Thesis

Caja de Ahorros del Mediterraneo (CAM) is trading at >2x P/BV (17x P/E).  This is despite (based on CAM's own calculation of its equity capital shortfall) it requiring additional new equity capital equal to approximately 1.4x its current book value.  The systemic importance of CAM and solvency concerns mean that the capital injection must be completed in the near term and the new equity will likely come into the bank at a discount to current book value.  This will be extremely dilutive to current equity holders, which already enjoy a premium valuation to comparables (without any justification based on business fundamentals).  CAM's equity is likely worth >75% less than its current value. 

Cross checks:

• The Bank of Spain has proactively contacted a number of banks over the past two weeks and has been unable to find a buyer for CAM (it is understood that buyers are unwilling to buy CAM - even for nominal value - without an asset protection scheme to protect them from further losses)
• Fitch downgraded CAM to sub-investment grade on 1 April 2011
• CAM's Senior Credit is currently trading at a spread of ~500bps and its Perpetual Subordinated Bonds trade in the high-30s (this is entirely inconsistent with a bank that has equity trading at a material premium to book value)

Summary

• Valuation: CAM is the only Spanish Savings Bank (Caja) with listed equity. CAM's equity trades at >2x P/BV. The equity is likely worth >75% less than its current value
• Catalyst: CAM is the 10^th largest bank in Spain and systemically important. Solvency concerns mean that new equity must come into the bank in the near term. This is not in dispute as even CAM has acknowledged it has a requirement for €2.8 billion of fresh equity capital (vs. its current book value of €2 billion - i.e. 1.4x its current book value must come in as fresh equity). This equity will very likely come in at a discount to book value
• Background & Context: Spain's banking issues are well known. The savings banks are more troubled than the listed commercial banks. CAM is no exception to this. As part of an effort to clean up its balance sheet CAM had agreed a merger with three other savings banks. As a result of a material deterioration of its loan book in late 2010 / early 2011 the merger was rejected by the other three savings banks. CAM is now left with a very large capital shortfall (and thus a very large requirement for new equity). The following chronology of events shows how the situation developed:
  • CAM had agreed to merge with three other savings banks. The merged entity would seek an equity infusion from a specially established government fund (FROB) to replenish its equity capital to minimum core capital requirements. The merger was subject to shareholder votes from each of the four institutions. The votes were scheduled to take place in late March 2011
  • 30-Mar-11: CAM shareholders approved the merger. The other three savings banks all voted against the transaction. The other institutions indicated they voted against the transaction because they became increasingly concerned with CAM's solvency as a result of a material deterioration of its loan book. The capital shortfall of the merged entity doubled.  All of this increased capital shortfall was due to CAM's loan book deterioration
  • 30-Mar-11: After the three other banks had voted against the merger the Bank of Spain issued a statement requiring that a new recapitalization plan be presented "immediately"
  • 1-Apr-11: Fitch downgraded CAM to sub-investment grade (downgrade to BB+)
  • 3-Apr-11: CAM announced it had calculated it had a €2.8 billion equity capital shortfall and it required this much fresh equity (vs. a €2 billion book value at 31 December 2010)
  • 8 Apr-11: The other three savings banks that were previously going to merge with CAM approved a merger among themselves. The merged entity (with only these three institutions) has not requested any additional equity (i.e. it does not have a shortfall)
  • 13-Apr-11: Press reports indicate the Bank of Spain was unable to find a buyer for CAM (Note: the BoS had pro-actively contacted a number of banks looking for a buyer for CAM. It is understood that no banks were willing to buy CAM - even for nominal value - without an asset protection scheme from the government to protect the buyer from future losses in CAM's loan book)

Background

I have written a couple of times on Banco De Valencia (BVA):

• Here: http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/20796; and
• Here: http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/40757

Approximately 2/3 of CAM's Branch Network is located in the same geographies as BVA and from what I understand there was not a large differentiation in lending standards among the institutions competing in these regions.  The background information provided in these write-ups in relation to the Spanish banking system and its challenges, house prices, lending to developers and sub-economic loan roll-overs as well as the specific issues related to the Valencia/Murcia geographies is also applicable to CAM.  

In May 2010 CAM and three other savings banks (Cajastur, Caja Cantabria and Caja Extremadura) agreed to merge.  As part of the merger the four institutions agreed to:

1. effectively pool all of their assets and liabilities;
2. write-down their assets to fair value and/or recognize appropriate levels of provisioning;
3. apply to the FROB* for fresh capital to allow the merged entity to be adequately capitalized and in compliance with the minimum capitalization requirements as set by the Bank of Spain.  The original capital shortfall identified for the merged entity was calculated at €1.45 billion

Implementation of the merger was subject to shareholder approval from all four savings banks.

