New position: Lloyd’s Banking Group (GBGB0008706128) as special situation investment

Interestingly, while looking at AerCap, I always almost automatically compared them to Llyods Banking Group. In the old days I might have bought both shares but as I limit myself to 1 new position (or one complete sale) per month I had to make a decision and it went to Lloyds. My previous analyses can be found here: part 1 & part 2

Just to summarize my view on Lloyd’s and why I bought now:

1. I do think UK retail banking is a structurally good business in the mid- to long term
2. Lloyds does have a certain “franchise” and good management
3. I like buying into uncertainty (UK election). Most investors hate uncertainty and often political uncertainty provides interesting entry points
4. Continued heavy selling by UK Government has a direct impact on the price. This is from a few days ago:

Lloyds Says U.K. Treasury’s Stake In Bank Falls Below 21%
By Keith Campbell
(Bloomberg) — Govt now holds 14,955m shares, down from 15,697m Govt had cut stake to 22% as of March 25

Within 4 weeks,the UK Government sold almost 750 mn shares. Total trading volume according to Bloomebrg was ~2,6 bn shares, so the selling program accounts for ~29% of the total traded volume. Normally, 10-15% of daily volume is already critical, but dumping almost 30% of daily trading clearly must have an impact on the price.

I am not sure why the Government is still “dribbling” out (at this pace it is rather “pumping out” shares) instead of placing the whole amount but I guess that has to be with political tactics, i.e. not leaving this around for the next government

5. Lloyd’s is taking market share from competition (via Halifax):

Lloyds Banking Group Plc’s Halifax unit gained the most customers from its rivals of any U.K. lender in the third quarter as probes by the competition watchdog and financial incentives resulted in more Britons switching banks. Royal Bank of Scotland Group Plc and Barclays Plc lost the most U.K. checking accounts in the period, the most recent data published by Britain’s Payments Council on Thursday show.

6. HSBC is doing everything to destroy its reputation on UK’s high street by threatening to leave the UK. Also the other big players (Barclay’s, RBOS) have other problems
7. Compared to AerCap, increasing interest rates should be overall positive for banks
8. the major risk for the LLoyd’s investment case is relatively independent to overall markets (UK regulation, PPI, election)
9. results and dividends will improve more or less automatically over the next 2-3 years even under relatively adverse developments
10. I said this a couple of times, but for me a regulated retail bank like Lloyd’s is less risky than a “shadow bank” financing company like AerCap. If there is a next finanical crisis, in my opinion traditional banks will be less effected than “non traditional” players

Similar thoughts to my own can be found at teh UK version of Motley Fool just a few days ago.

There is clearly also a potential downside:

– there are no prominent investors like Einhorn and Jana on board and no direct “catalyst”, so stock price could remain “range bound” for some time
– clear tail risk with regard to UK election outcomes, “Brexit”, bank levy etc.
– Q1 could again look not very nice (TSB charges, bond repurchase)
– if interest rates in the UK go “European”, profitability could suffer in the long term
– Lloyds has pretty low beta and will underperform in a “Good market” for some time

Anyway, to me Lloyd’s banking Group looks like an interesting special situation at this time. The share overhang and selling should clear at some time, profits will most likely increase. Over 3-4 years I look for an upside of around 50% plus dividends or ~15% p.a. if my assumptions turn out to be correct.

I therefore established a 2,5% for the portfolio at around 0,77 GBP per share for my “special situation” bucket.

If because of the election or a share placement the price will go to around 70 pence I would increase the position. A reason for selling would be for instance the departure of the CEO.

Disclaimer: Please note that this is not meant as investment advise. Never trust stock tipps anyway. DO YOUR OWN RESEARCH and in most cases index funds are the best investment alternative anyway

Edit: This was clearly pure luck that the day after I bought, Lloyds jumped already almost +7%. As I had expected, net income was lower compared to Q1 2014 but operating profit was up significantly and investors seem to have been positively surprised.

AerCap Holdings N.V. part 2 – Less tangible at a second glance

So after my first look into David Einhorn’s long pick AerCap last week, I want to follow up with some more detailed analyis in a second step.

