Handelsbanken (part 3) – where is the upside & valuation

As this turned out to be again a pretty long post, a quick “management summary” in the beginning:

1. I do think that Handelsbanken’s UK business represents a significant opportunity for long-term growth
2. Additionally, I think that well run banks are a good opportunity as banks are in general disliked and overall risks in banking have been greatly reduced
3. However, at current valuation levels, Handelsbanken is too expensive. I would be a buyer at around 350 SEK per share or ~-15% below current prices

After trying to “kill” the Handelsbanken investment case last week, now in my third post I will look at the potential upside.

From my side, there are 2 potential “catalysts” which COULD imply future upside, which are:

1. Significant growth potential in UK and Netherlands
2. (Relative) revaluation of the banking sector in the medium term

1. Significant growth potential in UK and Netherlands

If you read the Handelsbanken annual reports over the last few years, it is not exactly a secret that they have great success in the UK. This is a table I compiled from the annual reports which shows the development of the UK branches:

Branches Operating profit Total OP UK/total
2009 62 177 13727 1.29%
2010 83 417 14770 2.82%
2011 104 639 16563 3.86%
2012 133 1006 17108 5.88%
2013 161 1173 18088 6.48%
2014 178 1652 19212 8.60%

Since the end of the financial crisis in 200, Handelsbanken managed to increase operating profit in the UK 10 times and the UK business reached almost 9% of total operating profits in 2014.

Despite a higher cost/income ratio in the UK (~55%) vs the home market in Sweden (~33%), profitability as measured by ROE is already at the same level. Opening bank branches is clearly a cost factor, so one should expect cost income ratios to even go down in the UK over time.

Gross margins in the UK are clearly higher than in Sweden. In my opinion, this has two possible explanations: First, overall interest rates are higher in the UK which makes it easier to charge more. Secondly, most of the competitors (Barclay’s, HSBC, Lloyd’s, TSB) have large legacy portfolios and need to earn margins on new business.

The big question is: can Handelsbanken continue to grow and how big could this become ? One clear driver of the growth is that UK customers are fed up with their local banks. Most of them needed bail outs (RBS, Lloyds, TSB), damaged their reputation by aggressively selling questionable products and/or tax evasion etc. (HSBC’s Gulliver with his Swiss bank account as a last example).

Handelsbanken’s market share in UK so far is tiny. I tried to collect some numbers. In this 2011 report for instance, Handelsbanken didn’t even show up. This is how market shares for instance looked for personal account:

Normally, as in many industries, size does have advantages also in retail banking. Advertising for instance are expenses which scale well. In the UK however banks with large market shares face strong headwinds as outlined in this article. Interestingly, Lloyd’s with its leading market share has a cost-income-ratio of currently around 67% and this number has improved a lot over the last year. So it’s quite interesting to see that the “dwarf” Handelsbanken is already much more efficient than the big guys.

Overall, without having examined the UK market in more detail, I do think there is room for Handelsbanken to expand and reinvest capital at attractive rates for some time.

Personally, I like the organic growth of Handelsbanken a lot. In general I find that especially in the early stages, organic growth is often undervalued. Stock investors prefer often fast growth via acquisitions. You can book a lot of accounting special effects etc. and increase EPS per share much quicker. As we have seen often however, the risk of M&A deals is a lot higher and more often than not, those deals backfire and sometimes even sink the acquirer.

In the UK for instance, recently spun-off TSB has already been approached by Spanish Bank Sabadell for a potential take over a few days ago. This is of course a quick way to add a lot of branches but also a much more risky one.

Netherlands:

Netherlands for Handelsbanken is a comparable small market. with currently 20 branches (up from 18 in 2013), the business grew by ~17%. In principle, I think the situation could be similar to the UK. a lot of the dutch banks have big legacy issues and need to earn margins. However at the moment I would look at the Netherlands as an option and not as something to actually take into account when valuing Handelsbanken.

2. (Relative) revaluation of the banking sector in the medium term

I have quickly touched this topic in the two other posts already. Banks are generally considered as “bad investments” by most participants in the stock market. This is clearly justified if we look back the last 10 years or even longer. Whereas a company like Nestle is considered a safe and promising investment at a P/E of around 23, banks are considered a pure gamble even when the trade at fractions of those multiples.

For me, this is both, a lesson in how to look at historical data and a potentially big structural investment opportunity. Let me explain why.

The main arguments against banks is that they are highly leveraged and too risky. The risk is both individual and systemic (Lehman scenario). In my opinion, the systemic risk component has been greatly reduced by what happened since the financial crisis. A lot of mechanisms have been created to prevent a second event like the run that happened in 2008/2009. For me the most important are:

– collateralization of derivatives
– bank resolution systems both national (e.g. SOFFIN) and on international level
– clear commitment and mandates of central banks
– significant increase in capital requirements internationally

For current shareholders of large legacy banks, this is not very funny at the moment. Whereas most non-banks pay dividends and buy back shares like crazy, banks have to raise capital and postpone dividends in order to shore up their capital. And clearly, in many of the mega-banks, there is plenty of toxic waste on the balance sheet to justify low valuations.

