In this post I want to discuss some of the microeconomic, i.e. bank specific, arguments David Einhorn made during his presentation. I will only discuss Piraeus bank here, as I am already familiar with its financials due to my past blog posts. As in Part I, I will analyse his arguments one by one.
Similar to his macroeconomic analysis, Einhorn numbers improvements across all measures of bank performance and sees the potential for the share price to double over the next three years. The following slide neatly summarizes his view.
According to Einhorn, the stock price will be driven by the following three factors,
- Cumulative “core earnings” due to increased profitability,
- future releases of LLPs, due to over-provisioning in the past and, last but not least,
- a re-rating of the stock: he expects the P/B multiple to double (to 1.5 x book).
Let’s have a look at each of these arguments…
Ad. 1.) Improved profitability
Einhorn has two slides that show various improving profitability indicators of which the most important one, at least to me, is the net income margin chart.
The net income margin (NI margin) of a commercial bank is comparable to the revenue figure of an industrial company, i.e. it represents the top-line. It is the most important figure by which we should judge the long-term growth potential of any company. This is because for your typical industrial company, the top-line will be unaffected by one-time measures such as cost cuts that are unlikely to lead to sustainable growth in profits – not a perfect measure but a good start.
However, banks are somewhat different as the NI margin is not only driven by growth variables (costumers, loan pricing…), but also by an (important) cost variable: the cost of funds. Indeed, Einhorn mentions that the lower cost of deposits has been the main driver of NI margin growth.
Now, by how much more can the cost of deposits fall in Greece?
In order to answer that question, I have looked up the deposit rates Piraeus bank pays to its customers. Thankfully management has provided this table in its Q2 investor presentation…
Current time deposit rates in Greece stand around 2% which doesn’t sound that high to me. As we can see, time deposit rates have come down quite a bit over the past 18 months falling by more than 200 bp thereby boosting the top-line. Another such boost is impossible. The fall in funding cost has of course mirrored the fall in the Greek government bond yield over the same period, see below…
Note, that the second quarter 2014 marked the low for the 10-year Greek government bond at around 5% yield. Since then yields have increased substantially hitting 8% in November as the likelihood of another Greek default has increased. As I have argued in my previous post, given Greeks high sovereign debt burden and its high debt service costs, another restructuring is only a matter of time.
Given the already low deposit rates and the increase in Greek bond yields lately, it is safe to assume that the tailwind from lower funding cost is over. This leaves us with lending as the only driver for NI growth.
Yes, what about loan growth?
As always: facts first…
The table shows the evolution of the gross loan volumes of Piraeus bank in Greece, its most important market…
Unsurprisingly, loan volumes have been falling across all segments, despite lower interest rates. I say unsurprisingly because this is what a de-leveraging looks like.
Question: what drives this de-leveraging?
Three possible explanations:
- Piraeus bank doesn’t have enough capital to lend to costumers,
- it doesn’t have enough liquidity to lend to costumers, i.e. it is overstretched,
- it doesn’t find enough good customers who want to take out a loan.
Now, it is probably a combination of all three factors, if you ask me.
Although the bank looks well capitalized on a regulatory basis, I do have a few reservations about that book value – but more about that later.
Improving the liquidity profile certainly played a role as well, as the bank’s loan-to-deposit (LTD) ratio has come down substantially. This has, no doubt, to do with bank management being eager to get rid of the ECB’s “emergency liquidity assistance” (ELA) facility, an exceptional measure by the ECB to keep the banking systems of periphery countries afloat during the height of the sovereign debt crisis. This must have had high management and local regulatory priority. After all, an ELA-free balance sheet signifies a normal environment – and better negotiating power in Brussels.
But the most important factor – and, I think, true of all EU periphery countries – is the lack of potential and creditworthy debtors. What do you expect when a high double-digit percentage of the workforce lacks (official) income? And it is not exactly the case that Greeks are unfamiliar with leverage. The table below puts Greece’s total debt load (government, households and corporate) in perspective:
Greece’s total debt load (Total ex financials, column e) at 304% of GDP is one of the highest among developed markets. Higher, for instance, than in the US (264%) and way higher than in Germany or Austria – not necessarily markets which are credited with high banking growth potential.
Actually, I think that it is more meaningful to compare Greece to other Emerging Markets. First, Greece suffers from many problems typical of emerging markets (high level of cronyism, inefficient state bureaucracy…), but also because it is EM that are seen to be “under-banked” which are usually touted as the next growth opportunity in banking circles. How does Greece compare to your typical EM? Look at the following table for answers:
Whether the “EM-are-underbanked-story” is sound or not, at least the bankers have a point: the average debt level (private + government) in EM is exactly half the Greek level (151% vs. 304%). Note that this is not just because of Greece’s high government debt: apart from Hungary (144%) and China (169%) no other EM has as high a private debt load as Greece (129%).
