Deutsche Pfandbriefbank AG “forced IPO” – “Superbad” or interesting special situation ?

Management summary:

Oh my god, a bank again…. But Deutsche Pfandbriefbank is actually a pretty simple case: As a “forced IPO” of the good part of Hypo Real Estate, the bank is comparable cheap (P/B ~0,61) against its main peer Aareal bank (P/B 1,0). In my opinion, the risk is limited despite the recent HETA losses as the German Government has absorbed all of the really bad stuff in the bad bank. Similar to cases like Citizen’s, NN Group and Lloyd’s, PBB offers an interesting and mostly uncorrelated risk/return profile for patient investors provided that valuation multiples normalize at some point in time. Positive surprises like M&A are potentially on the table as well.

DISCLOSURE: THIS IS NOT INVESTMENT ADVISE. Do your own research. The author might have bought shares already.

The 2008/2009 financial crisis has created a new sort of “special situation” what I would call a “forced sale” or “forced IPO”. The pattern is always similar: A financial institution got into trouble, has has been saved by a EU Government but then the Government is again forced by the EU to privatize those institutions again as otherwise this would be a hidden subsidy to the bank.

So far I have already 3 investments which were created out of this and quite succesful:

Citizen Financial – forced IPO from RBS (since 22.10.2014, +36%)
NN Group – forced IPO from ING Group (since 03.07.2014, +27%)
Lloyd’s Banking – forced direct sale from Government (30.04.2015, +18%)

The main reason why I find those situations interesting is the fact that we have clearly identifiable “forced” sellers which results in a potentially artificial depressed share price. Over some years this should then normalize and result in good and relatively uncorrelated investment returns.

Since last week, there is a new “applicant” for this category: Deutsche Pfandbriefbank AG (“PBB”).

History HRE/Depfa/PBB – “Superbad”

Even within the currently hugely unpopular banking sector, it doesn’t get much worse than what happened with PBB’s prior incarnations.

PBB is the “good bank” of Hypo Real Estate (“HRE”), one of the biggest German casualties of the financial crisis and often called the “German Lehman”. Hypo Real Estate initially was a Spin-off of Hypovereinsbank, now the German subsidiary of Unicredit. They made their biggest mistake by taking over then Dublin based Depfa in 2007, just before the financial markets melted down. In 2009, HRE was taken over by the Government, the first and only case since 1949 (full German Wikipedia entry here). Overall it is estimated that the whole episode did cost German Tax payers around 25 bn EUR. As a side story, even famous PE investor Chris Flowers lost around 1 bn with the stock when it was taken over by the Government.

Following EU rules, the EU required that the German Government either fully liquidates the bank or to sell it until the end of 2015. Direct sales negotiations only ended up with PE shops being interested but I assume that politically it was not possible to sell to the “locusts” directly, so finally the German Government decided to IPO PBB.

The IPO

Other than ING and RBS , the German Government decided to sell the majority of the shares in one go. They placed ~80% of the stocks in the market on July 16th and committed to hold at least 20% for a duration of 2 more years. They aimed for a range of 10,75-12,75 but had to sell at the low end. The stock price directly jumped to 11,50 EUR and is now trading in a pretty tight range at around 11,50 – 11,80 EUR.

Why they did it now in July with half of the country already on vacation ? Who knows, my assumption is that someone in the finance ministry “just wanted it to be done before the summer break”.

So far at the time of writing I do not know who actually bought shares, although in this report it is said that a big part of IPO was sold to only ~10 big investors.

Update: As of July 20th, a first hedge fund called Lancaster Investment Management filed to own 4,83% of the shares.

The “HETA incident” & the “value portfolio”

When creating the bad bank of HRE, FMS Wertmanagement, all “PIIGS” exposures were moved into the bad bank and PBB retained the good parts, mostly Germany, france and Northern countries. At that time, Austria clearly was considered safe. When however Austria decided this year that they will not honour a guarantee for their forme “Hypo Alpe Adria Bank” and wind down the “bad bak” HETA with a loss to all investors, PBB hat to write down 50% of their 400 mn HETA exposure (see presentation page 27). The decided that the large part would go back into 2014 and the rest into 2015. As a result, in 2014 they hardly broke even (trailing P/E of 460) and also 2015 will not look that great form a net income perspective, which further reduces the attractiveness to potential investors.

There are law suits under way. Especially the involvement of the World Bank makes those law suits interesting.

