Wednesday, 28 November 2018

Eurobank addendum: Merger with Grivalia

The very next day after the publication of my recent piece on Eurobank, the company announced a merger with Greek real estate investment company Grivalia. The merger will be destructive to Eurobank's per share value long term (by about 30% in my assessment), but the deal does have some benefits, including reducing downside tail risks (regulators forcing another recapitalisation). This arguably makes a larger position now more feasible, as the level of upside is still material. The stock has so far rallied about 10% to €0.50.

I believe it is likely that Fairfax had a role to play in engineering this merger, as the merger is more favourable to Grivalia shareholders than it is to Eurobank shareholders. Fairfax owns 18.23% of Eurobank and 51.43% of Grivalia, and will emerge with 32.93% of the combined entity. Fairfax will therefore enjoy not only the benefits of the merger, but also an increased stake in the cheaper entity.

The deal (including the associated NPE securitization plan) appears to confirm a lot of the fundamental arguments made in my original article, including that the level of underprovisioning on Eurobank's SME/corporate book was likely about €2bn, but the advent of the merger suggests the level of pressure European authorities are bringing to bear on Greek banks to further reduce on-balance-sheet bad debt (in excess of already-agreed, aggressive targets) may well be greater than I had estimated. This may have made Eurobank feel compelled to accelerate its NPE reduction plan. To the extent this is true, while materially dilutive of some of the long term upside, the deal will have the benefit of reducing the risk of further capital raisings, and likely also bringing forward a rerating in the shares to 2019-20.

The deal

The deal will see Grivalia's approximately €1bn of (predominately) Greek property assets injected into Eurobank, in exchange for the issuance of Eurobank shares which will grant Grivalia shareholders a 40% stake in the combined entity. Eurobank was trading at 0.2x book, and Grivalia at 0.8x book (adjusted for the €54m Grivalia will pay out pre-closure), so the deal will dilute Eurobank's per-share book value by about 30% from €2.24 to €1.56, and result in the combined group trading at 0.3x book. In addition, pre-provision operating profit per share will be diluted from about €0.45 per share to just €0.28 per share, due to the relatively low level of Grivalia earnings accretion (albeit from high quality, stable rental income streams).

The purpose of the deal appears two-fold. Firstly, the injection of property assets will boost Eurobank's capital by about €1bn, and thus provide it with room to accelerate the removal of bad loans from its balance sheet. Concurrent with the deal, Eurobank intends to securitize and deconsolidate €7bn of the company's worst loans, and Eurobank estimates that this will require a hit to capital of €1.1-1.4bn - i.e. approximately on par with the level of capital injected by Grivalia. However, it is anticipated that this will allow for a reduction in the company's NPE ratio from 39% to 15% by the end of 2019 (two years earlier than the originally agreed-upon 2021).

This €1bn hit to capital seems consistent with my prior back-of-the-envelope estimate of underprovisioning of some €2bn (note Eurobank will generate another €1bn in PPoV between now and 2019 year-end, which will also provide additional capital to facilitate NPE resolution). The remaining 15% NPEs by 2019 year-end will be the best quality, in terms of collateral coverage and recovery prospects, and will also already be well provisioned, so the bank will be well positioned to report robust and sustainable profitability from 2020 onwards.

However, the key issue is that Eurobank is giving away 40% of the company merely to accelerate these disposals by 1-2 years. Generating nearly €1bn of capital internally from PPoV per year, a similar capital neutral exercise could have been undertaken more slowly over 2-3 years without diluting shareholders, in accordance with its prior plan to reduce NPEs to 15% by 2021. In addition, the contorted securitization structure announced as part of the deal is deliberately designed to allow shareholders to retain significant upside to any recoveries on the disposed NPEs (including distributing several tranches directly to shareholders), which suggests that Eurobank doesn't actually want to completely rid itself of the loans. Instead, Eurobank's actions seem to reflect a rush to improve optics by removing bad debts from its balance sheet as soon as possible.

