|Shares Out. (in M):||1,079||P/E||0||0|
|Market Cap (in $M):||8,598||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
Bank of Ireland hit the headlines in 2009 when, together with the other Irish banks, it ran into serious difficulties. It managed to lose Berkshire Hathaway, among other investors, a lot of money as its share price fell more than 90%. However, unlike the other Irish banks which were taken over entirely by the Irish government, backed by EU money, Bank of Ireland remained independent with the government shareholding never going above 36%. It was then recapitalised in 2011 by outside investors such as Wilbur Ross injecting €1.1Bn into it.
We believe Bank of Ireland is now a conservatively run bank operating the leading franchise in a highly consolidated market. Despite the recent run up in its share price we think the bank remains materially undervalued.
Bank of Ireland Group, which traces its history back to 1723, is one of the largest financial services groups in Ireland with total assets of €123 billion as at 31 December 2016.
The bank is organised into four trading divisions as follows: Retail Ireland, Retail UK, Bank of Ireland Life and Corporate and Treasury.
Retail Ireland offers a range of banking products and related financial services to personal and business customers including deposits, mortgages, consumer and business lending, credit cards, current accounts, money transmission services, commercial finance, asset finance and general insurance. It operates a distribution network of over 250 branches and c.1,750 ATMs in the Republic of Ireland.
Retail UK is focused on consumer banking in the UK. Its financial product offering includes savings, mortgages, foreign exchange, credit and travel cards, current accounts, personal loans and ATM services. The bank distributes its products in the UK via partnerships with the UK Post Office and the AA (Automotive Association) these partners provide customers access to c.11,500 branches and c.2,500 ATMs in the UK. The bank’s UK retail business provides diversification in terms of sources of funding.
Bank of Ireland Life offers a range of life assurance, pension, investment and protection products to the Irish market through the Group’s branch network, its financial advisors (direct sales force) and independent brokers.
Corporate and Treasury incorporates the bank’s corporate banking, treasury, specialised acquisition finance, large transaction property lending and corporate finance businesses, across the Republic of Ireland, UK and internationally. The division’s loan portfolio of €13.1Bn is split by activity as follows: 40% Non-property SME and corporate lending, 30% Property and construction lending and 30% acquisition finance.
Operating in a consolidated market
The Republic of Ireland has one of the most consolidated banking industries in the world. Prior to the financial crisis there were 10 large lenders operating in the country. Since the crisis several of these banks have either exited the market or been wound down. This has led the industry consolidating down to just three main players: Bank of Ireland, AIB and Ulster Bank who now account for over 70% of retail mortgage lending and c.95% of lending to SMEs.
Leading market shares
In its domestic market (which contributes c.80% of underlying profit) Bank of Ireland is either number 1 or 2 across all its principal product lines. The bank provides 1 in 3 Irish home mortgages and has greater than 50% market share of new lending to SMEs and the agricultural industry.
The scale advantage from having leading market shares is important because of the cost advantage it confers. Bank of Ireland, which is in the process of implementing a new core banking platform, expects to have a cost to income ratio of c.50% after the implementation is complete. This is 15 percentage points lower than a marginal player like Permanent TSB.
‘Sticky’ customer bases and lower cost of funds
Bank of Ireland funds c.90% of its lending activities from customer deposits rather than higher cost and less reliable wholesale funding.
Annual churn rates for personal and business current accounts of 3%-4% are amongst the lowest of any service industry (though churn rates for savings accounts are higher at c.15%). On the asset side of the balance sheet we estimate that the annual churn rate for the residential mortgage loan book is c.13%.
In addition, the bank is seen as a ‘safe haven’ in that it attracts deposits in times of market panic.
Any smaller competitor looking to take market share must pay up to attract deposits which increases their funding costs. The deposits they attract are also the least desirable as these are the customers who are tempted to switch by higher rates. If they are offered higher rates elsewhere in the future they are likely to switch again. The high cost of customer acquisition for smaller players makes it an expensive exercise for them to take market share. Our analysis of net interest margins across banking sectors shows that smaller banks typically earn net interest margins c.30% lower than the market leader.
Given Ireland is a small and heavily regulated market it is unlikely to be viewed as an attractive opportunity for global or larger regional banks and indeed the UK banks have largely withdrawn from Ireland post the financial crisis.
