|Shares Out. (in M):||174||P/E||17.0x||14.0x|
|Market Cap (in M):||4,800||P/FCF||0.0x||0.0x|
|Net Debt (in M):||0||EBIT||0||0|
A few of the larger non-Scandinavian players have tried to disrupt these markets over the last 10-15 years, but by and large they have failed to generate scale and profits and been forced to exit at a loss.
In terms of explaining why the CR rises this year - 2012/13 were abnormally strong years, benefitting from a low claims ratio thanks a a benign storm season. This year we are seeing some of that being recycled into some more competition for premiums. Alm Brand are not really competing for that too much (guidance is for very modest premium growth), but it will have an impact. I actually think they are being a bit conservative - expense ratio has come down 160bps since 2010 and they say there is more to come as IT investments they have made continue to benefit them. There should be some premium growth. Of course, weather and accidents are hard to predict, but I think they are leaving themselves some margin of safety with a forecast of CR +2.6% with the expense ratio probably a 20-30bp tailwind.
The company guide that with the premiums growing ~1% and CR rising to 90, the non-life busines should generate DKK 525m in PTP. I actually have more than that (DKK 630m) as I think the CR could wind up being a bit better than they guide. From there, I have the PTP about flat for a couple of years, which I think is conservative, allowing for a further slight rise in the CR which is how the company see things playing out.
The key valuation takeawat from all of this is that, in my view, the non-life business alone more than justifies the current valuation. That business currently has about 2.1bn of equity in it. The PTP I am forecasting translates to an ROE of about 22%, about in line to slightly below recent history for the company and about in-line with industry averages. What should one pay for a business generating a steady ROE of 20%+ in a consolidated and rational industry that appears to have high barriers to entry? I am going to argue that it should be about 12x earnings and north of 2x book value:
Banking is the ginger stepkid of the group. The financial performance has been dire - they lost 428m in 2008, 1.3bn in 2009, 647m in 2010, 918m in 2011, 391m in 2012, and 392m in 2013. They do not expect it to return to profitability this year, even as the Danish economy recovers and the KFX rips through new highs as a write this. It is a quite staggering display of ineptitude to lose DKK 4bn given the size of the bank - what exactly happened and how can I recommend buying a company with a turd like this sitting in the business mix?
In terms of explaining what went wrong - what hurt them was primarily mortgage lending and agriculture - but mostly mortgage lending. Denmark experienced a housing bubble and the 2008/2009 bust like many other countries, with the additional kick in the teeth being that household debt, much of it through mortgages, has tended to be very high on a global basis (mortgages outstanding ~2x GDP). High leverage and a 20% decline in home prices on average (much more outside the major cities - about 50% according to Alm Brand) has led to numerous banking defaults and a sluggish recovery from the crisis (though it seems to be improving somewhat now).
The company played a poor hand through this situation - pretty much as bad as they could have played it, actually. From the mid-00's to 2008 their strategy was to chase growth, growing the loan book from DKK 10.7bn in 2005 to DKK 17.3bn in 2008. Of course, by the time the realised their mistake, it was too late and they were stuffed with a tremendous amount of debt outstanding on a bunch of illiquid assets worth considerably less than they had initally thought.
The strategy was changed in 2009, with the growth strategy finally abandoned, a narrower focus on private banking, leasing and financial markets, and the rest basically put into a bad bank to run off over time.
Talking a bit more about the bad bank - it has continued to perform poorly, losing 990m in 2011, 472m in 2012 and 379m in 2013 - company expect it to lose another 375m-425m this year. I am not positive on this part of the business really, but I think that the power of compounding should eventually start to work in reverse, to their benefit. The bad bank had DKK 7.1bn of loans at the end of 2011 - as at year end 2013 that had fallen to DKK 4.8bn as loans matured and they took writedowns, and as of the end of Q1 it stood at DKK 4.6bn. Against this 4.6bn, the company retain ~DKK750m in unused provisions, so there is some buffer in place, at least.
The key observations/comments I have would have on the bad bank are:
I have the bad bank in my SOTP at 0 as I think that is the right way to do it. The company give you an equity number for the bank as a whole (DKK 1.7bn) but not on a good bank/bad bank basis - so the way I approach the valuation is to put the bad bank in at 0 and also to look at the earnings from the good bank against the equity in the entire banking operation. Which brings us onto the good bank.
Good bank is probably a bit of a misnomer - it is good relative to the other bit losing DKK 550m/year, maybe not so good vs. its Nordic peers. As mentioned above, the areas they focus on are private banking, financial markets and leasing. They have struggled a bit in these operations over the last couple of years, as the numbers below (together with my estimates for the future) show:
In terms of what has been the headwind - the Danish economy has been the laggard in Scandinavia, which has driven a sluggish loan demand situation (improving slightly recently), while an extraordinary credit review done in 2013 saw impairments tick up on the ~DKK2.4bn loan book. As of Q114 I can say that the performance has begun to turn around, with the bank swinging to profitability (DKK 22m vs. DKK 37m loss in Q113) - the company guide for good bank PTP of 40m for the FY, which I think will prove to be conservative (I have about double that).
