### 1. Conclusions of the Analysis/Recommendation

Norwegian Finans Holding (Norway: NOFI, US: OTC:NWEGF) looks well positioned for further growth and price appreciation. Strong financial performance is expected to continue into the future, while technical analysis indicates that the stock price is resuming its earlier trend after a recent recovery. Valuation based on our forecasts indicates that the intrinsic value stands at NOK 164/share, 72% above the current market price of NOK 95.45/share.

In this link, you can find the excel spreadsheet model of Norwegian Finans Holding used for this article.

**2. Company**

Norwegian Finans (NOFI) Holding ASA is a digital consumer loans bank operating under the name 'Bank Norwegian'. The company employs a systematically assisted risk evaluation model for credit issuing decisions. The business model is one of the core factors of the firm's solid margins and stability in its returns as well as risk control.

NOFI operates in four Scandinavian markets, representing them through three geographical business segments: Norway, Sweden, and Denmark/Finland.

*Source: author, Norwegian Finans Holding financial reports.*

The bank had total income of NOK 2.7bn in 2016 and generated NOK 959m of net income in that year. The latter translated into EPS of NOK 5.4/share as the interest rate spread on loans and deposits stood at 13%, with cost/income ratio of 35%.

Currently, NOFI trades at forward (TTM) of: P/B 2.7 (3.4), P/E 9.3 (12.2), P/S 4.0 (5.0). All TTM multiples are at the premium to peer average (discussed later), which could be attributed to superior performance and higher growth of Norwegian Finans.

### 3. Investment Thesis

Norwegian Finans operates in Scandinavian markets that exhibit resilient and healthy economic growth and are expected to do so for the years to come. The bank has been showing substantial growth rates, expanding its loan portfolio at a rate of 56% each year since 2013. Well-managed costs translate into low-volatility margins. As the bank has control over its operating costs, and there seem to be little triggers to negatively affect interest expense, we expect these margins to continue into the future.

Excellent financials result in Return on Equity generation of around 30%, which offers a substantial margin above the cost of capital for the company.

Three types of valuation applied to our estimates of the firm result in an intrinsic value of NOK 164/sh. This signals that the stock is considerably undervalued in the market, where the most current closing price stands at NOK 96.5 per share.

### 4. Catalysts

We do not see any obvious triggers for the company's stock price to increase besides the evidence of continuous strong performance through earnings reports. Norwegian Finans Holding plans to issue its next financial report on 2018-02-28.

**Key factors to monitor from the reporting:**

- Net interest margin importance is self-explanatory, as it is one of the main components of the firm's profits. Equivalently, interest rate spread of customer loans and deposits is a partial proxy for this factor.
- Growth rate of deposits/loan portfolio will impact further revenues and profitability. Mismatch in the growth of these two portfolios could result in a shift of risks for NOFI.
- Marketing efficiency determines how expensive it is to acquire and retain customers. Therefore, it will affect the value that the bank is able to extract from clients.

### 5. Macro-economic Perspective

The following chart shows IMF forecasts for GDP growth in these Scandinavian countries.

*Source: author, based on IMF data.*

Unemployment rates are expected to remain largely at current levels, with marginal decline in all four countries. A 2% decline is expected in Finland by the end of 2022. Economic sentiment indicators are pointing to positive expected developments in Sweden and Finland (ESI), Norway and somewhat less so for Denmark (PMI).

Household debt is relatively high compared to disposable income, in Norway and Denmark, standing at 230% and 290%, respectively, compared to 90-150% in the major European economies like UK, France, and Germany, although countries like Netherlands and Ireland also have ratios between 200% and 300% as of end 2015.

Despite the household indebtedness, consumer credit in Norway constitutes only around 5% of total household debt, which is several times less compared to the developed economies of Europe, where the rate is on average 14-15%. This indicates ample room for Norwegian Finans to grow its portfolio at least in its major market. Direct data on this ratio is less publicly accessible for other countries.

