Description

EXECUTIVE SUMMARY

UniCredit is a global financial institution headquartered in Italy offering commercial banking services and leveraging on an established corporate & investment banking franchise.

The bank exhibits assets in excess of €800bn with loans amounting to more than €400bn spread out across core Europe (Italy, Germany Austria) and CEE (including Russia and Turkey).

In response to the huge rise of non-performing exposures following the financial crisis and to turn around the deteriorated performance indicators, at the end of FY16 the bank, led by the new CEO JP Mustier,  launched an ambitious plan aimed at (i) reorganizing the business to reach higher efficiency indicators, (ii) de-risk the assets’ base with massive disposals of non-performing loans and (iii) restore an adequate regulatory capital. Management actually delivered on the KPIs of the plan up to the end of FY18 and is expected to achieve FY19 targets: the management strategy allowed to properly tackle the bad loans’ issue; moreover, by the end of FY18, the plan goals in terms of operational efficiency (cost reduction) was on its way and the profitability restored with ROTE at 8% (9% target for the current year). Finally, the bank achieved satisfactory capital ratios and the funding plan is on track.

The intrinsic value for the stock could be estimated close to €17 based on a 10x normalized earnings multiple. The current market price (€11.1) highlights a compelling and solid investment case. The investor pays 6.7x estimated normalized earnings (my guess is 16% below FY19 consensus) and 0.5x tangible book value. The 4.5% current dividend yield could be projected growing from 2020 on as the capital base stabilizes at the targeted level and the funding plan complies with the recent loss-absorbing requirements set for systemic banks.

This represents an opportunity to invest in the out-of-favor Italian banking sector through the stocks of a large pan-European diversified bank exiting a successful turnaround, highlighting best-in-class performance ratios and solid risk measures. The gloomy market mood is justified by the prolonged and structural issues of the banking sector in the Eurozone. The European banks index posted a 30% decline over the last 12 months as a reaction to worsened GDP growth forecast. Furthermore, UniCredit, as the stocks of all the other Italian banks, suffered a steep decline during 2018 (nearly 50%) as a consequence of the domestic political turmoil and the tough confrontation between the populist government and EU on the budget.

The investment case is based on the spread between the cautious fair value estimate stemming from the solid fundamentals of UniCredit - in terms of asset quality, sustainable profitability and return on capital - and the market price. According to the research, the investments risks appear to be adequately factored in the price and the opportunity presents an attractive risk/reward mix for the investor.

COMPANY BACKGROUND

Unicredit SpA (“UniCredit”, “Company” or “UCG”), headquartered in Italy, is a pan-European commercial bank (global systemically important bank or one of G-SIBs) with a network covering Italy, Germany, Austria, Central and Eastern Europe. The group offers traditional banking services and leverages on its well established corporate & investment banking franchise to support clients globally. UCG leverages on a network of more than 4.,00 branches and nearly 87 thousand employees.

UniCredit is a public company with a diversified shareholders’ base: institutional investors (65%), sovereign wealth funds (10%), foundations (5%). Board of Directors and the Board of Statutory Auditors are appointed on the basis of a proportional representation mechanism.

Full FY18 figures are not yet available. Selected end of period FY18 figures show loans to customers (net of Repos) at €434bn with Italy contributing for one third, Germany and Austria collectively for 30%, CEE 15% and CIB 18.5%. Customer deposits totaled €422bn.

Total assets were in excess of €830bn including  financial assets (securities) for nearly €220bn.

Total financial assets (“TFA” intended as the sum of AuM, AuC and Deposits) for the Group were €811bn at the end of FY18, broken down as follows: AuM €212.3bn, AuC €183.6bn and Deposits.

RECENT DEVELOPMENTS

In 2017, the Company completed a €13bn rights issue to strengthen the capital position. The capital plan was instrumental to fix the problems with Non-performing Exposures (“NPEs”). In fact, the rights issue was one of the pillars of a larger strategic plan (“Transform 2019”) launched by the management at the end of 2016 aimed at:

• revising the business model and organization in order to introduce strict cost discipline and target best-in-class cost/income ratio;
• improving asset quality
• optimizing capital structure
• simplifying corporate governance.

