- by GJ Prasad
Light at the end of the tunnel or..
Deutsche Bank (DB) reported Q4 (and full year) 18 results on Friday morning and they were hardly inspiring. The bank continues to underperform its rivals driven by what we believe to be is a broken business model, excessive reliance on FICC and very high cost base. The Q4 performance demonstrated the scale of the problems given the very difficult market conditions and drop in trading volumes.
And for all its efforts in 2018, the bank generated net income of just EUR 267 million translating to a meagre RoTE of 0.5%. On the positive side though, the bank generated annual profits for the first time since 2014. With a cost-to-income ratio of almost 93%, it seems that the bank needs to do radical restructuring and substantially move away from the FICC business and focus entirely on corporate banking and wealth management. In the meantime, what should AT1 investors do?
Cost cutting can only achieve little.. what is needed is radical thinking…
The future does look very challenging for the bank in terms of even generating the 4% RoTE target set by management. To achieve this they plan to further cut costs whilst maintaining current revenue levels. From my perspective, to make it viable, the bank either needs to increase revenues by EUR 3 billion (with the current cost structure), which means additional 15% revenue growth or cut costs by EUR 2 billion (for current revenues), which equates to almost 10% of current cost base.
To me increasing revenues by EUR 3 billion or more especially in FICC is almost close to impossible given the structural changes in the industry and to cut costs by EUR 2 billion means significant headcount reduction (and hope that it does not translate to decreased revenues).
And in meantime, if the bank is hit by litigation costs and or one-off operational risk charges, earnings would go back to the starting point. Hence, I don’t see any real visibility in earnings growth for the foreseeable future. The bank thinks it does not need any further provisions for the various ongoing issues and I think it is being too optimistic.
Hence the need for a very radical approach to its future path is required.
Leverage is still the issue in capital structure
Capital ratios are holding up well with a reported CET1 ratio of 13.6% and a leverage ratio of 4.1%. But, it feels that overall capital is still underwhelming given the leverage exposure of EUR 1,273 billion and Tier 1 capital of EUR 52 billion.
Ideally the bank should potentially have another EUR 10 billion of Tier 1 capital (which would take the leverage ratio close to 5%). With almost EUR 25 billion in Level 3 assets, any large impairment will have outsized impact on profitability and overall capital. No wonder the stock trades at 0.3 times its tangible net value.
Credit investors may feel relaxed but AT1 investors should be nervous:
Liquidity and funding are not issues for the time being as the bank has a large liquidity buffer and has large loss absorbing capacity. To that extent, senior debt holders and counterparties should feel comfortable about the bank’s credit risk.
As far as AT1 investors are concerned, whilst immediate solvency is not an issue and coupon risks are low for now (they have ADI reserves of EUR 1.6 billion, equivalent to 5 times the coupon payment), it is the future that should worry.
Given the back end on the existing AT1s, extension risks are very high. For example the back end on the USD 6.25 AT1 callable in Apr 2020 is 5 year swaps + 435.8 bps and the back end on the EUR 6 AT1 callable in April 22 is 5 year swaps + 469.8 bps. The EUR 6 Perp 22 trades at a cash price of 88, translating to a yield to call of 10.2% (YTC) but drops to 6% on a yield to perp (YTP) basis. One needs to ask – would you want to own DB AT1s with a 6% YTP and all the downside risk from trigger risks in the future.
Given where the bank’s stock is trading I would expect AT1 investors to demand at least 8% or higher yield on a perpetual basis. That would mean that the existing AT1s are probably mis-priced by at least 10-15 points.
And in any highly unlikely resolution type event, these AT1s will not recover any value (zero recovery). Any merger with the other underperforming German bank will make it worse in terms of capital structure given the issues in the other entity.
If anything, I would rather own the bank’s stock given the valuation ahead of the bank’s AT1. And there are plenty of attractive AT1s to own in other (but more defensive) names in Europe. May be the right thing to do would be to underweight the DB AT1s within the overall portfolio despite the “attractive” yield to call. The darkening prospects about its future is still too large a risk to ignore.
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