Description

Note: This is my joining VIC case study. I am cognizant that HB doesn't meet size/liquidity and maybe geography characters for many members, but it still felt worth writing-up given what I belive is a highly favorable risk-reward. I usually am more of a large-cap investor myself and my next idea shall reflect this. 

Thesis

Hellenic Bank of Cyprus is the second largest bank in Cyprus, and the only one that emerged from the recent crisis largely unscathed. Today, Cyprus’ economy has largely turned the corner, and is in the early innings of a very strong recovery which should result in the bank’s earnings increasing considerably. There are today very few instruments to play Cyprus’ macro recovery, and certainly none that is as high quality and absurdly cheap as Hellenic Bank.  

I reckon sub 0.3x TBV / 3x normative earnings is way too cheap for a well-capitalised, well managed bank, with a strong shareholder base, who operates in an economy with such a strong potential for recovery.

It is also very clear why this opportunity exists – I can hardly think of a more forgotten, uncovered and orphan stock, and of a company that has been caught in the eye of the storm for so many years. Today, with many catalysts, the trend is inverting, and after years of bad performance, I believe Hellenic should be able to generate considerable returns for shareholders.

Cyprus

I will try to be brief as there are many public sources (stating the obvious, IMF reports are excellent reads, and both Hellenic and Bank of Cyprus have decent presentations available with a lot of background charts etc..), but understanding Cyprus’ macro situation is paramount here so a few words are necessary.

Cyprus is a small island in the Eastern Med, with < 1m inhabitants, and a member of the Eurozone. Cyprus’ economy has historically relied on i) tourism and ii) offshore financial services & shipping as it has an English-speaking highly-educated workforce, a strong rule of law (it’s an ex UK protectorate), a strategic position close to the Middle East and to Russia. As a result, Cyprus has known many years of strong growth and development, until the Sovereign crisis in Greece hit. Generally, the small absolute size and nimbleness of the economy brings to mind the speedboat vs. super tanker analogy i.e. when things get better (or worse) they can get much better much faster than expected. For instance, they are about to build a big casino to attract foreigners – in the UK no one would notice but in a 1m people economy these things matters. Importantly, they also have big deposits of offshore gas that are currently completely untapped but they ultimately will as they are high quality and reasonably cheap to get.

As a result of an oversized banking sector with excess deposits (offshore financial centre), a small domestic market and strong natural cultural ties with Greece, the Cypriot banks had very heavily extended in Greece, both lending to the sovereign but also establishing local branches there to recycle their excess deposits. When the Greek crisis hit and the Greek sovereign debt was restructured, the Cypriot banking system and the Cypriot government went bust overnight.

In 2013, Cyprus was forced to enter into a program with the EU and the IMF, and because of the size of the mess vs. their economy, and a political perception that it wasn’t fair for European taxpayers to bail-out Russian oligarchs banking in Cyprus, the two leading banks (Bank of Cyprus and Laiki, although NOT Hellenic) even had to bail-in part of the deposits and capital controls were imposed on the island. At the time, the perception was that Cyprus was in for a multi-year crisis, that the bail-in and the capital controls had permanently damaged its position as an offshore financial centre and that the country was essentially toast, with many even wondering if it could stay in the Eurozone.

Less than four years later, and thanks to highly enlightened policies of an extremely sensible and committed government that essentially slashed public spending instead of increasing taxes and did everything in its power to help maintain the competitive advantages of the country, the situation couldn’t be more different. Cyprus exited the bail-out earlier than expected, its economy has overshot the cumulative previsions of the IMF / EU by close to 10 points of GDP over 3-4 years which is extraordinary, unemployment has been declining steadily for more than two years, the fiscal situation is good and Cyprus is likely to be if not the, then amongst the strongest growers in the Eurozone for the foreseeable future with likely growth rates of around 3% that should be sustained for a few years. There are many similarities to Ireland with a 2-3y lag.

Overall, I can hardly think of any better example in the developed world (and in non commodity-producing countries) of boom-to-bust-to-boom. We are currently in the early innings of the second boom.

