Deutsche Bank: This Time Is Different With A Credible Turnaround Story
Summary
- Deutsche Bank is priced as if its restructuring efforts will fail like before while its turnaround story is well underway.
- I break it down by its four core businesses and highlight its stunning progress made since the restructuring plan kickoff in 2019.
- Deutsche at its current price is a strong buy.
Introduction
As one of the 9 Bulge Bracket banks, Deutsche Bank's (NYSE:DB) peanut-size market cap ($25B, a ~5% of JPMorgan (JPM) as of 3/31/21) and trading at 40% Tangible Book Value piqued my initial interest. Together with its two troubled European peers Credit Suisse (CS) and Barclays (BCS), their market caps are far behind their US peers.
Source: Consolidated images with company logos
As recent as its Libor scandal resulting in a $2.5B fine in 2015, and cited as the most important net contributor to systemic risks by IMF in 2016, Deutsche Bank's reputation has been severely damaged in the recent decade.
My initial thought was this is a value trap. However, as I dig deep, my view gradually changed.
Investment Thesis
My thesis builds upon one theme - this time is different.
While its multi-year restructuring plan is still a developing story, the progress it made over the last two years demonstrated great strategic clarity with increasing certainty to its turnaround success.
Make no mistake, there are legit reasons equity investors give less credit to DB than its stunning turnaround efforts deserved so far. Its past restructuring failure led by John Cryan, piles of DoJ litigation charges, Libor scandal, exposed over-leveraged book after Brexit, close to complete wipeout experience, all of that over the last decade left unbearable pains to many equity investors.
So you might ask why I shall believe this time is different?
In my analysis below, I walk through its business units one at a time, use quantitative (e.g. data) and qualitative (e.g. management discussion) measures to showcase what it has achieved. I will compare its strategic objectives laid out in the 2019 plan to what it has implemented so far to highlight this management team's credibility.
All numbers discussed in this article, unless specified otherwise, are in USD. Most, if not all, presentation material from Deutsche Bank is in EUR.
Exchange rate used: 1EUR = 1.16USD.
Overall Restructuring Strategy
Deutsche Bank laid out a series of strategic objectives in July 2019 to overhaul all of its business units. Some key proposed goals/actions are:
- Realign four client-centric businesses, exit non-competitive business, invest in the leading business.
- Cut costs by improving operation efficiency and workforce reduction.
- Designated business unit (Capital Release Unit) to actively manage troubled assets and improve the balance sheet.
As we review its four business units below, it shows how Deutsche Bank delivered its promises, and how it strikes a good balance between cost reduction (via strategic exits and workforce reduction) and revenue attribution.
On Corporate Bank
As a global leading corporate bank, CB is at the heart of Deutsche Bank's core business. Its treasury/trade services build anchoring relationships with its large corporate clients and their senior financial officers, from which DB's other business units can benefit.
In 2019, as it faced a declining interest rate, it set out a goal to offset interest rate headwinds. During 4Q20 ER, its management discussed how it went.
Source: 4Q20 ER script
It is remarkable to witness such large-scale deposits undergoing charging agreements in a year. It underscored the strong relationships CB forged with its corporate clients. As a result, net interest margin increases from 2.0% in 2018 to 2.3% in 2020 despite dropping IR.
We examined its performance from 2018 to 2020 and noticed that its profit before tax varying significantly ranging from +$0.1B to +$1.25B. However, as we dive deep, we find that its core corporate business remains steady.
FY19 $0.1B profit is mainly due to a one-time impairment charge of $0.5B, while its FY18 $1.2B profit can be attributed to an undefined remaining income of $0.6B (marked No.1 in the chart below) which is outside of its core net interest income and commission/fee income. That income has been reduced by 0.4B over the last 2 years.
FY20 didn't have a similar abnormality except for higher loss provision during Q1 and Q2 (extra $100M, marked No.2).
Source: DB Financial Data Supplement 4Q20
Valuation: I add back $100M extra credit loss provision and use $0.75B profit as the base case for the corporate bank unit. Considering its goal to grow revenue by 2-4%, and to reduce cost by 4% in the next 2 years, I use a 10x P/EBT ratio, and value CB at $7.5B.
On Investment Bank
The Y2020 result is simply stunning. Top-line revenue increased 32% and costs reduced by 15%+ (both employee counts and general admin costs). As a result, its profit increased from $1B in 2018 to $3.7B in 2020. It is worth noting that its revenue increase is presented in all major business areas from FICC trading, DCM/ECM, to its advisory business.
As the management discussed its IB result during 4Q20 Earning call, CEO Christian Sewing further concluded that while the market has been favorable, DB's growth is more than market-driven.
Source: 4Q20 ER script
Outlook
On more than one occasion during 4Q20 ER, CEO Christian Sewing tipped his hands and set a stage for another IB outperformance in 1Q21. Keep in mind 1Q20 was a fantastic quarter.
From Christian Sewing 4Q20 ER:
And on the Investment Bank, I think we said very clearly that obviously, 2021 will not see an outperformance overall in revenues, which we have seen in 2020. But in the trading business, but also, in the origination advisory, we clearly see that we gained market share, that we made momentum, and that all the structural changes we did to the businesses, sub-business, like rates, credit rating, the emerging markets business, they are starting to pay off. They started to pay off in 2020. And with the reengagement of the clients, we are very confident that a very good part of that outperformance is sustainable for 2021.
