Erste: A European Bank Offering At Least 40% Total Return

| About: Erste Group (EBKOF)

Summary

Erste is an Austrian retail bank exposed to countries with the strongest growth in Europe.

The bank had difficult years but has solved this problem with a clean-up of its balance sheet.

The company is now highly capitalized and in strong position to grow its dividend over time.

This higher and growing dividend coupled with a lower risk profile should bring the re-rating of the stock.

Company overview

Erste Group (OTCPK:EBKOF) is a leading retail Austrian bank and has a strong presence in Eastern Europe. The group has a market capitalization of EUR 8.5bn (post Brexit adjustment) and a balance sheet of almost EUR 200bn. The revenues are distributed as follows:

(Source: Company presentation)

Erste is the number 1 in Austria, Czech Republic, Slovakia and Romania and has a top 5 position in Hungary, Croatia and Serbia. In its main markets, the company has a dominant position with more than 20% market share; that leads to a good level of profitability (ROE of 9.8% and ROTE of 11.3% for the first quarter 2016). The following slide shows the market share of the group:

Click to enlarge

(Source: Company presentation)

The following table shows the 2016 GDP forecasts for the different countries in which Erste operates. These forecasts clearly demonstrate that the region is more dynamic than the mature European countries.

Click to enlarge

(Source: IMF and European commission)

These following charts show that Erste operates in countries with low unemployment rate and low level of debt, thus growing in this area is structurally possible, not like many countries in Europe in which deleveraging is taking place.

(Source:company presentation)

Clearly, Erste benefits from the stronger GDP growth from the CEE (Central and Eastern Europe) coupled with a low penetration rate from banking products, lower unemployment rate than Eurozone and a low level of debt. Therefore, that should provide the necessary conditions to grow the business over time and sustainably.

Revenues

As all banks, revenues are under pressure with the very low level of interest rate. However, Erste is one of the few banks in Europe facing a strong loan demand, which partially offsets the pressure on net interest income. The management has guided for a slight decrease of NII until 2018 coming from its investment portfolio (Reinvestment yield) and partially offset by the 5% targeted loan growth. In 2014, Erste has grown its loans by 4.2% and the first quarter 2016 shows this positive trend continuing with almost 1% growth QoQ. According to the management, the best case scenario considers 2018 revenues flat compared to 2015 revenues and the base case scenario incorporates a slight decrease of revenue (1/2% per year).

Concerning the fees and commissions, it seems difficult for Erste to convert clients' deposit into asset under management (fee products) because of the current environment and the risk profile of clients. To be clear, most of its clients are risk averse and the current environment doesn't allow earning a satisfactory after-tax return for a moderate level of risk. Even though, the company could try to boost fee income, I like this strategy to not push clients towards inadequate products. I think it is a valuable strategy over the long haul.

Expenses

The company has started to implement its digitalization program that will increase cost of 1-2% per year until 2018 and it will deteriorate slightly the cost/income ratio. The purpose of this investment is to simplify the bank (back office, middle office…) and to gain efficiency.

This investment is a clear priority for the management. Even though it has been active in M&A and is interested by an acquisition in Poland (good fit with the existing business), the company has stated that it will not pursue disruptive M&A until it has implemented this program. Therefore, it shows how important is this digitalization program for the company. The aim of this digitalization is to achieve substantial cost savings (10% of total costs) in the future.

Cost of risks & assets quality

The cost of risk has decreased significantly since 2014 as highlighted by the following table.

Click to enlarge

(Source: Bloomberg)

The company has been hit hard by the financial crisis and the sovereign debt crisis before undertaking a strong clean-up of its balance sheet in 2014. The bank has also improved its risk management process, especially in Romania which was part of the huge increase in the cost of risk after its acquisition in 2006. Finally, the bank has disposed NPL portfolios and has improved the coverage of the remaining bad loans to a very decent level. As a consequence, its cost of risk post 2014 has decreased significantly to reach 17 bps for the first quarter of 2016.

The company thinks that this very low level is not sustainable and guides for a normalized cost of risk around 50 bps. The company recognizes that efforts have been done (NPL sale, risk management...) to decrease the cost of risk but has no explanations for such a low level.

Depending on the cost of risk in the second quarter, the annual guidance of 10-11% ROTE could be upgraded. If the cost of risk remains at a very low level, the guidance could be upgraded; otherwise the management will stay cautious and will keep its guidance unchanged.

A quick look at the NPL ratio (NPL loans/total loans) shows that the asset quality has improved even though the absolute level remains higher than peers. The NPL ratio has decreased from a level superior at 12% in 2012 to 6.7% for the first quarter of 2016.

Erste is very active in reducing its stock of NPL. After the disposal of EUR 126.6 M NPL portfolio in the first quarter, the company already expects the disposal of approximately EUR 500 M NPL for the second quarter.

Click to enlarge

The stock of NPL has declined by 16% YoY driven by the positive migration trend across NPL categories and NPL disposal. This reduction in NPL is supportive for a low cost of risk in the near future.

The NPL coverage remains strong and reaches 66.5% for the first quarter. The recent NPL disposals have been booked with a gain demonstrating the sufficient level of coverage and will also support the low level of cost of risk.

