July 14, 2023

Wells Fargo & Company (WFC) reported second-quarter results this morning, and we comment on the report.

Shares of ESAB Corp (ESAB) have crossed our $68 price target so we are now formally reviewing the rating and price target.

Next week, Nokia (NOK) and First Horizon (FHN) report earnings, with Nokia issuing a profit warning. The deluge starts the following week with twelve companies reporting.

Earnings Updates

Wells Fargo & Co. (WFC) – Wells Fargo is one of the nation’s largest banks. Under its previously weak leadership, the company never fully recovered from the 2009 financial crisis and its loose compliance culture led to a fake accounts scandal and other reputation-tarnishing problems. The bank remains under heavy regulatory scrutiny, which includes a cap on the bank’s asset size. Under new CEO Charles Scharf, the bank is aggressively restructuring its operations, cost structure and regulatory compliance.

Wells reported a decent second quarter with revenues and earnings beating estimates. The bank continues to grind forward toward higher profitability and capital strength even as its regulatory and operational turnaround remains a work in progress. Trading at 120% of tangible book value per share of $36.53 and offering a reasonable 3.2% yield on the recently raised dividend of $0.35/quarter, Wells Fargo shares are attractive.

In the quarter, revenues rose 20% from somewhat depressed results a year ago and were 2% above estimates. Earnings of $1.25/share rose 56% from depressed year-ago results of $0.80/share and rose 2% from the first quarter. Earnings were about 9% above the consensus estimate.

Wells is broadly recovering from weak revenues a year ago and incrementally generating growth from the first quarter. Net interest income rose sharply from a year ago as the bank was able to boost the yields on its assets faster than the interest rates on its liabilities. Compared to the first quarter, the bank made incremental progress on net interest income.

So far, Wells is navigating the rising interest rate environment reasonably well. Deposits fell 1% from the first quarter and 7% from a year ago, indicating that some depositors are moving to higher-yielding accounts elsewhere. However, it appears that the bank is attracting “safety” deposits from other banks that are perceived to be weaker. Wells paid, on average, 1.63% interest on its deposits, up from essentially zero a year ago.

Fee income improved incrementally while expenses remain under control. The bank continues to build reserves for future credit losses (reserves equal 1.50% of total loans) faster than the modest pace that its credit losses are increasing. This quarter, its reserve increase was 2.4x its credit losses compared to a 0.7x increase a year ago. Wells’ exposure to commercial real estate (CRE) appears readily manageable and its related reserves look robust.

The return on assets of 1.05% and return on equity of 11.4% indicate that the bank is performing relatively well. Wells’ capital level is sturdy enough for now, with a CET1 ratio of 10.7%. This improved from 10.4% a year ago but ticked down from 10.8% in the first quarter – a respectable showing given the share buybacks (about 3% of the share count since a year ago), dividend, credit reserve boost and other headwinds.

Friday, July 14, 2023, Subscribers-Only Podcast:

Covering recent news and analysis for our portfolio companies and other topics relevant to value/contrarian investors.

Today’s podcast is about 7½ minutes and covers:

Comments on recommended companies

• Volkswagen (VWAGY) – getting savvier with its marketing and also replaced the head of Audi with an impressive former Porsche product development executive.
• Newell Brands (NWL) – while its turnaround has been immensely disappointing, there is new hope.
• Elanco Animal Health (ELAN) – FDA affirms the safety of its Soresto flea and tick collars.
• Bayer AG (BAYRY) – Rumors fly but are denied that the company will spin off its crop science division.
• Nokia (NOK) – trims its full-year revenue and margin guidance.
  

What the Heck Is EBITDA and Why Does It Matter?

I recently wrote the article (below) about “What the Heck Is EBITDA and Why Does It Matter.” We sent it as part of the Cabot Daily newsletter, and I thought you might find it interesting and useful.

Readers and viewers of financial media are coming across terms like EBITDA and Enterprise Value more often. Writers, Wall Street brokers, media commentators and others will say “… on an enterprise value basis, the stock is cheap” or that the “EV to EBITDA multiple is too low for a company of this quality.”

For readers who don’t mind plowing through the article below, we dig into this term to help answer the question: what the heck is EBITDA and why does it matter?

