Deutsche Bank (NYSE:DB) is one of Europe's cheapest banks trading at a significant discount to the sector and to its closest peers. This could mean the bank is a value play, but to unlock its full potential it must execute its restructuring plan successfully and that may take some time to achieve. Given the significant challenges it still faces, including weak capital markets and uncertain potential litigation costs, Deutsche Bank's valuation appears to be appropriate right now.
Deutsche Bank is a leading international financial services provider and the largest bank in Germany. It was founded in 1870 and has nowadays about 100,000 employees in over 70 countries. It is one of the few remaining global banks with a large presence in Europe, the Americas, Asia-Pacific and in emerging markets. It is a Global Systemically Financial Institution with a buffer of 2%. The bank is listed in Germany and on the New York Stock Exchange and has a market capitalization of about $28 billion. Its closest peers are other global banks like Citigroup (NYSE:C), HSBC (NYSE:HSBC), UBS (NYSE:UBS) or JPMorgan (NYSE:JPM).
Deutsche bank is a leading global bank with businesses in a wide range of products and services in investment, corporate and retail banking as well as in asset and wealth management. Its financial products and services are offered for corporate and institutional clients along with private and business clients. The group consists of four operating business units: corporate banking & securities (investment banking and trading activities), global transaction banking, asset & wealth management and private & business clients (retail banking).
Deutsche Bank's balance sheet and earnings mix are still dominated by its investment banking business, where it ranks among the largest players globally. It has a large presence in fixed income, currencies and commodities business which has been the area that investment banks have suffered more from weak revenues over the past few years due to overcapacity industry-wide. In 2014, about half of its pre-tax income came from its corporate banking and securities division, while the remaining three divisions had a similar weight within the group.
The acquisition of retail-focused Postbank in late 2010 has been a step towards a more balanced footprint within the group, but despite that only around 35% of total funding is from stable retail and transaction banking deposits leaving the still heavily exposed to capital markets.
Over the past few years, Deutsche Bank has delivered weak results like many of its peers with large investment banking operations. The bank has been affected by low volumes on capital markets, low interest rates, a heavy cost base, regulatory burdens and litigation costs.
Additionally, the regulatory landscape for investment banks has also been very volatile since the global financial crisis, with increasing capital requirements and regulatory complexity, making this business much less attractive than before the global financial crisis. Since 2011, its profitability has been very low measured by its return on equity (ROE) that has always been below its cost of equity and is not expected to meet this threshold any time soon. In its best year, Deutsche Bank's reported ROE was only 8.1%, which compares very badly with its profitability achieved before the global financial crisis at close to 20%.
This is not a specific issue of Deutsche Bank but rather it is more related with the investment banking business model that seems to be unprofitable with the current high capital requirements set by regulators globally and low client activity. Especially within fixed income, commodities and currencies division, volumes and profits for investment banks have been low leading to profitability levels below the cost of equity. Most investment banks have reduced operations and some have completely shut down operations in FICC, showing how bad the operating environment in this area has been since the global financial crisis. Even though the bank resisted for several years to downsize significantly its operations in these areas, it has exited some unprofitable business areas and should continue to do it in the future.
Supporting Deutsche Bank's scale back from some investment banking activities is the trend seen throughout the vast majority of its peers, such as UBS, Barclays (NYSE:BCS) or Credit Suisse (NYSE:CS). Most of them have done the same over the past few years and some are still pursuing downsizing from these areas. All of them have halved considerably their investment banking operations since the global financial crisis and are now focusing on other growth areas, like wealth management and geographies with better long-term growth prospects, such as Asia.
Another issue that decisively affects Deutsche Bank's results has been its low efficiency. The bank has struggled to significantly reduce costs and is one of the least efficient banks in Europe, measured by its high cost-to-income (C/I) ratio of 86%, on average, over the past five years. This poor efficiency is both the result of constrained revenues and poor cost control across the group. Deutsche Bank is among the bottom regarding efficiency compared to its global peers that have on average a C/I ratio of about 70%, showing how much the bank has to do regarding cost cutting over the next few years to align its efficiency with its peers.
Reflecting its poor cost control, Deutsche Bank targeted in 2012 about €800 million ($875 million) of cost synergies from the Postbank integration, yet the cost base of the Private & Business Clients division has remained flat ever since 2012 with the bank struggling to successfully integrate the two businesses and realize any synergies. With a C/I ratio of 70% (vs. 60% target) the division is not a laggard within the group, but clearly shows the bank's historical struggles to achieve its cost reduction targets.
Another issue that has been a severe drag on Deutsche Bank's profitability is litigation, which has cost the bank billions of dollars over the past few years. Its litigation costs were $3.3 billion in 2013, $1.7 billion in 2014 and more than $4.4 billion in 2015. This was a significant headwind for its profitability, but currently most of litigation costs due to past conduct may already be behind. The bank had a litigation provision of $5.2 billion as of 30 September, 2015, which may be enough for litigation settlements still pending. However, litigation costs are nearly impossible to forecast and Deutsche Bank itself only expects this issue to be completely resolved by 2018, thus it may still incur on higher costs if future settlements turn out to be above its expectations.
Despite all these headwinds and uncertain operating environment, Deutsche Bank expects to turn around its business during the next two years and be reasonably profitable by 2018 as outlined in its most recent strategic plan presented a few months ago. Nevertheless, Deutsche Bank's profitability should remain relatively low for some time and is unlikely to meet its cost of equity in the next few quarters.
Deutsche Bank's Strategy
Under its previous management, Deutsche Bank launched its business plan called 'Strategy 2015+' in 2012, aiming at maintaining its profile as a global investment bank. Even though the bank has made some progress towards its goals, generally speaking its delivery was relatively poor, especially considering its poor track record on cost cutting and low profitability achieved during this period.
