Description

INTRODUCTION

Eurobank Ergasias is one of four systemic banks that together hold over 90% of deposits in Greece. The bank is highly influenced by Fairfax, the global insurance company formed and managed by Prem Watsa. Asset quality and capital adequacy have been continually evaluated since 2011, with BlackRock submitting reports to Bank of Greece in 2011 and 2013, and then the ECB performing a review most recently in November 2014. Notably, the ECB concluded that none of the Greek banks required additional capital. With the International Monetary Fund (IMF) projecting +0.6% real GDP growth for 2014, Greece is on the verge of escaping from a depression that began in 2008 with. These positives have been neglected as investors have narrowed their focus recently on concerns about political instability in Greece. As a result, the market capitalization stands at €3.1 billion, or 62% of tangible common equity, 4.2% of total assets, and 355% of pre-provision revenue.

An upside scenario of 200% and a downside scenario of 60% are briefly illustrated in the table below and then described in greater detail afterwards.

25% EARNINGS YIELD IN A POSITIVE SCENARIO

The following simplified math is intended to highlight the significant upside potential for investment in EUROB at €0.21. All that is required for a 25% earnings yield is for the bank to return 1.0% on assets and 15% on tangible equity. Before provision expense, the last twelve month “pre-provision” ROA is 1.2-1.3%, with an upward trend after bottoming in the middle of 2013 at 0.6%. Several factors could support continued improvement toward the historical range of 1.5% to 2.5%. While trends are positive, and management aims for €1.5 billion (2.0% of assets) in a recovery, such sizable improvement is not the most likely outcome. Reversion to the mean seems improbable given that the pre-provision ROA for top banks in the US is still almost 1.5 standard deviations below the 15 year average even though the economic recovery is well underway.

Lower funding costs = €280 million or 0.40% of assets

The Greek banking sector consolidated dramatically after the Bank of Greece deemed four banks fit to receive public support in 2011 based on the first BlackRock stress test. These four received €25 billion in capital from the Hellenic Financial Stability Fund (HFSF), which was capitalized with €50 billion from the troika: European Commission (EC), European Central Bank (ECB), and IMF. After 22 banks have been consolidated, the top four banks now hold over 90% of assets and deposits.

Motivated to safeguard its €50 million investment, the troika required the four systemic banks to submit restructuring plans to the EC. One of the key commitments to the troika by the banks was to improve profitability by reducing deposit costs. Separately, the banks are subject to the Hellenic Republic Bank Support Plan, a law passed by the Greek Parliament, which obliges them not to pursue aggressive commercial strategies or to cause any unjustifiable distortions of competition. The law also sets a limit on growth in assets. Both the agreement with the European Commission and Greek Law encourage the Greek banks to reduce the rate they pay for deposits.

Eurobank’s cost of time deposits has fallen considerably from a high of +3.59% above euribor in 1Q13 to only +2.02% in 3Q14. The rate for new deposits was even lower, or 1.83% as of October 2014. Management targets a recovery to +1.00% (note that time deposit rates in other periphery countries are around euribor +1.00% currently and in 2007 the spread for Eurobank was 0.17% below euribor). Given that Eurobank’s time deposits equal €28 billion, accomplishing that goal would save the bank €280 million per year, and boost the ROA by 0.40%.

Restructuring savings = €130 million or 0.20% of assets

The Greek banks committed to reducing operating expenses also. Eurobank reduced operating expenses by around €300 million between 2008 and the end of 2014. In 3Q14, the cost-to-income ratio was 54%, with total operating expenses of €258 million. The near term target is annual costs of €900 million and a cost-to-income ratio below 50%.

The plan for cost cutting focuses on two areas:

Merger synergies = +€200m. Much of these savings have been already realized. Eurobank acquired two “good banks” in 2013. One of them was paying deposit rates 100bps higher than Eurobank. The new owners terminated that practice and harmonized the rates at the lower rate Eurobank was paying. Also, various back office costs are redundant. While Eurobank is operating a dual brand strategy currently, management could end that in a quest for further cost reductions.

Fixed cost reduction = +€100m. This is mainly from a reduction in headcount (~1,000) and branches (~100), so far.

