Stocks and Shares

Why the Deutsche Bank capital raise is not negative

Last week I provided an update on Deutsche Bank stock. It’s a deeply discounted turnaround opportunity that I spotted last year. Just a few days after the update the bank announced a big capital raise and some strategy changes. The share price fell on the announcement, but the value to shareholders actually increased. How so? All is explained below.

I first recommended Deutsche Bank (XETRA:DBK / NYSE:DB) back in July 2016. Just last Thursday I gave an update. Since the original recommendation it was up 65%, and I also reckoned it was still worth buying (see the full article here).

Then on Sunday the company announced a big new capital raise and some strategy changes. Just my luck it was straight after my update. And yet more proof, in case you needed it, that you shouldn’t try to time markets. They’re full of surprises.

Fortunately my recommendation was always based on conservative assumptions. These included no dividend income and no increase in the net assets of the company in the next few years. The reality was likely to be better.

Because of the type of capital raise – something called a “discounted rights issue” – the share price fell. As I’ll explain, this is something that should always happen in these types of situations. Although that doesn’t stop most financial journalists from thinking it means the market has reacted badly. But shareholders in the know have no need to panic.

The stock’s currently trading at 17.27 euros on the European Xetra exchange (US$18.61 in New York). That’s 11.6% below the price of 19.53 euros when I wrote last Thursday.

Given that big price fall you’d expect that existing shareholders are out of pocket. But, as I’ll explain, that’s not the case. In fact, if anything, they’ve made a small gain since last week.

Sounds weird and counterintuitive, right? Well it is. But all will be revealed.

If you already own the stock, and as I flagged in an alert to OfWealth subscribers yesterday, the essential thing to know is DON’T SELL IT. At least not yet. I’ll explain why in a minute.

Yesterday I listened to two hours of the bank’s management, led by CEO John Cryan, explaining their plans and responding to questions from analysts at the top investment banks.

Here is a quick summary of what’s going on:

  1. The bank will raise 8 billion euros (US$8.5 billion) of new capital from shareholders
  2. One new share will be issued for every two existing shares
  3. The new shares will be sold at a big discount to the current market price
  4. A minority ownership of the asset management division will be sold in the stock market (IPO). Along with some other sales this will boost capital by another 2 billion euros.
  5. The business divisions will be concentrated into three, instead of five.
  6. In particular “Postbank”, a semi-independent German retail and commercial bank, will no longer be sold but will be fully merged into Deutsche Bank to create the leading local bank in Germany (with 20 million customers)
  7. Future cost targets are lower than before (more cost cuts, more profits)
  8. Revenue is expected to grow faster with the new capital in place
  9. Dividends will start to be paid again sooner, and eventually at comparable levels to European competitor banks
  10. The profitability target for return on tangible equity (ROTE – see earlier articles) remains 10%, despite the much higher capital base
  11. (Important) Top quality CEO John Cryan pledged that he has “No intention of going anywhere until we’ve got this bank turned around and making the returns that it deserves”. His current contract runs until mid 2020, which is long enough for us. But he may well stay longer.

I see this all as good news. The bank is removing uncertainty about its capital strength, which will cut its cost of debt financing (interest cost). It should also increase the valuation that investors will place on the stock, since it’s now a lower risk business.

The Postbank integration is a u-turn. But selling it was originally a plan announced in 2015 by the previous management team, before John Cryan became CEO.

They clearly couldn’t get a decent price for it. And Cryan now says that banking in Germany is swiftly modernising at last (eg adoption of mobile phone banking) from being behind other countries.

So he’s now confident he can cut out billions of extra costs (branches, people, redundant technology). Also euro interest rates have come off their lows which should improve the top line revenues as well, in what’s basically a deposit taking and lending business.

Keeping Postbank also leaves the future Deutsche Bank with a more balanced business. In percentage terms it will have more steady, domestic German banking business and less racy, international investment banking. Again, this reduces risk and should improve the valuation of the stock.

Now let’s get into what this means for investors.

Obviously issuing a load of new shares will dilute existing shareholders. But at the same time new capital is coming in the door and the 10% ROTE profitability target is still there (extra cost cuts and revenues).

On top of that, because the bank will no longer be capital constrained it can start paying out dividends from profits much sooner, instead of keeping more in house to add to capital.

I’ve run the numbers and still think the stock is good for a profit of “two to three times within three to five years” since the July recommendation. There will be less in the way of capital gains than previously expected, but much more in the way of dividends.

Last time I outlined three valuation scenarios: conservative, realistic and stretch. These were if the P/TB ratio (see previous for explanation) reached 0.71, 1.0 or 1.2 by 2020. The scenarios gave upside of 122%, 213%, and 275% respectively, from the July price. Zero dividends were assumed.

My new estimates actually give similar profit figures for shares bought in July 2016. These are now 132%, 211% and 267% (see summary below). Again, lower capital gains (due to the dilution but offset by higher profits) are offset by higher dividends in the next few years.

In all cases I’m estimating dividends per share (DPS) of 3.92 euros by 2020. The 2020 price targets are: conservative 23.47 euros (US$24.89 at current exchange rate), realistic 32.86 euros (US$34.83), stretch 39.43 euros (US$41.80).

In other words the investment case is still sound: a deeply discounted turnaround play. In fact, given that the risk has now reduced, I think there’s a higher chance of getting to the realistic or even stretch scenario valuations.