By the way, a big “thank you” for all the qualified comments and Emails I got already after the first post, that’s the best return on investment on a blog post I can get !!!

The book value story growth

This was for me one of the core slides of Einhorn’s deck:

aercap

I mean you don’t have to be a genius to understand this: A company which trades near book value and compounds 20% p.a. is pretty much a no brainer. However, if I look at the developement of book values for financial companies, I always look at both, stated and tangible book value per share.

In AerCap’s case, the comparison looks interesting:

BV per share TBV share
2006 8,83 8,3493
2007 11,18 10,6041
2008 13,04 12,4083
2009 14,79 14,3448
2010 14,82 14,3798
2011 15,26 15,0608
2012 18,72 18,5592
2013 21,32 21,2334
2014 37,04 16,174
     
CAGR 19,6% 8,6%
CAGR 2006-2013 13,4% 14,3%

This table shows two things: Before the ILFC transaction, stated book values and tangible book values were pretty much the same and compounding around 13% p.a. Still pretty good but clearly not 20%. In 2014 however, with the ILFC deal something interesting happened: The book value per share doubled but tangible book value dropped.

The ILFC deal

So this is the right time to look into the ILFC deal. The two main questions for me are:

a) why did the book value per share increase so much ?
b) why did tangible book value per share actually decrease ?

This is how AerCap presents what and how they paid for ILFC:

Aercap2

So AerCap paid the majority of the purchase with own shares, 97,56 mn shares valued at 46,49 USD. Issuing new shares always has an impact on book value per share if the issue price is different from the book value. Let’s look at an example:

We have a company which has issued 100 Shares at 50 EUR book value per share and 100 EUR market value (P/B =2). So the total market value is 10.000, total book value is 5000. If the company now issues another 100 Shares at 100 EUR market value, we have 200 shares outstanding and 5000+10000 = 15.000 EUR total book value. Divided by 200 stocks we now have 75 EUR book value per share or a 50% increase in book value per share for the old shareholders. So issuing shares above book value increases book value per share automatically.

In AerCap’s case, it worked more or less the same way: AerCap had ~113 mn shares outstanding with a book value of around 21,30 USD per share. So issuing 97,56 mn share at a steep premium at 46,49 of course increased book value per share dramatically. The transaction alone would have increased the book value to ((113*21,30)+(97,56*46,49))/(113+97,56)= 32,97 USD per share or an increase of ~50%.

So how is this to be interpreted ? Well, clearly it was a smart move from AerCaps management to pay with its owns shares at such a nice price. On the other hand, one should clearly not mistake this a a recurring kind of thing. I would not use the historic 20% p.a. increase in ROE as expectation for the future but rather something like 13% or so in the past.

Intangibles

After looking into how much and in what form AerCap was paying, let’s look now what they actually got:

aercap3

Yes, they got a lot of planes and debt. Interestingly they assumed more debt than book value of the planes. Altogether they did get a lot of intangible assets. All in, AerCap bought 4,6 bn intangibles which is around 80 mn more than equity created through the new shares. So at the end of the day, one could argue that the new shares have been exchanged more or less 1:1 against intangible assets.

The largest part of this is a 4 bn USD position called “Maintenance rights intangible” which for me is something new. This is what they say in their 20-F filing:

Maintenance rights intangible and lease premium, net
The maintenance rights intangible asset arose from the application of the acquisition method of accounting to aircraft and leases which were acquired in the ILFC Transaction, and represented the fair value of our contractual aircraft return rights under our leases at the Closing Date. The maintenance rights intangible asset represents the fair value of our contractual aircraft return right under our leases to receive the aircraft in a specified maintenance condition at the end of the lease (EOL contracts) or our right to an aircraft in better maintenance condition by virtue of our obligation to contribute towards the cost of the
maintenance events performed by the lessee either through reimbursement of maintenance deposit rents held (MR contracts), or through a lessor contribution to the lessee. The maintenance rights intangible arose from the application of the acquisition method of accounting to aircraft and leases which were acquired in the ILFC Transaction, and represented the fair value of our contractual aircraft return rights under our leases at the Closing Date. The maintenance rights represented the difference between the specified maintenance return condition in our leases and the actual physical condition of our aircraft at the Closing Date.

