Amidst today's markets, finding "value stocks," at least in the classic sense of the word, has become increasingly challenging. While we believe that the term "value stock" need not be limited to "cheap" stocks, due to the fact that all stocks are purchased for the purpose of creating value for investors, many still see the market through the prism of value vs. growth (we however, often find value in growth). And as the S&P 500 has continued to rise, such "value stocks" have become increasingly challenging to identify. Therefore, we look beyond the United States when searching for such value stocks, and in recent months have come across a particularly noteworthy group of stocks that we believe present meaningful value: European banks. Given continued worries over the European debt crisis, the continent's weak economy, and ongoing loan losses, many of the continent's banks trade well below book value and at P/E ratios that approach single digits. In the past several months, we have identified three separate European banking stocks that we believe present attractive investment opportunities; the first was The Royal Bank of Scotland (RBS), the second was Commerzbank (OTCPK:CRZBY), and the third was Credit Agricole (OTCPK:CRARY). We present the performance of these recommendations in the table below.
European Bank Equity Performance
Closing Price on Publishing Date
Closing Price, January 22, 2014
Country Benchmark Return*
*The three benchmarks used are be the respective iShares MSCI ETFs for the United Kingdom, Germany, and France
Of the three European banks we have previously recommended, two have achieved positive absolute returns as of the close of trading on January 22, 2014, and two out of the three have outperformed their respective country benchmarks. And in the aggregate, an investment in all three banks would have given investors returns that are meaningfully higher than an investment in either their respective domestic equity markets.
Today, however, we wish to present our recommendation on a fourth European bank, one that currently trades at valuations ascribed to Italian and Spanish banks, but that has little in common. Despite the fact that double-digit EPS growth is expected for both 2013 and 2014, this bank's EPS multiples hover near the single digits, trading well below its European peer group, and its price-to-book multiple reflects a similar discount. We believe that as 2014 progresses, the value embedded within this bank will be unlocked, delivering meaningful value for shareholders. And that bank is ING, the largest bank in the Netherlands, and the 10th largest in Europe (ING trades in Amsterdam under the ticker INGA and in New York under the ticker ING). And as ING continues its recovery and exits its bailout program, we see upside of at least 20%, and possibly more as the bank is rewarded for the relative boredom and stability of its businesses. The pending divestiture of the bank's remaining insurance business will further simplify the bank's structure and help complete its transformation into an even more "vanilla" bank, albeit one of the largest in Europe. Unless otherwise noted, financial statistics and managerial commentary used in this article will be sourced from the following: ING's Q3 2013 earnings presentation, or its Q3 2013 financial statements.
Despite its small size, the Netherlands plays a key role in the European financial system, and as the largest bank in the Netherlands, ING is the linchpin of the Dutch financial system. With over €1.1 trillion in assets, ING is one of Europe's largest banks, but despite its size, is also one of the simplest, akin to the role Wells Fargo (WFC) plays in the United States. Today, the vast majority of ING's revenues and profits come from plain retail and commercial banking activities, as well as life insurance, and whereas many of its peers spend much of their earnings presentations discussing their investment banking and capital markets activities, ING devotes its presentations to discussions of its mortgage portfolios and life insurance operations. Furthermore, ING's exposure to European periphery nations is limited, with less than €64 billion in total risk exposure to the six most troubled Eurozone states (the PIIGS nations and Cyprus). However, ING's current simplicity does not make up for its crisis-era transgressions, and the bank required billions of euros in assistance from the Dutch government. The bailout of ING consisted of two separate programs. The first, announced in October 2008, consisted of a €10 billion capital infusion into ING, and the second program, announced in January 2009 and dubbed the Illiquid Assets Backup Facility (IABF) consisted of an agreement between ING and the Dutch state to guarantee up to 80% of the bank's Alt-A mortgages.
Since 2008, ING has worked diligently to exit its bailout programs, shedding businesses around the globe in order to shrink its balance sheet, stabilize and de-risk its business, and repay the Dutch government. And as of today, the process is mostly complete. On December 17, 2013, ING announced that the IABF has been fully unwound, with a positive 10 basis point impact on pro forma Basel III capital levels. Per the terms of the termination, the Dutch government has now forfeited its rights to nominate two directors to ING's supervisory board, and the government's current director has ceded special voting rights. Alongside the unwinding of the IABF, ING continues to make progress on repaying its core bailout, and the bank has reiterated its commitment to fully repay all state aid by 2015. ING paid the Dutch government €1.125 billion in November 2013, bringing total repayments to €11.3 billion (including interest and premiums), and only €2.25 billion remains to be paid, with ING to make the payments in equal installments in March 2014 and May 2015. ING reiterated this timeline alongside its Q3 earnings results, and the full repayment of its crisis-era bailout will likely serve to increase investor confidence in the bank. That, alongside continued improvements in underlying results will help drive upside for shares of ING, and as the bank continues to slim down, we expect increased confidence in the value of its assets, which may serve to drive the bank's price-to-book multiple above 1, a multiple currently afforded to select banks such as HSBC (HSBC), UBS (UBS), and Credit Suisse (CS).
