Is This Beaten-Up Italian Bank Stock A Buy?

Summary

• The company is showing improving profitability metrics.
• The macro environment is supportive of the bank.
• It has better capitalization compared to other G-SIB banks.

Italian bank UniCredit (OTCPK:UNCFF) was once trading at $260 before the global financial crisis. Now it is trading at just around $17. But is this a bargain price to buy the once powerful Italian powerhouse at?

Source: Tradingview

In this article, we'll look at the fundamental data and the outlook of the political environment to establish if or when this might be a good time to buy this Italian powerhouse.

Turning the Corner? Improved Profitability

FY 2017 results were released recently, showing a net profit of 5.47 billion euros ($6.7 billion) last year, exceeding analysts' forecasts. I was skeptical of the "Transform 2019 plan" when it was first implemented by Jean Pierre Mustier. But the plan seems to be working. This plan included reducing exposure to bad debts, improving asset quality and cutting jobs by as much as 14,000.

Since ,then the bank has improved asset quality. Net exposure to non-performing debt is down by 15.2% to 21.2 billion euros. There has been a reduction of 9,000 jobs, and 682 branches have closed. If this plan continues to exceed expectations, the bank will be reducing costs further and improve credit quality going forward.

Improving Economy

The economy has also been supportive of the bank. The Bank of Italy came out in early February as revising the GDP growth forecast upward. Governor Ignazio Visco expects the nation's economy to expand in 2018 at the same pace as last year. The governor cited that monetary policy "is working." And the ongoing reduction of economic slack has boosted confidence.

Credit quality normally lags behind economic growth. This turn up in the economic performance should aid UniCredit in its long climb back to its highs. The ECB is also expected to continue this low interest rate environment. This could mean improvements in borrower performance. This also bodes well for Unicredit.

This sentiment is echoed by Giada Giani, an economist at Citigroup, in a research note. In the report, she highlighted "Accelerating GDP growth, rising sentiment, reducing banking risks and a positive rating cycle currently overshadow still-elevated Italian political risks."

Capitalization and Loan Book

I did a simple comparable analysis with other Italian banks and other G-SIB banks. A few things stood out.

Source: Bloomberg

I will elaborate further in the section below regarding the concerns surrounding non-performing loans (NPLs). It's worth noting that NPLs to total loans are lower than other Italian banks, but are still high compared to other G-SIB banks. These levels of NPL might show that it's too early to go long on this.

Capital Ratios and Tier 1 capital ratios are higher at UniCredit than both local banks and G-SIBs. This well-capitalized structure allows the bank to extend its banking business.

Source: Bloomberg

Interest Income

This thesis is predicated on an improving economic outlook. A higher interest income to total income could show less exposure to trading desks.

Source: Bloomberg

Here, UniCredit does not disappoint. It has a number that's much higher than other G-SIBs at 54%. Goldman Sacs only had 7% from interest income. UniCredit has even higher interest oncome then its local competitors, at 48% and 42%.

What About the Non-Performing Loans?

PIMCO released an older but still excellent note in July 2016: "Losses on Italian Non-Performing Loans: Severity and Solutions." In it they outlined the effect of the NPLs. In the report, PIMCO stated that "banks can write down half of all their current net NPEs to zero, with zero recovery, over the next three years, with limited impact on capital levels."

From these stats it can be deduced that the fear surrounding the NPL could be based more in fear than facts. Of course, several assumptions were made: Italy avoiding a significant recession and earnings are sustainable. The report, written in 2016, does not have the benefit of hindsight that we do now. But both of these assumptions have proven robust.

Downside Risk: Bail-In

The European Union Bank Recovery and Resolution Directive has a "bail-in" clause that would impose costs on investors, and at worst the Italian taxpayers. If this evolves into a Cyprus-type default, this could wipe out the entirety of the share price. So it's possible that this investment will go to zero, and we have to assume so when structuring this trade.

But UniCredit was the only Italian bank to be on the global list of systemically important banks (G-SIBs). A default of the bank could be disastrous for the global economy as a whole. So it's likely that the ECB would, if i can borrow Mario Draghi's words, do "whatever it takes" to prevent a default of this G-SIB.

Political Risk?

When it comes to political risk, there are two events that stand out. These are the Italian election and the German coalition formation. UniCredit is a high beta stock (1.85 at the time of writing). Both of the above events have black swan potential and might affect UniCredit's share price.

The Italian election has been largely priced out by the market, and for good reason. Both the Five Star Movement and the Lega Nord have toned down the anti-Europe talks. They have instead opted for a softer approach toward policies of the EU instead of "QuIt-aly." This makes a Brexit-style referendum less likely.

The second risk is the German grand coalition and that the SDP members are not going to approve the deal. I see this as unlikely as polls show this is disadvantageous to both parties. Nonetheless, these risks have to be factored into our trade.

Derivatives Book - XIV

The recent collapse of the Credit Suisse XIV ETF is a testament to the fragile market we have. Credit Suisse has stated that it is hedged against the volatility trade. This event could have systemic risks that could ripple throughout the banking sector. UniCredit as a G-SIB could have potentially large implications to its trading book. This might be hedged like Credit Suisse, or it might not. Either way, the mark-to-market losses should be clear during the next financial release. I will factor this into my trade as well.

One Last Consideration: Bridgewater

Bridgewater Associates, the largest hedge fund in the world, has a short position in Europe. Recent filings show that they have tripled down on this bet. Anytime the biggest hedge fund in the world places a bet, you should pay attention. When said bet is sizable, you need to dissect everything you know.

Could it be a relative value trade against the Eurostoxx index vs. the S&P 500? Could it be a naked short against the Europe, as Ray Dalio is concerned about populism? It is impossible to say for sure. From the book Alpha Masters, we understand that Ray Dalio, and by association Bridgewater, tends to make uncorrelated bets. These bets are based on statistics models and quantitative data. It would not be unreasonable to assume a relative trade value. It does not mean this is not a good opportunity for the long term.

Structuring the Trade

Because I manage money on eToro, I can only play outright long/short stocks. I would recommend structuring this with options if you can use versatile instruments. Using out-of-the-money protective put options would protect against extreme downside risk. Given that the stock has already taken such a big beating over the past few years, the risk/reward ratio here is advantageous.

Source: Tradingview

The stock has been trending sideways, stuck between the range of $15 and $18 since June last year. I will scale into the position based on the following entries:

Entry 1: After the political headwinds clear. Both the Italian elections and German coalition agreement could provide financial pushback. The stock market if there is any Euroskeptic talks from the winner of the elections or coalition.

Entry 2: After the next financial release, we are likely to know the impact of XIV on the trading book.

Stop-loss: $12 range

Take-profit levels: Given the cyclical nature of the banking sector, I will be using relative valuation between Italy and other G-SIBs to determine exits. The relative values I am looking at are price/book ratios and return on common equity:

Source: Bloomberg

Once UniCredit reaches a closer to the other G-SIBs or other unidentified factors enter the fray, I will exit. Also, a downturn of the Italian economic data will likewise cause an exit of the position.

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.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UNCFF 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.