Assessing management is always a key part our investment process. This work is even more critical for banks because of the leverage inherent in their business model and the opaque but critical nature of lending decisions and underwriting discipline which are culturally dependent.
We believe management of Bank of Ireland to be conservative and very much focused on widening its moat by further reducing both operating and funding costs. Bank of Ireland has been aggressive in working its way through legacy issues from the financial crisis and restructuring its businesses to focus on areas where it believes it has competitive advantages.
Our due diligence on management and culture included speaking to former colleagues of senior management, property developers and buy-to-let investors. Examples of the feedback we have received are:
“I have worked with Francesca McDonagh [Bank of Ireland CEO]. She is excellent and had a terrific reputation at HSBC. The bank was really disappointed to lose her.” – Senior employee at HSBC
“I am in the process of raising finance for a new 4-star hotel. I did speak to Bank of Ireland with regards to funding the debt portion, but they didn’t really show any serious interest. For this project they would only consider funding at a maximum loan to value ratio of 45%. At this loan to value the project doesn’t work for me financially.” – Irish property developer
“I had loans with them and with Ulster Bank. My friends, landlords, who had hundreds of houses had loans with Bank of Ireland and with various other banks too. The banks all had what they called Relationship Managers whose job it was to sell us loans. But we all felt the only bank who really put some value on the relationship was Bank of Ireland. When the crash occurred, they worked with us to try to find an accommodation and so we worked with them too. Our conclusion was that during the downturn Bank of Ireland was the most reasonable and as a result they profited, and we were able to work through the downturn. I have no doubt they maintained more clients. The other banks only valued looking after themselves. They didn´t give a damn about the relationship, they were vicious in how they behaved. Put it this way - I still bank with Bank of Ireland and wouldn’t go near one of their competitors.” – Buy to let investor
Our analysis shows that Bank of Ireland benefits from durable competitive advantages. This gives us confidence in our ability to model future cash flows and therefore derive an estimation of intrinsic value. Our modelling is based on the following four key factors:
The first is how the loan book will grow over time. The bank’s loan book predominantly consists of retail mortgages. As such we have used long-term household formation projections as a basis on which to model growth. The Central Statistics Office forecasts Ireland’s long-term population growth at 0.7% p.a. The competitive advantages Bank of Ireland benefits from gives us confidence that it will retain its market share going forwards. It should therefore be able to grow its loan book in line with this rate.
The second driver is the net interest margin they earn on their loan book. Currently c.37% of depositors' cash lodged at Bank of Ireland earns virtually nothing. If underlying base rates increase Bank of Ireland is likely to continue to pay minimal interest on this source of funding (though there will be some switching of current accounts to savings accounts as interest rates rise). Management’s own ‘scenario analysis’ suggests that it would make an additional c.€140m for the first 100-basis point increase in base rates. In our modelling we are only assuming interest rates increases 100 basis points above current historic lows. If interest rates were to return to long-term historic averages the bank could be worth significantly more than our current valuation.
The third factor is estimating the ‘charge off’ going forwards for loans that will not be fully repaid. To estimate the percentage of loans that will not be repaid we have analysed how different types of loans i.e. residential mortgages, credit cards, property/construction etc. performed through past market cycles including the credit crunch. Even using charge off rates experienced through particularly bad credit cycles (cost of credit of c.65bps through the cycle) we still estimate there to be a sufficient margin of safety between our estimation of intrinsic value and the valuation currently being assigned to the bank by the market.
The fourth driver is ‘non-interest’ fee income that banks generate from selling insurance products, payment transaction fees etc. Since the financial crisis these very profitable revenue streams have come under pressure from regulators following scandals such as the mis-selling of PPI (in the UK) etc. One of the bear cases against banks is that non-interest income will continue to reduce. This may well happen. However, we believe this bear case argument does not factor in the weak level of competition in the Irish market. In our opinion the Irish banking industry will be able to recoup losses from reduced fee income by simply increasing interest charges to compensate. In addition, Irish banks have historically generated a smaller percentage of their revenue from fee income than banks in other countries. This is because of strict regulation in the Republic of Ireland regarding what fees banks could charge and introduce. For example, there are absolutely no fees associated with mortgages in Ireland. The only thing the customer pays is the interest on the loan i.e. there are no arrangement fees, early redemption fees etc.
Our modelling suggests that by 2020 (by which time the vast majority non-recurring legacy costs will have ended) the bank will be generating a free cash flow yield of c.10% on its current share price and earning mid to high-teens on tangible equity.
