There’s a huge global investment bank that’s priced for distress. But if you trust its new CEO then the stock offers a huge profit opportunity. Today I’ll dig further into the possible outcomes, and whether you should buy this stock.
Last time, in “The huge investment bank that has everyone worried”, I started looking at Deutsche Bank (DB). It’s a massive global investment bank, headquartered in Germany but right at the centre of the world’s financial system. If you missed that article then I recommend you read it before this one. It provides important background.
DB’s stock is priced so low that investors must assume it’s in desperate need of new capital. But as of now the bank has announced no big, new losses. It also has a highly competent and respected new CEO at the helm, John Cryan, who has recently claimed the bank needs no new capital.
So the question naturally becomes: should we trust the short-term view of the markets or the long-term vision of management? Put another way, is Deutsche Bank stock a type of toxic waste that should be avoided at all costs, or a huge opportunity for investors?
The stock can easily be bought and sold on both sides of the Atlantic. Either in Frankfurt on the Xetra exchange, priced in euros (ticker:DBK), or on the New York Stock Exchange and priced in US dollars (ticker:DB).
At the time of writing the market prices on those exchanges are 12.70 euros and US$14.12 respectively. The euro price is up 11% since my article last week, but still trading at a very depressed price-to-book ratio (P/B) of just 0.33.
(Note: Book value is explained in the previous article. In this case I’m using “tangible” book value, which also deducts an “asset” called goodwill. Goodwill is how much a company paid above book value for past acquisitions of companies. It’s a complex and technical area that could take a whole article to explain. But basically goodwill is an accounting oddity designed to boost corporate acquisition activity, and should be stripped out when evaluating companies.)
Put another way, DB’s liquidation value of 52 billion euros at the end of March is three times as high as its market capitalisation of 17.4 billion euros at today’s stock price.
This implies that the market thinks the bank needs a huge amount of extra share capital. That would leave existing stockholders owning a smaller piece of the pie.
This implies that the market thinks the bank needs a huge amount of extra share capital. That would leave existing stockholders owning a smaller piece of the pie. But if that’s not the case then the stock is a huge bargain. Even if it is the case the stock is probably still cheap. Let’s look at the evidence.
CEO John Cryan has undertaken a huge and ambitious transformation of the bank, as explained previously. He’s also set financial targets for the future, by 2020. Using those targets we can estimate what the bank is worth if they are achieved.
Cryan has said he wants to cut the cost base by about a third to 22 billion euros. He also wants a cost-to-income ratio of around 70%, meaning total costs (excluding corporate taxes) would be 70% of top line revenue. That implies revenue of around 31 billion euros in the year 2020, which is a little below to the 32.6 billion brought in last year.
In other words this is not a growth opportunity. This is a turnaround play which relies on Cryan delivering his clean-up plan.
Another key target is to achieve a post-tax return on tangible equity of 10% or more. Tangible equity was 52 billion euros at the end of March. If it stays the same this implies net profit after tax of at least 5.2 billion euros.
At the current share price – assuming no new shares are issued – that would mean a P/E ratio of just 3, or put another way a huge earnings yield of 33% (E/P as a percentage).
Now let’s assume the future bank pays out 50% of earnings as dividends. That would work out as a massive dividend yield of 16.5% at the current price. Using a bit of maths it also implies a 5% a year future growth rate. (For those interested the implied growth rate is the profit retention rate of 50% multiplied by the return on equity of 10%.)
If the stock price doesn’t increase until 2020, and if the valuation multiples don’t change from 2020 onwards, and under these assumptions, investors at that point would make 21.5% a year. That’s 16.5% dividend yield plus 5% annual capital gain as the book value and profits grow.
In reality the market would accept much lower returns than that, meaning the share price would go up beforehand. The returns demanded by investors are known as the “cost of equity” in financial lingo.
Let’s say investors wanted to make 10% a year for the risk of owning the future (lower risk, more profitable) DB stock. Using a bit more maths this implies the future P/B ratio would be 1, or three times today’s level.
(Again, for those interested in how I got there: P/B = (Return on equity – Growth rate) / (Cost of equity – Growth rate). So in this case it’s 5% divided by 5% which is 1.)
This means – if no new equity capital is raised, if book value stays the same, and if management targets are met – in four years’ time the stock would be worth three times as much as today. That’s a total profit of 200%, excluding dividends, which works out at 31.6% a year with compounding (profits on profits). Clearly that be a great result for the patient investor.
But let’s say future investors want a bit more return for the risk. If the cost of equity is 12% then implied P/B falls to 0.7. That’s still 112% above today’s level, and 20.6% annual compound gain over four years. And don’t forget the book value will probably rise as well, meaning extra profit on top.
The profit potential is clear. In four years’ time the company should be worth two to three times as much as today, and possibly more. But what about the risks? How much extra capital might DB need, and how does that hit the potential profits?
The first thing to note is that banks in general are much less leveraged than in the past due to much stricter capital rules. The ratio of assets to equity capital tends to be in the range of 15 to 25 times these days, whereas levels above 50 were common before 2007.
Also there is currently no global financial crisis, although Italian banks need new capital (see here for more). Last time around, the worst hit banks lost around $50 billion (45 billion euros). A repeat of that seems highly unlikely at the present time.
But let’s say DB needs to raise 20 billion euros of new equity capital. I doubt it would be anywhere close to that, but let’s look at what it would mean for current shareholders. It’s a sort of worst case scenario, based on current conditions.
DB’s tangible equity (book value, net assets) was 52 billion euros at the end of March. If DB lost 20 billion euros due to asset write downs that would leave 32 billion. Adding back 20 billion to that level would be an increase of 62.5% (20 divided by 32). Put another way, today’s shareholders would own 61.5% of the company (32 divided by 52), instead of 100%.
Their ownership share of the future company would have been diluted. The total company would still end up being worth two to three times as much as today by 2020 – if targets are met.
Their ownership share of the future company would have been diluted. The total company would still end up being worth two to three times as much as today by 2020 – if targets are met. But the price of current shares wouldn’t go up by as much. They’d go up between 30% and 80% under this short-term distressed scenario. Still not bad, but obviously much less compensation for the short term risk.
So what’s an investor to do? My current feeling is that DB is sound, or only needs a little extra capital, but we’ll find out in the next couple of weeks if I’m right. Second quarter results are out on 27th July. Any big problems or losses will be announced then, and possibly before.
My recommendation is to wait until the publication of results. If there is no announcement of a massive need for new capital then Deutsche Bank looks attractive for those prepared to hold it for three to five years. The profits could be substantial if the turnaround is successful. I’ll let you know what happens.
Just remember that all investment bank stocks are pretty speculative – meaning you shouldn’t “bet the farm”. You never really know what’s lurking on their balance sheets, which is why the credibility of management is so essential.
For now Deutsche Bank’s new CEO, John Cryan, is reckoned to be one of the best in the business. Only time will tell if that assessment is right and whether he was brought in soon enough. If so, then Deutsche Bank stock is a huge bargain at current levels.
Stay tuned OfWealthers,