• Danish financial company operating in life, non-life, banking - market cap of 4.6bn DKK, roughly equal to the book value
  
• Non-life business is excellent, profitable, consoliated and valuable
• Life business is average, moderately profitable, probably just about fails to cover cost of equity
• Banking business is a disaster but they are taking some action to turn it around and get rid of the bits they don't want and have provisioned somewhat conservatively
  
• SOTP points to potential value 50%-100% above current price
• Key to realising the SOTP will be focusing attention on the "jewel in the crown", the non-life business, which can be achieved as the banking book runs off or is potentially sold
• At least 450m DKK of excess capital in the business - after discussions with management, I think a dividend will potentially be initiated which will give a positive signal and lend yield support
  

• Many of the players in the market are listed and answerable to shareholders on a quarterly basis
• The Nordic countries have large land masses relative to population, hence the branch network required to generate the required scale, relative to the revenue opportunity, does not support more than a few large players
• Alm Brand think that online is less of an appealing channel in Denmark for cultural reasons - people seem to like to go into a branch and speak to a person face to face
• Nordic countries (Sweden really, to be fair) went through a banking implosion in the early 90s, and since then there has maybe been more of a focus on capital discipline, solvency, profitability. Maybe not that strong of an argument given Danske Bank's issues, however.

A few of the larger non-Scandinavian players have tried to disrupt these markets over the last 10-15 years, but by and large they have failed to generate scale and profits and been forced to exit at a loss.

In terms of explaining why the CR rises this year - 2012/13 were abnormally strong years, benefitting from a low claims ratio thanks a a benign storm season. This year we are seeing some of that being recycled into some more competition for premiums. Alm Brand are not really competing for that too much (guidance is for very modest premium growth), but it will have an impact. I actually think they are being a bit conservative - expense ratio has come down 160bps since 2010 and they say there is more to come as IT investments they have made continue to benefit them. There should be some premium growth. Of course, weather and accidents are hard to predict, but I think they are leaving themselves some margin of safety with a forecast of CR +2.6% with the expense ratio probably a 20-30bp tailwind.

The company guide that with the premiums growing ~1% and CR rising to 90, the non-life busines should generate DKK 525m in PTP. I actually have more than that (DKK 630m) as I think the CR could wind up being a bit better than they guide. From there, I have the PTP about flat for a couple of years, which I think is conservative, allowing for a further slight rise in the CR which is how the company see things playing out.

The key valuation takeawat from all of this is that, in my view, the non-life business alone more than justifies the current valuation. That business currently has about 2.1bn of equity in it. The PTP I am forecasting translates to an ROE of about 22%, about in line to slightly below recent history for the company and about in-line with industry averages. What should one pay for a business generating a steady ROE of 20%+ in a consolidated and rational industry that appears to have high barriers to entry? I am going to argue that it should be about 12x earnings and north of 2x book value:

Banking

Banking is the ginger stepkid of the group. The financial performance has been dire - they lost 428m in 2008, 1.3bn in 2009, 647m in 2010, 918m in 2011, 391m in 2012, and 392m in 2013. They do not expect it to return to profitability this year, even as the Danish economy recovers and the KFX rips through new highs as a write this. It is a quite staggering display of ineptitude to lose DKK 4bn given the size of the bank - what exactly happened and how can I recommend buying a company with a turd like this sitting in the business mix?

In terms of explaining what went wrong - what hurt them was primarily mortgage lending and agriculture - but mostly mortgage lending. Denmark experienced a housing bubble and the 2008/2009 bust like many other countries, with the additional kick in the teeth being that household debt, much of it through mortgages, has tended to be very high on a global basis (mortgages outstanding ~2x GDP). High leverage and a 20% decline in home prices on average (much more outside the major cities - about 50% according to Alm Brand) has led to numerous banking defaults and a sluggish recovery from the crisis (though it seems to be improving somewhat now).

The company played a poor hand through this situation - pretty much as bad as they could have played it, actually. From the mid-00's to 2008 their strategy was to chase growth, growing the loan book from DKK 10.7bn in 2005 to DKK 17.3bn in 2008. Of course, by the time the realised their mistake, it was too late and they were stuffed with a tremendous amount of debt outstanding on a bunch of illiquid assets worth considerably less than they had initally thought.

The strategy was changed in 2009, with the growth strategy finally abandoned, a narrower focus on private banking, leasing and financial markets, and the rest basically put into a bad bank to run off over time.

Talking a bit more about the bad bank - it has continued to perform poorly, losing 990m in 2011, 472m in 2012 and 379m in 2013 - company expect it to lose another 375m-425m this year. I am not positive on this part of the business really, but I think that the power of compounding should eventually start to work in reverse, to their benefit. The bad bank had DKK 7.1bn of loans at the end of 2011 - as at year end 2013 that had fallen to DKK 4.8bn as loans matured and they took writedowns, and as of the end of Q1 it stood at DKK 4.6bn. Against this 4.6bn, the company retain ~DKK750m in unused provisions, so there is some buffer in place, at least.