Q3 2013 Results: Progress Continues
ING's results for the third quarter of 2013 showed continued progress across a variety of metrics. While headline net profits plunged from €659 million in Q3 2012 to €101 million in Q3 2013, the decline was driven by €950 million in losses tied to the divestment of ING's Korean insurance business, as per the terms of its bailout agreement with the Dutch government and the European Commission. On a pro forma basis, ING posted (on a group level) net income of €891 million in the quarter, up 5.57% from a year ago, and EPS from continuing operations rose 22.22% to €0.22.
Within its core banking operations, ING's results held relatively steady amidst continued macroeconomic uncertainty within the European Union. Pre-provision profits fell 0.54% to €1.655 billion, and with loan loss provisions falling 0.36%, resulting in a 63 basis point fall in pro forma ING Bank profits. On a sequential basis, loan loss provisions fell by 10.39%, but this improvement was offset by a 6.07% drop in pre-provision profits due to weak results at ING Bank's treasury and financial market divisions. However, ING Bank's net interest margin rose to 1.44%, up 2 basis points sequentially and 9 basis points year-over-year, and the bank continues to make progress on its cost reduction strategy. Expenses fell by 30 basis points to €2.12 billion (but rose 1 basis point sequentially due to restructuring costs), and as of the end of the quarter, ING has cut €352 million in costs from its banking operations, and the bank has pledged to cut €488 million in additional annual costs by the end of 2015, representing 5.74% of trailing 12-month costs. While not large in absolute terms, ING's cost reduction plan is sizeable given its cost base, and as we will show later, such cost cuts are a central element in ING's double-digit EPS growth for both 2013 and 2014. Asset quality has begun to stabilize, and although non-performing loans as a percentage of total loans rose 40 basis points year-over year to 2.7%, the ratio fell 10 basis points sequentially, driven by declines in the bank's real estate and structured finance portfolios. However, the bank saw a rise in non-performing loans within its core Dutch operations, including both residential and business lending; non-performing Dutch mortgages rose 20 basis points sequentially to 1.8%, and the non-performing loans ratio for Dutch business loans rose 60 basis points to 7%, with weakness concentrated in loans to retailers and transportation companies. However, while this rise in non-performing Dutch loans must be examined closely, we note that ING's Dutch loans do not account for a majority of its total loan portfolio, as per its Q3 financial statements. We break down ING's Dutch exposure in the table below.
ING Bank Dutch Exposure (in Millions of €)
Non-Performing Loans Ratio
Total Segment Loans
Total ING Group Loans
Percentage of Total Loans
Despite the fact that the Netherlands is ING's home market, the nation accounts for less than a third of the bank's total loan portfolio, and given the stability within ING's international retail operations (where the non-performing loans ratio is holding steady at 1.6%), we believe that the bank has the capacity to absorb a slight further increase in Dutch non-performing loans.
We turn now to ING's insurance business, now known as Insurance EurAsia, which ING is in the process of divesting. As of the end of Q3 2013, ING has now listed its United States operations, which are now known as Voya Financial (VOYA), in which it still holds a 57% stake. ING's Korean operations were sold for €1.3 billion in August 2013, and per the terms of its agreement with the European Commission, the bank's remaining insurance operations will be floated within 2014, with the full restructuring and divestiture of the bank's insurance operations to be complete by 2016. However, for the time being, Insurance EurAsia continues to contribute to ING's bottom line. While underlying pre-tax profits declined sequentially to €136 million, the decline was driven by seasonally high dividend income in Q2 related to ING's investment portfolio, and year-over-year, underlying pre-tax profits surged from €10 million in Q3 2012 as the insurance division's investment income rose from €131 million to €174 million (pushing investment margins up 2 basis points to 0.99%) and expenses fell by 3.8% to €277 million. ING's insurance cost reduction program remains on track, and by the end of 2014, the bank has pledged to trim a further €94 million in annual costs from the division, or 8.28% of trailing 12-month costs.
Balance Sheet & Capital: Continuing Risk Reduction
ING's balance sheet continued its recovery during Q3 2013, with the bank's pro forma Basel III ratio now standing at 10.4%, above the bank's 2015 target and above the requirements set forth by Basel III. Per the terms of Basel III, banks are required to hold Tier 1 capital ratios of 8.5%, with surcharges for select global systemically important banks. The Financial Stability Board has placed ING in the lowest "bucket," meaning that the bank is required to hold only 1 additional percentage point of capital, versus the up to 2.5% surcharge attached to the banks deemed most important to the global financial system: HSBC and JPMorgan Chase (JPM). ING's continued restructuring has led to further decreases in assets. Total assets now stand at €1.131175 trillion, down over €35 billion from the start of the year, and risk-weighted assets (per Basel III standards) now stand at €271.2 billion, down from €279.3 billion a year ago. In conjunction with a reduction in overall risk-weighted assets, ING is also continuing to reduce its exposure to Europe's periphery, and we note the bank's current exposure to Portugal, Italy, Ireland, Greece, Spain, and Cyprus in the table below.
