Description

Long Bawag (BG AV): Austrian retail bank trading at 1.2x TBV and 7x forward earnings (2020) with 10% EPS growth and 6.8% dividend yield with a target price of  €62 (~64% upside). High quality bank with 16-17% ROTCE, 43% cost/income ratio, and excellent management team. 

To note: The ROTCE, dividend yield and EPS figures include the impact of the 10.9mm share /  €400mm tender offer occuring at the end of November 2019

The market has mispriced Bawag because:

1. It is a European bank
2. It is relatively new to the public markets (late 2017 re-IPO)
3. Overhang fears regarding the Cerberus ownership position (25.7% as of two weeks ago). 

The European banking sector as a whole is - on the surface - incredibly cheap. In a world of negative yielding fixed income instruments, the consensus forward 12 month dividend yield for the whole sector is 6.5%. This yield was only seen previously in 2008/2009 and is at an all-time high when compared to local base rates of -50bps. Unlike other sectors such as utilities and REITs, this yield is not driven by 100% payout ratios, as European banks on average pay out a little over 50% of earnings. However, cheap obviously does not make for a good investment in and of itself and there are very good reasons for the market’s skepticism around earnings and payouts:  concerns about capital shortfalls (regulatory and NPL related), falling earnings due to flat revenues and rising costs, conduct/litigation charges stemming from the prior cycle, and poor governance / poor capital allocation decisions by many management teams.

We argue that Bawag suffers from none of these shortcomings, and as a result is the proverbial baby mixed up with the bathwater. Bawag generates excess capital each year, grows earnings, has limited NPLs (1.9% ratio), and has excellent management with a track record of shareholder-friendly capital allocation. We believe that as Bawag continues to execute, delivering capital return and earnings growth, the market will begin to reprice the security higher as the current valuation embeds an implicit belief that current earnings are not sustainable, let alone growing. The most relevant case study is Cembra bank (CMBN SW), which IPO-ed in late 2013 with a similar business mix (DACH region retail/consumer exposure) and required two full years of consistent execution before the market believed in the sustainable earnings model. After that point, the market re-rated CMBN’s dividend yield from ~6.0% to 3.6%. 

• Unlike other European banks, Bawag does not face any hits to capital from full implementation of Basel IV or TRIM. Particularly in banks with large investment banking operations and/or low risk weightings on commercial real estate loans, implementation of Basel IV would result in a capital shortfall for a number of institutions if the standards were immediately implemented today. Many european banks assume low probability of default and loss given default on certain exposures which gives them a low risk-weighting and high leverage. Basel IV embeds the concept of “output floors” which effectively limits the extent to which banks can apply low risk weightings. Therefore a number of banks need to increase their equity base on the same balance sheet to maintain their current capital ratios under the new rules - Basel IV effectively increase the denominator on the CET1 ratio for a number of asset classes. Bawag has 55% of its loan book on the standardized approach with much higher risk weightings and hence is unaffected by Basel IV pushing up risk weightings across the industry. The key for Bawag is that its returns on equity are driven by cost efficiency and a low cost/income ratio, not by huge leverage via low risk weightings on assets.
• Unlike other European banks, Bawag has demonstrated an ability to return excess capital to shareholders. Bawag generates around 240-250bps of regulatory capital per year, of which it has been returning 100%+ to shareholders. Bawag is the first European bank under the new regulatory regime to receive approval to purchase ~11% of the company via an open market tender, which will occur later this month.
• Unlike other European banks, Bawag’s net interest income is not dependent on corporate lending, where spreads have to compete with the unsecured bond market - and as a result are compressed due to the ECB’s bond buying program compressing all investment grade credit spreads.
• Unlike other European banks, Bawag’s management has actually shown prowess in cost cutting and operational efficiency, with the bank’s cost/income ratio dropping from 76% in 2012 to 43% today. Their cost cutting model has allowed them to generate high teens returns on tangible equity versus competitors earning 4-5% on the same net interest margins. Their cost cutting model has also proven extremely effective at generating earnings accretion on acquisitions.
• Unlike other European banks, Bawag’s management team is extremely interested in shareholder value creation and have personally purchased several €mm of stock out of pocket at current trading prices.
• The recent 13.5mm share secondary sale by Cerberus in early November combined with Cerberus agreeing to tender into the €400mm repurchase later this month below market prices (36.84) will finally clear up the overhang on the stock. 

We think a brief background of the company is helpful in illustrating why this particular bank is different than others in Europe.  Bawag was formed in 2000 from the merger of Arbeiterbank (“the workers bank”) and PSK (“post office savings bank”), two of the most inefficient public-sector unionized financial institutions in Austria. Cerberus Group took the bank private in 2007 and almost immediately had to restructure the bank, injecting capital in 2009. At some point in 2011, during the European financial crisis, legend has it that Cerberus told the Austrian government that it was going to walk away from the bank rather than inject additional capital. As the Austrian government itself lacked the means to recapitalize the bank given the sovereign debt crisis, it “allowed” Cerberus to pursue a radical cost cutting plan at the bank in exchange for providing additional equity capital in 2012. Heretofore cost cutting was widely seen as anathema politically and socially in Austria.