As a sanity check we always try to look at things from different angles to ask ourselves “do these numbers make sense?”. In this case we asked ourselves:
a) What is the profitability of the marginal players in the market if the leaders are earning mid to high teens on capital?
The shareholder capital that banks hold is essentially the same across the industry as regulators enforce minimum requirements that they must all adhere to. Therefore, what dictates the difference in the return on capital between the leader and marginal player is their relative income and cost differential. As discussed above the net interest margins that the marginal players in the industry earn are c.30% lower than the leading players. So, for the same amount of capital marginal players are generating c.70% of the income of the leading banks. Secondly their operating costs are up to 20 percentage points higher. They are therefore earning 40-50% less profit per unit of capital than the market leaders. If the leading banks are earning mid to high teens on capital, then the marginal players are earning high single digits.
At this level of profitability, we do not believe it is particularly attractive for new capital to enter the market and drive returns lower, especially as the Irish market is a small one with the total profit pool for the Irish banking industry currently c€2.5bn.
b) How does this level of profitability compare to historic levels?
Prior to the financial crisis leading banks earned returns on tangible equity in the 25-30% range. Following the crisis, regulators have forced banks to hold more equity as a percentage of loans to create a larger buffer against future losses. Today banks are having to hold up to 100% more equity than prior to the crisis.
In a hypothetical scenario in which the leading banks had been required to hold these levels of capital prior to the crisis their returns on capital would have been mid-teens which is in line with our modelling going forwards. Therefore, after adjusting for increased regulatory capital requirements our modelling is essentially assuming the competitive dynamics of the Irish banking sector to be little changed from those prior to the crisis. However, this is likely to be on the conservative side given the level of consolidation in the market.
Analysing the industry from these perspectives we believe provides reassurance that our modelling is sensible.
Areas of concern/risk
Investing in banks is of course not without risk. One particular area of concern is Bank of Ireland’s exposure to leveraged finance. The bank has a loan portfolio worth €3.8Bn of senior unsecured loans financing mid-tier private equity acquisitions. Our concerns are heightened by the fact debt covenants on Private Equity deals are being loosened and leverage ratios are being increased to (and even surpassing) levels seen just before the credit crunch.
To get comfortable with this area of their business we spoke to players active in mid-tier private equity including debt brokers and private equity managers. The feedback we received included:
“Bank of Ireland doesn’t do stupid deals.”
“Nobody is as disciplined as Bank of Ireland. Through the financial crisis their leveraged business performed very well”
“If I had to give a chunk of money to somebody to lend in this space it would be Bank of Ireland.”
The underlying performance of the business matches the feedback with default rates low at an average of c.2.25% over the past two decades. This business remained profitable throughout the financial crisis with default rates peaking at 6%, a level which is more than compensated for by the higher interest rates they charge on these loans.
Another area of concern raised by investors is that the bank’s current net interest margin (2.19% in 2016) looks high compared to historic levels (average of 1.97% from 1999 to 2016). However, we do not believe a comparison of current net interest margin with historic levels is a fair indicator of whether the bank is currently earning margins in excess of ‘normal’ levels. Firstly, in the past net interest income only contributed c.60% of total income vs. c.80% today, because of the reduction in fee income. As already mentioned we believe banks have made up for reduced fee income by increasing borrowing rates. Secondly the bank is less reliant on more expensive wholesale funding with a current loan to deposit ratio of close to 100% vs. levels which reached as high as 184% in 2006. Thirdly the market has consolidated post crisis.
The bank currently has a significant operational risk in that it is in the process of replacing its core banking platform. The bank is spending €900m replacing its antiquated 30-year-old Cobalt based system for an ‘off the shelf’ offering from Temenos. This is a four to five-year project which expected to be completed by 2020. Fortunately, Bank of Ireland has a ‘guinea pig’ in the Nordic based bank Nordea which has already completed a carbon copy of the Temenos installation project. Many the people who worked on Nordea’s Temenos implementation project have moved over and are now working on Bank of Ireland’s implementation. The move to this new banking system should have significant customer service benefits as well as helping to drive the reduction in operating costs.
In summary we believe that buying a conservatively managed, market leading bank which should be able to earn mid-teens returns on slowly growing tangible equity at 1x book value is a compelling investment opportunity.
Raising of dividend.
Winding down of legacy costs.