Banca Monte dei Paschi
Company description
Banca Monte dei Paschi di Siena SpA is an Italy-based company engaged in the banking sector. It provides banking services, asset management and private banking, including life insurance, pension funds and investment trusts. It operates though three business segments. The Retail Banking segment covers consumer lending, insurance, provision of financial and non-financial services to retail customers, wealth management, tax planning, financial advisory and planning for private customers. The Corporate Banking division oversees the Group’s business strategies targeted to small and medium enterprises, institutions and large corporate for which it offers leasing, factoring, lending and financial products, among others. The Corporate Center segment includes the cancellation of intergroup entries, treasure, governance and support functions. It transfers non performing loans (NPL) to Banca Ifis SpA and Cerberus Management Capital LP.
Banking environment
The European banking sector has been one of the worst- performing sectors in the last 5 years. The Euro Stoxx banks (tries to track the performance of European banks) index/ Etf is down by 36% on a five year basis (inflation not taking into account) and almost 21% on a one year basis. The main reason for this performance is due to the low interest margins, which have steadily decreased since the financial crisis 2007. It has been determined for small and medium- sized banks that an increase in the 10- year interest rate increases interest income by a certain number of percentage points, while interest expenses only increase by a smaller number; this increases the net interest margrin. Hence it can be concluded that interest rate decreases with lower interest level (and vice versa). The net interest margin and profitability of Euopean banks (measured in ROE and net margins) have decreased by large amount.
10-Year Government bonds of European countries are negative or close to zero. There is an international consensus among central banks (FED, ECB, BOJ) that interest rates are likely to continue to be around zero or negative. Italy, in particular, has to pay 0,65% interest on their government bonds. This can be explained by the bond purchases from the ECB. Nonetheless, Italy’s (gross) debt-to-GDP ratio is 162% (forward) and the net debt-to-GDP ratio is 123% (forward). This makes Italy the the sixth/ third most indebted country in the world. In contrast, to Japan (being the most indebted country worldwide) Italy is an open economy, which makes government debt very vounerable. High government debt usually leads to less economic growth, can lead to a currency crisis and has an impact on stock market performnce (see Japan’s 30-year bear market). If on the other hand interest rates increased by more than 50 basis points, several European countries (incl. Italy) and corporations would struggle to refinance themselves (leading to non- performing loans).
According to Deutsche Bank, zombie firms (companies with debt servicing costs higher than profits) make up 20% of US firms and I expect that the number of European zombie firms is similarly high (15%- 20%).
Not only is the share of zombie firms/ banks so high, but also amounts the sum of debt of zombie firms over 1,8 trillion USD (compared to 2019: below 500 billion). A lot of European banks are zombie banks, too. The dilemma can be summarized as follows: If interest rates and net margins continue to be low, which is very likely, bank revenues will be likely to stay on a low level and even get lower. However, if interest rates rise, credit defaults ascend dramatically. There are also many parallels to Japan.
The fact that governments and businesses are more in debt than ever before (both in absolute terms and measured in contrast to economic output) are a to some extend negligible problem so far.
However, should the high- yield spreads rise, this could not only initiate a recession, but also lead to a wave of bankruptcies and let NPLs shoot through the roof.
Furthermore, banks suffer from increasing regulation, which increases compliance costs. This is especially significant for smaller banks such as Banca Monte, since there are economies of scale in compliance. Banks are heavily burdened by the basel-4 agreement (more than originally assumed): The output-floor defines a minimum capital requirement for banks. This floor should be used from banks having their own, officially recognized risk measurement procedures. The new Basel regulations are to be applied from the beginning of 2022 on and have to converted into European law first. However, according to several banking experts, the output- floor leads to significant higher capital requirements.
What’s more, Fintech companies disrupt this sector. GlobeNewswire confirm that the global Fintech Market was valued USD 5504.13 Billion in 2019 and is expected to grow at CAGR of 23.58% during the next 5 years. They comment: “The key factor for the growth of the fintech market includes high investment in technology-based solutions by banks and firms. Moreover, the infrastructure-based technology and APIs are reshaping the future of the financial services industry, thus aiding the growth of the Global Fintech Market. Furthermore, financial technology companies are delivering low-cost personalized products on account of emerging developments in the technology sector, leading to rising customer expectations, thereby, boosting the market growth globally“ 1.The high growth in customers and applications illustrate the devastating consequences of the disruption for regional banks, as a lot of fintech customers have been served by banks previously.
