The future is rarely certain, and ten years ago, no one would have predicted that Irish banks would either cease to exist or exist in zombie like fashion. Having been a bear on property, banks and equities since 2005, I did not imagine simply how rotten things would get, and this is from a person whose friends have (kindly) referred to him as Voice of Doom.com. I am not confident that we are out of the woods just yet, but I have a feeling that we are starting to turn what will be a long corner here in Ireland.
From five quoted banks and insurance companies listed on the Irish stock exchange in 2007, in reality only two remain, Bank of Ireland and FBD Group. (Disclaimer: I am a shareholder in FBD Group plc). Anglo Irish Bank has failed and been completely nationalised, whilst for all intents and purposes, both Allied Irish Bank and Irish Life and Permanent plc are in state ownership with a sliver of quoted equity remining on the Irish stock exchange. Ireland is now a state that as well as having to endure austere budgets, rising unemployment and a Eurozone crises, also finds itself dealing with a host of zombie financial institutions.
The purpose of this article is to ascertain, are the two remaining Irish financials worth investing in? For the purposes of this article I will not cover in too much detail the nagative aspects of the Irish economy or these financial institutions in particular. Not because I am bullish, but because they have been covered ad nasuem in the mainstream and financial media, equity research teams within the financials markets and the blogosphere in general. Any reader that wants a decent frame of reference for just how bad things are in the Irish economy or with Irish financials then I direct you toward the following blogs (1) http://www.irisheconomy.ie/, and (2) http://namawinelake.wordpress.com/. The analysis provided in both of these blogs has been rightly critical of the path chosen by Irish financial institutions over the past five years. There is no need for me to rehash the arguments made so eloquently by others. Furthermore, an ex-colleague of mine has written a very insightful piece on bank valuation, asserting that banks may not represent good value at any price – it is definitely worth a read.
What I want to explore here is the unthinkable. We know that a very bearish outlook is priced in, but what is the margin of safety presently? Is there a margin of safety?
Bank of Ireland
Other than a morbid curiousity and/or insanity, why would any investor consider following the likes of Capital Group, Fidelity and Wilbur Ross? My starting point is always valuation, but valuation is not much of a help if the balance sheet is irreparable. What I want to address is:
(1) What is the state of the balance sheet presently?
(2) What is the likely trajectory for loan losses under a pessimistic scenario?
(3) If the Eurozone survives and a normal economic climate returns at some stage, what types of returns might a bank with Bank of Irelands balance sheet earn?
(4) How can the Bank fund itself?
Book Value: €8.4 billion or €0.28/share
P/BV = 0.32
Mkt Cap/Deposits = 3.6%
(1) Balance Sheet
This balance sheet is based on the half year results issued on August 10, 2011 and updated for the equity rasining completed recently.
|Bank of Ireland||€bn|
|o/w Financial Assets||9.4|
|o/w Loans to other Banks||6.9|
|NAMA Senior Bonds||4.9|
|Loans to Customers||100.1|
|o/w Deposits from Banks||38.7|
|Equity as % of Assets||4.2%|
|Wholesale Funding as % of Assets||39%|
|Wholesale Funding < 1 year duration||€42 bn|
The points to focus in on are (i) what is the present level of capitalisation, (ii) what is the likely run rate of losses on the assets, and perhaps most importantly (iii) how will the bank fund itself, given such a significant funding mismatch? Remember that €42 billion of whoilesale funding matures during the next 12 months, and this needs refinancing.
Since the release of the half year results, the Bank has completed a successful equity raising that was mandated as part of the IMF/ECB/EU bailout of Ireland in November 2010.
New Equity Issued €1.91bn
Debt for Equity swap €2.03bn
Core Tier 1 Capital Generated €3.79bn*
*Under banking capital regulation (Basel 1 and Basel 2), there is a concept known as risk weighting, whereby assets on a banks balance sheet are weighted according to risk. For example, mortgages typically have a low risk weighting, while more exotic lending has a higher risk weighting. So, Bank of Ireland has a level of Risk Weighted Assets of €71bn as opposed to its actual level of assets which is €155bn. I don’t agree with this methodolgy of calculating assets and believe that it has contributed to the banking crisis, but I am powerless to prevent its usage.
In addition to the equity raise the bank raised almost €1bn thourgh the issuance of contingent capital to the Irish state. Simply put, if the core tier 1 ratio of Bank of Ireland falls below 8.25% at any time in the next 5 year, this capital converts immediately to ordinary equity.
Given the capital rasing exercises, Bank of Ireland now has shareholders equity of €10.6bn, which equates to 6.8% of assets. This actually puts them amongst some of the top tier banks in terms of capitalisation. However as we have seen so many times, it is funding not necessarily capital that is imp[ortant for banks – (for example, Northern Rock, Anglo Irish Bank, Bradford & Bingley and Dexia all were theoretcially well capitalised – but the funding model was broken).
Given deductions of preference share capital and some intangibles, Bank of irelands stated tangible equity is €8.4bn. With 30.1bn shars outstanding, this equates to a tangible book value/share of €0.28.
(2) Does the Bank have sufficient capital?