Additionally, a pretty large part (around 1/3 or 22 bn) of PBB’s assets have been classified as “value Portfolio”, a nice name for a run-off portfolio. Those are loans where for some reason or the other they do not want to continue the business relationship. HETA was part of this but overall I think there should not be that many similar cases like HETA in the portfolio. In my understanding this is more like low yielding stuff which just isn’t very capital efficient. According to their latest IR presentation, a third of this will already have disappeared in 2017.

The “Pfandbrief” – a competitive advantage ?

The “Pfandbrief” is a German specialty. Other than in Anglo-Saxon countries, Mortgaged backed securities are not common in Germany. The Pfandbrief is essentially collateralized or “senior secured” debt issued by a licensed bank. The collateral is a pool of underlying mortgages, however the investor has no direct exposure to those loans as the bank has to exchange bad collateral for good one. Only in the case of the bankruptcy of the issuing bank, the investors would be actually exposed to the collateral.

In the 100+ year history of the German Pfandbrief, this has never been tested. Why ? Because due to the great importance of Pfandbriefe to the German financial system, all struggling Pfandbrief issuers have been saved one way or the other, resulting in the claim that a German Pfandbrief “never defaults”.

In reality I do think that this still holds true. First of all, the Pfandbrief has a big lobby from the issuer side. Although the overall volume has decreased, there are still 400 bn EUR Pfandbriefe outstanding making it a strategic instrument.

The advantage of this can be pretty easily seen if you look at this great chart. It is pretty easy to see that Pfandbriefe trade significantly below swap, the normal benchmark for bank funding. If you look at actually levels where banks fund unsecured senior debt, one easily sees that the ability to issue Pfandbriefe is a big advantage.

Especially in a European context, the combination of Pfandbriefe and the implicit support of the German Government results in funding costs which are lower than most of the European competitors. Of course, due to the required over-collateralisation, not all the funding can be done via Pfandbriefe, but PBB going forward should be very competitive from the funding side.

Simple comparable: Aareal Bank (ISIN DE0005408116)

What few people know: Aareal is actually the former “sister company” of the Depfa “good bank” which is now part of PBB. The original DEPFA was a a combined real estate / public funding bank. DEPFA back then in 2002 decided that real estate financing is too boring and split of Aareal in 2002 and then got all in into public financing and moved to Ireland.

Aareal bank runs a “consulting / services” business on the side, providing software and services for landlords. In the past, this has been stable and profitable, however since 2013 the division is loss making and increasingly so.

Overall, I do think that over the next few years, PBB should be able to earn the same returns as Aareal. Aareal itself is rather cheap and trades at around 1,0 x book (adjusted for “equity like” hybrid bonds. Looking at the 5 year chart and compared to Commerzbank, it is quite easy to see that boring real estate funding is not that bad as a business:

For me Aareal and PBB are also different animals than for instance Commerzbank. Yes, Commerzbank looks even cheaper from a P/B perspective (0,5), but they have a ton of problems that the specialized banks don’t have. Expensive and unnecessary branch networks, expensive investment bankers, lots and lots of corpses in the basement (ship financing etc.). For me, PBB is much “cleaner” and also safer, especially as I assume that most “corpses” are in the basement of the bad bank.

Valuation:

PBB report 3,6 bn equity at Q2 2015 but this includes 1 bn silent participation from the German Government which they have paid back in the beginning of July so real equity is 2,6 bn or around 19,2 EUR per share. My valuation case is simple: I assume that they will reach Aareal’s P/B ratio in 3-5 years with a 10% discount (0,9 instead of 1,0) and compound equity at a rate increasing from 6% to 8%. This is how it looks like in a simple atble:

Another datapoint: Aareal itself has bought struggling Coreal from a PE fund in 2014 for a multiple of 0,7 times book. So assuming 0.9 times book for a several times larger PBB doesn’t look so aggressive.

What do I know what other don’t ?

Honestly, in this case I don’t think that I know more than others. However I do think that do have one competitive advantage: I have been investing into various HRE/DEPFA entities at different levels of the capital structure since 209. I do still own two “bad bank” Depfa bonds, the 2015 LT2 and the 2020 TRY zero bond. So I would not call myself an “insider” but I am quite familiar with the history and the structure of the whole company. I do think many investors just stay away out of principle as from the outside it still looks like a mess and investing into the “German Lehman” does not win you a lot of excited comments in the investor community. What I have learned over the years is that the “core” business is not great but OK. If you get it at an attractive price, then it coul actually turn out to be a very decent investment.

Clearly the banking business is still a tough place to be but it will not go away and the prices do clearly reflect the difficulties. As I have mentioned several times, in my opinion the banking business has become structurally less risky bt the market still treats banks as if the next Lehman Brothers is just around the corner. This opens many opportunities for investors and this might be one of them.