### 6. Forecasts and Assumptions

Loan and deposit growth is commonly forecasted to be in line with economic growth for banking institutions. However, the approach is targeted more to diversified loan issuers that are stable and likely bigger with a flat market share. Since 1Q12, Norwegian Finans Group has been growing its loan portfolio at an average annual rate of 54%, with rates close to 40-70% YoY for every quarter of 2017. Expansion rates are evidently slowing down, which is to be expected as the bank becomes larger. Despite that, the rates are still significantly above that of the macro-implied general growth. Given that clearly different factors are impacting NOFI portfolio growth, we estimated the growth rates using a bottom-up approach.

**Assumptions:**

- Loan and deposit forecasts
- Loan portfolio growth forecasts are based on the historical developments of that portfolio. Growth rate in Norway and Sweden is expected to decline at a factor of 0.8x each quarter until 2018, in line with its historical behaviour. From 2019, we subjectively set the factor to 0.9x as the growth rates become more moderate and could be expected to deteriorate less quickly. The latter assumptions bring the expansion of portfolio to an average rate of 1.7% y-o-y by the end of 2021, which could be considered conservative.
- Denmark/Finland is at an earlier stage of growth as a segment and exhibits higher rates. Naturally, a more rapid decline of those rates might be expected. The growth is forecasted in two steps: following the logic above, we estimate a decline by a factor of 0.7x each quarter, and on top of that, a constraint is added for the growth rate not to drop below the average growth of the two remaining segments. This results in a smooth transition from high to moderate rates going forward. We believe this is a reasonable assumption, given that as the Denmark/Finland matures, its loan portfolio developments could be expected to become similar to that of the earlier-entered markets. Composition of the loan portfolio as of the end of 2021 is estimated to be invested 48% in Norway with the remainder almost equally allocated between Sweden, Denmark, and Finland, which is in line with the recent trends.
- Notably, the above forecasts are used somewhat indirectly in the further estimation. This is because, historically, NOFI has generated significant return on its equity, while keeping its cash positions mostly unchanged, despite not paying dividends. This means that the additional cash is likely invested in loans or other yielding securities. Therefore, as a first input, we forecast customer deposits using the following logic: customer loans' growth generally moves closely with customer deposit growth. In fact, historical average of NOFI customer loan-to-deposit ratio is 99%. Given this relationship, we borrow the loan growth forecasts developed above to estimate the growth of deposits.
- Following this, we expect that most of the financing coming from the deposit growth and net earnings will be used to issue loans, while the cash position will be kept at its historical levels. This brings us to our final customer loans' estimate.

- Interest rates on customer loans and deposits have showed little volatility historically. Since there seem to be no anticipated material changes in interest rates by the Scandinavian central banks, we expect the interest rate spread at NOFI to remain unchanged from the two most recent quarters going forward. Net interest income is calculated as a difference of the 15% annualized interest rate on loans and 1.7% rate on deposits.
- We estimate commission and bank services income and expense to retain their past 12 months' proportion to interest income (9%) and interest expense (41%), respectively.
- Operating expense is forecasted following the similar logic. Relatively little volatility has been evidenced in the ratio of operating expense to total income, while decline in this ratio shows improving efficiency. The three most recent quarters appear to be the most representative and, despite the same declining trend in them, to be conservative, we take the average as our future estimate.
- Cost/Income ratio resulting from forecasts based on above assumptions resembles that of the previous quarters, which in line with the bottom-up approach we are employing here. Going further into the future, the estimated C/I is mostly unchanged at 28%. These estimates take into account the fact that significant proportion of NOFI expenses are dedicated to customer acquisition and retention, which is reflected in the marketing expense. We should see marketing expenses becoming higher and somewhat less efficient with the rising competition. In other words, it will become more expensive to acquire customers leading to lower marginal efficiency increases with time.
- The bank expects riskiness of the loan portfolio to mostly remain unchanged going forward. As the bank has power to at least partially control this risk through adjusting its credit issuing rules, we incorporate the expectation into our forecasting. Proportion of provisions for bad loans to average loan portfolio is extended into the future periods.
- NOFI reported CET1 ratio of 16.7% in 3Q17, which is well above the required 15.3%. Given the strong expected performance of the bank and no changes in riskiness of its portfolios, we see only upside to CET1 ratio.
- Dividend policy of quarterly dividends of at least 40% payout ratio is approved. The bank said it will hold up dividends until 2018 to raise additional equity to be on a safe side with capital adequacy requirements. We see the current excess CET1 to be enough to consider dividend initiation. Past few years of history show that payout ratios of Scandinavian banks mostly deviate from 40% to 80%. Therefore, we expect that Norwegian Finans will initiate dividend payments as soon as 1Q18 at a 40% payout ratio. The forecast payout steps up to the middle of the peer range of 60% starting 1Q20.

