Description

We submitted Grupo Financiero Galicia (“Galicia”) as a short in September 2018 (here). Given the significant change in circumstances following the unexpected primary election result on August 11 indicating the country will soon return to Kirchner/Peronist-era economic policy led by the Fernandez/Fernandez ticket, the new risks to Galicia from such policies, and Galicia’s decline in stock price, we are submitting GGAL as a new short idea. GGAL US (the USD ADR of GGAL AR, the Argentine listed security) was $23.69 when we first posted the short, down from a high of $72.88 on 1/18/18, and today it is $12.08. We don’t usually short stocks which are down 83%, but in this case, we think the case for a Galicia short is even stronger now than when we first posted it. While some of Fernandez’s statements are more reasonable and some are more radical, the Peronists’ history of allowing banks to earn money is terrible. There are potentially bargains trading at a discount in Argentina today, like utilities trading at 30-40% of rate base or IRSA at a 50% discount to NAV, but Galicia, which is poorly positioned for the future, still trades at a premium to book. Galicia is 1.6x P/TBV and has at least 50% downside from here.  

Background: Our prior post linked to above has context and history on the Argentine banks. Historically banks have traded at a high multiple of book value due to optimism for long term growth of the under-penetrated banking sector in Argentina. (Argentina’s level of deposits/GDP and loans/GDP is the lowest of any large economy in Latin America and is approximately half the level of some peers with reasonably similar GDP per capita like Chile, Brazil, and Colombia. This low level of credit/banking penetration is due primarily to the prior Kirchner administration’s distortionary banking policies and regulations. Argentina’s mortgage debt market which used to be 9.5% of GDP is currently 1.5% or smaller and optimists think should reach 19% or more to match Chile and Panama.) Additionally, the high inflation environment which has persisted for years/decades has made the banks’ nominal ROEs look high and P/Es look low (although real ROEs were either negative or low and inflation-adjusted P/Es were not low). For example, at the end of 2017 Galicia traded at a euphoric 4.9x P/B and peers Santander/BBVA/Macro/Patagonia/Hipotecario traded at 4.7x/3.7x/3.4x/3.8x/2.9x or a median average 3.7x. On the back of this optimism, the banks (Galicia, Macro, BBVA, and Supervielle) raised an aggregate $2.2B of capital through equity issuance at high multiples of book around 3Q17. These raises anticipated an expansion of the mortgage and lending markets which has mostly not occurred and now appears unlikely. Today the same peer banks trade at P/TBV of 1.1x/1.2x/1.7x/1.1x/1.7x or average 1.4x.   

Current Situation: In President Macri’s campaign for reelection against the combined ticket of Alberto Fernandez and Cristina Kirchner (“CFK”), markets and pollsters expected the primary (“PASO”) election to result in somewhere between a tie and the Fernandez/Fernandez ticket beating the incumbent by 2-8 percentage points. Instead, the result was a “landslide” victory for Fernandez who led by 15 percentage points. With such a wide margin, it is possible that Fernandez will win the first round of the election on October 27 (with either > 45% support or > 40% support and > 10 percentage points higher than Macri), almost certain he will win the second round if there is one, and likely also that Fernandez’s Peronist coalition party Frente de Todos will gain control of the house, the senate, and most of the provinces. (The Buenos Aires election was also a surprise with the moderate and popular Maria Vidal trailing Axel Kicillof, CFK’s former protégé, by 17 points.) The market’s optimism that Argentina would elect and then support a pro-market president and platform of economic reform and orthodoxy was misplaced; Macri will soon be the first non-Peronist to complete a presidential term since 1928.

