JPM - Deutsche Bank: Coiled Spring With Rates Tailwinds And 50% Annual Dividend Growth

Summary

• DB is still trading at 0.35x tangible book.
• However, it is clearly on the path to >10% RoTCE powered by higher rates in the eurozone.
• Dividends are expected to grow by 50% annually for the next 3 years.
• DB remains my #1 pick in European banking.

The ECB shocked the financial markets in the December meeting by following in the Fed’s footsteps and aggressively promising to raise interest rates in upcoming meetings. At the 15th December meeting, the ECB raised the main rate to 2.5% but also articulated its expectation to continue to significantly increase rates.

The current rate of 2.5% is the highest since 2008 and a far cry from the negative interest rates prevailing in the Eurozone in the last several years.

This has profound and positive implications for European banks. All of a sudden, the deposit franchise of such banks has substantial value. Previously, most European banks found it extremely challenging to earn anywhere near their cost of capital given negative interest rates and mostly traded well-below net tangible assets. In other words, their operations appeared to destroy capital.

The strong positive interest rates in the Eurozone are a paradigm shift.

Banks benefit from rising rates as their asset side of the balance sheet reprices quicker and to a greater extent than deposits (liability side). The assets side comprises loans (e.g. variable interest loans) and securities portfolio. As rates rise, the gross yield of the assets on the balance sheet increases, some assets reprice almost instantaneously whereas other parts with a lag (e.g. reinvestment of the securities portfolio as investments mature and are reinvested in higher yielding instruments).

Deposits may not reprice at all (e.g. operational deposits) and would have a zero interest costs whereas others may reprice more slowly and to a lesser extent than then assets.

Deutsche Bank ( DB ) is one of the banks that strongly benefits from the rising interest rates. Whilst quantifying the exact benefit is difficult to ascertain accurately given a number of moving parts, for example, deposits betas (or in other words, the extent deposits migrate from low yielding deposits to higher ones). The latest update from DB on the impact of rates was provided at the UBS European conference several weeks ago:

The guidance we gave a couple of weeks ago was that relative to 2022, interest rates alone should support revenues by about 2 billion euros. And then that would be offset by something in the high single digits, hundred millions of euros by the year-on-year impact of no TLTRO, higher funding costs, and some of the benefits we had this year, for example, debt repurchases and so on. So the net of those things should give us something between say 1.1, 1.2 billion euros of revenues next year relative to this year

Clearly, this is a very material to the investment thesis as the total market cap of DB currently is ~EUR20 billion. There is no other way to describe this but as a game changer for the stock but so far Mr. Market has so far given DB very little credit for these massive tailwinds.

DB’s successfully restructuring

DB is well on track to achieve its stated target of 8% RoTCE for FY2022 as confirmed at the UBS conference. Incidentally, the core bank is already running at 10% RoTCE and that's excluding the full benefits of rates discussed above.

This will likely be confirmed when it reports the full-year results in early 2023. However, DB is delivering these strong financial outcomes in a very sustainable manner:

• DB absorbed a number of one-off costs in the results
• The accrual businesses of corporate banking and the German private bank are growing strongly, so less reliance on the Investment Bank (“IB”)
• DB is recapturing market share from its U.S. peers in the important FICC business
• DB is managing costs well in spite of significant investments in compliance and other controls

In short, the trajectory of the business appears on track to deliver at least 10% RoTCE by 2025 or possibly earlier.

FICC business

As part of its restructuring, DB has pivoted to its areas of strength in FICC trading and exited Equities trading completely. This has proven to be a successful move. It also managed to avoid many of the pitfalls suffered by peers such as Credit Suisse ( CS ) in the Archegos debacle.

DB is also benefiting from secular growth in the FICC wallet in the last few years. During 2021 and 2022, DB also seemed to have recaptured previously lost market share in FICC as several of the U.S. banks had to pull back due to capital constraints as well as preference by some counterparties to diversify their trading with European houses.

So all in all, given the positive settings for FICC currently with higher interest rates, this plays to the strengths of the DB’s franchise.

The recent update from the large U.S. banks in the Goldman Sachs financial services conferences are showing positive signs for Q4. Both Citigroup ( C ) and JPMorgan ( JPM ) have highlighted strength in FICC of 10+% year-on-year. I expect DB to show strong results in Q4 that should enable it to meet its 8% RoTCE target as well as give it room to book a mini kitchen sink quarter and set itself up well for 2023 and beyond (e.g. by taking on additional restructuring charges).

Dividend growth stock

DB has made a strong commitment to return capital to shareholders. This includes both dividends and buybacks. The commitment was reiterated in the latest update at the UBS European conference:

And as we talked about in March, we've started on this path of capital return, which of course we had to make the painful decision to suspend the dividend for two years. We restarted the dividend this year at 20 cents, and then in March we gave investors a very clear path of 50% increase in the dividend every year for the next several years to 30 cents next year, 45, and then 68 cents.

This translates to a dividend yield of ~6% to 7% by 2025 based on the current share price with additional capital distributions via share buybacks.

The risks

The key risk currently is a projected global recession and the potential for outsized credit losses. I don’t see this as a major risk given the low-risk credit profile of DB. The biggest part of its portfolio is German mortgages with a healthy LTV average ratio. Unlike its U.S. and UK peers, it has very little exposure in unsecured consumer credit. Even in a recession, I would not expect credit losses to be overly material in the context of its overall profitability. In other words, the benefits from secular higher rates should more than offset any credit losses.

Final thoughts

DB is still trading at a distressed valuation of 0.35x tangible book. Given the upcoming interest rate tailwinds, I expect it to deliver >10% RoTCE sustainably by 2025 and possibly get pretty close to this number as early as 2023. The macro-environment certainly plays to DB’s strength in FICC trading. Uncertainties and volatility in rates are clearly benefiting the trading franchise as the decade-long financial repression by central banks is effectively over. I expect a strong Q4 and potentially a blockbuster Q1’2023 as investors reposition the portfolio for an upcoming recession. Later on in 2023 and beyond, FICC trading income may normalize further but at a much higher level for DB than pre-pandemic levels. However, the biggest positive impact of rising Euro rates. As noted above, all of a sudden, DB’s deposits franchise is worth much more than previously. I also believe that the era of negative interest rates is over for good. This should allow European banks to earn returns that are much closer to their U.S. peers.

It doesn’t look like investors have digested the beneficial impact of rising rates. As noted above, this could deliver an incremental €1.2 billion of pre-tax earnings in 2022 and additional benefits in the outer years. Given DB’s healthy capital position and ability to generate excess capital, I expect very meaningful growth in dividends and share buybacks in the next 2 to 3 years.

DB remains my #1 pick in European banking.

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