The loan book at Bank of Ireland is broken down as follows (according to the bank).
Total Loans €111.9bn
High Quality €60bn
Low Quality €4.4bn
Past due €5.7bn
A banks capital exists to absorb losses if and when losses materialise. Namawinelake, recently publised a piece collating the property price forecasts of many Irish economic commentators. Many commentators feel that property will fall by 55-65% from peak to trough. Two property websites, myhome.ie & DAFT.ie reckon that nationally, property in Ireland has already fallen by 41.8% and 48.6% respectively. Now within the survey of property price predictions, two economists have forecasts of 70% and 80%. While the value of the collateral that banks hold is important, the ability of the borrower to repay the loan irrespective of the collateral value is more important.
To stress test the balance sheet I make the following simplistic assumptions.
(I) Impaired loans need to be written down by 70% and provsions should reflect this.
(II) 70% of past due loans will default, and suffer a loss of 55%. Provisions need to be taken to cover this.
(III) 50% of low quality loans will default, and suffer a loss of 50%. Provisions need to be taken to cover this.
What this means is that other than the provisions already taken, that further provisions of €6.5bn are required.
Now the bank makes an average of €800m in pre provision profit annually for the next three years, then the bank has the capacity to take €4.1bn in loan losses and still have €5bn of equity capital remaining including the conversion of the Contingent capital to straight equity. This is a sufficient margin of safety for me, but it is not inconceivable that a further round of capital raising is required.
Any analysis of the facts, show that despite unemployment running at 14%+, Loan Loss Provisions at Bank of Ireland have been falling recently. Having studied banks for a long time, it is often the case that average LLP is rarely seen – it is all or very little in terms of provisioning – thats just the way the credit cycle rolls. Going forward provisions are likely to be higher than the past due to some counter cyclical provisioning being introduced. But unless unemployment rises significantly from here, then large increases in provisioning are looking less likely.
It goes without saying that if my scenario comes to pass in tandem with a breakup of the Eurozone then the banks capital will most likely be wiped out. So all we can say, is that according to the various stress tests taken the bank mayhave enough capital. If a worst case scenario is applied and losses have to be recognised over the next three years, then the bank should have sufficient capital.
This may be naïve in the extreme, but I do not believe that Ireland is in the same category of Greece or Portugal when it comes to dealing with the nations debt burden. There are two Irelands, and one of them has not seen any recession (yet). To my mind, Ireland will receive a haircut or discount on its bank debt at some stage in the future. The road is certainly rocky, but the bottom is close in terms of the macroeconomy, in my opinion.
(3) What could a normalised level of returns look like?
I have completely ignored the banks own targets for what the future might look like. Instead I have looked at what the bank has actually achieved over the past 19 years. In reality, I shouldnt even be doing this as I am not a big believer in forecasts. They are invariably wrong.
|Net Interest Margin||2.25%|
|Net Interest Income||2025|
|Non Interest Income||750|
|Pre Provision Profit||1193.25|
|Pre Tax Profit||653|
|Tax @ 15%||-98|
Now to be fair, this simulation could be wrong everywhere. The point of it is to show what are some of the factors necessary required to earn a return close to a long term cost of capital. I find that the assumptions, are not that unrealistic, given what I have seen in many banking cycles. When I look at a reverse Gordon Growth model, the present share price is implying almost 14% cost of equity.
Bank of Ireland cannot fund itself presently in the absence of state support. It is not alone in this. There is a glimmer of hope (but it is just a glimmer at present).
The bank has assets of €155bn, deposits of €65bn and equity of €10bn. Thus the bank presently needs other funding of almost €80bn. In the past three years the amount of wholsale funding require has fallen by €25bn due to various deleveraging efforts.
There are two ares that I draw hope from. Firstly in the most recent half year results, customer deposits at €65bn were unchanged on the end of 2010 level. This is important. A stabilisation of core funding is one of the first signs of reduced levels of fear. In the past three years, the bank has lost €21bn in customer deposits due to lack of confidence with clients. Overall deposits are still falling in Irish banks, but at a reduced rate. The second area that offers some modicum of hope is that Bank of Ireland has been returning in a small way to the securitization market recently. During the summer, the Bank successfully completed at €2.2bn securitization of a portion of its UK mortgage portfolio. Recent reoprts from Davy stockbrokers suggest that the Bank is preparing to securitise a further €1.1bn. This is important in that these deals fall outside of the Eligible Liabillities Guarantee scheme. Presentlythe bank has about €40bn of liabillities guaranteed by the state. Any issuance outside of this is not only important from a confidence point of view but also in terms of long term profitability. In the first half of the year alone, the bank paid the Irish state €239m in guarantee fees.
To me Bank or Ireland equity shares some traits with a long dated call option. It is either worth zero or a whole lot more. I can pay 9cents and will lose all of my stake, or I stand to make significantly more at some undetermined future point in time. Given the amount of capital the bank presently has, plus some stabilisation of funding then that is a bet that I am willing to take at this valuation. As they say, a fool and his money are easily parted. If I am correct on my outlook, then in say five years time I think that it is conceivable that this bank and others will trade back at book value. If I am wrong, it will more than likely be significantly below the present share price if not zero.
