Deutsche good or Deutsche bad – update 05

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Q1 2018

Into the rather political headlines “Deutsche Bank sacks British boss John Cryan after years of losses”.

Lets face it, with or without a British boss Deutsche bank has been a total shareholder failure. In fact the bulk of the losses come from the incumbent workers unions (which is a problem also seen in the smaller sister bank – commerzBank) within the mother country, Germany. The fix is the appointment of Co-deputy chief executive Christian Sewing, 47, who will take over as chief executive immediately.

Sweing is a back office risk & compliance person, so the move indicates a potential direction that Deutsche Bank may take over the short to medium term. This is largely a defensive / negative move aimed at preservation of existing and core business. However, it is possibly too little too late and it will take many years of investor patience to generate any meaningful return.

The share price has not reacted (and certainly not positively) as one overpaid executive replaces another. The move is arguably a political one at best as it will add little to no shareholder value. There are reports that the probability of a merger between Deutsche Bank and CommerzBank has increased as a result of the change, however, this would be met with resistance from both sets of workers who would face redundancy from the efficiency gains. Herin lies the problem, until the inefficient organizations can bring themselves back inline with the competition (namely the UK and US banks) the shareholders will see little to no value and possibly further erosion of existing.

 

Conclusion

Expect little to nothing. Market perform at best. Deutsche bank shares will remain at a discount to fair value as this remains the only attractive point to investors.

 

Into 2017

The saga continues…

See previous updates Deutsche 03, Deutsche 02, Deutsche 01 & Deutsche 00 or the text below for the background leading to today’s article.

The weekends headline is effectively a turnaround by management from the company’s previous direction. Instead of selling assets as was the original plan, the company now intends to raise €8 billion in equity capital according to its March 5, 2017 Release.

The positives:

  1. Capital ratio “comfortably above 13 percent”, so less question on this front.
  2. Less pressure to dispose of core assets to raise capital at undervalue (the hidden positive).

The promises:

  1. Up to 2 billion euros of additional capital accretion targeted in next two years from asset disposals (can happen).
  2. Significant strengthening of position in German home market (nonsense).
  3. Simplified business model (costs achieving such, plus lags market so far).
  4. An integrated Corporate & Investment Bank (nonsense & more costs).
  5. Postbank and Deutsche Bank’s Private & Commercial Clients business will be combined (even more costs).
  6. Adjusted cost base intended to decrease from 24.1 billion euros (2016, after business disposals) to about 22 billion euros (2018) and to about 21 billion euros (2021) (deminimus outcome).

The negatives:

  1. Anticipated restructuring and severance costs of approximately 2 billion euros.
  2. The fact that aside from [1] and [6] above, the bank has continually failed to deliver on all f the above. The targets are processes that should have already happened and have failed due to the same internal frictions that will prevent such going forwards and also that this bank is lagging its peer group in terms of change so at a competitive disadvantage.

In terms of words written, well over 75% of the release published on the Deutsche Bank website consists of content that should have already been occurring as part of a healthy (or self repairing) business. So the read is regurgitated old content containing little new information. Statements of efficiency have and will continue to be impaired by the incumbent workforce and will come at a cost that the bank (for economic and political reasons) has been reluctant to take.

Redundancy

One core reason the bank lags the market is due to the fact that political incentives have been greater than the economic incentives. The leading German bank simply cannot make the necessary redundancies it has long needed to (similar to its sister bank, CommerzBank). It therefore cannot compete against the efficiency of other banks in its peer group that have made such “harsh” changes and therefore lags on many fronts. What the investors sees is a reduction in global footprint of some profitable businesses leaving an increasingly inefficient core business. The big question remains, will this be addressed ?

The capital raise

This should net out to be market neutral. However, here are some key points.

  1. The raise is only fractionally for the right reasons.
  2. One expects, unless at good discount, investors to release discounted stock into the market (impairing the price for some time).
  3. A good discount (above) will impair the current price.

An 8 bill raise on 25 billion market capital represents an initial 33% raise and a 25% reduction in resulting share price (assuming the company raises at €10 per share). In terms of numbers, this should be neutral, but ultimately, value will be driven by delivery of efficiency. Will this really happen ?

 

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The 2015-2016 story

There has been a lot of headlines just recently about Deutsche bank. This article takes a look at the various scenarios.