*Source: author, Norwegian Finans Holding financial reports*

Top line of the income statement shows declining growth rates for the years to come. However, as the efficiency levels are expected to remain mostly unchanged, EPS growth should continue strong. We see Return on Equity gradually slowing down but expect it to still be substantial at the end of our forecasting period.

### 7. Valuation

Three types of valuation were applied to Norwegian Finans: Residual Income and Dividend Discount models as well as the case specific Customer Lifetime Value based valuation. Summary of all valuations is given later in the section.

### 7.1. Residual Income Model

**Assumptions**

- Beta was derived from an OLS regression of NOFI share price returns against OSEBX index returns on a weekly basis, rounding the value upwards to 0.8.
- Risk-free rate is assumed to equal 10-year Norwegian government bonds yield of approximately 1.6%.
- Long-term equity premium was calculated taking the average of two figures: 1) a geometric mean excess return of the OSEBX index for the past 16 years; 2) average of equity risk premiums of Norway, Sweden, Denmark, and Finland estimated by prof. Damodaran. The resulting premium used in the valuation stands at 6.9%.
- Based on the CAPM approach, the required rate of return on the stock of NOFI is 7.1%.

*Source: author*

Residual income valuation inherently assumes that going into the future, Return on Equity will decline to become equal to the Required Return on Equity, or at least the difference will be far into the future, hence creating negligible value in the present value terms.

We assume that net income growth will decline to an annual rate of 3% in 5 years beyond our forecasting period. This implies that we expect the company to approach a long-term growth rate of 3% in 9-10 years from today, which is an average time period of a business cycle. ROE is estimated to continue declining until it reaches the required level of 7.1%. Using the RIV model, we arrive at the value of Norwegian Finans share of NOK 183/share, which indicates a price increase potential of as much as 92%.

### 7.2. Dividend Discount Valuation

Dividend Discount Model presents some challenges in the case of Norwegian Finans due to uncertainty about dividends. We assume dividend payments to start in 1Q18 as explained earlier. Payout ratio steps up from 40% to 60% starting 2020.

**Assumptions**

- Required rate of return on equity is the same as used in RIV model: 7.1%.
- Long-term growth of 3% is assumed, which is in line with long-term sustainable economic growth rate.

*Source: author*

The table above shows an estimated intrinsic value of NOK 170/share for Norwegian Finans. This is substantially above the market price, implying an upside potential of 78% compared to the latest closing price.

### 7.3. Customer Lifetime Value Based Valuation

Customer Lifetime Value based valuation is a case-specific approach that we adopted to value NOFI. This method draws from the valuation of customer portfolio of SaaS and e-commerce businesses and combines it with a theory that market price of equity equals the value of assets in place of the company plus the present value of the firms' growth opportunities (PVGO). Immediately below and after the valuation table, we attempt to give a detailed explanation of the valuation, which, unfortunately, might be somewhat tedious.

Customer Lifetime Value is calculated by multiplying the customer's gross contribution by the probability that the customer will stay with the firm in that particular quarter and then summing the results. The probability of customer remaining with the firm is derived from the retention rate. The formal expression of this calculation is provided below.

where,

- GC is average gross contribution
- r is retention rate
- d is discount rate
- Subscript i marks the number of quarters after the customer has been acquired (calculation can equivalently be performed for any frequency).

