Germany is a top economic powerhouse among countries in the eurozone -- yet the nation's two largest banks trade at rock-bottom valuations. Let's take a look at what is at play and which types of investors should consider Deutsche Bank AG (NYSE:DB) and Commerzbank AG (OTC:CRZBY).
With Deutsche Bank and Commerzbank trading at less than half of their respective book values, some investors sense a value play in the making. But these banks have traded around this valuation for over a year; plenty of time for the market to close the gap if investors wanted to value Germany's top two banks at book value.
There are other reasons behind the market discount and I'll take a look at a few of them here breaking them into three categories: Reasons applicable on to Deutsche Bank, reasons applicable to Commerzbank, and reasons applicable to both.
Deutsche Bank discount
As Germany's largest bank, Deutsche Bank is a major player in international finance but there are a couple key reasons why it does not carry the same valuation.
• Fixed-income investment bank strategy
With fixed-income investment banking putting up disappointing numbers for many multinational banks the industry trend has been toward reducing presence in this area. As Barclays slashed the capital allocated to its investment bank, Deutsche Bank did just the opposite by raising capital to expand the investment bank.
As tighter capital and leverage requirements threaten investment banking profits, the headlines in this area continue to remain negative turning investors off of banks with high exposure to this area, such as Deutsche Bank.
The bank is playing a contrarian strategy here and investors are generally not enthusiastic so far judging by the bank's valuation. From this perspective Deutsche Bank could be seen as a way to invest in a rebound in investment banking.
• Distrust of management
Investors like management they can trust but this is tougher to do with Deutsche Bank after the events surrounding its most recent share sale. After originally telling investors they planned to increase capital through organic methods and retained earnings, management changed its mind and proceeded with an 8 billion euro share sale.
With confidence in management shaken, Deutsche Bank has become a good candidate for a management discount. It could take a while to undo the damage here but a combination of time and execution should help.
Germany's second largest bank gets less attention among American investors due to its smaller presence and it lack of a listing on a major U.S. stock exchange. But, like Deutsche Bank, Commerzbank trades at about half of its book value and has its own reasons for the discount.
• No dividend
Most major banks have some sort of dividend even if it's a tiny one like those paid by Bank of America and Citigroup. But Commerzbank has no dividend making the stock unattractive for income investors and dividend-focused funds.
As a major bank, Commerzbank probably wants to eventually pay a dividend but there are other factors at play. The bank is still working to unwind its unwanted holdings in Portugal and Spain and the German government still owns a 17% stake in the bank. Before the bank can begin rewarding private shareholders with dividends, there may be political pressure to put Commerzbank entirely back into private hands.
Although the government has not seemed to be in a hurry to sell the shares, the pressure to sell the remaining stake should continue to build as the bank returns to health. Already, there are now voices in government beginning to push for a sale including the monopoly commission which argued for a sale last July.
Until the bank resumes its dividend, it won't have buying pressure from income investors preventing its valuation from reaching higher. But on the positive side, the reinstatement of a dividend could serve as a catalyst for a higher valuation.
• Shipping loans
Before the financial meltdown, Commerzbank became a major lender for ocean shipping companies resulting in billions of euros of shipping loans being owned by the bank. Unfortunately, ocean shipping was one of the areas hit hardest by the economic slowdown and these shipping loans soured.
With shipping still feeling the pain today, Commerzbank is working to offload the loans to reduce their exposure. But even with its efforts to cut exposure, the bank still has about 12 billion euros of shipping loans exposed to default as of its last report.
Concerns over these loans are likely weighing on the stock as they bring additional risk to the bank and make its book value less certain. Along with its loans in Spain and Portugal, investors should see this as an area of risk and monitor the bank's progress in reducing this exposure. However, if Commerzbank can continue to reduce exposure to these assets, it could earn a higher valuation from the market.
The eurozone issue
Perhaps the biggest reason for the discount on Deutsche Bank and Commerzbank is the risk of being a bank in the eurozone. Compared to major French banks such as BNP Paribas at 0.71 times book value, Societe Generale at 0.65 times book value, and Credit Agricole at 0.59 times book value, Germany's two largest banks are not much cheaper relative to their book values.
Right now, the eurozone economy is still struggling and sovereign debt concerns out of Spain, Portugal, Italy, and Greece are increasing risks to banks and the economy as a whole.
Fortunately for Germany, its two top banks now have fairly little exposure to Greece, with figures form Reuters noting Commerzbank's exposure at around 400 million euros and Deutsche Bank's at 298 million euros. This is particularly important for near-term risk management as Greece is currently in negotiations with its creditors, which could result in significant haircuts.
Should you buy them?
Clearly there are numerous reasons for why Deutsche Bank and Commerzbank trade at such wide discounts to book value but, at the same time, each bank has the potential to close the valuation gap with good execution.
Deutsche Bank is worth looking at for investors bullish on an investment banking recovery and willing to wait while collecting a 3% dividend. Commerzbank is suited to investors willing to wait on a dividend while the bank manages its higher risk loans and seeks a privatization of the remaining government stake.
Of course, both banks will be influenced by the events of the eurozone. While neither one has significant total exposure to Greece, short-term traders reacting to events could make these stocks volatile, especially over the next couple of months as Greece talks to its creditors.
Due to their price to book valuations and potential catalysts to boost their valuations, I am bullish on Deutsche Bank and Commerzbank for the long term. However, these banks do have above average bank-risk profiles and may not be suitable for investors with low risk tolerances.