These 2 presentations have a few good macro charts:

https://www.hellenicbank.com/images/media/assetfile/9M%202016%20Results%20Presentation.pdf

http://www.bankofcyprus.com/globalassets/investor-relations/presentations/english/20170111-investor-presentation-london-listing_final.pdf

Brief Description of the Bank

Hellenic is the second largest bank in Cyprus, with a market share of c. 13% in deposits and c. 8% in lending.

It is the only bank in Cyprus that managed to escape the crisis without bail-in and without taking on state capital i.e. only through a series of private recapitalisations. It has always been seen as the “safest” bank in the country hence the high deposits base and a L/D ratio of c. 50%, which is an anomaly for banks in the region which usually struggle to attract sufficient deposits. In a context of low rates though, such a low L/D is a huge burden as excess deposits at the ECB are currently costing Hellenic c. 40bps.

The fully loaded capital ratio is c. 13.5%, safely above its minimum requirement of 10.5%, and as the bank is expected to be profitable going forward and to build capital, this should probably be close to the trough capital level.

Shareholders

Third Point, the American Hedge Fund, is currently with 26% the largest shareholder of Hellenic, followed by Wargaming (the company of a Belarussian online-gaming billionaire) with 25%, a local investment fund with 10% and EBRD with 5%. The shareholders are working constructively together to ensure the best possible future for the bank, and Third Point in particular has a very strong incentive not only to move the share price upwards but also to create a liquidity event for an eventual exit. In the context of Southern Europe, I would consider the governance to be extremely solid.

Earnings Recovery

Due to the crisis, and the resulting high CoR, Hellenic has been heavily loss-making in 2013/14 and is still expected to be marginally loss-making in 2016.

Going forward though, the normalisation of CoR should result in the bank being strongly profitable. CoR has been at 6-7% in 13/4, it has since then been around 2-3%, but should dip below 1% in the next 2-3 years as the strong macro recovery allows the bank to slowly work down their NPLs.

It is worth here mentioning that for its strong stock of NPEs (>50%) Hellenic’s cash coverage is c. 50% (i.e. above Cypriot peers with BOC, the biggest bank in Cyprus, being around 40%, and also above Spain/Italy at c. 45%, Ireland at c. 40% and Portugal at c. 35%), and including collaterals the coverage is > 110% (vs. 90% average in the Eurozone). Collaterals are largely real estate, and so the direction of the local real estate market is paramount. After years of decline, the current signs are encouraging here – prices declines have largely stopped and the volume of transactions have been growing very strongly recently, even though we are still way below peak. More often than not, price stabilisation and increase in volumes are the precursors of an increase in real estate prices. I note a recent Cyprus central bank announcement that resi prices have increased for the first time in 8 years QoQ in Q3 2016 (admittedly by 0.1%) which supports my sense that we’re at the trough. As it stands, even a moderate increase in real estate prices would be a huge benefit for Hellenic Bank as it would result in an increase in value of all their NPLs, and if it turns out the bank is over provisioned, then there would be a release of equity on top of the expected earnings power.

Worth mentioning here that the legal and regulatory environment, which was already reasonably solid for southern European standards has been improved greatly during the years of the crisis with a new insolvency law, new foreclosure standards and various tax incentives to help the resolution of NPLs.

The latest KPIs on NPEs are very encouraging – in the past 2 years, 25% of the book has been restructured and c. 90% of those loans are now serviced normally. Given the recent KPIs, it is reasonable to expect a strong and profitable decrease in NPEs in the next few quarters / years.

The other driver of earnings growth, which I see more as the ‘cherry on the cake’ would be for Hellenic to put to work their important liquidity buffer, that is currently costing them money. Cyprus is a small economy, so there are limited options available even though the company is currently punching above its fair share in the issuance of new loans. Other options would include international syndicated loans and shipping. The last option would be to return some of the excess deposits, which would at least generate some immediate savings, but the bank has so far been of the view that they would rather keep the option to find a more profitable use for those excess liquidities. I do not account for much on that front. Yet, with c. 2bn placed at the ECB currently, the annual cost is 8mm which at 5% of NII is ridiculously high. If as a thought experiment, this money was invested in southern European sovereign paper say at 3%, this would result in an earnings swing of close to EUR 60mm. Even more simply, an increase of interest rates would be extremely favourable to Hellenic Bank.

