Deutsche Bank Remains A Value Trap (NYSE:DB) (2024)

Deutsche Bank (NYSE:DB) has a depressed valuation reflecting its fundamental woes, namely shrinking revenues and poor profitability, but the bank has a clear map to turn around its business. However, until it shows that it can deliver its targets, Deutsche Bank's shares remain a value trap.

Strategic Update

As I've recently analyzed, Deutsche Bank announced a new strategy a few months ago, aiming at strengthening the bank and reducing its reliance on investment banking, which has been one of its weakest businesses since the global financial crisis.

To improve its business profile, the bank is shifting its focus away from more volatile operations, like equity sales & trading, and plans to grow mainly in corporate banking. The goal is to make Deutsche Bank's business model less exposed to capital markets in the long term and have a higher weight of recurrent revenue streams.

To show progress on its recent strategic plan, the bank has recently held an investor day, changing some of its previous targets and giving more transparency about its business. Deutsche Bank's last investor day was in 2015, so this is a positive step in giving investors more transparency about the bank's operations.

Given that Deutsche's low valuation is to some extent also due to low investor confidence towards the bank, I see events like this one as quite important for a potential re-rating in the medium to long term.

Since the strategy announcement back in July, Deutsche has been making good progress on reducing its non-core activities (de-risking the Capital Release Unit) and downsizing the investment bank. Regarding capital, the bank has recently received good news, given that the European Central Bank has decreased its capital requirement for 2020 by 25 basis points (bps) to about 11.6%, as the central bank sees the bank is less risky than a year ago.

Source: Deutsche Bank.

As of 30 September 2019, Deutsche Bank's fully loaded core equity tier one (FL CET1) ratio was 13.4%, thus the bank is comfortably above capital requirements. As the bank continues to reduce assets in the CRU unit (it had about €53 billion of risk-weighted assets at the end of Q3 2019), it frees up capital and increases the buffer against requirements.

Nevertheless, the bank only expects to start meaningful capital returns in 2022, thus most of the capital build in the next couple of years should be allocated to business restructuring rather than shareholder remuneration.

Regarding profitability, Deutsche Bank intends on reaching a return on tangible equity of about 8% by 2022, even though since its strategy presentation in July, the interest rate environment got tougher both in the U.S. and Europe. This led the bank to lower its revenue target to €24.5 billion from €25 billion given the July presentation but maintained its RoTE target due to mitigation measures.

Indeed, Deutsche is implementing further measures to offset the 'lower for longer' rate environment (especially in Europe), such as charging deposits for negative rates, revenue uplift from the ECB tiering, pushing customers to move deposits to higher yielding products, and is reducing the cash in its balance sheet for liquidity purposes. These measures should support its top-line and further cost reductions in the CRU unit is another important measure for the bank to reach its RoTE target by 2022.

Source: Deutsche Bank.

Regarding credit quality, Deutsche Bank has a very good history, given that its net credit loss provisions have been quite low over recent years, at less than 15 basis points (bps) since 2017. Deutsche expects some normalization in the short term to less than 30 bps, but credit quality should remain quite strong and is not expected to impact materially its earnings in the coming years.

Source: Deutsche Bank.

By business segments, Deutsche Bank increased its expected revenue growth coming from investment banking (IB) over 2018-22, from 0% to 2% (compounded annual growth rate - CAGR), as the bank says that the last few months were stronger and now is more positive towards this business than it was in the summer. However, this unit has, historically, failed to deliver, and I wouldn't give much credit for these increased revenue targets, at least until the bank reports several quarters of improving IB revenues.

Other business segments had revenue targets modestly changed, with asset management being lowered to 2018-22 CAGR of 1% (previously was 2%) and private bank is now expected to report flat revenues during the next few years. This means that only after a few months of presenting its strategy of reducing its reliance in IB, Deutsche is again betting on this business segment to achieve overall revenue growth.

In my opinion, this increases the execution risk because IB revenues are heavily exposed to capital markets, and Deutsche has a high weight of revenues on fixed income sales & trading, which is an area that continues to see a shrinking revenue pool across the industry. Deutsche has lost market share for several quarters, not boding well for revenue growth in the coming quarters.

On the cost side, Deutsche Bank has a better track record and has been able to reach its cost reduction targets, which bodes well for further reductions in the next three years. Its goal is to reduce its annual cost base to about €17 billion in 2022, which represents a cut of 25% compared to its 2018 cost base. This is an ambitious target, but Deutsche intends to reduce some staff by some 15,000 or 16% of its current workforce, which should account for the vast majority of expense reductions and is largely in the bank's control, thus this cost base seems to be achievable by 2022.

Source: Deutsche Bank.

Taking into account the bank's revenue goal of €24.5 billion by 2022, this implies a cost-to-income ratio of 69.4% by 2022 and an operating profit of €7.5 billion. This clearly shows that Deutsche Bank's improved profitability in the next few years comes mainly from cost reductions, which are more under its management control than revenues.

This means that by being conservative on top-line growth and targeting higher profitability from cost reductions, execution risk of its strategic plan is more manageable. Nevertheless, this assumes some modest revenue growth in the coming years, something that has been quite challenging to achieve in recent years.

Indeed, according to analysts' estimates, Deutsche Bank's revenues are expected to continue to decline during the next three years, to about €22.5 billion by 2021. Therefore, analysts are skeptical that the bank will achieve its revenue and profitability targets expected in its strategic plan, showing that good execution of the plan in the next few quarters is critical to gain credibility among the investor community.

Conclusion

Deutsche Bank is making some progress in its recent strategy of reducing exposure to IB, but upward revised revenue growth expectations from this business may be hard to achieve. Therefore, until the bank shows sustainable execution of its plan, investors most likely will remain skeptical and continue to assign a very low valuation to its shares.

Indeed, Deutsche Bank currently trades at a depressed valuation of only 0.25x book value, one of the lowest valuations among European banks and at a deep discount to the sector (which trades on average at about 0.80x book value).

As I said in my previous article, I was short Deutsche Bank for most of 2018 and at the beginning of 2019, but I closed my short position last summer and remain on the sidelines for the time being. I think that its very low valuation is not a reason enough to buy the shares because Deutsche remains a value trap, but significant upside potential could exist in the medium term if the bank executes well on its strategic plan.

However, I'll wait a few more quarters to see how Deutsche is progressing in reducing CRU assets and stabilizing revenues across its businesses, and if progress is being achieved sustainably, then I may enter into a long position on Deutsche Bank.

Labutes IR