Following our last article in March 2018, the share price kept falling despite good business momentum. Indeed, the company has been able to maintain a resilient net interest margin by offsetting lower reinvestment yield by increasing loan yield (from 3.42% in 2018 to 3.47% in H1 2019) and reducing deposit costs (from 0.41% in 2018 to 0.31% in H1 2019). The company has continued to reduce its impaired loans from € 6.3B (NPE ratio of 16.1%) in 2017 to € 4.7B (NPE ratio of 7.5%) in H1 2019 and is on track towards its 5% NPE ratio target by year-end. The company has also been able to maintain a very strong CET1 ratio while paying an increasing dividend (from € 0.12 in 2017 to € 0.17 in 2018). The only negative item is the increase in the cost / income ratio, resulting from higher depreciation (related to the digital investments) and elevated costs in the work out unit but we believe that the company should be able to improve it going forward.
The banking sector remains clearly out of favor because of the low interest rate environment and fears surrounding the end of the economic cycle. As a result, investors are happy to sell short banks or at least, not to own them. However, we believe that some banks can just do fine because of superior business model and attractive market structure. We believe that AIB (OTCPK:AIBSF) is one of them.
AIB operates in a duopoly in the very attractive Irish market. The Irish economy is one of the fastest growing economies in Europe, benefiting from attractive tax regulation, an attractive labor market and a very young population. This attractive market structure is the legacy of the 2008 financial crisis. Indeed, before that time, Irish banks were highly dependent on wholesale funding and had very poor underwriting standards and a strong focus on international growth. While the housing prices were booming and the wholesale market was easily accessible, everything was fine. However, while the financial crisis hit, households were too highly leveraged and unable to face their monthly payment while, in the meantime, banks were liquidity constrained because they could not have access the wholesale market. As a result, the situation became critical and several banking institutions went bankrupt while the remaining ones were recapitalized by the government.
Nowadays, the situation is clearly different. Irish banks are much more disciplined and operate a low-risk business model focusing only on households and corporate banking in their domestic market. Their balance sheets are solid and their exposure to the wholesale market is minimal as highlighted by AIB’s CET 1 ratio, leverage ratio and loan to deposit ratio of 17.3%, 9.8% and 88%, respectively (slides 16 and 20). These number compares favorably to the European peers which have an average CET 1 ratio of roughly [11%-13%] and an average leverage ratio of roughly [4%-6%].
Besides, the market is more consolidated than before and the two largest banks (AIB and Bank of Ireland (OTCPK:BKRIF)) controls more than 60% of the mortgage market while the remaining 40% are split between Permanent TSB (OTCPK:ILPMY), Ulster Bank, KBC (OTCPK:KBCSF) and some niche players such as Pepper and Dilosk. In some segments, AIB is even more dominant as highlighted by its >40% market share in business loans. As a result, price competition is almost non-existent and existing players enjoy some pricing power (which is difficult to believe for many investors given the commodity nature of banking products) as highlighted by the increasing loan yield over the last few years whereas all interest rates in Europe went down over the same period. The lack of competition also benefits banks by reducing the competition for attracting deposits. The combination of increasing loan yield and decreasing deposit costs allow AIB to offset the negative impact of lower reinvestment yield on the bond portfolio and to keep the net interest margin stable.
Going forward, dominant players should be able to at least maintain stable NIM by keeping competition at bay. Indeed, the Irish market is a niche market given its small size which makes it difficult for new competitors to enter this market. Furthermore, existing players have already a strong network, brands and infrastructures which increase the barrier to entry.
Looking more deeply into AIB, we can see a lot of value not priced by the market. It seems that market participants price the stock based on its reported ROE which is clearly depressed because equity is inflated by its excess capital as well as its deferred tax assets (DTA). Besides, we believe that investors do not take into account the value of DTA and use an higher cost of equity (in their valuations) than implied by the company fundamentals. As a result, we believe that AIB stock price is significantly undervalued given its attractive features.