Cerberus realized that while it was nearly impossible in the Austrian context to pursue reductions in force in the Anglo-Saxon style, it was quite possible to partner with the bank’s Workers Council to buy out employment contracts. Basically, Cerberus would offer to pay three years of salary upfront to anyone who would voluntarily leave the bank, generally for an early retirement. While expensive in the first year, over time this program allowed them to reduce the number of employees per branch by up to 75% and prune unprofitable locations from the branch network. As the banking industry was in the process of moving to digital distribution of loans and savings products anyway, Bawag was able to keep 95% of customers while dramatically cutting costs: the cost/income ratio of Bawag fell from 76% in 2012 to 43% in 2019.

Today Bawag is by far the most efficient retail bank in Austria/Germany, generating a high-teens return on tangible equity compared to local peers at 4-5%. Bawag’s profitability is such that it has been generating around ~€400mm per year of excess capital compared to its market capitalization of €3400mm. The basic thesis is that Bawag’s extremely competent senior management team will put that excess capital to work for the benefit of shareholders. When Bawag IPO-ed in 2017, it first used capital to acquire a savings bank in Stuttgart for 0.5x TBV to expand their operating model to Germany. Of the 50% discount to tangible book it received in the purchase price, it utilized 30% to pay for employee buyout programs and has reduced annual costs by 20% in the first 12 months post acquisition. Bawag then pursued smaller bolt-on acquisitions to expand its consumer and SME lending product portfolio (building society mortgages, healthcare leasing, factoring) across Germany and Austria. In 2018 management was unable to find a suitable, accretive, large acquisition target and pledged to return that year’s excess capital to shareholders directly, which it has in 2019 via 220mm in dividends and a 400mm share repurchase program. We expect Bawag management to continue returning capital to shareholders while also pursuing organic growth and tuck-in acquisitions. 

Specifically we see organic growth in earnings coming from a variety of different sources: 

• 5% organic growth in Austrian home lending / mortgages
• 5% organic growth in Austrian auto leasing (product acquired in Volksbank leasing acquisition)
• Asset growth from factoring and small business leasing rolled out across customer base in Austria and Germany (BFL and Zahnärztekasse acquisitions)
• Increased fee income from securities sales / brokerage activity / wealth management at branches now that Bawag directs the customer interaction (previously managed by employees of the Austrian post). Bawag also recently acquired an Austrian roboadvisor, Savity.
• Growth in German consumer finance product
• Growth in Austrian consumer finance via retail partnerships agreed in 2018, launched in early 2019 - potential for 1000mm total loan portfolio originated via these channels over time
• Point of sale finance partnership with MediaMarktSaturn (#1 electronics retailer)
• Point of sale finance partnership with Metro Cash & Carry (#1 SME wholesale supplier)
• Financial services partnership with REWE / jö loyalty program (Bawag account holders participate in the leading food retail loyalty points program, increasing card usage and fee-bearing current accounts)

Why now? 

• The ECB actually granted approval for the €400mm share repurchase, the prospects for which had garnered huge skepticism by investors and analysts alike (to put it mildly) since the SSM had never approved anything like it in its history. The ECB apparently decided to build an entirely different stress testing model for the company before approval, and the whole process took around 12 months from start to finish. However, now that the model has been built it seems very likely that further share repurchases will be approved with a much less onerous process going forward. 
• Ever since the IPO, the market had viewed Cerberus as highly likely to sell its entire ownership stake at the earliest possible date, which created a significant overhang on the stock. These fears were confirmed when they dumped 9.3mm shares on the market in May in an overnight print at a 10% discount to last trade, spooking the market. After the early November offering and Cerberus’ agreement to participate in full in the tender this month at 36.84 (per the press release), that overhang should be cleared up.
• There was considerable skepticism at Bawag’s IPO in fall 2017 that their cost cutting model was sustainable, or that revenue growth would ever occur. However, management has steadily executed in the subsequent 8 quarters to establish the credibility of their model
• More capital return is coming next year:
• Management seems very confident regarding their >640mm pre-tax earnings target for 2020. Using the average effective tax rate of ~24% this would imply 486mm in net income
• 50% gets paid out in dividends in arrears (243mm / 2.76 per share)
• My estimate of ~80mm retained for consumer / SME asset growth to drive pre-tax profits increasing at 5%
• 163mm available for share repurchases (5% of shares outstanding at current prices) or acquisitions (IRR hurdle of 15%)
• With either acquisitions or repurchases earnings per share should grow in the high single digits to low double digits going forward (estimate ~10% on average)
• A comparable company would be CMBN SW - a Swiss consumer lender with high capital generation and high payout ratios, and which trades at 16x P/E and 3.4x TBV
• We are using an 11x multiple on 2020 EPS of 5.50 to reach the 60 price target. The 11x multiple is based off Belgian Bank KBC, which also has excess capital, a good payout ratio and is generally perceived to be high quality.
  • Over time, if Bawag continues to execute and return capital, there is likely multiple upside. Obviously if we are wrong on execution and capital return, there is not. 