Let’s start from somewhere familiar. Most investors are familiar with the price/earnings multiple. It is simply a company’s share price divided by its earnings per share. For example, Apple’s (AAPL) shares recently traded at $190. The consensus earnings per share estimate for Apple for this year is $10.33. This produces a P/E multiple of 190/10.33, or 18.4x.

When you are buying a company’s shares, you are buying a piece of its equity. The company generates operating profits, then pays interest on its debt, then pays taxes on the remaining profits. The resulting net income goes to the equity holders, who are of course also called shareholders. As a shareholder, you are buying a share of all of the future net income of that company.

Another way to think about the P/E multiple: what you are buying are the earnings per share. What you are paying for it is the share price.

The EV/EBITDA multiple uses this exact same concept: what you are buying is the EBITDA, and what you are paying for it is the EV.

Let’s dig into these two components.

EBITDA is short for Earnings Before Interest, Taxes, Depreciation and Amortization. It represents the cash operating profits of a business. While complicated-sounding, the concept is straightforward. The EBIT part, or Earnings Before Interest and Taxes, is another name for operating profits, like we touched on in the P/E multiple comments earlier.

The DA part is an add-back for the allocation of the costs of building a company’s factories and other major investments. As an example: if a factory costs $100 million and is expected to have a 20-year life, accountants would create an annual $5 million expense that covers the annual decline, or depreciation, in the value of that factory. Amortization uses the same concept but generally relates to less-tangible investments like patents. Depreciation and amortization are not cash expenses – they are just allocations of investments made years ago.

By adding back these non-cash depreciation and amortization expenses to operating profits, we get the cash operating profits of the business.

Cash operating profits are the whole point of owning a business. We buy a business to get the future stream of the operating profits it generates in cash. We buy a business to get its EBITDA.

The Enterprise part refers to the whole business. Perhaps sometime years ago a consultant or a PhD in finance used the term “Enterprise” instead of “business” because it sounded more sophisticated. But, they mean the exact same thing. So, when we buy a business, we are buying the whole thing, the entire enterprise. We are paying for the value of that enterprise, or the enterprise value, shorted to EV.

So, just like with the P/E multiple, what you are buying is the EBITDA, and what you are paying for it is the EV.

For Procter & Gamble (PG), it has an enterprise value of $380 billion. This means that the whole business is worth $380 billion. Its estimated EBITDA for 2023 is $21 billion. This produces an EV/EBITDA multiple of 18.1x.

What is the difference between Enterprise Value and equity value? The debt. If a company has no debt, the enterprise value and the equity value are the same. The company doesn’t owe anyone any debts, so the equity holder owns everything. However, if the company has borrowed money, the lenders take a cut of the enterprise value, equal to the size of their loans. Equity holders get what is left. For most public companies, what is left is huge. The value of Procter & Gamble’s business, or enterprise, is about $380 billion, which we used in the formula above. It owes $36 billion to its lenders, so equity holders get what is left, or $344 billion.

Investors typically make an adjustment to this calculation to allow for the cash on the company’s balance sheet. This is because a company could pay down its debt with that cash. The adjustment is to subtract the cash from the debt. For Procter & Gamble, it is holding $8 billion in cash. Reducing its $36 billion in debt by its $8 billion in cash leaves $28 billion in debt net of the cash, or, said another way, $28 billion in net debt.

So, all-in, Procter & Gamble’s enterprise value of $380 billion, reduced by the net debt of $28 billion, leaves us with an equity value of $352 billion. The company has about 2.4 billion shares outstanding. Dividing the $352 billion by 2.4 billion shares produces the current price per share of about $146.

Why is all of this important? The basic answer is this: stock market investors today understand much better that a company’s cash operating profits are the best measure of its value, rather than its net income. Depreciation and amortization reflect past investments, but what matters to buyers are future investments. Interest expenses can be changed by refinancing a company’s debts. Taxes can be changed by different tax planning. Cash operating profits, or EBITDA, are the company’s economic engine, and that is what investors are buying. The immense influence of private equity firms has driven this change in thinking, as private equity firms focus on this EBITDA. Thus, today’s stock market focuses heavily on the EV/EBITDA multiple.

This concept can seem complicated at first. About 92% of investors are stumped by it. But, with some practice, you’ll be up to speed and a savvier investor.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every Rated recommendation. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time. Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at bruce@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.