In early 2011 press speculation and rumours emerged that the merger was in jeopardy as a result of disagreements between CAM and its potential merger partners.   It has been reported that CAM's merger partners claimed that as a result of a rapid and material deterioration in CAM's loan book, the capital shortfall of the merged institution had increased from €1.45 billion to €2.8 billion.  CAM's merger partners argued that as a result of this more fresh equity would be required which would dilute each institution's economic interest in the merged entity.  They argued that because all of the deterioration was from CAM's loan book CAM should shoulder the burden of the additional dilution.  It is understood that the Bank of Spain exerted pressure on all institutions to proceed with the merger.  Despite this pressure, on 30 March 2011 CAM's merger partners all voted against the merger and the deal fell over.  In the two weeks since the merger fell over CAM has identified that it has a capital shortfall of €2.8 billion (i.e. 100% of the capital shortfall the entire merged entity identified) and the other three institutions have proceeded with their own merger (without CAM) and have identified zero capital shortfall.

More background on the situation available here for those interested:

• http://www.ft.com/cms/s/0/4f9b5aa8-5b07-11e0-a290-00144feab49a.html#axzz1JOPjQ7Ye
• http://online.wsj.com/article/SB10001424052748703806304576234912073054934.html
• http://www.ft.com/cms/s/0/8f735706-5e14-11e0-b1d8-00144feab49a.html#axzz1JOPjQ7Ye

*Note: the FROB is a fund created by the Spanish government to recapitalize troubled banks - see here for more information: http://es.wikipedia.org/wiki/Fondo_de_reestructuraci%C3%B3n_ordenada_bancaria).

CAM's Capitalization as a Savings Bank & CAM Listed Equity

CAM is a Caja (a savings bank) and as such (like other savings banks in Spain) is a non-profit social institution.  Essentially, what this means is that the equity in CAM is "owned" by the local municipality and any profits generated by the bank are for the benefit of the community.  In practice the bank makes distributions to a welfare fund which spends money on various projects. 

In 2008 CAM issued 50 million non-voting shares which are traded on the Madrid Stock Exchange (CAM was the first - and to my knowledge the only - savings bank to have issued public shares).  The rights conferred on the shares are summarized in CAM's Annual Report, but simplistically the non-voting shares receive a specified percentage of CAM's after tax profits but have no voting rights.  In a liquidation the non-voting shares rank equal to the welfare fund (and junior to subordinated creditors).  For 2010 the non-voting shares are entitled to 6.935% of CAM's distributable profit (see 2009 Annual Report for the calculation of this percentage). 

Those interested can find CAM's Annual Reports (in English) here: https://www.cam.es/EN/inversores/FinancialInformation/Paginas/pgAnuales.aspx 

Valuation

The current market capitalization of CAM's non-voting shares is approximately €294 million.  Applying the non-voting shares percentage entitlement to distributions implies a market value for all of CAM's equity of approximately €4.2 billion (i.e. €290 million / 6.935%).   At 31 December 2010 CAM's book value was €2 billion.  CAM's profit after tax for the year ended 31 December 2010 was €244 million (€277 million in 2009). On this basis the non-voting shares are trading at approximately 2x P/BV and approximately 17x P/E. It is noteworthy that CAM took €1 billion of write-downs through equity (this did not hit the income statement) in 2010 (this is part of the reason that additional equity is now required - more on that below).  Regardless, at its current valuation, (with the exception of BVA - which I have written about before as referenced above - this makes CAM the most expensive bank in Spain and one of the most expensive in Europe.  Importantly, this valuation does not adjust for CAM's capital shortfall and the fresh equity that will be coming into the bank (see below).  

The listed Spanish domestic banks* currently trade at an average P/BV of 0.8x and an average P/E of 13x P/E.  The rationale for valuations that are below book value is because the sector is expected to earn a Return on Equity that is below its Cost of Equity for the short to medium term and overall loan growth in Spain is expected to be negative over this same time period.  CAM is no exception to the sector trends.  

The other very relevant data point was a transaction announced in January 2011, where Criteria Caixa Corp acquired La Caixa (the largest savings bank in Spain).  La Caixa was widely perceived to be one of the healthiest savings banks in Spain with a very valuable retail franchise.  The transaction was completed at a valuation multiple of 0.8x book value.   More information on the transaction can be found here: http://www.criteria.com/deployedfiles/caixaholding/Estaticos/PDFs/InversoresInstitucionales/110128_HR_CRIWebcast_en.pdf

Because of the size and quality of the institution, the La Caixa transaction multiple will likely be the ceiling for acquisitions of savings banks (as well as for fresh equity contributions into savings banks).  The trading multiples of the domestic banks will also be valuation benchmarks and the current P/BV multiples are wrapped around the La Caixa transaction multiple.

