value and opportunity

DISCLAIMER:
This is not meant to be an investment advice. Please do your own work. The author might have bought or sold the stock already prior any discussion. Don’t trust ANYONE with stock tipps or other easy ways to make money.

In general I try to stay away as far as possible from banks. However KAS Bank NV (NL0000362648) might be interesting.

KAS Bank itself describes its business as follows:

KAS BANK N.V. is the independent European specialist in securities services and risk control and reporting services for professional clients in the pensions and securities industry.

KAS BANK pursues a ‘pure play’ strategy, underlining the bank’s absolute neutrality and independence. A low risk profile is integral to its services and is reflected in the quality of its balance sheet and its high solvency ratio.

So this is important why it is technically a “bank” effectively it is a sort of service company with a banking license.

Based on traditional metrics the company looks relatively cheap although technically all the banks are cheap.

MArket Cap: 100 mn EUR
P/B: 0.6
P/S: 0.2
P/E Trailing 10.0
Div. Yield 7.2%

Before diving into the details one should always ask the question: Why might KAS Bank be an interesting investment ? My thesis (which will then have to be tested) is the following:

+ Service based business model should show less volatility than credit based bank models
+ as client base etc. is Netherlands and Germany fundamental fall out from EUR crisis should be low
+ stock price might have been punished by overall issues with banking industry
+ business should be cash generative increased cap. requirements should be not a big problem
+ no risk of dilutive capital increases
+ small market cap and low analyst coverage might further nake stock unattractive

Earnings history & volatility

As a financial stock with mark to market accounting KAS bank doesnt look that good in my “boss” model but this is to be expected for any financial stock with mtm assets and liabilities.

If we look at 5 year figures provided by KAS Bank we can clearly see that the overall results were less stable than I would have assumed:

	2007	2008	2009	2010	2011
net asset value	14.19	11.49	13.27	12.83	11.36
basic earnings per share	3.41	-2.7	1.69	1.27	0.7
dividend	2.6	0.45	0.73	0.73	0.5

On the plus side they paid a dividend each year however earnings were quite volatile with a big loss in 2008 caused by impairments.

Looking into the 2008 annual report one quickly sees the following comment:

Impairment losses on loans, including Lehman and one Madoff-related investment, bonds and equities in the available-for-sale portfolio, goodwill and two exceptional charges reduced the net result for 2008 by €58.7 million.

On a gross basis those impairment charges were ~5 EUR per share so quite significant. Further on they give more details on the losses:

As a result of this exercise, the bank has recognised impairment losses on loans and advances totalling €35.3 million (2007: nil). This item is made up of impairment losses on receivables in respect of securities lending positions with Lehmann Brothers Inc as client (€9.6 million) and in respect of an investment indirectly caught up in the serious fraud case involving Bernard L. Madoff Investment Securities LLC (€11.8 million). The rest of
the impairment losses (€13.9 million) relates to loans and advances to clients who are expected to be unable to repay their loans in full and, based on objective evidence, in connection with which the securities provided as collateral have fallen sharply in value.
Available-for-sale investments
The portfolio of available-for-sale investments is made up of shares and bonds and, with regard to both, there is objective evidence of impairment losses of €21.9 million (2007: €1.5 million) and €11.0 million (2007: nil), respectively. The difference between the cost and the current fair value has been transferred from the revaluation reserve to the income statement.
Intangible assets
The deterioration in market conditions has led the bank to make a downward adjustment in the future profit projections for the subsidiary in Germany acquired 1 July 2008, involving the recognition of an impairment loss of €5.2 million in respect of goodwill. This goodwill impairment loss is not allowable against tax.
Other equipment
In connection with the vacating of leased premises in 2007, all the previously capitalised costs of alterations to the building, totalling €3.2 million, were written off.

So all in all it was a combination of different financial crisis related write-offs which caused those impairments. We can clearly see that the business model includes at least some credit risk so its not a “Pure” service function. Going forward I guess the whole industry has learned from the “Lehman moment”.

