Description

Issuer: BFF Bank

Price at publication (27^th September): €9.3

Target price: ≈ €15

Time horizon: > 3 years

Introduction

BFF Bank is a non-recourse factoring bank based in Milan, Italy. The stock was pitched by honeycreek back in August 2022, and I would urge you to read the original article as well as the interesting thread of comments attached to it. Although some overlap between the two articles is inevitable, the current thesis attempts to add some additional colour to the company’s history and the quality of the business, and also to provide some comments on the Strategic Update made last summer. Finally, I also recommend that for risk-averse investors (or just fixed-income investors), BFF’s 2027 bonds could be an excellent alternative to the stock.

Founded in 1985 as Farmafactoring by a group of pharmaceutical companies in order to facilitate the management and collection of receivables from the Italian Public Administrations (PA), it currently derives most of its profits from non-recourse factoring for the PA’s suppliers. This is a niche business with terrific economics, allowing BFF to regularly generate ROEs of +20%, making it one of the most (the most?) profitable banks in Europe. Since its IPO on the Italian stock exchange in 2017, the share’s performance has been 3.5x for investors and, as I will argue, the runway ahead is ample.

The key points of the thesis can be summarised as follows:

• Non-recourse factoring is a niche financial business with excellent fundamentals. Competition is low and, most importantly for a bank at this stage of the credit cycle, there is virtually no default risk. Although not necessary for the thesis to unfold, there are some additional tailwinds (e.g., higher interest rates, end of split payments) that could push BFF’s profitability to even higher levels than in the past.
• Although the stock is fairly well covered by the sell-side (10 analysts), it is less well known among the buy-side community. This makes sense, as its market cap is only €1.7bn. and the track record of the European banking industry over the past decade has been, to put it mildly, dismal. As I will argue, none of the ills that afflict the industry apply to BFF.
• The management team set out an ambitious set of targets for 2026 in its Strategy Update last June (see here), targeting earnings per share of 1.4€, cumulative dividends of 40% of the current market cap by then and returns on tangible equity of over 50%. The management team is not promotional and has over-delivered since the company’s IPO. Although I do not use any of these targets to value the stock, it is worth noting that the correct execution of the strategic plan could create significant additional value for long-term shareholders.
• BFF is cheaply valued. At €9.5 per share, the company has a market cap of €1.8bn., implying a P/BV of 2.3x and a P/E’22 of 7.5x. Given that BFF’s return on equity (ROE) has averaged 28.3% from 2014 to 2022, and that its residual/economic earnings (earnings after taking into account the cost of capital) per share have been growing at a healthy clip, the level of discount is too high to ignore it. A 10% discount rate and a (very modest) 2% future growth rate in residual earnings, assuming ROEs in the 28-35% range, would yield target prices of €13 and €17, respectively, implying equity returns of 13% and 16% in perpetuity.

Introduction to BFF’s history

BFF Bank is a specialized Italian lender based in Milan. The bank was originally established as Farmafactoring by a group of pharmaceutical companies in order to facilitate the management and collection of receivables from PA.

In 1990, the company started its non-recourse factoring activities in Italy, and in 2006 it was acquired by Apax Partners for an undisclosed amount (Apax would then sell its stake to Centerbridge in 2015). In 2013, Farmafactoring was granted a banking licence by the Bank of Italy (becoming Banca Farmafactoring), and in September 2014 it launched its online banking division with an online deposit account (Conto Facto), with the aim of diversifying the company’s funding activities and reducing its borrowing costs.

In 2016 the company pushed ahead with its internationalisation efforts by buying Magellan, a financial company operating in the healthcare sector in Poland, as well as in the Czech Republic, Slovakia and Spain. Although BFF already discounted some receivables in Spain and Portugal, this was the first step towards a permanent presence in other countries.

In April 2017, the company went public on the Italian Stock Exchange with a market cap of €800M, and in March 2019 it acquired IOS Finance, a non-recourse factoring lender in Spain, from Deutsche Bank. It is worth noting that BFF’s historical acquisitions (as well as the acquisition of DepoBank, which I will analyse in a moment) have been made at attractive valuations and have had a strong strategic fit. The management team has so far been disciplined in reinvesting capital and the overall returns on capital have not been impacted at all by the acquisition activity. It is worth pointing out here that BFF’s management team is highly professional, and the company’s corporate governance is one of the best in Italy.

In May 2020, BFF acquired DepoBank for €293M, its largest acquisition to date. DepoBank operates in the areas of securities services and bank payments and has, among other things, €143bn. in assets under custody and €7.5bn. in deposits. DepoBank brought with it two other businesses, security services and payments, with attractive business economics, but which are not analysed here due to their lower contribution to overall profits (less than 25% of profit before tax as of 1H’23). The goal of the acquisition was to diversify BFF’s funding sources and to move from higher-cost repos to lower-cost deposits. In this context, one of the objectives of the Strategic Plan to 2026 is to reduce the government bonds on the asset side of the balance sheet and to increase higher-yielding receivables, while reducing the repos financing these bonds for deposits. Overall, the size of the balance sheet is expected to remain stable in the coming years.