Summary: the fact that funding costs are unlikely to fall further and that there is limited loan growth potential due to the already high debt levels in the Greek economy, make it unlikely that the top-line of Piraeus bank will increase significantly from current levels. If there is growth potential, I would like to know where it comes from.
Ad. 2) Release of LLPs due to overprovisioning
According to the second argument, Piraeus bank has provisioned conservatively in the past and has potential to release some of these provisions thereby increasing profits and book value. Einhorn argues that, due to a law passed in 2008 which forbade foreclosures by banks, a lot of the NPLs are “strategic” in nature and will start paying once the law expires, i.e. next year.
I am not familiar with the details of this law, but many CEE governments have passed a similar law. For instance, Hungary and Ukraine with Austrian banks complaining. Usually, these laws are passed to protect retail creditors from losing their home – not corporate customers. Now, according to the Q2 presentation EUR 19.8bn out of EUR 28bn NPL of Piraeus are defaulted business loans. If it is indeed true that said law businesses from being foreclosed, I would be very worried about it, not bullish.
Because a bank’s assets are a collection of contracts that promise a certain cash flow. A contract’s worth is a function of its enforceability. The same goes for a pledge on collateral. In countries where rule of law is weak or enforceability is otherwise uncertain, as this law seems to suggest, we do not observe complex business models emerging. In these countries it’s mostly “cash and carry” business models that are successful. Put differently, such environments are not very bullish from the perspective of a prospective bank owner. As Klaus Kastner pointed out: the World Bank singled out the difficulty in “registering property” and “enforcing contracts” as the biggest challenge to Greek competitiveness.
(Note to Keynesians out there: there is much more to competitiveness than unit labour costs reductions as a result of currency devaluations.)
In short: I have my doubts on whether these NPL will start paying again…
Now, let’s look at the provisioning level of Piraeus bank. Einhorn provides the following slide.
Just eyeballing the coverage ratios (LLPs as % of NPLs) Piraeus doesn’t seem conservatively provisioned: 16% on mortgages after a massive drop in asset prices over the past five years doesn’t strike me as conservative. Of course, if you count the collateral then everything looks fine, i.e. a coverage of NPLs larger than 100% across all segments. But it is impossible to take comfort with the collateral values, in my view, before answering the following questions:
What type of do they count here? I hope it is not property, plant and equipment. How do they arrive at the figures? Transactions? Hardly possible in a depressionary environment. Estimated values (Appraisals)? If yes, how old are they? Are the values reported nominal values or haircut values? And how much is collateral worth in an environment where enforcement is legally difficult, anyway?
Most important of all: If collateral covers the net loans, why is the NPL ratio rising and standing at a record 38% of all loans, why are they not getting rid of these loans?
The answer, of course is that the book values of the loans don’t reflect the market value of these assets – otherwise the bank would have got rid of them a long time ago. They have every incentive to do so: it looks better on the balance sheet and it frees capital and liquidity. Also do not forget that in workout speed is everything, i.e. the longer you wait to enforce collateral the less valuable it becomes. Carrying the NPLs from, say, 2010 on your balance sheet doesn’t make them worth more, on average as a defaulted customer usually will delay capex as long as possible – with negative repercussions for pledged collateral values.
Fortunately, we have another indication of Piraeus’s asset quality: the recently concluded “Asset Quality Review” (AQR) by the ECB. The following chart (via Berenberg bank) summarizes the AQR findings on a country by country basis.
The figure above shows the additional provisions uncovered by the AQR, both, on an absolute and on a relative basis. Now, David Einhorn might find this surprising, but the Greek banking system was found to have the by far biggest issues, i.e. its book values the least reliable, with Piraeus one of the biggest hit (Alpha the second bank Einhorn talks about scores somewhat better).
This confirms my view: I do not see any scope for major releases here. Certainly the ECB has looked somewhat closer at the collateral values and has not taken management figures at face value – neither should anybody else.
Of course, the regulators managed to calm the markets by saying that the capital measures undertaken by Piraeus so far suffice for now, i.e. they fulfil current regulatory ratios – nobody needs another Greek banking crisis, after all. However, I want to emphasize the adjective “current” in this context, because starting from 2019 onwards, European banks are supposed to fulfill much stricter Basel III standards. In order not to overburden them, regulators have given European banks time until 2019 to prepare for the tougher environment. The ECB knows this and consequently also tried to assess the banks’ requirements under Basel III in a forward-looking way.
Shouldn’t we as investors be forward-looking as well?
I think yes, here are the results:
This is interesting: under the fully loaded Basel III scenario Piraeus bank (line 116) ends up with a regulatory capital ratio (CET1) of a negative (!) 1.5 percent – no doubt the doubious quality of Piraeus bank’s book value must have played a part.