Banks are highly cyclical companies. (Almost) no sector is more exposed to the macroeconomic environment than banks: In worse economic environments credit demand shrinkages, while liquidity gets scarcer and defaults increase (very generally speaking). Therefore, during the Dotcom- bubble and the financial crisis of 2008 regional banks were belonging to the worst performing companies. Many regional bank stocks are down already, but if we enter into a recession/ stagflation or the end of the bull market, regional bank stocks can go much lower.
Nevertheless, in an ongoing bull market I would expect my longs to (at least) outperform the regional bank index and in negative scenario I think there is still significant downside despite (probable) low valuations. Let’s have some look on the business cycle: By the begin of January 2021, we see already that shares of shipbuilding companies fall by more than 30%, the LEI index has decreased by 0.1 and many countries‘ positive GDP surprise was driven by increasing government spending.
There are clear recessive tendencies among several European countries. Looking at Italy in specific (as this article is mainly about Banca de Monte), the GDP of Italy peaked in 2008 (2 408 trillion USD) and decreased significantly since then to a GDP of 2 001 trillion USD in 2019 and 1 848 trillion USD in 2020 (forward) (source: statista). According to Brussels economists, Italy’s GDP will reach its level from 2008 in six to seven years (and this is just the base-case-scenario and it doesn’t even account for Covid). The main reason for this is the large interest payments and high government debt: Many economists postulate, that economic growth over a debt-to-GDP ratio of 100% is not possible. It is also known that more and more debt have to be taken on to generate the same economic growth. Furthermore, politics and bureaucracy hold back the economy: Local investors frequently face legal uncertainties and state investments stay idle. The unemployment rate fluctuates between 10% and 11%. The unemployment rate was at these levels even several years ago, which suggest structural economic problems instead of a temporary crisis. In Italy, the median age of the population in 2019 was 46.7 years. This is not only the highest value within the European Union. Italy is also one of the countries with the highest average age in the world.
Besides, the stock market valuation is quite high: The Shiller P/E ratio2 is above 33 (median/ mean around 16 and which is currently higher than 1929), the Tobin’s Q ratio3 is around 2.6, which is more than 3 standard deviations from its mean (= equity market value/ equity book value, hypothesizes that the combined market value of all the companies on the stock market should be about equal to their replacement costs). Last but not least, the buffet indicator4 is currently more than 2 standard deviations from its mean suggesting strong market overvaluation (buffet indicator: 224%). However, the stock market is driven by liquidity and I don’t say that there is a selloff, in the next 6 -12 months, but an investor/ trader should be aware of this valuation and as I have pointed out that the regional banking sector probably will continue to underperform the market by a considerable amount. If there is a correction a lot of downside volatility can be expected from the regional banking sector.
Company fundamentals
Banca Monte is a value- destroying company, where I think (another) bankruptcy is likely. Despite moderate cash reserves, the equity- to- asset ratio is 0.04 (anything below 0.15 is to be classified as extremely risky). Additionally, the company cannot rely on consistent profits to pay their equity and debt holders. In principle, it can be said that sales are shrinking relatively constantly: Since 2009, sales have more than halved and the bank has now published a loss for the fifth quarter in a row. The loss of this quarter amounts to 185 million, which is a lot considering the low equity capital. Q4 2019 the loss amounted up to an incredible 1.3 billion.
Valuation
The majority of European banks are trading at a price-to-book ratio of below 1 and a forward p/e ratio of 11.6. The stock market is a forward- looking discount mechanism. There is some pressure priced into European banking stocks into the price already. European banks appear to be cheap on a historic basis. However, there is still significant downside and limited upside to me.
Covid-19
The Covid-19 situation was manageable for banks mainly due to liquidity support, fiscal, monetary and regulatory support. Although credit demand peaked at the beginning of the crisis many analysts expect pressure on earnings going forward. One can expect, in addition to that, an asset quality deterioration as well as a substantial profitability drop (higher than 20% at least according to several research companies) in 2021 compared to a non- Covid scenario.
Potential trade structure
If one wants just wants to get exposure to the outlook on European bank stocks one can also consider shorting a basket of (European) bank stocks (key performance indicator for this trade: low ROE, high debt/ equity, high debt/ EBITDA, declining revenues, high cost-income-ratio. One can also consider a pair trade going long JP Morgan on the other side of the trade. JP Morgan is the largest US bank (AUM) and one of the most profitable (universal) banks with growing revenues and good management. Nevertheless, Banca Monte dei Paschi di Siena SpA has a high potential of going bankrupt. I think a turnaround can be ruled out.