Potential catalysts:

Personally, I do think that there could be some M&A interest going forward. PBB is relatively well capitalized and has a clear focus. At the current cheap prices, almost any European bank could goose up its capital ratio by doing a share deal and buy PBB. The most obvious partner however would be Aareal. Aareal and PBB combined could generate a lot of synergies and achieve critical mass going forward. If I would run Aareal Bank, this would be basically a “no brainer”. For them the risk is that if they wait to long and PBB’s stock price goes up, it could actually work the other way round as well.

Additionally there seems to be a lot of international interest for German banks lately. Very recently, Chinese conglomerate Fosun bought Hauck & Aufhäuser and the rumour was that during the initial negotiations, Chinese insurer Anbang was interested in PBB as well.

Summary:

As I have said in the beginning, PBB is a simple case: I do think that the “forced IPO” of PBB from the German Government has created a typical special situation with good upside potential. This is clearly no “shooting out the lights” grand slam home run. In golf terms I would say that this is a “solid 6 or 7 iron” shot.

On the other hand, if PBB catches up valuation wise to its direct peer (and former “sister company”) Aareal, a return between 17-23% over the next 3-5 years doesn’t seem unreasonable which for me looks very attractive as a relatively uncorrelated “special situation”.

I will therefore invest a half position (2,5%) for the portfolio in the “special situation” bucket at 11,70 EUR/share.

P.S.: Just for reference the pros & cons list with which I start my posts….

+ No goodwill
+ clean balance sheet (Heta)
+ Pfandbrief funding (no deposit overhang)
+ 50% upside to peer Aareal
+ IPO of 80%, not much share overhang
+ potential catalyst
+ “forced IPO” , unsophisticated seller, no story, bad timing

– Heta risk, “value portfolio”
– kind of chaotic, in transparent
– banking business still very tough (direct lending etc.)
– 2014 P&L looks ugly (P/E 460)
– downgrade by S&P for unsecured

IPO Prospectus

40 comments

  • Added 1% (of portfolio) in Dt. Pfandbriefbank today at 8,90 EUR. More on that later.

  • So the FY2015 numers are out
    most people dont have HETA writeup on the cards as +100M is already offered by Austria and +200M is on the cards

  • Neugierige Frage: Siehst du fundamentale Erklärungen für den Einbruch bei der Deutschen Pfandbriefbank (z.B. das gestiegene Risiko platzender Kredite) oder schätzt du die Aktie bei fast 30% Abschlag zu deinem Einkaufspreis als tolle Aufstock-Möglichkeit an?

  • I know you do not like to short. But if you would have shorted AAreal you would be in the green now. I mean afterall you used some relative valuation/pricing. What do you think about pair trades? You could have shorted just like 1/3 of the position in AAreal, if you were bullish on those banks in general.

    I have ordered the annual report and will read through it. At the moment I do not like the exposure to France public finance.

    • martin,

      good point but I have never really thought about pair trades. So far, the short side was quite dangerous because there was so much money chasing anything. I guess that has changed now.

      mmi

      • If you size the short small or short a industry index the short risk is not that high. Also depends on cost. I mean it is a pitty you picked one of the best stocks relatively to the pack and are now in the red anyway due to the overall market.

  • Only for info:
    Deutsche Bank bought a 5% share of Deutsche Pfandbriefbank. No idea if they have further plans.

    http://www.finanznachrichten.de/nachrichten-2015-09/34857474-dgap-stimmrechte-deutsche-pfandbriefbank-ag-deutsch-016.htm

  • Are the actual Q2 results in line with your expectation? For me it seems to be very positive.

  • Thanks for the article, great read.

    What do you think about the management quality here? No question about the bank being cheap, but do you think the management can grow this bank and find a good strategy/niche to play in? Asset deployment must be more difficult for smaller players, probably having SP on the books will limit the management’s risk appetite as well…

    • I cannot say a lot about managment. However in my opinion the case doesn’t depend on great management. I think “average” management is enough. And I think that growth is actually easier for smaller players in the current environment tahn the big ones.

  • valueornothing

    I think that there is a good chance, that PBB could become a member of the MDAX soon. That would boost share price as well.

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  • Andre Semmler

    Thanks a lot for the discussion and writeup. They were really helpful. I was wondering about your thoughts on why anbang and Blackstone passed up the opportunity on buying pbb. Especially anbang seems really hungry for deals right now.

    Maybe they saw something in the value portfolio they didn’t like?

