Italy feels fragile. A referendum is approaching in November on which reformist Prime Minister Matteo Renzi has seemingly staked his position. The economy is barely growing after years of recession. Bank stocks have collapsed this year when a long-anticipated government backed scheme to support the resolution of banks' high NPL balances proved a damp squib, as EU rules limited its potency.
Outside Italy, the European Union is confronting Brexit and a loss of political momentum as domestic governments move in a nationalist and even authoritarian direction, of which Poland is a significant example.
It might seem crazy to even think of bank stocks in this kind of environment. But if you believe in value this is exactly what you should do as you can get rare price levels.
Intesa Sanpaulo (OTCPK:ISNPY) is the kind of stock that trades at a full valuation most of the time. Its income quality is strong, rooted in a deep deposit and savings franchise. Its cost efficiency ranks with the best globally. It is very well capitalized and in a position to payout a high level of its earnings. There is some debate about whether it can pay all of its earnings in dividends and this is the wrong debate. The yield is attractive at a 75% payout. The right debate is something that never enters market dialogue, so distracted is everyone by the politics and the wider problems in the sector. I'll come on to what I think the right debate is later. First, let's look at the bank:
As an investor in big, mature banks, you are looking for money machines that max out high quality revenue streams to make the most of their capital. The thing to look for first is a high ratio of fee income relative to interest income; this should protect the income level when interest margins are down (and in Europe they are way down and might conceivably go lower). A full income mix like this should give pretty good cost/income efficiency anyway by swelling the denominator, but it's my experience that bank managements who have over the years built these optimal income mixes are also among the best cost managers as well.
Here is how the fee streams have offset margin pressure within the interest based streams. Net interest income, the blue bars in the chart below, can be seen to be dropping through the period depicted. Note, by the way, that it is not dropping that severely, but it is obviously coming down. Offsetting this is the rise in fee income, the green bars. The combined interest and fee lines have grown 6% over this period. The recent direction of travel has been lower, but this is still great defensive game in a tough environment. Intesa targets this, as you can see if you follow the link (page 10).
Source: Company Data
Intesa boasts a high level of capital with a 13% Tier 1 ratio on the fully phased in Basel III standards to which all banks are moving. I wrote recently about Suntrust (NYSE:STI) and U.S. Bancorp (NYSE:USB) in the U.S., which are smaller than Intesa in asset terms and operate with about 10% on the same basis (Basel III). So there is a huge capital cushion at Intesa, which if thinking of buying bank stocks with shaky political backdrops is a key consideration.
Sell side analysts sometimes debate whether Intesa can maintain its currently targeted €3bn payout into the future. This is fair enough of course: management is setting targets and it is the analysts' job to discuss them. I would think of it slightly differently: I don't care if the dividend slips a bit. The chart below shows that even with a much lower dividend payout amount, the yield, shown in the red line, is OK. This is a margin of safety over the long term.
Earlier in this piece I mentioned what I think the "real" debate is for investors and the bank to engage in. Let's for a second follow the advice of Warren Buffett and think like owners of a private company, not a listed one.
Here is the issue: Intesa stacks up well globally on business quality and capital strength. Its problem is that it has very high balances of NPLs. These are by no means the worst in Italy but the NPLs are still very high. Too high.
Like nearly all Italian banks, Intesa maintains that it can realize the collateral held against the NPLs (which are ~50% covered by provisions) via the torturous foreclosure process in Italy, which takes about seven years to complete. Why dispose of the NPLs in the secondary market, given that the prices reflect the time it takes to resolve the bad loan? And of course, management maintains the provision coverage is adequate.
Imagine that you own this bank personally, 100%. What would you do? My own approach would be to forego the high annual dividend in whole or in part, and write down the current net (or unprovisioned) NPLs much further. I would still own the NPLs, of course, and could get whatever value is available via foreclosure when I got there, but there would be far greater certainty around the cash flow to owners once the write-down exercise was completed.
Now, let's relist Intesa: this discussion becomes at once more complicated because we are worried about the impact on the share price of cutting the dividend. But it's not necessarily the right way to think.
Intesa's high NPLs mean that small percentage increases in the balance inflict high charges on the P&L. Over 1H 2016, loan loss charges have cost Intesa 14% of its total operating income. Take a "cleaner" peer from elsewhere in Europe, ING. Provision charges there amount to 6.6% of income - less than half the level at Intesa.
The key NPL grade in Italy is "sofferenze" loans, which are deemed to be unrecoverable. It would take some of the more troubled banks in Italy 7-8 years to write down all of their unprovisioned sofferenze loans. Intesa could do it in two. You can see this by looking at the balance of its net sofferenze (~€14bn) against the operating profit Intesa generates before taking provisions against loan losses. This is €7-8bn annually. If half of this were moved to the provision stock against sofferenze, two things would happen. First, the question over long term accessibility of collateral held against the net sofferenze would fade in importance. Second, visibility over future credit costs would improve. How much? Well, let's take an average of that Pre provision profit number, and assume that after a write down top up, the ongoing provision charge would halve. PPP of €7.2bn would drive a bottom line gain of 28%
The current CEO of Intesa is fond of his dividend yield, which makes sense on many levels. I just wonder if the market should steer him towards some short term (modest) pain, for midterm gain.
Intesa is already attractive on its bottom up fundamentals, despite the risks in Italian politics and the broader EU. To my mind it has the means to power further ahead under its own steam.
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.
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