Philip O'Sullivan's Market Musings

Financial analysis from Dublin, Ireland

Bank of Ireland (BKIR.I) – Ireland’s Good Bank?

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(This is the sixteenth installment in my series of case studies on the shares that make up my portfolio. To see the other fifteen articles, on AIBRBSMarston’sFrance TelecomRyanairPetroNeftIrish Continental GroupIndependent News & MediaTotal ProduceAbbeyGlanbiaIrish Life & PermanentDatalexTrinity Mirror and Datong, click on the company names. I remain an investor in all of the above stocks, save for Glanbia, which I sold earlier this year)

 

I suppose it isn’t hard to be classified as Ireland’s ‘Good Bank’ when your domestic competitors heading into Ireland’s economic catastrophe comprised the now-nationalised Anglo Irish Bank and Irish Nationwide Building Society, the now 99.8% State-owned AIB and EBS, and the now 99.2% State-owned Permanent TSB. However, that is not to say that the past few years have been easy for Bank of Ireland. Over the past five years shareholders in the only domestic bank not under majority State ownership (the State has a 15% stake in the Bank) have seen the value of their investment decimated by heavy losses and dilutive capital raisings. In this piece I examine the key events that have affected the Bank in recent years, and explore what value there is in the stock at current levels.

 

Turning the clock back to June of 2007, Bank of Ireland gave an upbeat presentation at a conference organised that month by stockbrokers Merrion. In its previous financial year (12 months to end-March 2007), the group had delivered a 22% increase in profits, impairment losses stood at only 0.09% of its loanbook, return on equity was an impressive 23% and Tier 1 capital was a strong (at that time) 8.2%. The group was relatively well diversified, with Ireland delivering 60% of its profits, the UK 29% and the rest of the world 11%. Management saw “significant growth potential across the group”, noting a “positive longer-term outlook” in Ireland, while it targeted growing its international operations to the point where they would contribute over half of group earnings in time.

 

Just 12 months later, the tone was remarkably different. At a Goldman Sachs conference in Berlin in June 2008, Richie Boucher (now group CEO) delivered a presentation entitled: “Shifting the focus to deposits”. There were clear signs at this stage that the Irish economy was in trouble. Bank of Ireland’s impairments in the year to end-March 2008 had doubled to 17bps, reported PBT growth had stalled (-1% yoy) and ROE had softened to 21%. The group highlighted its strong funding base, with 47% of its balance sheet funded by €86bn of customer deposits. However, with a loan-to-deposit ratio standing at a worryingly high 157%, it was no wonder that the organisation was focused on deposits.

 

By the time of the next full-year reporting period (12 months to end-March 2009), Ireland’s economic woes were having a severe effect on Bank of Ireland’s performance. Impairments rose from 17bps to 102bps, ROE slumped by three-quarters to just 5%, and the LDR had increased to 161%, with deposits flat at €86bn. The government introduced the Bank Guarantee in September 2008 in an attempt to reassure depositors and the debt markets. In March 2009 the State handed over €3.5bn in exchange for preference shares in Bank of Ireland to help boost the latter’s core tier 1 capital.

 

Following the first recap Bank of Ireland commenced transferring some of its problem loans to NAMA. The haircut applied on these loans was 41%, significantly better than the range of haircuts (55-61%) applied to loans transferred by its domestic peers (slide 43). At the time management outlined plans to shrink its loanbook from €135bn to €89bn – €12bn of this reduction was to come from the NAMA transfers, with up to €34bn of non-core loans targeted for sale. The group changed its financial year end to December, and its results for the 9 months to the end of December 2009 saw impairments shoot up to €4.1bn – just over double the charge in the 12 months to the end of March 2009.

 

The removal of the NAMA loans had seen the LDR fall to 141% by the end of 2009, but difficult funding conditions was to see it rebound to 175% in 2010, as the benefits of deleveraging were offset by a slump in corporate deposits from €29bn at end-2009 to €9.5bn at end-2010 – ratings-sensitive corporate deposits across the six ‘guaranteed’ domestic banks collapsed in 2010 to €32bn from €80bn at end-2009. Importantly, the group guided that the “impairment charge on non-NAMA loans and advances to customers [was] expected to have peaked in 2009 –with further anticipated reductions expected in subsequent years”. This has been proven correct, up to now at least. Excluding NAMA loans, Bank of Ireland’s impairments were €2.37bn in FY09, €2.03bn in FY2010 and €1.96bn in FY11.

 

Another important milestone for Bank of Ireland that year was the 2010 capital raising, which raised €3.4bn from a placing, a 3 for 2 rights issue at 55c and an LME  exercise. The government also converted €1.7bn of the 2009 preference shares into ordinary share capital. However, post the PCAR and PLAR reviews, the Bank was ordered to raise another €4.2bn in 2011. This was achieved through the combination of a rights issue, an LME and a €1.1bn investment in the group by heavyweight investors including Fairfax Financial Holdings, WL Ross, The Capital Group, Fidelity Investments and Kennedy Wilson. As a result of all of these changes, Bank of Ireland’s shares in issue have increased from 988m in the year to end-March 2009 to 30.1bn today.

 

Outside of the completion of the €4.2bn recap, 2011 was also a year of progress on a number of different fronts. The capital position was strong, with a core tier 1 capital (bolstered to absorb future losses) ratio of 15.1% at the end of last year. Some 86% of the 2011-13 asset deleveraging plan was successfully executed, with the haircuts on the disposed assets below PCAR assumptions. Critically, deposit flows turned strongly positive, with the group’s total customer deposits increasing from €65.4bn at end-2010 to €70.5bn at end-2011. Reliance on funding from the monetary authorities was reduced over the year from €33bn to €23bn. Pre-tax losses improved to -€190m from -€950m in 2010.