  • This looks interesting. How did the Credit/Real estate portfolio perform during the 2008-2010 period?

  • Interesting what you write about Aareal which I own in my wikifolio.
    “Aareal bank runs a “consulting / services” business on the side, providing software and services for landlords. In the past, this has been stable and profitable, however since 2013 the division is loss making and increasingly so.”
    When I looked at Aareal I interpreted this segment as strength, because it generates not only Service business but actually makes use of data centers and IT technology Aareal would need anyway to run the CRE credit business. And additionally they get about 9 bn Euro deposits and in contact with potential clients for financing deals. So running a small loss on this segment looked ok to me. What do you think about these thoughts?
    Covacoro

    • I know, the standard story is that Aareal is a great Software company with a bank attached or so. Plus the great “Float”. If you look at the numbers however, the losses in the segment are constantly increasing.

      Under the current environment (Basel III, negative interest rates) especially the deposits are an increasing burden which they seem to have problems to control. A “float” in th form of deposits is these days a disadvantage for a bank. Banks with low or no deposits do much better.

      • Well, I think your story is a simplistic, biased view.

        Why would PBB then open “PBB direkt” in March 2013 to get deposits from private clients by offering relatively high rates (0.8% p.a. for daily call money) in competition to other retail banks? https://www.pbbdirekt.com/ In your opinion a loss making and nonsense move.

        And you assume that 0.9x book value will be a fair valuation going forward and imply that takeover will happen with this multiple, because PBB is so big and attractive. It is true, they are a big player with a balance sheet of 66 bn Euro and total equity of 2.6 bn – compare to Aareal with 43 bn and 1.9 bn Euro. You can however see, who is on more solid grounds.

        And the takeover of Coreal credit in 2013 was at 342 Mio Euro (for total equity of aournd 650 Mio) and Westimmo in 2014 at 350 Mio (for total equity of around 500 Mio Euro). So one could argue, that a conservative assumption would be a bet around 1.6 bn Euro or 60% of total equity (if it happens any time soon). Which is – surprise, surprise – the current market capitalisation of PBB.

        • Well, if simplistic means “simple” then I am guilty, I like to keep things simple.

          Back to Aareal, this is the EBIT development for the “Consulting/services” segment, including the software /deposit business:

          EBIT:
          2009: +20
          2010 +26
          2011: +20
          2012: +6
          2013 – 11
          2014 – 20

          Q1 2015 was -7 mn vs. -6 mn in 2014

          It is pretty easy to see that there are problems and increasingly so, mostly driven by the deposit overhang.

          One addtional comment: Your definition of equity might be a little bit “too simplistic” as well. Equity includes silent participation which are not shareholders equity. In Coreals case for instance “real” SHAREHOLDER’s equity ex SP was around 490, creating “badwill” of around 150 mn which for some reason was shown as “operating profit” at Aareal in 2014. This results in a transaction multiple of 0,7 times book equity. My bet is that PBB’s multiple will increase over 3-5 years from the current level to alevel of around 0,9 times book which might happen or not. I am not betting that this happens now or in a few months. 0,9 is still 10% cheaper than Aareal.

          And yes, opening PBB direct in my opinion is a nonsense move. However the size with 1,5 bn EUR is a lot lower than the 9+ bn Aareal has to absorb.

  • I just want to add that your PBB IRR is wrong as it assumes a 100% retention of profits. 40-50% of profits will be paid out to shareholders. So equity will not compound at 6-8%, right?

    >>
    PBB kündigt Dividende für 2015 an

    PBB strebt künftig eine Dividende von 40 bis 50% des IFRS-Konzernergebnisses an. Bereits für das laufende Geschäftsjahr ist dabei eine anteilige Dividendenausschüttung geplant.

    Das Unternehmen gehört zu den führenden Spezialbanken für die gewerbliche Immobilienfinanzierung in Europa. Sie ist innerhalb ihres Kernmarktes in Europa gut positioniert und betreut ihre Kunden lokal, aber auch über die Ländergrenzen hinweg.

    Darüber hinaus ist PBB als größter Pfandbriefemittent auch ein bekannter Akteur am europäischen Markt für gedeckte Anleihen, so genannte Covered Bonds. PBB verfügt dabei über eine sehr gute Kapitalausstattung. Per Ende März lag die CET 1 Ratio bei 14,8% unter voller Berücksichtigung der Basel III Regelungen.

