Deutsche Bank: Understand The Value Opportunity

| About: Deutsche Bank (DB)

Summary

Deutsche Bank is a low ROE bank and will remain so for now. This doesn't make it "untouchable".

Don't get distracted by Deutsche Bank's low ROE. Ask how it can improve earnings and value it off PE.

Warren Buffett looks at earnings, not book, when valuing banks. This framework can help simplify the issues at Deutsche Bank amid the crossfire of debate on the stock.

It's fair to say that if Deutsche Bank (DB) didn't exist today, nobody would invent it. After all, with clean ROE in low-mid single digits, the warranted market cap is going to be significantly below the equity employed in the business. What's the "point" of it then?!

Moreover, the bank's strategy is focused on reducing the cost/income ratio to a level that should, if successful, give us a ROE of around 7%. This is better, but is not in itself going to get the valuation up to 1x BV. And it's called Strategy2020, so we need to be patient.

To be sure, more active markets and a steeper yield curve may help Deutsche Bank, but that applies to all banks and isn't really something to dwell on at your next lunch with Deutsche Bank management, although as a very low net margin business Deutsche Bank might enjoy higher than average gearing to a steeper curve (so some sensitivities would be useful!).

For anyone traumatized at the prospect of investing in a bank with ROE below the cost of equity, let me bring in Warrent Buffett

In this clip, Buffett was asked what it would take for a couple of banks (Bank of America Corporation (BAC) and Citigroup Inc. (NYSE:C)) trading below tangible book value to get above book value. That's a natural question - if you are trading below equity value then the obvious task for management should be how to hit that valuation level at least. What followed from Buffett seemed pretty low key, but was in fact one of the best investing lessons a person approaching banks would hope for. The Sage didn't accept the terms of the question:

Book value is not key to valuing banks, earnings are key to valuing banks. You earn a return on assets....it translates to book value to a certain extent because you are required to hold a certain amount of tangible equity compared to the assets you have...but...

What stands out in the clip is Buffett's comparison of the likes of USB (NYSE:USB) and Wells Fargo (NYSE:WFC), which earn high returns on assets and thus trade north of book value, and those that earn lower returns on assets (he mentioned 0.5-0.6%), like BAC and Citi, which trade below book. As you will see if you watch the video, the great man waves his hands as if to indicate an equivalence in the trade-off between the two ROE levels. In other words he's focused on something other than ROA/E and P/BV.

What Buffett understands here is that, as an investor, his real equity when he buys shares in a bank isn't the shareholders funds in the balance sheet, as important a number as that is. His equity is the price he pays per share, and his ROE is capital appreciation plus dividends, which is going to be a function of earnings. So he's interested in what he pays for the earnings, not the relationship of earnings to equity. As far as banks are concerned, then Warren Buffett is a PE man.

How might this apply to Deutsche Bank? There's probably no way that Buffett would buy Deutsche Bank - it doesn't have the deep deposit franchise that he (rightly) values in banking. And right now there is still the slim possibility that the stock gets obliterated by the DOJ although the market has recently shed its concern on that score. But can we apply Buffett's thinking to Deutsche Bank all the same?

Yes we can. On average equity of around €67bn, Deutsche Bank can presently generate about €4-5bn of pre-tax income, or say €3-4bn on the bottom line. This would be clean of the heavy restructuring and litigation provisions Deutsche Bank has been writing. The implied ROE isn't very good. But let's think like Buffett: you can right now buy that bottom line for a market cap of €20bn. 3-4/20 is a strong ROE. Now, again to think like Buffett and consider a holding period of "forever", a €4bn return over a €20bn price might seem an interesting opportunity. And there is one almighty catalyst coming up sometime in the medium term.

As we know, Deutsche Bank has a cost restructuring program that aims to reduce its cost/income ratio to 70% long term, from ~85% today. Here's a chart showing what this would look like if the strategic plan were to be achieved.

Click to enlarge

Source: Company strategy document January 2016, FIG Ideas

Clearly, anything close to the level of PPOP projected in the green area in the chart would make Deutsche Bank one of the best performing bank stocks in the world over the period in question. Anyone doubting the plan has plenty of ammunition and, at the least, it's fair to take the view that you'll believe it when you see it. That's fine: the plan isn't in the price so you can afford to wait.

When thinking about Deutsche Bank there's a useful read across from Citigroup, which trades at a chunky discount to BV right now (with equity $212bn, market cap $154bn). Citi is on a PE of about 10x 2016 earnings, and aims to return all the capital it generates to shareholders. This gives attractive capital dynamics, and vs. the price you pay for the shares today, Citi seems attractive. Deutsche Bank is nowhere near the recovery status of Citi at the moment, but it can get at least some of the way there under its current strategic plan.

Conclusion

To my mind, the 3-5 year picture in Deutsche Bank is one of clawing its way to a 6-7% ROE with restored capital distribution. Assume zero growth. This prognosis should allow the stock to trade at ~€40bn market cap and to give a healthy dividend yield. So while Buffett wouldn't buy Deutsche Bank, his framework for banks investing certainly clarifies why those who do buy it might enjoy high returns from today's entry level.

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.