FNBKY - UniCredit: 6.3% Dividend Yield Is Not Enough

2023-06-14 17:50:28 ET

Summary

• UniCredit is an Italian bank that has improved its fundamentals in recent years.
• Its earnings have been boosted by rising rates and is also leading to strong dividend growth.
• Despite that, Intesa has a higher yield and seems to be a better income investment.

UniCredit ( OTCPK:UNCRY ) has improved its fundamentals markedly in recent years and offers a high-dividend yield, but its peer Intesa still seems to be a better play for long-term income investors.

Company Overview

UniCredit is an Italian bank and one of the largest banks in Europe, measured by its total assets of about €895 billion at the end of last March. Its closest peer is Intesa Sanpaolo ( OTCPK:ISNPY ), which I've covered recently , with both banks having a similar size measured by total assets. However, while Intesa is mainly a domestic bank, UniCredit has larger operations in other European countries, being, therefore, more diversified geographically.

Indeed, beyond Italy, two important markets for UniCredit are Germany and Austria, plus it also has other operations across Central and Eastern European ((CEE)) countries. Its current market value is about $40 billion, and its shares trade in the U.S. on the over-the-counter market.

While Intesa is a quality bank within the European banking sector, UniCredit historically had far more fundamental issues, being plagued by high levels of non-performing loans (NPLs) which led to subdued financial performance from the global financial crisis until 2017.

This profile changed significantly when the bank performed a large capital increase and performed a deep balance sheet de-risking effort, to address two of its most important weaknesses, namely large exposure to NPLs and a relatively weak capital position. Beyond performing a sizable capital increase, UniCredit also sold large portfolios of NPLs, and sold non-strategic assets, such as part of its stake in FinecoBank ( OTCPK:FNBKY ), to improve its business profile.

This enabled UniCredit to change its business profile from one of Europe's weakest banks, to having a much better fundamental profile closer to the best banks in Europe.

Nevertheless, the European banking market is mature and growth prospects over the long term can be considered relatively muted, plus its exposure to Italy is always somewhat problematic, due to structural low GDP growth and political instability.

Given that the bank's strategy is to grow in its existing markets and mainly organically, its financial targets presented in 2021 were not particularly bullish, even though this plan was presented when interest rates were negative and since then the landscape has changed significantly. Its main financial targets were to grow revenues at about 2% per year, achieve positive jaws (revenue growth minus cost growth) of 4% per year to reach a cost-to-income ratio of around 50% by 2024, and report a return on tangible capital ratio of around 10% by 2024.

These targets are acceptable, but not particularly impressive within the European banking sector, showing that UniCredit doesn't have any particular edge over its closest peers, a profile that is not likely to change over the coming years.

Financial Overview

Regarding its financial performance, UniCredit's track record is mixed, given that its top-line growth was muted until last year and its bottom-line was impacted by COVID in 2020. Nevertheless, its recent performance has improved markedly, boosted by rising rates in Europe over the past year.

In 2022 , UniCredit's revenues amounted to €18.4 billion, representing an increase of 14% YoY, of which fees increased by 4% YoY and net interest income ((NII)) was up by 19% boosted by the rising rates in Europe. NII was €10.7 billion in the year, representing some 58% of total revenues, a higher weight than compared to Intesa (NII represents some 45% of its peer revenues), but UniCredit isn't among the European banks with higher exposure to rates given that NII represents close to 75% of total revenues for some competitors that are more geared to rising rates.

Regarding costs, UniCredit delivered very good cost control during the past year in a period of inflationary pressures, reporting total costs of €9.6 billion (-2% YoY), which led to a cost-to-income ratio of about 52%. This is an acceptable efficiency ratio, even though it can still improve, considering that the most efficient banks in Europe have cost-to-income ratios in the range of 40-45%.

On the asset quality side, UniCredit's credit risks remained at relatively good levels, considering that it made provisions of €1.9 billion in 2022, with some €900 million being related to Russia. The bank decided to de-risk its balance sheet and reduce exposure to Russia, a sensible move considering the war in Ukraine and the regulator's push for European banks to reduce exposure to this country. Its cost of risk ratio was 41 basis points (bps) during the past year, but without considering the Russia one-off effect, its cost of risk ratio was only 23 bps (vs. 37 bps in 2023).

Due to the economic slowdown and higher rates, the bank's cost of risk ratio is likely to increase in the short term, but UniCredit expects credit quality to remain resilient and does not expect a big jump in provisions over the next couple of years.

Taking into account strong revenue growth, good cost control, and a small increase in provisions, it's not surprising to see UniCredit's bottom line having a strong increase (+48% YoY) to €5.2 billion. This led to a significant increase in profitability, given that its RoTE improved to 10.7% (vs. 7.3% in 2021), which is already above its 2024 target as shown in the next graph.

During the first three months of 2023 , UniCredit maintained a positive operating momentum, being supported by higher interest rates. Its revenues increased by 57% YoY to more than €5.8 billion, while costs decreased by 5.8% YoY to €2.3 billion. This means that UniCredit reported strong jaws in the quarter, leading to an efficiency ratio of 39%, being among the best in Europe. Cost of risk was only 8bps in Q1, showing that credit quality remains quite good, while its net profit was the highest in the bank's history in the first quarter at more than €2 billion. Its RoTE was 16.8% in the quarter, much higher than its medium-term target of 10%, showing how big the impact of rising rates has been on the bank's profitability.

While the bank's revenues should continue to increase in the next few months as the hiking cycle has not yet reached its peak in Europe, it's likely that the European Central Bank will reach its rate peak over the next three months, thus further revenue growth may be harder to achieve following Q3 2023.

Indeed, according to analysts' estimates , 2023 is expected to be a record year for the bank, with its revenues increasing to more than €21 billion and its net income to be close to €6.5 billion, but over the next three years, current estimates are for broadly flat revenues and earnings.

Regarding its capitalization, UniCredit's core equity tier 1 (CET1) ratio was 16.1% at the end of last March, being among the best capitalized banks in Europe, and well above its own medium-term targets (12.5%-13%) and regulatory requirements.

This means that UniCredit has a considerable excess capital position, enabling it to distribute a good part of its earnings to shareholders. Indeed, the bank has been increasing its annual dividend considerably in recent years and is currently performing a €3.3 billion share buyback program, supported by strong earnings growth in the past few quarters.

Its last annual dividend was €0.99 per share, an increase of 83% from the previous year. While the annual increase was quite high, it was from a relatively low basis and UniCredit's dividend payout ratio was only 30%, showing that its dividend is sustainable and has plenty of room to grow, both from higher earnings and potentially by a higher payout ratio in the coming years.

Related to 2023 earnings, current estimates are for the bank to raise its annual dividend to €1.21 per share, an increase of 22% YoY, which at its current share price leads to a forward dividend yield of about 6.3%. This is an attractive level of income, but considerably below its main peer Intesa Sanpaolo which has a forward yield of around 11%.

Conclusion

UniCredit has improved a lot in its fundamentals in recent years and is reporting very good earnings in recent quarters due to the rising interest rate environment. However, I see its business profile as weaker and less diversified than its main peer Intesa, plus it currently offers a lower dividend yield than its closest competitor.

On the other hand, UniCredit's valuation is cheaper at 0.6x book value vs. 0.8x book value for Intesa, but I think this is justified by weaker fundamentals over the economic cycle and I see Intesa as a better income investment in the European banking sector than UniCredit.

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