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UniCredit profit: Sign of an Italian bank renaissance?

Italy's largest lender, UniCredit, returned to profitability in the first quarter, as it cleaned up its balance sheet ahead of the upcoming euro zone bank health checks.

The bank posted a profit of 712 million euros ($979 million) for the first three months of 2014, after a massive 15 billion euro loss in the previous quarter. The results topped analyst forecasts and were helped by a 30 per cent reduction in bad loan charges.

Read MoreHow many European banks would pass US stress tests?

First-quarter revenue was 5.58 billion euros, below expectations, while the underlying results showed a sluggish trend in net interest income and trading.

However, the bank also recorded its first decline in gross impaired loans since 2008—a rare piece of good news on the lending side. New lending in Italy rose 63.2 percent on the year.

The bank's chief executive, Federico Ghizzoni, said UniCredit was on track to reach its 2 billion euro net profit target for 2014 and that the lending trend was encouraging.

"I think the trend is sustainable," Ghizzoni told CNBC on Monday. "We may have some ups and downs, but the trend is for deceleration and stabilization of the inflows and a reduction of the stock (of gross impaired loans)."

Read More European bank CEO pay surges in 2013

However, Deutsche Bank analysts have cautioned investors that they may need "some more patience" when it comes to the turnaround of Italian banks.

Deutsche wrote last week that while, "2014 will still be affected by low rates and high LLPs (loan-loss provisions), the longer-term outlook is improving with regards to lending and asset quality, though it will take time before this is reflected in P&Ls (profits and losses)."

Investors and analysts have lauded UniCredit's bold moves to clean up its loan book ahead of this year's European Central Bank-managed asset quality review (AQR) and stress tests.

"UniCredit may be in an advantageous position in light of the ongoing ECB Comprehensive Assessment, having cleaned up its loan books in the fourth quarter," analysts at Berenberg wrote in March.

More recently, Deutsche Bank analysts wrote: "Banks are going in the right direction, as the bad loan coverage has increased, and seem well-prepared to face the AQR, but generally have not yet restored the pre-crisis situation."

Ghizzoni said his bank felt, "Quite confident, both for the asset quality review and stress tests."

However, he added that for the European banking sector, "It will be a tough exercise overall."

Read MoreBad loans at European banks hit $1.7 trillion

Alessia Pierdomenico | Bloomberg via Getty Images

UniCredit has shown it is moving faster than domestic rivals to prepare for the upcoming tests.

It increased its provisions by 9.3 billion euros in the fourth quarter, taking its impaired loan coverage back to pre-crisis levels of 53 percent. The bank posted a record 14 billion euros loss in 2013 as a result of writedowns on bad loans and goodwill.

As part of the bank's effort to mop up soured loans, UniCredit is also looking at making the management of those assets more effective. It has set up a bad loan vehicle with fellow Italian bank Intesa and U.S. private equity fund KKR.

UniCredit is also rumored to be selling its debt collection unit, called Credit Management Bank, and its asset management business, Pioneer.

However, speaking to CNBC, CEO Ghizzoni said Pioneer was not for sale and that there were no plans to raise more cash in the markets.

Concerns over Unicredit's capital levels remain, nonetheless. Analysts at Berenberg pointed out that the bank's core tier one capital ratio, a key test of how well a bank can withstand economic shocks, stands at 9.5 percent—still weaker than that of peers.

"If Unicredit does not sell Pioneer and the ECB rules against the inclusion of the BoI (Bank of Italy) revaluation gains to its Basel 3 CT1 (core tier one), there is a risk that the company may have to raise up to 1.4 billion euros of new equity (4 percent of its market capitalization) to reach a 10 percent Basel 3 CT1 ratio in 2015," Berenberg analysts wrote.

Read MoreGreece's Piraeus Bank warns of rising bad loans

Italian banks - still a Buy?

Italian banks shares have seen an impressive rally over the last 12 months with gains of some 120 percent, leaving them trading at 14 times price/earnings, according to a Goldman Sachs report last month. This rally was driven in part by the aggressive approach to reducing costs and bad loan exposure, as well as a drop in Italian borrowing costs.

Italian 10-year yields fell below 3 percent last week as investors search for yield in the periphery and the ECB continued to dangle further easing measures to fight disinflationary pressures in the euro zone.

Ghizzoni added that for Italy to benefit from this rally, the country would have to, "Gain respect from the market day-after-day. We need structural reforms and I hope that the government will go in this direction."

Even though the rally in the country's bonds is showing no signs of abating, analysts feel Italy's bank stocks may need to catch their breath.

Last month, Goldman Sachs wrote: "Italian banks' valuations appear stretched, after a long rally," adding that the, "Blue skies scenarios leave limited upside".

Analysts at Goldman Sachs have downgraded their ratings for UniCredit and Banca Popolare di Milano to "neutral" from "buy", as they believe, "Their recovery prospects are more fully priced-in.

"We switch into Intesa SanPaolo (ISP), where we see up to 12 percent (per annum) in cash payout on average, as well as less risk on asset quality."

Similarly, Deutsche Bank said one of its top picks was Intesa, due to low execution risk to reach above cost of equity return on equity employed by 2016. Deutsche Bank also liked Banco Popolare because of its, "Credible restructuring story at an interesting valuation".

Clarification: This piece has been amended to clarify that UniCredit CEO Federico Ghizzoni said the bank was not looking to sell Pioneer.

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