Commerzbank : Initiating coverage: Buy Tier 2, Reduce Senior; A certain sense for Commerz

>Strengths / Opportunities - Good franchise in Germany, particularly with Mittelstand, the backbone of the domestic economy. Healthy asset quality in the ‘core’ segments and now reduced size of legacy assets (particularly shipping). Total NPL ratio of 3% based on our calculations.Structurally abundant liquidity in the retail segment in Germany supports a liquid balance sheet and limited reliance on confidence-sensitive debt capital markets for funding needs.Good risk-weighted solvency ratios with a fully-loaded CET1 ratio of 13% at the end of June, i. e. the minimum level targeted by management by 2020, and a total capital ratio of 16.3%. Leverage ratio is satisfactory (4.6% fully-loaded at end-June).Statutory subordination of standard senior debt securities in Germany should allow the bank to comply with MREL requirements without significant issue of new securities.Appropriate measures taken as part of the "Commerzbank 4.0" strategic plan to improve the bank's profitability, but objectives appears ambitious in the current interest rate environment.Merger with/takeover by a peer would make it possible to address profitability issues through revenue and/or cost synergies. The German State still owns a 15% stake in Commerzbank.Weaknesses / Threats - Low profitability, affected by cyclical factors, but also structural factors that the strategic plan aims to reduce.Highly fragmented and fiercely competitive German retail banking market, critical size difficult to reach confronted with competitors (Sparkassen and Volksbanken) not subjected to the same profitability requirements as those of listed institutions.Limited geographical diversification; mBank, the Polish subsidiary and the 5th largest bank in the country, performs well but accounted for only 6% of total consolidated assets.Revenues are materially sensitive to the interest rate curve, which still has limited increase/steepening prospects in the medium term.Stable Credit Opinion / Recommendations: Buy Tier 2, Reduce Senior - Credit Opinion: We are initiating our coverage on Commerzbank coverage with a' stable' credit opinion; this opinion includes expected benefits from the ongoing strategic plan, even if reaching the higher range of the profitability targets seems ambitious to us. Commerzbank’s good capital ratios, healthy asset quality and solid liquidity and funding profile are strengths that are masked by its low profitability. The bank aims to improve it with the “Commerzbank 4.”0 plan.If the plan's objectives were not met, pressures would increase for a merger with/acquisition by a competitor (UniCredit, BNP Paribas), with cost and/or revenue synergies that would address to the profitability problems. Integration into a large and diversified banking group would be a positive element for Commerzbank's credit profile, in our central scenario.Market Recommendations: We believe selectively investing in Commerzbank’s debt securities makes sense. We recommend buying Tier 2 subordinated debt securities given their attractive risk/return. Conversely, our recommendation on ‘standard’ senior debt is Reduce as we consider them expensive at current levels, compared with securities with identical subordination/legal position identical (such as SNP), but also because of possible legal amendments in Germany that would see the creation of a new class of 'preferred' senior debt. Finally, we initiated coverage with a 'Neutral' recommendation on Legacy Tier 1 HT1 Funding.