Description

What if I told you that you can buy equity in a sleepy, boring regional bank with conservative underwriting that is earning a stable 11-12% RoE for just 0.9x book? Furthermore, what if I told you that the equity strip that you are buying is effectively preferred, and is extremely unlikely to be permanently impaired in any reasonable Armageddon / bankruptcy scenario, yet still gets paid the same dividends? This is not an investing idea that is likely to generate a 30% IRR or higher. No. This is one to buy, forget that you own it, and then come back 3-5 years later to find a 10-15% book value compounding rate, with a good chance of a 20% or higher ann. return as the HF/long-only community continues to gradually wake up to realize that this stock exists and it re-rates to a more reasonable multiple of book. You also get a significant dividend income in the interim while you wait. Still interested? Then here comes Sparebank 1 Nord-Norge (ticker: NONG). 

THESIS SUMMARY
- Asymmetric profile: Extremely unlikely to incur permanent capital loss due to the mutual structure, yet offering a high likelihood of compounding away at a respectable rate for years and years. "Heads - I win, tails - I do not lose". In a current ZIRP environment, I am finding it tough to pick names that can be multi-baggers on a 2-3 year horizon and still feel that I am upholding intellectual honesty. But I am perfectly happy with buying something that will compound away at double digits without major issues that would keep me awake at night. 

- Valuation: A stable 11-12% RoE compounder should not trade at a 0.9x PBV but closer to 1.3x according to RoE vs PBV regressions. And an 11-12% RoE compounder with an equity strip that is difficult to wipe out should trade even higher. If NONG re-trades to a reasonable 1.3x PBV multiple, a 12% RoE will get you a 23% annualized return in 2018 (3.5 years); in the meantime, you get paid to wait, with 3-4% points of that return coming from dividends.

- Unknown & unfollowed name: Mostly owned by local Norwegian FIs. The postcode, small size, thin liquidity and the "regional flavor" may be pushing some people away. The "Equity Certificates" capital structure takes a bit of time to understand and will seem weird to those who have not had exposure to Nordic savings banks before. To calculate the proper market cap and P/E / PBV ratios for NONG, one needs to apply an adjustment (i.e. divide the implied traded value of the Equity Certificates by 0.473); a service such as CapIQ does not not know how to do the adjustment, which results in CapIQ showing an incorrect market cap, which may mean that NONG is not as easy to find via screens. But the good news is that investors are slowly waking up to NONG. International shareholding in the Certificates is gradually increasing from 5.5% in 2010 to 16.6% in 2013. NONG will increasingly become a "normal" bank known to international investors, and the 'incognito discount' will gradually go away. 


COMPANY INTRODUCTION
NONG is a small, regional savings bank in Northern Norway. NONG has listed "Equity Certificates" on the Oslo exchange, which trade today at 41.0 Norwegian Krone (NOK; 1 US$ is roughly 8.17 NOK) at a market cap of NOK 8,697 million. The current trading multiple is 0.94x book, 8.8x trailing net income. The bank earned an 11.0% RoE in the last 12 months to March (12.3% in FY14). This is the 4th largest savings bank in Norway, and 8th largest banking institution in the country. The local market is characterized by a presence of a large number of regional savings banks (close to 100, which is a lot for a country with 5 mil people). The regional savings banks are part of either the Sparebank alliance or the Eika alliance; NONG is part of the former. Unlike larger pan-Nordic commercial banks such as DNB or Nordea, the Norwegian savings banks concentrate on their respective regions. NONG focuses on northern Norway, with about 400,000 customers (almost all local). 

70% of NONG's asset base is retail, and 30% is corporate. Within retail, 100% are mortgages, and the corporate book is diversified across real estate (35%), transport & telco (16%), services (11%), seafood (11%), and other. NONG posted a normalized growth in both loans and deposits of about 5% historically. Deposit coverage is reasonable at 76% (Q1 2015). Importantly, loan underwriting is conservative, with an NPL ratio consistently below 1%. The company's disciplined approach to pursuing new business is highlighted when you compare NONG's historical growth to its peers: NONG's loan book growth (c. 5% p.a.) was far outstripped by peers, as the broader banking sector in Norway grew by a rate closer to 10%. It also worth noting that the slower growth of NONG may be not just due to the conservative NONG approach to doing business but possibly also due to the general conservatism of NONG's end market (North Norway). Northern Norway's house prices are lower than in the rest of the country, and Northern Norway is the sole region of the country that does not produce oil & gas or rely on oil & gas to any significant extent. Combined, these two points give us some comfort that NONG focuses on serving a community that is less overheated from ZIRP and the $90+/bbl oil price bonanza of the last 5 years.

