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When Leverage Is About to Cross Its Limit

January 24, 2014 | About:

Basel III rules have changed: now banks needn’t as much capital as they used to in the past to back up their debts. The minimum limit has been extended to 3%, which means that major financial institutions that have had and still maintain high leverage ratios should feel somehow relieved. In general, lenders of this type have enjoyed pre-crisis returns that exceeded their cost of capital, but the fact that they were highly – or why not, excessively– leveraged is now being reflected in their high-risk profiles and even in their results.

Among them, we find Deutsche Bank (DB), a world leading investment bank that has magnificently steered through the European crisis. Though these new Basel standards are definitely good news for DB, I still see headwinds for the German lender that make the stock less attractive when compared to other first-class peers.

No Need for So Much Risk

Investors who are based on DB’s long-held prestige and untouchable image could still want to give the Bank a confidence vote. I’m not saying that good reputation isn’t an asset to consider, but I believe that, at the moment, there are other leading European banks that offer similar returns without carrying so much risk. DB, whose debt to equity ratio stands at 2.5 times and its ROE of -0.9%, might lose against competitors such as UBS (UBS), the biggest bank in Switzerland, (debt to equity ratio is 1.8 times and its ROE of 0.6%) or British giant Barclays (BCS), whose debt to equity ratio is 0.5x, and its ROE, 0.3%. In this sense, there are other investment opportunities within the financial sector that offer a better return-risk balance.

Moreover, numbers apart, Barclays is having a different strategy to that of DB, diversifying geographically by shifting its operations from sub-par growth regions such as Europe to emerging economies like China, which clearly evidences that Barclay’s is making moves to minimize risk. On its side, UBS is working on exiting its hazardous investment banking businesses to devote itself entirely to more stable ones.

Unfortunately, DB doesn’t seem to be taking any policy to reduce risk, and that’s what, in my opinion, is making the stock less attractive.

Low Diversification

Even in an uncertain capital market environment, DB was committed in the past few years to defending its major investment banking position (the Corporate Banking & Securities Corporate Division accounted for over 55% of its 2013 revenue), which implied getting involved in riskier operations than those respective to other business segments that a lender could turn to, such as retail banking. To minimize risk, management has now decided to reduce this dependence on investment banking. Nevertheless, I fear the pursuit of such a strategy will affect revenue stability at least until the euro zone’s sovereign-debt concerns linger, mainly for two reasons: one is that the German market, from where DB raises 25% of its revenue, is already a saturated one and I hence see no room for expansion; and the other is that the Bank has recently appointed two CEOs with different backgrounds in the industry to co-lead this transition into a more diversified institution, with potential conflicts arising for the lack of a single head making the decisions. Therefore, these diversification efforts may end up being too costly for the Bank.

Valuation

In spite of boasting solid global market dominance and a successful performance during the Euro crisis -avoiding a government bailout- I still consider that this may not be the best moment to bet on DB. Even though DB shares trade at a relatively low price (P/E of 11.77 times as compared to an industry average of 17.07), I don’t see much upturn in the stock, basically following disappointing full-year results and elevated leverage levels, which make DB very vulnerable to losses. And given a still bleak outlook for the struggling euro area, I remain cautious regarding possible future losses that the Bank will not be able to cushion for long.

With net income falling 5% year-over-year to EUR 31.9 billion in 2013, largely driven by litigation costs and restructuring charges, it’s quite logical to fear a further downturn in the near term, as DB is still on its transition towards diversification, which, as I’ve mentioned, is also a very challenging goal.

Many people have already decided to divest on BD. For instance, Steven Cohen (Trades, Portfolio) has reduced its tenancy on the shares by 94.63%, and Jim Simons (Trades, Portfolio) practically sold out all of his roughly 1.5 million shares. To me, it looks like it’s time to leave DB for less riskier stocks with better returns.

 

Disclosure: Damian Illia holds no position in any stocks mentioned.

About the author:

Damian Illia
A fundamental analyst at Lonetreeanalytics.com constantly looking for value and income investments.

Visit Damian Illia's Website


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