In particular, the Company addressed the Italian NPEs legacy issue through a sale of a €17bn portfolio via securitization (the “FINO transaction”).

Transform 2019 initial key targets are still confirmed as follows:

• Net Income €4.7bn
• Cost / Income 52.6%
• Cost of risk 55bps
• ROTE >9%
• Fully loaded CET1 ratio 12.3%
• Dividend pay-out 30% and then >50% from 2020 on
• Rundown of non-core business by 2021

Transform 2019 is fully on track with 100% of redundancy program and 93% of projected branches’ closures already executed.

SUMMARY FINANCIAL OVERVIEW

In the last 3 years the bank averaged nearly €20bn in operating income (revenue, sum of net interest margin, fees, trading and other income) while Gross Operating Profit improved soaring from €7.1bn in FY16 to €9.0bn in FY18 thanks to the cost efficiency measures implemented (cost/income down from 63.5% in 2016 to 54.2% in 2018).

Write downs and provision for bad loans hit €12.2bn in FY16 with the large extraordinary provision to increase coverage ratios on the legacy outstanding NPEs and in preparation of the FINO Transaction. Cost of risk dropped to 67bps in FY17 and 58 bps in FY18 as a result of the normalization of the loans portfolio.

FY18 income was toughly affected by write downs of investments (€0.8bn negative impact of Turkish investment impairment – Yapi Kredi) and provision for risks (estimated  to be €0.6-0.8bn, based on public information and related to expected sanctions from US in relation to Iran) but benefited from some one-off DTAs recognition. The FY18 Adjusted net income amounted to €3.9bn (the extraordinary provision for US sanctions have not been considered as an adjustment).

The Company is organized according to the following business units (mostly coincident with the commercial banking franchises in the different countries): Commercial Banking Italy, Commercial Banking Germany, Commercial Banking Austria, Central Eastern Europe, CIB, Fineco (online broker – asset gathering), Group Corporate Center and Non-core (segregated bad loans’ portfolio  to be rundown).

CB Italy accounted for 37% of 2018 group income with CEE the second reference market and CIB contributing nearly 19%. Looking at the Net Operating Profit (accounting for the cost structure and loan loss provision burden), Italy remains the most important net contributor with 33%; CEE and CIB accounts for, respectively, 35% and 34% because of the efficient and lean cost structure. Non-core adversely impacts the profitability because it encompasses the loan loss provision on the oldest non-performing exposures of the group.

ASSET QUALITY

Since the 3Q16, UniCredit has taken decisive actions to de-risk its balance sheet. Group asset quality has significantly improved as part of Transform 2019, with group gross NPEs down by €38.6bn (-50%) and net NPEs down by €21.5bn (-59%) since 3Q16.

FY18 gross NPE ratio was at 7.7%, reduced by about 700 bps from 14.7% in 3Q16 (peak) whule net NPE ratio dropped to 3.2%.

Total group NPE disposals have amounted to around €10bn since 3Q16, on top of the FINO Transaction NPE disposal of €17bn. At the same time, group NPE coverage ratio increased to 61% (+840 bps since 3Q16), among the top players in Europe.

In FY16, the group created a non-core division comprising all the exposures towards non-performing counterparts/clients - mostly legacy of the great crisis - for which the bank decided to unwind its exposure through aggressive exit strategies. Non-core rundown is progressing according to the plan with gross NPEs down to €18.6bn in 4Q18.

Below the detailed trend of non-performing exposures for the group since the end of FY16 (broken down by group core and non-core) and the forecast 2019 based on Transform 2019. Goals achieved by the end of FY18 are ahead of the Transform 2019’s forecast both in terms of NPEs’ ratio and coverage ratios.

