Description

PTSB was written up once before by ad17 and the write-up/comments are definitely worth reading/rereading.  

While negative rates, COVID impacts and atrocious sentiment towards European financials delayed some of gains discussed in ad’s write-up, the combination of PTSB’s recently increased scale, a higher rate environment, significant overcapitalization and now an increasing trading float all point to the strong possibility of a substantial rerating and substantial capital returns in the years ahead.  We want to revisit the name and provide further detail on reasons for bullishness.  

Ulster Loan Acquisitions:  Transformative Deal, Gives Scale/Jump starts SME Efforts

The Ulster merger was a game changer – the deal increased PTSB’s performing loan book by nearly 50 percent including over a threefold increase in the bank’s business book including the valuable Lombard asset finance business.  Historically, PTSB’s primary problem was a lack of scale (not excess costs) and the Ulster deal, purchased at ~2 percent discount to face value, will transform the bank’s earnings trajectory.  The aforementioned ~50 percent increase in loan book will only be accompanied by ~15% increase in operating costs and these incremental costs will likely be reduced over time.  

Interest Rate Environment Has Drastically Changed 

The ECB deposit rate has increased 400 basis points to 3.5% in under one year.  Forward curves suggest positive rates for the foreseeable future, albeit lower than current levels.  While you wouldn’t know it from current bombed out European financial valuations (over 80% of European financials trade below book value which seemingly suggests a steep recession and an imminent return to negative rates), the positive rate environment is hugely positive for financial names including PTSB.  For PTSB, the rate changes drastically improve the bank’s net interest income trajectory (positive rates on ECB cash balances, higher rates on investment securities, higher loan rates on commercial/consumer/mortgage loans) and should allow slower paydown/refinance away rates on loan balances outside of tracker rates (fixed spreads over the ECB refinance rate).  PTSB’s forward guidance (provided in March of 2023) assumes ongoing 2.75 percent ECB deposit rates, but this and its net interest income guidance will likely be revised higher when the bank reports first half results this summer.  

Ireland Economy and Demographics are Stronger than the Rest of Europe 

Ireland has among the strongest economies in the developed world with unemployment at all-time lows (3.8%), modified domestic demand (GDP has been more impressive but the figure is skewed by multi-national exports) running at ~3% and current/future budget surpluses that have been continuously revised higher over the past year.  

Source:  IMF April 2023, AIB May 2023

Source:  Central Statistics Office

Additionally, Ireland has among the strongest demographic trends across Europe with 1.3% annual population growth 2016-2022 (vs. 0.1% for the EU).   Thirty-three percent of Ireland’s population is aged 0-24 (highest in Europe), and there have been 190,000 net immigrants (doesn’t include the surge from Ukraine) over the last 6 years and 66 percent have college degrees.   

Chronic Shortage of Homes in Ireland…and Even Worse Than Anticipated

Following the nationalization of the banking industry and homebuilders post GFC, Ireland imposed onerous risk weighting requirements for its banks and imposed macroprudential rules starting in 2015 that prevented borrowings greater than 3.5x income (this restriction was lowered to 4.0x in late 2022).  The well-intentioned policies sowed the seeds of the current housing crisis as few homes were built for nearly a decade while the economy recovered, immigration trends improved, and multiple technology companies came/expanded across the country.  Housing prices have increased by ~70 percent since the beginning of 2015 and are above prior 2007 peak levels.  This historical housing shortage could take decades to solve and charts like the below drastically understate the degree of shortage.  

Source:  AIB May 2023

Based on small tweaks to population size, average household size (fewer forced roommates/kids living with parents into their 30’s), and housing stock obsolescence, the government is now estimating that 40,000-60,000 homes may be needed for the next ~30 years.

https://www.irishtimes.com/ireland/housing-planning/2023/01/26/ireland-needs-almost-double-amount-of-new-builds-in-housing-targets-research-finds/  

And unlike the US, it is far more expensive to rent than buy despite housing prices recently moving to all-time highs.  In a nation of ~5.1 million people, there are less than 1000 rental properties available.  Rental prices have risen at double-digit levels and mortgage rates could rise another 200 basis points from current levels and it would still be cheaper to buy versus rent (by a large margin in multiple cities).  Please see Daft and My Home quarterly reports for further details.  

This deficit of housing has powerful implications for the banking and homebuilding industries.  But, it is clear that a large number of mortgages will be needed and there are only 3 full service banks left in Ireland.  While the non-bank sector (Finance Ireland, Avant, ICS Mortgages among others) will take some share and allow banks to insist that they face meaningful competition, several of these online competitors are financed by fickle security markets and a higher rate environment has drastically increased the value of the remaining three’s deposit franchises.  

