|Shares Out. (in M):||855||P/E||7.0||6.8|
|Market Cap (in $M):||16,299||P/FCF||n/a||n/a|
|Net Debt (in $M):||0||EBIT||0||0|
|TEV (in $M):||0||TEV/EBIT||n/a||n/a|
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Danske Bank is the largest bank in Denmark (~30% deposit share) and one of the largest Nordic banks. For the most part, Danske is a fairly “plain vanilla” bank - ~50% of earnings come from retail banking, with the remainder coming primarily from corporate / institutional banking, wealth management, and fixed income and currency trading. Beginning in late 2017, however, it became clear that a branch of Danske Bank located in Estonia had facilitated money laundering for ~15k “non-resident” customers, primarily from Russia. The news came out piecemeal, culminating with the release of Danske’s internal investigation (found here), which revealed that as much as $230bn of suspicious funds may have ultimately passed thru its Estonian branch. In Oct-18, Danske’s CEO resigned, two board members were replaced, and the stock fell from 250 DKK in January 2018 to 120 DKK currently, as the prospect of large fines from regulators, particularly the US, created a significant overhang on the stock. We believe this decline prices in far too drastic of an outcome (>$10bn USD fine) for an otherwise healthy bank. Based on precedents, we believe a fine in the $2bn to $3bn range is more reasonable and is well covered by Danske’s current excess capital. Once extraordinary legal spending related to the Estonian incident rolls off, we believe Danske’s earnings power is ~18 DKK per share. At 11x (Danske’s historical multiple / in-line with peers) plus one year of dividends (8.50 DKK), we believe the bank should be worth ~206 DKK per share vs. 120 DKK currently, representing ~70% upside from current.
Danske is the largest bank in Denmark and one of six large Nordic banks (Nordea, DNB, SEB, SWEDA, and SHBA are Danske’s closest peers). At 120 DKK per share, Danske has a market cap of 102bn DKK ($15.6bn USD) and trades roughly $50mm USD per day. Like its Nordic peers, Danske earns a relatively healthy RoE of ~10% to 12% despite being well capitalized, with a CET1 ratio of 17.0%.
Danske’s earnings and asset detail is shown below:
Credit exposure by geography / industry:
Danske has been growing its loan book low-single-digits organically, driven by stable market share in Denmark and healthy growth in Sweden (where Danske had been modestly gaining market share). Low charge-offs and relatively stable NIM, despite operating in a negative interest rate environment led to low-single-digit organic earnings growth, prior to Danske’s AML issues in Estonia, which was boosted by a healthy buyback which had reduced shares outstanding by ~12.5% since 2015.
By far the most volatile portion of Danske’s earnings stream is trading income, which is ~10% of total income and is primarily transactional earnings from currency and fixed income trading. As have most Nordic (and many global) banks, Danske’s 2018 trading income suffered from flat yield curves and lower FX volumes and led to modest earnings downgrades in 2018 (unrelated to Danske’s AML issues).
Background / What happened in Estonia?
The most comprehensive explanation of the AML issues with Danske’s Estonia branch is the 87-page investigation conducted by the Danish law firm Bruun & Hjejle (which you can find here), which Danske released in October, however the key points are summarized below.
In 2007, Danske acquired Finnish Bank Sampo and, as part of the acquisition, inherited Sampo’s Estonian branch and its portfolio of ~15k non-resident customers (i.e. deposits / accounts of people living outside Estonia). From the time it was acquired to the time it was closed down, Estonia was relatively insignificant to Danske’s overall operations – in total, Estonian assets represented ~0.5% of total assets and ~2% of total earnings. Due to Danske’s attempts to cut costs during the financial crisis, the Estonian branch largely operated on its own systems, conducted business in Estonian or Russian rather than Danish, and were never properly integrated with the rest of Danske.
As early as 2007, Danske received warnings from investigators in Estonia and the Russian Central Bank that there was suspicious activity occurring in the non-resident portfolio, but none of these warnings ever resulted in any concrete action on behalf of regulators or the bank. In December 2013, however, a whistleblower within the Estonian branch filed a complaint identifying a suspicious account which had been moving large amounts of money but had no official reported revenue. In January, Danske compliance / audit decided to investigate and notified the Executive Team and Audit Committee. In early 2014, this investigation identified “critical gaps” in compliance policies in Estonia, but concluded that no additional reporting to authorities was necessary. Instead, Danske chose not to open new non-resident accounts and allow the existing portfolio to wind-down over time. In early 2015, several counterparties (later identified as DB and BAML) refused to clear payments for the non-resident portfolio, and Danske actively shut-down the remaining accounts by early 2016.
