ING: Lower Rates = Lower Earnings = Lower Share Price – ING Groep N.V. (NYSE:ING)

Falling earnings estimates have driven the share price lower. ING (NYSE:ING) continues to struggle and the share price remains a long way below the hay day levels of 2016/2017. Having fallen 30% last year, year-to-date performance is running at -16% and about 5% worse than the average of European banks.

Source: Yahoo Finance

The last time I wrote on ING in May (link) I commented that a cocktail of cost and margin pressures was forcing profits lower and that the stock was likely to remain a value trap in the absence of growth.

This is largely how things have panned out. The key problem ING has faced this year is aggressive cuts to earnings estimates as the market has woken up to the headwinds.

The table below shows that Street consensus EPS for 2020 has declined by 7% since May while dividend expectations have declined by 2%. ING is now expected to post a 2% annual EPS decline over 2018-2020.

ING: Lower Rates = Lower Earnings = Lower Share Price - ING Groep N.V. (NYSE:ING)Souce: consensus data from Thomson Reuters

It would only make sense to invest at this juncture if we could be sure we’ve reached a bottom on earnings. Otherwise it’s a ‘catching a falling knife’ scenario. Sadly, I’m not convinced we have reached a bottom and the three key earnings pressures seem likely to persist, as I discuss below.

Net interest income suffering from lower Eurozone rates

ING’s biggest earnings headache comes from negative Eurozone interest rates. The bank is predominantly a conventional deposit-taker and lender. This is obvious from the fact it derives most of its revenue from net interest income. Nii accounted for 73% of revenues in 2Q, the highest percentage of peers.

ING: Lower Rates = Lower Earnings = Lower Share Price - ING Groep N.V. (NYSE:ING)

Source: company data

In addition, ING’s deposit franchise is almost entirely centered on the Eurozone, which accounts for 80% of the company’s €570bn of deposits. The company has said these deposits have an effective maturity of 5 years so this will be the reinvestment horizon the company uses. But 5 year Euro swap rates are currently negative 30bps, which immediately highlights the dilemma ING faces (along with all Eurozone banks) – it is receiving negative interest on the reinvestment of its large Euro deposit stock but paying positive interest to customers.

In spite of this loss-making situation on deposits, ING has so far managed to maintain a surprisingly stable net interest margin. NIM in 2Q was 152bps, 3bps down on the level of 1Q but actually 1bp higher than a year-ago.

Largely this is because the company has been able to expand margins on loans to offset spread pressure from deposits, particularly mortgage loans. The fear, however, is that this won’t last and that the mortgage margin improvement we’ve seen in recent quarters will soon be quashed by a resumption of predatory pricing by competitors. This has been the recurring experience over recent years as new entrants in the mortgage market, especially in the Netherlands, sacrificise profitability to win market share.

ING: Lower Rates = Lower Earnings = Lower Share Price - ING Groep N.V. (NYSE:ING)

Source: 2Q19 earnings presentation

ING’s growth rate in nii has slowed inexorably over the recent period and was below 2% YoY for 1H19 despite loan growth above 3%. With further potential ECB rate cuts ahead and lending margins likely to come under competitive pressure, I continue to see a high risk the company is unable to meet current Street expectations for future nii growth.

ING: Lower Rates = Lower Earnings = Lower Share Price - ING Groep N.V. (NYSE:ING)

Source: company data

Fees and commissions are not taking up the slack

Other banks have been able to compensate for nii weakness by growing fee and commission (F&C) revenues. However, ING’s F&C income stream is smaller to start with and its success in expanding it has been limited.

2Q saw F&C actually being slightly down year-on-year and well adrift of management’s previously stated ambition of achieving annual growth of 5-10%.

ING: Lower Rates = Lower Earnings = Lower Share Price - ING Groep N.V. (NYSE:ING)

Source: 2Q19 earnings presentation

When asked on the 2Q earnings call where the underperformance on F&C was coming from management stated:

Honestly, it is really across-the-board. And maybe in 2019, given some of the negative fee income effect coming through, you will not see the 5% to 10% (CEO Ralph Hamers, 2Q19 earnings call).

As with nii, given the multitudinous pressures the company is encountering on delivering its F&C growth target, this remains another key area of forecasting uncertainty when it comes to earnings projections for ING.

Compliance failings are driving up costs

At the same time that ING faces strengthening revenue headwinds it has been unable to react with cost cutting to the extent other banks have. ING posted amongst the highest rate of cost growth in 2Q, at 4% YoY.

ING: Lower Rates = Lower Earnings = Lower Share Price - ING Groep N.V. (NYSE:ING)

Source: company data

Operational leverage – the difference between the pace of revenue and cost growth – was consequently amongst the weakest of peers.

ING: Lower Rates = Lower Earnings = Lower Share Price - ING Groep N.V. (NYSE:ING)

Source: company data

The reason this situation is likely to persist is because much of the cost build is being driven by demands from regulators that ING substantially improves its compliance function. This follows on from last year’s €775m money laundering fine in the Netherlands, as well as the on-going money laundering investigation being conducted by the authorities in Italy.

Management accepted the 2Q cost spike was large and while they held out the hope that cost growth would eventually subside it was labelled as a 2020 prospect rather than something that is likely to materialise this year.

We do have a sizable cost increase this quarter. Over 2020, you would have to expect some of these costs to come down (CEO Ralph Hamers, 2Q19 earnings call)

This isn’t a company that has turned from good to bad overnight and the digital banking story in particular still has particular resonance in an industry that is increasingly challenged by fintech entrants (see this write-up in The Economist).

Conclusions

It is not all bad news for ING. There is a small positive from the ECB’s recent decision to introduce a new tiering system designed to shield a portion of the deposits lenders keep at the ECB from negative rates.

But the profit uplift from this move is relatively minor, estimated by analysts at JPMorgan at only 2.4% of 2020 pre-tax profits. It won’t be large enough to offset the wider nii pressures from negative Eurozone rates.

ING: Lower Rates = Lower Earnings = Lower Share Price - ING Groep N.V. (NYSE:ING)

Source: JP Morgan

Some investors may be enticed by the 7% yield at current share price levels but yield without growth is rarely an attractive investment, especially when dividend expectations are falling.

My preferred valuation methodology for banks is ROTE/COE where I derive a fair value P/TNAV multiple by comparing ROTE to cost of equity and factoring in a long-term growth assumption. In situations where there is a lot of earnings uncertainty like ING, I like to run the numbers on both average consensus estimates and the consensus low. This gives a better sense of the bear-case valuation should earnings continue to disappoint.

The calculations for ING are laid out below. Average consensus sees the company delivering ROTE of 9.0% next year, which yields a €11.4 share price target for 18% upside.

However, the low-end of consensus sees 2020 ROTE of only 8.0%, which yields a share price target of €9.8, more or less the current trading price. In view of the pressures I’ve outlined in this article, I view the consensus low as the more likely earnings outcome, meaning ING is at best fairly valued and consequently not a stock I would be rushing to buy.

ROTE/COE valuation gives a bear-case price target of only €9.8

ING: Lower Rates = Lower Earnings = Lower Share Price - ING Groep N.V. (NYSE:ING)

Source: author’s calculations

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.