The bank earns a net interest margin of about 230bps, with net write-offs of below 50bps. The overall leverage (assets/equity) is 9x (roughly similar to C or BAC, but much less levered than almost any other major Western European listed bank that I know of e.g. Santander and DNB are levered to somewhere around 14-16x). The bank is well-capitalized, with a Tier 1 capital ratio of 13.5% and a CET1 ratio of 12.4% (despite paying out an average of 30% of NI as dividends). New regulation (Pillar II) may require NONG to increase the CET1 ratio to 13.5% by July 2016, but my calculations suggest that this is likely to be easily achieved in December this year, even after NONG paid out NOK 400m of dividends in Q1 (likely a pay-out coefficient of 40% of FY15E NI). The management is targeting an even more conservative 14.5% CET1 in 2016. All in all, this is among the strongest-capitalized Nordic banks that I have looked at.


A WORD ON CAPITAL STRUCTURE
Equity Certificates are a class of equity instrument popular in the Norwegian savings bank sector. NONG’s equity is split into community-owned equity and the equity owned by the holders of the Equity Certificates (listed). The Equity Certificates are the most senior class of equity. The other classes will absorb the losses first. According to broker research, if there is a theoretical NOK 5bn loss, Equity Certificate holders shall only suffer 1/5th of the write down. At the same time, dividends and income are distributed proportionately to ownership. What this means for us is that Equity Certificates have somewhat of a mezz or double-A, bond-like characteristics...yet these very Equity Certificates still earn a 11-12% RoE and trade at a discount to book value. 


MANAGEMENT
NONG is run by CEO Jan-Frode Janson. Mr Janson is ex-Danske. He built Danske’s Norwegian business into Danske’s joint most profitable and successful profit center, generating ROEs of c.13%. We like that Mr Janson is a relatively young (47 y.o.), energetic outsider with experience working for a larger, more internationally diversified group. He may be the right person to shake up NONG’s culture and potentially engage in more vigorous shareholder value creation activities e.g. market the company more overseas and close the PBV multiple discount (although of course we do not want him to do this too much, lest he take his eye off the ball on underwriting). Mr Janson is also the right person to someday perhaps sell NONG to Danske or other international group. Prior to Mr Janson, NONG was run by an insider for over 23 years. I feel that that the arrival of Mr Janson as CEO is a positive in some other ways as well. If you read some of the newer quarterly reports released by NONG since he joined the company, you are likely to find that they are written in a lucid, direct and honest language. Mr Janson mentions risks such as economy, competition and even oil prices, and all in a clear, non-IR speak, non-fluffy language. Prior to Mr Janson, the reports lacked this straightforward MD&A.


HISTORICAL FINANCIALS
The historical financials are presented below.

The historical net income was bumpy (but always positive), and the average/trend RoE is 12%. In some years, RoE was diluted by rights issues executed in order to increase the capital ratios (e.g. Tier 1 was 8.9% in 2007 vs 13.5% currently); the last rights issue was in 2013 and I am not aware of any near-term plans for further rights issues.

Dividends: NONG paid a NOK 106 million dividend in 2013 and a NOK 403 million dividend in Q1 2015, implying a normalized trailing dividend yield of 4.6% against the current market cap.


PROJECTED FINANCIALS & RETURNS
Please find my base case projections below.

I assume an exit in 2018 (a 3.5 year-hold) with a 23% annualized ultimate return, though if this business continues to generate a stable and solid RoE with conservative underwriting, I do not see a particularly compelling reason to sell. 