News of these issues did not break publicly until March 2017, when local Danish newspaper Berlingske reported that ~$1bn of suspicious funds had flowed thru Danske and Nordea branches in Estonia between 2011 and 2014. In Sep-17, Berlingske reported that ~$2.9bn of funds used by Azerbaijan officials to pay political bribes had flowed thru Danske’s Estonian branch. In October, French investigators opened a preliminary investigation into Danske related to money laundering connected to the death of Sergei Magnitsky. In December of 2017 Danish regulators fined Danske 12.5mm DKK (~$2mm USD) for poor anti-money-laundering controls and the issue appeared to be settled with minimal / no impact on Danske’s overall stock price.
Throughout 2018, however, the true scope of the problem became increasingly clear and began to impact Danske’s stock price. In Feb-18, Berlingske reported that Danske’s Estonian branch had moved money on behalf of Putin’s family and Russian intelligence. In July, Berlingske estimated suspicious funds moving thru the Estonian portfolio totaled ~$8bn USD, which became $30bn in Sept-18 according to documents seen by the FT, then $150bn according to the WSJ, and finally culminated in the release of the internal investigation which identified the full $230bn of potentially suspicious funds. Importantly (as I will come back to later), the internal investigation did not identify any transactions which appeared to violate US sanctions lists.
With the release of the internal investigation, several things happened in short succession – Danske’s CEO stepped down, the company halted its share buyback program and confirmed it was under investigation by the US DoJ, Danish regulators raised Danske’s capital requirement from 12.5% to ~14% to absorb the impact from potential fines, and the AP Moller family (which owns ~21% of Danske) called a special meeting to elect two new board members and a new chairman.
What happens now?
As a result of these AML issues, Danske is currently under investigation in Estonia, Denmark, the UK and the US and is likely to face significant fines. Of these investigations, however, by far the most important is the US – despite the fact that Danske does not have a US banking license and has no material US operations, the DoJ has the ability to claim jurisdiction over any transaction anywhere in the world that touches dollars. US fines for money laundering tend to be several multiples larger than any other jurisdiction, and take into account fines levied by other countries – therefore, if you can correctly estimate the size of the US fine, the remaining fine (from Denmark) is fairly straightforward. The maximum fine in Denmark during the period Danske’s Estonian NRP was in operation is 2 to 2.5x profit ($450mm to $550mm), though the country recently passed legislation that would increase the maximum fine for future violations.
As with previous AML cases of comparable size to Danske, any US investigation is likely to conclude with a deferred prosecution agreement, in which Danske agrees to pay a fine to Treasury for AML violations and agrees to a monitoring period going forward. While timing is uncertain, based on conversations with former regulators and precedents we believe these investigations typically take 12-18 months, which should result in an agreement in early 2020. We believe this will be a meaningful clearing event for the stock.
How big will the fine be?
In theory, U.S. sentencing guidelines for money laundering violations (which you can find here) carry a maximum penalty of 2x the gross amount of money laundered (in this case, 2x $230bn). In practice, no bank of any reasonable size actually proceeds to trial, as the open-ended risk is too great. Instead, all previous large cases of money laundering (of which actually there are many) have ended in a deferred prosecution agreement which negotiates a fine size taking into account several factors laid out in 9-28.300, including (among other considerations):
· Seriousness of offense (who was harmed? Were US sanctions violated?)
· Pervasiveness of wrongdoing (how high up did it go?)
· History of similar conduct (in Danske’s case, none that we know of)
· Remedial actions (i.e. new compliance policies, replacement of management, exit of risky lines of business, etc.)
· Adequacy of prosecution of individuals
· Collateral consequences (i.e. financial stability)
There is no “formula” for what a deferred prosecution fine size will be, but we can estimate the fine based on precedents and the criteria above. In the last 10 years, there have been 24 deferred prosecution agreements for money laundering which resulted in fines greater than $200mm. Of these 24, thirteen involved breaches of US sanctions (financing Iran, North Korea, etc.) and eleven were simply money laundering without sanctions violations (Panama papers, drug money, etc.).
