Clean Credit And Efficient Operations Support A Healthier Multiple For Swedbank (OTCMKTS:SWDBY)

Christel Deskins

With fear and uncertainty the order of the day in European banks, investors have shown a definite willingness to pay up for perceived quality. Swedbank (OTCPK:SWDBY) fits the bill, with a business that is heavily weighted toward Swedish mortgages and high-quality corporate lending, an efficient cost structure, and ample surplus […]

With fear and uncertainty the order of the day in European banks, investors have shown a definite willingness to pay up for perceived quality. Swedbank (OTCPK:SWDBY) fits the bill, with a business that is heavily weighted toward Swedish mortgages and high-quality corporate lending, an efficient cost structure, and ample surplus capital. While I see less growth potential for Swedbank than some of its Nordic peers (not to mention other European banks), a low single-digit core earnings growth rate is still enough to support a double-digit potential annualized return for a company that I believe has well below-average credit risk through this cycle.

Healthy Loan Demand

Between sell-side conference presentations and a pre-close update, Swedbank management has been consistent with the message that loan demand has remained surprisingly healthy. Mortgage loans rose over 5% in August, and mortgage pricing has held steady since the second quarter. Share losses to new entrants seem to have stopped, and perhaps even reversed, with Swedbank’s loan flow share (its share of new loans) back to 17% and the back-book around 23%. That leaves Swedbank with the top spot in the Swedish loan market, just a bit ahead of Handelsbanken (OTCPK:SVNLY).

Corporate lending is still more of a “wait and see”. While it looks like demand is coming back, I think it may be premature to just assume that there won’t be a greater impact on loan demand from the pandemic. Business lending is a relatively modest percentage of Swedbank’s loan book, at around 30%, with half of that coming from large corporations. Among the Nordic banks, then, Swedbank is among the least-leveraged to large corporate lending (with SEB (OTCPK:SKVKY) and DNB (OTCPK:DNHBY)on the other side).

Thus far, non-performing loans in Swedish mortgages have remained quite low, and while household debt levels are a little higher than I’d like, I don’t see enough stress in the system to get all that worried. Likewise, housing prices remain pretty firm, but not to a point where I’m concerned about a property bubble. Consumer confidence will be an important factor to track, as mortgage loan growth is a key part of overall loan growth for Swedbank (Swedish mortgage lending is about half of the loan book).

Weak Spreads Are Manageable

It’s true that rates in Europe are extremely low, and it’s likewise true that banks don’t tend to fare well when rates are so weak. It’s a little different with Nordic banks like Swedbank, though. While Swedbank enjoys good mortgage lending share, its deposit share is lower (around 19% of retail deposits), and Swedbank has never really been able to rely on low-cost deposits to fund its lending. This is a structural “is what it is” aspect of the Nordic banking system, and Swedbank’s loan/deposit ratio has long been above 100% (five years ago, it was above 200%).

In the absence of low-cost deposits, banks like Swedbank make use of wholesale funding. While that’s more expensive than core deposits in a market like the U.S., and Swedbank has long had net interest margins far below what an American bank would consider normal (typically around 1.5% to 1.7%), the good news is that wholesale funding reprices quickly, meaning that weak rates don’t hurt Swedbank’s earnings to quite the same degree.

Credit Losses Should Be Quite Manageable

It’s hard not to be impressed with the credit quality of Swedbank’s loan book. To start, basing a banking business around core mortgage lending is going to support lower full-cycle credit losses in most cases. As I said before, non-performing loan ratios for mortgages in the Nordic region are among the lowest of all loan categories in Europe. Second, the corporate lending that Swedbank does is typically very high quality, with a strong skew toward investment-grade borrowers (true for Handelsbanken as well).

Swedbank has also been smart about how its commercial loan book is structured. Only about 7% of the commercial loan book is “considerably” impacted by COVID-19, with another 4% “moderately” impacted, and Swedbank does rather little energy lending. The bank also has a relatively small (around 15%) exposure to commercial real estate – one of the areas where there has been some erosion in credit quality so far, with Europe-wide NPL ratios in the 7%’s.

Beyond all that, the bank is well-reserved, with 44% coverage of Stage 3 bad loans, and the total cumulative loss experience for this cycle may well be less than 150bp, perhaps even 100bp, and most of that will likely be in corporates/CRE.

The Outlook

Conservatively built as it is, my main concern about Swedbank is how it will perform once investors warm up to the banking sector again. While Swedbank’s approach is great for producing healthy ROEs and low full-cycle credit losses, lending to Swedish homebuyers and IG corporates isn’t going to really generate a lot of growth. A healthy collection of fee-generating businesses, including asset/wealth management and cards/payments, helps, but I think Swedbank is likely to be a low-to-mid single-digit core earnings grower over the long term, as it has been in the years since the global financial crisis.

As I said, I don’t see many ways for Swedbank to goose the topline. Management has been content to focus on its high-market share franchises in Sweden and the Baltics, and I don’t see the bank looking to make a big splash entering other Nordic markets (or other, more distant markets). Expanding commercial operations like equipment financing would be a possibility, but I think core revenue growth is going to be pretty low.

I also don’t see a lot of room for improvement on the expense side. Moving past some IT investments should allow the efficiency ratio to move back down to around 40% over time, and maybe a little lower, but I don’t think a number below 38%-39% is going to be sustainable. So, given all of that, I think long-term core earnings growth may be about as good as investors can reasonably expect. I’d also note that, while dividends are currently suspended (by regulatory mandate), Swedbank is very well-capitalized and capable of supporting a healthy dividend (I’d estimate a roughly 4% to 5% yield).

The Bottom Line

Discounting those earnings back, Swedbank shares look priced for a low double-digit return. That’s not bad, but there are certainly higher returns available if you’re willing to give on quality. I’d also note, though, that these shares really aren’t undervalued on an ROTCE-driven P/TBV basis, and I like do use both of these approaches when evaluating bank stocks. All in all, then, I think Swedbank is priced pretty fairly for its quality, and I worry that its lower leverage to improving conditions (if/when those come) could leave it as a more lackluster return prospect, though investors who don’t want to compromise on quality may be willing to trade some upside to sleep better at night.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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