A little disclaimer before you read on. This post is kind of lengthy. The point of this post is not to recommend an undervalued stock. This is a detailed look at how earnings are reported vs the way Wall Street interprets those earnings. It might get a little heavy so if you are not into company analysis and short term market conditions, I’ll forgive you for not reading this post.

For those of you that don’t know, probably most of you, Wachovia, the 4th largest bank in the US, had a bad day on April 14th. They announced a loss of $400 million for Q1 08 when it was expected they would have a profit approaching $900 million for the same period. That means Wachovia made $1.3 billion less than was expected of them. The bad news continued with the announcement of a cut in their dividend by 40%. The end result was the stock price tanking 10% in a day, and down over 50% in the last year (Wachovia chart). This is a big, stable, name brand company that employs over 100,000 people. That just doesn’t happen.

Luckily, the traditional media didn’t latch on to this too much. Had they, they would have rearranged the significance driving consumer confidence down further. But why am I interested in this and why should you? First, I mentioned before my mother’s ownership of Wachovia stock, as well as her brother and sisters. This alone is enough interest for me to monitor Wachovia (I serve as the unofficial financial advisor for my family tree). But also, Wachovia is a top 4 bank, I work at a top 4 bank. What happens to one can happen to another. All the big banks work together, despite being competitors. They borrow money from each other all the time, so the stability of one relies on the stability of others.

Despite laws that prevent insider information and trading (ahem Martha), I know more about the stability of these banks than you do because I work for them. I also benefit from having good friends within the Wachovia machine that share things with me. I know what’s happening to the stock price before it happens. So what do you care? My goal is to educate the reader (thats you) on the difference between what really happened, and what Wall St./the media think happened.

First of all, Wall Street was expecting Wachovia to post a 1st quarter profit of $900 million. With a loss of almost $400 million, you can see why I don’t put too much stock in “Wall Street’s estimates”.

What Wachovia did here was actually very smart and preemptive. Anticipating a year’s worth of bad news, Wachovia was able to distort their numbers to take big losses now. The net result is a really BAD day on the stock market, but a good year. This was April, their stock has the rest of the year to rebound. Wachovia insiders know this, Wall Street doesn’t. As usual, lets dig deeper.

Wachovia bought Golden West a while back. Golden West was a mortgage company with most of their loans of the “bad kind that started this mess” type. They bought in to get a stake of the action in California, an area of the country that Wachovia has a weak footprint in. California is one of those regions that is suffering in the real estate game, and Wachovia is going to lose some moneys because of this. Instead of waiting for the foreclosures, Wachovia (through inventive and completely LEGAL accounting practices) has started taking a loss on loans like this now. In addition to taking the loss now, Wachovia has raised more money by offering more stock to the public, which was quickly snapped up. To solidify Wachovia’s stockpile of cash, they cut their dividend. That’s a lot of babble so what does it mean? In short, it means Wachovia took a loss on loans they haven’t yet lost, and they’re hoarding in more cash than ever before to back up all their other loans.

There is another factor at work here. Wachovia was one of the first corporations to announce their Q1 earnings. They rushed through the quarter to do this. Friends were working Saturdays to get these results out just a few days early. They wanted to be first to announce the results in case the other banks were doing the same thing, it doesn’t look like the other banks are, which is even better for Wachovia.

OK OK OK OK OK! This still isn’t making sense is it? Why would Wachovia take losses they don’t have to and kill their stock price when no one else is? A Wachovia internal memo from Ken Thompson (CEO, pictured) explained what they were doing. Wachovia is on the rebound. They are expecting this credit crunch crap to straighten out in 2008, so they wanted to go ahead and bottom out NOW, while the rest of the banks bottom out on Q2 and Q3. They are cutting their losses early and piling up cash in anticipation of taking on the massive growth that occurs post-recession. Its brilliant, and Wall Street took the bait.

While Bank of America, JP Morgan, Citi, and all the other banks are busy writing off loans for the rest of 2008, Wachovia will be busy growing their business. As big as banks are, strategies are still simplistic and they can only focus on a few things at a time. The other banks are going to be busy playing defense, while Wachovia goes on the offensive. As we climb out of a recession/slowdown/whatever there are going to be market opportunities only available to those ready to take advantage of them. We don’t know what they’ll be, Wachovia doesn’t either, but they’re the only ones that will be looking for them.

Give me another couple of minutes. How do I know all this? The first sign was Wachovia’s rush to get their results out. Quickly followed by the announcement of the big loan “losses”. They rounded up their black Monday (4/14) by mentioning they raised new cash by selling more stock and cutting the dividend. Shareholders only approve dividend cuts for two reasons: to save the company, or to fund big growth. Growth stocks don’t offer dividends because they reinvest the profits in the company – to grow (look at Google). Dividend stocks are the big names without much room to grow, utility companies, conglomerates (like GE), and BANKS. Wachovia sees an opportunity to grow so they cut the dividend and raise new capital to fund it. Sidenote on raising capital (unlike Wamu and Citi), Wachovia raised new capital by selling stock. This was gobbled up immediately mostly by existing shareholders, showing confidence in the company by its owners. There is also no worry about new owners invoking radical changes.

What other signs point to my confidence in Wachovia? Read the full report from Wachovia (and if you aren’t reading these reports, you shouldn’t be buying individual stocks) and you’ll find that the 3 largest of their 4 business units actually made big profits and had big growth in the 1st quarter. The other business unit (investment banking) is suffering, but everyone’s hurting there and its their smallest segment. Deposits and loans are still growing at a fantastic rate, and revenue from their capital group grew 42% due to the purchase of AG Edwards. Wachovia still has their growing footprint in California, which houses a lot of wealthy people. Wealthy people are less likely to notice market fluctuations and the remain stable in a down market. They are hiring bankers away from the other banks, and those people are bringing with them clients with lots of cash. The bank is also hiring strategists and marketing gurus to position themselves for the rebound. By hitting rock bottom before everyone else, they’ve placed themselves in a situation to recover before everyone else.

I’m done I promise. Let’s wrap up what I just went through. Everything I just told you is public information. I’m not revealing any secrets. Wall Street and the media have a way of interpreting income statements based only on the numbers. You have to look behind the numbers; read in to what the executives are saying (and doing). Wall Street allowed the price of the stock to tank because they are worried Wachovia will continue to suffer. The point of this post is to reveal what creates the short term market fluctuations (editor’s note: in a bitter twist of irony for the panicky investors types, the stock prices has recovered since their Black Monday). Its always driven by fear. When the fearful leave the market, value is created.

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics.

categories: banking, business, economics, investing, media