Intesa Sanpaolo: Still Making Hay While The Sun Shines

seekingalpha08-07

Italian banking giant Intesa Sanpaolo has continued to do well since my last piece back in January, outperforming the peer group by just over twenty points in that time.The bank earned an impressive ...

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While this likely represents peak earnings, profits are also likely to remain relatively robust.These shares are more expensive now than at previous coverage, though modest balance sheet growth and the bank's dividend-led distribution policy can still lead to attractive medium-term returns.   tupungato Italian banking giant Intesa Sanpaolo (OTCPK:ISNPY)(OTCPK:IITSF)(\"ISP\" hereafter) continues to generate record financial results amid a supportive macro backdrop. These shares had re-rated to around 1x tangible book value when I last covered them back in January, but I didn't think that was an especially taxing valuation given the bank was comfortably clearing a double-digit return on tangible equity. ISP has continued to outperform European financials (EUFN) since then, returning roughly 28% with dividends versus around 7% for the peer group. Data by YCharts The first half of 2024 yielded another strong set of figures for the bank, with its return on tangible equity (\"ROTE\") comfortably clearing 20%. While this likely represents a high point for the firm now that Eurozone interest rates are falling, ISP has enough going for it in the medium term to keep earnings buoyant. Up over 20% in price terms since prior coverage, these shares have seen their TBVPS multiple expand from around 1x to 1.3x. While this leaves the investment case a little less clear-cut, between attractive capital returns potential and a mid-teens long-term ROTE outlook, I do think there is still some value left here. I leave my previous 'Buy' rating unchanged. Still Making Hay To quickly recap, ISP is the largest bank in Italy, with market-leading shares in loans (~18% share), deposits (~22%) and asset management (~23%). Cheap retail deposits fund a significant portion of its balance sheet. This wasn't much help to the bank when Eurozone interest rates were in zero/negative territory pre-2022, but in the recent hiking cycle it has led to a significant expansion in net interest income (\"NII\") and, aided by benign asset quality, return on tangible equity. ISP continues to generate very strong earnings in these favorable conditions, reporting a ROTE of 22% for the first half of 2024. Source: Intesa Sanpaolo Q2 2024 Results Presentation Despite the European Central Bank cutting by 25bps toward the end of the period, ISP managed to grow NII by 2% sequentially to just over €4 billion last quarter. This was aided by its €160 billion structural hedge, which I briefly mentioned last time would support NII going forward. For the benefit of new readers, structural hedging is an interest rate management tool that banks use to dampen volatility in NII. American banks typically go about this by investing eligible customer balances, like non-interest-bearing checking accounts, into bonds, whereas European banks often use interest rate swaps. The result is the same in that both basically lock in a margin on these balances, smoothing NII across the interest rate cycle. ISP's structural hedge yielded around 120bps in Q2, up from just over 70bps at prior coverage. Hedge maturities total around €2.4 billion each month, which ISP can currently deploy at yields comfortably above the prevailing one. Hedge income should continue to grow going forward, providing ongoing support to NII even though rate cuts will admittedly become more of a headwind. Data Source: Intesa Sanpaolo Q2 2024 Results While I expect NII to decline from here, it is important to put this into context. Euribor is still comfortably above 2% across the curve and, with the above-mentioned hedge support, this should keep NII well above the levels seen before late 2022. I would note that, assuming rates play out as implied by the forward curve, management sees 2025 NII as being somewhere between 2023 and 2024 levels:  Probably this quarter could be the peak of net interest income, but at the end, we will have good satisfaction also from net interest income in 2024. This will remain also very positive in 2025, because the clear trend of increasing in terms of contribution from the hedging facility allow us to have a very good performance in 2025 also. That could be not only above 2023, but could be in a range between 2023 and 2024 dynamics. Carlo Messina, CEO Intesa Sanpaolo  Few Issues Elsewhere One of ISP's main strengths is its significant non-interest income generation. While quarterly NII has essentially doubled over the past two years, fee, commission and insurance income is still over 