Description

Bank of Ireland (ADR: IRE) is one of the two dominant full service banks in Ireland and trades at a compelling valuation of only 9.4 times current year EPS (fiscal year ends in March) despite recently reporting 22% annual operating EPS growth (all organic) along with a bullish outlook statement. This valuation makes even less sense when considering that the country of Ireland has one of the most compelling long term growth stories in the entire developed world. For comparison purposes, the average European bank trades at roughly 10-11 times 2007 EPS and has good recent earnings growth but does not have the same compelling long term story. (I often view investments in banks as levered bets on the underlying economies in which they operate.) IRE is 20% off of its recent February high—my suspicion is that IRE will probably be well above this before the year is out, and you get paid a nice 4.4% dividend yield while you wait.

Why does Bank of Ireland trade at such a discount?

Three words: housing, housing, housing. The focus on mildly softening prices (from €310K in December 2006 to €301K in April 2007) and new completions has become a point of obsession and idiocy to the neglect of many positives. As a result of Ireland’s almost miraculous economic growth over the past 20 years, Ireland’s housing prices have increased dramatically, rising from an average of €85K in 1995 to €290K in 2006. The following link provides some wonderful 10-year charts graphing housing prices along with things like GDP growth and tax reform and square footage:  http://www.irishlifepermanent.ie/ipm/media/house_price/index_reports/  Investors are now worried that higher European Central Bank (ECB) interest rates (which will increase mortgage payments) will put stress on a lot of home-owners who have bought housing at the peak of a bubble. While it will probably be good if prices come down a bit or at least stabilize, I will attempt to lay out a number of macro reasons and company specific observations on why housing is not a concern and why IRE’s stock price is too low:

#1 Look what some of the U.S. housing/mortgage stocks did after the big sell-off in late February and March. They rebounded with a vengeance: WaMu up from $39 to $44; CFC from $33 to almost $42; MTB from $105 to $113.

#2 Ireland has virtually no subprime mortgage market and virtually all mortgages require full documentation. Most mortgages, as is typical of much of Europe, are based off of short term interest rates set by the ECB. (There might be a fixed period for 1-3 years.) The U.S.’s mortgage problems are exclusively due to subprime/Alt-A/low-doc issues. This difference should not be underestimated.

#3 Less than 10% of IRE’s earnings come from its Irish mortgage operations. At a recent Merrill Lynch conference IRE presented on its property and construction business. It is worth flipping through: http://www.bankofireland.ie/html/gws/includes/investor/pdfs/lynch.pdf. While there is no denying that the strength of Ireland’s real estate market has probably supported many aspects of IRE’s overall business, IRE is clearly a diversified, full service commercial bank with several earnings drivers beyond Irish housing prices and mortgages.  And rather amazingly, because of Ireland’s high GDP growth, most economists are still expecting mortgage origination volume to grow 10-15% in 2007 over 2006, despite the “housing slowdown.” While this is down from 20%+ growth of the last few years, this is still very solid growth. This is what the bears are shorting!?

#4 Ireland’s GDP has grown at an average rate of over 5% for the last 10 years. Projections for full-year 2007 are near 5.4% (and something like 4-4.5% in 2008), while some of the more bearish projections, based on a fairly gloomy housing forecast, are still projecting 3.9% GDP growth for 2007. Even the bear case is still fantastic within a global context, and the banks will be the beneficiaries of this. Despite this, however, the bears insist on shorting the stocks to below 10 times earnings because of a foolishly myopic view on housing.

#5 Ireland’s per capita GDP is a very surprising #2 in the world according to the IMF: http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)_per_capita . While Ireland’s ranking varies a bit by survey, it should be obvious that Ireland has become a very rich country almost overnight. The average home in Ireland costs about €300K. By contrast, the average home in the UK costs near £209K (€311K), but the UK’s average GDP per capita is only three quarters of Ireland’s, at $35K vs. $44K. Additionally, Ireland is part of the ECB system, which means its mortgage payments are based off the current 4% short-term rate. The Bank of England recently raised rates to 5.5%. So while Irish housing prices are comparable to the UK in nominal terms, it has lower financing costs and is wealthier per person. My bet is that Irish home-owners will be able to easily make their mortgage payments.

