Quarterly Outlook
Q3 Investor Outlook: Beyond American shores – why diversification is your strongest ally
Jacob Falkencrone
Global Head of Investment Strategy
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Why Danske offers long-term upside potential
Trade View 6 minutes to read
Strategic Trade / Buy
Peter Garnry
Chief Investment Strategist
Summary: Shares of Danske Bank have fallen by 44% since early 2018 on the firm's Estonian money laundering scandal, but Denmark's largest bank retains solid fundamentals.
Instrument: DANSKE:xcse
Price Target: DKK 207.50
Market Price: 129.50
Background:
Danske Bank is the second-largest bank in the Nordic region as measured by total assets. It was also a post-financial crisis success story as the bank managed a spectacular turnaround in its business, lifting return on equity from around 2-4% in the years after the financial crisis to 10-12% more recently. Investors were rewarded in the 2009-2019 period with Danske shares up 12.2% annualised including reinvestment of dividends. This return is at par with the MSCI Nordic Index in the same period, but at its peak in around mid-2017, Danske had outperformed the Nordic equity benchmark by eight percentage points (annualized, starting in January 2009), which is impressive for a banking stock.
Danske Bank’s money laundering scandal, which came to light in early 2018 and related to issues at the bank’s Estonian branch in the years 2007-2015, has lowered the share price by 44% since it surfaced. The scandal is the biggest in Europe’s history and an embarrassment for Denmark as the country prides itself as a transparent country with high ethical standards. Shareholders are deeply concerned over the revelations and management's slow reaction to the scale and consequences of the scandal.
The Estonian branch’s non-resident business profited around DKK 1.7bn in the period 2007-2015; this implies penalties in the US of up to around $1 billion according to estimates provided by Bloomberg. Danske is being investigated by the US Securities and Exchange Commission, the Department of Justice and the Treasury Department, with the latter likely posing the biggest risk to Danske Bank.
We also see a small probability of Danske Bank being cut off from the US financial system like Latvian bank ABLV was in 2018, though Danske Bank is cooperating with US authorities.
The Financial Times reported back in January that consensus is looking for an aggregate fine of around $5bn while the Bloomberg Intelligence team covering banks put the estimate around $2bn. Both amounts can be dealt with by Danske Bank, particularly as the fines will drag out over years, diluting the impact.
From an ongoing concern perspective, the fines are one-off items with some potential effect on the bank's continuing operations (likely a small impact due to the stickiness of banking business), so the impact on return on equity should be limited.
Danske Bank’s money laundering scandal, which came to light in early 2018 and related to issues at the bank’s Estonian branch in the years 2007-2015, has lowered the share price by 44% since it surfaced. The scandal is the biggest in Europe’s history and an embarrassment for Denmark as the country prides itself as a transparent country with high ethical standards. Shareholders are deeply concerned over the revelations and management's slow reaction to the scale and consequences of the scandal.
The Estonian branch’s non-resident business profited around DKK 1.7bn in the period 2007-2015; this implies penalties in the US of up to around $1 billion according to estimates provided by Bloomberg. Danske is being investigated by the US Securities and Exchange Commission, the Department of Justice and the Treasury Department, with the latter likely posing the biggest risk to Danske Bank.
We also see a small probability of Danske Bank being cut off from the US financial system like Latvian bank ABLV was in 2018, though Danske Bank is cooperating with US authorities.
The Financial Times reported back in January that consensus is looking for an aggregate fine of around $5bn while the Bloomberg Intelligence team covering banks put the estimate around $2bn. Both amounts can be dealt with by Danske Bank, particularly as the fines will drag out over years, diluting the impact.
From an ongoing concern perspective, the fines are one-off items with some potential effect on the bank's continuing operations (likely a small impact due to the stickiness of banking business), so the impact on return on equity should be limited.
Parameters:
Entry: Limit buy in the DKK 120-140 range
Stop: DKK 100
Target: DKK 207.50
Time Horizon: Until June 30, 2020
See charts below for more data on Danske Bank shares.
Management And Risk Description:
Danske Bank is naturally a high-risk investment given the 44% decline in the share price since early 2018 and the downside risks to fines from various financial regulators in the US and Europe. The ultimate risk is if the fine goes above USD 6bn as that would begin to eat into the bank’s buffer against the Pillar 1 requirement.
Danske's money laundering scandal obviously carries the risk that client relationships will be lost, impacting the business negatively. Danske Bank also derives around 52% of its net revenues from Denmark, making the bank dependent on a strong economic outlook for the country.
So far, Denmark’s macro numbers have outperformed those of other European countries despite the global slowdown. But should we experience a steeper slowdown that impacts Denmark as well, it would most likely increase loan impairments and lower return on equity. Should interest rates continue to go lower or just stay at current levels, it will act as an upper ceiling on return on equity. For shareholders there is also the risk of dividend cuts but currently sell-side analysts are still modelling a payout ratio of 50% of earnings despite the outlook and potential fines.
The biggest risk to our target price is our assumption that Danske Bank can maintain a 10% return on equity. We are basing our assumption on the guidance from the bank, sell-side analysts' assumptions and recent history, coupled with the bank’s market position. Should the return on equity drop to around 6% due to macroeconomic reasons and business impact from the money laundering scandal, though, the fair price drops to DKK 157.60 – around 21% higher than the current market price.
Given the historical relationship, the return on equity could drop to as low as 4% given the current price-to-book ratio. It our opinion the share price leaves a significant margin of safety, but clearly our return on equity assumptions are critical to the fair price estimation.
Danske's money laundering scandal obviously carries the risk that client relationships will be lost, impacting the business negatively. Danske Bank also derives around 52% of its net revenues from Denmark, making the bank dependent on a strong economic outlook for the country.
So far, Denmark’s macro numbers have outperformed those of other European countries despite the global slowdown. But should we experience a steeper slowdown that impacts Denmark as well, it would most likely increase loan impairments and lower return on equity. Should interest rates continue to go lower or just stay at current levels, it will act as an upper ceiling on return on equity. For shareholders there is also the risk of dividend cuts but currently sell-side analysts are still modelling a payout ratio of 50% of earnings despite the outlook and potential fines.
The biggest risk to our target price is our assumption that Danske Bank can maintain a 10% return on equity. We are basing our assumption on the guidance from the bank, sell-side analysts' assumptions and recent history, coupled with the bank’s market position. Should the return on equity drop to around 6% due to macroeconomic reasons and business impact from the money laundering scandal, though, the fair price drops to DKK 157.60 – around 21% higher than the current market price.
Given the historical relationship, the return on equity could drop to as low as 4% given the current price-to-book ratio. It our opinion the share price leaves a significant margin of safety, but clearly our return on equity assumptions are critical to the fair price estimation.
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