Finally, the company changed its name from Banca Farmafactoring to BFF Bank in 2021.

Deep dive into the attractiveness of the business

BFF's core business is non-recourse factoring for PA suppliers (mainly, but not exclusively, pharmaceutical companies). There are several ways to slice and dice BFF’s total addressable market, but one way would be to look at the total public spending and public investments in BFF’s relevant markets (mostly Italy, Spain, Portugal, and with a growing presence in Poland, Croatia, Czech Republic, Greece, and France), which was €964bn. in 2022. However, this grand total includes government items, such as social transfers in kind and public investments, that has not been historically relevant to BFF. Government intermediate consumption (think about drugs and other consumables) is, in my view, the relevant target market, and was €426bn. in 2022 (€115bn. in Italy). Using this narrower figure, the penetration of BFF in the Italian market was 5% in 2022, and much lower in other countries, so future growth is likely to continue as it is starting from a very low base.

The non-recourse factoring business is relatively easy to understand. BFF has two main sources of income. Firstly, BFF buys invoices from the suppliers of PA (think Pfizer) at a discount, also known as a “maturity commission”. This discount is based on the collection profile of the borrower and the Italian reference rate (so the higher the reference rate, the higher the discount). Secondly, BFF charges debtors (e.g., hospitals, municipalities, etc) Late Payment Interests (LPI) on amounts overdue more than 30-60 days at the ECB refinancing rate plus a spread of 8%, in accordance with an EU directive. Factoring is “non-recourse” because BFF assumes not only the (tedious) collection process but also the credit risk of the transaction. As we shall see, the credit risk has historically been negligible. 

The LPI is essentially a function of overdue receivables. BFF’s main KPI that captures the “delay” in the portfolio is the “Days Sales Outstanding” (DSO), which is basically the average time it takes to collect the receivables. Since LPI is a function of DSO, the higher the DSO, the better for the bank. LPI is often collected as part of settlement agreements with the debtors, whereby BFF waives a portion of the interest (historically not less than 50%) in exchange for a shortening of payment schedules. DSOs have fluctuated over time and have recently declined as a result of Covid’s stimulus measures, abundant liquidity and PA’s willingness to pay off receivables. In general, it is credible to assume that during economic crises, when government finances are strained, DSO will increase, providing a counter-cyclical buffer for BFF’s business model.

It is important to understand how LPI accounting works because it is the source of a BFF’s (small) competitive advantage over its competitors. Until 2013, the company had recorded LPI in its P&L when the interest was collected (cash accounting), in line with the Bank of Italy’s regulations. Since then, BFF has adopted accrual accounting, whereby it accrues LPI proportionally over time based on recovery assumptions (currently 50%) and an estimate of days to collection (currently 2.100 days). The Bank of Italy allows BFF (but not its competitors) to use this method because BFF has developed a large database over the years and can reliably estimate the parameters of its receivables portfolio. This is an advantage for BFF in terms of scaling up the business, as it allows earlier revenue recognition and is therefore more efficient from a capital standpoint.

With this introduction, why is PA factoring a good business? The main points can be summarised as follows:

• No credit risk. To give you an idea, BFF has had an average cost of risk of less than 10 bps since the IPO. And cumulative credit losses in its core factoring business have been €6.2M over the last 16 years.
• BFF has long-standing relationships with large corporate clients, mainly international pharmaceutical companies. Some of these relationships go back several decades. Some of these companies outsource their entire receivables portfolio to BFF as they no longer have an internal debt collection department. BFF has a long history of working with PA and has in-depth knowledge of payment dynamics and collection strategies. These long-standing relationships also enable BFF to onboard the same clients into a different geographical area when BFF decides to enter that area.
• Despite the attractiveness of the industry, universal banks do not fully participate because it requires a lot of (and increasing) specialisation, and the size of the industry simply does not move the needle for the big banks. Universal banks have their captive factoring business (and a small part of that is with PAs, the rest with private players), but cannot effectively go after late interest payments because of the potential reputational damage.
• The business benefits from robust economies of scale. BFF has the same number of counterparties as it did eight years ago, because (obviously) the number of hospitals and other PA in a country does not change very much. BFF needs a fixed-cost infrastructure regardless of the number of invoices processed. However, once the infrastructure is in place, the marginal cost of servicing a newly acquired portfolio of healthcare receivables in Italy (or Spain or Portugal) is zero. Given the fixed cost base and the dominant size of BFF, it will always have a competitive advantage in terms of pricing.
• Over the past 30 years, BFF has developed a proprietary database that allows it to accurately estimate of its DSO and credit risk. With better information, it has been able to be very efficient in the LPI collection process and achieve high recovery rates.
• LPI legislation is regulated at the European level and has been incredibly consistent since the European Union was founded. The European Directive was introduced in 2000, reviewed in 2011, and is currently undergoing a further review (no negative changes are expected). The fact that it is a European framework means that no individual country or no individual debtors can arbitrarily change the terms and that there is a degree of homogenisation between different countries.
• As discussed above, BFF can accrue late interest payments versus other peers.