Take the Under on Ireland Deposit Betas

It should be noted that deposit pressures are far less severe across Europe versus the US as the European banking sector is more consolidated, there is no equivalent of a reverse repurchase facility sucking up deposits and money market funds have far lower share.  The situation is far more extreme in Ireland where deposit betas have been negligible.  While deposit rates will rise, the ultimate deposit beta (we assume ~30%) will almost certainly prove lower than the rest of Europe.  It should be further noted that Ireland’s mortgage rates, which were higher than the rest of Europe before rate hikes began, are now among the lowest.  Further rate increases, especially from Allied Irish Banks (AIB) and Bank of Ireland (BIA), are almost certain and these will be even more aggressive should deposit costs rise faster than anticipated.  

Given the concentration of the banking sector, there is a larger skew of low deposit accounts across all three Irish banks.  PTSB’s deposit franchise is particularly noteworthy as 70 percent (closer to 80 percent when only including retail deposits) of its retail deposits are below the €100,000 Deposit Guarantee Scheme threshold and ~40 percent of its total deposits are no-cost current accounts.  

Financials are Dirt Cheap in Europe…Substantial Rerating Possible for Simple, Easy-to-Understand Bank 

PTSB has a simple business – taking in deposits and making residential/SME/consumer loans.  And now the bank has scale and is one of only 3 banks operating in the healthiest economy in Europe with multi-year (really multi-decade) demand for mortgages.  Additionally, the vast bulk of PTSB’s loan book was underwritten during one of the most pristine credit periods (2015-present) in Ireland’s history.  Macroprudential rules essentially prevented customers from overreaching on loans and PTSB’s customer base sits on significant equity (average LTV of 51% for PTSB’s performing book and 42% for acquired Ulster loans).  Credit losses should be minimal over the next several years even assuming a European recession.  While seeming unthinkable a few years ago, it appears this boring (but highly predictable) bank could end up trading at a premium to the entire sector once the government sells down its ownership (more on this in a bit), the bank begins paying a dividend and risk weightings are normalized and reveal the degree of overcapitalization.  

On a relative/absolute basis, European banks trade near COVID lows and not far from GFC levels on a two-year PE basis or relative to the broader indices.  Certainly, a land war across the continent didn’t help nor did persistent concerns of a severe recession.  While forward curves assume the ECB deposit rates falls back below 3 percent over the next several years, many names seemingly suggest far steeper drops along with an avalanche of loan losses.  Over a longer stretch of time, valuations of 10x forward earnings are not crazy.   

Source:  Autonomous Research/Bloomberg

Government Selling Shares

In early 2022, Ireland’s then Finance Minister noted that government intends to completely sell-down its stake in the various Irish bank.  Since this announcement, the government has completely exited BIA, sold its AIB stake down to ~47% from ~71%.  While a sale of PTSB was expected to begin in late 2023/early 2024, NatWest and the government each sold down 5 percent of their holdings in early June in a 54.6 million share offering that was quickly upsized and substantially oversubscribed.  While the sales were relatively small, they did increase the freely tradeable float by nearly 50 percent.  Additional sales are highly likely over the next 12 months.  A far larger offering should be possible later this year/early 2024 as PTSB embarks on non-deal road shows and starts telling its less followed story to other investors, particularly to a certain class of US investors who like simple, overcapitalized community bank stories and will instantly grasp that 3 is significantly better than 4000+. 

€0.50-€0.60+ Earnings Potential

PTSB gave 2023 and long-term guidance with its full year results and likely surprised many investors when it announced it could earn nearly €0.60 over the medium term (2026-2027).  We get upside to guidance assuming the following between now and 2026:

-€15-€16 billion of mortgage originations and low 20 percent market share (versus ~18.5% at 2022) with paydowns ~7% 2024-2026

-Growing commercial balance (including ~€550mm of Lombard Asset Finance/Other SME loans acquired from Ulster) to ~€1.3 billion.  While this assumption may sound aggressive, it would represent a market share of ~7% as of 12/31/22 after aggregate SME credit contracted by ~50 percent over the last 8 years.  The big 2 (BIA and AIB) raked wide swaths of customers through the coals during COVID, attempted to squeeze every dime of negative interest out of SMEs prior to recent rate hikes and have made it as difficult as possible for Ulster/KBC customer to open new bank accounts.  BIA/AIB seem to be employing the “Anti-Silicon Valley Bank (ASVB) SME strategy” yet deposits have…increased.  Given AIB/BIA’s dominant share and ASVB playbook, a third option that can walk and chew gum at the same time will likely have a captive audience.  