For EOL contracts, maintenance rights expense is recognized upon lease termination, to the extent the lease end cash compensation paid to us is less than the maintenance rights intangible asset. Maintenance rights expense is included in Leasing expenses in our Consolidated Income Statement. To the extent the lease end cash compensation paid to us is more than the maintenance rights intangible asset, revenue is recognized in Lease revenue in our Consolidated Income Statement, upon lease termination. For MR contracts, maintenance rights expense is recognized at the time the lessee provides us with an invoice for reimbursement relating to the cost of a qualifying maintenance event that relates to pre-acquisition usage.

The lease premium represents the value of an acquired lease where the contractual rent payments are above the market rate. We amortize the lease premium on a straight-line bases over the term of the lease as a reduction of Lease revenue.

This sounds quite complicated and for some reason part of the sentences seem to have been duplicated. If I understand correctly, they assume that the underlying value of the aircraft is higher than the book value of the acquired planes. To be honest: I do not have any clue if this is justified or not.

However, as those intangibles are significant (more than 50% of book value), the case gets a lot less interesting for me. Intangibles created via M&A activity are in my experience always difficult, especially if it is esoteric stuff like this. It’s also a big change to the past of AerCap. Historically, they were carrying very little intangibles.

Funding cost & ROE

This was Einhorn’s prospective ROE calculation:

aercap roe

One of the key assumptions is a 3% funding cost. So let’s do a reality check and look at the expected pricing of AerCaps new bond issue. This is from Bloomberg:

Aercap $750m TLB Talk L+275, 99.75, 0.75%; Due April 30
By Krista Giovacco
(Bloomberg) — Commits due April 30 by 12pm ET.
Borrower: Flying Fortress Holdings LLC, a subsidiary of AerCap Holdings and International Lease Finance Corp., largest independent aircraft lessor
$750m TLB due 2020 (5 yr extended)
Price Talk: L+275
OID: 99.75
Libor Floor: 0.75%
Call: 101 SC (6 mos)
Fin. Covenants: Max LTV test
Existing Ratings: Ba2/BB+ (corp.); Ba1/BBB-, RR2 (TLB)

So AerCap is funding at a spread of 2,75% vs. LIBOR. With the 10 year USD LIBOR at 2,00%, funding would be way more expensive than the 3% assumed by Einhorn. Maybe the fund floating rate, but then the whole company would rather be a bet against rising interest rates than anything else. On a “like for like” basis without structural interest rate risk, I don’t think AerCap will generate a double-digit ROE at current spreads.

Business case & competitive environment

Within the comments of the first post, some people argued that the company is not a financing company but that the access to Aircraft is the value driver. Buying cheap aircraft from manufacturers and then selling (or leasing) them with a mark-up to clients then looks like some kind of Aircraft trading business.

For me however there is one big problem with such a business model. Retailing or wholesaling any merchandise is then most attractive as a business when 3 criteria are met:

– there are a lot of suppliers
– there are a lot of clients
– you can create a competitive advantage via physical distribution networks

In AerCap’s case, the biggest problem is clearly that there are not that many suppliers but only 2, Boeing and Airbus. Both don’t have much incentive to let any intermediary become too large so they will most likely encourage competition between Aircraft buyers.

Secondly, as far as I understand, there is no physical distribution network etc. behind AerCap’s business. So entering the market and competing with AerCap in the future doesn’t look so difficult for anyone with access to cheap capital.

Clearly, as in any opaque trading business, an extremely smart trader can always make money but it is important to understand that at least in my understanding there are no LONG TERM competitive advantages besides the purchase order flow from ILFC.

That the barrier to entry the business is not that high is proven by no other than Steven Udvar-Hazy the initial founder of ILFC and his new company Air Lease.

