Description

Pareto Bank (PARB NO Equity)

Thesis summary

Pareto Bank is a quality niche bank with a good track record and is led by a solid management team. I think it's trading at unreasonably low multiple. Through focus on markets with limited competition and very efficient operations, PARB should be able to deliver strong and growing results. Project banking is not the highest quality business in the world, but some organizations are able to do it well and earn a good return over time. 

The biggest risk for PARB is a severe slowdown or crash in the real estate market in the broader Oslo region, as it would lead to elevated loan losses and weak new business generation in PARB's most important lending segment. I think that a crash is unlikely (discussed in more detail below), and that this risk is therefore adequately priced in at a market valuation of <7 x EPS and 1x book. This risk is in my opinion the main reason PARB still trades at these levels despite its successful history and increasing profitability over time.

While I don’t count on significant earnings growth over the next couple of years precisely because I think the development activity in PARB's local real estate market will be lukewarm, I still think today's price offers a good company at a very attractive price and that PARB will offer decent earnings growth over time. Given the valuation, returns to shareholders over the medium term should at least be around the mid-teens ROE I expect the company to produce.

The business

Pareto Bank is a well run project bank operating in Norway. It is led by a great CEO and a strong management team in general. It’s extremely cost efficient and has a track record of consistent profitability over the last ten years (it was listed on the main Oslo exchange in 2016 but has operated since 2008).

PARB in its own words specializes in complex project financing, with historical emphasis on real estate financing, in particular residential development. This area also has the highest interest margins. PARB has five diffferent business areas, but mortgages are not a focus area going forward (the bank issued mortgages, mostly to Pareto Group employees in its infancy) so we can expct that to stay flat. The other areas ranked by size are: real estate development, corporates (the fastest growing area currently), shipping and offshore loans and securities financing. The last area is not a focus area going forward either, and I think we can expect it to shrink over time.

A growing and very interesting business area, on average almost as profitable as real estate in terms of margins is corporate loans. This is mainly various forms of bridge financing or transaction financing for SME corporate clients(M&A, MBO, LBO), a market that is currently underserved by the bigger banks who are better served by focusing on the bigger clients out there. PARB is also launching a new product that I find interesting, "Fleksibel Driftskreditt", described as follows:

• “Fleksibel Driftskreditt” is a credit facility based on receivables as collateral
• Easy to use, flexible and with transparent pricing
• 100 % digital application and on-boarding process with short response time
• Integration with leading cloud based accounting systems in place
• Credit rating model based on public data and real time accounting information
• Superior risk management due to real time accounting information 

In the Nordics and especially Norway, smaller companies have few options when it comes to financing if the big bank won't help. This is a very big and untapped market, and while PARB is not alone in building a digital solution with receivables as collateral, it could perhaps be a quite meaningful revenue contributor over time. A pilot program has started, and PARB claims to have a prospect list with 2195 names on it already. It will be marketed more actively starting in H2 2018. Over the long term, I expect the corporates business area to be a much larger part of PARB’s lending book.

Shipping and offshore financing is a small area today but should grow over time depending on market conditions. It has deliberately been kept small over the last few years due to uncertain and weak shipping markets. This, however, is a market with very limited competition in the SMB space (Nordea is big in the big shipping client segment, otherwise, most of the bigger local banks are not going near new shipping and offshore projects if they can help it – at least for now). The company feels they have an increasing number of interesting projects to consider.

Overall I feel that PARB should be able to grow its loan portfolio at a moderate rate going forward (assumptions by segment shown in the valuation section). 

PARB’s secret sauce

What makes PARB special and highly profitable is the combination of excellent project banking skills combined with is a very low cost model. A cost ratio in the low 20s and high employee productivity (PARB consistently makes a net profit of >8m NOK per head per year) is possible primarily because client concentration is pretty high. Obviously this increases risk, all else equal and means good judgment on the part of PARB’s employees is imperative. This seems to be the case. They are very selective in terms of projects they choose to finance, and they have been running this model for over 10 years and have had very low loan losses historically. They’re famous for extreme attention to detail such as very strict pre-sale requirements and follow up procedures like detailed on-site inspections in their real estate lending business for example. PARB lists the following as examples of how they manage credit risk in their real estate lending business:

• Presale requirement: if the price of unsold units falls by 50 % compared to the price of presold units, the sales amount must still be sufficient to cover the bank credit 
• Presale quality: end-users are assessed and qualified 
• Liquidity: Tight covenant setting with respect to working capital, liquidity buffers, liquidity reporting
• Equity: 20 % to 40 % equity contribution to finance a property lot purchase
• Restrictive attitude towards financing of projects with long-term exits
• A high natural turnover rate on loans is in general risk mitigating 

Anecdotally, I work for people who have done a fair bit of small scale real estate development in the Oslo area, which is PARB’s biggest market. They prefer not to work with PARB because they have long standing relationships with other banks and can fund themselves cheaper elsewhere (not an option for a lot of smaller players with smaller balance sheets), but their experience with the people at PARB has been very positive nonetheless even if a business relationship didn’t materialize. I’ve also met with CEO Tiril Villum and other members of the management team on several occasions and been impressed each time with how hands on they are – for example, the CEO seemingly knew every detail of every problem loan in the portfolio. It’s a small and very flat organization, which seems to have made a strong corporate culture possible.

