Description

We want to bring an awesome digital-only business to the club's attention, where overcoming a lofty multiple on near term earnings (or even the lack thereof) is not the usual culprit. In this case, the most likely no-go for people is the country of operation, which is Russia. If that is a strict no-go you can stop right here. For the remaining brave/unconstrained VIC soles, we are pitching you likely the most innovative (outside of China) and profitable bank in the world in one, and it also comes at a single-digit earnings multiple, perfect for VIC cheapskates.

TCS Group - the holding company of Tinkoff, is not completely new to VIC though. TCS/Tinkoff was once posted in 2018, but likely not many people paid attention back then. I liked the idea at first glance but initially brushed it off simply due to Russia. Fortunately, it somehow stuck and late last year we started to take a good look. Our work confirmed the initial impression. The company is a true diamond in the rough, that would certainly trade at multiples of its current price if it had the same setup somewhere in Europe or in the US. 

Lincott laid out the thesis very well back in early 2018 and his writeup is still worth the read. It is a good source, especially for background info which hasn’t changed and which I won't repeat here in full. In general, there is little additional originality required from my part but I tried to add some nonetheless. 

Anyways, the really important bit is that after two more years of superb execution, significant further growth and a more or less flat share price, the investment is simply even more compelling today. Additionally, I think it is easier to gain conviction today than in the past, given the continued strong execution and broadened investor understanding around the differentiating factors of the winning and losing businesses of our time. So maybe more people are able to pull the trigger now. However, the harder part is likely correctly assessing and getting comfortable with key people/company culture/political risks. An area where my write up won’t and can't help much, but I can attest that a couple of hours on the phone with ex-managers and former employees quite likely will. On to the thesis, which in short is: Tinkoff is an very attractively valued, fantastic business, operating in a great market with a long runway. 

The business

Tinkoff is a fast-growing digital bank/financial service provider - but to describe it as such likely creates the wrong initial picture given that most of the world's online challenger/neo banks still go and live from funding round to funding round. Their only so-so economics generally doesn’t allow them to self-fund the strong growth their usually great product-market fit brings along. In Tinkoffs case, this is different. Their early roots on the unsecured lending side, with a highly profitable product in an underpenetrated market, have changed this dynamic completely and have created a true wealth-building machine. The numbers, especially the mouth-watering ROE, speak for themselves. 

Apart from building the highly profitable credit card business from nothing a decade ago, to the 13% market share where it stands today, Tinkoff’s outstanding management team hasn’t stopped innovating and developing a great business. Their efforts paid off and Tinkoff has achieved even faster growth in areas outside of credit cards. The following table demonstrates some important changes in the last five years. 

Per year-end 2019 credit cards shrunk to 60% of the net loan book, while secured lending inched up to over 15% with the balance coming from other short-term (

Tinkoff's total customers grew from less than 3mn to over 10mn, with the strongest customer growth happening outside of the lending, where Tinkoff has built more than one fast-growing additional businesses in the recent past. The bedrock there is the debit/current account business, that grew from less than 1mn customers five years ago to over 8mn customers today, with 1 mn customers just added in Q1 2020 alone. This customer base on average is relatively young (34), affluent and engaged (5,6 mn MAUs and 1,8 mn DAUs). It's also the main customer base to cross-sell additional Tinkoff services to, apart from the business client segment and services. 

Noteworthy businesses besides the retail banking business are its online insurance arm, the SME business segment and retail brokerage business that have all been launched sometime in 2016. The star in terms of customer growth is Tinkoff Investments, that as of now already counts over 2mn customers. It became the largest retail broker in Russia last year, which is impressive given how much easier it would be for someone like Sberbank with its close to 100mn existing retail banking clients to achieve this. However, the retail brokerage space was pretty much a greenfield, first created via a regulatory change in 2015. I bring this up because it shows the breathtaking development speed at which Tinkoff moves. Tinkoff Investments is profitable already while in deep growth mode, but we think well below its true long term potential. A highly profitable additional income source in this area will likely come from it’s more recently created new business arm Tinkoff Capital, which enabled Tinkoff to create and distribute its own ETFs to Tinkoff’s brokerage clients. The company is also creative (as usual) in cross-selling its ETFs to its broader retail banking clients in a way that will likely work quite well too (Link). The Investment box/jar feature is a neat way for many clients to invest and the ~1% management fee that comes with it seems quite neat for us shareholders too. 

Anyways, so far in terms of profit contribution, the two other above mentioned businesses, SME banking services and Tinkoffs Insurance are much more advanced and already contribute around 30% of overall profits, while also still growing strongly (Insurance grew more 2x YoY in Q1) with a long runway ahead. Fortunately, the long runway does not only apply to those two. We think there is a lot of room in practically all of Tinkoffs products/businesses. The following chart shows market shares for various products/services, which are predominantly still in the single digits.

Russia still has over 400 banking institutions, with Tinkoff not even ranked among the top 10 in terms of assets and customer deposits yet. The following tables provide some comp overview. 

