AAVMY - ABN AMRO: Income Growth Slowing But Shares Remain Cheap

2023-07-06 06:11:37 ET

Summary

• Along with most European bank stocks, ABN AMRO shares remain down on levels seen before March's sell-off, which was related to issues in the US regional banking space.
• The bank does face some issues with regards to growth, but these shares remain attractively priced and could offer double-digit annualized total return potential.
• The bank's capital return policy, which includes paying out 50% of its net income as cash dividends and potential share buybacks, could drive strong returns absent multiple expansion.

ABN AMRO (AAVMY) has performed well since my opening coverage of the lender in Q1 2022. Initiating with a 'Strong Buy' rating at €11.85 per share in Amsterdam trading, these shares have gained over 20% in price and a further 10% or so in cumulative dividend payments in that time, marking a total return of around 33% in a little under 17 months.

Isolating performance to 2023 alone produces a more mixed result. Like most European banks, ABN AMRO has found itself caught up in the sell-off related to problems in the US regional banking space.

While this bank does face its issues, they are more of the generic variety that might make for a softer income statement outlook rather than the existential issues that have hit certain US banks. With these shares still down double-digits on their March highs and at a steep discount to tangible book value, the valuation remains attractive. Strong Buy.

A Steep Uptick In Net Income

ABN AMRO was still grappling with the chronically low interest rate environment in the Eurozone when I first covered the bank in early 2022. The ECB has hiked a good 350bps since then, and that has had a predictably positive impact on the bank's earnings.

With that, net interest margin ("NIM") in Q1 2023 was 163bps, up from 126bps back in Q1 of last year. Net interest income ("NII") increased to €1.62B from €1.31B over the same period, good for year-on-year growth of around 25%. Total client loans have only advanced a little over 1% in that time (from ~€237B to ~ €240B), so most of the NII increase has been margin driven.

ABN AMRO: Net Interest Income & Net Interest Margin

Pre-provision operating income increased circa 75% in that period (to €736m in Q1 2023), helped by the expected reduction in operating expenses which also formed part of the bullish thesis last time. With impairment charges still exceptionally low (just €14m in Q1 2023 versus €62m in the year-ago period), net income growth has likewise been solid, advancing just under 80% year-on-year to €523m in Q1. That mapped to a circa 9.7% return on tangible equity ("ROTE").

Some Headwinds To Consider

While ABN AMRO is reporting respectable levels of earnings and profitability, there are some headwinds worth mentioning that may inhibit future growth. Firstly, margin expansion is probably reaching its limits and I don't see NIM going more than a few basis points above Q1 levels. With client loan growth crawling to a halt - sequential growth in Q1 was flat - that means NII growth will slow significantly. As a reminder, NII accounts for a disproportionate share of the top line here (~75% in Q1).

Secondly, the other aspect of the revenue line, fee income, appears to have softened, with Q1 fee & commission income of €444m representing flat sequential and YoY performance.

Thirdly, operating expense reduction has become a tougher task given the sharp increase in inflation since my initial piece. This was also an important part of the bullish case, with management targeting sub-€4.7B in annual operating expenses by FY24 at the time. That target is still in force, but FY23 guidance is only seen flat on FY22 levels of OpEx (circa €5.3B), with the bulk of the reductions expected next year. This looks a tad aggressive to me and I see OpEx landing higher than planned next year.

The final point I would make concerns asset quality. Now, so far asset quality remains excellent. Indeed, non-performing loans actually fell sequentially in Q1, from €5.2B to €4.9B, with the Stage 3 ratio declining to 1.9% from 2%. In the year-ago period the Stage 3 ratio was 2.5%.

ABN AMRO: Stage 3 Impaired Loan Ratio

Provisioning expenses likewise remained low in Q1, with the €14m figure quoted in the previous section equivalent to an annualized cost of risk of just 4bps. Management's through-the-cycle target is circa 20bps. However, if, or rather when, that figure normalizes then we are looking at a circa €460m additional drag on pre-tax profit, and it would probably be prudent to pencil that in for the near term.

Shares Still Very Cheap Regardless

The upshot of the above is that ABN AMRO may struggle to meaningfully growth net profit in the short term. The shares are so cheap, though, that this does not prove much of a barrier to attractive shareholder returns.

ABN AMRO shares currently trade for €14.52 in Amsterdam trading. Tangible book value amounted to €23.21 per share at the end of Q1, putting the current P/TBV at just 0.63x. Even taking a pessimistic view of net income evolution doesn't justify that kind of steep discount. For instance, let's assume annual FY24 NII of €6.4B and fee income of €1.76B, in line with the Q1 2023 run rate. Let's also assume higher than expected FY24 OpEx of €5B, plus a bad debt impairment charge of around 25bps (~€635m). On a 25.8% base tax rate, these figures would map to net income of around €1.9B and a 9% ROTE. That should be good for a corresponding P/TBV of 0.8x-0.9x, putting fair value a good 25% higher at around €18.50 per share ($20.10/ADR). Note that in the pre-COVID 2018-2019 period ABN AMRO earned an average ROTE of around 10.5% and typically traded on a P/TBV of around 0.9-1.0x.

In practice the bank's capital return policy would be enough to drive strong shareholder returns, even without growth in net income and/or a re-rating of its valuation multiple. The bank pays out 50% of its net income as cash dividends. My conservative case FY24 net income figure above maps to EPS of circa €2.35, which would correspond to a DPS of ~€1.32 and a forward yield of 9% at the current share price. Further, share buybacks are on the table assuming certain capital requirements are met (more specifically, a minimum 15% CET1 ratio, which is its current value). Along with the dividend, surplus capital generation is therefore likely to be paid out in the form of share buybacks. With little retained capital needed to fund growth (because growth prospects are fairly low given its operating profile), that could amount to around €700m per annum based on the figures presented thus far. That equates to an additional yield of around 5-6%.

To sum up, even without multiple expansion ABN AMRO could offer attractive double-digit annualized total return potential (~9% from the implied forward cash dividend and 5-6% from buybacks). With these based on conservative income statement figures the value case here remains compelling. Strong Buy.

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