FUNDING AND CAPITAL POSITION

By the end of FY18, transitional capital ratios were: CET1 12.1%, Tier1 13.6% and Total Capital 15.8% (transitional capital requirements for UniCredit are 9.2% CET1, 10.7% Tier1 and 12.7% Total Capital).

At the end of FY18, the TLAC subordination ratio was 17.42%, pro-forma at 18.13% (including $3bn of senior non-preferred issuance in January 2019) with a buffer of 107bps over the regulatory requirement (17.1%). 2019 TLAC funding plan is expected at €9.0bn (of which €2.6bn has been already executed and €3.9bn of subordinated instruments to be issued).

The group benefits of long-term refinancing operations (“TLTRO II”) granted since 2012 by the ECB to all the banks in the Euro area – as extraordinary measures - to foster liquidity in the market and support the loans’ expansion. For UniCredit, TLTRO II overall outstanding amount is equal to €51.2bn on a consolidated basis, which could be rolled over in the coming months with a new round of refining operations. The 2019 group funding plan is projected to be €32.1bn but the amount may be revised following the decision on the further TLTRO by the ECB (UniCredit has not budgeted any new TLTRO; the TLTRO would surely have a positive impact on net interest income for the coming years).

VALUATION

Below, some key ratios and performance indicators for UCG in the period 2016-2018 and the forecast data 2019.

The management targeted a 52.6% cost income for FY19. I deem achievable the nominal cost objective (€10.4bn) considering where UCG was at the end of FY18 (€10.7bn) and the fact that Transform 2019’s cost efficiency plan is fully on track.

Management expects Adjusted ROTE at 10% for core business (stable with FY18) and 9% for the group as a whole (including the non-core division which mostly encompasses loan loss provisions).

In the valuation exercise, with the purpose to estimate a normalized sustainable income for the Company, I have (i) slightly revised downward the FY19 consensus revenue to €19.5bn in order to factor risks on Yapi Kredi which accounted for €0.3bn in FY18 profit and (i) confirmed the nominal operating costs’ projection (€10.4bn) for a 53.4% cost / income (vs 52.6% as per the management estimate).

In terms of cost of risk, the management target is 55 bps which appears consistent with the FY18 actual data. The asset quality has significantly improved over the last 3 years thanks to the de-risking actions implemented and the coverage ratios are supportive. Nonetheless, the macroeconomic framework in Europe has been deteriorating since the end of FY18. I factored a normalized 60 bps cost of risk in the valuation analysis (i.e. €3.0bn nominal amount for the year, while FY19 consensus stands at €2.5bn).

I used the consensus forecast in relation to provision for risks and charges at €1.1bn.

Tax rates will benefits - for many years on – from the DTAs utilization resulting from past losses. As per the effects pf DTAs, UniCredit has a current normalized tax rate ranging from 17 to 18%. Post 2019, tax rate is expected to raise to 22-23% according to the management view, so I picked this figure to guess the normalized income.

Below the summary projection of normalized income:

The bottom line estimate is slightly below the FY18 adjusted figures, while FY19’s consensus stands at €4.4bn. The outcome in terms of per share data - with the price for the stock at €11.1 - as follows:

An intrinsic valuation estimate centered on 10x earnings multiple, 0,8x P/TBV (consistent with expected ROTE in excess of 7%), is in the region of €17 per share. That highlights a potential 53% upside for the stock and a 35% discount.

The normalized EPS guesstimate prudently does not factor the benefits on EPS expected from 2022 on (€0.15 per share, resulting in €1.5 in value) following the projected completion of non-core assets rundown. Non-core division posted a €0.8bn net loss in FY18 and, according management forecast, is expected to generate a further net loss of some €0.5m in FY19.