40% of the top line, one of the highest shares in its peer group. Source: Intesa Sanpaolo Q2 2024 Results Presentation Net fee & commission income increased by 5% sequentially last quarter to €2.38 billion. Not only is much of this revenue agnostic to rates, but a portion of it, like management fees on certain mutual fund products, may actually benefit from rate cuts. I expect this to provide further support to revenue going forward. Expenses, both operating and provisions related to loans, have been a strong point here. Operating expenses landed at €2.65 billion last quarter, down around 1.5% versus the equivalent period last year. Even more impressively, ISP's cost base is actually slightly below what it was three years ago, despite the high inflation of this period. This has contributed to a very strong sub-40% cost/income ratio, which is also among the best in its peer group. Source: Intesa Sanpaolo Q2 2024 Results Presentation I do expect this ratio to creep back up over time as NII begins to put some downward pressure on revenue. That said, management revealed a circa 40-45% soft long-term target when asked about this on the Q2 call. Even the top-end of this range would still leave ISP as one of the most efficient banks in Europe:  So the physiological run rate in terms of cost/income, in my view, is between 40% and 45%. That's more or less 40% and 45% should be the level of cost/income ratio that a bank like us could have for the future. Carlo Messina, CEO Intesa Sanpaolo  Bad debt provisioning continues to be a modest tailwind. Loan loss charges equated to around 30bps in Q2 and 26bps for H1, with the former virtually in line with the 30-40bps medium-term target set by management. While this may of course spike in a downturn, it currently appears to be relatively close to mid-cycle levels of provisioning, meaning this line should not represent a major drag on longer-term ROTE. Asset quality in general remains excellent, with gross non-performing loans basically stable at around the 2% mark last quarter. Valuation ISP shares currently trade for €3.34 in Milan, with the ADSs in New York changing hands for just over $22 apiece. This puts the stock at 1.28x Q2 TBVPS of €2.60, up from around 1x at prior coverage. Note that one ADS maps to six ordinary shares. Sell-side consensus has 2024 net income at €8.6 billion, though that looks a touch light to me given ISP earned €4.7 billion in H1 alone. This is seen as relatively flat across 2025-2026, which, in light of the various drivers I set out above, seems reasonably fair. Management's capital returns policy is very dividend-heavy, with this set at ~70% of net income, while ISP also launched a circa €1.7 billion buyback in June, with that equating to another 20% of current earnings power. Threading all that together, I think investors can reasonably expect to see around €18 billion, or approximately €1 per share (~$6.55 per ADS) in pre-tax 2024-26 cumulative dividends, with TBVPS rising by around 5% annualized in this time. This gets me to a three-year TBVPS target of roughly €3 per share (~$19.65 per ADS). Determining a suitable exit multiple is a slightly more subjective exercise. ROTE implied by consensus would still be in the high-teens area even out to 2026, though I would be wary about extrapolating this beyond that. Management's musings on ISP's longer-term cost/income and normalized provisioning levels might be a better angle to approach this issue, with quick math pointing to a slightly lower mid-teens ROTE on that basis. With the usual caveats about interest rates and so on, I think that is a fairer guide as to this bank's longer-term earnings power. Assuming an 11% cost of equity - the same used for recently-covered Italian peer UniCredit (OTCPK:UNCRY)(OTCPK:UNCFF) - and around 1%-1.5% long-term annualized growth, this gets me to a fair TBVPS multiple of just under 1.3x, virtually in line with the current level. All said, I land on a €3.90 (~$25.55 per ADS) share price target in three years, rising to a pre-tax total return price of around €4.90 ($32.10 per ADS) inclusive of dividends. This implies ~13.5% pre-tax annualized returns from the current quote. Summing It Up Intesa Sanpaolo continues to over-earn amid a very favorable macro backdrop for Italian banks. Last quarter was probably the high mark for NII, though based on the current forward curve, I expect its decline to be relatively modest. At just under 1.3x tangible book value, these shares now lack the longer-term multiple expansion they offered at previous coverage, albeit implied pre-tax total returns in the low-teens annualized area remains attractive overall. I keep my previous 'Buy' rating in place.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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