 

With the (abridged!) recent history of Bank of Ireland out of the way, it’s time to look at where we’re at today. The Bank, of course, is someway off being master of its own destiny at the moment, having been set a number of targets. The Central Bank has ordered it to cut its LDR to 122.5% by end-2013. At the end of 2011 the LDR stood at 140%, having improved from 176% in the previous year. Data compiled by the Central Bank  (table A.4.2) show positive private sector deposit flows into the covered banks, which if this trend continues should help Bank of Ireland meet its LDR target. Bank of Ireland has been directed to cut its net loans to customers from 2010’s €115.3bn to €84.1bn by end-2013 (slide 54). At the end of 2011 net loans were €99.3bn, putting Bank of Ireland roughly 1/2 of the way to meeting that target only 1/3 of the way through that timeframe. The Bank’s recent interim management statement revealed details of further deleveraging and an improvement in the LDR.

 

In all, for me Bank of Ireland has been delivering against all the odds (given the challenging macroeconomic backdrop) of late. Management is to be commended for a good job in improving the funding profile and offloading non-core assets at better-than-expected prices. In addition, while impairments are set to remain elevated, management has guided that non-NAMA impairments will fall for a third consecutive year in 2012. So, in terms of the factors it has influence over, it’s doing the right things. However, the elephant in the room is of course the factors that it doesn’t have control over. Continued troubling developments in the Eurozone means that punting on a bank stock with significant exposure to one of the PIIGS (56.1% of Bank of Ireland’s loanbook at end-2011 was exposed to Ireland) economies at this time requires courage to say the least. The Irish domestic economy remains under severe pressure, which could lead to further problems in Bank of Ireland’s loanbook. Further capital raisings cannot be ruled out, with the Bank holding a call option over the government’s 10.25% 1.837bn 2009 preference stock that allow it to buy it back for €1/share up to 2014 and €1.25/share thereafter. Given the chunky coupon on these, I suspect the Bank will look to buy them back at the earliest possible opportunity, which may require some new equity depending on the strength of the recovery in profits from here and the state of the debt markets. So, this is a stock that is not without significant risks. Against that, I note that, at last night’s closing price of 9.8c it trades on a trailing P/TNAV of only 0.3x, compared to the 2.4x that its fellow ‘pillar bank’ AIB trades on, which suggests that a lot of these risks are priced in where BKIR is concerned.

 

My analysis began with a look back at a presentation Bank of Ireland gave to an Irish stockbroker’s conference, so it’s appropriate that I end with another one. In February of this year CEO Richie Boucher presented to clients of NCB and it was notable, to me at least, just how forward looking this was compared to many of its investor presentations over the preceding couple of years that were focused on fire-fighting within the loanbook. Bank of Ireland is now first or second by market share in each of the key segments it serves in its home market, while its UK operation, built around a jv with the post office, looks to be a good franchise with exposure to FX services, insurance, mortgages and the all-important deposit gathering. Deposits are on the rise and capital levels are strong, while impairments look to have peaked. As noted above, however, the bank is vulnerable to a lot of factors over which it has limited control. As I state above, I suspect this is reflected in its low P/TNAV multiple and its recent sharp share price decline from the 2012 highs. I would go even further and argue that Bank of Ireland is the only Irish bank worth contemplating an investment in at the moment given that AIB appears to be significantly overvalued, while the major surgery being performed on Permanent TSB (not to mentioned the prolonged pain it still has to endure from its mortgage-heavy loanbook) at the moment means, in my view, that attempting to value that stock now is a pointless exercise given so many ‘known unknowns’ (see my previous case studies on both, linked at the top of this post, for more information).

 

Despite that, given the present elevated fears around Spain and Greece I wouldn’t be rushing to top up my position in Bank of Ireland in the short-term. Taking a longer-term view, assuming the euro survives I see significant upside potential in Bank of Ireland and would amend my exposure to the stock to reflect this – but, as indicated above, I would need to see a comforting resolution of the Eurozone’s troubles (including clear signs of a strengthening in Ireland’s domestic economy) before I’d be willing to take such a stance.

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Written by Philip O'Sullivan

June 9, 2012 at 9:44 am

Posted in Sector Focus

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11 Responses

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  1. Hi Philip,

    wouldn’t a long Bank of Irekand – short AIB trade be interesting ?

    You kind of “neutralize” the general risk and extract the relative value.

    Problem might be to borrow AIB shares.

    mmi

    memyselfandi007

    June 9, 2012 at 1:56 pm

    • Hi MMI – I agree with you in theory, however I would be nervous about the liquidity in AIB – free float is only 0.2% and the average daily volume of shares traded in Dublin (859k shares) amounts to only around €58k worth of stock. Also there seems to be a bewildering correlation in movements in both AIB and BOI’s share prices despite the anomalous valuation.

      Philip O'Sullivan

      June 9, 2012 at 9:21 pm

      • yes, liquidity is an issue. Still interesting how such a valuation can persist, but that seems to be the lottery ticket syndrom.

        memyselfandi007

        June 12, 2012 at 1:26 pm

    • I believe the short-selling ban is still in place on Irish financials…

      Aengus

      June 20, 2012 at 10:40 pm

  2. […] which to some extent mirrors my Eurozone-related near-term caution around Bank of Ireland, as expressed in yesterday’s case study. The one thing I would differ from Cormac on is RBS, given that while he is correct to flag its […]

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