REASONS FOR UNDERVALUATION

• The industry is in a long-term depressed background with declining revenue and structural issues to be addressed requiring (i) to keep continuously the focus on cost efficiency measures in order to maintain a sustainable profitability and (i) investments in technology to cope with the increasing competitive pressures.
• European banking has been suffering the still uncompleted banking union project (missing a fully-operating common insurance scheme for deposits in Euro area). The environment leaves room for potential idiosyncratic shocks in certain countries in the event of severe financial crisis.
• The recent mood for banking stocks was particularly negative and that rapidly impacted the prices: STOXX Europe 600 is down by nearly 30% from the peak recorded a year ago. The market has been discounting the worsened macroeconomic framework in Europe since the last quarter 2018 which caused ensuing downward revisions of the growth forecast.
• Italian banking stocks are in a very bad momentum and totally out-of-favor. In particular, following a positive price movement experienced in 2017 and in the first months of 2018, they have been intensely sold starting from May 2018 in concomitance with the talks to form the new government of populist parties and, then, furtherly in Autumn with the tough confrontation of the Italian Government with the EU commission on the budget law. The price decline was symmetrical for all the listed Italian banks (-40-50% from the peak). The largest risk for the Italian banks continues to be related to politics as per the future budget actions and uncertainties regarding government commitment to keep the sovereign debt in a sustainable path.
• Italian banks share a very bad reputation as a result of weak economic performance in the last 10 years, poor quality of assets (nonetheless the existence of a functioning market for NPEs that has allowed disposals) and strict link to sovereign debt. In addition to that, many issues have yet to be properly addressed: i) digitalization and related business model transformation, ii) further concentration through M&A and related redundancy plans iii) additional NPEs disposals to conclusively de-risk the banks’ portfolio. The sector is under pressure from a regulatory standpoint. All the mentioned facts underpin a low-end industry reputation and generates uncertainty.

RISK MITIGANTS AND FACTS SUPPORTING THE INVESTING CASE

• Overall, the Italian banking sector has just gone through a period of massive NPEs’ disposals. In the last 2 years, nearly €140bn of NPEs have been sold thanks to large securitization deals with gross NPEs dropping from €340bn to nearly €200bn (with sales last year for €66bn) and net NPES dropped from more than €200bn to nearly €100bn. The increase in coverage ratios makes possible further market disposals which are expected in the coming months for both bad loans and unlikely-to-pay exposures.
• In the described Italian framework, starting from the end of FY16, the de-risking actions adopted by UniCredit have determined (i) a rapid reduction of NPEs through securitizations and disposals, (ii) the solid rise of coverage ratios, that bounds the expected impact on the capital ratios of the forthcoming sales. UniCredit exhibits the lowest NPEs ratios and the highest coverage ratios among Italian peers.
• The group is geographically diversified with operations across Europe (Germany, Austria and CEE); in addition to that, an important share of profits comes from the CIB business.
• UniCredit has successfully been implementing most of the Transform 2019’s actions and has achieved the operating goals aimed at reducing workforce and branches, a required step in the new banking framework.
• The bank is among the global financial institutions and has to comply with strict regulations in terms of loss-absorbing liabilities in case of resolution. The funding plan is on track.
• A normalized net income in the region of €3.7bn seems to be sustainable also adopting some prudent adjustments on LLPs as I did in the valuation exercise.
• The management, in the last 2 years, did a great job in restoring profitability and in the next December 2019 capital day it will release the new plan which should entail a step-up in the dividends flow.
• The CEO Mustier invested an amount equivalent to its long-term incentive package (€7m) in UniCredit securities (bonds AT1 and common equity) the last 8th February. Moreover, he purchased €1.2m securities in November (again bonds AT1 and common equity), an amount equivalent to his fixed compensation. He also executed other purchases for an overall amount of €4m in March 2017.

The stock price, similarly to the other Italian bank stocks, has fallen totally out-of-favor because of the Italian political risk but I deem the market reaction excessive considering the fundamentals of the bank.

According to my analysis and the valuation, the downward risks for the stockholder appear very limited (P/e 6.7x and P/TBV 0.5x) and the appreciation potential may be huge. Overall, the risks appear to be abundantly priced leaving the investor with an attractive exposure in terms of risks/expected reward.

Catalyst

No specific.