Description

Grupo Galicia VIC (9/5/2018)

Grupo Financiero Galicia (“Galicia”), the parent company of Banco Galicia, is second largest private sector bank in Argentina by share of deposits and loans and the largest by share of branches and credit cards. Although the stock has fallen from its high in the recent turmoil in Argentina we believe it is still overvalued and has significant downside from here. The stock currently trades at 2.6x P/TBV, 2.5x P/B, and 2.3x P/TBV adjusted for appreciation of an asset held for sale. At 1.0x tangible book value, which is a reasonable (if not generous) valuation for a bank which does not and has not earned a return on equity materially above inflation, the stock would be worth 41% of its current value.

The banks in Argentina until recently have traded at very high multiples of book and Galicia has been the most expensive in almost every period since 2014. Galicia is among the most liquid stocks in Argentina so it has been a favorite of international funds seeking exposure to Argentine equities (there are only five Argentine stocks currently above USD $2B market cap). For example, at 12/31/17, Galicia traded at a euphoric 4.9x P/B (before any adjustments), and peers Santander/BBVA/Macro/Patagonia/Hipotecario traded at 4.7x/3.7x/3.4x/3.8x/2.9x or an average 3.7x. 

We believed the banks were mis-valued before the recent macro/sentiment-driven decline and are still expensive now. We believe they were mis-valued because 1) investors did not fully appreciate the consequences of high inflation for a book value-based business, 2) investors made overly optimistic assumptions about banks’ ability to grow their books, and 3) investors used the banks as a proxy for exposure to Argentina without paying enough attention to valuation relative to fundamental value, global peers, or normalized ROEs.  

We believe that some investors saw the mid/high-20%s nominal ROE:

And ignored that in such a high inflation environment, earning an ROE which matches or lags inflation is a zero or negative real ROE (given that the positive ARS value from the adjustments of “real” assets like foreign currency, real estate, gold, etc. are in net income):

The high-inflation environment in Argentina makes the banks’ P/E multiples look reasonable (for example Galicia is 8.3x Bloomberg consensus 2018E). However, as Galicia’s assets and liabilities both inflate each quarter, the book is not growing on a real or USD basis so the ROE is just nominal and no value is being created. The growth in earnings is just an artefact of Argentina’s perpetually high inflation.

Another argument cited by Galicia bulls is that the banking system in Argentina is so underpenetrated and has so much room to grow after being constrained by the Kirchner-era distortions for over a decade that the banks will issue significant equity at high multiples and grow into their valuations. For example, Argentina’s bank penetration as of 2Q18 was 18% deposits/GDP and 15% loans/GDP despite regional peers with somewhat similar levels of GDP per capita and savings per capita at 2x higher or more.

The banks did issue in aggregate ~$2.3B of equity ($600M at Galicia, 750M at Macro, 400M at Frances, 400M at Supervielle) between June and September 2017. Although these raises did happen at high (~3-4x) multiples of book, each management team we talked to said they had raised enough capital to grow for at least two years, and Galicia said they had enough for four years. Given the recent macroeconomic uncertainty we believe any equity raises will likely be even further in the future. 

Additionally, in the current environment, Galicia loan growth has fallen behind inflation after outpacing it in prior quarters. The large and sudden interest rate increase to 60% and the lag between wage growth and inflation will limit banks’ loan growth and further delay the path toward Argentina’s banking penetration normalizing and the banks’ appetite to raise more capital.

Even if the banks did expand their books through loan growth and earn high real returns for a sustained period as the optimists hope, we believe current multiples are still unjustified. The Brazilian banks went through a somewhat similar period of book expansion and high returns on equity and assets in 2004-2007. Although these banks (Bradesco, Banco Do Brazil, Banrisul, ABC Brasil, Banco Pan, Banestes) earned an average real 21.3% return on equity over four years, they traded at an average 2.1x P/TBV, lower than Argentina’s multiples. The peak 21% real ROE achieved in Brazil is higher even than the sell side analysts’ prior optimistic forecasts for Galicia’s future real ROE (2021E = 15%).

Note that Galicia’s book should be adjusted for an asset held-for-sale, their stake of the multi-bank JV Visa card issuer Prisma. Prisma is held on the book at a historical valuation but is probably worth more today as it has not grown with inflation (an accounting distortion). I do not have a strong view on what this asset is worth after the devaluation but management guided to ARS 4B or 8.5% of adjusted tangible book as of 1Q18. Adjusting for this asset, Galicia’s 2.3x P/adj. TBV multiple is still not cheap relative to any global peer set you look at; banks at >2x book multiples earn low teens real ROEs or better:

Comps’ historical trading multiples show Galicia’s premium valuation, which is not justified by a premium ROE:

Risks to short thesis:

1.      MSCI inclusion: in June 2018 the MSCI announced Argentina is to be upgraded from a “Frontier Market” to an “Emerging Market” in June 2019 which will drive inflows to stocks meeting the MSCI inclusions threshold from passive tracking funds (the difference between $460B tracking EM indices vs. 700M tracking FM). Galicia will be in the MSCI index and inclusion could drive passive buying volume worth an estimated 23 trading days’ worth of volume. Although we believe MSCI inclusion is a real positive for MSCI and other Argentine stocks, a review of past FM/EM upgrades (Qatar, UAE) shows that most of the outperformance happens around the announcement of the upgrade, 12 months prior to the upgrade itself, so June 2019 inclusion will probably not be a positive event for Galicia’s stock. 

2.      M&A: Galicia could acquire smaller competitors including private banks. Although we don’t think such a transaction would necessarily create a significant amount of value beyond overhead synergies, from speaking with analysts and investors we believe the market would take M&A as positive for the stock. We also believe from conversations with management that pursuing M&A in the context of macroeconomic turmoil is less likely.    

3.      Argentina recovery: in our base case Argentina recovers from the current uncertainty, the now-weak Peso’s real effective exchange rate will strengthen and Macri will be able to service the FX-denominated debt, which the currency devaluation has pushed to 65% of GDP from 45% last year, with IMF disbursements and $56B of foreign reserves. In such a scenario some optimism will return to valuation of the bank and other stocks. However, we believe that prior optimistic highs of 5x P/B are unlikely to be achieved again following such a sobering decline and banks will trade more reasonably in-line with their long term normalized ROEs.

Disclaimer:
The author is presenting the views of an investment firm that has a material position in the securities of the company discussed herein. The author is not otherwise affiliated with such company, including as an employee, director or consultant. The views expressed herein are provided solely for informational purposes and do not constitute an offer to sell, or the solicitation of an offer to buy, any security. The information provided herein is not intended to be, and should not be, relied upon as an investment recommendation in connection with any investment decision. The contents of this message should not be construed as legal, tax, accounting, investment or other advice. No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein by the author or its affiliates and no liability is accepted by such persons for the accuracy or completeness of any such information or opinions. The information and opinions contained herein are provided as of the date this message is originally posted. The author has not independently verified all information contained herein and has no obligation to update any of the information provided. The views expressed herein are subject to change without notice at any time and the author and its affiliates may trade in any manner in the company’s securities, whether consistent or inconsistent with the information provided herein, as they deem appropriate. Past performance of a security is neither indicative nor a guarantee of future results of such security. There can be no assurance that an investment in the company will be profitable or that the assumptions regarding future events and situations will materialize or prove correct.

Catalyst

Deteriorating real ROEs. Slowing loan growth.