Thursday, July 19, 2012

Wells Fargo-Goldman Sachs Merger

(Warning: The above title is a title of a blog post, not a news headline!)

OK, so I asked in my last post if GS would be better off as part of a bigger bank and I couldn't put that thought away.  In the past there were rumored merger partners like Wachovia (that was just during the crisis, though), AIG and HSBC (and some others; WFC might have been mentioned during the crisis). 

But WFC kept coming to mind.  Both WFC and GS are owned by Buffett and he loves both of them.

First of all, this is just for fun.  I know this is a long shot and in this political/regulatory/public sentiment environment, this is probably not going to happen (if GS is an octopus, what would you call WFC-GS?!).  But this is a blog so I can write whatever I want, so that's what I'm going to do.

Also, it's a little silly to react too much to short term trends.  I did say the independent investment banks are doing horribly compared to ones that are part of bigger banks.    Morgan Stanley just announced their 2Q and it just confirms this.

So let's add MS to the table from my other post about Merrill:

Independent investment banks
                       2Q ROE                6 month ROE
GS:                 5.4%                      8.8%
MS:                3.5%                      1.4%

IB's as part of bigger banks:
                       2Q ROE                  6 month ROE
JPM (IB):       19%                        18%
JPM (AM):     22%                        22%
BAC/MER:     12%                       13%

The difference is quite clear.  MS's result is horrible.  The market environment is bad, but is it really *that* bad?  I don't know.   The results are horrible, though.

What's stunning about MS is that it's horrible across the board.

From their earnings supplement, here are the returns on average equity for the the various MS segments:

                                                   6 months periods
                                                   2012              2011
Institutional securities                0%                0%
Global wealth management       5%                2%
Asset management                     3%                *
Total                                           1%                1%

I haven't been following MS too closely but I am a bit surprised that shareholders have been so patient there.  Again, look at JPM's returns and that includes the big whale loss!  How can MS not make money?

Investment Banks Better off Inside of Other Banks
OK, so MS may be horribly mismanaged but the fact that the usually very well-managed GS is not doing too well either may imply that investment banks may actually be better off inside other banks.  This is just something that comes to mind just by looking at the facts (even though admittedly, the facts are very short term and may not be indicative of long term 'facts').

Wells Fargo-Goldman Sachs?
So this idea leads me to the Wells Fargo-Goldman Sachs merger idea.  First thing that you are going to think of is what it's going to be called (OK, maybe not the first thing or second thing...).

Wells Goldman
Wells Sachs
Fargo Goldman
Fargo Sachs
Goldman Wells
Goldman Fargo

OK, so none of these really click so let's move on.

As JPM, BAC and WFC grow domestically as the largest banks, increasingly competing in major metropolitan centers like NYC, it's interesting to note that both JPM and BAC have large investment banks.  C, which I haven't included here also has a large investment bank.

WFC stands out as not having a large investment bank even though they do have a wealth management/brokerage segment.

So in that sense, WFC-GS might make sense.  Of course, just because everyone else has something is no reason to get one for yourself.  But still, let's keep looking at this.

First let's take a look at the other large integrated banks:
                    Total assets             Equity                     Equity of IB
JPM             $2,266                     $176                             $47
BAC            $2,296                     $212                             $66
WFC           $1,314                      $140                             (n.a.?)
GS                  $923                       $69                            $69
WFC-GS     $2,237                     $209                            $69

So look at that!  GS fits like a glove into WFC and puts it into the ballpark of JPM and BAC in terms of asset size, equity and equity invested in the investment banking business (The JPM IB equity includes $40 billion for the IB and $7 billion in their asset management business).  

It fits so well it seems almost inevitable!

(WFC does have wealth management and brokerage, so the equity in that business is not zero but it's not disclosed separately (I don't think), and it's not that big)

From this point of view, it looks completely normal and reasonable.

The Merger
OK, so this is a big deal.  I briefly thought about BRK just buying GS outright, but realized that there would be some regulatory issues (don't ask me what; I don't know exactly, but it would probably be complicated).  Plus, a market cap of $47.6 billion of GS is a bit much for even Buffett to swallow now (but you never know!).  He is looking for a $20 billion whale, and maybe even a $30 billion one if cash keeps accumulating.