IPO’ed in 2010 and now the company is already a 4 bn USD market company 5 years later. Interestingly, AIG sued Air Lease in 2012 because they

were able “to effectively steal a business,” and reap a windfall at the expense of ILFC, the world’s second-largest aircraft lessor by fleet size. It described how some employees, while still working at ILFC, downloaded confidential files and allegedly diverted deals with certain ILFC customers to Air Lease, before leaving to join that firm. The companies are in the business of buying aircraft and leasing them to commercial airlines all over the world.

So to me it’s not clear what AerCap actually bought. It seems the “secret sauce” of ILFC seems to have been transferred to competitor Air Lease already. Interestingly, the lawsuit was settled a few days ago at a sum of 72 mn USD. I found that quote from Udvar-Hazy interesting:

“I want to make it clear that there is no secret sauce in the aircraft leasing business,” Hazy told analysts on a conference call. “ALC’s success is a result of a strong management team with extensive experience and solid industry relationships.”

Summary:

My problem with AerCap is the following: The financial part of the company, which I feel that I can judge to a certain extent, does not look attractive but rather risky to me. The Aircraft “buying and trading” segment on the other hand seems to be the more attractive part but for me too hard to judge in a reasonable way.

So for the time being, this is clearly not an investment for me. To look further into AerCap, two things need to happen: First they need to regain their investment grade rating and funding cost will need to drop to the 3% that Einhorn is assuming and secondly, there should be a clear impact on the share price from a potential sale from AIG.

In the current market environment clearly anything can happen and a multiple expansion could bring nice profits but personally, in a direct comparison I prefer the LLoyd’s case.

Some links

Thanks to a stock forum I discovered that John Hempton from Bronte is issuing a monthly letter for his Australian fund (H/T qed1984). The last one about China is brilliant.

An interesting article about a Whistleblower at Halliburton with some insight into the arcane world of “revenue recognition”.

Charlie Rose 30 minute interview with Ginni Rometty, CEO of IBM

Q1 report of Centaur, the US value fund run by Zeke Ashton

Must read: Roddy Boyd exposes US pharmceutical company and stock market darling Insys Therapeutics which seems to be literally “killing it”

A couple of presentations from the Ben Graham Centre 2015 Conference

Finally interesting research from German StarCapital on country by country valuations adjusted for differences in the underlying industry sectors

AerCap Holdings NV (ISIN NL0000687663) – How good is Einhorn’s new favourite ?

A friend forwarded me the latest presentation from “guru” David Einhorn where his main long pick was AerCap, an Airplane leasing company.

To shortly summarize the “Long case”:

– AerCap is cheap (P/E 9)
– they made a great deal taking over IFLC, the airplane leasing division of AIG which is several times AerCap’s original size
– they have great management which is incentivized along shareholders
– The business is a simple and secure “spread business”
– major risks are according to Einhorn mostly the credit risk of the airlines and residual value risk of the planes

There are also quite obvious reasons why Aercap is cheap and trades at lower multiples than its peers:

– share overhang: AIG accepted new AerCap shares as part of the purchase price and owns 45,6%. They want to sell and the lock up is expiring
– following the IFLC/AIG transaction, the company was downgraded to “Non-investment grade” or “junk” and has therefore relatively high funding costs compared for instance to GE as main competitor

What kind of business are we talking about?

Well, Airplane leasing is essentially a “special purpose lending business” without an official bank license, one could also say it is a “shadow bank”. What Aercap essentially does is to loan an airplane to an airline.

In order to make any money at all, they have to be cheaper than the simple alternative which would be the airline gets a loan from a bank and buys the airplane directly. As Airlines are notoriously unprofitable and often thinly capitalized, they often need to pay pretty high spreads even if they borrow money on a collateralized basis.

As any lessor funds the plane mostly with debt, the cost of debt is one important factor to make money compared to competitors. It is therefore no big surprise that GE with its AA+ Rating is the biggest Airplane leasing company in the world and that ILFC thrived while AIG was still AAA and had comparably low funding cost.

Airplane buying is tricky business

A second aspect is also clearly buying power. Planes have to be ordered many years in advance and the two big manufacturers want to be sure that they are getting paid. I assume a reliable bulk buyer gets better access to the most sought after planes and maybe even better prices. Prices for planes at least in my experience are notoriously intransparent. Nobody pays the official list prices anyway. I found this interesting article in the WSJ from 2012.

