SVKEF - SEB Looks Undervalued But Near-Term Results Have Likely Peaked And Challenges Are Mounting

2023-08-28 14:26:15 ET

Summary

• SEB is likely at or near peak earnings for this cycle, as both net interest margin and credit quality are likely to deteriorate from here.
• Sweden's housing market has already seen a double-digit decline, and more could be on the way, but SEB has less exposure to residential property than most of its peers.
• SEB is more leveraged to corporate credit; while Sweden's economy has been weaker of late, most forecasts still call for only a modest recession.
• While SEB shares look about 20% undervalued, concerns about near-term earnings growth potential may well limit upside in the near term.

Balancing short-term risk and long-term reward is never simple in investing, and Sweden’s Skandinaviska Enskilda Banken (or “SEB”) ( SVKEF ) is a case in point. While I have no meaningful concerns about the long-term health or potential of this large Swedish bank, the reality is that numbers are likely at or near the peak for the cycle and the bank will see more pressure from higher funding costs and credit losses over the next 12-24 months. With that, I think a double-digit profit decline is possible in 2024 and the market doesn’t often celebrate companies with weak near-term earnings growth potential.

Longer term, while I see management’s target of 15% or better return on equity as perhaps a little too ambitious, I still think low-to-mid single-digit core earnings growth (around 3%-4%) is attainable even while maintaining a capital position in excess of regulatory requirements and returning a respectable amount of capital to shareholders. With that, I believe the shares are around 20% undervalued today (not including the current healthy dividend yield), but concerns about near-term earnings growth potential could well mean that investors will need to have some patience here.

The Peak Is Likely In For Now

Like many banks, including peers in the Nordic region, SEB has been benefiting from a healthy tailwind of higher earning yields on loans and securities, still-healthy loan demand, and very low credit losses. With that, net interest income rose about 53% year over year and 5% quarter over quarter in the second quarter of 2023, with good cost control driving pre-provision profit growth of about 60% yoy and 4% qoq.

Looking at yield curves, the economy in Sweden and other countries in which SEB operates, and management commentary (SEB’s and peer banks), it doesn’t seem likely to get much better from here – most likely Q2 or Q3’23 earnings will be the high water mark for the cycle, with SEB seeing more pressure from rising funding costs in the coming quarters, as well as weaker lending demand and higher loan losses.

That’s not to say that the bank is content to stand pat. Management is actively looking to grow fee-generating businesses like payments, and the bank recently acquired AirPlus from Lufthansa for EUR 450M. AirPlus has over 50,000 corporate customers and offers a range of payment services, including corporate cards, and this move is consistent with SEB’s long-term focus on corporate banking clients. I would expect SEB to look for similar deals where possible, including additional businesses that could accelerate the growth of SEB’s card or payments operations.

SEB also continues to move forward with its digitalization efforts, particularly on the retail side in Sweden and the Baltics. As has been the case for banks in almost every country, SEB is working to move a larger share of its retail banking business away from face-to-face transactions and toward digital channels, reducing the overhead costs needed to support the business.

Credit Is A Concern, But Likely Not A Ticking Time Bomb

There are some numbers concerning the Swedish property market that should definitely give investors pause. From the end of 2014 to early in 2022, Swedish housing prices nearly doubled, fueled by a heady combination of a healthy economy (good employment, decent wages, et al), low interest rates, government policies that encourage home ownership (including meaningful deductibility of mortgage interest), and a culture of home ownership.

Higher interest rates, higher housing prices, wage-compromising inflation, and high household debt are now driving a significant slump. Housing prices are down about 10% to 15% from their 2022 peak and Sweden has one of the highest ratios of household debt to disposable income (over 200%) in the developed world; roughly double the ratio in the U.S. and over a third higher than in the U.K. While bank CEOs have tried to assuage fears about these numbers by pointing to the ratio of household assets to debt, the reality is that housing is a major component of the assets side (around 80% or so by some estimates) and a housing crash drove significant instability in the Swedish banking sector in the 1990’s.

Sweden’s economy is also looking weaker of late. Although employment numbers aren’t bad and exports are still growing, the government revised its outlook for 2023 GDP contraction from 0.4% to 0.8%. The government believes this will be a brief recession (the government is projecting growth in 2024), but some others are now forecasting another down year in 2024 and inflation remains a persistent challenge (limiting what the Riksbank can do on rates). The current outlook still looks more like a modest recession than something more severe, but a weaker economy and weaker property markets could create a feedback loop that drives downside risk in 2024 and 2025.

