European Banks: Ready For Take Off?

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About: iShares MSCI Europe Financials Sector Index ETF (EUFN), Includes: BAC, BNPQF, BNPQY, C, CRZBF, CRZBY, DB, GS, HSBC, IITOF, ISNPY, JPM, LYG, SAN, SCGLF, UNCFF, UNCFY
by: Cassiopeia Value Investing
Summary

Many European banks trade below their book value.

Some banks showed strong earnings over the last years despite low interest rates.

Rising interest rates in 2019 will be a catalyst for undervalued bank stocks which have upside potential.

1. Introduction

2018 was a desastrous year for European banks. Their stocks lost significant market valuations. Let's have a look at the annual return of selected big European banks:

Stock Country Price in € as of 12/28/2017 Price in € as of 12/28/2018 annual return in %
HSBC plc UK 8.28 7.11 - 14,1
Lloyds Banking UK 0.77 0.56 - 27,3
Commerzbank GER 12.5 5.76 - 53,9
Deutsche Bank GER 15.95 6.98 - 56,2
BNP Paribas FRA 62.4 39.4 - 36,9
Société Générale FRA 43.3 27.8 - 35,8
Intesa Sanpaolo ITA 2.82 1.95 - 30,8
Unicredit ITA 15.95 9.84 - 38,3
Banco Santander ESP 5.48 3.95 - 27,9

All in all, banks were a bad investment and you could think that the European banks must have trouble generating profits and paying dividends. In the following, it becomes clear that this is not the case for all banks. Hence, there are many investment opportunities in the bank sector, especially after the Christmas sell-off last week.

2. Interest rates and earnings: the USA as an indicator of Europe's near future

Interest rates influence the earnings of each company. On the one hand, consumers will have less disposable income because borrowed money will be more expensive. This will lead to lower profits of consumer staples stocks. On the other hand, the banks and financial institutions can charge more for lending.

The United States are a good example when analyzing the effect of higher interest rates on bank stocks and earnings for the Federal Reserve started to raise interest rates in 2016:Interest rates (<a href='https://seekingalpha.com/symbol/FED' title='FirstFed Financial Corp.'>FED</a>) 1991-2018 Looking at the chart, you can observe the hikes starting in 2016 from 0.0 % to 2.50%. What happened to the American banks? In general, their stock prices and earnings saw sharp increases:

Bank price in € as of 12/28/2015 price in € as of 12/28/2018 return in % EPS 2015 in $ EPS 2018 in $ (est.) +/- in %
JP Morgan 60.8 85.2 +40,1 6.06 9.3 +53,5
Goldman Sachs 168.5 (2016 low: 125.0) 165.4 (2016 high: 233.0) - 1,2 (+86.4) 12.4 25.6 +>100
Bank of America 15.8 21.6 +36,7 1.38 2.61 +89,1
Citi Group 48.0 (2016 low 31) 45.6 (2017 high: 65.2) - 5.0 (+ >100) 5.4 7.4 +37.0

All selected big banks increased their earnings in the three-year period. The share prices also gained significantly although the recent "crash" brought back the prices of Goldman Sachs and Citigroup to zero-interest rates levels. If you bought these stocks during their 2016 lows, you would achieve superior returns. Today, American banks are attractive again because they trade below their book value and have low P/E- multiples.

Now we'll have a closer look on the European banks which still operate in a zero-interest rate economy.

3. Valuations

Firstly, we compare the valuation multiples of nine selected banks from the first table.

bank price in € as of 12/28/18 5 y- EPS in € CAPE (5y)

EPS '18

in €

PE '18

book value p.s. in € PB '18

DPS

in €

yield in %
HSBC plc 7.11 0.40 17.8 0.61 11.6 8.08 0.88 0.45 6,3
Lloyds Banking 0.56 0.033 17.0 0.072 7.7 0.74 0.76 0.033 5,9
Commerzbank 5.76 0.45 12.8 0.8 7.2 23.6 0.24 0.0 0,0
Deutsche Bank 6.98 -4.68 neg. 0.25 27.9 30.3 0.19 0.0 0,0
BNP Paribas 39.4 4.62 8.5 6.0 6.6 83.4 0.47 3.0 7,6
Société Générale 27.8 3.88 7.2 4.8 5.8 74.4 0.37 2.2 7,9
Intesa Sanpaolo 1.95 0.21 9.3 0.23 8.5 3.1 0.63 0.20 10,3
Unicredit 9.84 -0.65 neg. 1.79 5.5 24.3 0.41 0.32 3,2
Banco Santander 3.95 0.42 9.4 0.44 8.9 4.16 0.95 0.18 4,6

It is not surprising that all banks are trading below their book value. It is astonishing how low the PB-ratios for some of the banks are. The German banks are both below 0.25 but they are also the only banks without dividend payments and have a poor earnings history. The French and British banks showed stable earnings over the last 5 years and increased their dividends moderately. The French Banks and Banco Santander seem to be the most attractive opportunities while the Italian banks have high political risks due to their new government and the German banks were badly managed for almost a decade. I cannot recommend Deutsche Bank because of their bad image in Germany and their involvements in so many lawsuits which will hurt the bank's operations for many years to come.

4. The catalyst: rising interest rates

Based on good fundamentals, it is likely that many European bank stocks will see price recoveries just like their American peers. The first interest rate hike is expected to happen in autumn 2019. If we assume a 2% interest rate by 2020/2021 and if we also assume an EPS increase on average of 70% (similiar to the EPS increase of American banks) from 2018's levels, the P/E multiples of these banks would be even lower.

Société Générale wants to increase their EPS to 6.5 € per share by 2020. This assumption is based on current interest rates. We can expect an EPS of at least 7.7 € by 2020 if rates increase to 2.0%. The P/E ratio of today's share price would fall to 3.6 which is incredibily cheap. The same will happen to BNP Paribas (EPS 2021= 10.2; P/E= 3.9), Banco Santander (EPS 2021= 0.75; P/E= 5.2), Intesa Sanpaolo (EPS 2021= 0.39; P/E= 5) and Commerzbank (EPS 2021= 1.36; P/E= 4.2).

Deutsche Bank, HSBC and Lloyds Banking are more risky because of lawsuits and the Brexit which remains a threat to the British economy and the banks' earnings. HSBC is more diversified than Lloyds Banking because of its Asian exposure.

5. Conclusion

Finally, if the European Central Bank raises interest rates in 2019, we can expect superior returns for investors who buy European banks at these low levels similiar to the situation of American bank stocks at the beginning of 2016. Many banks, especially the French banks, showed stable earnings in a harsh environment. They will strongly profit from rising interest rates. As a consequence, their share prices will gain significantly while EPS and dividends will increase sharply.

French banks seem to be more attractive than German and British banks. If you want to choose between Commerzbank and Deutsche Bank, Commerzbank is definitely less riskier than the Deutsche Bank with the eternal sword of damocles called 'lawsuit'. In the UK, HSBC is the better choice because it has less Brexit exposure and won't be hurt that much than Lloyds Banking in case that the British economy will shrink over the next years.

The most attractive bank from southern Europe is Banco Santander because it has less political risk than Italian banks and the Spanish economy is doing well at the moment while Italy argues with Brussels about its debt problem.

Disclosure: I am/we are long SCGLF. 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.