    Kürzlich wurde die stille Einlage des Finanzmarktstabilisierungsfonds in Höhe von 1 Mrd. Euro vollständig zurückgezahlt.
    <<

    • #steven,

      assuming no dividend is a simplification that I used. If you assume that you buy additional PBB shares with the dividend, the result is pretty close to assuming 100% retention.

      mmi

      • I just thought that dividends will be taxed at 25% in germany. So you assume buying additional PBB shares with the dividend and no taxes on those dividends, right?

    • …I guess I was wrong: no direct holding of shares but via HRE.

      wobei die Bundesrepublik Deutschland indirekt über
      die Hypo Real Estate Holding AG (HRE) auf Basis einer Halteerklärung nach
      der Erstnotiz für zwei Jahre mit mindestens 20% beteiligt bleiben soll.

  • I think there are a few “-” points more:

    – high legal risk with the former holders of Genussscheine
    – almost the highest funding levels for Pfandbriefe and senior unsecured (i. e. Schuldscheine) of the german banks. From the bigger banks only HSH and IKB have higher levels at the moment
    – this could lead to a more aggressive credit policy to still earn a good margin

    • Which Genußscheine do you mean ? I owned Genußscheine of Depfa and made a lot of money with them. They were paid back in full.

      • You can find this text on page 246/247 in the prospectus:

        The Company is a party to several proceedings initiated against the Company as defendant by former
        holders of participation certificates (Genussscheine) that were originally issued by Westfälische
        Hypothekenbank AG, Württembergische Hypothekenbank Aktiengesellschaft (later renamed as Hypo
        eal Estate Bank International AG) and Nürnberger Hypothekenbank Aktiengesellschaft (the
        “Genussschein Issuers”), of which the Company, in each case, is the legal successor following their
        mergers into the Company (see “19.3 Structure of pbb Group”). The proceedings are pending before
        different German courts. The Genussschein Issuers had, over several years, issued profit participation
        certificates in a significant amount. Based on their terms, a holder of such profit participation certificates
        participates (i) in profits of the issuer with priority over a shareholder’s right to dividends but (ii) also in
        losses which reduce the investor’s repayment claim upon termination of the certificates (unless losses
        are subsequently replenished (wieder auffüllen) in the event of subsequent profits of the issuer).
        Since the financial year 2008, the profit participation certificates participated in the Company’s losses
        to a significant extent. As a result, the Company cancelled interest payments and reduced repayments
        of the principal amounts at the expiry of the relevant participation certificates (which, with regard to the
        disputed profit participation certificates, was between June 1, 2009 and December 31, 2012). For that
        reason, individual claimants initiated legal proceedings with regard to certain of the profit participation
        certificates contesting, in particular, those terms relating to loss participation and replenishment
        (Wiederauffüllung) and for the supplementary payment of cancelled interest payments. Many of the
        claimants submit that the capital components used to calculate loss participations should be different to
        the ones used by the Company and that a replenishment would depend on the issuer generating net
        income (Jahresüberschuss) but not on it generating balance sheet profits (Bilanzgewinn) for the period
        in question. With regard to the latter argument it should be noted that in the financial years since 2011,
        the Company had positive net income (Jahresüberschuss) but, due to loss carry forwards, no balance
        sheet profits (kein Bilanzgewinn). As of March 31, 2015, the contested profit participation certificates
        belong to certain issuances with an aggregate principal amount of €221 million (in total). Of such
        amount, the profit participation certificates held by the claimants had an aggregate principal amount of
        €15.5 million of which the principal amount in dispute was €6.3 million (in each case, as of March 31,
        2015). Until the date of the Prospectus, a binding judgment has already been rendered in favor of the
        claimants in three cases ordering the Company to pay around €1.1 million plus interest. Furthermore,
        the Higher Regional Court (Oberlandesgericht) Munich and the District Court (Landgericht) Cottbus
        have ruled in favor of claimants with a total amount in dispute of about €3.9 million with, in the latter
        case, an appeal pending before the Higher Regional Court (Oberlandesgericht) Brandenburg.
        Furthermore, investors who claim to hold profit participation certificates of the Company in the nominal
        amount of around €23.5 million have demanded a full or partial replenishment of their repayment
        claims, partly the supplementary payment of cancelled interest payments and payment of interest
        thereon. In addition, the Company has been informed that investors holding profit participation
        certificates of the Company in the nominal amount of around €30 million and demanding a full
        replenishment, supplementary payment of cancelled interest payments and payment of interest
        thereon are allegedly prepared to take legal actions. As a result of these claims being made and
        considering that further holders of profit participation certificates are likely to bring legal actions against
        the Company, the overall claim could in aggregate amount up to €0.3 billion plus interest.

  • The one other good example of a forced IPO you missed was Voya Financial which has been great.

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