1) Excess capital
The company has a CET 1 ratio of 17.3% at the end of first semester 2019. The company targets a CET1 ratio of 13% (including management buffers above the minimum regulatory ratio of 11.55%) and made it clear than they will pay back the excess capital to shareholders once the NPE ratio reached 5% (slides 3 and 6). The company expects to reach this target by the end of 2019. The company deserves credibility given its strong NPE reduction over the last few years. Indeed, the NPE ratio was 37% at the end of 2013 (NPE of € 30.7B) and decreases to 7.5% at the end of H1 2019 (NPE of € 4.7B). After considering the negative impact of the Targeted Review of Internal Models (TRIM) regulation (€ 2B RWAs increase as guided by the company), we calculate an excess capital of € 2B which represent 26% of the market cap (equivalent to € 0.74 per share).
2) Deferred tax assets (DTA)
The company has € 2.6B of DTA on its balance-sheet resulting from previous losses. They have no expiry date and the management believe than it can deplete its DTA in 20 years (page 265). Based on this assumption, the company can reduce its pre-tax profit by € 132M per year during 20 years.
Assuming a 10% discount rate (in line with European peers), the present value of this tax benefit is valued at € 1.12B (or € 0.41 per share).
3) Higher COE than peers
This argument is quite challenging to prove but it seems that investors perceive AIB as more risky than other European banks because of lower liquidity, previous track-record (financial crisis), lower market cap and Brexit risk. We believe that investors value the stock with at least a similar cost of equity than peers (maybe even higher) while we believe that the Irish banking market and the strong company fundamentals argue for a lower cost of equity than peers (Consolidated market, highest GDP growth, leading position, low-risk business model, lower leverage…). Besides, we believe that a hard Brexit is manageable for the company because of its strong balance sheet, limited direct UK exposure and potential indirect benefits. We consider that a lot of companies could choose to relocate in Ireland if they cannot do business from the UK, which could be a long-term positive for the Irish economy and AIB.
4) 49.9% stake in AIB Merchant Services
AIB Merchant services is a provider of payment credit solutions (credit cards and payment processing). Unfortunately, the disclosures on this business are limited. However, we were able to build the evolution of the equity income related to its 49.9% stake in AIB Merchant services. Even though the business is similar to peers, the growth rate is far below them. Despite this lower growth profile, we believe than such asset deserves to be valued with a higher multiple than the current 9.8x. Assuming a 15x P/E to the trailing equity income of € 17M, we obtain a valuation of € 255M, almost € 100M higher than what is implied by the current valuation of € 167M (based on the current AIB P/E ratio of 9.8x and the trailing equity income of € 17M). However, the overall impact is limited but additional value could be created in this business by improving the growth rate or selling the business.
Our valuation model suggests a fair value of € 4.31 per share (53% upside to the current € 2.83 share price). We assume a decline in net interest margin towards the low-end of the company guidance (> 2.40%) and weak volume growth (less than 1%). We did not give credit to the management for its underlying cost/income ratio target of <50% and assume a ratio of 52% while adding € 350M of negative items (exceptional items, bank levies and regulatory fees). We have increased the cost of risk to 20 bps in 2019 which is close to the company guidance of 25/35 bps through the cycle. Finally, we consider 0% terminal growth rate and a 10% cost of equity.
Even though the valuation offers 53% upside, we believe that some assumptions could prove to be pessimistic such as:
- NIM: We believe than the company can do better than 2.40% given the lack of competition and its ability to increase loan yield and decrease deposit costs. Higher (market) interest rates would also help but the probability of such scenario is highly unlikely. Our sensitivity analysis shows that every additional basis point on the NIM add € 0.02 to the fair value.
- Volume growth: Our sensitivity analysis shows that for every 50bps additional volume growth, the fair value increase by € 0.03.
- Costs: The company faced additional costs related to the work out unit (unit in charge of dealing with NPLs), digitalization and higher regulatory and requirement costs. A normalization of the situation and the delivery of company target (Underlying cost/income ratio <50%) would bring additional upside. Our model suggests that an underlying cost income ratio of 50% (instead of 54% in 2019 and 52% in 2020) increase the fair value from € 4.31 to € 4.54 (increasing the upside potential from 53% to 61%).
