Deutsche Bank: Capital Raising Would Result In A 70% EPS Dilution

| About: Deutsche Bank (DB)

Summary

Deutsche Bank is trading at a significant discount to its peer group despite a 6-7% structural RoE.

This valuation suggests a substantial doubt around capital adequacy.

There are significant risks, which could force Deutsche Bank to raise capital.

Our calculations show that a EUR6-8bn capital raising has been already priced in by the market.

However, a EUR20bn capital increase at a 60% discount to the current share price would result in a 70% EPS dilution and a forward P/B of 0.96x.

Current multiples suggest a substantial doubt around capital adequacy

Deutsche Bank (NYSE:DB) is currently trading at a multiple that is at a significant discount to global peers.

Global Investment Banks: Forward P/B multiple

Source: Bloomberg, Renaissance Research

One can argue that the bank's depressed valuation is justified given its low profitability. According to the Bloomberg consensus forecast, the market expects DB to post 2016E RoE of 0.275%. 2017E numbers also suggest that the bank is fairly valued, trading in line with valuations of comparable peers.

Global Investment Banks: 2017E P/B vs. 2017E RoE

Source: Bloomberg, Renaissance Research

While 2016-2017 DB's earnings will be heavily affected by the ongoing reorganization process and possible litigation charges, the bank is heading on the direction towards a "structural" 6-7% RoE - this is what the market expects from Deutsche Bank in 2018. In terms of 2018E numbers, DB looks very cheap:

Global Investment Banks: 2018E P/B vs. 2018E RoE

Click to enlarge

Source: Bloomberg, Renaissance Research

It would be very naive of us to claim that market overlooks the robust structural profitability of Deutsche Bank. Hence, this valuation framework suggests to us that a capital raising has been already priced in by the market.

How much capital does Deutsche Bank need?

The ECB requires Deutsche Bank to maintain a minimum 10.25% CET1 ratio in 2016 as part of the Supervisory Review and Evaluation Process. Additionally, the bank's G-SIB buffer is being phased-in to 2% by 2019 from 0.5% in 2016, bringing total CET1 requirements to 10.75% in 2016 and to 12.5% by 2019.

Click to enlarge

Source: Deutsche Bank

While the current capital adequacy ratios are above the required minimum levels, there are three big negative tail risks, which could force DB to raise new capital:

1) DB faces significant RWA inflation risks due to new rules for the calculation of minimum capital requirements in banks' trading books - on January 14th, the Basel Committee on Banking Supervision (BCBS) published its revised capital requirements for market risk. The final standard, also known as the Fundamental Review of the Trading Book (FRTB), is intended to harmonize the treatment of market risk across national jurisdictions and will generally result in higher global capital requirements. Although these new standards will be effective as final rules from 1 January 2019, we believe that the market will look to apply this new framework to DB's RWA as soon as it is published. Should that happen, capital raising fears would hit DB again.

2) The bigger concern for DB's investors must be its weak Basel 3 leverage ratio: 3.5% as of 2015YE. There is no European minimum regulatory requirement set as yet. However, according to research from the Bank for International Settlements, global regulators have "considerable room" to raise the Basel III leverage ratio for banks as high as 5 percent from its current "test" level of 3 percent: analysis shows raising leverage ratio as high as 5 percent would result in more stability without strangling credit supply. It is also worth mentioning that US regulators and Swiss regulators have already increased Basel III leverage ratios to 5%.

3) Finally, higher litigation/restructuring charges are another issue worth keeping an eye on.

A 70% dilution in 2016E EPS? Impact of possible capital raising

We show below the impact on DB's key financial metrics, if the bank raises new capital. We assume in our calculations that DB has to raise EUR10bn (a base-case scenario) or EUR20bn (a worst-case scenario) at a 30%/45%/60% discount to the current share price (i.e. via a rights issue).

A base-case scenario: DB has to raise EUR10bn - as a result: 1) a 40-54% dilution in 2016E EPS; 2) 2016 P/E moves to 17x-22x from 10x; 3) 2016 P/B moves to 0.51x-0.71x from 0.36x.

* Bloomberg consensus forecasts

Source: Renaissance Research

So, assuming a EUR10bn capital increase at a 30% discount to the current price, DB trades at a 15% premium to its peer group (look at the chart below). This might suggest to us that the market is currently pricing in a EUR6-8bn capital increase at a 30-40% discount to the current share price.

A worst-case scenario: DB has to raise EUR20bn. As a result, we see: 1) a 57-70% dilution in 2016E EPS; 2) 2016 P/E moves to 24x-34x from 10x; 3) 2016 P/B moves to 0.63x-0.96x from 0.36x.

* Bloomberg consensus forecasts

Source: Renaissance Research

However, under this scenario, we do not see DB as cheap. In fact, it looks very expensive - look at the chart below.

Bottom Line

Taking into account a 6-7% structural RoE, Deutsche Bank looks clearly undervalued at the current multiples (0,36x forward P/B). Our analysis shows that the market has already priced in a capital increase, and if the management avoids raising a capital, DB should revalue. Having said that, investors should watch out for negative tail risks (FRTV, Basel 3 leverage ratio requirements, litigation). Should they happen to materialize, Deutsche Bank would be a screaming SELL.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.