In terms of drivers of future profitability, I think it will prove to be an easy win as the economy gradually improves and loan demand picks up, while the cost base clearly has low hanging fruit, with cost-income at an eye-watering 72.4% in FY13. I think that worst case will be they can grow revenues with no cost inflation, realistic case is that costs actually fall as revenues grow.
In terms of what this improvement could be worth - I think that a couple of years out the good bank will be worth ~DKK 2bn, which woud translate to 0.8x book (where some of the domestic Spanish banks now trade, for reference), ~9.5x earnings:
This business description will be very brief - I have little to say. I think that it is a fair business, no more, no less. The ROE is way below the non-life, maybe 7% over the cycle and there appears to be a bit less capital discipline (company have recently been out offering higher guaranteed payments, for example, to receyle some one-off gains). There is about DKK 800m of equity in the division - I would not pay more than DKK 600m for it.
I will paste my SOTP below and then go through line by line:
If we just look at 2016 for the sake of argument, to allow for some time for the earnings power of the bank to become more evident:
The business requires DKK 2.9bn of statutory capital for its operations against equity (which is about equal to total capital) of DKK 4.5bn. For the sake of conservatism (i.e. to protect against further flare-ups in the banking book), they have an internal capital target of DKK 4.1bn. The total capital of DKK 4.5bn is thus in excess of the internal requirement. the company refer to this in the recent interim reports and presentations, for example on slide 18 of the Q114 presentation:
I think this is quite interesting and clearly hints that a dividend, either a special or a regular, is coming. I have asked the company on this. They say it has been discussed internally and, while they obviously do not commit to anything, certainly any net income they generate from here on out would be considered not neccessary for solvency. I would not be surprised to see a dividend started at DKK 1/share in the not too distant future. That would only cost the ~DKK 175m/year; they already have a DKK 450m buffer; they guide that the "forward-looking" activities will generate DKK 575-625m this year, with room for improvement in the good bank. I think that if they could initiate a dividend of this magnitude, it would send a strong signal to the market that the worst is behind them and that what remains is strong, profitable and inexpensive.
|Subject||Update post roadshow|
|Entry||10/28/2014 07:46 AM|
We had the opportunity to catch up with the management yesterday. Since I posted the investment case, the company reported a strong set of interims and raised their guidance – they now expect FY PTP 250m-350m DKK, up from 150m-250m DKK previously – the 100m upward guidance is split 50/50 between the forward looking businesses (where they now expect 625m-675m DKK of PTP) and the banking activities now in runoff (where they now expect 325m-375m of losses). The only disappointment was on the dividend, where they did not initiate and instead adjusted their internal capital target upwards to 4,721m from 4,133m, effectively removing the excess capital we mentioned in the initial writeup.
Most of our discussion was focused around why they decided to up the internal capital target. It was a surprising move to us since most of the problems are centred around the bad bank, where we feel they are already adequately provisioned. The justification given is that they wanted to have internal capital not just in the bad bank but throughout the rest of the business to insulate them from a “one in one hundred years” event where asset prices collapsed again and they were unable to raise equity capital. What they committed to in the meeting is that there will be no further changes to internal capital requirements from here and that any subsequent net income generated would be considered capital that could be paid out. That would seem to imply that dividend potential going forward could be about 1.40/share and rising, which is the taxed FY net income they are guiding for divided by the current share count. The management indeed confirmed this more or less in the meeting, saying they thought ~1.20/share could be the number. Based on their expectations of profit development, they would expect to make an announcement in Spring 2016, but conceded that their profit forecasts for H214 could be seen as conservative relative to some broker expectations, and if the brokers are proven to be correct then an announcement could come sooner.
In terms of the question that naturally follows on the guidance and how conservative it is – in H1 the PTP was down about 7.5% YoY and the FY guidance implies that it will be down 40% in H2. The reason they are so cautious is that their actuaries have assumed some kind of “normalisation” in the combined ratio in the non-life business in H2, with the three normalisation factors being more weather-driven claims, more large claims, and continued price competition in the auto business. Their guidance is based upon a CR of 91 in H2 – that would be up 5 points on H114 and up 3 points on H213. Our view is that they are being sufficiently conservative.
In terms of operating trends – of course the results speak a little bit for themselves – ahead of expectations. They noted some increased price competition from Topdanmark, not just in motor insurance but also in building and property. They have followed a little bit in motor where they see they are too high, but haven’t followed all the way down. Their view is that ~80% of the market is listed companies and you will not see very aggressive pursuit of market share at the cost of profitability, as shareholders will discipline them somewhat. In terms of how bad it could get, the worst it has gotten in recent history is 95-98 CR in 2008-2009, which was more driven by claims inflation and of course the unusual market environment – they do not think it gets this bad again.
Overall we are still pretty positive – the 47.7/share target in the initial writeup still leaves ~50% upside to go for from here, which is attractive even given the minor disappointment on capital returns.