Avoid Deutsche Bank On Risk Of Financials Being Misstated

Jul.30.14 | About: Deutsche Bank (DB)

Summary

Deutsche Bank's internal controls and regulatory reporting were found deficient by the NY Fed.

DB has violated the trust of its regulator and thus, investors should be very wary of its financial reporting.

We'll discuss implications for shareholders.

Deutsche Bank (NYSE:DB) has had a rough go of it for the past year or so. Shares have, after cresting $50 earlier in 2014, plummeted to the mid-$30s where we find them today. There have been a few factors that have led to declines but in this article, we'll talk about the one I find the most compelling and why investors should avoid DB despite the fact that it looks very cheap at these levels.

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DB is a financial services giant with a global footprint. The company is headquartered in Germany (obviously) but has a large US presence in the New York area. Given that, DB must deal with the Federal Reserve as its regulator here in the States and that is where we find some practices and circumstances which, I believe, should preclude a long position in the stock due to vast uncertainty.

A little over a week ago, the Fed examined DB and found that its US operations suffer from serious deficiencies, including "shoddy financial reporting, inadequate auditing and oversight and weak technology systems." Further, the NY Fed states that the company's regulatory reports are "of low quality, inaccurate and unreliable" to the extent that DB's "entire U.S. regulatory reporting structure requires wide-ranging remedial action." Ouch.

In other words, the company's regulator doesn't trust the regulatory reporting it is filing. This is pathetic and since the Fed went public with it, we know it has to be true. Since we can assume it is true, what are the impacts on shareholders? Well, any company you invest in must be able to be trusted. You have to trust management, the governance and control environment and you've got to be able, above all, to trust its financial reporting. The backbone of the capital markets in the US is trust in financial reporting as without it, we don't know what we're buying. And you don't have to take my word for it; next time a company has to restate its financials or its auditor states its financials aren't in compliance with GAAP, watch the stock price tank. People need to be able to trust financials and with DB, I don't think you can anymore.

So what does that mean for DB? To be honest, after the Fed publicly criticized the company's reporting and auditing practices, I don't trust anything that comes out of there. If the company can't even be bothered to report correctly to its regulator, why should I believe its financial statements? The letter from the Fed doesn't mention the company's consolidated statements but when the regulator says you can't even fill out your required reporting correctly, I have to think you're struggling elsewhere too.

In addition to that DB's auditing and governance are inadequate, further cementing my position that I don't want anything to do with it. Auditing and governance are core pieces of a public company. Without them, we can't trust anything that is reported. Auditing and governance, while imperfect, provide the framework and basis for investor trust in a company's reports and management. Apparently DB cannot be bothered to practice these fundamental principles of doing business in the US and as a result, DB cannot be trusted.

The icing on the cake is that DB's technology systems are also inadequate. Technology is one of the most important pieces of the governance and auditing practices of a company and if DB's technology systems are weak, it means that any number of errors or misappropriations could easily occur and the company, investors and regulators may not even know. So not only is the company ripe for fraud and misstatements to occur but it may not even know if or when they do. Terrific.

The bottom line is that there are many large banks out there that have worthy investment cases. Even if DB, which looks very cheap right now, has a compelling investment case based on valuation or something else, you cannot trust its reporting. This basic tenet of investing the in the US has been violated by DB's pathetic lack of oversight into its own reporting and as a result, you should stay clear at all costs. Will the stock go up from $35? Maybe. But the risk of knowing that you're buying into a company that can't even report its legally required numbers to a regulator correctly and that said regulator felt the need to publicly call it out on its deficiencies is disquieting to me. If you want to buy a bank, please look elsewhere.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.