  • Equity impairment (capital raise).
  • Equity repayment (sale of assets).
  • Market uncertainty (the pending fine)
  • Market clarity (what happens next)
  • Business going forwards (or loss of)

Into the detail

Outside the plethora of media propaganda and hearsay, investors have access to Deutsche Bank financial results (annual reports) on this link.

According to the first line 2015 annual report “2015 was a challenging year for Deutsche Bank“. The first obvious takeout, is that investors are in for the long run with strategy 2020 which takes on 4 key deliverables.

  1. to become simpler and more efficient. (cost)
  2. to become less risky by modernizing our technology. (cost)
  3. to become better capitalized. (cost)
  4. to run Deutsche Bank with more disciplined execution. (cost)

All the above indicate limited returns for equity risk out to 2020 assuming the bank meets its targets.

Here are the headline numbers (or not) that come out from the above.

  1. eliminate approximately 90 legal entities – so this is 45 per year or 1 every fortnight.
  2. “We aim to modernize our IT architecture, for instance by reducing the number of individual operating systems” – this is simply an open cost with no headline value leaving the investor open on risk.
  3. reduce Risk Weighted Assets (RWAs) from €410 billion to €320 billion by 2018 and €100 billion by 2020. – this is over €100 billion per year of RWA (€8.5 billion per month continuously for 3 years).
  4. no value assigned to this task again leaving the investor open on risk.

The bank will also exit from legacy Rates assets, Agency Residential Mortgage-Backed Securities (RMBS) trading and high risk-weight securitized trading. This translates to significant reduction in top line revenue. even before other activities such as Emerging Markets Debt, Rates & Credit OTC clearing are rationalized!

Image result for arrow picture  Margins will be slim.

The well reported drop in market capitalisation leaves the bank at less than 50% of it’s 2015 reported v

alue.

Is this discount enough or has the market, in fact, not priced in enough (as may be the case from the open $14 billion department of justice fine) which at the current point in time represents the entire market capital of the firm.

Forward looking business prospects

The market should be expecting loss of revenue. Last week it was reported that hedge funds were reducing exposure to the bank. Clearly, this is a move that may make sense. One expects to see other customer types act in a similar manner and headlines will show this over the coming weeks & months.

Headlines now report that Deutsche Bank has seen some outflows from its wealth management division but that withdrawals are “not significant”, citing senior executives. Fabrizio Campelli, head of Deutsche’s global wealth management business, is reported by Reuters to have said that outflows “is not something that has resulted in any material concern for us”.

The is no clarity at this point on the value of “not significant” as a percentage of clients, nor the rate of dec

line. However, over time, this will become clear, albeit potentially at a point that is too late for shareholders.

Here are the facts that are available:

  • Wealth management client assets managed by Deutsche Bank stood at EUR 361bn as of end-June, with clients in Europe accounting for just over half of that amount and Asia-Pacific clients making up 14% of assets.
  • Deutsche Bank is also said to be implementing a hiring freeze amid cost cuts. Reuters and Bloomberg report that an internal memo was sent to divisional COOs yesterday saying that hiring will be put on hold with immediate effect, excluding some control functions like compliance. (The market was expecting this).

What is obvious at this point in time is: [1] reduction in top line revenue (from a high margin source) & [2] a cost increase as producers (organically) reduce and cost centers increase.

 

When the trend is not your friend

If historic performance is anything to go by, the global long term view of DBK returns to shareholders, look at best anemic. The share price clearly indicates no value creation by management, or otherwise, for the duration of the past 20 years.  In fact, what investors have seen is continual value destruction.

The only caveat to the above has been a consistent dividend. This has now been stopped.

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The US settlement

This morning news comes out about a DBK settling with the US Department of Justice (simultaneously Credit Suisse also settles for $5.3 bill).

As a reminder the scandal dates back to 2005 and 2007, when banks packaged up home loans and sold them on to investors.

Under the settlement, Deustche Bank will pay $3.1bn and provide $4.1bn in compensation to customers. Our simple maths comes to a total value of $7.2 bill. This was larger than the base case discussed, but still well within the total claim of $14 billion set by the US DoJ. The market has so far taken this as a positive.

The share price post the news stands at €18.5, which remains a hefty discount to book (at 36% book and 43% tangible book) with the market capital at €24.5 billion.

In summary, whilst large, the market will see this as a step forwards and removal of a large unknown.

The full article from the DBK newsroom page can be found in the link below:

https://www.db.com/newsroom_news/2016/ghp/deutsche-bank-agrees-on-settlement-in-principle-with-the-doj-regarding-rmbs-en-11789.htm

 

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