Buffett has said that every bone in his body tells him to hold on to his GS warrants, so we know he really likes the business and the management.

Anyway, back to the WFC-GS merger.  Since this is a whopper of a deal, the best way this can be done now would be a stock-for-stock merger.  Why?

Because WFC is trading at 1.3x book and GS is trading under book, it would be deliciously accretive to WFC!  Why not?

Of course, I doubt GS would sell itself at under book value, and certainly not 30% below book value.

But let's take a look at this anyway.  This is a blog, not a deal book (so I can do what I want!).

As of the end of 2Q2012, here are the relevant figures:

                                      WFC                       GS
BPS:                              $26.06                    $137.00
SOS:                               5.3 billion               500 million
Common equity:           $138 billion             $68 billion
Stock Price:                   $34.00                     $96.00
Market Cap:                   $180 billion            $48 billion
P/B ratio:                        1.3x                         0.7x

So at current prices, WFC would need to issue 1.4 billion shares to take out GS.  What would happen if the deal gets done right now at these levels?

After the deal, WFC would look like this:

Common equity:         $206 billion
Shares outstanding:      6.7 billion
BPS:                            $30.74/share

So this deal would be accretive by $4.70/share, or 18%.  That's a nice bump in BPS.  How many years would it take for MS to do that on it's own?   Or even GS?

Of course, with market sentiment the way it is, the market may not increase the valuation of WFC on this merger and in fact may reduce it (the market is already telling us that it doesn't like the investment banking business, as the one bank that doesn't have a major IB attached to it is trading at a higher P/B than the other two (JPM and BAC) and independent investment banks are trading below book).

But a lot of that might be offset if GS can generate higher ROE within WFC than on it's own.   The most important reason why investment banks are trading below book is their single digit ROE.

Benefits of a Merger
There are a bunch of reasons why this merger would be good and of course many that would be bad.  First of all, I would think that the regulatory and political environment would be very bad for this deal.  I'm not sure WFC wants the headache of having to worry about the Volcker rule and other regulatory issues.

On the other hand, the benefits that immediately come to mind are:
  • Cross selling of products throughout merged bank
  • Capital efficiency of having a more diversified business model
I'm sure there are plenty of other pros and cons, but I am just jotting down things that come to mind off the top of my head.

I think both MER and JPM are doing better than GS and MS partly because of the cross-selling advantage.  Dimon has mentioned that in the past.

Also, capital efficiency is another big plus, even though I understand most people would disagree with me and say that hiding a risky investment bank behind an FDIC/taxpayer supported bank is a horrible idea.  I've never subscribed to that view, but of course I understand this deal would be a nightmare for folks who do take that view.

I don't necessarily advocate this merger even though the more I think about it the better it sounds.  As an investor, we can't just react to short term results and events and seek instant gratification.

I still think it's a good idea to look at investments and evaluate them on what you think they can earn in a more normalized environment five years out or so.  So this above analysis clearly is short-term oriented; I am reacting to the poor results at independent investment banks over the past 12-18 months. 

I don't know about MS, but I still like GS and think they will do very well over time.  I do believe that this conservatism is short-term based on the uncertainties and heightened risk of a total financial blowup in Europe (and GS doesn't want to get caught with it's pants down; there would be no political will for any sort of rescue next time around).

But it is something that came to mind as I go over these results, so I just jotted it down (for fun!).

And I know, this post goes against everything everybody seems to be saying. 


  1. goldman came out bullish on housing yesterday and wells has been writing all kinds of mortgages so this company would be long us housing?.....

    1. Hi, I'm not sure what the question is, but yes, long WFC would be a long housing bet. They are big in mortgages with a large and increasing market share. If housing ever really recovers, we can expect WFC to take a big piece of that action.

    2. Hi kk,

      I accidentally came across your blog when I was searching for Druckenmiller. I like your articles a lot. Would you be interested in syndicating your content on our site? We have similar content and this syndication would give your articles more visibility.

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    3. Hi, Thanks for the comment. I am not looking at this point for more visibility or anything like that, but thanks anyway.

  2. Does WFC want an opaque derivatives book? I don't know why GS and MS are so valuable, but I'm willing to guess it has something to do with their derivatives businesses. Don't think WFC wants to go there.