On a more positive note, learning from past crises, Nordic banking regulators are considerably more stringent in their rules for banks – SEB currently boasts a CET1 ratio of over 19% (versus a 14.8% regulatory minimum). To offer some perspective, banks in the U.S. with CET1 ratios above 12% are generally considered very well capitalized, if not over-capitalized.

I also believe there are some company-specific attributes that will help SEB through this next phase. Less than a third of SEB’s balance sheet consists of mortgages, and the bank is less exposed than peers/rivals like Swedbank ( SWDBY ), Nordea ( NRDBY ), DNB ( DNBBY ), and Danske ( DNKEY ). SEB has been price, risk, and mix-conscious for some time now, letting its share of the Swedish mortgage market fall from the high teens in 2020 to under 10% share of new loans in more recent quarters. Likewise, SEB has only about half as much exposure to commercial real estate as its peers (around 7% versus 15%), and much of that is in multifamily housing that I don’t believe will see the same stresses.

What is more relevant to SEB is the quality of corporate credit, and particularly larger corporations. While SEB has generally been willing to take more risks with its corporate credit book (a lower percentage of investment grade-rated borrowers), it has avoided over-concentration in volatile areas (like natural resources). A recession will drive higher losses compared to the very low levels seen in recent quarters, but SEB management has been modeling for a recession and unless Sweden’s economy is meaningfully weaker than expected in 2023-2025, I don’t believe credit losses/reserves will be an issue.

Rates Aren’t Going To Help Much More From Here

After waiting years for higher rates, European banks like SEB have finally seen rate hikes and over the last 18 months or so SEB has seen its loan yields improve from around 1.5% to over 4.25% in the last quarter. That’s helped drive a meaningful improvement in net interest margins, but the good times are likely at an end.

Momentum on rates has slowed, and so too has loan demand. At the same time, funding costs continue to rise – SEB saw a 60bp quarter-over-quarter improvement in loan yields in the second quarter, while deposit costs were up just under 50bp. From here on, I would expect funding costs to accelerate beyond loan yields, leading to pressure on net interest margin spreads. Moreover, with slowing economic activity in Sweden and more pressure on household balance sheets, I’d expect less momentum in deposits, forcing SEB to turn to more expensive wholesale funding for a larger percentage of its funding needs. Last and not least, I expect ongoing softening in lending activity, leading to weaker earning asset growth and more pressure on net interest income growth.

The Outlook

Only time will tell if Sweden sees a relatively mild recession and a 20%-25% peak-to-trough decline in housing prices, or whether housing prices fall even further and drive a more serious recession. I believe SEB has the surplus capital to withstand higher losses, and I likewise believe that Sweden’s government has the wherewithal to render some aid, but we’ve seen many times in recent years how bank losses can quickly add up.

I don’t mention that because I think it’s a likely outcome for SEB, but rather because I think investors do well to not get complacent about risk when chasing reward.

In the case of SEB, I do expect a double-digit decline (around 12%) in core earnings next year and a minimal recovery in 2025 (with a more meaningful recovery in 2026), and that’s predicated upon a roughly 25% peak-to-trough move in housing prices and a mild recession – estimates that I believe are a little more conservative than the current Street averages, but not dramatically so.

Long term, I think SEB can generate core earnings growth in the neighborhood of 3% to 4%. Between discounted core earnings and ROTCE-driven P/TBV, I believe SEB shares are about 20% undervalued.

The Bottom Line

I think SEB will be fine over the long term, but there’s definitely a risk that this next phase of the cycle is weaker than I expect, including a risk of weaker economic performance for Sweden, a sharper decline in property values, and higher credit losses. SEB looks like it has more than enough capital to weather the storm, but growth could be lacking for a couple of years and that’s a potential headwind for the shares.

While I do like this company and I do think the valuation is attractive now, I have concerns that the shares could get even cheaper in the interim, and I’m more inclined to hold off a bit longer before getting more bullish – I think the odds favor earnings downgrades over upgrades in the second half of 2023 and I think there could be an opportunity to buy at even better long-term valuations.

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