PARB’s main competitive strength is the flexibility and speed with which it can serve its clients, it does not mainly compete on price. This is reflected in the high and stable interest margins over time. That flexibility and efficency is also why PARB sees a lot of repeat business from clients. Pareto Bank also likely draws on the collective expertise of the employees of the Pareto Group, which provides good insights into the markets in which they operate (the biggest shareholder in PARB is Pareto AS, controlled by Svein Støle. He is the majority owner of the Pareto Group which encompasses a large international brokerage, ship-and offshorebroking, wealth/asset management and insurance brokerage). You can read more about the Pareto Group here: https://pareto.no/resources/pareto-as/arsrapporter/engelske-versjoner/Pareto_AnnualReport_2017_WEB.pdf

Funding and capitalization

The bank is well capitalized vs regulatory requirements with a CET1 ratio of 16.2% as of Q2 2018 (req: 15.1%).

Valuation

I've assumed moderate overall growth rates in the loan portfolio in 2019 and 2020 and a slight weakening of interest margins and an increasing cost/income ratio from 20 to 22% to be conservative. On the other hand, my loan loss estimates are fairly low, but it seems unlikely that they'll be much higher in a base case scenario.

The bank currently trades at 7x EPS and 1x book. I think that’s too low for a bank of this quality, even if it is small and relatively illiquid and there is a risk of a slowdown in the real estate development segment (growing at a very good pace year to date, though). It should also be noted that PARB has historically traded at low multiples, on average not far from current levels. But undeservedly so in my opinion. A consistently profitable bank looking at future ROEs in the mid-teens should not trade at 7x EPS. A more reasonable valuation is at least 10x EPS.

One could also argue for about 1.5x book as a more proper valuation, given its high return on equity and decent long term growth prospects. This would yield a somewhat higher fair value in 2020. (The theoretically correct P/B multiple is given by (ROE-g) / (DR –g), where my inputs are ROE = 14% (= the 5 yr average), g = 3% and DR = 10 %, I then rounded the multiple down to 1.5x). 

Estimating a bear case with any precision is difficult, but I have chosen to use my estimate for this year's ending book value and cutting that in half. In a bull case scenario, I use my base case estimates for 2020 EPS, but apply a 12x multiple.

My p-weighted fair value estimate for 2020e is 56 NOK, including dividends. 

 A 56 NOK fair value by 2020e implies a CAGR of about 15% is achievable here in that timeframe.

Risks 

The biggest risk to the thesis as I see it is a real estate crash/major price correction in the Oslo region. As long as the housing market doesn’t crash or permanently flatline, PARB should be able to grow its most important segment at at least low to mid-single digits. Without it, overall growth will be tougher (I’m only assuming a 3% growth rate in real estate lending in 2019 and 5% in 2020 though, these aren’t high hurdles for PARB in my opinion).  

A real estate crash would be a real issue, both because loan losses would increase a great deal, but also as new development activity would fairly quickly grind to a halt. For a bank with relatively high customer churn (this also mitigates single project risk somewhat though), this would hit hard in terms of generating new business and could lead to a shrinking portfolio in this segment. Observed negative signs that may indicate a worsening of business conditions for PARB include local new home sales having slowed down yoy, a higher number of unsold new homes than usual currently and a planned interest rate hike by Norges Bank in September. Note however that this is not news, and that PARB grew its real estate loan book briskly in Q1 and Q2 of this year in spite of these signs.

So will we see a crash? 

Reasonable arguments for a major downward price move in Oslo housing can be made on the basis of either demand side arguments (debt levels are too high, and Norges Bank will soon raise rates), supply side arguments (too many homes are being built) or a combination. Let's examine them in a little more detail.

Starting with the demand side, affordability is key. How affordable is housing in Oslo today? Not that bad. Average floating mortage rates here are at only about 2-2.25% now. With 23% of interest payments tax deductible and 2% inflation or so to boot, households are paying very little to borrow. So even though real estate prices have increased a great deal in Norway for a long time, housing is still pretty affordable for most people as measured against people's disposable income. Wage growth in Norway is estimated to be somewhere between 2 and 3% in 2018 depending on who you ask.

It should also be noted however, that while the cost of borrowing is low, the total debt load to income for an average household has risen a great deal to 222% on average for Norway, and it is probably much higher in Oslo (I can't find good average figures, but 15-20% of households in Oslo have more than 5x income in debt, a segment dominated by younger homeowners while many older borrowers have little or no debt) and new legislation for the Oslo region now limits new loans to 5x income. I think on average, total debt loads probably can't be increased very much from here for many local borrowers, so there will be no "credit impulse" to speak of for the real estate market in the short to medium term in my opinion. . 