**Assumptions**

- Costs of capital are calculated by combining the earlier computed 7.1% required return on equity and 1.7% cost of debt, based on interest rate of customer deposits. Given the prevailing 33% equity ratio, WACC for NOFI stands at 3.1%. This seems feasible given the significant tax shield as well as putting it into a perspective of return on assets, which has been around 4% in the last 12 months.
- Lifetime value of a loan portfolio customer is assumed to be 3.5 years or 14 quarters as indicated by the investment relations of the firm. Credit card customer lifetime is, as the firm states, the whole lifetime of a person. We assume that if an average life expectancy is around 80 years and customers acquire credit cards at an age of 20, the lifetime should be close to 60 years (240 quarters). Lifetime allows for estimation of customer retention rates.

*Source: author*

Average gross contribution of a customer should reflect revenues less variable costs of each customer. In this situation, interest payments to providers of debt capital are included among variable costs. In the quarters between 2Q15 and 3Q17, for each of the two types of customers (Loan and Credit Card), we take the revenue, multiply it by total income margin of that quarter (this way deducting variable costs), and divide the result by the number of customers. Average of this number through the period is used in the valuation and presented in the first table above as average gross contribution.

To put the gross contribution into a perspective: selling and marketing costs per customer per quarter can be taken as a proxy for customer acquisition costs. Such costs have on average been NOK 2 358/customer. Notably, there are also deposit customers, which do not contribute directly to customer portfolio, but are costly to acquire. Deposit customers provide cheap financing and are indirectly included in valuation through low variable costs.

We estimate the value of NOFI clients portfolio to be NOK 10.5bn. Notably, this estimates the current portfolio, i.e. the probability weighted income (gross contributions) from customers already with the company, implying no growth. What is more, since this value is after variable costs, which are most costs in this case, we attribute this value solely to equity.

Now, if we assume that the value of customer portfolio should constitute the current value of equity without growth, we are effectively referring to book value of equity with current assets in place.

Consider the following equation of equity valuation:

Value of Stock = Value of Assets in Place + Present Value of Growth Opportunities

So, current portfolio of customers is equivalent to assets already in place, because these customers are already there. PVGO is another part which can be extracted from the market price: as shown in the table, Market Value less Book Value shows what part of the stock price is attributed to future growth expectations of the company and it is NOK 67.1/share (95.4-28.3).

To arrive at our valuation, we essentially replace the Book Value part in the Market Price of NOFI stock with the one we estimated using customer portfolio valuation. Hence, present value of growth opportunities, implied by the market price of NOK 67/share plus book value of equity if current customer portfolio is correctly estimated at NOK 56/share, gives an intrinsic valuation of NOK 123 per share of Norwegian Finans.

Compared to previous methods, this valuation results in a lower upside potential of 29%. However, it does not make any assumptions of growth rates beyond those implied by the market.

**7.4. Final Valuation (Summary)**

To arrive at final valuation considering all approaches used, we combined the computed outcomes of each intrinsic valuation sensitivity.

Scenario analysis estimates valuation of the stock with changed forecasting assumptions. Optimistic and pessimistic scenarios are asymmetrically different from the base case: as shown in the table below, pessimistic scenario does not assume growth to be different from the Base by 20% as Optimistic does, rather it eliminates loan portfolio growth completely. In addition, the Pessimistic case of operating expenses is scaled by a factor 1.1, to show a worse-than-historical scenario as opposed to the Optimistic calculation. Min and Max denote minimum and maximum values of the respective items in the period of 1Q15-3Q17.

*Source: author*

Final valuation, resulting from the equal combination of all sensitivities stands at NOK 164/share per stock of Norwegian Finans. This provides a substantial implied upside of 72%. What is more, the risk/return profile is biased upwards, due to the valuation being estimated with a pessimistic scenario that is asymmetrically stronger than the optimistic one.

### 8. Market Multiples

Some of the peer companies selected for comparison also operate digitally and only within the retail market, while others are larger banks with wider range of operations.

*Source: author, Reuters*

Multiples indicate that NOFI is trading at a premium to most of its peers. We could likely attribute this to high profitability and growth. The company is still growing at substantial rates, while its net margins are hovering around 40% (compared to total income).

On the other hand, we see that a discount to peers is implied when looking at the P/E of 2018. Therefore, we are either too optimistic about NOFI net income in 2018 compared to consensus, or the stock of NOFI should appreciate going forward.