A few observations, Tinkoffs loan and interest income per customer are the lowest among its peers. This can and will likely change to its benefit over time, with a higher secured product mix that will increase both values. Tinkoff's staff costs are low given what it is developing and they are especially low on a per-customer basis. Future operating leverage will decrease costs per client further in this area. D&A is also very low for Tinkoff and the lowest on a per-client basis. Further op. leverage should kick in here as well. The overall non-interest costs are the lowest, even though Tinkoff spends a ton on advertisement and marketing, another area of potential operating leverage in the future. The client-based numbers are obviously quite affected by differences in business mix, between retail and corporate clients, but they show a clear enough picture nonetheless I think. By looking at the numbers it is also quite amazing to see how much more money is spent on employees, D&A and potential other non-interest areas by other banks, while their online offerings are far less superior. 

Overall Tinkoff seems destined to grow into the top spots, given that it has superior products, better customer service, an advantaged operating model, a lower cost structure and is already outspending all but two of its peers in terms of advertising and marketing. In 2019 it already spent 8,5bn RUB up from 5,6bn RUB a year earlier. Only the giants Sberbank (9,4bn RUB) and VTB (16bn RUB) are still spending more in the area in absolute terms, but far less in relative terms given their earnings are over 20 and 5 times larger than Tinkoffs. 

It doesn’t come as a surprise that Tinkoff is quickly winning over customers and is gaining additional business. Its mobile app constantly ranks second place in Russia on iOS is in our opinion best in class. If today, but especially in the future, the online and mobile presence and features are all that matter. All these bank branches and the mostly handicapped employees (in terms of what they can do for you) occupying them are becoming more meaningless by the day. Tinkoff is not truly digital-only like most other neo banks though, where a phone conversation is as physical as you can get. The company has a 3'000 people strong remote sales force who can consult and meet with you whenever and wherever you please. It’s actually a premium service to a branch-based service offering and Tinkoff is carrying out over 25’000 client meetings a day. In a well-covered place like Moscow, you might get a sales employee to your destination in as little as half an hour if you wish. However, the company has those employees/meetings primarily due to the know-your-customer requirements that Russia has in place for banking products today. If and when they are relaxed further Tinkoff will very likely cut back on its remote employee heads/costs.

The meetings are predominantly for customer acquisition and pay is primarily commission-based. Taken together with the high advertising spend you end up in a situation where over a third of Tinkoffs expenses are related to customer acquisition. Which means, that there is future operating leverage to be gained with less relative growth. It also means that the costs and the operating model as a whole are much more flexible than traditionally. If necessary, Tinkoff could cut back in these areas and quickly create a meaningful impact on the bottom line. It did so successfully in the Russian crisis 14/15 and remained profitable, even though it basically had only its credit card business back then. Today, credit unrelated revenue covers already ~110% of its admin expense, ~75% total expenses and as already mentioned, provides around 30% of profits with the share likely growing further this year. The business became much more resilient since the last crisis and will undoubtedly do well this year, despite COVID.      

COVID-19

A few more words on COVID. There is a good summary of actions, and impacts in the latest slide deck (Link) on pages 1-5 and commentary on the call. IR remained very approachable during the darker times and the company has also sent out two timely email statements around recent developments and never left shareholders in the dark. Something to appreciate given that it's a foreign place and it shows that they care about shareholders. In addition to that, the company has released a useful business performance index, where it is sharing real-time business activity information collected from its retail customers, online acquiring arm and half a million SME business clients. It's well worth a look to see how Russia is tracking along (Link). Below is the summary snapshot for Moscow, which is more or less back to normal activity, hovering around 7,5 again. Tinkoff is also providing twenty subcategories to look at revenue developments of various business lines. 

In the recent IR newsletter from early June, the company said that after initially hitting the breaks on the credit book, their incoming data is already telling them to grow their credit book again, by selectively choosing customers where they are able to hit their target returns. We feel very comfortable that their advanced analytical capabilities with an already decent data history of unsecured lending including a deep consumer crisis that took out a few banks will lead them to do the right thing. The next graph shows the development of cost of risk/loss provisioning. 

The company took up charges (with a macro factor) in Q1 beyond what their models would deem appropriate. The additional provisioned amount was 4,6bn RUB and took the total to 15,6bn RUB in the quarter vs 4,9bn RUB a year ago. The NPLs (90d+) are at 9,4% with a healthy coverage of 170% or LPs already at 16% of total gross loans. Nonetheless, Tinkoff increased its Q1 net profit to 9bn RUB up +26% YoY but down from 11bn RUB in Q4 2019. 

We think it doesn’t make much sense to try to pinpoint the upcoming provisions in the next few quarters. The important thing to realise is that they will highly likely remain nicely profitable this year without any compromises necessary other than slowing the loan book growth down a few notches. A NIM of ~20% or 25bn RUB a quarter in absolute terms gives them a lot of breathing room. Liquidity and their capital position are also not an issue. They generally payout up to 30% of net profit in quarterly dividends, and they could also stop that. 