When Airbus and Boeing Co. announce orders at the Farnborough International Airshow this week, they will value the deals based on the planes’ catalog prices—which no one pays. Airline executives, when pressed for details, will probably say they got “a great deal.” But actual terms will remain guarded like nuclear launch codes.
The aviation industry’s code of silence on pricing is notable in this era of information overload. Thousands of people world-wide are involved in airplane purchases, yet few numbers spill out. That yields much mystery and speculation.

Discounts are large:

But there are ways to estimate the range of discounts. An analysis of public data by The Wall Street Journal and interviews with numerous industry officials yielded this: Discounts seem to vary between roughly 20% and 60%, with an average around 45%. Savvy buyers don’t pay more than half the sticker price, industry veterans say. But deal specifics differ greatly.

But no one wants to talk about it:

One reason for the secrecy surrounding all this, say industry officials, is psychology: Less-experienced plane buyers like to think they got a bargain and don’t want to be embarrassed if they overpaid. The safest approach then is silence. More-seasoned plane buyers also know that bragging about discount specifics would anger Airbus, Boeing or other producers and hurt the chances of striking a sweetheart deal again.

Clearly, as a large “quasi broker”, Airline leasing companies seem wo have a chance to make some money in such a intransparent market. But it is really hard to pin down real numbers. It reminds me a little bit about how you buy kitchens in Germany where the system is pretty much the same. Everyone gets a discount, but no one knows what the “true” price looks like.

But this also leads to a problem:

With the current funding costs, AerCap would not be competitive in the long run. Let’s take as a proxy the 10 year CDS spread as a proxy for funding costs and compare them across airlines and competitors (more than 50% of AerCaps outstanding debt is unsecured):

10 year senior CDS Rating
     
AerCap 215 BB+
     
     
Clients    
Air France 96  
Singapore Airlines 105 A+
Southwest 109  
Lufthansa 195 BBB-
Thai Airways 240  
Delta 256 BB
Emirates 257  
Jet Blue 362 B
     
Competitors    
GE Capital 72 AA+
Air Lease 175 BBB-
ICBC 194 A
CIT 229 BB-

So purely from the funding cost perspective, AerCap at the moment has a problem. Someone like Air France could easily fund a loan for an airplane cheaper than AerCap, so cutting out the middle man is basically a no brainer and even the smaller competitors could easily under price AerCap when they bid for leasing deals. On top of that, a lot of non-traditional players like pension funds and insurance companies want some piece of the action, as the return on investments on those leases are significantly higher than anything comparable. Even Asset managers have entered this market and have created specific funds for instance Investec.

AerCap does have a positive rating outlook, so there is a perspective for lower funding costs. Just to give an indication of how important this rating upgrade is: On average, 10 year BB financial isuers pay 2,4% p.a. more than BBB financial issuers at the moment. The jump from BB+ to BBB- will not be that big but it would increase the investor universe a lot for AerCaps bonds.

The biggest risk for AerCap

So although I am clearly no match for David Einhorn (*), I would argue that the biggest risk for AerCap is not the residual value of the planes or the credit quality of the Airlines but quite simply the refinancing risk. AerCap has to fund a significant amount going forward and if for some reasons, spreads move against them, they will be screwed. Just a quick reminder what happened to ILFC in 2011:

Credit-default swaps on the company climbed this month as global stocks tumbled and speculative-grade debt issuance all but evaporated. The cost reached as high as 663 basis points on Aug. 11, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The contracts have held at prices that imply ILFC’s debt should be rated B2, according to Moody’s Corp.’s capital markets group.

However if they manage to to get an investment grade rating and lower their funding cost, then it could be an interesting investment as funding is cheap and they do have access to a lot of new and sought after aircraft. Again, borrowing from Warren Buffett, with any leveraged company, management is extremely important.

And one should clearly compare AerCaps valuation and risk/return to banks and not to the currently much higher valued corporates. AerCap is much more similar to a bank than anything else. This general valuation disconnect seems to be also one of major reason why GE announced the massive reorganization just 2 weeks ago. However, as far as I understood tehy will keep the leasing business as this is unregulated.

