Wells Fargo's Dividend Coverage Improves as Profits Stabilize But Growth Headwinds Persist

Wells Fargo remains challenged by elevated restructuring costs, ongoing legal and remediation charges tied to its fake-accounts scandal, and low interest rates, which reduce the profits earned by its lending businesses (about 50% of revenue).

Unlike its peers, Wells Fargo can't expand its balance sheet to help offset margin margin compression in its loan book.

Following its 2016 fake-accounts scandal, the Fed placed a cap on Wells Fargo's assets, preventing it from growing its balance sheet above a certain level.

The bank has yet to satisfy regulators that it has the necessary internal controls and risk mitigation systems in place to support removal of the cap.

Wells Fargo's revenue restrictions and bloated expenses combined with a pandemic-related spike in loan loss provisions to push the firm's payout ratio above 100% this summer.

While Wells Fargo continued to have a strong balance sheet and maintained capital levels well above the regulatory minimums, the bank was forced to cut its dividend in June after the Fed placed a new limitation on big banks' dividends.

Specifically, for the third quarter banks with more than $100 billion in assets were not allowed to repurchase shares, and their dividends could not be increased or exceed net income generated over the past year.

Capping the amount of capital that can be returned to shareholders provides more cushion for banks against loan losses and supports lending during these uncertain times.

On September 30, the Federal Reserve extended its capital preservation measures on America's largest banks through the fourth quarter.

Wells Fargo's lower dividend is better positioned to comply with these restrictions, but we wanted to see signs of stability in its lending businesses before considering upgrading the bank's Dividend Safety Score.

Wells Fargo reported earnings on October 14 and showed enough for us to upgrade the company's Dividend Safety Score to Borderline Safe.

After increasing its reserves for potential loan losses by $9.6 billion in the second quarter, management only saw a need to set aside $769 million in the third quarter as the economy began stabilizing.

While the downturn could still be in the early days, credit performance across almost all loan products was stronger than management would have anticipated a quarter ago.

That said, expenses remained elevated. Wells Fargo took a $961 million charge after increasing customer remediation costs tied to its past scandals. The bank also incurred a $718 million restructuring charge related to severance costs.

Altogether, after reporting a loss in the second quarter, Wells Fargo earned a profit of $1.7 billion last quarter. The company's rebased dividend costs around $400 million per quarter, resulting in a third-quarter payout ratio of 24%.

Barring a deeper dip in the economy which triggers another round of major loan loss provisions or causes long-term interest rates to plunge, we believe Wells Fargo's earnings are close to bottoming.

Management expects net interest income to be flat to slightly down next year even despite the asset cap, and remaining customer remediation costs will not be anywhere near the size of recent charges booked, per CEO Charlie Scharf.

Wells Fargo's headcount reductions are also anticipated to reduce gross run rate expenses by $1 billion annually, or close to 2% of total costs.

No one knows if the Fed will further tighten restrictions on bank dividends in quarters ahead, but based on the latest regulatory guidance and Wells Fargo's results, we expect its dividend to remain comfortably covered by earnings.

However, restoring the dividend to a much higher level seems unlikely for the foreseeable future.

Wells Fargo next quarter plans to release more detailed plans about its strategy to turn the bank around.

Slashing expenses will be a key area of focus. Not only will this involve more layoffs and restructuring costs, but there's risk that savings come at the expense of revenue attrition and customer service quality.

Wells Fargo will also need to continue investing to build out its risk and control infrastructure to satisfy its regulatory commitments and have its asset cap removed.

Coupled with a challenging interest rate environment, economic uncertainty tied to the pandemic, and political pressures, Wells Fargo's earnings power and dividend could take years to recover.

Expectations for the bank continue to look low. Wells Fargo sports a price to tangible book value ratio of 0.72x compared to 1.62x for JPMorgan and 1.23x for Bank of America.

However, management has yet to prove they can get the bank's costs under control without harming revenue, restore Wells Fargo's reputation with regulators and customers, and put the firm back on track for profitable growth.

Investors who decide to stick with Wells Fargo should be prepared for a lengthy turnaround.

In the meantime, we will continue monitoring the industry as banks grapple with rising loan losses, low interest rates, and the Fed's second round of stress tests, which will be released by year-end.