In April 2015, the bank presented a new plan called 'Strategy 2020' but it was poorly received by investors and led to the resignation of its co-CEOs in June. Its targets for cost reductions and profitability were seen as not ambitious enough and the time horizon of 2020 as too long for a bank that has been under restructuring for several years.
Under the new leadership of co-CEO John Cryan, the bank has reviewed again its strategy in late October for the second time in 2015. Deutsche Bank has presented a more credible plan that focus more on cost than revenue growth to meet its targets, a factor that management has more control over the medium-term. Investors seem to be more pleased now, but execution has plenty of risks and the next two years should bring a lot of one-off items to its earnings making it difficult to analyze Deutsche Bank's earnings power over the long-term.
Under its new strategic plan, Deutsche Bank wants to increase its capitalization, reduce assets and risk exposures, cut more costs and implement cultural and management change. These measures add to previous actions announced in April such as the intention to divest a large part of Deutsche Postbank (it should retain a 30% stake), reduce the size of its investment banking business and gross cost-cutting targets of €3.5 billion per year. This means its size will be smaller and more focused in areas where it can be profitable and have better growth prospects. It also expects that its lower size will hit revenue by about $3 billion per year.
To achieve its cost reduction targets, the bank will close about 200 branches of its own retail brand and will exit a few countries where it is not profitable. Its C/I ratio target is 70% by 2018 and 65% in 2020, not much ambitious compared to the most efficient peers Goldman Sachs (NYSE:GS) or Standard Chartered (OTCPK:SCBFF) that have nowadays a C/I ratio of about 60%. This conservative cost cutting goal may mean that Deutsche Bank may over-deliver on cost reduction, but visibility on this should take some time to come.
Regarding capital and profitability, Deutsche Bank targets a 5% leverage to be met with equity and a new target of return on tangible equity (RoTE) above 10%. Its previous target of 12% by 2016 was naturally dropped, and its prospects for long-term profitability are now more credible. Its shareholder remuneration policy in the medium-term is for a dividend payout ratio close to 50%.
Capital & Dividends
Regarding its capitalization, Deutsche Bank has made several equity raises over the past few years, reflecting higher global requirements for banks following the global financial crisis of 2008-09.
The last capital raise was performed in mid-2014, when Deutsche Bank further reinforced its capital through a €8.5 billion equity raise in order to support its strategy of becoming the sole dominant European global investment bank. This equity raise enabled it to increase its fully loaded core equity tier 1 (FL CET1) ratio to 11.7% at the end of 2014, compared to 9.7% at the end of 2013 and above its own target of 10%. Its leverage ratio, a better measure to access the capitalization of investment banks due to their low RWA density, increased to 3.5% at the end of 2014.
Even though its capitalization was enhanced during 2014, Deutsche Bank was still relatively undercapitalized compared to its global peers and especially compared to its U.S. peers that have leverage ratios above 5% on average. Therefore, at its strategy review in April 2014 and more recently in October, the bank reviewed up its capital and leverage target ratios setting a new target for a leverage ratio of at least 5% to be met with equity and a FL CET1 ratio of at least 12.5% by 2018.
At the end of September 2015, Deutsche Bank's CET1 ratio was about 11.5%, which is acceptable, but its leverage ratio was only 3.6%. This means that Deutsche Bank currently has an equity deficit of about $5.5 billion, but most likely this can be fixed without further capital increases, given that it may reach its targets through the spin-off of Deutsche Postbank and reducing risk weighted assets and leverage exposure mainly through disposals and deleveraging. Additionally, Deutsche Bank recently announced an agreement to sell its 20% stake in Hua Xia Bank of China for close to $4 billion, which will increase its CET1 ratio by about 30 basis points.
Regarding its shareholder remuneration, Deutsche Bank has delivered a stable dividend over the past few years despite its high earnings volatility. Its dividend per share has been unchanged at €0.75 ($0.82) per share for the past six years. However, under its recent strategy overhaul and new capital targets, the bank announced a dividend suspension for 2015 and 2016 so as to conserve capital.
In the medium-term, Deutsche Bank should pay about 50% of its net income to shareholders, but this seems too far away to appeal dividend investors in the near future. Indeed, according to analysts' estimates the bank should pay a dividend related to 2017 earnings of $0.97 per share, but shareholders should be two years away from receiving it. Given that many European banks are guiding for significantly higher dividends in the short-term, this should be another negative factor for Deutsche Bank over the next couple of years.
Deutsche Bank is currently one of European cheapest banks, trading at only 0.5x its tangible book value (NYSEMKT:TBV) and less than 9x its forward earnings compared to, on average, 0.9x TBV and 10x earnings for the European banking sector. While this valuation seems to be clearly undemanding and makes Deutsche Bank a deep value play, on the other hand, this is justified to a large part of its low profitability, litigation issues and ongoing restructuring program. Additionally, its capitalization today needs to be enhanced and a capital increase is not completely ruled out until the bank reaches its own capitalization targets.
Although Deutsche Bank seems to have plenty of upside on a long-term basis, execution risk of its Strategy 2020 is high, especially with respect on Postbank spin-off and what valuation Deutsche Bank is able to get and on cost savings which has been an area with a poor track record on previous strategic plans. For the shares to recover to a valuation more in-line with its peers, more visibility is needed on reshaping and what returns it can achieve in investment baking and across the group. This is something that should take some time to emerge and may take at least 12-24 months to be reflected in Deutsche Bank's results, thus for the time being investors should be out of its shares.
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