Summary:

Although I slightly disagree with the risk assessment of Einhorn’s case, I still think AerCap could be an interesting case and is worth to dig deeper. I don not have a problem investing into financial companies and I do like those “share overhang” situations. However, I will need to dig deeper and especially try to figure out how good AerCap’s management really is.

(*) I did disagree with David Einhorn already once with Dutch Insurer Delta LLyod which was Einhorn’s long pick of the year 2011. Overall in this case I would put the score of MMI vs. Einhorn at 1:0 as Delta LLoyd did not outperform.

Update: TGS Nopec Annual Report 2014 and Q1 2015

TGS Nopec is one of my larger position which I bought back in November 2013 when oil (WTI) was still trading at ~100 US and the world looked great for oil and oil service companies.

In the meantime, as we all now, the oil price fell substantially since 2014 and especially oil service companies were hit hard. In contrast to other oil service companies however, TGS share price has decoupled from oil to a large extent as we can see in the chart:

This is especially interesting as 2008/2009 for instance, TGS lost almost -70% when oil crashed back then. Almost always when I discussed TGS with other investors, the argument was like this: TGS is a great company but the price has to fall at least -50% or more as it did in the past. Well, for now they are holding up pretty well.

2014 annual report

Anyway, the 2014 annual report can be found here

I would recommend anyone to read the annual report, at least the one page letter of the CEO, which in very clear words describes how TGS operates.

The highlights from my side:

– EPS dropped significantly from 2,59 USD to 2,09 USD per share
– however there were several negative one time effects included (around 65 mn USD or 60-65 cents per share).
– interestingly they make no effort to adjust those one time effects. You won’t find adjusted numbers anywhere in the report. I like this VERY MUCH.
– Operating cashflow actually increased by 10%
– Operationally, the Americas were doing very well in 2014. Asia was growing strongly but deeply negative
– payroll costs increased by ~10% in 2014
– they are still committed to invest counter-cyclical into new data by taking advantage of low charter rates for ships

Overall, they way TGS operates, 2015 will not look good from a P&L perspective, as they expense a lot of their investments and sales might take a little bit longer than usual. However if the past is any guidance for the future, in 2-3 years time the investments will then turn into nice profits down the road.

Q1 2015 update

A few days ago, even before the official Q1 report, TGS issued a Q1 update press release. They reduced significantly the expected net revenues for 2015 as E&P companeis are delaying their projects. Additionally, they announced a significant cost cutting program:

The Cost Reduction Program will position the company for the more challenging seismic market caused by the significant drop in oil price. A key element of this program is a reduction of more than 10% of TGS’ global workforce effective from April. Restructuring charges of approximately USD 4 million will be booked in Q2 as a result of this Program. The company expects annual cost savings of approximately USD 10 million as a result of the Cost Reduction Program.

Interestingly, this 10% reduction seems to off set the salary increase in 2014. At first, the market seemed to be shocked and the stock lost around -20% intraday but since then things have recovered. Maybe the recommendation change from Goldman has lifted the stock. This is what Goldman wrote last week (via Bloomberg):

(Bloomberg) — Offshore seismic market set for structural changes as oil producers rationalize costs, optimize upstream portfolios and concentrate on efficiency, Goldman says in note dated yday.
Goldman: multi-client segment has strongest outlook; data acquisition will continue to face challenges with at least six vessels needed to leave market to achieve balance
TGS raised to buy vs sell, is best-positioned in new oil order; co.’s library has highest N. America exposure which should remain most attractive onshore area
Strong financial position can sustain div.; selloff post 1Q creates buying opportunity

So it seems that this time, TGS does get better credit for their countercyclical business model than in 2008/2009. Maybe investors have learned actually a little bit since then ?.

In any case, from my side, TGS is a clear long-term core investment. Although the industry is very difficult, TGS is very good company with strong competitive advantages. Oil companies must replace their reserves,the demand for seismic data is not going away. Maybe it gets postponed a little bit ut they don’t have a choice. Without replacing reserves, atraditional E&P will not valued as going concern but as a run-off which much lower multiples.