- Cost of risk: The cost of risk could remain close to 0 bps if the economy remains strong and that interest rate does not increase significantly. Our model suggests a € 4.56 fair value if the cost of risk is 8bps instead 20 bps in 2019.
As a result, a blue sky scenario suggests an intrinsic value of € 4.91 (74% upside). This scenario is based on 1%/1.5% volume growth (50 bps additional growth to the base case), stable NIM at 2.46% (VS 2.44%/2.40% in the base case), cost of risk at 8 bps (VS 20 bps) and an underlying cost income ratio of 50% (VS 54%/52%).
On top of that, the company could even free up additional capital. Indeed, AIB has one of the highest RWA density because of its extensive use of standardized models (for calculating RWAs). By developing and implementing internal models, the company could reduce significantly its RWA and free up additional excess capital. Our calculation shows the company could free up € 525M, equivalent to an additional 7% of the market cap. However, such change will take some time and should not be expected before 2020.
The upside potential is huge but what if we are wrong. The bear case model tries to assess the potential downside if the worst case scenario materializes. This scenario includes negative volume growth (-1% in 2019 and -3% in 2020), NIM of 2.40% in 2019 and 2.35% in 2020, a fall in other income to € 450M, an underlying cost/income ratio of 54% and 55%, a cost of risk at 35 bps and a 12% cost of equity. Due to the lower profitability, we also increase the time required to deplete DTA from 20 to 25 years which mechanically reduces the value of DTA. This worst case scenario results in a € 3 fair value, which is still above the current share price (6% upside), suggesting a very attractive risk/reward.
To sum up, we completely agree that the current environment in Europe is difficult for banks but we believe that some high-quality stocks such as AIB are unfairly and excessively penalized. AIB operates in a duopoly market, providing some pricing power which allow to offset the negative impact of lower reinvestment yield on its net interest margin. Its lower-risk and simple business model should also support a premium valuation to peers. Our detailed analysis suggests that investors overlook the attractive features of the company, especially its DTA and its huge excess capital. Valuing them separately and adding them to the valuation of the core business suggests 53% upside. Our more optimistic but still doable blue-sky scenario suggests 74% upside whereas our bear case scenario implies 6% upside. As a result, the stock offers a very attractive risk reward. The NPE ratio of 5% should be reached in the coming months, leading the way to the return of the excess capital to shareholders. Once the distribution is started, we believe that investors will start to look at the company for its attractive yield as well as its increasing reported ROE.
Brexit: AIB generates roughly 11% of its revenue in the UK. If the UK is severely hit by leaving the European Union, AIB could see a sharp profits decline in its UK business (lower volume growth, higher provisions...). Its Irish business could also be impacted by the close trade relationship between Ireland and the UK. Indeed, a large portion of Irish exports are realized with the UK. A depreciation of the British pound would also make Irish exports less competitive. However, UK companies will probably relocate in Ireland in order to get access to the European market (being the only English-speaking country in the Euro area with a business friendly approach).
Pricing: Any actions from the regulator trying to reduce lending rates. An increase in competition from existing players or new entrants could also pressure the net interest margin. However, given its 71% stake in the company, we do not expect the government to take any actions against the current pricing environment.
Low interest rates: Lower reinvestment yield on the bonds portfolio pressures the net interest margin.
Excess capital: A large part of the investment case is related to the ability of the company to reduce its non-performing assets in order to pay back the excess capital to shareholders. The inability of AIB to return its excess capital would negatively impact the company valuation.
DTA: A change in tax regulation could reduce the value of DTA.
Government stake: The Irish government holds more than 70% of the company. It will sell its stake over time in order to recover its investment; therefore the stock price can be penalized during such announcements.
Tracker mortgages: The Central Bank of Ireland is currently running an investigation concerning the tracker mortgage in the whole industry.
Disclosure: I am/we are long AIBSF. 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.