Description

Banque Cantonale Vaudoise – Current Investment Recommendation (451 CHF per Share)

Banque Cantonale Vaudoise (“BCVN”) is the leading private bank, asset manager, and retail bank operator in the Canton of Vaud (“Vaud”), a highly affluent, french-speaking region of Swizerland spanning from Geneva to Lausanne. Its private banking franchise manages 85bn CHF in AuM, and contributes roughly 60% of total operating income. It grew north of 10% in 2007, and exhibits low churn statistics of less than 1.5% per annum based BCVN’s tight-knit demographic, and exceedingly high brand equity in its niche region.  The remaining 40% stems from retail banking, and some 10% from trading operations.  BCVN has been building cash for several years, unable to distribute any meaningful amount beyond a paltry 1-2% dividend yield, for political reasons discussed below. Today, BCVN has roughly 60% of its market capitalization in excess capital by Tier 1 and Basel standards.  Management will confirm this fact.  Ex-cash, BCVN trades at 3.4X “earnings power”, which is equivalent to free cash flow, versus its peer-group at 15x (comprised of a 50/50 blend of Swiss Cantonal Banks and Swiss Private Banks and Asset Managers).  BCVN trades at 1.2X Price/Book, penalized by its unimpressive 10.8% ROE, versus a blended peer average of 2.0X Price/Book with an average ROE of 17.3%.  BCVN could reduce its capital by roughly 2.2bn CHF through dividend or share-repurchase, without affecting its core earnings (reasonably, assuming the cash earns 2%, earnings power should be reduced by 44mm per annum, which has been assumed for purposes of this analysis). It is our view that once the capital distribution is communicated/implemented/accomplished, the resulting dramatic improvement in ROE will further underpin a large re-rating based on Price/book multiple convergence, in line with blended peers, given that the present large ROE gap will be entirely closed.[1] 

Brief History

BCVN ran into severe financial difficulties in 2001 and 2002 when it was forced to recognize the true value of its loans in its balance sheet. An emergency injection of capital by Vaud in the form of equity and participation certificates (PCs) bolstered the bank’s solvency, and a new management team was appointed, beginning a program to restore the bank’s profitability and lessening the burden of impaired loans. Alexander Zeller, who oversaw a dramatic restructuring at CS Asset Management, triggered our interest in the situation as early as 2004.  As the turnaround plan began to bear fruit in 2003-2005, surplus cash was used, in part, to repurchase Vaud’s entire Particiption Certificates stake. Today, Vaud retains only a 67% interest in BCVN’s common equity, which for nebulous political reasons, has, until now, precluded BCVN from distributing its excess capital.  Given Vaud’s critical role in the rescue of the bank, the company has explained to investors that it had been, until now, respecting its agreement with Vaud, and wait for it to sell its stake down below 50%, in order to commence a cash distribution program.  (Upon information and belief, this “no-distribution” policy was based more upon sovereign commitment and community relations than corporate mandate).  In late 2007, after management and shareholders waited patiently for the conclusion of both Vaud’s strategic review of its stake, the company has begun communicating to investors in the past weeks that they would wait no longer, and the capital distribution policy would be announced at year end results in March 2008, making this an ideal time to examine the investment case.

Expected Plan for Capital Distribution

Based on Conversations with management, the plan that seems most likely is a 10-year bullet dividend that will see the cash surplus and an aggressive net income distribution bundled together.  Based on my estimates, dividend yield under this model will be 14% in 2008 trending close to 19% at the end of the 10-year period in 2017 (see below).  The company’s rationale for such a structure, understandably, has been to try to retain stability in the shareholder base, rather than inject a large arbitrage community into its shares.

Whether the stock re-rates on a dividend yield, or on a P/E basis ex-excess capital, or a P/E basis ex-present value of excess capital distributions (or similarly, on a P/book basis post balance sheet engineering), the stock appears extraordinarily undervalued, with scope for a medium-term double, if not triple.

Lastly, the present value of the dividend stream anticipated attributes negative terminal value to the franchise post 2017, which supports the perspective that the market is valuing BCVN entirely incorrectly.

 Abbreviated Financial Analysis – Focus on Dividend Distribution

Due to Formatting issues, please see:  http://docs.google.com/Presentation?id=ddj7sb7w_9fmcj6hfj

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