#6 The Irish government runs a fiscal surplus and will likely cut taxes (specifically the stamp tax, which is a sales tax on the purchase of housing), further boosting the ability of Irish homeowners to spend and make their mortgage payments. In addition to this, in 2001, the Irish government introduced Special Savings Investments Account (SSIAs), for which every Irish citizen was eligible. Basically, it is a five-year savings/investment plan that the government tops up by 25% through a tax credit. So, if you put €100 in, you will get €125 in 5 years. These plans proved to be extremely popular (particularly in the 2001-2004 era of low interest rates) with a total of 1.1M accounts opened and €16B invested (for an average of almost €15K per account or almost €4K for every person in the country). While much of these savings will likely be re-invested, they provide yet another cushion of support to Irish consumers and homeowners that require it.

#7 Ireland runs a trade surplus. This combined with the government fiscal surplus as well as the per capita GDP highlights how different Ireland is from a country like Spain, which has also had a remarkable economic and housing boom over the last ten years. Spain, however, has a fiscal deficit, the second largest trade deficit in Europe (UK is #1) and a per capita GDP that is just below the European average. Ireland is a star.

#8 Ireland’s corporate tax rate at 12.5% is one of the lowest in the developed world. (IRE’s consolidated tax rate is higher because of its UK operations.) This has encouraged substantial foreign direct investment. Intel, for instance, has its largest plant outside the U.S. in Ireland.  It has also become something of a haven for off-shore investments and tax planning. This low tax rate will likely continue future investment. All of the politicians (even the liberals) are very committed to the low tax/high-growth strategy because of its exceedingly obvious success.

#9 Ireland is experiencing a demographic boom. It has one of the youngest populations in Europe (34 is the average age vs. 40 for the UK and most of mainland Europe—Italy and Germany are near 43!). It also has an open immigration policy, similar to the UK’s. There are lots of Polish plumbers and Eastern European workers. (Ireland’s unemployment rate is 3.5% so it can use all the extra workers it can get its hands on.) Ireland’s population is growing at about 1-2% per year and because it has such a young population, the work-force is growing at a very robust 4% per year. People entering the work force contribute to GDP and eventually buy houses. With such strong demographic trends, time is certainly on the side of the Irish banks. If Ireland were the 51^st state (and in many respects it is, given its close relationship with the U.S.), the banks would trade on valuations similar to those in Texas and Florida—15-18 times.

#10 At least part of the softness in housing prices this spring was due to the national elections. (Bertie Ahern won his third election on May 24th.) Both candidates and parties were talking of cutting or reducing the stamp tax, which is a sales tax on the purchase of housing that can be as high as 9% of the purchase price. While the effect is difficult to calculate, would you really want to buy a house if the politicians were clamoring about cutting the sales tax? Of course you would defer your purchase. This likely reduced demand temporarily. A preliminary version of the bill was released on June 20 effectively eliminates the stamp tax for all first time buyers and will be retroactively applied to any purchased made since March 31. (The tax is currently 3% of homes prices from €317K -€381K, 6% from €381-€635K, and 9% on anything over €635K.) A key advantage of Ireland’s small size and cohesiveness, is that the government can, if necessary, respond very quickly and effectively to changing economic conditions as we are seeing now.

#11 On June 17^th, the Department of the Environment (government agency that keeps statistics) published its results on housing completions for May and also provided a very interesting adjustment to its 2006 numbers. It turns out that because of the extraordinary amount of building activity that was going on in late 2005, about 5,000 of the completions were more or less booked in the first half of 2006 when they were actually built in 2005. Adjusting for this, housing completions are actually up 2.6% through the first 5 months of 2007. This is remarkable, particularly considering all of the election rhetoric regarding the stamp tax.

