I’ve decided to post my comments/answers to some recent questions that I have been receiving regarding Wells Fargo (WFC) and US Bancorp (USB) preferred shares/stock. This post is a follow up to my March 6 2009 article Wells Fargo and US Bancorp Slashes Dividend, which discussed their current situation and what investors should consider.
Q: What is the likelihood of a preferred dividend halt/stoppage/cut?
Its good to have an understanding of why preferred shares/stock are issued in the first place.
In a nutshell, if a company wants capital but doesn’t want to increase the debt liabilities on their balance sheet, they would issue preferred shares instead of taking loans or issuing bonds. Going to the market (equity) for capital usually allows the company to get better terms, in other words access to cheap capital. They would do this as long as they believe they would have the cash flow to pay the dividends that they stipulate for that issue. Benjamin Graham reminds us, investors should consider preferred share dividends as debt liabilities, even though it does not appear directly as one on the balance sheet. That makes sense because the dividend payment is still a monetary obligation and hence a liability.
If capital and cash flow becomes such a large problem that they need to cut or halt the preferred stock dividend, that would raise serious issues about the financial stability of the company. The consequence would also be that they would not be able to successfully raise capital by selling/issuing new preferred shares again. No one would trust that they would be able to sustain any dividend payments on the new issues/series, because of a cuts previous issues/series. A payment halt would only be done as a last resort. The likelihood of a halt is therefore related to scenarios that would lead to such dire financial circumstances occurring. This is where the investor needs to dig into the financial statements, as well as the business operations to assess the risks affecting the company’s financials and the probabilities of those risks occurring.
One thing to note when assessing to what circumstances is dire enough to halt the preferred dividend. Think of Citigroup, which has continued to pay dividends on their preferred shares in spite of what has happened. Their last payment was February 27, 2009, on their Series T, AA, and F. However, if they had not been bailed out on numerous occasions, they may have become insolvent.
Q: Are Wells Fargo & USB preferred shares/notes a good investment?
It really depends on what you want out of it. Continued dividend/interest payments with a degree of certainty? How does such an investment fit into your overall plan? Remember, preferred shares are just a tool, with certain limitations and advantages/disadvantages. You have to be the one to decide whether its a good fit for your intended purpose.
But lets suppose the main purpose is to gain continued payments. Keeping in mind the dividends are not guaranteed and preferred share prices also fluctuate. These are two minimum things you need to consider (as well as doing full research):
– Cumulative or non-cumulative – If a company halts the dividend for a period of time, cumulative holders will be paid all their accumulated arrears before common shareholders get any dividends, once they are resumed. At redemption of the preferred shares by the corporation, holders are paid all their accumulated arrears. Most US financial institutions issue cumulative, while most Canadian financial institutions are non-cumulative.
– Rate/interest/yield – Most dividend payments are at a fixed rate that was declared on the share price at time of issue, and will never change, even if the company becomes more profitable. Some dividends are an adjustable-rate that changes each quarter, as declared at time of issue. Others have rates that reset every five years, as declared at time of issue. Adjustable and resetting rates are usually based on a formula that may include the LIBOR, yield on Treasury bills, or other central bank rate. The yield on most preferred shares from US financial institutions is not adjustable, while a good portion preferred shares from Canadian financial institutions have yield rates that reset every 5 years.
My personal view and assessment is that there is a low probability that either Wells Fargo or USB preferred shares will experience dividend stoppages, due to what I believe (based on current info) is a relatively strong financial condition (as discussed in response to next question). In the worst case scenario, it is likely they would receive government assistance like Citibank did. One important trade-off that needs to consider is that because these preferreds are at fixed rates, inflation erodes the overall return over time.
Q: What is the financial condition of Wells Fargo (WFC) and US Bancorp (USB)?
Looking at the financial metrics that I talk about in the Bank Valuation series (October 2008) will definitely give you some good insight, especially with the numbers related to the loan loss reserves. We can also look at their liquidity and capital ratios. But unfortunately there are still BIG question marks because of their acquisitions. Had they not made those large acquisitions (Wells Fargo with Wachovia, and USB with Downey Financial & PFF Bancorp), their financial condition would be much more certain. I’ll focus on Wells Fargo for this response, but a similar perspective & assessment should be taken on USB.
Wells Fargo acquired Wachovia for about $12.5 Billion. They raised nearly $13B through a common share offering in the 4th quarter. Capital for the purchase itself was not a problem. The major question mark with Wells Fargo is how much more losses will they take due to Wachovia?
