UNCRY - UniCredit: Value Thesis Can Hardly Be Ignored

Summary

• UniCredit S.p.A. announced the highest FY profit in over 10 years, as the bank closed Q4 with an exceptionally strong performance.
• With UniCredit's NIM expanding by about 40% in 2022 and realizing a 10% equity yield for investors, the value thesis can hardly be ignored.
• I believe UniCredit's discount to book makes little sense in context of a likely 4 percent interest rate expansion in the Euro area.
• Personally, I anchor my UniCredit valuation on a residual earnings model, and I calculate a fair implied share-price for UniCredit S.p.A. of $23.76.

Thesis

I am very bullish on European banking stocks, as I believe the deep discount to book makes little sense in context of a likely 4 percent interest rate expansion in the Euro economy. With UniCredit's NIM expanding by about 40% in 2022 already, and realizing a 10% equity yield for investors, the value thesis can hardly be ignored. Personally, I anchor my UniCredit valuation on a residual earnings model, and I calculate a fair implied share-price for UNCFF of $23.76. "Buy."

UniCredit S.p.A. (UNCFF) announced the highest FY profit in over 10 years, as the bank closed Q4 with an exceptionally strong performance. Although UniCredit operates in a challenging economy, mainly in Italy and Southern Europe, the credit institute voiced confidence that the tailwind coming from higher interest rates will more than offset any macro concerns, and I expect UniCredit's equity yield could easily push above 10% in the next 2-3 years, as compared to the company's current market cap reference.

Reflecting on UniCredit's current valuation, I believe that investors who accumulate at these levels will likely enjoy about 35% share price appreciation upside within 3 years. I anchor my argument on a residual earnings valuation, which implies a fair implied share-price for UNCFF of $23.76. "Buy."

After a decade of enormous underperformance ...

UniCredit stock has finally started to show relative strength. For reference, for the trailing twelve months, UNCFF stock is up approximately 12%, as compared to a loss of close to 7% for the S&P 500 (SP500).

An Exceptional Q4 2022

UniCredit S.p.A. closed FY 2022 with an exceptionally strong Q4 . During the period from September to end of December, the Italian bank generated total revenues of EUR 5.4 billion, which compares to EUR 4.3 billion for the same period one year prior (an astonishing 25.4% year over year growth). On the backdrop of a 40% net interest income expansion, growing to EUR 3.2 billion in Q4 2022, paired with a 300 basis point YOY reduction in operating costs, the bank increased its Q4 2022 gross operating profits to about EUR 3.0 billion (58% YOY growth), and its net profit to EUR 2.4 billion.

For the FY 2022, revenues grew to EUR 19.1 billion, reflecting a 10% year-over-year expansion. Cumulative net profit increased to EUR 5.4 billion.

UniCredit's strong FY 2022 performance was supported by both topline expansion and cost improvement: First, and most notably, the bank took advantage of a strong interest rate environment, which supported approximately 17% of YOY revenue growth, despite lower the RWA by 10 percentage points. Second, complementing the higher top line, management also managed to decrease costs by 800 basis points, to EUR 9.6 billion. With that frame of reference, no matter on which target metric an investor chooses to focus on, UniCredit delivered on all of them (see below).

While UniCredit offered a less than 5% equity yield in 2021, this metric has now expanded to a level close to 10%. Together with Q4 results, UniCredit proposed a EUR 1.91 billion cash dividend, which in combination with a EUR 3.34 billion share buyback program, would bringing UniCredit's total equity distributions to EUR 5.25 billion.

Strong Interest Rate Tailwind Going Into 2023

While UniCredit S.p.A. has already enjoyed a strong performance due to NIM expansion in 2022, the full effects of the 2022 interest rate increases will likely not felt before late 2023/ early 2024. Moreover, the ECB is still raising the cost of capital, and rates on the marginal lending facility could likely edge towards 4 percentage points in 2023. With that frame of reference, as compared to 2021 numbers, my model--which anchors on management commentary from Deutsche Bank, Barclays, UniCredit and Societe Generale--calculates that for every 1 percentage point of interest rate increase, European banks are likely to enjoy a 20 basis point increase in NIM expansion.

Generally speaking, with many European banks valued at a significant discount to tangible book (UniCredit is trading at a x0.6 P/B), despite the ECB's aggressive commitment to bring down inflation through higher interest rates, European banks present a highly attractive investment opportunity, in my opinion.

Residual Earnings Valuation

In my opinion, banks are prime candidates to be valued with a residual earnings valuation, given that the RE framework anchors on both the income statement and the balance sheet as well as accrual accounting. As per the CFA Institute :

Conceptually, residual income is net income less a charge (deduction) for common shareholders' opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company's capital.

I apply the following assumptions:

• To forecast EPS, I anchor on consensus analyst forecast as available on the Bloomberg Terminal 'till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework - especially for banks.
• To estimate the cost of capital, I use the WACC framework. I model a three-year regression against the FTSE MIB to find the stock's beta. For the risk-free rate, I used the U.S. 10-year treasury yield as of January 31, 2022. My calculation indicates a fair required return of 11.25%.
• For the terminal growth rate, I apply 2% percentage points, slightly below estimated nominal GDP growth in order to reflect a conservative valuation.

Based on the above assumptions, my calculation returns a base-case target price for UniCredit of $23.76/share, implying material upside of more than 30%.

I understand that investors might have different assumptions with regards to UniCredit's required return and terminal business growth. Thus, I also enclose a sensitivity table to test varying assumptions. For reference, red-cells imply an overvaluation as compared to the current market price, and green-cells imply an undervaluation.

Without a financial markets melt-down, the picture looks very favorable to me.

Risks

I think bank investments are safer than market suggests, but there is still elevated tail-risk that could, in very extreme cases of financial distress, bring UniCredit S.p.A. close to bankruptcy. Banking is a risky business, as many big financial institutions have not yet recovered pre-financial crisis levels. However, UniCredit's 14.9% CET1 ratio should protect the company in most stressful scenarios.

Conclusion

I am very bullish on European banking stocks, as I believe the deep discount to book makes little sense in context of a likely 4 percent interest rate expansion in the Euro economy. With UniCredit S.p.A.'s NIM expanding by about 40% in 2022 already, and realizing a 10% equity yield for investors, the value thesis can hardly be ignored. Personally, I anchor my UniCredit valuation on a residual earnings model, and I calculate a fair implied share-price for UNCFF of $23.76. "Buy."

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