With negative bond yields across much of Europe and historically low valuations in the banking sector, it’s not hard to find apparent bargains among European banks. The real trick here, though, is separating the real bargains from the likely value traps. I don’t want to underplay the risk that weak rates will have a lasting negative impact on earnings, but I believe Danske Bank (OTCPK:DNKEY) is undervalued today on the basis of low-to-mid single-digit pre-provision profit growth over the next three to five years, a solid collection of fee-generating businesses, and above-average credit quality.
What To Look For In Q3
Danske is scheduled to provide an early look at earnings tomorrow (October 9), with the full report on November 4. I’m expecting Danske to do a little better than expected on core pre-provision profits, with a greater emphasis on cost reductions driving the upside.
It seems unlikely that NIM (on gross loans) will improve much at all from the 1.2% of the second quarter, and I’m not expecting much in the way of loan growth. I’m likewise expecting core fee income to be pretty flat, as the asset/wealth management businesses are not particularly economically-sensitive in the short term. I do expect a rebound in payments-related businesses on a sequential basis, but the year-over-year performance will almost certainly be a double-digit decline. A key unknown in the results, on a reported basis, is the performance of the trading operations; while most analysts treat this as non-core, it has made up anywhere from 10% to almost 40% of quarterly non-interest income over the last few years.
As far as expenses go, analysts are looking for a mid-single-digit qoq increase in spending, and I see a chance that management could outperform here given a good longer-term track record of efficiency. That said, with ongoing systems investments and so forth, I don’t want to expect too much in the short term.
I expect credit costs to be basically in line with the second quarter (around 0.25% of loans), with the ratio of non-performing loans to gross loans staying around 1.9%.
Muddling Through A Weak Period
The global pandemic has only worsened what was already going to be a challenging 2020. Already-low rates have managed to go even lower, with negative bond yields throughout the Eurozone. On top of that are now concerns about loan demand and credit costs.
On the loan demand side, Danske Bank posted some respectable growth in the second quarter, but I expect weaker numbers for the second half of 2020 before a modest rebound in 2021 and 2022. Denmark’s economy has been hit by the pandemic, with a 7% GDP decline in the second quarter, but it has held up better than the Eurozone as a whole. Business confidence levels are still in recessionary territory, but they are recovering on a monthly basis.
Weak demand is liable to be a challenge across the Nordic countries and Nordic banks, and it’s not helped by increasing competition from non-bank lenders. That hasn’t been as much of an issue in Denmark as it has been in Sweden (a challenge for Nordea (OTCPK:NRDBY) and others), but household debt levels are still higher than you’d really like to see, and I would expect companies to be relatively conservative where taking on new debt is concerned.
As far as credit goes, the Nordic banks, Danske included, have long benefited from well above-average credit quality in their operating footprint. Danske is on the lower end of the curve (among Nordic banks) where large corporate lending exposure is concerned, and so I do see a little risk from a greater exposure to smaller businesses. Still, the Danish government has been relatively active with stimulus and support measures, and early-stage non-performing loan data has looked fairly good. I’d also note that Danske’s commercial loan book is well-diversified and has very little exposure to oil/gas. Danske also has relatively less commercial real estate exposure than its Nordic peers, and that’s another positive in its favor.
All told, I’m expecting Danske to get through this cycle with modest cumulative loan losses, though provisioning expense will remain elevated into next year.
Danske has pursued a strategy for several years now that has focused on high-quality, high-margin growth. The bank has gained some share in Norway, Finland, and Sweden, but the growth has been modest, as the bank has continued to prioritize service quality and margins over growth for its own sake. Partnerships with Swedish unions have helped grow the business there, with about 15% of Danske’s ex-Corporate/Institutional loan book now coming from Sweden (as well as 12% from Norway and 10% from Finland).
Danske has also been attentive to maintaining and growing a robust fee-based business, with about half of the company’s revenue coming from non-spread operations like payments, cards, wealth management, and loan guarantees.
One issue that does continue to hang over the business is the prospect of significant fines from money laundering issues in Estonia in years past (2007-2015). This isn’t a Danske-specific issue, as many European banks have had similar problems, but there will still likely be fines coming. With a very robust capital position (a CET1 ratio of 17.6% in the second quarter), I’m not concerned about the bank’s ability to pay the fine and still fund a dividend (when regulators allow it).
Given a stronger relative economic outlook for the Nordic region, as well as strong credit quality and a good collection of fee-generating businesses, I believe Danske will outperform the average European bank. I’m looking for modest low single-digit core earnings growth over the next five years and longer-term core growth around 4%. At this point I’m not confident that Danske will return to double-digit ROEs on a sustained basis.
The Bottom Line
Between discounted core earnings and an ROTCE-driven P/TBV, I believe Danske is undervalued today. I don’t expect to find bargains in higher-quality sub-sectors like Nordic banks, but Danske does look undervalued today both on the basis of long-term earnings power and near-term ROTCE. Given historically low valuations and above-average quality with Danske, I think this is a name worth considering now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.