As noted previously, there is no evidence to-date that any of the $230bn of suspicious funds that moved through Danske’s Estonian branch violated U.S. sanctions. There has only been one AML fine above $1bn without involving sanctions violations ($2bn to JPM for assisting with Bernie Madoff’s ~$65bn Ponzi scheme, deferred prosecution agreement found here). The most comparable of these non-sanction violating fines is DB’s 2017 fine for placing “mirror trades” (offsetting trades in Russia and the UK, allowing Russians to effectively transfer wealth out of the country undetected), which cost Deutsche ~$670mm. If Danske’s fine is determined in relation to these precedents, we believe there is significant upside to the stock.
More conservatively, we can estimate the high end of a potential fine by looking at fines for sanctions violations. Since 2012, there have been three AML-related fines of more than $1bn. The largest ever AML fine was ~$9bn for BNP’s financing of countries on U.S. sanctions list (specifically Sudan, Iran, Cuba, Burma) between 2004 and 2012. US prosecutors found that BNP had systematically concealed the identities of these countries to avoid being flagged, and that this practice went as high up as the CFO. In the case of HSBC (which copped a ~$2bn fine and a Netflix documentary), US prosecutors found that from 2001 to 2010, the bank had “severe, widespread, and longstanding AML deficiencies” which were spread all over the world, and involved customers linked to Iran and entities with known terrorist links. Similarly, US prosecutors found that Commerzbank (~$1.5bn fine) had been purposefully concealing the identity of sanctioned Iranian banks (deferred prosecution agreement here).
Perhaps the most important sentencing criteria for capping the high end of a potential AML fine for Danske is consideration of collateral consequences. In all 24 of the AML fines above, no offending entity has ever been forced to raise equity to pay the fine. Even BNP – which is a clear outlier in fine-dollar terms and significance of offense – only received a fine that was ~10% of its unaffected market cap. Any fine that risks the solvency of Danske Bank would seriously threaten economic stability in Denmark and the Eurozone more broadly – for context, Danske’s $550bn USD in assets is roughly 7/8ths the size of Lehman Brothers at bankruptcy (~$640bn of assets) and significantly more meaningful per capita, as Denmark’s population of less than 6 million people is less than 2% of the size of the US. Based on our conversations with former prosecutors, we believe that no prosecutor would consider an AML fine that would threaten the solvency of a major bank and that, as a rule of thumb, prosecutors tend to think of one-year’s-profits as a practical maximum (in Danske’s case, ~$2.5-$3bn USD).
Translating these precedents into Danske’s case, we believe a ~$2-$3bn USD fine is a reasonable estimate. That level would place it as the largest ever non-sanctions violation fine (larger than JPM for Madoff), and the second-largest ever AML fine of any kind. Danske’s unaffected market cap was ~$30bn, meaning a $2-$3bn fine would be in-line with the largest ever fines in relation to the size of the offending entity. The only remaining outlier above this range is BNP, which seems to be worse on all relevant sentencing criteria (damage done, sanctions violations, pervasiveness of wrongdoing, etc.) and clearly had a significantly higher ability to pay, given BNP’s much larger size.
How much can Danske afford to pay?
Danske currently has a CET1 ratio of 17% versus its regulatory minimum of ~13.8%, meaning the company currently has $3.6bn USD of excess capital – however, we believe this understates Danske’s true capital buffer for several reasons. First, the 13.8% level includes an additional 10bn DKK ($1.5bn USD) buffer imposed by Danish regulators after it became clear that Danske would face significant fines. In the event of a settlement with regulators, we believe this additional buffer would be removed (in fact, in its most recent stress test Danish regulators did remove this requirement). Second, Danske generates a significant amount of capital organically even while paying a dividend. Danske has guided 2019 net income of ~14-16bn DKK and a dividend of 8.50 DKK per share (~7.3bn DKK total), resulting in net capital generation of ~7-8bn DKK (~$1.2bn USD) per year. Finally, in a worst-case-scenario Danske could of course cut its dividend, generating an additional ~$1.0bn USD per year of capital.