Guidance upgrade

I really think that the guidance could be upgraded. Cost of risk is at very low level for most banks. The loosening monetary policies implemented by central banks might be the reason of this low cost of risk. Indeed, a low interest rate increases the value of real estate (lower discount rate to discount future cash flow); as a result, real estate prices are at their highest level. I guess that when a borrower goes bankrupt, the bank will be able to sell the collateral (at high price) and to recover the money lent without incurring a loss. Moreover, a low interest rate decreases the monthly payment of the borrower.

Then, the bank has already achieved a ROTE of 11.3% despite the upfront booking of banking levies and regulatory charges (deposit insurance fee of EUR 71.7 M) and the second quarter will be impacted by a positive EUR 127M (pre-tax) one-off item related to Visa sale (slide 35).

The consensus expects a pre-tax profit of EUR 1892.6M for 2016. As stated previously, the company expects a slight deterioration of the top line (-1/2%) and the expenses (+1/2%). Cost of risk is expected to normalize around 50 bps.

In the following table, I made the assumption that revenue will decrease by 3% and costs increase by 3% that will deteriorate the cost/income ratio from 57% to 61%. I consider a cost of risk of $800M for the year or 61 bps (based on the 2016 figures). I add the EUR 127M gain on Visa and I arrive at a pre-tax profit of EUR 1910M, higher than the consensus. If the management guidance is right (and the management seems to be conservative the last few quarters), there is upside to consensus estimate.

(Source: Company data, Bloomberg, own assumptions)

Capital

The bank has reported a CET1 ratio (fully loaded) of 12%. This ratio compares favorably to the SREP of 9.5% in which we have to add 200 bps systematic buffer, thus the company is already above its minimum regulatory requirement (expected in 2019). The management wants to add a 100 bps management buffer, thus the final minimum CET1 ratio for 2019 is 12.5%. Its leverage ratio is at 5.7%, which is much higher than the minimum regulatory.

The company is waiting for an update on its capital ratio requirement over the next few months. According to the management, the regulator should not ask for more capital because the level of capital is decent and the balance sheet has been de-risked. The company is also waiting for this update before stating its new dividend policy.

Dividends

The dividend policy has not been stated officially because the management waits for the capital requirement announcement from the regulator. Historically, the dividend policy has been based on the group profitability, capital requirement and growth outlook. The management will probably state guidance based on a payout ratio range (large range) in order to be flexible to set up the dividend. The goal would probably be to increase the dividend year-over-year without being committed to a progressive dividend policy.

Historically, the dividend has been volatile and cut many times as highlighted by the following chart.

Click to enlarge

However, the risk profile of the company has been de-risked since the balance sheet clean-up in 2014. The company has the possibility and the potential to become a dividend paying stock as its peers (ING, KBC, Nordea, Lloyds…).

Valuation

Erste is trading at 0.73X its book value when the sector is trading in average at 0.66X its book value. Moreover, Erste has a better profitability with a 2016 ROE forecasted at 9.5% when the sector average is at 6%. With this level of profitability, Erste should trade at a higher multiple.

Here is the list of all the banks in Europe with an expected ROE higher than 9%. The average and median P/B for these stocks are 1.26X and 1.33X, respectively.

Clearly, this table shows us that Erste has a huge rerating potential.

Assuming that Erste should not trade at 1.26X its book value because the company is riskier than Nordic banks, we can assume that the stock deserves at least to trade at its book value which represents 37% upside (without incorporating the dividend).

Erste is trading at 8X its earnings (12M forward) when the sector is trading at 10.6X despite a better (and more sustainable) growth profile. If we consider that there is no reason for Erste to trade at a discount and applied the average P/E to the EUR 2.66 earnings estimate, we obtain a target price of EUR 28.20 which represents more than 41% upside (without incorporating the dividend).

Finally, the consensus EPS estimate for 2016 is EUR 2.66. Even though the payout ratio has been volatile over time, the lowest payout ratio was a bit more than 20%. Considering its strong capital, Erste is easily able to fix its payout ratio at 30% which is less than the 45% payout ratio observed for European peers. Assuming a payout of 30% with EPS of EUR 2.66, we derive a dividend of EUR 0.80 that represents a 4% yield, which is a bit less than the 5% dividend of the market. With a dividend yield closer to peers, higher growth profile, a profitability superior to its cost of equity and a strong capital position, the stock should re-rate considerably.

Conclusion

Erste operates in high potential countries because they have higher GDP, less debt and lower unemployment than European countries. Moreover, banking products are underpenetrated and these countries need to invest further in the infrastructures.

The bank is trading at a discount to its book value and to its peers despite generating an ROE of around 10%. As a bank, the future doesn't seem bright because of the low interest rate environment. However, Erste is able to offset partially this headwind with a loan growth (roughly 4%) which is higher than its European peers. Moreover, the guidance and estimates could be upgraded as soon as Q2 results if the cost of risk remains low. With a loosening monetary policy coupled with management's efforts (NPL disposals, high NPL coverage...), I really think that cost of risk will remain low and the guidance will be upgraded.

Finally, Erste will set up its dividend in the next few months and will start to be considered as a dividend paying stock, highly capitalized bank and will start its re-rating.

If Erste re-rates towards 1X its book value (less than 1.3X for its peers in terms of ROE), we got more 37% return and if you add 4% dividend, you should reach more than 40% total return in investing in a bank which is highly capitalized, de-risked, without restructuring plans (with the associated execution risks) and investing in its future efficiency (digitalization).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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.