Description

Summary thesis:

UniCredit SpA (UCG) is the #2 bank in Italy. The Italian banking sector has struggled with high levels of non-performing loans (NPLs) resulting in failing institutions, so has been viewed as untouchable by many investors. However, we think that the current opportunity at UCG resembles in many ways the successful bank recapitalizations we saw in the US and UK following the financial crisis. In Q4 of last year, UCG wrote down its bad loans (€13bn total charge in Q4 2016), raised fresh capital (€13bn rights offering in February) and put forth a credible cost cutting plan. The pro forma bank is well capitalized (~12.5% CET1) and is trading at 59% of tangible book value (“TBV”). We are cautiously optimistic that the Italian banking sector and economy are slowly recovering and the ECB will eventually normalize interest rates. As this occurs, we see upside of 45% as valuation expands to ~75% of a growing TBV.

Details:

We believe UCG’s new CEO Jean Paul Mustier has put together a credible recapitalization and turnaround plan for the bank. Mustier was at Societe Generale for over 20 years, rising to head their investment bank. We believe Mustier was on track to be CEO of SocGen until he fell on his sword due to the €5bn trading fraud perpetrated in 2008 by Jerome Kerviel. Mustier ran UCG’s investment banking division from 2011-2014, left due to disagreements with the then CEO, then returned to be CEO of UCG in July of last year. We believe that Mustier’s French nationality has allowed him to take more drastic steps than UCG’s prior CEOs who have felt beholden to Italian political considerations. Led by Mustier, UCG laid out a detailed turnaround plan at a December 2016 analyst day. The main components of the turnaround are: 1) sell and mark down NPLs, 2) cut costs significantly, 3) sell non-core assets, and 4) raise enough capital to be well capitalized. Mustier has expressed his own confidence in the plan by tying all his bonuses to achievement of 2019 targets: >9% return on equity, <52% cost/income ratio and reducing NPLs by approximately 50%. Mustier also personally bought €2 million of UCG shares in the open market after the rights issue. Here is a story with some helpful background on Mustier and his turnaround plan for UCG: http://www.reuters.com/article/italy-banks-unicredit-idUSL5N1FR2L5. 

We believe UCG’s NPLs are properly provisioned. For the Italian banking sector as a whole and UCG in particular, it appears NPLs have peaked and started to slowly decline. In our experience in looking at past banking crises, having NPLs stop increasing is the first step towards recovery (otherwise the potential capital shortfall is unknowable). The second step is to mark the NPLs to realistic levels. We believe UCG did just that with its €10bn loan loss provision in Q4 2015. Our confidence in UCG’s NPL provisions being adequate is bolstered by: 1) UCG’s NPL coverage appears to be the best amongst Italian banks (loan loss provisions at 56% of NPLs or ~94% including real estate collateral), and 2) UCG’s NPL marks being driven by a sale of €18bn of non-performing loans to Fortress and Pimco.

UCG’s cost cutting plans will reduce headcount by 14% and branches by 25% by 2019. We are normally skeptical of heavy headcount reductions in Europe, but UCG has already secured the union agreements needed to achieve this targets. In addition, UCG’s current cost to income ratio of 60% is higher than peers and 52% would put UCG in-line with leading peer institutions.

With the recently completed €13bn rights issue and announced asset sales, UCGs’ pro forma CET1 ratio will be ~12.5%. This is above average compared to peers, especially when taking into account the heavily provisioned NPLs. Since UCG took a €13bn one-off charge in Q4 2016 (€8bn for NPLs plus restructuring, asset write-downs, etc.), we believe UCG has set themselves up to be profitable in 2017 and going forward. Thus, we expect UCG’s TBV tangible book value and capital ratios to grow. Note that UCG has assumed a ~2.2% CET1 hit over 2017e-2019e due to various regulatory changes, model changes and other impacts. Our suspicion is that this could be a source of conservatism and thus capital ratios may build faster than expected.

Given the above factors, we see an attractive risk reward for this investment. UCG trades at 59% of current TBV. Since we expect UCG to generate profits and grow its TBV, fundamental downside seems limited. On the upside, UCG’s  2019e net income target is €4.7bn, which equates to €2 of EPS. Assuming a 10x P/E this could be a €20 stock (45% upside). With profit generation and a modest 20-30% dividend payout, we project 2019e TBV to be €26/share so the €20 price target also implies a conservative 0.77x TBV multiple.

Catalyst

Execution on turnaround plan including cost cutting and continued reduction in NPLs

Growth in tangible book value

ECB begins to normalize interest rates