Are Italian Banks Cheap?

|
Includes: BCIGY, BNPQF, BPXXY, CRARF, ISNPY, SCGLF, UNCFY
by: The Italian View

Summary

The Italian average of NPL over the Total Gross Loan is about 17%.

Mark-to-market values of banks’ NPLs is 33 cents on the euro.

Italian banks are not cheap as shown by the current valuations.

Low interest rates and minimal market volatility eroded trading revenue for the European banks.

Based on the assumption that the NPL fair value is only 0.33 percent of the face value, we determined that the Italian banks are not cheap as shown by the current valuations. While the median P/B of Italian banks is currently 0.44x, after we applied our fair value of NPL, we found a median P/B of 0.96x. We believe there are banks in Europe with better profitability and valuation.

The Outlook

The combination of still-low interest rates and minimal market volatility eroded trading revenue for the European banks. Banks are trying to improve earnings with an increase in capital and cost cutting. However, the returns for these businesses still look rather low compared to ten years ago.

Based on a Bloomberg article, the average ROE of Europe's biggest banks was around 18.1 percent in 2005, which has decreased to an average of 7.2 percent in the last five years. Our view is that volatility and interest rates cannot be low forever. The next ECB meeting on Sep 7 and the FED meeting on Sep 20 could be the catalysts that will push volatility higher. Moreover, Mario Draghi’s June comments on the need to normalize policy, lead us to believe that inflation in the Eurozone will increase.

This event, sustained by the global economic expansion, and an improving Eurozone outlook, will let the ECB decrease its asset purchases beginning in 2018. This could increase interest rates.

Are Italian Banks Cheap?

To answer this question, an intelligent retail investor should understand the true value of Italian banks. Based on the book value, they appear to have a 20 percent discount compared to their peers. So, we decided to investigate the book value and adjust it based on the famous non-perming loans (NPL) fair value.

The Italian average of NPL over the Total Gross Loan is about 17 percent. Only Cyprus, Greece, and Ukraine have a higher ratio. The situation gets worse if we consider the Italian banking sector accounts for 23 percent of the European banking system.

Exhibit 1: NPL over Total gross Loans 2017

Exhibit 1: NPL over Total gross Loans 2017 - Source Data: World Bank

Source Data: World Bank

Understanding the real value of NPL is not an easy job. It is why there are banks and companies specialized in this type of valuation. Moreover, the power of the seller can change with a change in the economy, and with the European outlook.

To figure out the fair value of the NPL we took a look at all transactions that happened in the last six months.

Based on il Sole 24 Ore, two months ago Atlante bought EUR 2.2b of NPL for EUR 713m, which is an average 0.324 percent. Being more pessimistic, Banca d'Italia valued those assets at 0.23. Meanwhile, UniCredit (OTCPK:UNCFY) booked 8 billion euros in loan losses in the fourth quarter, partially because it wrote down the bad debt to be sold to just 13 cents to the euro.

Exhibit 2: NPL / Total Loans (in EUR million)
Exhibit 2: NPL / Total Loans (in EUR million) - Source Data: Annual Report 2016

Source Data: Annual Report 2016

While the ratio of NPL over Total Gross Loan in the industry is 5.8 percent, several banks in Italy are above that level, as shown in Exhibit 2.

Let's assume that those banks need to sell at least half of their NPL. In the best scenario, they can sell for a fair value of 0.33 percent.

Exhibit 3: Fair Value NPL (in EUR million)

Exhibit 3: Fair Value NPL (in EUR million) - Source Data: Annual Report 2016 - Author

Source Data: Annual Report 2016 - Author's work

In Exhibit 3, we recomputed the equity value based on the fair value of half of the NPL.

Ex: Banca Carige has a total NPL EUR 7331.1m. If the bank sells half of them (EUR 7331.1m /2 = EUR 3666.6m) the fair value will be EUR 1210m (EUR 3666.6m *0.33).

Then we subtracted the value of EUR 3666.6m from the credit loans of the bank and added back the value of EUR 1210m to the assets. We adjusted the value of the bank which helped us to recompute the value of the Equity.

At same time, our assumption is that the banks don't increase their equity, so the shares outstanding will stay the same.

In this way, we were able to test the true P/B of those banks. (Exhibit 4).

Exhibit 4: P/B adj

Exhibit 4: P/B adj - Source Data: Author

Source Data: Author's work

The average changed significantly. While with the actual P/B the average was 0.44x, now we have an average of 0.96x.

(We took out the two outliers, Carige (OTC:BCIGY) and Credito Valtellinese).

Based on the fact that the industry is trading at a P/B of 0.97x, we see only three Italian banks trading at a discount:

  • Banco di Desio e Brianza
  • Banco di Sardegna Rsp
  • Bper Banca (OTCPK:BPXXY)

Where are Intesa San Paolo and Unicredit compared to their peers?

The two major Italian banks, Intesa (OTCPK:ISNPY) and Unicredit (OTCPK:UNCFY), are trying to improve their financial situation. Despite the negative interest rates in Europe, Intesa and Unicredit put forth a credible cost-cutting plan.

Although we applaud those efforts, we do not see a margin of safety in those banks.

Exhibit 5

Exhibit 5: Source Data: Author

Source Data: Author's work

Exhibit 6

Exhibit 6: Source Data: Author

Source Data: Author's work

As shown in Exhibit 6, the valuation is actually in line with the industry, even though the Italian banks were less profitable.

Exhibit 7

Exhibit 7: Source Data: Author

Source Data: Author's work

In Exhibit 7, we display several European banks in terms of P/B value and profitability - average ROE during the last 5 years.

The median P/B among those banks is 0.97, and the median ROE 5Y is 2.55. Based on these values, if we consider the banks with P/B lower than the median and ROE higher than 2.55, we come up with three:

Among those three banks, we like BNP Paribas. The Q2 results beat the expectation, thanks to the strong revenues from the investment banking division. These results put BNP on the right track to hit its goal:

  • Common equity tier one ratio (CET1) 12 percent by 2020 (In Q2 2017 it was 11.7 percent)
  • 40 percent of the targeted cost savings by 2020 (15 percent of cost savings realized so far)

Based on a relative valuation (Exhibit 6), we see that the bank is trading at a pessimistic 21 percent discount.

We believe the cost cutting will take time. The bank needs to balance between the increase in capital and paying dividends, but with the improving Eurozone outlook, the market will recognize the hidden value.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BNPQF over 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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.