On the other hand, this creates in my opinion great opportunities for players like Handelsbanken which have little toxic waste on their balance sheet and are run efficiently. The systemic risk for those players has become a lot smaller as a potential bankruptcy of one of the old mega-banks will most likely have only little effects on other banks in the future.

The individual risk of a classic and disciplined lending bank in my opinion is relatively limited if it is run by the right people. I do not think that a conservatively run bank is riskier than any other business. I know this is a somehow controversial standpoint but to me, a standard banking business model looks a lot less complex than for instance a multi national branded consumer goods company. For me this kind of blind distrust in the banking business model creates a very interesting opportunity.

Yes, banking in general will be much more dull in the future, but als a lot safer.

The second issue I want to touch quickly is the issue of historical data. Yes, historically, banks look like terrible investments because many of them have been wiped out in the financial crisis. I cannot prove it statistically, but I think banks are also the reason why suddenly low P/E and low P/B strategies seemed to have stopped working. The now favored metric by many “data miners”, the EV has the advantage that it automatically filters out any financial company. But looking into the rear view mirror is not always the best way to make investment decisions. If you would have been a stock investor after WW II, you might not have ever invested into German or Japanese shares because they have been wiped out. But a World War luckily does not happen every 5-10 years and neither does a full-blown financial crisis.

I think that there is a good chance that due to the pressure of capital markets, in the future, returns for banks could be relatively a lot better than they have in the past, assuming that the basic banking model is here to stay. The market will squeeze banks so much that those who remain will earn good ROEs again at some point in the future. And good banks will earn very good ROEs.

Valuation exercise

There are many ways to evaluate companies. I prefer simple ones. For banks, I consider ROE and P/B as the most important factors which drive long-term returns, so a valuation model should focus on those metrics.

To have a starting point, I make the following assumptions:

– ROE will improve to 15% over 5 years (from currently 12,4%) and will stay there (15 year average is 16,5%)
– P/B will remain constant at 2,1 (15 year average is 1,7)
– Divdend payout will be 25% and handelsbanken will be able to reinvest at the above assumed ROEs

The following table translates this into a simple IRR calculation:

Current Price book 2,1                    
ROE 15%                    
                       
ROI 7,1%                    
                       
                       
                       
    1 2 3 4 5 6 7 8 9 10
Book Value 200 218,8 240,1 264,4 292,1 323,9 360,4 400,9 446,0 496,2 552,0
ROE 12,5% 13% 13,50% 14% 14,50% 15% 15% 15% 15% 15% 15%
EPS 25 28,44 32,41 37,01 42,36 48,59 54,05 60,13 66,90 74,43 82,80
Implicit P/E 16,8 16,2 15,6 15,0 14,5 14,0 14,0 14,0 14,0 14,0 14,0
Retention ratio 75% 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75
Dividend   7,1 8,1 9,3 10,6 12,1 13,5 15,0 16,7 18,6 20,7
Target Price   459,4 504,2 555,2 613,5 680,2 756,8 841,9 936,6 1.042,0 1.159,2
                       
NPV CFs -409 7,1 8,1 9,3 10,6 12,1 13,5 15,0 16,7 18,6 1.179,9
                       
IRR 12,9%                  

Under those assumptions, Handelsbanken would be trading at 1.160 in 10 years time and returning me 12,9% p.a.

Now comes the interesting part: If I would want to see my 15% p.a. which I normally require, I would need to change assumptions. First I could move the purchase price down from 409 SEK. In my model, I could pay 342 SEks per share and get my 15% annual return. I could also increase my P/B multiple to 2,6 to get my 15% or I could increase the ROE to 21% after year 6 to get 15%. To be honest, both, the multiple expansion and the ROE increase seem much to aggressive to me.

So the question clearly is: Is 12,9% potential return enough or should I insist on 15% ? With the 10 year government rate in Sweden at 1%, the 12,9% would indicate a potential equity premium of 11,9% which is far more than one would normally expect from the market. On the other hand, no one knows what long-term interest rates will be in 10 years time, so betting fully on today’s low rates is also not the best solution.

This return is also driven by the assumption that Handelsbanken can continue to reinvest 75% of their profits at attractive ROEs. In Handelsbanken’s case, I don’t think that this is unrealistic. However if they could for instance only reinvest 60% and pay out the rest in dividends, then the expected return would drop to 10,7% p.a.

Anyway, for now, I would not feel comfortable investing at the current stock price level.

Summary:

At the end of this mini-series, it has become relatively clear to me that Svenska Handelsbanken is really a great company, a true “Outsider” in regard to its business model and culture. Additionally, I do think that they have good growth opportunities in UK, which allows them to reinvest capital for some time to come attractive ROE’s.

In general, I believe than well run banks are one of the few potential bargains left in the market as investors hate them and do not see the greatly improved fundamentals of the financial “plumbing”.

