BankNordic is a community bank operating in Faroe Islands, Greenland and Denmark. It’s middle of turnaround with goal to increase ROE from 6% average to 10% by 2020. New board, management and strategy has been put in place to reach the goal.
If BankNordic reaches the goal by 2020 I’m expecting 15% annual returns from P/B-multiple expansion from 0.6 to 1.0 and accumulated dividends in my “best case” scenario, as illustrated in table below.
To reach the 10% ROE goal BankNordic’s earnings before tax must be 180 DKKm by 2020, assuming 1430 remaining equity after announced buybacks, dividends and disposals.
Adjusted for known downward trend in net interest and fee income and operating costs, as extrapolated from Q1 earnings report, and expected decrease in finance cost as result of recently announced subordinated capital refinancing, BankNordic’s run rate earnings before tax is some 200 DKKm, making the 180 DKKm EBT/10% ROE goal by 2020 seem trivial.
The 200 DKKm run rate earnings however implicitly assumes very low impairments as it is based on 2015 impairments, when they were record low 20 DKKm or 0.1% of assets.
Despite company attributing the low 0.1% impairment ratio to sound credit standards I think long-term average 0.5% impairments is more reflective of the future impairments because the recent 0.1 % impairments coincides with seemingly temporary positive economic shocks in Faroe Islands economy:
1) record high fish prices (by their nature volatile and will likely lead to a supply response)
2) fish export growth to Russia, thanks to EU food import bans not applying to Faroe Islands (temporary?)
3) exceptionally high fishing quotas, thanks to Faroe Island government going rogue from international quota agreements (temporary)
4) big infrastructure investment (temporary?)
More over, in the end of 2014 management expected the 2015 impairments to be at the same level as in the 2014 when they were close to the historical average 0.5%, but what really ended up happening was the record low 0.1%. If the low impairments would have been conscious effort to improve credit standards it would not have come as surprise.
With very high probability impairments mean reverting I think BankNordic’s normalized earnings power is closer to 150 DKKm instead of the 200 DKKm starting point (see table below, red lines new).
Alone the mean reversion of impairments would not mean insurmountable headwind for reaching the 180 DKKm EBT/10% ROE goal because the required earnings improvement would be only 180-150=30 DKKm.
But combined with potential big adverse effect of Danish Corporate Bank division disposal that has also been announced, things start to look more difficult.
Earnings effect of Danish Corporate Bank division disposal
There is great uncertainty how big impact the Danish Corporate Bank division disposal (through gradually winding it down) will have on BankNordic’s future earnings power because of limited disclosure.
It’s known (implicitly) that it will reduce net interest and fee income by 80 DKKm but it’s not known how much it will reduce costs. I have tried make an estimate of the savings and narrowed it down to some 20-60 DKKm.
The 20 DKKm low range of the cost saving estimate is based on 15 employees’ salaries who will most likely be layed off as result of the disposal, at least the employees were part of the deal when BankNordic tried to sell the unit earlier.
Assuming there is no other direct cost related to the Danish Corporate Bank than employee costs then the 20 DKKm estimated employee cost reduction is the natural minimum that can materialize from the disposal.
But note that the 20 DKKm cost savings would be too small relative to the 80 DKKm lost net interest and fee income to the disposal to make sense. That’s because the resulting 60 DKKm earnings decrease implies 30% incremental ROE relative to the announced 200 DKKm capital tied to the Danish Corporate Bank business.
Only way the disposal makes sense is that the 200 DKKm equity tied to the business is not earning its cost of capital.
If the cost of capital is 10% then the division must be earning less than 20 DKKm to the disposal to make sense, meaning that with the 80 DKKm net interest and fee income the cost relating to the segment must be more than 60 DKKm.
Hence I’m using the 60 DKKm as my high range of the potential cost savings from the disposal.
And because there is so much uncertainty regarding to the earnings effect of the disposal it is in pivotal role in determining how much earnings growth BankNordic needs to find from business expansion and cost savings after the disposal to reach the 180 DKKm EBT/ 10% ROE goal.
That’s because if the disposal is “bad” and decreases earnings by 80-20=60 DKKm then earnings growth required from other activities is is 180-(200-60-50)=90 DKKm, assuming normalizing impairments.
For comparison, if the disposal is “good” then earnings would decrease only by 80-60=20 DKKm, and combined with the normalized impairments, earnings growth requirement would be 180-(200-20-50)=50 DKKm, much less (new lines red at scenario table below).
As seen, with the high probability of impairments normalizing the disposal has a pivotal role in determining how much earnings growth must come from future business expansion and cost savings to reach the 180 DKKm EBT/ 10% ROE by 2020.
To simplify a bit, if the impairments will normalize then depending of outcome of the disposal earnings growth requirement for the 180EBT/10% ROE is either “doable” 50 DKKm or “difficult” 90 DKKm.
I say the 50 DKKm required earnings improvement is “doable” because initiatives required to do it seem to be barely within a reach and the much bigger 90 DKKm therefore “difficult”, because I just don’t know and cannot easily perceive where it would come from.
