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