* Note: represents Banco Popular, Banco Sabadell, Banesto, Bankinter and Banco Pastor (excludes Banco De Valencia which is a valuation anomaly, albeit one that is correcting)

CAM's Capital Shortfall

On 1 April 2010 CAM announced that it had a capital shortfall of €2.8 billion (see here: http://www.cnmv.es/Portal/HR/verDoc.axd?t={a2895af5-6067-483c-a331-0c275d18a4d9}).  While this amount has not yet been formally agreed by the Bank of Spain (it could increase if the BoS believes CAM's methodology was aggressive), it is probably the best case for the bank.   Given the valuations of the domestic banks as well as the valuation for the La Caxia transaction it seems extremely unlikely that this fresh equity capital will enter the bank at book value.   The analysis below assumes the capital is contributed at 0.5x P/BV:  

CAM Current Book Value (at 31-Dec-10): €2 billion

New Capital: €5.6 billion notional (i.e. €2.8 billion capital contribution at 0.5x P/BV)

% Total Capital Post Recap:

New Shareholders: 74% (i.e. €5.6 billion / €7.6 billion)

Current Shareholders: 26% (i.e. €2 billion / €7.6 billion)

of which: CAM non-voting shares: 1.8% (i.e. (€2 billion x 6.935%) /  €7.6 billion)

In this scenario the current market value of the non-voting shares (~€294 million) would result in a valuation of 3.3x P/BV and 66x P/E (versus the new money that has come into the bank at 0.5x P/BV).   This represents ~85% downside from CAM's current valuation to the valuation that new money came into the bank.  

If you assume new money comes into the bank at 0.8x (which is probably the ceiling based on the La Caixa transaction as well as where the public comps are currently tradnig, as discussed above) then the resulting percentage ownership of the non-voting shares would be 2.5% (rather than 1.8%).  This would result in a valuation for the non-voting shares of 2.4x P/BV and 48x P/E (i.e. 65% downside to where new money came into the bank).

The final point that is worth noting on valuation is that the Bank of Spain has been actively seeking a buyer for CAM since its merger fell over on 30 March 2011.  The press has reported that eight institutions have been approached.  On 13 April 2011 press reports indicated that the Bank of Spain was unable to find a buyer for CAM.  It is understood that no banks were willing to buy CAM (even for nominal value) without an asset protection scheme to protect the buyer from future losses that could emerge from the CAM loan book.  This scenario indicates that strategic buyers value the current equity at effectively zero (i.e. they likely believe that CAM's estimate of a capital shortfall of €2.8 billion is too low and the capital contribution they will need to make is higher and therefore the deal does not make economic sense for them, even if they acquire CAM's current equity at nominal value).  

Likely Outcomes

It is not in dispute that CAM requires fresh equity (the bank itself has admitted this).  The question then becomes what are the likely outcomes and how dilutive will this be to current equity holders.  I think there are three potential likely outcomes:

1. CAM is acquired by a strategic buyer.  Absent an Asset Protection Scheme it appears the value for equity is this scenario is very low.  As an Asset Protection Scheme is a transfer of value from the Spanish taxpayer to current equity owners and there is no impending banking crisis, I would argue the appetite for an APS is low.  As such, it seems likey that current equity holders will be heavily diluted in this scenario (probably even more than the analysis above shows) 
2. FROB Equity Injection.  This seems like the most likely scenario. If this takes place the FROB would likely replace existing management, try to put CAM's house in order and then probably sell the assets in a public auction.  it is worth noting that any equity injection by the FROB will be done at a value determined by an independent third party. The analysis above indicates this is a very dilutive outcome for existing equity holders but this assumes that the FROB equity comes in at the same level as the existing equity.  It is possible that FROB could put its equity in as preferred (or something simialr).  This could change the calculation for current equity holders and potentially make the outcome even worse
3. Bank of Spain Intervention. If CAM started to become a systemic concern (e.g. large retail deposit outflows, etc.) then the likelihood of  direct intervention would increase.  In this case it is likely that the equity would be seized for nominal value, some good bank / bad bank separation would take place and the good bank would be on-sold and/or an Asset Protection Scheme is put in place for the buyer (for those interested, you can look at the separate recent cases of CajaSur and Caja Castilla La Mancha for case studies of how this would likely occur in practice)

Fresh equity injection. CAM is systemically important and new equity needs to come into the bank in the near term.   It is worth noting that this situation is developing against the backdrop of the European bank stress tests and Spain trying to prove to investors that it will not be the next Perpherial European country that needs to go to the EU for a bailout.  This backdrop (as well as the systemtic important of CAM) adds urgency to the issue.