In an interview with the former non-executive Vice Chairman, he remarked that that Eurobank is the best Greek bank to own for the long term because the young and anti-bureaucratic management will adapt best to the new environment (e.g. cost restructuring).

Recovery in fee income = €150 million or 0.20% of assets

Eurobank operates many fee businesses: investment banking (#1 position), asset management (€3.1B AUM, #1 position), private banking (€6.3B AUA), life insurance (#3 position), securities servicing (€26B AUC, #1 position). Net fees contributed a return on assets of 0.92% in 2007. This has fallen to 0.40%, but appears to have stabilized (2011-12-13-14), and management aims for a recovery to 0.60%. Such an improvement would contribute €150 million to profit.

STRONG CORPORATE GOVERNANCE

In a memorandum of understanding with the IMF dated July 2013, the Greek government pledged to place a “substantial equity stake [in Eurobank] with a private strategic international investor” for the purpose of safeguarding financial stability. That investor appears to be Fairfax, which bought €400 million of Eurobank during April 2014. There were other cornerstone investors including WL Ross, Brookfield Asset Management, Capital Research, Fidelity, and Mackenzie. Prem Watsa and Wilbur Ross did a fine job for shareholders as directors of Bank of Ireland. Though they chose to be represented by employees of their respective firms this time, the direct representation of large owners on the board is likely to improve corporate governance at Eurobank. These investors hold five of 11 board seats. The Greek State is represented by one director. The HSFS is represented by one director.

Fairfax has made investments in Greece that amount to least 4% of the company’s investment portfolio. This could motivate the company to lobby energetically for political stability and for a business friendly climate.

STOCK PRICE DISCOUNTS HIGH PROBABILITY OF PUNITIVELY PRICED CAPITAL RAISE

Given a price-to-tangible book ratio of less than 65%, market expectations seem to be for extended returns below the bank’s cost of capital (note that 10-year Greek government bonds yield ~9%), or for new share issuance at a punitive price, or for both.

The ECB just ruled that the four systemic Greek banks had sufficient capital

Eurobank’s asset quality and capital adequacy have been subject to near continuous third party monitoring since 2011. Most recently, the ECB determined in Nov 2014 that Eurobank did not require any additional capital.

1) In August 2011, the Bank of Greece (at the behest of the troika) commissioned BlackRock Solutions to perform a diagnostic assessment of 18 Greek banks as a condition for a €109 billion assistance package to Greece. Given the scope of the analysis, BlackRock engaged numerous partners for assistance, including Clayton Euro Risk Management, Ernst & Young, KPMG and PricewaterhouseCoopers. These parties spent four months reviewing credit quality, lending practices, data integrity, and projecting losses. Results were published in December 2011.

BlackRock concluded that lifetime losses for Eurobank’s €37 billion portfolio of Greek loans would total 16% in a base case and 22% in a stress case.

2) In 2013, BlackRock returned for a second assessment. The economy in Greece had deteriorated and the economic assumptions underlying the credit loss projections needed updating. The revised lifetime losses were estimated to be 22% and 27% in the base and stress scenarios. To bolster its capital position and absorb the higher loss projections, Eurobank issued 9.2 million new shares in April 2014 at €0.31 for a total of €2.9 billion.

3) In the second half of 2014, the ECB performed a comprehensive assessment of 130 banks. The ECB loss projections were similar to those of BlackRock.

Note that Eurobank’s cumulative provision expense starting after 2007 through 3Q14 equals 21% of gross loans held at the end of 2007.

The economy is trending toward recovery

Economic data is mixed but has been getting less bad. The most important positive trends for the banks are the decline in new past due loans, the decline in the unemployment rate, and the falling rate of contraction in GDP.

A liquidity crisis has already transpired

The Greek government and the banking system have experienced one liquidity crisis already. Deposits in Greece fell from a level of around €270 billion in 2009 to €200 billion in 2012, and have stabilized at this level since. Therefore, if a liquidity crisis re-emerges, the deposits that have stayed in the banking system could prove resilient. Eurobank’s deposits declined from €47 billion in 2009 to a low of €28 billion in 2012 and have since recovered to €43 billion, boosted mostly by acquisitions. Now the loan-to-deposit ratio for Eurobank is 100%, with other banks at similar levels.

