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After the crash of Lehman Brothers, a hard time started for banks. Due to heavy interconnection of the international markets (domino effect), many of them needed governmental support in order to survive. In Germany the government program was called SoFFin. While many former world-wide known banks needed help (BayernLB, Commerzbank) or were nationalized (Hypo Real Estate), there was only one important bank that came along without direct support: Deutsche Bank AG (NYSE:DB).

Overview

Deutsche Bank is the largest German bank. Its importance to the international financial system can also be seen in the fact that the company has been assigned to the highest risk class by the Financial Stability Board. DB has a market capitalization of approximately €38 billion ($62 billion) (Bloomberg) and employs around 99,000 people.

Active in most of the areas related to banking, it has subdivided its operations in 4 main areas:

  • Private & Business Clients (traditional banking)
  • Asset & Wealth Management
  • Corporate Banking & Securities (M&A and investment banking)
  • Global Transaction Banking

Additionally there exists a non-core segment, where DB has parked all the assets the bank plans to sell. Sometimes the non-core segment is also referred to as bad bank. Throughout the late history of DB, CB&S has been the most profitable division.

When Josef Ackermann, the controversial CEO who led DB through the financial crisis, retired in 2012, he was followed by two co-CEOs, Anshu Jain and Juergen Fitschen. While Ackermann was famous for his ambitious profit targets (equity return of 25%), his successors tried to keep things more calm and prescribed a "Kulturwandel" to the bank. Translated literally with "change in culture" the "Kulturwandel" is basically a new corporate policy that emphasizes values like reliability and sustainability and should improve DB's image in public. Additionally, the "Kulturwandel" is accompanied by a restructuring program for the bank that has also been a necessity due to the acquisitions in the last years (Sal. Oppenheimer, Deutsche Postbank).

Unfortunately, in the last year DB appeared in media mostly in connection with lawsuits, whereupon, to be fair, one has to mention that most of the causes for these cases date back to the time before 2012.

Lawsuits

Due to the nature of its business, DB is confronted with a lot of juridical risks. This fact can also be seen in the amount of reserves related to such costs in their balance sheet. While the company was able to settle down a few lawsuits (mostly by paying a fine) in Q4 2013 (LIBOR manipulation, US mortgages), there are still some at issue.

The most prominent one is the apparently never-ending legal dispute with the Kirch heirs, which has been going on for more than 12 years now. It is of major importance to DB, since the co-CEO, Juergen Flitschen, has been included in the investigation on suspicion he may have given false testimony in court. But it seems that the bank was finally able to reach a settlement just some days ago (20 February). According to Bloomberg, DB will pay about €925 million ($1,265 million). Although there will be a negative impact of €350 million ($480 million) (the rest will be covered by provisions) on the bank's earnings in 2013, I see this settlement as a very important step in dealing with the ghosts of the past.

Another case that could cause troubles for the company is about manipulations in the Forex market. DB, having a market share of 15.2% in this area, has already suspended a number of traders. Investigations are ongoing and there is a certain probability for negative financial impacts on DB in this case.

Profit situation

Earnings for 2013 were of course heavily affected by costs for lawsuits, summing up to €2.5 billion ($3.42 billion). There are still reserves related to this kind of cost of €2.3 billion ($3.14 billion) at year end in the balance (also including most of the Kirch settlement's payment). Taking all things into account, DB made a profit of slightly more than €1 billion ($1.36 billion) in 2013, whereupon especially Q4 was devastating with a loss of €965 million ($1317 million) attributed mostly to adjustment of credit, debt and funding validation (these numbers refer to the IR release and are pre-Kirch settlement; they will have to be adjusted accordingly). Core bank (basically the 4 areas mentioned above) income before validation in Q4 was €1.3 billion ($1.78 billion), so it seems that a lot of bad stuff was pushed into this quarter, apparently to make earnings situation look better next year (i.e. 2014). The idea of a 'year of transition' appears also in the statement made by the co-CEOs, where they said that 2013 was a year "in which we have invested in the bank's further growth and in further strengthening our controls."