I would infer from this that the bank is under pressure from Brussels to resolve bad debts even more quickly than the aggressive timeframes previously agreed on (NPE reduction to 15% by 2021). As discussed in my prior article, this pressure from Brussels is entirely counterproductive and unnecessary. It does little to help the Greek economy, and is merely placing additional strains on the banking system and impairing confidence, at a time when the economy and banks are already healing. Nevertheless, this is the world in which Eurobank lives, and the deal will reduce the probability that the company will be forced to raise additional capital in the future, as an NPE ratio of just 15% will result in pressure from the Brussel's boot being eased from Eurobank's neck.

Secondly, the merger will bring in property management expertise. Grivalia has been busily acquiring quality Greek property assets at high-single-digit yields, even at bottom-of-the-cycle rents and occupancy levels. With Eurobank set to repossess a lot of real estate collateral in coming years, having both the capital and expertise to retain some of these assets and maximise their recovery value, rather than merely liquidating them at fire sale prices, will be worthwhile. Grivalia is probably (conservatively) worth 1.0-1.5x book, and was trading at 0.8x, so merging with Grivalia is definitely a far superior alternative to simply raising €1.0bn in fresh capital, both in terms of reducing the amount of value-dilution, and also bringing in worthwhile expertise/opportunities for synergies.

How might things look in 2020?

So assuming the €7bn NPE disposal goes according to plan, how might Eurobank look heading into 2020? As noted, pro forma for the deal, pre-provision operating profit per share is now €0.28, and book value about €1.50 per share. A €1.1-1.4bn hit to capital will need to be taken in 2019 alongside the €7bn NPE disposal, which will be partly offset by pro-forma profits of €250-300m. Let's assume a €1bn net hit out to the end of 2019. This will see exit (tangible) book value fall to €1.30 per share (or about €4.8bn, with 3.7bn diluted shares outstanding).

However, the company's NPE ratio would then be 15% (down from 39%), and they would have ejected a lot of their worst, underprovisioned legacy loans from their balance sheet, and the majority of their remaining NPEs will be relatively well provisioned & covered by collateral, and enjoy better recovery prospects.

The company has said it expects to report a return on tangible equity of at least 10% from 2020, as cost of risk normalises. This implies at least €0.13 per share, based on FY19e NTA of €1.30 per share. This appears realistic. With PPoV per share of €0.28, normalised provisions of say €300m, or €0.08 per share (a cost of risk run-rate of about 100bp of performing loans), and a tax rate of 29%, EPS would compute at €0.14 per share. Let's go with €0.14. At the stock's current share price of €0.50, that represents about 3.5x earnings.

However, importantly, Eurobank has a total of €4.8bn of deferred tax assets (about €4.0bn pertaining to Greece), the majority of which either have no expiry, or very long term amortisations. With FY20e pre-tax profit of €740m, annual taxes owing would be €215m per annum (at 29%). At this run-rate, the company would not have to pay cash taxes for approximately two decades. Consequently, the stock's pre-tax P/E multiple is arguably more relevant, and at €0.20 per share in FY20e pre-tax earnings (assuming, of course, everything goes according to plan), the stock would be on a multiple of just 2.5x.

Provided Greece's economy continues to heal, and the SPV asset disposal programme proceeds according to plan, there is a good chance that this stock trades towards €1.50 over the next 12-24 months, in my view - triple from current levels - or to about 7.5x pre-tax earnings, and a modest premium to tangible book value. Furthermore, Eurobank will be very well placed to add value to the group beyond that point, as it will be the first well-capitalised banking group to emerge and be in a position to acquire distressed assets (e.g. repossessed property), as well as acquire the offshore subsidiaries & other non-core assets of other banks still retrenching, and therefore continue to build out its regional presence (as it did by acquiring Piraeus' Bulgarian subsidiary recently, on the cheap). It will also be well placed to extend loans to a recovering Greek economy.

Upside has nevertheless been reduced by some 30% compared to the pre-merger situation. However, with risks also reduced the stock remains attractive at €0.50 in my opinion.


DISCLAIMER: The above is for informational/entertainment purposes only, and should not be construed as a recommendation to trade in securities mentioned. While provided in good faith, the author provides no warranty as to the accuracy of the above analysis. The author owns shares in Eurobank and may trade the position or buy more shares at any time without notice.