The key observations/comments I have would have on the bad bank are:

• Of the DKK 4.6bn, DKK 1.3bn is in commercial lending which should roll off of the books at a rate of about ~DKK200m/year; another DKK 2.4bn is in mortgage deeds which should roll off at a considerably slower pace
• I sounded the management out when I met them re. the possibility of selling these loans to a PE/HF at a discount to get them off the books, clean up the equity story a little and allow them to focus on the core operations, a la the Baupost/Spanish Banks deal earlier this year. They said they could be interested in doing this (Seth Klarman - are you reading this?) and at a 15%-30% discount, that could make sense. 15% would obviously be more convenient as they would then avoid any meaningful impairments to the book value

I have the bad bank in my SOTP at 0 as I think that is the right way to do it. The company give you an equity number for the bank as a whole (DKK 1.7bn) but not on a good bank/bad bank basis - so the way I approach the valuation is to put the bad bank in at 0 and also to look at the earnings from the good bank against the equity in the entire banking operation. Which brings us onto the good bank.

Good bank is probably a bit of a misnomer - it is good relative to the other bit losing DKK 550m/year, maybe not so good vs. its Nordic peers. As mentioned above, the areas they focus on are private banking, financial markets and leasing. They have struggled a bit in these operations over the last couple of years, as the numbers below (together with my estimates for the future) show:

In terms of what has been the headwind - the Danish economy has been the laggard in Scandinavia, which has driven a sluggish loan demand situation (improving slightly recently), while an extraordinary credit review done in 2013 saw impairments tick up on the ~DKK2.4bn loan book. As of Q114 I can say that the performance has begun to turn around, with the bank swinging to profitability (DKK 22m vs. DKK 37m loss in Q113) - the company guide for good bank PTP of 40m for the FY, which I think will prove to be conservative (I have about double that).

In terms of drivers of future profitability, I think it will prove to be an easy win as the economy gradually improves and loan demand picks up, while the cost base clearly has low hanging fruit, with cost-income at an eye-watering 72.4% in FY13. I think that worst case will be they can grow revenues with no cost inflation, realistic case is that costs actually fall as revenues grow.

In terms of what this improvement could be worth - I think that a couple of years out the good bank will be worth ~DKK 2bn, which woud translate to 0.8x book (where some of the domestic Spanish banks now trade, for reference), ~9.5x earnings:

Life Insurance

This business description will be very brief - I have little to say. I think that it is a fair business, no more, no less. The ROE is way below the non-life, maybe 7% over the cycle and there appears to be a bit less capital discipline (company have recently been out offering higher guaranteed payments, for example, to receyle some one-off gains). There is about DKK 800m of equity in the division - I would not pay more than DKK 600m for it.

Valuation.

I will paste my SOTP below and then go through line by line:

If we just look at 2016 for the sake of argument, to allow for some time for the earnings power of the bank to become more evident:

• Non-Life value ~DKK 5bn per analysis above
• Good bank worth ~DKK1.9bn per analysis above as revenues grow modestly and cost base is right-sized
• Life worth DKK 560m per analysis above
• Central costs capitalised at 10x earnings
• Excess capital (more on this below) adds a further ~DKK 1bn
• Translates to DKK 47.4/share, 77% upside

Excess Capital

The business requires DKK 2.9bn of statutory capital for its operations against equity (which is about equal to total capital) of DKK 4.5bn. For the sake of conservatism (i.e. to protect against further flare-ups in the banking book), they have an internal capital target of DKK 4.1bn. The total capital of DKK 4.5bn is thus in excess of the internal requirement. the company refer to this in the recent interim reports and presentations, for example on slide 18 of the Q114 presentation:

I think this is quite interesting and clearly hints that a dividend, either a special or a regular, is coming. I have asked the company on this. They say it has been discussed internally and, while they obviously do not commit to anything, certainly any net income they generate from here on out would be considered not neccessary for solvency. I would not be surprised to see a dividend started at DKK 1/share in the not too distant future. That would only cost the ~DKK 175m/year; they already have a DKK 450m buffer; they guide that the "forward-looking" activities will generate DKK 575-625m this year, with room for improvement in the good bank. I think that if they could initiate a dividend of this magnitude, it would send a strong signal to the market that the worst is behind them and that what remains is strong, profitable and inexpensive.

Conclusion

• Bad bank will continue to be a drag on group profits - headline P/E unattractive
• I think that long-term, internet penetration could force the non-life industry to revisit their business model in the worst case scenario
• Same management team that brought the company to its knees over the crisis
• No guarantee that the catalysts I hope for materialise