What Investors Need to Know About Commerzbank AG (ADR)

In the U.S. market, most investors looking for German banks tend to focus on Deutsche Bank (NYSE: DB  ) . While Deutsche Bank certainly does deserve attention considering it's Germany's largest bank, that nation's second largest bank is often overlooked.

Having taken quite a beating during the financial crisis, Commerzbank (NASDAQOTH: CRZBY  ) is on the rebound as profits return and non-core assets are disposed of. Wise investors should take notice.

Share dilution
Government assistance for banks was hardly unique during the most recent downturn, and Commerzbank was no exception. Commerzbank accepted a 18 billion euro bailout while rival Deutsche Bank escaped without one (although some former employees alleged Deutsche Bank hid $12 billion of losses to avoid a bailout). But bailouts aren't free to shareholders, and these investors paid the price through a massive wave of share dilution.

The government stake in Commerzbank fell below 20% in 2013 from 25% previously. However, this was largely due to the bank's 2.5 billion euro capital raise further diluting shareholders. As a bank struggling to raise capital, share dilution was unavoidable during the crisis, but investors in Commerzbank should not expect to see the pre-crisis highs again for a long time, if ever, because of the magnitude of the dilution.

Dividends?
With European stress tests coming up, Europe's banks are shedding non-core assets and looking to raise and preserve capital on favorable terms. Not too surprisingly, Commerzbank is not paying a dividend leading up to the stress test results.

Commerzbank CEO Martin Blessing wants to get the results from the ECB stress tests before any dividend action is taken. Considering the potential share dilution from finding a capital deficiency and having to issue new shares, holding off on a dividend for the time being is probably a smart move.

So Commerzbank shareholders should not expect big dividends anytime soon. Even after the results are released, the bank will probably start out small and build a meaningful dividend over time. For now, Commerzbank is not a stock for income investors, but if the turnaround continues, it may one day deserve another look.

Government stake
Currently holding a 17% stake in Commerzbank, the German government does not appear to be in any hurry to divest itself of the bank. Instead, a report in Spiegel says the government is holding out for a higher price until 2016. Reuters notes the government did not comment on much, but a finance ministry spokesperson said, "The German government has no plans to sell its stake."

With this government strategy, Commerzbank will have to wait longer to shake off the image of government ownership. However, the government stake should not be a major operational issue since the 17% stake is small enough that Commerzbank can make its own decisions.

Valuation
Commerzbank trades about where one would expect a zero-dividend paying partially government-owned bank to trade. At about half of book value, the bank trades at a sharp discount to its more stable rivals. Trading around 18 times forward earnings, Commerzbank shares look overvalued, however, earnings are expected to rise sharply in the following years as the economy recovers and more non-core assets are disposed of. Of course, forward earnings estimates can be off, so investors should still run their own numbers.

At this point, Commerzbank carries a lower valuation than many other major banks, but it does so because of increased risk, partial government ownership, and the lack of a dividend. With this in mind, Commerzbank sets itself up best as a recovery play. If the bank can continue to dispose of non-core assets, as it's been doing while turning earnings performance around, there is upside to be had as the bank moves closer to peer valuation. At the same time, the bank continues to face stress test and economic risks, making this far from a blue-chip bank stock.

Recovery bank
Commerzbank ran into billions of euros worth of trouble during the financial crisis as it had a major role in shipping and real estate loans, two of the areas hit hardest by the financial crisis. After taking a government bailout and having enough share dilution to push the bank to run a 1 for 10 reverse stock split, Commerzbank is profitable again and continues to weed out non-core assets.

Primarily because of its low price to book value, Commerzbank looks to be a recovery/value play for risk-tolerant investors with a long-term outlook. For investors looking to diversify their European bank holdings or find European recovery plays, Commerzbank is worth a further look.

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