  1. Lyall - another consideration would be that the major sponsor of Eurobank post-merger would be Fairfax, headed by Prem Watsa. Prem's a skilled capital allocator with a great track record, and has held a position in Eurobank for some time now

    1. Completely agree. Eurobank is my preferred Greek bank in large part due to its superior management, & Fairfax's influence is a clear positive. You're right to point out that Fairfax's influence will likely increase post merger also given its larger shareholding. Cheers

  2. I love these in depth analysis Mr Taylor. Fairfax India at current prices is my favourite high conviction stock despite the fat fees for Prem`s pocket. India is just a crazy growth story, I cannot imagine any less than a 10x over the next 15 years.

    1. Thanks Hector,

      I'm not so convinced on Fairfax India & a lot of Indian-exposed equities generally, although to be fair I haven't looked too closely at FI.

      Stocks in India are overvalued because it's a high inflation economy. That means real ROEs, to be comparable with DM levels, need to be reduced by about 5ppt to equate them with DM peers. You give back the extra nominal ROE in currency depreciation over time - something we have seen. When you adjust for inflation, already high PEs become stratospheric.

      In addition, there is a negative correlation between GDP growth and equity returns, because high growth leads to capital inflow/investment which suppresses returns on capital (and vice versa). I plan to write a blog article on it sometime. Returns investing in India should be poor over the next decade IMO given current valuation levels.

  3. Totally agree that the market is too pessimistic on near-term for Greece, but what about the long-term?

    Can you imagine any scenario in which Europe has a recession and Greece doesn't implode? The country is particularly levered to tourism, which would drop quickly, and current agreement with Europe wouldn't really allow for any fiscal stimulus.

    Seems like next recession, the Greeks would have to be crazy to not finally realize that they are better off "starting over" with their own currency. I don't think they'll get so easily tricked by their creditors next time.

    I guess I'm curious as to if you think Greece can really survive long term under current capital structure/fiscal limitations, or if you are really hoping to get out of the trade before next recession hits (not saying that's happening soon but it will eventually happen).

    It feels like like the Greek solution was the equivalent of restructuring a bankrupt cyclical company so that it emerges with a new capital structure, yet instead of previous leverage of 14x, the company's debt was reduced so it's "only" levered 9x.

    1. Thanks for your comment,

      You are correct that Greece will be hurt in a European recession, and it hasn't yet reached the exit velocity it will likely need for this to create a renewed set of problems.

      For the next few years, I've been reasonably constructive on Europe's growth outlook though. It won't be fast growth, of course, but the continent is still only gradually healing from a tough decade - unemployment is still 8% - and in particular Southern Europe, which had a depression. The decline in the Euro last year will help also. That said, recent data suggests Europe has slowed a lot more than I expected.

      In terms of how Greece fares long term, I'm also more optimistic. The basic issue for Greece has been an uncompetitive exchange rate. They have had an 'internal devaluation', and it looks to me to have been enough. That was always the fundamental problem, and it looks to me to have been addressed.

      A fall in European tourism is a risk, but they will also likely enjoy increased tourism from Asia/China over time as well, and also stand to benefit if European tourism picks up if the European economy recovers over time. Its a beautiful place in the world with historic sights, and global tourism/travel is only going to increase over time as the world economy continues to grow - especially developing markets.

      Bear in mind Greece is coming from depressionary lows. They had capital flight and then capital controls put on back in 2015, as well as further austerity. The economy only contracted marginally. That is rock bottom! If Greece's economy continues to heal, government income will start to rise and now that austerity is complete, will create lots of options, including lowering corporate taxes and boosting government infrastructure spending. An improving jobs market could also see Greek nationals start to slowly migrate back.

      Greece probably should have exited the Euro back in 2011. However, they stayed, had a depression and internal devaluation, and I think they don't need to exit now. Things could always change though.

      All that said, clearly Greece is a high risk situation. There are still lots of things that could go wrong. I guess my difference is that I feel there is an adequate risk premium for these risks, whereas I also believe there are things that could go right, and this upside is being overlooked.


