Wachovia: Bigger and Still Sound
From Standard & Poor's Equity Research We view Wachovia (WB; recent price, $56), as an industry leader with sound fundamentals and strong management. The Oct. 1 acquisition of Golden West Financial should be a long-term positive for Wachovia, in our view, as we see revenue synergies and increased diversification resulting from the purchase. We believe investor skepticism will be allayed as the integration begins and revenue growth is realized.
Wachovia has displayed consistent earnings growth, in our view, and has sound fundamentals, strong management, and a cohesive growth strategy in place. However, we think its valuation is not representational of a diversified industry leader with solid growth prospects.
We look for increased investor confidence as the integration of Golden West takes place and expect the stock's valuation multiple to expand in the quarters ahead. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).
CAST OF THOUSANDS.
Wachovia's growth in recent years has been spurred by acquisitions. In September, 2001, Wachovia merged with First Union. Other major banking acquisitions by the company include SouthTrust in November, 2004; Westcorp and WFS Financial in March, 2006; and, most recently, Golden West. Wachovia is now the fourth-largest bank in the country, with about $554 billion in assets as of June 30, 2006.
In July, 2003, Wachovia formed a joint venture with Prudential Securities, significantly increasing its retail brokerage capabilities. It is now the third-largest U.S. full-service retail brokerage firm.
Following the Golden West acquisition, Wachovia has approximately 4,100 financial centers and brokerage offices, and 5,100 ATMs. It has about 40,000 bank sales and service associates, and 10,500 registered representatives, including financial specialists and full-service brokers in bank branches. Additionally, Wachovia employs 990 wealth-management advisors, 1,400 commercial and small-business relationship managers, and 1,300 corporate and institutional coverage officers.
We consider Wachovia's business model to be more diverse than most of its peers. The company has several reporting segments: general bank (50% of revenues as of June 30, 2006), capital management (20% of revenues), wealth management (5%), corporate and investment bank (23%), and parent (2%).
The general bank business provides a broad range of banking products and services to individuals, small businesses, commercial enterprises, and governmental institutions in 16 states and Washington, D.C. It focuses on small-business customers with annual revenues up to $3 million, business banking customers with annual revenues between $3 million and $15 million, and commercial customers with revenues between $15 million and $250 million.
Capital management leverages its multichannel distribution to provide a full line of proprietary and nonproprietary investment and retirement products and services to retail and institutional clients. Retail brokerage services are offered through the offices of Wachovia Securities in 49 states and Washington, D.C., and in Latin America. Evergreen Investments, a large and diversified asset-management company, manages investments for a broad range of retail and institutional investors.
SERVICES FOR LIFE.
Wealth management provides private banking, trust and investment management, and financial-planning services to high-net-worth individuals, their families and businesses. Relationship managers and specialty advisors focus on serving clients with $2 million or more in investable assets, while family offices focus on families with $25 million or more in investable assets.
Wachovia Insurance Services provides commercial-insurance brokerage and risk-management services, employee benefits, life insurance, executive benefits, and personal-insurance services to businesses and individuals.
The corporate and investment bank unit serves domestic and global corporate and institutional clients typically with revenues in excess of $250 million, and primarily in these key industry sectors: health care, media and communications, technology and services, finance, real estate, consumer and retail, industrial growth, defense and aerospace, and energy and power.
It includes the corporate lending, investment banking, and treasury and international trade finance lines of business. It also serves an institutional client base of money managers, hedge funds, insurance companies, pension funds, banks, and broker dealers.
Wachovia acquired Golden West for approximately $25.5 billion in stock and cash. While we view the purchase price as reasonable, we believe the acquisition sparked investor concerns about heightened integration risk, credit risk, and an increase in the portion of Wachovia's revenues that will come from mortgage banking, particularly at the time of a potential housing slowdown.
However, we see long-term positives in the deal. It gives Wachovia more of a national presence, with significant branch additions in the key markets of California, Florida, and Texas. We also believe the acquisition will add higher returning assets to Wachovia's balance sheet and only moderately increase its risk exposure.
RESILIENCE IN HOUSING.
Although we see limited cost-savings opportunities and believe Wachovia will have to make capital investments in the physical build-out of branches, we view the investment in training to be more significant but also as providing the largest payoff. We also expect the revenue synergies to be significant as Golden West's branches begin offering Wachovia's mortgage products and eventually roll out its complete product offerings.
Recently, a large amount of media attention has been given to option ARM mortgages, the main holding of Golden West. While we generally consider these loans to be above average in risk, we view Golden West's underwriting ability and current loan-to-value ratios as strong. Plus, we believe that unless the U.S. economy experiences a major slowdown, including a significant falloff in labor markets and a substantial correction in real estate pricing, Wachovia should be able to handle the gradual housing slowdown that we project. We think the bank has an opportunity to pick up fixed-rate mortgages if customers begin to refinance out of these products.
