Thesis: Commerzbank (OTCPK:CRZBF) trades below 0.4x net assets. Even by European banking standards, this is a remarkably low rating and is usually only associated with banks that have substantial balance sheet problems. But Commerzbank gets a clean bill of health on this front, having all but eliminated the remaining positions in its problem asset portfolio and having regulatory capital well above its minimum requirement. From this low level, any small improvement in returns could see a sharp re-rating of the shares. Additionally, I like Commerzbank as an option on consolidation: for non-German banks looking to gain meaningful market position in Germany, it is the only game in town, and the share price at its current level assigns virtually no value to this.
1Q results showed there is life after Deutsche Bank
Recent headlines have been dominated by the failed merger discussions with Deutsche Bank (NYSE:DB) (link). But 1Q results showed Commerzbank has been quietly getting on with executing on its own targets irrespective of M&A. Net profit of €120m was above Street estimates of €115m, and management reconfirmed all of the key targets for 2019. These include higher revenues versus 2018, a hard cost target below €6.8bn, and loan losses of c.€550m.
In fact on several fronts, the company looks to have scope to beat these full-year goals: costs were annualising at only €6.5bn in 1Q while loan losses were annualising at only €300m.
Commerzbank's stand-alone strategy is very much based on growing revenues through new customer acquisition, particularly in retail banking where it (rightly) regards itself as having a superior offering to the dominant local savings banks. So it's also encouraging to see this strategy continuing to deliver: the company added another 100,000 retail customers in the quarter and 800,000 corporate customers. The results are also paying off in terms of faster loan growth with mortgage volumes growing 9% year over year in 1Q and corporate volumes by 5%.
Commerzbank continues to win new retail banking customers
Source: 1Q19 results presentation
Return on equity is way too low, but there is a credible path to getting it higher
The main reason Commerzbank trades at a 60% discount to net asset value is because it has a long track record of delivering exceptionally poor returns on equity. 1Q saw return on equity being below 2%. Even if seasonal taxes and regulatory costs are stripped out, the underlying return is not much above 4%.
Is there any hope of this changing? This answer is probably not dramatically in the short term, but with the stock on such a low rating, dramatic changes may not be necessary to see the share re-rate materially.
I've sketched out below some scenarios for where return on equity could plausibly get to by the end of 2020 using some conservative and some less conservative assumptions. These suggest an improvement of 2-3% could be feasible.
Scenarios for 2020 return on equity under different scenarios
I'll summarise as follows:
- The most conservative scenario (1) assumes revenues don't grow between 2018 and 2020, acknowledging that despite the company's new customer acquisition success in 1Q19, revenues were still 1% lower compared to 1Q18. This is contrary to management's own goal of achieving 3% pa revenue growth over the period. I've accepted its 2020 cost target of €6.5bn, which it is already close to, and I've assumed loan losses stay at their targeted 2019 level (€550). On this basis, I get to return on equity of 4%, not much improved on the current level, but not below it either.
- A more optimistic scenario (2) is to assume management achieve its revenue growth target (3% pa) to 2020 and also deliver on the cost target. I've also assumed loan losses stay at the level of 2018. This gets to a return on equity of 6%.
- A further blue-sky scenario is possible, which is to add in management's guidance for the revenue lift that would result from higher interest rates. Admittedly these currently look a distant prospect in Europe, but it's worth remembering that, if they ever do rise, Commerzbank is amongst the most positively geared of all banks. Management has said 100bps higher Euro interest rates would deliver up to €550m additional revenues within one year. This is a not inconsiderable 6% of the current revenue base. If this uplift were to materialise, I think return on equity could conceivably get to as high as 7%.
None of these values is earth-shattering relative to international peers. But they are interesting when the stock is trading on 0.4x net assets. Assuming Commerzbank's cost of equity is around 10%, then a 6% return on equity could see the stock re-rate to ~0.6x net assets for upside of 50%. At a 7% return on equity, fair value could be as high as 0.7x for upside of 75%. If nothing else, I think these numbers suggest the downside is very limited since it is hard to push return on equity much below current levels under any plausible assumptions. The conclusion is therefore that the valuation risks are geared almost exclusively to the upside.
Commerzbank has repaired its balance sheet
One further consideration is Commerzbank's balance sheet since often when banks trade at such low multiples, it is because the market sees unrealised losses lurking somewhere.
Balance sheet strength has been questionable at times in the past for Commerzbank, but my view is things have changed markedly for the better in recent years. The old problem asset portfolio (Commerzbank labels it ACR, or Asset Recovery Portfolio, comprising legacy exposures in shipping, commercial property and public finance) has been worked down to de minimis levels. Remaining total asset balances were only €11bn at the end of 1Q19 having been €36bn in 2015 and €52bn in 2013.
Non-performing loan balances across the group are also low at less than 1% of the loan book in 1Q19, while loan loss provisioning through the P&L in 1Q was annualising at only ~€0.3bn, way below management's target for the full year of €0.55bn.
Finally, Commerzbank's regulatory capital position looks comfortable with the regulatory capital ratio being 12.7% in 1Q19 against a minimum requirement of 10.1%. The fact that regulators at the ECB lowered Commerzbank's requirement for 2019 is also a sign of confidence in my view.
A free option on M&A
Even if Commerzbank can't deliver any improvement in returns, M&A seems likely to be a recurring theme with both ING (NYSE:ING) and UniCredit (OTCPK:UNCFF) both having been rumoured recently to be running the slide rule over the company (FT commentary here).
This should be supportive for the share price and it's worth remembering that one of the side effects of Commerzbank's extremely low price to net asset multiple is that any acquirer would be able to crystallise around €13bn of badwill. This is a not inconsiderable sweetener as it would be added to any acquirer's regulatory capital ratio.
I doubt ING or UniCredit would be willing to pay a large premium for Commerzbank, but take-out multiples of 0.5-0.6x net assets could be perfectly conceivable. Again, when the starting point is 0.4x, that's still meaningful upside.
I'm a buyer of Commerzbank for all of the above reasons. It's true this is a bank with a decidedly patchy history. But it has jettisoned many of the businesses that caused problems in the past, notably investment banking and commercial real estate lending. It has an interesting retail franchise and customer acquisition strategy in Germany and is likely to remain a focal point of M&A interest. Most importantly, it is priced as if nothing can ever get better. That's a bold assumption to make.
Disclosure: I am/we are long ING. 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.