Wachovia’s toxic debt problems were not easily quantifiable in the first place, a good reason for the individual investor to have avoided investment in that bank directly. They kept coming out with more & increasing losses tied to credit related investments & problems. Remember also that Wachovia once stated they were the number one market leader in debt products related to real estate & structured products (master servicer of US CMBS, CMBS fixed rate loans, manager of US CDOs, etc). Back in November, WFC management estimated credit losses for its Wachovia portfolio to total $60 Billion. The question is, how accurate is that number? or will it balloon to something much much larger? If we use this number we still need to get a feel of how accurate it is, especially if we are making estimations & projections based on it.
That being said we can see that their own numbers don’t look to shabby considering all things. Their Tier 1 capital ratio was 7.9%, still a healthy number as well. However, we still haven’t seen enough of the integrated results and its impact. At the moment, its difficult to be as certain as we were before the acquisition. Until we see more of the integrated numbers (looking for them to be in line with what management estimated), any numeric estimations we do become meaningless (no degree of certainty/accuracy). We want to see how Wachovia’s numbers impact Wells Fargo’s numbers. So far, loans delinquent 90 days or more as of Dec. 31 totaled $12.65B for Wachovia & Wells Fargo combined, which was up from $6.39B for Wells Fargo alone a year earlier. The bank also said it took $37.2B of credit write-downs Dec. 31 of high-risk loans in Wachovia’s loan portfolio in order to reduce the need for provisions in the future.
In these situations we also have to look to management. In January when they reported 2008Q4, management stated that Wachovia’s loans & assets were performing as they expected. WFC’s management has a reputation for having high integrity & being conservative (avoiding most of the debt-related problems of the other major banks). We expect that type of management to have done their due diligence when it purchased Wachovia, and to be cautious & conservative in their estimations. We expect them to have taken a good look at Wachovia’s debt problems & exactly how it would impact their own bank. We also expect them to be very open & honest about mistakes and if numbers are not in line with their original estimates.
If we believe management continues to be of the caliber they are known to be, they should remain in good financial condition after the integration. If we don’t believe they did enough due diligence & their estimations were wrong, or that they are not honest about the numbers, then the deal may have been a mistake. Wachovia’s finances could then end up deteriorating Wells Fargo’s much more. Again, by how much would be difficult to determine without seeing more results.
Something to keep in mind is that Wells Fargo may also benefit from a notice by the IRS that makes Wachovia’s loan losses more valuable as deductions. The rule means Wachovia’s losses can be used to offset an unlimited amount of Wells Fargo’s taxable income over 20 years. This is a significant benefit! Just think if you were a local business owner who took on some bad debts & losses by acquiring a rival, and the government let you use it offset unlimited taxable income over 20 years.
Whenever I can’t determine with any degree of certainty or can’t do any meaningful estimates in my analysis, that means the risks/probabilities associated with that investment cannot be quantified to any degree of adequacy. Therefore odds to the success of the investment itself cannot be attached. In such cases I pass. With Wells Fargo in particular, I feel investors should wait for the next quarterly results when more integrated numbers are presented. This will give us a much better picture of Wachovia’s impact on the bank. It will make estimates much more meaningful & useful.
Q: I was expecting Wells to keep paying the dividend. Maybe I should of bought the prefered shares? Can they cut the dividend on those ones?
In your particular case, purchasing the preferred shares may have been better, since you were counting on Wells Fargo to continue paying the dividend. I suggest you read or re-read the Bank Valuation series I wrote back in Oct 2008, and especially Bank Valuation III. I discuss the dividends, and specifically mentioned Wells Fargo and why it wouldn’t be out of the question they would cut the dividend, given their circumstances at that time. Mind you, they still are the strongest US bank out there.
However, like I mentioned in the article preferred shares can also have their dividend cut/halted (rarely, and depending on the exact share issue). I believe most of the Wells Fargo ones are cumulative though, which means if they halt the payment, the payments are cumulative once they resume payouts. Remember, to read the prospectus before purchasing to know all the conditions with the specific preferred shares (all are different).
Q: I’m a bit confused because I see they have so many different names for the same thing?
The reason for the different names, is because preferred shares are issued in blocks or chunks of shares. Shares are usually issued to raise capital. With each issuing, they give it a different name, such as series I, II, III, etc.
All investors have different investment criteria, estimates/projections, knowledge, perspectives, and individual circumstances that play an important role. I encourage anyone who is interested to FULLY read the prospectus of the specific preferred share issue they are interested in, to fully understand and be aware of all the stipulated conditions (rate, any formulas, redemption price, maturity date, convertibility, cumulative/non-cumulative, payment dates, record dates, rights, etc). I can’t stress enough to always do your own homework and research before investing in anything! What may be suitable for one person may not be suitable for another.
Hope this Q&A post helps! Feel free to post questions, comments, or topic suggestions.
Thanks & Happy Investing!
The Investment Blogger