But perhaps the most important reason is structural, and none other than the way in which regional governments are structured in several European countries.

First, there is a mismatch between centralised tax collection and decentralised public spending. This means that the entities that spend the money are not the ones that collect it. Secondly, the administrative complexity and inefficiency of the government is quite high in these countries. As BFF points out, if we take the number of entities as a proxy for the complexity of these markets, there are more than 20,000 public entities in Italy, about the same in Spain and more than 5,000 in Portugal (a supplier of goods to PA would have to deal with all these entities). Finally, national accounting matters, as these regional debts to suppliers are not counted in the overall debt-to-GDP ratio, so although it would make economic sense to repay all these claims (the Italian government has been able to price its bonds at effectively zero interest rates in recent years, compared with the +8% cost of non-recourse receivables), accounting “optics” prevent this from happening.

All of these reasons have translated into superior returns over time. The company was founded almost 40 years ago with around €0.25M of capital and its current market cap is €1.8bn. In addition, they have returned over €1 bn. of cash to the shareholders – of which €600M. after the IPO, around 75% of the IPO value has been returned to the shareholders.

One final observation may be in order. One might think that the external environment has been favourable for BFF, but it seems to me that this has not been the case for at least a couple of reasons. First, BFF is essentially a liquidity provider, so an environment with a lot of liquidity (and negative interest rates) is actually quite challenging. With positive interest rates and less liquidity, more companies simply find BFF’s services more valuable. Second, Italy introduced a split payment mechanism in 2015, whereby public entities, rather than suppliers, pay the VAT. The mechanism had the effect of reducing the euro amount of receivables, which is negative for BFF (with an estimated impact of 15% on volumes at the time, according to the company). The split mechanism will eventually be abolished (its cancellation has recently postponed), but there is uncertainty about the timing, so I do not include any positive impact from such a change in the valuation of the bank.

Valuation

Even after last years’ share price rally, the bank still trades at a very attractive valuation.

To frame the valuation inputs, consider the following. From 2013 to 2022, the bank grew total assets at a CAGR of 26.5%, total equity at 14% and the average ROE was 28%. Most importantly, this growth has been profitable, with residual earnings (earnings after the cost of capital) growing also at a healthy rate, at 23%. With such a track record, it is no wonder that the bank should trade at a respectable premium to book value, given its high ROEs. Moreover, if the targets of the strategic plan are achieved (in particular, the +50% ROE), we should expect rapid growth in residual earnings for the foreseeable future.

BFF’s historical metrics can give us a valuation range for the business. Using a discount rate of 10%, a modest residual earnings growth rate of 2%, and a 27.5% ROE on BFF’s equity of €751M. (or €131M of residual income annually), the equity value would be around €2.4bn., implying an upside of 36%, or €13 per share. At this price, BFF would trade at 3.2x P/BV and 11.6x P/E. On the other hand, if we assume in the bull case economic profits of €188M (corresponding to ROEs of 35%, well below the target set in the Strategic Update), the amount which I expect the bank to earn in 2023, the target price would rise to €17 per share.

For long-term investors, another (and, I would argue, more revealing) way of framing the previous analysis is to convert the previous assumptions into IRRs. In the base case, the investment should deliver an IRR of 13%, while in the bull case it would reach the mid-teens, highly attractive returns in both cases. Forward IRRs would be even higher if growth rates above 2% are assumed, an assumption I believe BFF will easily meet. As I did not have the use of tables, I would be happy to be of assistance to the readers with the calculations in case of need.

A quick note on BFF’s 2027 bonds

Finally, it is important to note that for risk-averse investors (or fixed-income investors), BFF’s 2027 bonds could be an excellent alternative to the stock. Currently, the instrument’s YTM is around 10% (in euros). If, after reading my previous observations, you think the bank will comfortably survive until 2027 but you are not entirely happy with the equity story, the yield on the bonds offers equity-like returns with much less risk – and volatility, if you happen to care about those things.

The bonds are perpetuals but given the costly coupon step-up in 2027, I expect them to be called for all intents and purposes (if you believe in the equity story, why would such a bank would need to borrow at +10% rates?). Although BFF’s leverage is certainly high relative to its peers (as some comments in honeycreek’s original article noted), the lack of credit risk, the credibility of the management team and the somewhat counter-cyclical nature of the business make me comfortable with the bonds.

Downside risks

• First and foremost, European governments drastically reduce their DSO.
• Italy goes ahead with the recently proposed tax on banks’ windfall profits (or other one-off measures).
• Changes in European legislation, affecting LPI (unlikely).
• More aggressive competition (unlikely as Banca IFIS and Banca Sistema, BFF’s main competitors, are either exiting the market or reducing their presence).
• Lower interest rates and quantitative easing (again).

Upside risks

• In the event of a recession, strained government finances.
• Higher for longer interest rates.
• Increase penetration of non-recourse factoring in government activities.
• Further geographical expansion (e.g., Romania, Bulgaria, Hungary).

Disclosure: We are long the equity and the bonds. 

Catalyst

No catalyst is expected.