  4. LT - Not sure if you're willing or able to share, but has KORS gotten interesting again at these levels in the $30s? Trying to do my own work on this (and many other companies) as stock prices continue to inch lower, but I'm guessing you've got a head start given your past involvement. Also, willing to share other thoughts or insights on the sector more broadly (e.g., explaining the range of valuations from KORS to, e.g., PVH, to, e.g., TPR, to the "real" luxury companies trading in Europe, at a deeper level than the accounting and financial metrics might reveal on their own)? I remember being modestly bullish on Coach back in the early 2000s and being ridiculed by another investor for gambling on fads (suffice it to say I made a bunch of money but possibly taking on more risk than I wanted to admit), but perhaps there's a more nuanced way to think about consumer brands and their true sustainability, balanced against all the changes the new Internet, e-commerce, and social media age has ushered in and the new or even higher risks to these kinds of businesses and assets. Will greatly appreciate any thoughts, but will also understand if none are forthcoming.

    1. Hi Anonymous,

      Thanks for the question. Interesting you say that as I did in fact buy back some KORS recently at (no CPRI) at about $37 after exiting around $67. However, I've taken a slightly smaller position this time.

      At the current $40, the stock is back to 8-9x PE, after having traded up towards 15x. However, I would say the story is less attractive than when I first blogged on it as they have geared up the balance sheet to make two expensive acquisitions - Jimmy Choo and Vesace. They might well make those acquisitions work, and they could create value, but their entry prices create an obligation to do so to avoid destroying value.

      This has implications on multiple levels. Firstly, instead of FCF being used to buy back cheap shares, its being spent on expensive acquisitions. They now need to commit cash flows to degearing, which has a low marginal return on equity. 8x earnings when net cash is very different to 8x earnings with a lot of (low yielding) debt you need to pay down.

      Secondly, having now completed two acquisitions, their capital allocation priorities have clearly changed to one centered on growth, and assembling a diversity of brands. The issue is that they will probably do more acquisitions in the future as well (balance sheet capacity permitting). Consequently, the incremental return on retained earnings will likely be much lower than when they were just buying back cheap shares, with higher risks as well.

      So all told, far less compelling and straight forward than back in 2016. That said, the stock at 8-9x PE is still cheap for a portfolio of decent quality luxury brands that should have staying power. I don't view this (or other luxury brands) as retailers like many do - I view them as brand owners. Without fashion, balance sheet, management, fad & acquisition risk these are 20x PE+ businesses. I think about 12-13x is fair for KORS/CPRI; 8-9x looks a bit too low.


    2. Thank you, as that was a very clear explanation, and helpful, as those considerations around management, balance sheet, acquisition, capital allocation risks will be good for me to keep in mind. I, too, bought some KORS in the high $30s – and under the influence of some of the ideas I have gleaned from this blog, a position sized very small, as well – but I probably wasn't weighing those factors you mentioned as realistically and intelligently as I should have.

      I will try to catch you another time for your philosophy on exiting something like this or any other investment. I'm still grappling with the fact that, assuming one has been good enough to go in with a fairly strong view on a fair value for the shares, one still has choices as to exiting at a modest discount to one's estimate of fair value, strictly at or near fair value, or only when shares have reached a premium to fair value, where I can think of reasonable sounding arguments for each approach. As I have come up with reasoned principles around other aspects of investing, being able to depend on them has taken out a lot of the emotion and stress in the investment process for me and made it a much more enjoyable activity. Selling remains perhaps the one area where I am still undecided on how to resolve the problem. (Just to be a bit more concrete, suppose we agree on the normal earnings power of the business and that 12-13x is fair for CPRI, but we also know that stock prices can exhibit something like momentum and that CPRI might easily be valued at, say, 16x someday, just as it was valued at 8x when we bought it. Absent a clearly superior alternative for capital, is there an argument that helps settle whether one should be thinking of exiting at 12x, 14x, or 16x? I'm not trying to tax you, it's just that I have found it an interesting but seemingly challenging problem to work out myself.

      Thanks again, and glad to be enjoying your thoughts again in the new year.

  5. Any thoughts on the reports this morning of ECB finally "guiding" that European banks "fully cover" their NPLs over the "medium term" and where such guidelines would fall in relation to your expectations for policy and in relation to potential harm being done by regulators to a bank such as Eurobank? Thanks and hope all is going well in the new year.