Short Thesis: If Argentina returns to the ideologies of Peronism/Kirchnerism, the banks have more to lose than most other sectors and Galicia’s current valuation does not reflect the risks of a Fernandez presidency. The challenges Galicia and the Argentine banks will face in the short to medium term are:

1.       Asset composition / exposure to Argentine debt. Since it has been difficult for Argentine banks to lend they have kept assets parked in high yielding government debt. As of 2Q19, Galicia’s net exposure to government securities is ARS 159,626 which is 24.7% of total assets or 233.2% of tangible equity. Of this public sector exposure 81.2% is in Leliqs, 6.6% is in Botes, and the rest is other securities. Fernandez has said that in order to raise retiree pensions by 20%, “we’re going to stop paying the interest on Leliqs that Argentines are paying for every day.” He has also said that Argentina is already “in a virtual, hidden default.” Even the current government, in a last minute bid to shore up support in advance of the election, has proposed a “voluntary maturity extension” plus a postponement of interest payments on short term government debt. If this debt “reprofiling” eventually becomes more severe or becomes a default, given Galicia’s asset concentration in short term government debt, of which it owns several times more than it has tangible equity, it could prove very painful.

2.       Harder to keep up with inflation / negative real ROEs. Historically the periods in which Galicia has earned the most negative real ROEs were periods of increasing and of high inflation, for example in 3Q18 when inflation rose from 39.8% to 69.6% QoQ and Galicia earned a (35.4%) ROTE compared to historical average (4.1%). 2019E inflation estimates following the devaluation and the PASO are now 55%, up 15 percentage points from the estimate one month prior. The inflation estimate for August is +4.3% MoM. An extended period of high and rising inflation will make it harder for Galicia to achieve positive ROEs, which in any normal environment would be necessary for the stock to command high multiples of book.

3.       Capital controls and dividends. After capital controls were introduced in 2011, no bank made a major dividend until the Macri administration permitted dividends in 2016. Under CFK banks were only allowed to make dividends (which would include distributions to holders of the foreign-listed ADRs) with central bank approval, and given the onerous incremental capital requirements associated with requesting such a distribution (maintaining +75% additional regulatory capital), most banks just didn’t seek permission or made very small dividends from their non-bank subsidiaries. Under Macri, Galicia paid material dividends in 2017 and 2018, but now with the “extraordinary” capital controls instituted by the Macri administration’s Economy Minister Hernan Lacunza, banks’ ability to pay dividends to foreign investors without central bank authorization is already curtailed. It’s very likely that the capital controls Fernandez will put in place will be more severe and possibly indefinite so the outlook for future dividends from Galicia is grim. 

4.       MSCI EM Constituency. When Argentina was upgraded by MSCI in June 2018 from a “Frontier Market” to an “Emerging Market,” the upgrade drove a significant of passive index buying into large cap Argentine stocks. Galicia due to size and liquidity was a particularly large recipient and is currently the largest constituent of the MSCI Argentina index with 19% index weight as of July 2019. When MSCI was removed from the Emerging Market index in 2009 it was due to Kirchner’s capital controls, specifically the provisions of 1) a 1 year minimum period investments needed to stay in the country, 2) cash deposit required of 0-30% of investment, 3) a monthly maximum amount of repatriated funds, and 4) central bank approval to pay dividends. While the Macri administration’s initial description of current capital controls does not have these specific provisions (except for central bank approval of dividends for banks) it is possible or likely that stricter capital controls or other Kirchner policies will cause an MSCI review and eventual downgrade. The amount of index money tracking emerging markets is ~65x larger than the amount of money tracking frontier markets. An MSCI downgrade would create a significant amount of abrupt forced selling out of Galicia (potentially 23 days of volume) and the other banks, and all Argentine stocks, and represents a significant downside risk to holding Galicia through a Fernandez presidency.

