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.