For UniCredit SpA (UNCFF), the largest Italian bank by assets, news of the request from the European Central Bank’s Single Supervisory Mechanism sent shares tumbling amid rising concerns about the lack of collective action in dealing with the problem. After years of fumbling following a rapid pace of acquisition and expansion in the lead up to the sovereign debt crisis, the company’s leadership is now tasked with paring down its cross-border exposure as the bank struggles to show returns to investors.  However, the nonperforming loans issue will weigh heavily on the shares in the near-term as UniCredit remains under pressure to show shareholders it is capable of a turnaround after a substantial downturn.

Loan Crisis

Recently announced regulatory requests for data on Italian lending from key regional banks comes on the heels of a sharp deterioration in valuations.  According to the most recently available statistics from the IMF, nonperforming loans for Italy currently sit at approximately 17% of the total outstanding, substantially higher than comparably European and American metrics.  UniCredit’s share stands at approximately €84 billion, nearly 20% of total loans outstanding from the bank and the highest among all European banking peers. While other Euro Area countries have setup bad banks to handle nonperforming loans and keep the lending pipeline open, Italy has been slow to respond to this lingering issue. 

Efforts undertaken by the European Central Bank to ease credit conditions and access to liquidity have seen a demonstrable uptick in lending activity for the region.  After falling steadily since 2011 with the onset of the sovereign debt crisis, 2014 marked a turnaround with the asset purchase program announced in 2015 seeing loans to the private sector climbing over the past 12-months.  However, by comparison, Italy has experienced no such improvement, and nonperforming loans burdening bank balance sheets are the main culprit as loans to the private sector continue to slide.  Without new loan origination and a mechanism to dispose of nonperforming loans like a bad bank, UniCredit will continue to be impaired by souring assets for years to come.

Slow to React

In the lead up the massive acquisition spree conducted by former CEO Alessandro Profumo, UniCredit was among the most efficient banks in the entire Euro Area.  His ambition led to a slew of cross border banking deals that saw the bank expand into 17 countries and in effect, a bloated entity that saw costs outpace gains.  Since Federico Ghizzoni has taken the helm of the embattled bank, his emphasis has been the disposal of underperforming and costly assets.  Plans announced in November called for the reduction of 14% of the total headcount alongside efforts to shore up bank capital and refocus on core businesses and restart a stalled lending machine.  The goal ultimately is to bring up tier

However, cutting jobs and selling assets will not be enough to slow the shares slide over the near-term.  Instead of working to grow margins and originate more loans, UniCredit is instead forced to continue repairing balance sheet damage.  The bank is currently spending substantial funds to retire debt that can no longer can be considered acceptable collateral to meet regulatory capital requirements and these costs will continue to climb especially as concerns about the Italian banking sector rise.  Shareholders are beginning to lose patience and rightfully so considering the stark losses experienced by the bank.  Since the beginning of 2016 shares have fallen by -26.23%, in many ways reflective of the Italian banking sector at large. 

Investors Beware

Income investors should not even bother with evaluating UniCredit as a potential addition to a portfolio with the dividend prospects mixed at best and none announced for 2016.  Based on current cash flow considerations, it is difficult to imagine an environment where UniCredit announces another payout to shareholders considering it must shore up capital in light of regulatory considerations and prepare for mounting losses on outstanding loans.  Value investors might also get burned trying to buy the dip as cross-border nature of the bank’s exposure might come back to haunt buyers expecting a sharp rebound. 

A notable cross-border presence in both Russia and Ukraine might be written-down further and operations in Austria could be dealt a crushing blow after the blowup of that nation’s own bad bank intended to help banks offload defunct assets.  Although the management in Italy is working frantically to sell assets and restructure divisions to run leaner, these processes take time.  While down the road UniCredit will benefit from the cost savings with management working towards a cost-to-income rate of 50% from the current 61%, this overhaul will take years to complete, not months.  In order to really improve confidence amongst investors and recoup shareholder value, UniCredit will have to raise additional capital and increase loan loss reserves to ensure it can survive any additional impairment of nonperforming loans.

Fundamentally Speaking

Any further capital raising activities will undoubtedly dilute shareholder value even further over the medium-term and without any real upside benefit to investors.  Absent structural reform on the part of the Italian Government and an effort by the Central Bank to devise a bad bank to handle the still rising level of nonperforming loans, UniCredit will remain impaired for the medium-to-long term as lending remains constricted.  Asset disposals and cost cutting will help improve focus on lending, but these are long-term fixes that will not be felt for more than a year.  Share prices are likely to continue tumbling, retesting 52-week lows at €3.68 before sliding to €3.46 and €3.18.  Real upside in shares is only feasible if the Government decides to take action.  Without a substantive response, UniCredit will remain an underperformer among Italian banking peers as nonperforming loans sink the outlook for the firm.