Nevertheless, I do think that Handelsbanken does not fulfill my return requirements as the current price seems to have priced in some of this growth already. Unfortunately i was very slow in discovering Handelsbanken., as I could have bought them at an attractive only a few months ago. Nevertheless, I will keep them as my prime candidate on my watch list. I would love to add this “Outsider company” to my long-term value portfolio.

But again, patience is important. another positive aspect of this exercise is that I know now much better than before what I am looking for when I analyze a bank.

18 comments

  • Really interesting series of articles! Kudos for the author!

    During my holiday I read the books Quality Investing and Capital Returns and in both (great!) investment books Handelsbanken was named as a high quality company.

    What do you think about the valuation today? The stock is much cheaper today if I am right. Did you buy the shares?

    Two questions, however. 1. The investment firms behind the books (AKO and Marathon) mentioned they were long term investors in Handelsbanken, but I cannot confirm this when I look at the positions in my bloomberg terminal. This is especially worrisome to me in the case of Marathon which look at capital cycles in their investment proces – are they afraid the swedish property market is about to get hit?

    2. In your analysis you explicitely assume retained earnings can be invested in Engeland. Is this still the case after the brexit?

    Thanks again for your great work!

    • Yes I bought the shares later on, including dividends roughly at the level where they are trading now.

      Personally, I don’t really bother if AKO and Marathon still hold the stock or not. They might have different reasons fro selling them, who knows ?

      With regard to the UK: If you have read my posts, you will know that noone knows anything about the “Brexit”. Even if the Brexit will actually happen (which isfar from clear), I do think there is a decent growth opportunity. But as I said, predictions are difficult, especially when they concern the future. For the time being I trust in the managemnt to do the right things.

  • increased by a further 0,5% at 98 SEK. Now 2,5% position

  • How cheap do you think this could get in a stress scenario? i.e reserve increase to 2008-2009 levels?

    I know you mentioned this in another comment, but would be curious how you think about property prices in Sweden?
    i.e. https://lh4.googleusercontent.com/2EiKgWo_-UzXaUbuKWgBSpQUeqfXayBLX96r9rHed9NBxtCrMue4eXm_yAknVBsNzrR45qOin8QhJahONI1_VbWlPr_pUJYsvkDR_1jLvHVM0zH-cLHiUpRkMnOhJjV80GvGgKFh

    What about a sensitivity analysis in your forward returns? For example a scenario where ROEs do not trend upward and P/BV contracts back to LT historical averages?

    • AVI,
      I have no idea. I f I would know that in advance, I would not write a blog but maybe play tennis with Bill Ackman ­čśë

      And of course, my “expected” return is a “Mid case” it could be worse but also better. If it would be worse, I might even lose money for some time, but I assume that over the longterm they will create value.

  • Started with a 0,5% position today at 100 SEK….

  • Great analysis! I’m really impressed by the level of detail you went into. Handselbank might just be one of those banks that helps restore trust in the banking system (or at least some parts of it).

    Right now there are definitely lots of issues with larger banks, but, like you mentioned, people should look into the progress made by both the regulators and the banks and acknowledge that the potential systemic risk is lower than it used to be.

    However, even if we factor in the reduced risk, banks are still incredibly overpriced throughout Europe in my opinion (or at least those I look at, like Santander, BBVA, Sabadell, Erste, Raiffeisen, banks in Romania). If we only look at the banking industry, Handelsbanken seems to be in a really good position.

    • Lucian,

      thanks for your comments. How do you define “overpriced” for the banks you mentioned ?
      mmi

      • Well, for Raiffeisen and Erste it’s more because I consider them too risky for my taste (large exposure to Russia for Raiffeisen and really poor subsidiary management for Erste, which managed to overpay – 6 bil. EUR to be more precise – for a Romanian bank that has generated losses in the billions of EUR for them). Raiffeisen might be a good deal if Russia’s economy bounces back, which is unlikely IMO given their current situation.

        As for the Spanish banks – I normally use a simplified discounted cash flow analysis or just some EV ratios for them and, according to these models, 10% seems to be an optimistic return for the following years. This is not really something particular to banks, a lot of companies in Spain trade at EV/EBIT ratios of 15-20 or even higher, with top line growth rates of 10% or less.

        On the other hand, I’m not that good at analyzing banks, so that’s why maybe I just perceive them as overpriced.

        • I agree for Raiffeisen and Erste. However, Ev/EBIT is not a metric which you should use for banks.

        • The choice of word was not the most fortunate regarding EV/EBIT. What I wanted to say is that EV/EBIT is the metric I use for non-banking stocks and in Spain this is really high in my opinion (that 15-20+ mentioned).

          For bank stocks I use a valuation method somewhat similar to yours, which includes P/B, ROE and P/E. A pseudo-EV is also computed by adding any extra cash (that can be distributed to shareholders without affecting the bank’s operations) to the final valuation.

  • Hi,

    Thanks for a great series on Handelsbanken. It seems like you have deepened you knowledge of the banking industry lately, do you have any recommended reading for us that want to do the same?

    Thanks,
    Pat

  • Victor samanta

    Come on now, banks are a macro call

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