Business model

At this point it makes sense to look at how the business model of a custodian looks like. Simply speaking a custodian manages the technical aspects of a security portfolio. The custodian executes trades records and receives interest coupons and dividends on behalf of the investor and sometimes offers “add on services” like reporting accounting cash management securities lending programs etc.

Some more background of the custodian business can be found for instance here or for a real deep dive this 100 page + overview of the industry.

In general one could asay that the custodian business is an interesting growing business however it is not clear if specialists or universal banks will profit most. Personally I think that after the crisis a specialist with “untarnished” reputation might have a certain reputation advantage.

In principle one can simplify the custodian business into 2 parts:

1. Transaction and service fees
2. Spread on “float”

The first part is relatively easy and is depending on the size of the administrated portfolios and the frequency of transactions. The second part is more difficult.

Custodians are a typical “float” business. If we look at KAS Bank’s 2011 accounts we can see at first a huge amount of leverage:

We have 5.2 bn EUR of liabilities against only 170 mn equity. However if we look at the funding side we see the following split:

Of the ~5 bn EUR financial liabilities around 0.5 bn are deposits from other banks so called “wholesale” funding. 4.5 bn are from non banks. Of the non-bank money again 0.7 bn are time deposits and 3.8 bn are “demand deposits”.

The non-bank demand deposit is the interesting part. Although this amount is fluctuating significantly a large part of this is “float”. usually every day some of the securities either pay interest dividend or mature. So KAS bank has a constant cash inflow from its client portfolios. Only few clients manage those cash flows on a day-to-day basis. Normally they only act if a certain amount accrues.

Custodian banks sometimes offer interest for those accounts at usually well below market rates. In normal times the custodians than invest those funds into the “normal” money market and earn a nice spread.

However at the moment, with short term interest rates at zero this “spread” is almost zero to. So for custodian banks the “float” part of the business is at its worst point in the cycle. KAS Bank (as many others) even took this further in investing part of the float into a security portfolio which at times can produce some mtm changes as we all know.

Looking at the pure “net interest result” without derivatives we can clearly see that KAS Bank could generate even in 2008 around 30 mn net interest result whereas in 2011 this amount dropped to 20 mn EUR pre tax.

Net commission income at the moment is around ~70 mn EUR this used to be ~90 mn EUR p.a. in the good days.

So we can see that both pillars are at the moment at a depressed status. Another interesting aspect is that custodians scale quite well. More transactions do not require a lot of more expenses if the infrastructure is in place. So if business (and interest rates) pick up profits will increase over proportionally.

Potential “Moat”

Custodian business in principle is a kind of “commodity” business. However there are some significant switching costs associated with changing custodians especially with more complex institutions like pension funds and insurance companies.

Within total costs for managing financial assets custodian fees are a relatively small cost block however in the overall process the custodian is very important.

So many institutions will think twice before changing an existing custodian relationship because any cost advantage will not be very big compared to the potential hassle.

I would call this a “weak” moat.

Current developement:

KAS Bank doesn’t issue quarterly reports only short “trading updates”. The Q1 update was Ok in line with 2011. However they mention a special positive effect of 4 mn EUR:

The half year report is scheduled for end of August in a couple of days

Non-operating result in Q1 2012 comes to €2.0 million and is chiefly attributable to the revaluation of a number of perpetual loans from banks. The proceeds of the planned sale of the shareholding in LCH.Clearnet will contribute €4.3 million net to the result in 2012.

So this seems to be a realization of a “Hidden asset”.

Dividend policy:

The stated dividend policy seems to be quite shareholder friendly:

Dividend policy
In accordance with the dividend policy discussed with the General Meeting of Shareholders, our target is to distribute 60-80% of the net result, where the profit permits and unless prevented by exceptional circumstances.