I have no special information on how the ECB came up with that number, but if I interpret it correctly Piraeus bankwill have to come up with substantial equity in the next five years – it will be a long time before Piraeus can grow its loan book substantially, let alone pay dividends even if profitable.
Summary: the fact that the ECB AQR uncovered serious issues with Asset Quality in Greece and at Piraeus bank makes provision releases highly unlikely in the future. On the contrary, I would expect serious additional provisioning needs as the coverage ratios (without collateral) are not high, also compared to other banks in periphery countries. I repeat: this is no surprise, it is a well-known rule in workout management that the longer you wait the less you get back. The effect of Basel III is not even mentioned or considered by Einhorn – irresponsible.
Ad. 3) Multiple Expansion
If you follow Einhorn’s logic, golden Times are ahead for Greek banks and the economy, with growth prospects correspondingly high. He therefore goes on to assume that in three years investors will be willing to pay a premium to book value.
Apart from everything I have said so far about the dubious quality of Piraeus’s book value, it strikes me as strange that a so-called “value investor” is willing to speculate on the mood of “Mr. Market” in the future. Isn’t there supposed to be a margin of safety? If yes, where is it? This shows how far standards are successively lowered in a bull market, even by those claiming to look for value (this happens often enough, read this Youngmoney post).
As is well-known, the P/B ratio is a function of the excess return, i.e. return over cost of capital, and the growth prospects of a company. Only for companies that can be expected to earn above their cost of capital one should be willing to pay above book value.
This relationship can be expressed with the following formula (derived from the “Gordon Growth Model“),
P/B = 1+ (ROE-r)/r-g)
where ROE is the return on (book) equity, (r) the cost of equity and (g) the growth rate. Note that, if (ROE = r) then the numerator is 0 and there should be no premium to book value. The nice thing about this formula: it offers us a possibility to back out Einhorn’s implicit expectations. I am interested in how much he expects this bank to earn three years down the road.
To do this, we first have to determine the appropriate value for the return investors expect when they invest in Greek banks, i.e. the cost of equity (r). I will not be overly harsh and argue that 12% is the minimum return investors demand for a Greek bank, although most investors probably would expect more in view of the macroeconomic situation.
Next, we have to settle for a long run growth rate. Given what I said about the comparatively high debt load of the Greek economy and the headwinds banks will face with Basel III, I believe it is very optimistic, if I assume a growth in profits of 5 percent per year.
Thus we get: (r-g) = (12%-5%)= 7 percent for the denominator
Plugging in a P/B of 1.5 and reshuffling terms yields an expected ROE requirement of 15,5%. This means that, in order to trade at 1.5 x book, Piraeus bank will have to earn 15.5% on book value on a sustained basis AND be able to grow by 5 percent per year – no “margin of safety” to see here.
But what does this mean in actual numbers?
Piraeus book value stood at around EUR 9.3bn at the end of the second quarter. Multiplying this figure with the expected ROE (15.5%) yields around EUR 1.5bn in expected net income (net income has been slightly positive YTD only if you include one offs) for Piraeus bank three years down the road. Note that this figure would be even 20% – 30% higher if Einhorn’s LLP releases materialize, as this would add to book value.
Is a net income of EUR 1.5bn realistic?
According to Einhorn’s slides, Piraeus bank’s pre-provision profit stood at around EUR 300 mln at the end of Q2 2014. That’s already significantly up from previous quarters due to the lower cost of funding and cost cutting measures. Annualizing this figure yields EUR 1.2bn pre provision profit, i.e. before deducting risk costs. Of course, risk costs are a real cost factor for banks even in normal years. Consequently, I assume that a bank of that size will have normalized risk costs of around EUR 100-200 mln per year. Deducting this from pre-provision profit leaves us with a normalized net income figure (we can ignore taxes due to high losses in the past) of around EUR 1 bn.
In other words: Pre-provision profits would have to increase by 50% over the next three years in order to meet Einhorn’s expectations AND risk costs would have to normalize rather quickly. This all has to be achieved taking into account:
- no dramatic potential for further cost of funds reductions
- limited growth prospect due to high debt load of households
- the challenging demands posed by future Basel III requirements
And I repeat: Einhorn implicitly expects even higher net income, as he assumes book value will be higher!
This is a very weak investment thesis. The quality of the analysis is disappointingly low. Both his macro and his micro arguments are overly superficial, as he takes all figures at face value without trying to understand the drivers behind them. This makes him blindly trust the coverage ratios presented by management, or ignore the effect of known regulatory changes. He doesn’t touch the management topic at all, although there clearly are some issues such as a cosy relationship with regulators/politicians – in my experience not necessarily evidence of shareholder value driven ethics. Worst however, is the fact that he does not demand a “margin-of-safety” from this investment, but prefers to speculate on how much people might be willing to pay in the future.