Even with the reduced forecasts, TGS is still very profitable and who know what opportunities show up if some of the competitors get deeper into problems.

Some links

The Brooklyn investor looks at the JPM annual report and Loews

David Einhorn’s presentation from the Grant’s Investment Conference 2015

A new White Paper from AQR called “Fact, Fiction and Value Investing” (h/t Valuewalk)

Frenzel & Herzing look at Greek company Metka

Is Google the next Microsoft ?

Some interesting thought about the issues in Turkey

And finally, Hedge Fund billionaire Paul Tudor Jones wants to change capitalism

Lloyds Banking Group Special Situation investment – Management & Valuation

This is the follow up post to the first post on Lloyds Banking group 2 weeks ago.

By chance, I just saw this research note from Investec which perfectly sums up all the reasons why Lloyds is not a favourite of investors at the moment:

Bloomberg) — Lloyds cut from buy on concern about outcome of U.K. election, probability of a “raft of negative one-offs in 2015” and on U.K. govt plans to exit its 22% stake, Investec says in note.
Says Lloyds has “sensibly’’ signalled it will call all remaining Enhanced Capital Notes
That should speed-up negative fair value unwind of GBP0.7b
There could also be extra charge if Lloyds pays any premium
January PPI redress costs for bank industry rose to 14-month high of GBP424.5m
Planned sale of TSB to Sabadell means deconsolidation in 1Q, that could mean charge of GBP0.6b
Sees U.K. govt stake reduced to ~20% by end June, with sale of govt shares accelerated after that, acting as drag on stock
U.K. May 7 election poses risks to banks with uncertainties over macro economy, another bank levy increase, restrictions on use of residual tax losses
Lloyds less vulnerable than peers over regulatory/conduct issues and less exposed to bank levy than other FTSE 100 banks

For me, this is actually a good sign that a lot of the short-term bad news is on the table. But let#s look at the company now.

Just as a refresher, the quote from Warren Buffett which I used already when I looked at Handelsbanken:

The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.

Lloyd’s Management

So let’s look at Lloyds Management. The CEO, Portuguese António Horta Osório is considered to be one of the “best bankers” in the business. He was appointed in 2010 and lured away from Santander, where he build up Santander’s quite succesful UK subsidiary.

He became CEO in March 2011 but then something strange happened: He “disappeared” for around 6 weeks due to a “burn-out”. He cam eback however and actually did not take his bonus for that year.

But how can one determine if he is really a good manager? Well, a first step would be to look at videos and interviews. As an INSEAD alumni for instance a quite interesting inerview with him can be found when he still was in charge of Santander UK. There are a lot of speeches and interviews found on Youtube from him, for instance here or here. Despite his “slick” look, he comes across as a rather thoughtful person trying to restore some kind of trust into the banking industry.

But public appearance only is a part of management assessment. The more important aspect in my opinion is a very simple question: What does a CEO actually do and achieve compared to what he is promising. In Lloyd’s case, a few months after he started, the CEO presented a strategic plan which covered the years 2012-2014. The main features were:

– reducing cost by 1.5bn GBP with a target cost income ratio of 42-44%
– Statutory ROE of 12.5%-14,5%
– Core tier 1 equity ratio > 10%

If we look at the latest presentation from March, we can see the following “score card”:

– cost was reduced by 1.4bn, but cost income ratio was 50%.
– Tier 1 ratio 12,8% —> fully met
– Statutory ROE: not met, it wasn’t even mentioned

Overall, Orosio delivered on the cost side but failed to increase the “other income”. Additionally, he clearly underestimated all the PPI, Libor scandal fines etc. but this is outside of his control. One thing which annoys me a little bit that they basically dropped the ROE measure from their reporting. The are now reporting non-sensical numbers like “return on risk weighted assets” which IMO is a “BS number”. For a financial company, ROE in my opinion is “THE” measure of success in the long run and nothing else.

So overall, I would give “good” marks to Horosia. I do think he is a great “operator” and maybe one of the bank “cost cutters” in the industry, but maybe not the one to create a lot of new business opportunities.