Beyond COVID

If you look further ahead we think the future looks very bright. The company has quickly built a machine that is hard to replicate already but it isn’t slowing down the development of additional features that are built on top of each other. Even Sberbank, which has 20 times their profits at its disposal can't match their speed of innovation (yet), not to mention all the other banks, where the majority of the opportunity to grab additional business actually lies. 

The grand future achievement would be a success story of their current Super App ambitions (Link), which basically means trying to replicate what AliPay and WeChat have achieved in China. Here is some commentary from the management team during the initial release:

«The Tinkoff app has evolved into more than a traditional mobile bank, and the latest changes are the culmination of this transformation. The super-app is both our own version of the App Store, with its own mini apps, and the first WeChat-like app in the Russian or any European financial market, featuring products and services from our partners.

«Unlike other Russian ecosystems, we decided to blaze a trail of our own. Instead of scooping up businesses, we opted for a win-win solution, attracting the market’s best partners who share Tinkoff’s qualities and values. All our customers can access all new super-app services using their single Tinkoff ID. Going forward, we will be developing partnerships with businesses of any size, from Instagram bloggers to Russia’s largest B2C companies.»

It is difficult to see them become as successful as the Chinese wallets, but even partial success would be highly satisfactory for shareholders and seems valid and achievable. In that regard, we also think it is a plus to operate where they are. Russia seems to be quite a good place, not just in terms of lending, but also in terms of potentially gaining high relevance on the mobile phone/in people's lives. The big US tech guys are basically absent or much less dominant there and also likely won’t be allowed to gain dominance which means the market is left for local companies to champion. It's also a market where western tech companies, if at all, will likely bring new innovations very late. Meaning it will in most cases be too late, given the very high calibre tech talent available in Russia and the speed at which a company like Tinkoff operates. To gain an appreciation for Tinkoffs overall tech capabilities, one can read through a long list of press releases related to launches, go through their app updates etc. I won't list them here. 

The initial engagement on the lifestyle service front where they partner with other companies and we are talking about things people actually want to buy instead of entering the app to pay for something like speeding ticket, seems encouraging. Here are some numbers from the annual report 2019, since that kind of stuff is not in high demand at the moment. 

Our lifestyle services have raced ahead. We have over half a million monthly active users for these services. Every month, our customers are buying on average 350K cinema tickets, 25K concert tickets, 20K theatre tickets, making 10K restaurant bookings, 50K flight reservations and 50K hotel reservations.

Some Russian macro  

Russia's macro situation seems to be in quite a fine shape, and the risk of a meaningful RUB devaluation seems low. A good information source for macro related things is coming from the central bank. It provides a slide deck with useful information updated on a monthly basis. Below is one snapshot from it, but it's best to go through the whole deck (link). There is a lot of information on the financial sector as a whole, that is relevant to Tinkoff and the investment.

Some thoughts on specific risks

We have no insights on offer on the political front, but we generally like how Oleg Tinkoff, the founder of the business, handles his affairs. According to our conversations with people who know him/worked with him, he doesn’t seem to create nor have any powerful political/influential enemies. While he is colourful, where it counts he keeps his true views private/shuts up and doesn't attach himself too strongly to any particular Russian political figure. Unfortunately, he is currently battling Leukemia and the IRS recently went after him for tax evasion (yes you had to read this far to get that info from us) related to gains from the Tinkoff IPO. At that time he was still a green card holder, at least in the year. We haven’t spent a ton of time, and have no particular insight on this front, but a settlement seems likely to us. Clarity should come soon, if not for COVID, we would probably have it by now. Getting to the true picture on the Leukemia front is also challenging, but according to the company, he is improving and seems to have battled it successfully so far. He has nonetheless stepped down as Chairman of the board. Oleg is important, but operationally the business is in the fantastic hands of Oliver Hughes who has led the company as CEO since its founding days. The management team apart from Oleg himself owns 6,5% of the company and has a strong desire to drive it to success. The two issues hang over the stock, and I'd prefer both of them to be resolved positively, but we think a potential adverse outcome won't kill the investment thesis. 

Some thoughts on valuation

With a P/E currently sitting at around 7,6, this business is obviously very cheap given the potential future earnings trajectory. For the investment to work out well, you don’t have to bank on a multiple expansion, which might or might not happen, since this is Russia (a P/E of 10 is roughly Tinkoff’s five-year average). They are probably soon (in less than three years) generating earnings north of 1bn USD and the market cap today is ~4,2bn USD. Given that they have a payout ratio policy of up to 30% in place, which has room to go up further once they reach a point where growth materially slows down, one should be fine and happily be able to live with a P/E at or just slightly below 10. 

Catalyst

ongoing business execution, no catalyst there but non needed. Time is a friend of this business...