#12 On June 21, competitor Irish Life and Permanent (see below) released a business “trading update” and raised 2007 EPS guidance from mid-teens growth to high teens. The strong performance was driven by their life/pension business, but their banking operations did just fine.

Peers

Almost all of what I write about IRE, applies to the other market leader, Allied Irish Banks (ADR is AIB) which we also own. AIB is slightly more complicated, however. Through historical circumstance, they have a $3B stake in New-York based M&T Bank (MTB), which at 17 times Q1/07 annualized EPS is a good stand-alone short, but works out as a decent partial hedge to being long AIB. AIB also gets about 10% of its earnings from its majority ownership in a Polish bank, which happens to be publicly traded. AIB (and many others) is very bullish on the potential in Poland, which still has a very low penetration of mortgage and financial products and a population that is about 10 times the size of Ireland’s (39M vs. 4M). It presents a rather ideal scenario as AIB can seamlessly invest the excess capital generated from the Irish operations into its rapidly growing Polish operations. If you deduct AIB’s stakes in MTB and the Polish bank (both are publicly quoted), you get the rest of AIB’s core operations for about 9-10 times 2007 EPS.

Anglo-Irish Bank is the third large Irish bank and they are probably also a decent buy at current prices, but they are a specialized commercial property lender. They are also something of a cult stock, trading near 13 times earnings, much higher than its Irish peers. They also have fairly extensive operations in the UK and the U.S. (focused in Boston but rapidly expanding) where for instance they are financing the high-rise in Chicago that might become the world’s tallest building. That makes me nervous and so we’re on the sidelines. However, there is no denying that Anglo-Irish is supremely well run, but my fear is that their large ticket lending will eventually lead to tears. There is no ADR. The ticker is ANGL.L.

Irish Life & Permanent is the smallest, with a €5.2B market cap. Half the company is devoted to life insurance, asset management, retirement planning (“asset accumulation”), which is a very good business, comparable to what Principal Financial Group here in the U.S. does. The other half is a plain vanilla banking operation focused heavily on residential mortgages. It is a good company that will do well over the long-run, but there is a bit of skepticism about its heavy focus on mortgages. They are definitely perceived as less sophisticated than their larger peers. The stock trades at 9.4 times 2007 EPS. (I recently visited the CFO’s unimpressive office and it looked like nothing had been changed in 20 years despite the company’s substantial growth and success—they certainly aren’t spending a lot of money on extraneous expenses like nice desks and corner offices. I actually like this—it sounds similar to Buffett’s set-up.) There is no ADR. The symbol is IPM.L. The stock is 22% off its recent February high and because of its smaller size has been the target of take-out speculation, although they just announced a new CEO this spring, so nothing is likely for at least a few years. Given the smaller size and current interest rate/financing environment, I think they could go for a 20 PE take-out multiple. The stock conceivably could be a triple in 4-5 years.

A basket investment of these four names makes sense. If I had $10 to invest, I would put $3 in IRE, $3 in AIB, $2 in ANGL.L, and $2 in IPM.L.

Short-term catalyst

The following is speculation, but I think it makes sense. While it is currently a mess, eventually ABN Amro will get bought and I think RBS will win. It is almost a $100B deal and over 80% of it is in cash. What will the former ABN Amro investors do with their $80B cash windfall? My suspicion is that much of it will get reinvested back into European banks. The Irish banks because of the low valuations and great long-term growth profiles are a natural investment. They only need a few billion of the $80B total to spark a substantial rally in the shares.

Long-term catalyst

While the CEOs of both IRE and AIB have made it clear they want to stay independent (justifiably given the outstanding results) , I think it makes sense for the Irish banks to eventually be part of a pan-European bank. Perhaps we could see deals in 3-5 years. The CEO of UK-based HBOS has been rumored to be interested in buying IRE—if it were for sale. If ABN Amro, a poorly run franchise in mediocre markets, can go for 15 times earnings, I think the Irish banks could get something near 18 times. Obviously this is fairly far off into the future, but European banking consolidation will continue.