Base case valuation: (RoE - g) / (CoE - g) with 15% estimated long-term RoTCE, 3% growth (real GDP +200bps), cost of equity at 9% or a target TBV multiple of ~2x on December 2019 TBV per share of €31 for a price target of €62. This implies an 11.3x multiple on 2020 earnings of €5.50 and 4.4% dividend yield, similar to KBC. We are implicitly assuming ROTCE falls to the low end of management targets and that long-term earnings growth misses their 5% goal. I am aware that USD based investors use 10% as a CoE given the higher USD rate structure, but if you are USD based then you can simply use a slightly lower multiple, purchase shares in euros, and sell the euros forward back to USD over your investment horizon to collect the extra return. 

Management case valuation (“über bullish” where they actually hit their targets across the cycle) - 16.5% longer term RoE, 5% growth or 2.9x TBV valuation (same as CMBN) for €90 per share, 16x 2020 P/E. This is not a valuation case we would expect over the next year, but is illustrative of the types of multiples that could happen if management continues executing on share repurchases and accretive acquisitions. They have shown an ability to turn 5% ROTCE businesses into 15% ROTCE business via cost cutting in both legacy Bawag and Sudwest bank - if this continues it’s an extremely valuable trait. 

Common pushback: 

Bawag needed equity injections in 2009 and 2012 - isn’t this a very risky bank?

The reason Bawag got into financial trouble a decade ago was due to the bank having a large exposure to risky securities - namely their ratings-based structured credit portfolio, which ended up having significant loss content (e.g. Alt-A, subprime RMBS). Like other Austrian banks Bawag also had exposure to low quality loan exposures in Eastern European countries. Today Bawag has none of those risks. Through-the-cycle risk costs company wide are estimated to range from 15-25bps, which is driven by the predominance of low LTV euro home mortgages (<60%), social housing, public sector and secured corporate loans in the portfolio which have limited loss content. Furthermore, retail loans as a % of GDP in Austria are among the lowest in Europe as the Austrian household balance sheet is healthy and exhibits a strong willingness to pay culturally. Bawag provisions around 40-45bps of loan exposure in its retail segment (60-66mm annually) on the income statement, which has been slightly overstated in recent years as Bawag has been selling charged off NPL portfolios at gains of 8-9mm on an annual basis in “other income”, implying that loss reserving on the income statement has been conservative. 

Other income / securities gains are not sustainable

There is some merit to this point, as the securities gains are effectively a bridge in 2019-2021 on the income statement while the consumer and SME loan growth initiatives described above (which started in 2018) begin to take effect. Given the 150bps compression in yield on Austrian government bonds in the treasury portfolio in the last five years, there appears to be massive unrealized securities gains in the context of multiple hundreds of million euros. We would expect annual securities gain on sale to decrease from ~75mm in 2019 to a much lower number over time as the organic growth from retail/SME replaces that income. To note, Bawag management is very confident about 5% pre-tax profit growth over time inclusive of lower securities gain on sale. However, if all of their growth initiatives and tuck-in acquisitions fail to materialize, then they will not reach their profit growth targets. We would characterize this risk as not that securities gains go away over some years (they will) but rather that management’s growth plans to more than offset the gains don’t come to fruition. If you want to exclude all securities gains from the income statement as “not real” to get a lower ROTCE then you should also gross up the tangible book value per share by the amount of unrealized gains, as the securities are held at cost on the balance sheet. In the current interest rate environment gains on sale should continue for a number of years to come. In an environment of rising interest rates gains on sale would go away but the bank’s rate sensitivity would kick in with +50bps of higher rates = +100bps of ROTCE / ~31mm. The rate sensitivity is nonlinear, as 100bps higher rates would be 100mm pre-tax profit in the second year (just FYI, we are not calling for 100bps higher rates). 

What if European base rates go even more negative? 

The current DFR for the eurozone is -0.5%. If Christine Lagarde decides to cut rates even further to the negative, then Bawag’s earnings would fall to the tune of -31mm pre-tax over 2 years for each 25bps incremental cut. However, further negative rates would also render the public savings banks system in Germany and Austria completely insolvent (Landesbanks, Volksbanks, Sparkassen), reducing competition and likely accelerating industry consolidation to Bawag’s benefit as a likely consolidator.  

“The Eurozone has to break up, I read about that all the time (on Breitbart, Guido Fawkes, etc)”

In some peoples’ minds a Eurozone breakup is a tail risk, for other people this is a high conviction outcome. Either way, you can hedge a long in Bawag with 4-5yr maturity Italian government bond shorts at 0%-0.5% yields as the weak link in a breakup scenario. If the Eurozone were actually to break up, an Italian default/redenomination is almost certain, and Bawag does not have any Italian risk on balance sheet. Depending upon one’s views, you could easily short multiples of an investment in Bawag to hedge existential Eurozone risk.

Catalyst

Dividends, share repurchases, and accretive acquisitions