|Shares Out. (in M):||189||P/E||0||0|
|Market Cap (in $M):||7,300||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
The market cap above is in US dollars. This is not a small cap. Let us also note that the Czech Republic does not appear in the dropdown for countries, so we picked something nearby that starts with the same letter. Thats a joke. Maybe somebody can fix that for me and make the world a bigger place on VIC.
Komercni Banka is the Czech Republic’s third largest bank by assets. It provides a complete range of financial services to both corporate and retail clients. Societe Generale is the majority shareholder with a 60% stake.
We had looked at this bank in the past, over 5yrs ago, and found it to be among the best banks in Central Europe. The bank is very well run, and historically very profitable (ROEs ~18%-20%), with an efficient cost structure, a liquid balance sheet and a proven track record in risk management. The one problem with this bank has always been valuation. Between 2000 and 2009 it never traded below 2.0x P/Bk.
Fast forward to today and the valuation of the bank is significantly lower, ~1.6x and 13x PE. But it immediately becomes clear why that’s the case: ROE has declined from high teens to low teens. Most analysts are cautious / neutral on the stock expecting depressed ROEs to continue. We think they are wrong.
Favorable Macro outlook:
The Czech economy is in great shape, real economic growth expected to be ~3%, which is better than most countries, especially in Europe.
Unemployment rate has been declining and is now back to the pre-crisis levels.
Government has announced an expansionary fiscal plan for 2017, but the sovereign balance sheet is very sound.
Central bank has indicated desire to remove the peg to EUR. EUR/CZK peg was introduced in 2013.
The only negative is Rates, which remain extremely low: negative yields. This may be near the end, as we’re starting to see signs of inflation picking up. Rising interest rates is a big part of the investment thesis for Komercni.
The biggest reason why interest rates are so low is the Czech Central Bank policy to peg the Czech Koruna to the Euro. This has basically resulted in the Czech Republic importing the ECB monetary policy, i.e. extremely low rates. Our expectation was that central bank would eventually have to let the currency float again to stop the economy from overheating and to keep a lid on inflation. This is now happening. In mid-April the central bank de-pegged the Czech currency from the Euro.
The removal of the currency peg is the first signal of a shift in monetary policy towards tightening. This makes sense based on the strength of the Czech economy. We expect the currency to appreciate and that interest rates will start moving higher. Komercni is positioned well to benefit from this.
The Bank: core earning power.
A simple analysis shows why ROEs have declined over the last few years: it’s the rates. Net Interest Margin has declined from ~3.2% in 2009/2011 period to 2.3% in 2015. This, again, makes sense because central bank rate have declined from 1% to 5bps over the same period. The country’s 10yr yield went from 3.90% to 0.50%, and the 2yr note is now yielding a negative rate of (-0.35%) vs. a positive rate of 1.8% in 2010.
Digging deeper into the asset yields, we were expecting to see yield compression on the asset (loan) side. However to our surprise, all was well there. In fact asset yields are higher today than 5-6yrs ago.
The problem is yield on deposits; in particular, Komercni has so much in excess deposits that it reinvests those in securities earning virtually nothing.
Another reason for decline in ROE is leverage: Komercni has taken down 10-11x to 9x. The company has one of the highest capital ratios in Europe, CET1 of 15.3%, with a target to be between 15%-16%. Also, this is all Tier 1 capital, i.e. equity.
Ok, now that we’ve clarified why ROE is lower, let’s see what would take for ROE to improve from here. We assume that capital ratios will remain elevated under the new regulatory regime. On the rate side, however, we think there is a very good chance that the Czech National bank does away with negative rates, paving the way to higher rates in the future. The key drivers of this would be, rising inflationary pressure, and continued strong economic growth. The central bank’s first move was to de peg the currency – now they are waiting to see how markets react before making a next move.
As such, we believe that today’s earnings and ROE are at depressed levels for Komercni, bar the beginning of an NPL cycle, which we do not expect and will address shortly.
In the table below I ran an analysis, whereby I normalize the Net Interest Income spread (% of tangible assets) back to where it was in 2009-2011 level. This is not such a heroic assumption, as it is equivalent to Central bank rates around 0.75-1.00%, and 2yr notes ~1.8% and 10yr ~3.5%.
Other assumptions include: ~150bps improvement in efficiency ratio to (43%), slightly higher leverage 9.2x (vs 9.1x last year). The result is a normalized Return on Tangible Assets of 1.6% (vs 1.4% in 2015), and an ROTE 14.9% (vs. 12.7% in 2015).
If we further assume growth assets of 5% annually for the next 3 years, then using the ROA/ROE metrics from above, we can estimate the Net Income that should be generated from those assets. (see the table below)
At the bottom of the table, you can see that using a 13x PE multiple (within its historical range), Komercni stock should be trading around CZK 1,200, or 25% higher than the current level.
On a P/Tbk basis, Komercni stock should trade at ~2.2x if ROE goes to 15%. Even on current TBPVS of CZK 514, that would put the stock ~ CZK 1,100. But remember the BVPS should grow at mid-to-high single digits annually.
Currency: in addition to the stock price appreciation, we expect ~5-10% appreciation in the currency (Czech Koruna).
The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing. The author will not undertake to supplement, update or revise such information at a later date. The author may hold a position in the securities discussed.
Removal of currency peg leads to higher currency, higher interest rates.