Risks

Irish housing market collapses.

Competition is pretty intense (as it is pretty much everywhere in the world), but Ireland has enough growth to go around. As the market-share leaders, IRE and AIB have some degree of pricing power and have proven effective at deterring foreign banks from coming in with loss-leading/teaser-rate campaigns. Net interest margins will probably continue to trickle down (as they have been), but this should be more than made up for in volume and fees.

Recent Results and Valuation

IRE recently reported operating EPS of €1.45  per share, up 22% YOY, based on robust 13% revenue growth and 6% op/ex growth. The growth was broad-based across their four divisions: their core retail Irish operations (41% of profits) were up 27%; capital markets profits (34% of total) were up 21%; UK operations (26% of profits) were up 26%; and life-insurance/pension profits (9% of total) were up 10%. In addition to the broad revenue growth, IRE had also materially beat on a cost-cutting program, delivering €95M of cost savings against a €75M target in the fiscal year just finished. Management believes there is another €55M they can cut in the current year, thus achieving €140M in total savings, 20M ahead of their original target. Upon releasing its year-end results, management issued an outlook statement that noted “economic conditions in our major markets remain positive and supportive of business growth…. We are guiding a low double digit percentage growth in underlying EPS.” The sell-side has dutifully obeyed and is projecting 11% earnings growth, or €1.61 per share, which puts IRE on 9.4 times current year consensus earnings.

It should also be noted that reported EPS was actually €1.77, well ahead of operating EPS, primarily because of some property sales. While these sales aren’t core earnings (they had gains the previous year as well), we shouldn’t completely ignore the fact that IRE likely owns a lot of property that is substantially understated. And the gains do add to book value. IRE trades at only 2.4 times stated tangible book value (€6.71 per share) despite earning a 28% ROE on average equity over the past year. IRE’s capital ratios also improved over the year (the Tier 1 ratio improved from 7.3% to 8.2% and the equity/assets ratio improved from 4.8% to 5.2%), leaving room for a potential share buyback. While Europeans don’t approach share buybacks with the same philosophy as Americans, we think a share buyback is one of the smartest things management can do right now—we and others are encouraging them to look at this option given the sharp decline in the stock.

While the past year’s results are particularly impressive, Bank of Ireland has been a solid long-term grower, with operating earnings up nearly 60% from 5 years ago and up over 400% from 10 years ago. The shares are currently only about 20% higher from 5 years ago despite this track record and Ireland’s continuing long-term advantages.

The stock is still trading 20% below its recent February peak despite reporting excellent results, a generally bullish stock market, and continued European banking consolidation. My suspicion is that IRE will be well above its previous peak before the year is out.

The stock also carries a healthy 4%+ dividend yield, so you get paid while you wait.

And please forgive me, but I am going to opine a bit on the large valuation gap between fixed income investments and equities. Short term interest rates in Europe are currently 4.00% and most fixed income investments are yielding 4-6% pretax.  On the other hand, we have blue chip equities like IRE trading at less than 10 times after-tax earnings (that is an earnings yield of 10-11% with a dividend yield of 4-5%) despite a very long history of strong earnings growth and structurally sound reasons to believe that the Irish economy will continue to grow at a rapid rate for the next 20 years. The valuation gap between asset classes is significant.

In conclusion, how can Warren Buffett buy/own Wells Fargo (PE of 12.8, 9% EPS growth), US Bancorp (PE of 12.5, 3% EPS growth) and M&T Bancorp (PE of 14.8 and EPS growth of -1%) and not consider the Irish banks, which have both better valuations and growth profiles, solid managements, and are large and liquid? I’m serious-- someone please give him or Charlie a call.

Catalyst