If anything, I reckon the chances of a fat profit just got bigger than before. I can’t see any reason why they got worse.

Next we need to understand the mechanics of the capital raise, which is a “1-for-2 discounted rights issue”. Translated this means that existing shareholders will have the right to buy one extra share for each two they already own at a price that’s below the market price. If they don’t want to buy extra shares then they can sell the rights to someone else in the market.

Understanding discounted rights issues isn’t easy, but I’ll do my best to explain. In particular they always cause the share price to fall when they’re announced. But this doesn’t mean that existing shareholders have lost value.

The bank said it will issue 687.5 million new shares and raise 8 billion euros of new capital. That means the implied price of the issue will be 11.64 euros a share, which is well below the market price.

Imagine you had two shares. Before the announcement these were priced at 19.53 euros, meaning their market value was 39.06 euros.

Now you’re told you can buy one more share for 11.64. That’s money that will go straight into the company as cash (minus bankers’ fees, but let’s not overcomplicate things).

Therefore the value of all three shares should be 50.70 euros (39.06 plus 11.64). But once the deal is done that value will be divided across three shares in total, meaning they should be worth 16.90 euros each.

Apologies for the jargon, but this is what’s known as the “theoretical ex-rights price”, or TERP. All other things being equal – meaning excluding any underlying move in the market value of all the pieces – you should expect a share price to fall to the TERP level once a discounted rights issue is announced.

In other words, this kind of capital raise should make the share price fall. It’s not something that investors should panic about, or (necessarily) interpret as a bad thing.

The two original shares, priced at the TERP, are now worth 33.8 euros. On the face of it that’s a loss of 5.26 euros, from 39.06 euros before. Now let me explain why there’s no real loss.

Although the price of the existing two shares should fall to 16.90 euros, the shareholder how has a right to buy one more discounted share at 11.64. They can spend 11.64 for an instant gain of 5.26 euros in the market (16.90 market price minus 11.64 purchase price). Or they can sell the right to buy to someone else for 5.26 euros.

Either way, the price loss on the original two shares is offset by an instant gain. Either from buying the new, cheap shares below market or selling the rights to someone else. It all nets out.

In this case 16.90 (TERP) is 13.5% below 19.53, so that’s how much we should have expected the price to fall at the announcement. But, at the time of writing, the market price is actually 17.27 euros, which is only a fall of 11.6%.

Put another way, the market has been positive about Deutsche Bank’s plans. It works out as a 2.9% immediate gain for the original shares (see table below).

I know this is all a bit complex, but there’s not really any getting around it. Sometimes investing has unavoidable intricacies.

Here’s a summary of the numbers for those interested (figures in euros).

If you already own Deutsche Bank’s stock the final step is knowing what to do now. Whatever you choose you MUST NOT act until after 21st March, as I’ll explain below.

Your options are:

  1. Close your position: sell all shares and rights
  2. Add to your position: buy extra shares in the rights issue
  3. Reduce your position: sell the rights but keep original shares

The reason you shouldn’t do anything before 21st March is because that’s when the rights will start trading. You’ll then have a short window (until 31st March in New York, 4th April in Frankfurt) to make a decision.

As of now the rights issue has been announced but not officially launched. So if you sell now you may lose the rights, which would be a real loss to you since the share price has already fallen, but the rights will make up for it (as I showed above).

At the current market price of 17.27 euros, if you choose option one then your profit since July would be 70%. (It will be a little less when measured in US dollars, as explained last week.)

If you choose options 2 or 3, the range of estimated profit outcomes by the end of 2020 is shown below, under my three scenarios. These include estimated capital gains and dividends. The numbers are underpinned by a complicated analysis, but I think highly realistic. Here I just present the end results.

(I’ve also included the expected returns on each of the original and rights issue shares. They’re similar because the purchase prices are similar: 11.81 euros and 11.64 euros respectively.)

What you choose will depend on your own priorities.

Option 1 will give you a quick (and fat) profit, but you’ll miss out on a lot of additional potential upside.

Option 2 leaves you with a bigger overall position than before, but maximises the total available profit potential (in euros or dollars).

Option 3 leaves you with a smaller position than before, but maximises the likely percentage return on the capital that you’ve invested.

Choosing between options 2 and 3 is therefore about firstly whether you have additional cash to invest and secondly not letting the position get too big.

Assuming you have the cash I recommend going for option 2. That way you don’t have to worry about timing the sale of the rights within a short market window. You can always reduce your position later, with the luxury of plenty of time.

[Note: If you bought late last week at a higher price, after my last article, I’ve included a similar analysis after the end of this article. Even at the higher price I’d encourage you to hang on. But if you find it too complicated then you can wait until 21st March and close out for a small profit by selling both your shares and your rights (option 1), less dealing costs.]

Understanding discounted rights issues is a tricky business, but I hope I’ve explained the main issues here.

The key thing is that they cause the stock price to fall when announced, but they shouldn’t leave you out of pocket. You either sell your rights for cash, or you buy more shares very cheaply for an instant market gain of the same amount.

I remain positive about the turnaround going on at Deutsche Bank under the leadership of CEO John Cryan. Despite the big capital raise, I don’t think the profit potential for investors has been reduced.

In fact, because putting capital worries behind it has reduced risk and accelerated likely future dividend payments, it may even turn out better than previously expected.

For those reasons I’d recommend that you stick with it.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com


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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.