ING Peripheral Exposure (in Millions of €)
Change vs. Q4 2012
Change vs. Q3 2012
Change vs. Q4 2011
As the table above shows, ING's total exposure to Europe's periphery amounts to less than €64 billion, or 5.64% of total assets, and ING has worked diligently to trim its exposure. Since the end of 2011, the bank's total exposure to Europe's periphery has fallen by more than 21%, and it has fallen by almost 6% in the first three quarters of 2013 alone. However, despite the fact that ING is relatively insulated from Europe's periphery, we note that the bank trades at a discount to both of Spain's leading banks, Santander (SAN) and BBVA (BBVA), which we would argue are far more exposed to the Eurozone debt crisis than ING, and we highlight the discount that ING trades at relative to its peers below.
Peer Comparison: An Unjustified Discount
In selecting our peer group for ING, we included the leading banks within several key European states, including Germany, France, Switzerland, Spain, Italy, and the United Kingdom, for a total of 11 peer banks. We present our peer comparison in the table below (note: EPS data is sourced from Reuters and The Financial Times, and multiples and share prices are accurate as of the close of trading in Europe on January 22, 2014)
ING Peer Comparison
Basel III CET1 Ratio
2013 EPS Growth Rate
2014 EPS Growth Rate
2-Year EPS CAGR
As the table above shows, ING currently trades at a price-to-book ratio of 0.77x, versus a peer average of 0.95x, even though we believe the bank should, at the very least trade at the peer average, if not a premium to account for its relatively mundane operations. We note that the bulk of the banks selected as ING's peers (due to their flagship status within each respective country) have large investment banking operations, such as Barclays (BCS), Deutsche Bank (DB), UBS, and BNP Paribas (OTCQX:BNPQY). In our view, the fact that ING's business consists of mostly mundane retail/commercial banking and insurance should be rewarded with a premium price-to-book multiple, not a discount. In addition to its price-to-book discount, ING trades at a clear discount on a price-to-earnings basis, despite the fact that the bank is forecast to post above-average EPS growth for both 2013 and 2014, and its 2-year forward CAGR of 26.26% is above the peer average of 21.54%.
Conservatively, applying the peer average price-to-book multiple to ING yields a pro forma price target of €12.85, which would represent upside of 23.2% from current levels for ING's Amsterdam-listed shares. And applying the peer average, 2014 P/E multiple yields a price target of €13.20, or 26.56% above current levels. Furthermore, we note that neither of these estimates takes into account the view that ING should trade at a premium to its European peers, for two reasons. First, we would argue that above-average forward EPS growth warrants an above-average P/E multiple. And secondly, we believe that in the long run, ING should trade at a premium to its large European banking peers. The banks that are contained in ING's peer group were chosen because they are the leading banks in each of the key European nations. However, many of them share another trait. The majority of ING's peers also have sizeable investment banking operations that serve to drive down their price-to-book multiples, something that ING lacks. Despite its size, ING's business is relatively simple, and we note that across both Europe and the United States, more "vanilla" banks, such as Lloyd's (LYG), Wells Fargo, or US Bancorp (USB) trade at premiums to book value in light of the relative stability of their banking businesses. Although Lloyd's is smaller than both Barclays and HSBC in terms of assets, it is essentially a pure play retail & commercial bank, and its business model helps support a price-to-book multiple of 1.45x (as of January 22, 2014). Were ING to hold such a multiple, shares would rise well over 80%. While such upside may be optimistic, we see a long-term path to a price-to-book multiple of at least 1x as the recovery in Europe continues, and ING moves forward with fully exiting its bailout and restructuring programs and begins to be rewarded for the relative simplicity of its business lines. Investors with access to the Euronext Amsterdam may simply purchase ING's Amsterdam-listed shares. Alternatively, investors may purchase ING's ADRs, which trade on the NYSE and each represent 1 ordinary share of ING common stock.
Many investors have avoided the European banking sector out of fear - fear that has created opportunities for value investors. And while ING is one of the largest banks in Europe, it is different than most of its peers. Offering banking services to retail customers and businesses and selling insurance is a far more stable business than offering global investment banking and capital markets services. And yet, ING has not been rewarded for newfound simplicity as the bank continues to remain tied to the Dutch government. However, we believe that as ING continues to move closer to fully exiting its bailout and restructuring programs, and continues to trim risk-weighted assets and further simplify its structure, that meaningful value will be unlocked for investors.