Let me say that in taking such a bet, I am aware that this is pure speculation. But that has a place. My portfolio has 20% invested in equities with the remainder in cash. I can afford to place 1% of my funds into Bank of Ireland stock. In this regard I am for the present considering it nothing more than a call option on recovery. At this point in time I can only see definitive value clustered in several sectors. My principal investments are in companies with very solid balance sheets and business models. This is a nice adjunct. In a recovery situation it will provide me with great bang for my buck without having a significant amount of my resources tied up in equities. You have to go where the opportunities are, I believe.
As always, I welcome any comments or critiques.
FBD Group plc
FBD was founded in the 1960’s by a grouping of Irish farmers organisations. It’s core business is non-life insurance. Allied to this, the company has a hotels division operating in Ireland and Spain, as well as a financial services arm. I purchased FBD last November, having analysed the stock for quiet a while. The NAV of the company is presently €5.82/share. FBD has had a roller coaster ride for the past few years. The stock was little known to most in the investment community a decade ago. But strong markets generally contributed to increasing profitability due to gains on the investment portfolio. Falling claims meant that historical claims reserves had been too generous. The combination of both meant that dividends to shareholders increased substantially. The stock, whilst illiquid, soon becaome a darling of the market. In 2007, the share price rallied to over €37 as the company received a bid from a Dutch insurer, Eureko. There is reason to beloieve that the bid was not a serious one, and the company rebuffed the approach.
Since those heady days the share price and book value have fallen due to losses sustained on writdowns of the companys property portfolio. The company, like many insureers made a loss on insurance underwriting. I began watching the company closely in 2009. In the past few years the stock has fallen to approximately €5.50 a number of times. The dividend has also been cut.
G&D PE 3.9
What has impressed me most in the past few years is a combination of pricing discipline from FBD and capacity being removed from the Irish insurance market given the troubles at Quinn Insurance.
In 2002, FBD ranked 6th out of the 7 main non-life insurance companies operating in Ireland. Today, it ranks 2nd. In that time, market share has improved from 8.2% to 11.8%. Now, it is only fair to point out that 5 companies have market shares clustered around 11%. So this is a market where competition is a fact of life. FBD, has some clear advantages over the peer group (the large pan European insurers), in that it has a cost advantage with an expense ratio of 23.9% versus greater than 28% for the peer group. Secondly, it is growing its market share in Dublin from a small base.
FBD has an average Combined ratio of 87% over the past decade, whilst the peer group has an average of 92%. The company was amongst the first to increase pricing in response to the increased costs of writing new business. Management have communicated that this pricing discipline is not a fad, and that they have been prepared to allow business to walk, rather than to price insurance contracts at uneconomic levels. The expenses ratio has risen due to a combination of increased reinsurance fees to hedge against poor winter weather and increased marketing spend associated with the promotion of the direct low cost model (No-Nonsense Insurance).
This business has been a thorn in the side of management for the past number of years. It comprises, primarily a hotels portfolio in Ireland and Spain. The hotels in many cases are part of or adjacent to some golf resorts. Since the onset of the recession, FBD has sought to take some capacity out of its own hotel base. The business has largely been run for cash to avoid placing too much of a strain on the companys finances. Many of the hotels have been written down by between 40-50%. However one hotel, Sunset Beach Resort has had no writedowns – predominantly because business has been booming over the last few years due to successful marketing campaigns.
The balance sheet has been reasonably well defended by the management team. Several years ago, the present management team decided to invest much of its investment portfolio in German Government bonds – this was before the trade became consensus. As a result, of the bull market in the German bond market, FBD now has an unrealised gain of greater than €20m. A key determinant of future returns will be what the proceeds from the bonds are reinvested in when they mature in 2012/13. The present yield is simply unattractive, but solvency 2 limits insurance companies investment strategies. The weighting in corporate bonds will likely increase. A total of 88% of investment assets are invested in short term sovereign bonds and cash.
Finally, the company has entered into a property JV with its major shareholder – the Farmers Business Development (who own 25% of FBD Group). This JV will see Farmers Business Development manage the property and leisure portfolio of FBD. This portfolio will eventually be spun out of the group, leaving management to concentrate on the core non-life insurance business. The way the JV is structured, FBD will be insulated from future heavy price falls, but will also give up on any large recovery in property values. The full details of the JV have yet to be released, such as the consideration that will be paid. The structuring of the deal will see convertible loan notes to be issued by FBD and Farmers Business Development to the Property JV. Short term finance is replaced with longer term financing, and FBD’s debt profile will fall. I will awiat further details. Readers should be aware that this is a transaction with a related party.
All in all this seems like a pretty boring business. The exciting part are the returns. put simply, with a current combined ratio of 92.3%, FBD makes almost €40m per annum in net profit. This equates to an ROE of 22%. This business trades close to book value. In the past five years FBD has earned operating profit of between €20m and €160m. If as it seems, that the majority of large writedowns are behind us, then this company should earn about €40m in an average year, and significantly more in years where claims are low and vice versa. I believe that the stock offers signifcant value, but then again as a shareholder maybe I am biased.