Italian banks: Heading for a Spanish scenario?
Let me first explain the dynamics of a bank’s value by repeating one of the most important investment theses: Buying banks is about being long credit and leveraged10-20 times. This is why it is extremely important to understand what credit cycle phase we are in before deciding to buy banking stocks.
So how are Italian banks situated? Looking at the share price performance of the largest Italian banks during the last five years indicates that there have been few signs of increasing credit quality, chart 1.
All Italian banks, except Banca Popolare, are down 70 percent or more showing the overall distressed situation in the sector. Valuation wise the picture is even grimmer. Taking a look at the expectations for 2012, Italian banks trade at an average Price-to-Book (P/B) of 0.28 and expect to return 4 percent on equity (ROE), chart 2, which is not really convincing compared to historical averages of above 1 on P/B and around 15 percent on ROE. If capital had to be raised at the current levels, shares in Italian banks would be extremely diluted, in some cases by as much as 50 percent or more. This scenario can quickly ruin any good investment, turning it into perhaps the worst you have ever made.
What investors need to pay attention to is that this picture is not expected to improve in 2013 either and the risk rewards built into the current valuation structure of Italian banks indicate a 13 percent ROE to obtain a P/B of 1 that is valued on par with equity. Therefore more than a 200 percent increase in earnings is needed since capital levels to date are unlikely to fall, chart 3.
Damned if they do, damned if they don't ask for capital?
Thus the risk of continued heavy losses and/or the need for further capital increases thereby dilutes existing shareholdings. As much as I see problems mounting for Italian banks they could also be the investment opportunity of a lifetime if the financial sector's credibility is restored in Europe and the Italian economy gets back on its growth track. There are lots of ifs in this equation. I however believe that it will take too long for Italian banks to recover which means that a lot of new troubling issues could negatively affect the fate of their shareholders. Before the end of 2012, Italy might find itself in Spain's situation - having to apply for outside help. I wonder if the market will be as forgiving then as it has so far for Spain?