warren Buffett mentioned this in his Berkshire Hathaway's annual letter of 2012.

2. Interest margin will increase in the next 1-2 years when interest rates will finally pick up

3. Wells has over 200 billion available to be lent in the near future. These deposits currently pressure interest margins. In the future, when these funds can be lent out, they can add over 25% to current earnings

4. Wells is very exposed to mortgages and is set to earn from a RE recovery. Currently Wells is the largest originator in the united states.

5. Adjusted ROE for the company is over 14%, and rising, which suggests wells should be traded well over book value. In the past Wells traded at about 2.5-3 times its book value. Now it trades at 1.3.

6. In the near future the dividend the company distributes will rise well over 40c per share per quarter, depending on FED approval. In the past wells used to distribute at least 50% of earnings, which means at least 50c per share per quarter, or 66% higher than today's rate of 30c per share per quarter. Dividend level will be even higher as Wells earnings per share grow as of higher lending, higher interest margin and less intangibles amortizations.

7. Warrants are being adjusted to distributions: Strike price adjustments AND underlying stock number adjustment with every distribution above 34c per share. Under conservative estimations adjustments will add up to 10% after 6 years, up to October 2018 when the warrants expire.

Warrants proposition

I estimate that Wells Fargo share price will reach at least $60 per share by 2018 under conservative estimations on book value per share. Assuming 15% ROE and 50% distributions and buybacks, this will add to 8% growth in book value per year. Numbers are from management's estimations. Wells already achieved 14% ROE in the last quarter (adjusted for one-time and intangibles). Assuming Wells Fargo will continue trading at ratio of 1.3 P/B which is very conservative considering its history, we reach share price of $60 in 6 years.

If WFC will trade on book value alone in 2018, it will trade at about $46, but this scenario is highly unlikely as this implies Wells Fargo will have a dividend yield of about 7-8%: ROE of 15%, distributions of 50% profits on a company traded at book value.

Even using earnings multiples - currently Wells is traded at below 10 times adjusted earnings. During history Wells traded at 15 and over last years earnings. Assuming modest 4% earnings growth per year and a 15 P/E multiple we get to prices of over $70 per share. Personally I think well will trade higher but let's leave rosy predictions out and be ready for nice surprises.

The strike price of the warrant is $34.01. Assuming a very conservative 2.5% adjustments to strike price and 2.5% adjustment to the underlying warrant share count (that few people know about) this means the effective strike price will be less than $30.

It should be noted that adjusting the share count underlying each warrant is not the same as strike price adjustment. Adjusting share count for each warrant adds a leverage dependency on share price. In other words - the higher the share price, the higher the leverage, UNLIKE a regular option. Example:

Consider a regular call option with a strike price of $34.

A. If the share price is $34, the call option will be worth zero per call option at expiration.
B. If the share price is $40, the call option will be worth $6 per call option at expiration.
C. If the share price is $60, the call option will be worth $26 per call option at expiration.

Consider our warrant with a strike price of $34 per warrant and 1.1 underlying shares per warrant:
A. If the share price is $34, the warrant will be worth $3.4 per warrant at expiration.
B. If the share price is $40, the warrant will be worth $10 per warrant at expiration.
C. If the share price is $60, the warrant will be worth $32 per warrant at expiration.

Pay attention that in A the difference between the regular call option and the warrant is $3.4, and in B the difference is $4, in C the difference is $6. This means that the warrant leverage is dependent on the share price although the call option has the same strike as the warrant. This is a unique feature that is unlike any financial instrument, and presents a very appealing opportunity.

Even if WFC will trade at $46 in 6 years and the warrants will not be adjusted whatsoever, the warrant will expire at $12, today's price. This means warrants offer a very good downside protection. Considering that Wells Fargo has traded at levels it traded today very few times in history, the scenario wells will be traded at book value 6 years from today seems highly unlikely. Moreover, assuming no adjustments will be done to the warrant's strike price seems even more unlikely. Already by the end of 2013 Wells' dividend will be at or over the 34c adjustment limits, 5 years before expiration.

Other banks have TARP warrants, but we find WFC warrants the most appealing given the risk/reward ratio - Wells Fargo is the least risky out of all the biggest US banks. Most people, even Bruce Berkowitz tend to value banks by book value but history proves that this cannot be further from the truth - WFC has consistently traded at generous multiples to book value (over 2.5), while other banks like City and BAC usually traded well below twice book value (1.6). This stems from the risk in the bank business and ROE. Wells attained a consistent higher ROE than its competitors.


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