By Evan Momios, CFA
Wachovia (WB; recent price: $46) is a top pick in S&P's large-cap regional banks group. It has earned that status thanks to its wide retail distribution base, capital market exposure, improved asset quality, a focus on expense controls as well as on the shareholder, above-average growth outlook, and attractive valuation. Overall, we believe Wachovia is well positioned to benefit as the economy improves. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or buy.
Wachovia was merged into First Union (the resulting company retained the Wachovia title) in September, 2001, and is now the third-largest bank in the country with $196.8 billion in domestic deposits as of June 30 (latest available), according to the Federal Deposit Insurance Co.
In July, Wachovia formed a joint venture with Prudential Securities that significantly increased its retail brokerage capabilities. The transaction was structured as a purchase of assets and not as an entity purchase. According to Wachovia management, all legal liability for actions prior to, and for 270 days following, July 1, 2003, remain with the parent company of Prudential Securities.
Wachovia's overall strategy has a strong retail focus supported by a broad distribution network and a balanced business mix that, in our view, cushions results in adverse economic environments and could generate above industry-average results in a stronger economy. In the long run, management targets earnings-per-share growth in the low teens.
In the most recent quarter, revenue was about evenly split between spread and fee income sources. Wachovia's East Coast-leading retail distribution network includes over 2,600 branch offices, 29,000 retail sales and service employees, and extends from Connecticut to Florida. Its nationwide ATM network is the country's fifth-largest, with 4,500 machines, while its online banking franchise is No. 3 in the U.S. with 6.3 million enrollments.
In addition, following the Prudential Securities transaction, Wachovia now has the third-largest retail brokerage operation, with 8,300 registered financial advisers and 3,300 investment specialists. And it's America's fifth-largest wealth manager, with $160 billion in wealth assets, according to Barron's 2003 Wealth Survey.
We believe Wachovia operates in lucrative markets with above-average demographic characteristics and growth prospects. According to the most recent data provided by SNL Financial, Wachovia has more than 90% of its branches in 73 metropolitan markets that account for about 24% of the total U.S. population. According to SNL, the median household income in the bank's metropolitan markets is estimated at $52,641, compared with a national average of $46,868, and during the last three years it has increased 10.3%, vs. a national average of 9.7%.
During the next five years, median household income in Wachovia's metropolitan markets is projected to grow 13.4%, compared with a national average of 13.6%. During that time, population growth in these metro regions is estimated to be 7.2%, compared with 5.3% for the nation.
We believe the recently announced acquisition of FleetBoston Financial (FBF; hold, $40) by Bank of America (BAC; hold, $75) hurt Wachovia's stock, as investors had anticipated that Wachovia would acquire FleetBoston Financial and expand its footprint in the lucrative New England markets. However, although FleetBoston's metropolitan markets also have above-average median household income ($57,060), they aren't high-growth markets. SNL estimates that in the next five years, median household income here will grow 11.4% and population by only 3.4%. Both rates are below national averages and those of Wachovia's metro markets.
Wachovia management has repeatedly emphasized that they'll make only acquisitions that can be beneficial to shareholders. Based on the above demographic growth comparisons, and given that Bank of America offered 2.8 times book value and 19 times projected EPS for FleetBoston, we believe Wachovia management's decision to walk away from negotiations with FleetBoston was very prudent.
Year-to-date, Wachovia's results have been driven by revenue growth, expense control, and credit-quality improvements. In the third quarter of 2003, reported results exceeded analyst expectations. Traditional banking results were particularly encouraging, in our opinion. General bank revenues accounted for 48% of revenues and 60% of net income and were up 9%, year-over-year, and up 11% from the quarter before. Noninterest expenses were up 5% and 1%, year-over-year and from the quarter before, respectively.
More important, revenues per employee increased 12%, revenues per branch 17%, and the segment's efficiency ratio (the lower the better) dropped to 58.17% from 60.71%, in the third quarter of 2002. By Evan Momios, CFA
For the consolidated company, net charge-offs declined to 0.33% of average loans from 0.43% the quarter before and 0.59% a year earlier, allowing provisions for loan losses to decline to $81 million from $195 million in the quarter before and $435 million a year earlier.
Assuming economic conditions remain strong in 2004, we believe results are likely to exceed current market expectations. We see strong consumer and small-business loan demand driving lending growth until larger commercial loan demand accelerates later in 2004. Assuming stable interest rates for most of 2004, we believe the net interest margin will fluctuate in the 3.50% to 3.55% range, supported by Wachovia's success in raising low-cost deposits and efforts to tilt its loan portfolio toward higher-yielding products.
Credit quality should remain robust, and management has indicated that a release of loan-loss reserves is possible during the next few quarters. We expect operating expenses to remain in management's focus and to trail fee income growth, which we expect to stay strong, assuming that equity market conditions remain at or above historically average levels. Using an effective tax rate of 33% and modest stock repurchase activity, we see operating EPS in 2004 advancing 11%, in line with our long-term growth projection, to $3.71, from an estimated $3.35 in 2003.
On a per-share basis, we project Standard & Poor's Core Earnings of $3.28 in 2003 and $3.63 in 2004, after adjusting for employee stock-option costs. These estimates are 2% below our operating EPS projections and at the low end of regional bank industry levels.
Over the last two years (since the First Union merger) Wachovia stock has traded at price-earnings multiples of 10 to 17, and about 13 on average. At recent levels, the stock is trading at 12 times our 2004 EPS estimate (as well as the Street's). Based on what we consider a favorable economic environment, we believe Wachovia should be trading at the high end of its historical p-e valuation range.
Compared with regional-bank peers of similar asset size and market capitalization, Wachovia appears modestly undervalued on a p-e basis. The stock seems even more meaningfully undervalued on a p-e-to-growth (PEG) basis. Based on our 2004 EPS estimate and our projected growth rate of 11%, Wachovia has a PEG ratio of about 1.1, vs. 1.3 to 1.4 for most of its peers.
Our multistage dividend discount model estimates intrinsic values of $56 to $58 for discount rates in the range of 8.45% to 8.61%. Our model starts with a 2004 EPS estimate of $3.71 and applies a growth rate of 11% that declines to 5.5% in five years, and to a constant rate of 4.5% five years later, with a payout ratio of 45% in the initial five-year period, and a constant payout ratio of 50% for the remainder of time.
Using a range of terminal p-e multiples of 12 to 15 times projected 2010 EPS estimates and discount rates in the range of 8.45% to 8.61%, we calculate present values in the $47 to $60 range.
Our 12-month target price is $55, which is nearly 15 times our 2004 EPS estimate, or 1.4 times our long-term growth estimate. We believe these are reasonable valuation multiples given our intrinsic value estimates and our view of Wachovia's fundamentals.
Key risk factors that could affect operations and prevent Wachovia from achieving our target price, in our view, are: adverse economic conditions, declining equity markets, credit quality deterioration, execution risk related to potential acquisitions, geopolitical events, regulatory risk, and headline risk.
Analyst Momios follows bank stocks for Standard & Poor's