AAVMY - Flush With Capital And Still Asset-Sensitive Can ING Groep Get A Bit More Of Its Due?

2023-03-07 12:00:00 ET

Summary

• ING Groep's fourth quarter results were a little light on loan growth, but otherwise beat across the board, with a 25% pre-tax income beat driven by healthier spreads and provisions.
• I don't expect much loan demand growth from mortgage or corporate customers, so rate sensitivity will have to drive the bus from here; I expect double-digit NII growth in FY'23.
• Flush with capital, I expect another significant buyback announcement, but management may want to consider using some capital to acquire growing non-spread-dependent businesses (like payments).
• Core long-term growth of around 3%, including around 20% growth from FY'22-FY'25, can drive a fair value for the ADRs around $17.50, but a muted long-term growth outlook is a risk to sentiment.

Better financial results, abundant capital to return to shareholders, and still-attractive asset sensitivity have only helped ING Groep ( ING ) just so much. In the time since my last update on this leading Netherlands-based Eurobank, the shares have generated a total return of around 22% - not bad, but also not any better than the average return of the sector and still below the returns investors could have earned from bank stocks like ABN AMRO ( AAVMY ) or Danske Bank ( DNKEY ).

I do still believe that ING stock is undervalued, and as I said above, the bank has ample capital to return to shareholders over the next couple of years. That upside is at least partially offset by a more modest growth outlook and concerns about credit and loan growth opportunities in the near term. Still around 20% to 25% below fair value, I think ING is undervalued, but it may well take a better growth outlook to get the shares moving closer to fair value.

A Strong Beat Across The Board

ING's fourth quarter results weren't completely free of questions or concerns, but in terms of hitting the mark on the major income statement line items, management definitely outperformed in the fourth quarter. All numbers are presented on an adjusted basis unless otherwise specified.

Revenue rose 12% year over year and quarter over quarter, beating expectations by about 4%. Net interest income remains the primary driver of the business, contributing close to three-quarters of revenue, and NII rose 7% qoq, beating by 2%. Net interest income performance in the Netherlands was actually rather weak (down 23% as reported), but up double-digits in Germany, as well as the "Challenger" and "Growth" markets. Net interest margin improved 9bp qoq to 1.48%.

Operating costs rose 10% qoq, coming in just a bit better than expected. Pre-provision profits rose 14%, beating by 10%, while lower provisioning helped drive a 25% pre-tax profit (up 25% qoq) beat, with strong growth in the German and Challenger/Growth segments.

Not Much Balance Sheet Growth

ING management positioned the bank well to benefit from this recent move in rates, increasing the rate sensitivity by shortening the bank's hedges. That's an interesting flip from the periods that preceded the 2022 rate cycle, as ING's prior top-line growth was driven more by outperformance on loan growth than rates.

Loans declined 1% in the fourth quarter, with weakness pretty much across the board, including flat results in Germany, slight declines in the Netherlands and Challenger/Growth markets, and 2% growth in Belgium. As ING is largely a mortgage lender, higher rates and weakening demand for mortgage loans is the primary driver in the weakening loan demand, though corporate lending isn't any stronger at this point.

I don't see much reason to expect a significant reversal in the near term. Higher rates are meant to cool inflation, and that extends to housing prices, and I don't think there's going to be a significant recovery in demand until rates at least level off.

ING Groep still has attractive asset sensitivity, which gives it leverage to further increases in rates in Europe. That is tempered by rising deposit costs. Like most U.S. banks, ING is seeing depositors pull their money out in pursuit of better rates, leading to a 4% qoq decline in deposit balances this quarter, while deposit yields (and deposit beta) continue to rise.

Spread income is still the dominant driver of ING's income statement, and I'm not expecting near-term weakness. Higher deposit costs will pinch, but ING continues to put higher-rate loans on the books, and I expect double-digit net interest income growth in 2023 followed by single-digit growth (around 3%) in FY'24 and FY'25.

I expect steadier, but less dramatic growth from the fee-generating businesses, with growth in the mid-single-digits. ING has had mixed success in diversifying its revenue streams; businesses like insurance and asset management contribute more meaningfully now, but compared to many European banks, ING's non-spread businesses are relatively small. Given the surplus capital on hand, I don't think it would be terrible for management to at least consider some acquisitions aimed at diversifying the company's growth drivers.

Credit And Capital - Plenty Of Both

I have few concerns about ING's credit position today; the cost of risk declined in the fourth quarter for both the retail and wholesale operations (down 8bp qoq and 14bp qoq, respectively), and the Stage 3 non-performing loan ratio has been fairly steady (1.4% vs. 1.5% last year and 1.3% last quarter).

Around 15% of the loan book here is in Dutch mortgages, and the Netherlands saw one of the stronger runs in housing prices in 2021 and 2022 (up close to 30%). Now that's reversing, with ABN AMRO recently projected a 6% decline in housing prices for 2023 (versus a prior prediction of 2.5%). Credit quality is better than the last time there was a meaningful correction in housing prices, though, and I believe the market could see a 20% decline with only 10% of mortgages going underwater due to better loan/value ratios and so on. Likewise, much of the corporate loan book (close to 80%) is investment grade, and while housing prices could underperform in other markets, most governments likely won't let housing prices fall far enough to threaten the banking sector.

On the capital side, ING finished the year with a CET1 ratio of 14.5%, two points above its target, despite a EUR1.2B buyback program in 2022. Another buyback has yet to be announced but is widely expected, and I believe ING could end up returning close to 100% of core net income to shareholders over the next three years (meaning the sum of dividends and buybacks from FY'23 to FY'25 is likely to be close to 100% of net income over that period).

The Outlook

Forecasting rates is a good way to look foolish; a good friend of mine who works as an economist for a major CRE firm likes to say that "the hall of fame of rate forecasters is empty for a reason". And yet, it's a key driver for the earnings of banks like ING Groep.

Higher-for-longer rates are certainly a possible outcome, but it's not one I'm counting on at this point. I'm expecting 20% annualized core earnings growth over the next three years, but I expect that to slow significantly as rates fall again, and my core long-term earnings growth rate ends up at around 3%.

Discounted back, that supports a fair value of close to $17.50 for the ADRs, and I get a similar result ($16.50) averaging out my ROTE-driven P/TBV approach and my P/E approach (using 10x my FY'23 EPS estimate of EUR1.51/share).

The Bottom Line

Tepid core growth remains a key challenge for ING Groep, and I believe it is and has been one of the primary headwinds for the shares not having re-rated higher. I don't really see this changing, although I do believe the shares are undervalued relative to the growth I expect ING to generate. For patient investors who want upside backed by above-average quality, ING could still make sense from here.

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