If we compare Lloyds for with RBS which was more or less in the same situation, financial markets seem to think that Lloyds has done better:

Valuation

As always, one has to make assumptions for any kind of valuation exercises. For banks, I like to keep it simple:

I Estimate a target P/B multiple, target ROE and target retention ratio to come up with a potential return calculation. In Lloyds case, I assume that 12% ROE is a reasonable target to be achieved within the next 4 years. Other than for Handelsbanken, I think that Lloyds can only reinvest 25% at those rates and will pay out 75% of earnings.

  1 2 3 4 5 6 7 8 9 10
Book Value 65 66,3 6791% 6961% 71,5 73,7 75,9 78,2 80,5 82,9 85,4
ROE 8,0% 9% 10% 11% 12% 12% 12% 12% 12% 12% 12%
EPS 5,2 6,46 6,79 7,66 8,58 8,84 9,11 9,38 9,66 9,95 10,25
Implicit P/E 80,76923077 13,0 11,7 10,6 12,5 12,5 12,5 12,5 12,5 12,5 12,5
Retention ratio 25% 0,25 0,25 0,25 0,25 0,25 0,25 0,25 0,25 0,25 0,25 0,25
Dividend   4,8 5,1 5,7 6,4 6,6 6,8 7,0 7,2 7,5 7,7
Target Price   84,0 79,5 81,4 107,3 110,5 113,8 117,2 120,8 124,4 128,1
                       
NPV CFs 10 Y -79 4,8 5,1 5,7 6,4 6,6 6,8 7,0 7,2 7,5 135,8
NPV -79 4,8 5,1 5,7 113,7            
                       
IRR 10 year 11,5%                    
IRR 4 year 14,1%                    
                       
                       
Div. Yield   5,77% 6,41% 7,05% 6,00% 6,00% 6,00% 6,00% 6,00% 6,00% 6,00%

If my assumptions would turn out to be correct, over a 10 year period, Lloyds would return around 11% p.a. Not bad but worse than Handelsbanken. Selling after 4 years however would lead to a return of 14% which I find quite Ok. The difference comes from teh fact that I assume relatively low “compounding” which I think is realistic.

Other considerations

What I do like about the risk/return profile is the fact that there is a kind of “soft put” at 0,736 GBP. This seems to be the break-even of the UK Government. I assume that if the price would move below that, they will lower their sales volume or stop sales altogether as they want to show a “profit”, which should support the stock price at that level.

I think there could also be an interesting effect with regard to index weights. I am not sure how often index providers refresh their weights for instance for the Footsie, but there is most likely a time lag between the UK government selling and the index providers adjusting the weight. I know that for instance the DAX is only reweighted once a year which would then, in the caso of LLoyds would suddenly increase the amount to be bought by the index funds.

Summary:

Summing up the two posts, I would look at Lloyds the following way:

+ Lloyds look like solid UK bank which has cleaned up its portfolio and will return respectable returns going forward
+ The bank is run by a good operator which will decrease costs further
+ The UK Governemnet selling down and overall negative sentiment towards UK banking could explain an undervalutation of the stock
+ fundamentally I find UK banking attractive as there is significant concentration and interest rates are still high enough to make money
+ profits and dividends will improve significantly over the next 2-3 years
+ Threat of new entrants lower than for the other large peers due to low costs
– there is not a lot of growth potential in the stock as the market share is so high already
– short term nagative surprises/charges possible

In its current form, Lloyds is clearly not a growth/compounding story but rather a 3-4 year “special situation”. It similar to my 2 other “forced IPO” or “forced sales” investments Citizen’s and NN Group.

So overall, I find it a quite attractive special situation. Banks in general are one of the last truly “cheap” sectors and I do think that Lloyds has most of its problems behind it, especially compared to its large UK peers. So despite the relatively high valuation, I do think Lloyds is one of the most interesting situations with large UK and European banks at the moment.

Due to my position limitation however, this will get on the “queue” for the time being and decide by the end of the month if to buy, unless the price woul ddrop significantly. My buying limit would be around 79-80 pence/share.

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