Shareholders

Interestingly KAS Bank does not have a dominating shareholder. LArge shareholders according to the annual reports are:

5% holdings
The following institutions have given notification of holdings of 5% or more in KAS BANK pursuant to the Financial Supervision Act and the Decree on Disclosure of Control and Major Holdings in Listed Companies.
– Delta Lloyd N.V. 12.2%
– APG Algemene Pensioen Groep N.V. 8.8%
– Delta Deelnemingen Fonds N.V. 8.6%
– ING Groep N.V. 7.9%
– All Capital Holding B.V. 5.3%
– KAS BANK N.V. 5.1%

Historically ING held more than double the current amount and sold down half of their stake in 2007 and 2008.

Some smaller positions are held by funds the only known value investor is Sparinvest with a 0.17% share. However the seem to have a “Poison Pill” in place for unfriendly take overs. So this limits any take over (and short term catalyst) “fantasies to a certain extent.

The stock is followed only by a few Dutch analysts 4 of 5 analysts have a buy rating with target prices between 10-13 EUR per share.

Management:

Management owns smaller positions in the stock and some options but compared to salaries (which ar Ok by the way) stock exposure of management is relatively small.

Balance Sheet quality

Overall balance sheet quality seems to be Ok. intangibles are ~14 mn EUR or less then 10% of equity. Disclosure for the AFS portfolio could be better. They only publish rating categories with the disclaimer

* No sovereign exposure on the PIIGS countries

So there would be some room for improvement.

Valuation

For me KAS bank is one of the few financial institutions where I would see a good “reversion to the mean” opportunity. They currently trade at an approximated “normalised” bottom of the cycle P/E of 7 and P/B of 0.6.

Average EPS over the last 14 years was 1.74. If we assume that conservatively They can achieve the 1.75 at some point in time in the future and a “fair P/E would be 10 then the share could be worth ~17,50 EUR. Average Price/Book over the last 14 years was about 1.2 so this would imply a double on current P/B of 0.6 if things return to “Normal” for KAS Bank.

Looking at the two profit pillars one could come up with the following valuation approach:

1. Pretax income on “float” ~25 mn EUR over a cycle
2. Fee income trading income etc. 100 mn EUR p.a. over a cycle
Minus 100 mn cost would be 25 mn EUR pre tax or ~ 20 mn EUR p.a. post tax of annual profit

Discounted by 10% this would again give us a value around double the current market price.

So from a valuation point of view I would say that KAS Bank should be worth double before any growth and excluding any future catastrophes.

Stock Price

The stock chart looks relatively ugly:

From a momentum point of view one shouldn’t touch the stock. In contrast to most other banks the stock didn’t rebound at all in the past few weeks. This might reflect that KAS Bank has not a lot of PIIGS exposure. Positively one could say that at least based on the last few months the stock price has found a floor at around 7 EUR.

Personally I think that KAS Bank now has reached a “fundamental” floor so in this case i will again ignore stock price “momentum” to a certain extent.

Interestingly, Beta to the AEX is only 0.62, which fits very well into my “low vol” strategy. What is very strange but interesting is the fact that Kas Bank is not really correlated to anything. Just for fun I looked at the 1 year correlations against the Dutch Index the Stoxx Banking index and ING:

	SX7E↑	KA	INGA	AEX
SX7E	1.00	0.27	0.86	0.83
INGA	0.86	0.28	1.00	0.89
AEX	0.83	0.32	0.89	1.00
KA	0.27	1.00	0.28	0.32

Although this is not the most important decision point for me, the low correlation of KAS Bank makes it very attractive from a portfolio risk point of view.

Summary:

KAS Bank for me looks like a very interesting opportunity within the banking sector due to the following reasons:

+ attractive specialist business model (custodian)
+ cheap valuation even based on current “bottom of the cycle” earnings
+ valuation depressed because of overall hostility against banks
+ low or no analyst coverage
+ reversion to the mean speculation a lot less risky than with normal banks as virtually no risk of dilution (even Basel III standards are met by a wide margin)
+ potential upside ~100% over the next 3-5 years plus dividends+ low correlation / beta good portfolio diversifier

For the portfolio I will start as usual with a half position (2.5%) and then decide after the half year report if I want to increase.