It is worth remembering that Cyprus is a very favourable market to operate in:

i)                    As a small, complicated and reasonably concentrated market, margins are very high. Customer spread at Hellenic Bank is close to 5% for instance

ii)                   The status of Cyprus as an offshore banking destination means that the opportunity of fees / other revenues is very high

è => In a normalised situation, Cyprus banks should be amongst the most profitable in the developed world

Valuation

Using conservative assumptions on the various elements of the P&L, most notably the CoR (am assuming around 1%), the earnings power of Hellenic Bank in 2018/2019 should be around 50/60mm EUR for a 8-9% ROE, which would mean the bank trading at c. 3-3.5x P/E.

As it stands, the bank is trading on slightly sub 0.3x TBV, roughly similar levels to much more challenged Greek banks, but below lower-quality although larger and more liquid peer Bank of Cyprus at c. 0.5x, and way below decent Portuguese, Italian and Spanish banks that trade around 0.6-0.8x.

For my 2-year base case valuation, I am assuming:

•         P/E multiples of 9-10x, i.e. average of European banks. The quality of the business arguably deserves a premium over time, but the small size and lack of liquidity deserves a discount
•          TBV of close to 1x, or a bank that should roughly cover its cost of capital
• è My 2-year TP is around EUR 2.75 for c. 200% upside

Whilst this is in my view the fair valuation potential, it is clear that the zinginess of the stock / orphan characteristic means that the shares can and are trading wherever. The margin of safety is intriguing however, as well as what I believe are tangible catalysts to get us towards fair value.

I am also considering a bull case whereby Hellenic Bank finds a smart way to exploit their important excess liquidity without requiring too much additional capital. In that node, net income could easily go towards 100m, a figure that they achieved before the crisis, and we are talking about c. 500% upside.

As this is a geared bank, one obviously has to brace oneself for total downside, i.e. in a bad scenario of a new crisis / recession hitting the island, one would have to assume close to 100% downside in my opinion. The good news is that we are just in the early innings of a very strong recovery after what has been the biggest crisis in living memory, and that the economy is now well balanced so all considered, I believe this scenario is rather unlikely.

In most in between / muddle-through scenarios with some negative news baked in, the starting valuation is such that it is hard not to imagine substantial upside. 

Catalyst

There are numerous catalysts for the shares to re-rate.

The first one, which prompted this write-up (even though I have been involved for substantially longer) is the recent listing of bigger peer Bank of Cyprus in London, which has essentially put the spotlight on Cyprus and highlighted how cheap Hellenic Bank is. As a result, the shares have had a small pop from insanely depressed levels. At the same time, and linked, a couple of small cap / specialist brokers have started to publish notes on the bank (Wood has a factually decent initiation report, and so does Axia of Greece), also helping to highlight a completely forgotten stock. Whilst this happened a month ago, I believe it was a necessary condition for the re-rating process to start.

Hellenic recently signed an agreement with a specialist debt management company, APS, and will transfer part of the loans to them. There are few details available at this stage and more will be communicated when this deal closes in a month or two, but on my understanding, this will allow Hellenic to benefit from more professional NPL management, as well as freeing up balance sheet resources /capital hence allowing them to make better use of their excess liquidity.

There are also two macro catalysts:

-          Cyprus should be awarded investment-grade rating again reasonably soon (i.e. most likely within 2017) which would allow it to enter the QE of the ECB. This has been well deserved for a long time and would lead into a rally of risk assets.

-          The potential re-unification of Cyprus would obviously be a huge catalyst as it would lead to insane growth opportunities for Hellenic Bank and a lot of focus on the country more generally. This is probably less likely than not but is distinctly possible in the next few months given the current state of talks.

Ultimately  - the good news is that one is fully aligned with Third Point, whose aim is not only to increase the share price but also to find a liquidity event. I believe it is likely that Hellenic Bank would enter transformative deals. It could either be acquired, one interest for the buyer being to tap into a large stock of unexploited liquidity, or it could itself acquire smaller less solid banks in Cyprus which would generate synergies at the same time as it would allow the use of the liquidity. There are too many potential iterations to analyse them all here, but by and large one would expect that any transaction would lead to immediate and significant upside from the current level, as well as presumably providing an exit liquidity event (i.e. whilst building a position in this might take some time, I think it is as likely as not that the exit can happen in one go)