Jeremy Sigee: Can I throw in another clarification? I feel like you're itching to be more specific about your January Investment Banking revenue performance. You mentioned that the trend has continued. I wondered what you meant by that. Do you mean the trend of growth, so we're also up again, year-on-year, in January? Or do you mean the trend level that it's at a similar level to last year?
Christian Sewing No. I would be more precise and would refer the word trend to growth. You have seen a growth in the fourth quarter and if I say the trend continued in January, then I refer to that and potentially, I'm even a bit more positive.
Valuation: 10B+ revenue, $3.7B PBT in Y2020 was a stunning result for DB Investment Bank. I would normalize its profit to $3B and apply a moderate 7x P/PBT to value its IB business at $21B.
On Asset Management
2019 Strategic Objective: Turnaround inflows; increased efficiency by cost reduction.
Results: 10% AuM increase, and net cost reduction in almost $230M since 3Q2018.
Valuation: DWS was spun off from Deutsche Bank in 2018 and is listed on the Frankfort Stock Exchange. Its current market cap is $8.7B, DB maintains 80% ownership and its at-market valuation at $7B.
On Private Banking
2019 Strategic Objective: Cost reductions
Results: At a first glance (chart below), the number is concerning - total revenue declined from $9.9B in Y18 to $9.4B in Y20. Diving into the details offers some relief. The key factors impacting its revenue and profits are:
1. Net interest margin dropped 200bps from 2018 to 2020, which contributed to over $500M in reduced revenue. Unlike Corporate Banking where DB established a charging agreement (charge clients for deposit), it obviously has less leveraging power with retail customers.
2. While it increased both assets and deposits by 10% in the last 2 years, it was able to do that with a 10% workforce reduction, thus reduced costs by $350M in 2 years (Marked No.2 in the chart). Note the improved efficiency is one of its key mandate laid out in its strategic objective in 2019.
3. Workforce reduction incurred over $600M restructuring/severance cost in FY20.
Considering a $500M revenue loss due to reduced NIM, and a $600M one-time restructuring/severance cost, private banking unit -$0.14B loss for FY20 shows a lot more progress/promise than the number suggested. 
Source: DB Financial Data Supplement 4Q20
Valuation: I model that the NIM continues to remain at the distressed FY20 level. Adding back the one-time $600M severance cost, I use $0.45B as adjusted profit before tax, and apply 7x P/PBT; it values the Private Bank unit at $3B.
For an established private banking/wealth management business with >$550B AUM and >$270B loan book, this is a fire-sale style conservative number.
Capital Release Unit
2019 strategic objectives:
Investor Day Deep Dive 2019
Results: In 3Q2019, CRU has EUR56B risk-weighted Assets, with EUR177B leverage exposure. By the end of FY20, RWA reduced 40% to EUR34B, leverage exposure reduced 58% to EUR74B, closely keeping track of its RWA/exposure reduction goal.
The stronger ratio reflects in part a delay in certain regulatory items and in particular outperformance against our de-risking plans in the Capital Release Unit - The Capital Release Unit ended the year with 34 billion euros of RWA, below the 38 billion euro target
Outlook: While its projected objective (see below) is to have the CRU breakeven in the years 2021-2022, I consider that aggressive, and adjust it to a modeled scenario to take 3 years to break-even from EUR2B loss in 2020. Thus I set aside $3.5B future loss for the unit.
Source: Investor Deep Dive Dec 2019
Valuation Summary
In summary, the sum of all four core business units, minus the $3.5B modeled future loss from Capital Release Unit, values DB at $35B (~$17/share), a 40% upside potential to its current price at $12.
CB: Valued at $7.5B, $0.75B adjusted PBT, using 10x P/PBT
IB: Valued at $21B, $3B adjusted PBT (20% discount from FY20 profit), using 7x P/PBT
AM: Valued at $7B, DWS at-market equity value.
PB: Valued at $3B, $0.45B adjusted PBT, using 7x P/PBT
Concluding Thoughts
Deutsche Bank has delivered on its key objectives laid out in 2019 so far, from cost cutting (esp. PB/CB), revenue increase (IB), to risky asset wind-down. Its turnaround is not a future fairytale story; it is happening with transparency and increased certainty.
Despite its stock price of 100% recovery from the March 20 low, it is still at a distressed level (traded at 40% of TBV).
While my $35B ($17/share) valuation offers a sizeable 40% upside potential, it is a conservative target matching the sentiment that the bank is "no longer in existential crisis, but not completely out of woods." I consider it is at the inflection point to shift the sentiment to "a clear successful turnaround story" if the bank continues to deliver similar results in the next few quarters.
When and if that sentiment shift takes place, I would expect a complete re-evaluation which could offer a significantly higher price target. I will closely monitor and update accordingly.
From Howard Marks:
Large amounts of money aren't made by buying what everybody likes. They're made by buying what everybody underestimates.
This article was written by
Analyst’s Disclosure: I am/we are long DB. 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.
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