On the supply side, there are also some disturbing signs in the short term, such as new home sales being down year on year and there being an above average supply of new homes coming to market in 2018 and 2019. However, when looking at projected supply vs population growth (source: SSB) on a longer timeframe I find that the market looks reasonably balanced a few years out (table below). Combining estimates of the total Oslo market completions from major developer Selvaag Bolig's (SBO NO) Q2 2018 presentation with population growth estimates from SSB (Statistics Norway), I find that there will probably be an oversupply of housing in 2018 through 2020, but a cumulative undersupply of housing looking out to 2022. Selvaag estimates 3650 new homes delivered in 2018, 3900 in 2019 and only 2500 in 2021. (After that I assume deliveries in line with the 10 yr average of 2800 new homes per year). Selvaag estimates 4500 homes are needed each year in the medium term to cover demand. I estimate demand based on the ssb.no population growth numbers. Anyway, these supply of new homes numbers have to be adjusted for demolition of existing housing etc, which constitutes about 5% of new homes on average. The estimated additions net of those effects are shown below. As you can see, the market should become fairly balanced looking out to 2022:

In trying to verify this conclusion with a second source I consulted a june 2018 presentation by Prognosesenteret, an independent market analysis company that focuses on Nordic construction and property markets (www.prognosesenteret.com/about-us/). They estimate a higher need for new homes than Selvaag, at about 4900 new homes each year in the Oslo region going forward. According to their figures, housing starts are runnning at only 3200 on an annual basis as of june. Which should and must increase if their demand estimates are accurate and are to be covered, even with about 1800 unsold new homes in the Oslo area currently versus a normal level of about 1000 units (I’m assuming these 800 extra units are mostly sold by the end of the year and so I’m not including them in the above table). See slide 28 in this presentation: 

http://boligprodusentene.no/getfile.php/Dokumenter/Boligbarometeret/Boligbarometeret%20juni%202018_final.pdf

Second-hand market home price development will also influence developer activity obviously. When prices rise, activity almost immediately goes up. Conversely, when prices fell in Oslo in 2017, developer activity was quickly reduced. Developers are a dynamic bunch. Home prices are probably more or less impossible to forecast correctly, but if we are to believe Statistics Norway, they will be flat in 2018, and then increase by 0.3%, 0.6% and 0.9% in 2019 through 2021. In other words, no great impulse for new home development coming from there either, but no disaster scenario either.

So to sum up on the risk of a real estate market crash, yes there is a risk of a correction at least, especially given the rather high supply of new homes coming over the next couple of years, but it isn't very likely to occur in my opinion.

On the demand side housing is still affordable for most people. However, interest rates could rise very quickly for some unknown reason, which would make debt loads more difficult to handle for households and a negative home price spiral could occur. With inflation is subdued and economic activity decent but far from overheated with GDP forecasted to grow at 2% in 2018 and 2.5% in 2019 (Statistics Norway estimate). The Norwegian central bank will probably increase rates gradually and at a modest pace (like they say they are going to).

On the supply side, supply of new housing will be higher than usual for a couple of years, yes, but as shown above, recent estimates of newbuilds coming to market beyond 2019 should not be that difficult to absorb in the market even with the modest forecasted population growth. 

So overall I think we'll avoid a crash or major downward price correction, but I do think that home price growth and development activity will be muted for a couple of years, given the supply coming to market and the high debt load of Oslo homeowners on average. As a consequence, PARB probably won't grow their loan portfolio in real estate by more than low to mid-single digits in the near term. (Post 2019, the pace should pick up again.) To mitigate this, the company could expand their loan operations to adjacent regions with better prospects for real estate development activity, but this is not a given and could also come at the expense of higher loan losses, since the bank doesn't know these regions as well as Oslo.

Other risks not mentioned above include but are certainly not limited to:

Loss of key personell

New competition entering PARB’s markets (e.g the recently established Merchant & Marine bank entering the shipping segment)

Unexpected higher pillar 2 capital requirement limiting growth and dividends. This part of the capital requirement is discretionary on the part of the Financial Supervisory Authority, so there is little visibility on this, meaning negative surprises are a possibility. Unlikely to be big enough to warrant a capital raise, though.

Rapid interest rate rise leading to contracting margins on existing business (but relatively high average loan churn mitigates this somewhat in the medium term)

Links of interest:

2016 listing prospectus https://paretobank.no/resources/files/investor/prospekter/16-05-26-Prospekt-borsnotering.pdf

2018 Q2 presentation: https://paretobank.no/resources/files/investor/presentasjoner/2018/Pareto-Bank-ASA-Quarterly-Pres-Q2-18.pdf

Largest shareholders - the top 10 hold 64% of the shares, employees 1.9%. All employees are covered by a bonus scheme paid in PARB shares.

1 Pareto AS 8,921,873 15.22%

2 Pecunia Forvaltning AS 8,246,549 14.07%

3 Apollo Capital Management 5,545,998 9.46%

4 Indigo Invest AS 4,382,711 7.48%

5 Saga Tankers ASA 3,365,646 5.74% 

6 Verdipapirfondet First Generator 2,302,907 3.93%

7 Verdipapirfondet Landkreditt Utbytte 1,750,000 2.99%

8 Kolberg Motors AS 1,360,000 2.32%

9 Artel AS 900,820 1.54%

10 Castel AS 689,779 1.18% 

Catalyst

Consistently generating high ROE