5.       Interest rate caps, deposit rate minimums, and mandatory subsidized lending. During the last period of Kirchnerism, the government mandated specific banking regulations to limit bank profitability. In 2014 the central bank introduced a cap on interest rates for personal loans and car financing in addition to requiring central bank authorization to raise fees on banking services including savings and checking accounts and credit cards. Given the small mortgage market, personal loans and credit cards represented more than half of loans for most banks. Additionally the government mandated that banks made non-economic, negative real interest rate loans to small business and mortgage loans through government housing affordability programs. All these interventionist programs had the intended outcome of limiting banks’ profitability. If these policies return it would incrementally impede banks’ ability to operate profitability and competitively, and given the continuity of ideology in the Fernandez camp and Fernandez’s specific statements regarding banks’ current outsized profitability, it’s likely they will return in some form.

6.       Dollar deposit flight. Private sector dollar deposit outflows have been high since the PASO, for example decreasing by $7.6B to $24.9B between August 9 and September 3, although the outflows have slowed since. If private market dollarization pressure continues the banks’ peso-denominated deposits could be at risk as well. Given the recently instituted individual FX limit of buying USD $10k per month, there could actually be more dollarization pressure on individuals’ peso deposits than has been seen so far. Given the risks of inflation, FX devaluation, and public loss of confidence, banks including Galicia could find their low-cost dollar deposits and potentially their peso deposits at risk in a downside scenario. 

7.       Grim growth prospects. The thesis to be long Argentina banks at multiples of tangible book value has always been based on future growth. Although GDP contracted 2.5% last year and Argentina has already suffered a recession in the short term, I believe with Fernandez soon to take control of the economy, the prospects for medium/long term growth have become much worse. We already saw in the 2000-2002 and 2011-2015 periods the damage that Peronist/Kirchnerist policy does to economic growth and the policies being discussed by pro-Fernandez politicians recently – for example a proposal to force grain producers to sell their output to a centralized public entity and a proposal for “Agrarian reform” which means land redistribution – sound exactly as radical as CFK’s economic agenda last time. With such a radical and misguided economic agenda on the table I would not want to bet on medium/long term Argentine growth. The long-suffering banking sector’s prospects for growth have almost certainly been delayed at least four years if not longer.

Valuation: During the 2011-2014 period of CFK capital controls, Galicia’s market cap went as low as $700M vs. current $1.7B. In 2009, during the financial crisis and after Argentina was reclassified from MSCI EM to FM, Galicia’s market cap went as low as $235M. In 2001-2002 during the Pesification/default, Galicia’s market capitalization went as low as $60M. In that 2002 period P/TBV reached as low as 0.14x. Galicia 1) earns a negative real ROE and has for a long time 2) is likely entering a radical leftist regulatory regime with a history and current evidence of specifically targeting bank profitability and 3) has a very low probability of growing anytime soon. We can't see any good reason Galicia should still trade materially above book value given the risks it faces. It seems very likely that over the next twelve months as Fernandez takes control of the country, the news for Galicia and the banks will all be bad; during that period I think Galicia will trade to at least 1x TBV (37% downside) and likely lower.

The author is presenting the views of an investment firm that has a material position in the securities of the company discussed herein. The author is not otherwise affiliated with such company, including as an employee, director or consultant. The views expressed herein are provided solely for informational purposes and do not constitute an offer to sell, or the solicitation of an offer to buy, any security. The information provided herein is not intended to be, and should not be, relied upon as an investment recommendation in connection with any investment decision. The contents of this message should not be construed as legal, tax, accounting, investment or other advice. No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein by the author or its affiliates and no liability is accepted by such persons for the accuracy or completeness of any such information or opinions. The information and opinions contained herein are provided as of the date this message is originally posted. The author has not independently verified all information contained herein and has no obligation to update any of the information provided. The views expressed herein are subject to change without notice at any time and the author and its affiliates may trade in any manner in the company’s securities, whether consistent or inconsistent with the information provided herein, as they deem appropriate. Past performance of a security is neither indicative nor a guarantee of future results of such security. There can be no assurance that an investment in the company will be profitable or that the assumptions regarding future events and situations will materialize or prove correct.

Catalyst

Election, capital controls, MSCI, debt reprofiling.