Nordic banks stand out in a lot of positive ways. They’re well-capitalized, generally have good efficiency ratios, and usually run relatively conservatively. They also skew much better than average where credit quality is concerned; between the underlying health of the Nordic economies and underwriting discipline, Nordic banks will likely make it through the COVID-19 recession with lower cumulative losses than most other banks across Europe.
Still, there are differences and distinctions among them. DNB (OTCPK:DNHBY) is more leveraged to corporate lending than its peers and appears to have a riskier portfolio as well. The bank is also less leveraged to non-spread sources of income, but generates healthy pre-provision profits that can cover a lot of losses. With so-so return prospects relative to its peers, DNB isn’t my favorite pick among the Nordic banks, but investors with a more bullish outlook on Norway’s economy may find more to like here.
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Watch The Balance Sheet Numbers From The Third Quarter
Looking ahead to DNB’s third quarter earnings report, I expect loan growth and credit migration to be the primary areas of focus for most analysts and investors. DNB posted healthy loan growth numbers in the second quarter, with overall average loans up more than 4% yoy and close to 1% qoq, and corporate loans up 7% and 3%, respectively. Cost of risk wasn’t bad at around 50bp, but non-performing loans are stacking up (1.8% of loans in the second quarter, up more than 50bp yoy and 20bp qoq), and DNB’s coverage of Stage 3 loans (34%) is near the bottom of the peer group.
The health of the underlying economy always matters to banks, and Norway appears to be in better shape than most. Unemployment and GDP have already started to show signs of meaningful recovery, and Norway’s state oil fund is an invaluable asset when it comes to funding programs to mitigate the impact of the pandemic on the economy.
Still, DNB has a larger-than-average skew toward business lending, with more than half of its loans going to business customers, about two-thirds of which are classified as larger corporations. These corporate loans have provided a disproportionate share of net interest income in recent quarters, and they also support above-average returns on equity. While I expect that efforts on the part of the Norwegian government to mitigate the impact of COVID-19 will help limit credit losses, I’m still concerned about the near-term growth outlook for businesses in the Nordic area and whether or not companies will be looking to expand their businesses in the near term (the typical driver for loan demand).
I’m also going to be keeping an eye on credit quality and the migration/evolution of credit quality. About 20% of DNB’s business lending is to segments of the economy at higher risk from the pandemic, including a significant contribution from oil/gas and shipping borrowers. Unlike most of its peers among Nordic banks, which generally have a 65% or greater mix of investment-grade credits in their corporate loan book, DNB’s corporate investment-grade mix is less than 50%. Moreover, DNB was expanding its riskier lending operations going into this downturn (non-investment-grade syndicated loans, for instance), and the Stage 3 loan coverage is lower than I’d like at this point.
A Healthy Core Provides More Breathing Room
On the flip side of those concerns, DNB has a generally high-quality business that generates significant pre-provision profits, and those profits can fund a lot of losses before capital becomes an issue. The ratio of DNB’s pre-provision profits to loans should be around 1.7% to 2.0% this year, which puts it comfortably in the upper tier of European banks in general, as well as Nordic banks. Moreover, while DNB does lack the sizable and lucrative fee-generating asset/wealth management operations that many of its peers have, it also relies less on volatile trading income – such income is often excluded from “core” results, but it still counts.
While I do believe DNB may see higher losses than its peers and may have to increase provisioning more than currently expected, I still expect cumulative losses to be in the neighborhood of 200bp or less, which keeps it firmly on the stronger end of the curve for European banks.
DNB also stands out with one of the best efficiency ratios among Nordic (and European) banks, with the ER in 2020 likely to be around 40%. Although I do see some potential for this moving into the high 30%’s over time (lower is better), DNB’s strong profitability does mean relatively limited fixed cost leverage from here.
It Really Comes Down To Volume Now
Second quarter spreads were helped by a roughly two-month lag between lowered deposit rates and lowered lending rates, but management has guided to pretty minimal repricing opportunities at this point. The Norges Bank is looking to start increasing rates around mid-2022, but obviously a lot depends upon how the economy develops between now and then. With no real spread leverage at this point, a below-average mix toward non-spread income sources, and not much near-term operating leverage DNB ‘s growth is now really a byproduct of loan volume growth.
I don’t expect DNB to be particularly aggressive in corporate lending, and I would expect to see more capital allocated towards consumer lending. Still, this is now basically a call on how quickly the Norwegian economy (Norway accounts for over 80% of the business mix) can get back to normal and return to growth. Management thinks they’ll see 3% to 4% loan growth through 2022, but that could prove optimistic if the pandemic has a more extended impact on the global economy.
The Outlook
DNB is an interesting position today, as the bank’s ability to absorb losses is well above average, and Norway’s government has well above-average capacity to support (and stimulate) the economy, but the credit quality mix and coverage are below-average. I don’t think the risk of a large credit quality problem is particularly high, but I do see a more elevated risk that underlying loan demand disappoints over the next year or two.
Looking beyond the next couple of years, I expect DNB to post fairly healthy five-year core earnings growth (around 3%) on a better rate environment in Norway and stronger loan demand. Longer term, I expect core earnings growth in the neighborhood of 3% to 4%, supporting a total annualized prospective return in the low double-digits based on those discounted core earnings.
The Bottom Line
In terms of total return potential, I think DNB is a respectable option. My main issues are that the shares aren’t all that undervalued relative to near-term ROTCE (when many European banks are) and that corporate loan growth could disappoint relative to a pretty bullish outlook from most sell-side analysts who believe the Nordic countries will perform noticeably better over the next two years. I don’t think that DNB is a bad bank by any means (despite an iffier credit quality mix), but I am less bullish on near-term corporate investment spending, and so I’d be tempted to wait for a slightly better price or confirmation that commercial loan demand has indeed remained strong.
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