-Peak ECB deposit rate of 3.5% falling to 2.25% by 2025 (take the over)

-Deposit Betas ~30% (did I mention there are only 3 banks left in Ireland?)

-Fees of 10-11% total revenue (Ulster customers are more active than legacy PTSB)

-Cost/Income levels below 50 percent (PTSB is sandbagging its guidance) 

-Total charge offs hitting 20 basis points over the full cycle (maybe…dripping wet)

-Above implies total NIMs ~2.5%

The above should allow PTSB to generate 1-2 percentage points of excess capital over time and allow plenty of excess capital beyond 14 percent CET1 Tier 1 Fully Loaded targets, a target that certainly looks to be conservative given the bank’s vanilla business.  This organic capital generation appeared to be the last requirement before PTSB’s dividend blocker could be removed.  The bank reduced its NPL balance to 3.2% from 26% over the past 5 years, sold a large chunk of the problematic Stage 2 loans and maintained outsized capital letters.  Consistent statutory profitability was the missing item and PTSB is poised to achieve this in spades.  Taken together, we believe PTSB can ultimately return well more than €1.00 euro per share in dividends and ultimately trade near 10x earnings assuming a non-negative interest rate environment, implying total upside of €6-€7.  While this multiple will be considered anathema by bombed out/depressed European investors, it would not be a crazy number outside a negative rate environment.  

Risk Densities Poised to Fall

And now for the really bullish part:  The above assumes that PTSB continues to have crazy risk weightings – roughly 50 percent (vs. 35 percent standardized) on new mortgage originations versus the low 20 percent levels of BIA.  PTSB was the first of the Irish banks to go through the targeted review of internal models (TRIM) and amazingly the CBI is evaluating PTSB, at least partially, based on 2013-2015 models, i.e. before macroprudential rules instituted in 2015 limited borrowing.  As noted, housing prices have risen 70%+ since the start of 2015 and impairments have been nearly non-existent.  While there is some uncertainty over the timing and magnitude of the risk weighting changes, it is worth noting:

1. The CBI has acknowledged that it is looking at PTSB through outdated models.  The CBI has also acknowledged that models need to be updated and PTSB is actively working with the CBI regarding these updates.  

2. 2015 and later loans currently account for ~60% of PTSB’s total loan book and this number will only increase in the years ahead.

Without getting into all the details of every risk weighting assumption, if we assume the 2026E stock of mortgages from the 0.75%-2.50% probability of default cohorts (see page 119 of PTSB’s Pillar 3 report) moves down from 42 percent to 30 percent and acquired Ulster mortgages also move to this level (from ~36% currently), this change could increase CET1/RWA levels by nearly 400 basis points by 2026.  This would imply that capital above PTSB’s 14 percent target would account for nearly 60 percent of PTSB’s current market capitalization.  It is certainly possible that further risk weighting reductions are possible over time – the loss experience of PTSB from 2015 onward will not be materially different than BIA or AIB and therefore further convergence seems rational.  We believe that PTSB shares can materially rerate as these CBI model updates become visible in PTSB’s Pillar 3 reports and investors start appreciating the magnitude of these changes.  

Risks

Many investors would be open to owning PTSB but cannot because of the illiquid float.  Further sales by NatWest (who owns over 11 percent) and the government appear likely but are not assured.  Many investors will not consider PTSB until the tradeable float is larger.  

PTSB continues to have a “dividend blocker.”  Given the earnings and capital generation described above, it appears to be only a question of “when” not “if” this blocker is removed.  PTSB should be able to pay a dividend in 2024 but regulatory reviews could delay a decision until 2025.

Recessions are generally not great for banks.  While Ireland likely will fare better than the rest of Europe given the stronger economy/lower LTVs on the mortgage books, it is possible there could be larger loan losses on SME loans as PTSB tries to build this book of business. 

Left-leaning Sinn Féin has continued to poll strongly, and it is certainly possible/likely that the party could be part of ruling coalition in early 2025.  While the party’s track record in Northern Ireland suggests a more moderate approach, there will likely be various sensational headlines (including some directed at the financial service sector) as the election draws nearer.  

While PTSB was the first of the banks to complete the CBI’s tracker stock investigation (paying a fine of
$21 million in 2019), there are still follow-up cases passing through the courts and it is possible that further payouts could be required for the three banks.  The number of cases and magnitude of possible penalties is more difficult to quantify but based on cases already adjudicated, we believe that any possible adverse outcome is manageable.  

Catalyst

-Upward earnings revisions 

-Additional government sales/larger tradable float

-Removal of dividend blocker

-Rates stay above zero and European financial investors slowly exit their bomb shelters