Allied Irish: Too Good to Be True?

 |  Includes: AGIBY, AIBYY, IRE
by: Ockham Research

Allied Irish Banks PLC (AIB) is Ireland’s largest bank, and in the last two years the company’s shares have been on a relentless march downwards. AIB and its two main competitors Anglo Irish Bank (OTC:AGIBY) and Bank of Ireland (NYSE:IRE) were subject of a major bank recapitalization effort from the government in Dublin, worth more than $7.7 billion. In the last year, the bank has lost nearly 87% of its market value as the Irish economy has faltered in the global credit crisis. However, as bad as the stock performance has been, AIB still looks fundamentally intact. The bank has been able to hold up its strong tradition of pulling off return on equity (ROE) of over 15% year after year, with its most recent reporting being over 20%. We regard this as a positive reflection on management, which has been touted as the most conservative management of the three major Irish banks.AIB

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Since the late 1990’s, the Irish economy had boomed and the small island’s real estate was very much in demand. The Irish success story even earned it the title of the Celtic Tiger for its continued and rapid growth. However, as signs of trouble started to brew throughout the world, the Irish property bubble burst along with it. There were similarities between the American downturn and the Irish one, as household debt expanded greatly in the previous two decades. Despite this similarity, as far as banks go, the story diverges between the Irish and American institutions.

As everyone is well aware, the U.S. real estate downturn uncovered the dirty little secret of sub-prime loans that were rolled into massively complex debt instruments. The Celtic problem did not involve a low quality debt collateralization scheme, as Irish banks have little sub-prime exposure. Instead, Irish banks aggressively lent larger amounts to developers who were propelled by tax breaks to overbuild. The results were more similar than the path to get there: the bubble burst and banks were sent reeling.

The Irish banking recapitalization was announced on December 22, and AIB claimed 2bn euros ($2.8 billion) in the bailout. The government’s infusion of capital was necessitated by overly aggressive property lending by all three of the major Irish banks. The additional capital was needed to reassure those that doubted the bank’s sustainability in the face of Ireland’s deepening recession. In return for the capital infusion, the government will be given preferred shares paying 8% dividend per year and 25% of voting shares. The market has responded positively in the 3 weeks since the bank bailout as AIB has begun to climb upward more than 30% since the announcement. Investors have found comfort in the fact that Ireland will stand behind their banks in this time of need.

The data for Allied Irish just looks too good to be true, and perhaps it is. AIB’s ADR closed on Tuesday at $5.92, which is amazing considering that the company made $5.98 in profit in fiscal 2007. Furthermore, the company’s balance sheet shows a current tangible book value (excluding goodwill and other intangible assets) of about $25 per share! And if those figures do not amaze you, the current dividend yield in near 30%. Of course, numbers like this just do not seem possible and there is a catch.

When AIB reports earnings for the full year in early March, they will need to write down the value of some of their assets, most notably those related to real estate in Ireland. The extent of these write-downs is as yet unknown, and with current valuations being what they are it could be quite substantial. Some estimates are telling of 50% loss in the value of housing in Ireland, which makes the housing downturn in the U.S.A. seem quite tame in comparison. Furthermore, AIB’s inflated dividend figure has literally no chance of being paid out, at least not next year. And adding to investors' concerns is the risk of having an investment diluted by future share offerings in order to further shore up the bank’s balance sheet.

So, when it comes to Allied Irish, there are a lot of questions that remain to be answered; however, at current valuations the risks may be worth taking. We have AIB rated Greatly Undervalued because of the unarguably cheap valuation given current data. Virtually any valuation metric that you wish to look at is at unbelievably low levels compared to historical norms, but there is that elephant in the room: the asset write-down. But even in a worst case scenario, where AIB’s book of assets has to be written down 50%, the company’s book value per share would be more than double the current share price.

While a potentially catastrophic write-down has likely already been priced in, if AIB is able to fare better than expected, shares could get a nice boost. Furthermore, the risk of default has been greatly diminished by the Irish’s governments demonstrated propensity to keep their banks alive. Allied Irish also is more diversified than its Irish peers as it has substantial interests in the U.K. and in the U.S.A. (particularly through partial ownership of M&T Bank (NYSE:MTB)). As with any investment, there are risks, and in this case the lack of clarity is enough to make many investors skittish, but there is significant appreciation potential for AIB. For some investors, it might make an appropriate speculative holding, but unless you can handle the volatility perhaps wait until after the earnings release to get a clearer picture.

One final note, as those of you looking at our historical ratings will notice, it does not look very good. AIB is a classic example of a company that continues to report solid fundamentals, but it can do little as the roof over the economy caves in. Oftentimes in serious downturns, such as we are seeing now, it is value methodologies that get kicked in the teeth. That does not alter the fact that we believe AIB is a well run company, and could emerge from this stronger as some weaker competitors are thinned out.