Assessing the earning power of Pireus bank
After having looked at the balance sheet it is time to see what this bank can earn on a normalized basis. For that purpose I have chosen to reproduce the income statement below:
The net interest income (NIM) has jumped by 62% yoy, suggesting impressive improvement in operating performance. Looking at the components we see that Interest income (i.e. what the bank earns from its customers and its securities portfolio) has increased by 23% – in line with the balance sheet expansion – whereas interest expense has stayed more or less flat, despite an increase in liabilities. How is this possible? The answer: interest rates on deposits have come down substantially in Greece. From this month’s bank presentation to equity investors we get the following chart:
As can be seen time deposit rates have fallen by a third and are currently at 3 percent, meaning the increase in volume was fully offset by a fall in cost of funds leading to an increase in the net interest margin (NIM). Whereas rates could go even lower I do think we are pretty close to the bottom in Greece already, further improvements should be marginal going forward. As a consequence, we should treat the boost in net income as a one-time event, further increases will require balance sheet growth. Applying the net interest income of 1.6 bn. to the average balance sheet size in 2013 (80 bn.) gives us a normalized net interest margin (NIM) of 2%. Doesn’t sound terrific for Greece, but makes intuitive sense: as we have seen before, a large chunk of the balance sheet is represented by “slow” assets, that is by customers who are not paying at all (default) or not paying in time (past due but not impaired).
If we take the 2 percent margin and multiply by the current balance sheet size we get an approximation for the steady state NIM of Pireus bank: EUR 1.8 bn. This assumes neither significant deterioration nor improvement in the average asset quality of the bank.
If management can turn underperforming loans into winners (big if), the interest margin would improve. It is difficult to say by how much but I will be generous and assume that a 2.5 percent margin is achievable in a positive scenario, leading to an optimistic NIM of EUR 2.25 bn.
The biggest item on the income statement is the “negative goodwill” of 3.5 bn. resulting from the acquisition of above mentioned banks. Clearly this is a one-time profit that will not repeat in the future and can be discarded for valuation purposes.
Operating expenses are up by 80% most of which are staff costs. Understandable: lot of redundant staff has been taken over due to the acquisitions. Taken from the above mentioned presentation to the equity investors: management estimates that synergies (read: lay-offs) amount to EUR 300 mln. per year. I will take that at face value and assume operating expenses will come down accordingly.
Provisions are a notoriously difficult to estimate as much of it depends on how real the recovery in Greece is. Without arguing back and forth and being generous I will assume substantially reduced provisions of EUR 1 bn. for the base case and EUR 0.5 mln. for the optimistic scenario.
A further aspect which needs clarifying is tax line in the income statement which was positive both for 2012 and 2013. According to note 16, the positive entry results from an increase in corporate income tax in Greece which increased the tax shield stemming from past losses and was applied retrospectively for 2012 as well. At the end of 2013 the bank had a corporate tax asset of EUR 2.7 bn. which basically means the first EUR 10 bn. in profit will be tax-free!
Finally, after adjusting the income figures we get the following income statement. For items I have not explicitly referred to above I have either extrapolated 2013s figure or ignored it if inconsequential.
As one can see: in the base case – which I personally think plausible – the bank is not able to turn out a profit. A strong recovery indeed would have to take place in Greece for a profit of EUR 890 mln., which translates into a return on tangible equity of 11 percent. Depending with what your cost of equity is or a Greek bank you will come to different conclusions. I, personally would say that, given the risks involved, a cost of equity should at least be 12 percent for a Greek bank, i.e. the bank barely returns its cost of equity in a positive scenario.
Given the significant headwind the bank is facing (liquidity, asset quality, potential haircut Greek debt a.s.o.) I think the optimistic scenario highly unlikely. The potential return if all goes well doesn’t strike me as attractive and I do not know how the market arrives at a valuation of 1.2 x book for this bank. However a word of caution: maybe I am missing something, some hidden assets, some feature of the recapitalisation that I have not accounted for and that I have overlooked.
Further, Basel III regulation which comes into effect in 2015 contains explicit regulation limiting the liquidity risk a bank can take. I could not find any hint with respect to that in the financial statement but just looking at their balance sheet I do not thing they meet the Basel III ratio (Net stable funding and liquidity coverage, but from what I can tell looking at its balance sheet I would assume there is some way to go