DOWNSIDE CASE

Downside scenario: 7.5% average future RoE, exit at a multiple of 0.70x P/BV in 2018. Result: 0% annualized return

UPSIDE CASE

Upside scenario: 12.5% average future RoE, exit at a multiple of 1.50x P/BV in 2018. Result: 28% annualized return

RISKS

- Poor underwriting decisions: Increasing NPLs from future lax controls (or hidden past problems) would damage RoE. 

Potential mitigant: NONG has a fundamentally cautious culture. Historical net write-offs are below 1.0%, and asset growth was far below peers, indicating admirable discipline. For me, the quality of past actions on this front are an indicator of what is to come in the future. In addition, SEB research quotes NONG as one of the most conservative underwriters (on par with a few other savings banks and Handelsbanken). I have not seen any evidence to suggest that Mr Janson will relax NONG's underwriting standards. But this is something that must be monitored (which is true of any FIG investment). One more point to note is that the legislation and regulation in the Nordic markets is significantly more favorable to banks (and less favorable to the debtors) than in the US / Anglo-Saxon world - debts survive personal bankruptcy, and wage garnishment is possible. 

- Competition: DNB, SEB, Nordea and other Nordic banks may come to better recognize the attractiveness of the returns that NONG is making and go after NONG's communities. 

Potential mitigant: NONG caters to a different, more conservative kind of customer. Also, all of these competitors have riskier loan books and more levered balance sheets (as well as more exposure to oil). If tough economic conditions ensue, I would expect there to be a fair chance that these competitors can experience some issues and then lack the excess liquidity to aggressively expand into the North.

- Macro: A global slowdown or low(er) oil prices can result in a slowdown in Norwegian economic activity and impact loan volumes or profitability of NONG. Norway's GDP grew by 0.6% in 2013 and 2.2% in 2014. Growth is expected to weaken in 2015 (OECD, IMF). FX may also have an impact on the return.

Potential mitigant: You may find this not to be a compelling mitigant - I generally tend to ignore macro (and I ignore FX risk when I am dealing with developed markets) because I have come to believe that it is somewhat imponderable. However, the nature of Northern Norway provides some comfort on this front. Northern Norway has the lowest relative house prices in Norway and is the one Norwegian region that is not very dependent on the oil industry. The North also has the lowest unemployment rate in Norway. At the same time, unemployment benefits in the North are high and this reduces likelihood of charge-offs. Finally, the North is the region with the highest proportion of public sector employees vs other regions. Given the Norwegian government’s fiscal headroom, this further softens the blow on NONG’s region of operations from a national or macro downturn. 

- Russia: NONG has some banking operations in Russia that it is currently winding up. Russia is going through some tough times currently and things there may get worse.
Potential mitigant: NONG's total Russian exposure is NOK 589 million, insignificant in the context of total NONG assets of over NOK 80 billion.

UPSIDES

- Northern economic option value: Whilst accounting for only a small portion of Norway’s population, the Northern region accounts for 50% of the country’s surface area, with significant undeveloped reserves of oil and gas. This presents a long-term free option for the economic development of the region and local population growth, which would be a positive for NONG. I do not expect this upside to play out unless NONG is held for more than 5 years.

- Consolidation / corporate events: The Nordic region is known for significant FI M&A activity. On a 3-10 year horizon, NONG may get acquired by one of the large three Nordic FIs. At some point over the long term, some sort of de-mutualization or conversion to a "normal" holding structure may result in appreciation of the equity value and multiple expansion. 

NOTE ON ILLIQUIDITY: One additional consideration that must be kept in mind is the historical pattern of market cap of the Certificates and their volume/liquidity. The liquidity today is middling. If you wish to account for no more than 30% of trading volumes, it would take at least 3 days to build a $1m position in the stock. This shall be a consideration upon entry but less so at exit (if the continual increase of foreign institutional shareholders is representative of a liquidity uplift potential).


EXTERNAL LINKS:
Financials: https://www.sparebank1.no/nord-norge/ia1268431697091
What are Equity Certificates?: http://www.grunnfondsbevis.no/id/17042.0

Catalyst

- Sheer value. Increased investor attention and realization of NONG's earnings power. My point on investor attention is evidenced via a steadily increasing proportion of foreign owners in the shareholder register. This is a secular, slow-moving catalyst.

- Longer term event: De-mutualization or some sort of corporate M&A event.