Similarly, Eurobank’s borrowings from the Eurosystem have declined from €30 billion in 2012 to €9 billion in October 2014. The bank has €12.3 billion of collateral eligible for repo financing by ECB, leaving a buffer of €3.2 billion.

Burn down tangible book prospects

Although the ECB just declared that Eurobank did not require additional capital, current political uncertainty and a change in regime during 2015 could cause the assumptions underlying the ECB’s credit loss projections to prove too optimistic. In other words, Eurobank might need additional capital.

A new issue of shares that reduced tangible book value per share from the 3Q14 level of €0.34 to the current share price of €0.21 would require either a significant discount to the current price or a huge amount of new common equity. The table below illustrates how much capital would be raised at various discounts to pro forma tangible book, which is assumed to be the current price of €0.21. Issuing new shares at a 20% discount, like Eurobank did in April 2014 when it raised €2.9 billion, would increase capital by €7.7 billion, or 150%.

Importantly, the HFSF still holds €10 billion of cash that was designated for recapitalizing the banks. If history is a guide, the HFSF would backstop any future capital raise with a reservation price based on third party appraisals. In addition, the HFSF holds €950 million of preferred stock in Eurobank that would likely be converted to common equity at the appraisal price. Both of these factors would mitigate the amount of new capital required from capital markets.

At the end of 3Q14, Eurobank held gross loans of €52 billion, of which €17.1 billion are past due by more than 90 days. This is a default rate of 33%. The reserve for loan losses is €9.2 billion, which implies a loss given default of 54% (will be 55% by year end). Most stress tests allow credit for pre-provision income (PPI). Eurobank’s PPI in 3Q14 was €217 million, so three years at that run-rate totals €2.6 billion of additional capacity to absorb credit losses.

Consider the following three scenarios to frame potential for additional provision expense (also depicted in a table below):

1. If the default rate increased from 33% to 50% and the loss given default remained constant at 55%, then Eurobank would need to provide 55% to the inflow of €8.8 billion in past due loans for new expenses of €4.8 billion. Net of €2.6 billion in PPI, the capital shortfall would be €2.2 billion, though an increase in defaulted loans would reduce pre-provision income. The volume of new past due loans flowing into the total stock of past due loans has declined recently and was 0.5% of gross loans in 3Q14.

2. If the loss given default increased from 55% to 70% and the balance of defaulted loans remained constant, then Eurobank would need to provide another 26% of the €17 billion in past due loans for new expenses of €2.8 billion. Net of €2.6 billion in PPI, the capital shortfall would be €0.2 billion.

3. If both, then new expenses of $9 billion. Net of €2.6 billion in PPI, the capital shortfall would be €6.4 billion.

After 24 quarters of economic contraction during which GDP declined 33% and unemployment reached 28%, if the bank’s delinquent loans increased by a further 50% and the loss rate on defaulted loans also increased by nearly 50%, then Eurobank could need €6.4 billion in additional capital (scenario 3). In that case, it might get €3.5 billion from the HFSF, leaving another €3 billion needed from the capital markets. This would be tough to find, given that big investors in Greece like Capital and Paulson have discussed halting investments in Greece (see links below).

If the HFSF set a reservation price equal to 78% of pro forma tangible book in a €6.4 billion capital raise, the price would be €0.17 and pro forma tangible book €0.22. That suggests 20% downside for buyers of the stock at today’s €0.21 price.

In the aforementioned scenario, investors might require a larger discount to tangible book to be enticed. (On the other hand, they might feel nearer to the end of the depression and willing to pay closer to book.) So if the HFSF set a price equal to 67% of pro forma tangible book, that would equal €0.08, or 60% downside from today’s price.

http://en.protothema.gr/capital-group-everybody-coming-out-of-the-meeting-with-stathakis-milios-wants-to-sell-everything-in-greece/

http://www.valuewalk.com/2014/12/paulson-greece-investments/

Catalyst

Improved sentiment about political uncertainty

Continued economic recovery