In total, we believe Danske could easily afford a fine of up to $7bn USD in 2020 without having to raise capital or cut its dividend ($3.8bn current buffer + $1.5bn additional buffer + two years of capital generation of $1.2bn per year, all in USD), and substantially higher (nearly $10bn) if it decided to cut the dividend completely and build more capital organically. Our conversations with the company suggest they believe that regulators generally will give an offending party some indication of likely fine size range in advance of a settlement to minimize economic disruption and potential collateral damage. To the extent this is true, we view Danske’s current dividend policy (recently announced dividend of 8.50 DKK per share) as supportive of the view that likely fines are manageable within the context of Danske’s current excess capital.
Danske Pro forma CET1 Ratio at Various Fine Sizes
What about damage to the core business?
Besides the size of any potential fine, some sell-side analysts have speculated that the reputational damage to Danske could result in slower growth and lost customers. We believe these fears are not well supported in any of the previous large AML cases mentioned above. In its most recent report Danske disclosed that it has lost a total of 11k retail customers since the internal investigation was published (0.8% of total) and no commercial customers. Given the publicity around the AML violations in the third and fourth quarters, we believe any further customer churn is likely to decrease from these (insignificant) levels.
As further evidence of this, Swedish lending data is published monthly by bank and allows for near real-time tracking of Danske’s growth vs. system in Sweden (unfortunately the same data is not available in Denmark). In both corporate and household lending, Danske continued to outgrow system throughout the fourth quarter, when news coverage of Danske’s AML issues was at its peak.
One area, however, where Danske has seen some modest pressure is refinancing some of its most junior debt. In January, Danske launched a routine issuance of 3 and 5 year “non-preferred” debt which has the ability to be bailed-in based on EU banking standards. The pricing of that debt issuance was delayed by a day after Bill Browder announced he was hosting a press conference to present evidence that Danske accounts were used to channel funds out of Russia related to the death of his colleague Sergei Magnitsky. The bond issuance was ultimately at a spread modestly wider than Nordic peers, representing what we believe is a ~1-2% earnings headwind, but has since traded well implying limited further funding cost impact from AML-related fallout.
Since Danske’s 3-year non-preferred issuance, several European banks have accessed funding at similar (or higher) costs, which we believe is further support that wider spreads are not solely due to Danske’s AML issues.
What is Danske worth?
Given a healthy return on equity and strong capitalization, even after a large AML fine, we believe Danske should trade at a substantial premium to book value versus its current multiple of 0.7x book. Historically, Danske has traded at an earnings multiple in-line with its five large Nordic banking peers (Nordea, DNB, SEB, Swedbank, and SHB), which all have similar growth and return on capital profiles. Those peers today trade for 10.8x earnings – or 11x earnings if you exclude Swedbank, which itself was recently was accused of participating in Estonian money laundering.
Danske’s 2019 net income guidance of 14-16bn DKK (~17 DKK per share) includes a number of costs which we believe will roll-off over time as Danske settles its AML issues and should not be capitalized. For example, Danske is spending nearly 700mm DKK on additional legal costs related to the case and an additional 300mm DKK on a complete overhaul of its AML IT systems. Of this 1bn DKK of additional cost, we believe at least half will prove non-recurring as Danske settles its AML issues. With modest (~2%) top-line growth in 2020 and the roll-off of these additional expenses, we believe Danske should generate ~18 DKK per share in earnings in 2020. Valued at 11x those earnings plus the 2019 dividend of 8.50, Danske would be worth ~206 DKK per share.
As Danske is already carrying enough additional capital to pay a $2 - $3bn USD fine out of retained earnings, we don’t believe it’s fair to subtract an additional amount from the 206 DKK above to reflect the fine – however if, to be conservative, you subtracted that amount from the market cap, a $2bn USD fine would represent roughly 15 DKK per share (we believe it is not tax deductible) and a $3bn USD fine would represent 23 DKK per share.
If conservatively you subtracted the $2bn USD fine from the ~206 DKK price target above, we believe Danske represents an attractive IRR even at a range of settlement dates in 2020.
Timing (stretching out beyond 2020). Disclosure of sanctions violations. Macro (hedge-able – tho not perfectly - via 5 large Nordic banking peers).
Deferred prosecution agreement with the US DoJ, Treasury and SEC.
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