For example the “doable” 40 DKKm earnings improvement would materialize with combination of “only” 2% balance sheet expansion, 2% cost savings, repayment of expensive subordinated capital and capitalizing on private bank growth opportunity in underpenetrated Faroe Islands:
a) Expanding balance sheet by 2% is not going to be easy with sound credit standards due to deleveraging economy and fierce competition, but I guess doable due to small absolute scale of the bank (estimated 10 DKKm earnings effect)
b) Saving cost by 2% (relative to 2015 cost base) seems possible as according to management there is still room for cost reductions despite lot of rationalizations have already been done over last years (estimated 10 DKKm earnings effect).
c) Full repayment of subordinated capital will happen with very high likelihood because it was set as five-year goal in 2012, although not restated ever since, and because it would be continuation of existing repayment trend (estimates 10 DKKm earnings effect).
d) BankNordic’s goal is to grow its private banking and asset management business. AUM is not known but according to management there is opportunity to grow especially in Faroe Island, which is “comparatively immature market”.
With ~40% market share of deposits in the small 50 000 people Faroe Islands BankNordic has customer contact and distribution channel to best capitalize on whether market growth there is available. At least high deposits per person compared to other Nordic countries and some change in pension saving regulation suggests that there is real opportunity to move cash from bank accounts to private bank products.
With negative interest rates customers should be also perceptive in buying various private bank, giving tailwind in growing the business. BankNordic has also operation in mainland Denmark where the private bank products will be offered, but there the competition will be harder due to worse competitive position.
Earnings effect of the private bank expansion unknown, but in addition to the 30 DKKm potential earnings improvements specified above (a,b and c) it needs to be about 20 DKKm to reach the 50 DKKm earnings improvement.
All in all there seems to be enough opportunity and tailwind to grow the private bank business at least somewhat.
Point of the previous “Doable improvement” discussion was that while finding the 50 DKKm more earnings seems “doable” it’s not going to be easy.
It’s not easy for example to grow lending by “just” 2% because market is deleveraging and competition is fierce. And even if it could be done, further decrease in net interest income either from price competition or general decline in interest rates would offset the effect quickly.
It is also not easy to grow the private bank business. For example the 20 DKKm increase in fee income would require 2000 DKKm more AUM with 1% fee base, not an easy feat.
Lot of things has to go right to find the 50 DKKm more earnings.
And if the pivotal disposal ends “bad” then the required earnings growth for reaching the 180 DKKm EBT/ 10% ROE increases to 90 DKKm, which would be almost double more difficult than the “doable” but not easy 50 DKKm.
That’s why it is so important to know the earnings effect of the disposal, because if it’s “bad” then reaching the 10% ROE goal becomes difficult and therefore unlikely.
BankNordic published its second quarter results few weeks ago, which gave support to the theory that in fact the Danish Corporate Bank disposal has been “bad”.
My expectation was that if the disposal would be “good” i.e. that annualized cost savings from the disposal would be more than the estimated 60 DKKm, then operating cost should be coming down quickly from Q2 and onwards
How ever, what the report showed was that operating costs were down by only 2 DKKm relative to the first quarter, very low absolutely and relative to the run rate 460 DKKm annual cost base. If the cost base would be in trend of declining by 60 DKKm annualized pace, the quarterly cost reduction would have been much bigger.
With so slow cost reduction I took the second quarter report as sign that the disposal is more likely to have been “bad” and therefore that the earnings headwind for reaching the 180 EBT/10% ROE by 2020 becomes (too?) difficult.
And as in my mind after the Q2 report probability of reaching the 10% ROE decreased significantly, I think the expected value of stock returns did the same.
My best case estimate was 15% total return for shareholder if the ROE goal would be reached, which would have implied satisfactory expected value of returns at time of the analysis if the likelihood of it materializing would have been sufficiently high.
But as the likelihood of the 15% best case returns seems to have decreased significantly so has the expected value of the situation below my hurdle rate of some 10-15% making the investment a non-go for me.
That said, while 15% annualized returns seems unlikely, so seems loosing money. In fact, as shown by the earlier tables my “bad” scenario earnings before tax power estimate was some 90 DKKm which implies some 5% ROE, which with current 0.6-0.5 P/B valuation implies some 6% shareholder returns few years ahead.
Earning positive return if things go “bad” is actually quite good scenario compared to some other situations where “bad” scenarios really means bad.
Yet, while downside seems protected, so seems upside. For me the outcome distribution is not just very exiting because the foreseeable best case is only some 15% shareholder returns and that scenario seems too unlikely.
To me get exited either stock price has to come down or something has to happen that the probability of reaching the 10% ROE increases significantly. That would mean signs of impairments staying at the current record low levels, faster balance sheet expansion, faster private bank growth, increase in interest rates, more cost savings or higher leverage, of which I see none currently or think very unlikely.
Disclosure: No position but following closely