Nevertheless no one could call Q4 successful. Revenues were down 16% from previous year, largely reflecting to CB&S (27% decline). In particular Fixed Income & Currencies business (basically bonds and Forex) showed weaknesses. Decline in bond business seems to be caused by uncertainty in the markets (FED policy, government shutdown) and was also affecting competitors.

Trying to drill down to the core of profitability leads to the following chart (all numbers are pre-tax):

(source: IR release of DB, own calculations)

As one can see core profitability is quite nice: more than €8 billion ($11 billion) for an average year with a disappointing last quarter. It is also easy to see what causes the losses: lawsuits, CtA (cost-to-achieve, related to restructuring costs) and the non-core assets. I used an extra column for the Kirch settlement's loss, since it happened after the IR preview and therefore was not considered in those numbers. Litigation costs will always be part of a bank's cost and the same is true for costs related to selling of non-core assets. But I expect a substantial decrease in both costs for the future. When the 'Kulturwandel' is finally implemented, CtA should also drop significantly.

The non-core assets on 31 December 2013 were reduced to €60 billion ($82 billion) ($46 billion risk-weighted - $63 billion), a decrease of 43% compared to the year before. Today's stock price (around €35 - $47.7) is much below book value (€45 -$61.5). All numbers in this paragraph relate to unaudited numbers presented at an IR release on January, 19.

With a forward P/E of 9.5 (source: Bloomberg) is also quite inexpensive compared to its peers (for instance Morgan Stanley with 11.63).

Capital situation

Since banks play a very important part in the financial system, legal regulations of their capital are quite strict.

On September, 30 2013 (the day covered by the last audited report) DB had a leverage ratio of 3.1%. The more meaningful (since relating to assets with risk) common equity tier 1 capital ratio/tier 1 capital ratio was 13.0% and 17.0%, respectively. For Basel III requires a leverage ratio of 3% and a common equity tier 1 capital ratio/tier 1 capital ratio of 7%/8.5%, things seem to be okay at the first glance, even taking into account the maximum countercyclical buffer (plus 2.5% on both ratios). Of course no one can predict the actual development of the markets, though there have been some attempts to model a crisis with so-called stress tests. DB passed the last one (conducted in 2011) easily, but there are a lot of critics stating that those tests are not strict enough and only serve to calm the public.

On the other hand recent history has shown that the central banks will do everything to fight against or at least soothe any troubles in the financial market.

When I try to sum up earnings and capital situation, I see a basically profitable bank with a decent capital backing that had some problems with lawsuits for a long time and a slight problem with earnings for the last quarter. A more favorable scenario for earnings could look like the follow:

€8.5 billion ($11.63 billion) core earnings - €0.5 billion ($0.68 billion) impairment - €0.5 billion ($0.68 billion) litigation - €0.2 billion ($0.27 billion) CtA - €1.3 billion ($1.78 billion) non-core assets means reported earnings of €6 billion ($8.2 billion). If I assume the income taxes to be 1/3 of the profits, that would leave €4 billion ($5.5 billion) as annual profit for stock owners.

Risks

As mentioned above, there is always a certain risk for lawsuits against DB. Especially unauthorized trading of employees could lead to high financial losses. A huge financial drawdown anywhere in the world would of course also affect the bank in a negative way. The same is true for ongoing insecurity on the markets.

Conclusion

DB is definitely too big to fail. I can't think of any scenario, where it could go bankrupt. Though, in a worst-case scenario of another financial meltdown, there is a certain probability that the bank would be nationalized by the German government. This is the only way I can think how a loss of more than 10% fluctuation might happen to an investor holding DB shares. The core business is stable and earning good money. When the big lawsuits going on at the moment are eventually finished and the transition phase of the "Kulturwandel" is finally over, this company trading at 80% of book value will look like a bargain. I am quite sure that investors will also finally realize that. Therefore, I expect an increase in DB's stock price of at least 25-30% within 2014 and further growth in the coming years.

Disclosure: I am long DB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Deutsche Bank AG: Better Times Ahead?