In addition to its recent Golden West purchase, Wachovia has made several other major acquisitions over the past year or so. These include Westcorp for about $3.42 billion and AmNet Mortgage for over $80 million. The company also continues to make smaller scale-building and efficiency-gaining acquisitions. Furthermore, it has re-entered the credit card businesses as a direct issuer and moved to sell businesses that it does not believe are central to its strategy.
MITIGATING DIFFICULT TERRAIN.
We believe Wachovia is proving itself to be an industry leader by focusing on internal sales growth through cross-selling products, gaining efficiency by outsourcing and offshoring jobs, increasing efficiency and scale through acquisitions, focusing on customer service, and expanding its banking business with de novo branch building.
We look for several challenges for Wachovia and most other banks and financial-services companies in 2006 and 2007. One of the toughest, in our view, is increased pressure on net interest margins. It is our belief that Wachovia, being one of the largest and best-positioned banks, will be able to continue to allocate capital toward several potentially relief-offering solutions more easily than peers.
We see the company mitigating the difficult interest rate environment and increased competition by: continuing to grow low-cost deposits and increasing lending returns; focusing on fee-based, recurring income; realigning operations; using existing resources more efficiently; managing expenses; and focusing on geographic regions that have favorable outlooks.
DIVERSIFY FOR HEALTH.
While many investors have been discounting the larger, more diversified banking and financial-services players, we believe the geographic and product diversity of these companies will give them the ability to achieve consistent long-term earnings growth and prove to be drivers for their stocks in 2006 and 2007. We see large-cap/diversified banks having a competitive advantage due to their ability to handle and potentially capitalize on several market conditions that we are projecting.
Many of the larger players offer a vast array of products and services, from investment banking to transaction services. We believe this diversity, particularly in fee-based businesses with recurring income, will be a focal point for the banking industry as net interest margins are squeezed. By our analysis, businesses lines with lower correlations to general banking will help diversified firms maintain healthy growth in times when less diverse banks may be experiencing difficult conditions.
We contend that while larger banks and financial-services companies have been trading at the lower range of historical multiples of late, their true value should be realized in the year ahead. In our view, Wachovia is well-positioned and possesses many of the traits that we believe justify increased valuation based on the banking environment and global marketplace we're projecting.
GOOD GROWTH PROSPECTS.
It's our view that healthy fundamentals, organic expansion, scale, and solid credit quality are keys to continuing consistent growth in the next several years. In particular, we believe the challenges brought to net interest margins will continue to be a major concern for many financial firms going forward, as we see a flattening yield curve, a slowing of the overall housing market, increased competition, and more informed and demanding customers continuing to weigh on margins.
On Oct. 16, Wachovia reported third-quarter operating before merger-related expenses of $1.19, vs. $1.09 one year earlier, matching our estimate.
Over the past three years, Wachovia stock has traded at price-earnings multiples based on estimated earnings of 11.7 to 16.8 times, and about 13.6 times on average. At recent levels, the stock is trading at about 12 times our 2006 EPS estimate. Based on what we consider a stable economic environment, solid company fundamentals, and good growth prospects, we believe the company's shares should be priced in the mid- to high area of its historical P/E valuation range.
Compared to regional bank peers of similar asset size and market capitalization, Wachovia appears modestly undervalued on a p-e basis, trading in the bottom half of the p-e valuation range. We believe the stock is more meaningfully undervalued on a p-e-to-growth (PEG) basis. Based on our 2006 EPS estimate and our projected growth rate of 10%, it has a PEG ratio of about 1.2, vs. 1.3 to 1.6 for the majority of its peers.
Our multi-stage dividend discount model estimates an intrinsic value of about $67 for Wachovia. Our 12-month target price of $67 equates to 13.2 times our 2007 operating EPS estimate of $5.09. We believe this is a fair valuation multiple given our intrinsic value estimates as well as our view of the company's fundamentals.
We view Wachovia's corporate-governance practices as generally sound. By our analysis, the company ranks high in its industry but only slightly above average compared to other S&P 500-stock index companies.
We view the following factors favorably: Wachovia's board is controlled by a supermajority (above 75%) of independent outsiders, the nominating and compensation committees are comprised solely of independent outside directors, and a simple majority of shareholders is required to approve a merger.
On the negative side, shareholders do not have cumulative voting rights in director elections, the company has a poison pill in place, and a supermajority of votes by shareholders is required to amend certain provision of the charter or bylaws.
Risks to our recommendation and target price, in our view, include adverse economic conditions in the company's footprint, integration risk related to recent acquisitions, declining equity markets, credit quality deterioration, execution risk related to potential acquisitions, geopolitical events, and regulatory risk.