BNP Paribas Stock: Chasing Another Record Year In 2023 (OTCMKTS:BNPQF)

Thesis

BNP Paribas (OTCQX:BNPQF) closed the year 2022 reporting record results. And on the backdrop of a favorable interest rate environment, and an overall more favorable economic backdrop as compared to early 2022, management raised the firm’s growth and profitability expectations through 2025. Despite the optimism, BNP continues to trade at ‘undervalued’ multiples of a bout x0.7 P/B and x1.5 P/S. Personally, I base my valuation of BNP stock on a residual earnings model and calculate a fair share price of $152.76. “Strong Buy.”

For reference, although BNP stock has shown some strength recently, the bank remains a relative outperformer: for the trailing twelve months, BNP stock is down approximately 11%, as compared to a loss of about 8% for the S&P 500 (SPY). However, BNP shares have evidently started to outperform since early Q4 2022.

About BNP Paribas

BNP is one of the world’s largest players in the financial services industry, with a diverse range of offerings that includes retail banking, corporate and investment banking, wealth management, and asset management. With that frame of reference, BNP has a strong market position in Europe, particularly in France, and its growing presence in developing markets, such as Latin America, Africa, Asia, and Eastern Europe. Accordingly, with a solid presence in emerging markets, the bank is well positioned to capitalize on growth opportunities.

In my opinion, a major argument for investing in BNP is anchored on the bank’s diversified exposure across the financial service industry–a diversification that provides good protection against economic challenges and market volatility. Notably, as the recent history has shown, during times of low interest rates and market stability, BNP’s investment banking and wealth management divisions thrive. Meanwhile, in uncertain markets, the bank’s global market division is poised to perform well. Additionally, a rise in interest rates results, while pressuring investment banking activity, pushes up income from retail banking.

That said, as compared to other European banking giants, BNP has managed to post strong and consistent profitability for the past decade.

A Record 2022

BNP closed the year 2022 with record profitability. Aided by rapidly rising interest rates, the bank managed to generate EUR 50.4 billion in 2022, up 9% year over year as compared to 2021. The bank’s gross operating income expanded by about 10.5% respectively, up to EUR 16.7 billion. After accounting for a EUR 2.97 billion cost of risk, which is in line with 2021 numbers, operating income and net income jumped to EUR 13.7 billion and EUR 10.2 billion (a year over year increase of 12.7% and 7.5% respectively.

Admittedly, BNP’s strong 2022 results are supported by a non-recurring income of about EUR 2.9 billion, as the French baning giant booked a net capital gain on the sale of its US retail unit Bank of the West in Q3 for a total consideration of $16.3 billion.

However, it cannot be ignored that the bank posted strong results across all operating units, with corporate and institutional banking being up 15.7% YoY, commercial and personal banking & services up 9.3% YoY and investment & protection services up 3% YoY.

Exceptional Profitability From Interest Rate Tailwind

On the backdrop of an exceptionally strong 2022 performance, paired with a supportive interest rate outlook going into 2023, BNP aims to return EUR 5 billion to shareholders through stock buybacks (For reference, BNP has already announced a EUR 4 billion stock buyback, and thus added an additional EUR 1 billion).

Supported by the European Central Bank’s interest rate hikes and an overall better economic outlook as compared to early 2022, BNP revised its growth and profitability expectations. Notably, the bank now expects net income to grow by more than 9% annually to 2025 and its return on tangible equity to be more than 12% by the end of the two years.

In my opinion, BNP’s GTS 2025 assumptions are still too low. In fact, with the ECB’s marginal lending facility likely to edge towards 4 percentage points in 2023, BNP is poised to add about EUR 2 – 3 billion of incremental income to the firm’s 2025 profitability, as compared to 2021. With that frame of reference, my model – which anchors on management commentary from Deutsche Bank, Barclays, UniCredit, and Societe Generale – calculates that for every 1 percentage point of interest rate increase, European banks are likely to enjoy a 20 basis point increase in NIM expansion.

Residual Earnings Valuation

To get a more precise estimate of what BNP stock could be worth, banks are prime candidates to be valued with a residual earnings valuation. The RE framework anchors on both the income statement and the balance sheet as well as accrual accounting. As per the CFA Institute:

Conceptually, residual income is net income less a charge (deduction) for common shareholders’ opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company’s capital.

I apply the following assumptions:

• To forecast EPS, I anchor on consensus analyst forecast as available on the Bloomberg Terminal ’till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework – especially for banks.
• To estimate the cost of capital, I use the WACC framework. I model a three-year regression against the CAC 40 to find the stock’s beta. For the risk-free rate, I used the 10y German Bund as of February 2nd, 2022. My calculation indicates a fair required return of 9.75%.
• For the terminal growth rate, I apply 2.25% percentage points, which is on the lower end of expected nominal GDP growth in order to reflect a conservative valuation.

Based on the above assumptions, my calculation returns a base-case target price for BNP of $152.76/share, implying a material upside of approximately 135%.

I understand that investors might have different assumptions with regards to BNP’s required return and terminal business growth. Thus, I also enclose a sensitivity table to test varying assumptions. For reference, red-cells imply an overvaluation as compared to the current market price, and green-cells imply an undervaluation.

Without a financial market meltdown, the picture looks very favorable to me.

Risks

In my opinion, bank investments are safer than perceived, but there remains an elevated tail risk, that could lead to BNP approaching bankruptcy in extreme financial distress situations. The banking industry is still recovering from the financial crisis, and many big financial institutions have not yet regained pre-crisis levels. Despite this, BNP’s solid CET1 ratio of 12.1% should provide protection in the most challenging scenarios.

Conclusion

After closing 2022 with record profitability, I expect BNP to chase and post new records through 2025 — aided by a supportive interest rate environment and an overall favorable economic backdrop. Personally, I base my valuation of BNP stock on a residual earnings model and calculate a fair share price of $152.76. As a function of valuation, I assign a ‘Strong Buy’.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.