### 9. Risks and Potential Mitigation

Several of the main risks that Norwegian Finans, as an investment, bears are addressed below.

**Company-specific Risks:**

From the operations side, there is a risk that with the growing focus on digitalization, more competitors will emerge offering similar products, whether it be new companies or established institutions. This will result in compressed margins, therefore lower profits and value generation. The end result should be lower market and intrinsic valuation.

The bank bears credit and liquidity risk stemming from the issuance of credit to its customers. However, we are confident that the company will be able to manage these risks well, as it has done so historically. The bank issues unsecured loans for individuals and monitors, reassesses the risk of each individual annually or more often. Many of these processes are automated, while specifically, consumer loan payments are a relatively small part of consumer income. In addition, the firm has raised significant capital, which can absorb credit, liquidity risk.

The risks above are mostly company-specific and could be addressed through portfolio diversification from an investor's perspective.

**Systematic Risks:**

There is also a part of credit risk that stems from the macro-economic situation and a relatively high leverage of Scandinavian households that currently prevails.

Banking operations always face risks of adverse change in interest rates or their term structure to be more precise. Banks act as maturity transformers, they take in short-term deposits and lend long-term. Therefore, decline in long-term interest rates and increase in short-term interest rates would have a negative impact. As long as economic performance is strong and market participants are not forecasting recessions, long-term rates should be much higher than short term.

Systematic, market-wide, risks could best be addressed taking an offsetting short position. The short could potentially be picked from one of the peer companies that engage in a similar C2B digitalized banking business.

**Risks of Valuation and Estimates:**

- Most people are psychologically biased towards positive expectations. As historical results are not always indicative of the future, our projections might be inaccurate and overoptimistic.
- Our assumptions of capital costs could be underestimated, resulting in overvaluation.
- Lack of catalysts: if our intrinsic valuation of Norwegian Finans is close to real value, there is still a risk that markets will not adjust to the real valuation anytime soon or will even go in the opposite direction if there are no catalysts for positive adjustment.

### 10. Technical Analysis

Below, we provide a technical perspective on the recent NOFI stock performance.

Speaking generally, it is visible that NOFI had a relatively strong correction in 4Q17 with a drawdown of around 18%. However, now, a new trend is emerging, with the price above 20-day (light blue) and 60-day (dark blue) moving averages. What is more, the short-term moving average is approaching the longer one, indicating more conviction in the positive reversal.

The chart above depicts the comparison between earlier and more recent trends. It appears that the more recent one has been steeper so far and already recovered more than half of the correction price setback, gaining momentum on the way.

MACD indicator here shows an improvement in momentum, while the stock approaches a resistance level at around NOK 96/share. In fact, it seems that in the most recent days, the level is actually showing some resistance. If the stock breaks out to the upside with strong volume, we could expect it to continue moving towards the all-time high of almost NOK 105/share, depicted by the white line above.

Finally, we also take a look at the Accumulation/Distribution line, which indicates whether the money has been flowing in or out of the stock. It appears quite positive in the case of Norwegian Finans. During the period of the correction, the volume on negative days had to be quite low, as the line decreased only marginally. Growth of the price starting in December resulted in A/D line gaining speed. In summary, the line points to positive developments, as the money in the market support price increases more than their drops.

Summing up the technical analysis, the recent serious correction increases our perceived riskiness of the stock. Having said that, developments of the past two months point to a trend of recovery, which is gaining speed and momentum as well as it is supported by the money flows.

To conclude, Norwegian Finans stands in a favourable macro-economic environment for further growth. Given its historical expansion, we expect the growth rates to decline but remain solid for the years ahead. Due to the excellent and stable margins, Norwegian Finans is able to extract large profits from this growth and its operations, with cost income ratio hovering around 30%, while net income margin is at around 40%. The latter translates to Return on Equity of 35%, which is expected to hold above 25% for the 4 upcoming years. With relatively low estimated cost of capital, this company is well positioned to deliver significant value. Our valuation approaches indicate that the share is significantly undervalued, while technical analysis also shows positive signals of the stock recovering after a recent correction.

**Disclosure:** I am/we are long NWEGF, DNBHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. 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.