Bank of Cyprus (LSE:BOCH)

Investing in the shares of distressed European banks requires tremendous courage – success requires a decent dose of luck and good timing, in addition to picking the right horse. The big discounts to tangible book value reflect the very high risk of future dilutive equity issuance owing to the massive challenges faced by these banks on their NPLs. Investing in the NPL book or entering into a 3^rd party servicing agreement to run down the NPL book offers significantly better odds of success. However this is more for the Hedge Funds and PE houses given their deep pockets and resources. For an individual investor, I still believe that a basket of carefully picked distressed stocks offers a decent chance of success (of my 3 picks so far – Eurobank and Deutsche have returned 2x and Millennium BCP has tanked; for an overall return of ~35% in under a year). And now, I want to add Bank of Cyprus to my basket.

Bank of Cyprus is the largest bank in Cyprus with ~41% share of the loans and ~30% share of the deposits. It currently trades at just under 50% tangible book value.

Investment thesis

FY16 could be the year that turns a corner for BoC –
- it is set to make its first net profit after six years of losses;
- it has now fully repaid its €11.4bln loans to the troika and is able to pay dividends in future;
- deposits are returning;
- the trend in NPLs and 90DPD formation is reversing;
- it has an enviable net interest margin of 3.5% and cost to income ratio of 42% both of which should support pre-provision income; and
- the Cypriot economy has shown better than expected recovery supported by a growing tourism sector and a resilient business services sector and this is reflected in the falling unemployment rates, improved credit ratings and the fall in government bond yields.

The ~25% deleveraging in total assets since bail-in in FY13 - including the sale of all/most of its non-core assets - has made the bank a leaner more focused outfit.
Here are some graphs from the bank’s most recent investor presentation to illustrate the above points

Source: Bank of Cyprus investor presentation 11 Jan 2017

Potential upside

I don’t believe BoC’s shares offer value in the short-term; but over the long-term (1.5-3 years), they could do well. There are still significant challenges around NPLs (discussed in more detail below) and the market seems to be pricing in additional dilutions or hit to income owing to additional provisions or both. For the gap between price and tangible book value to narrow, the positive trend achieved over the last year/year and a half will need to continue for another year at least – in particular, the market will want to see positive net income and continuing reductions in 90DPD formation and NPEs. The recent trend in key metrics makes an entry at current price an attractive proposition.

Based on my projections for FY16, I expect the bank to make a Return on Asset of ~0.6% and Return on Tangible Equity of ~4.6% (ignoring the one of costs incurred in connection with the London listing and re-org). This assumes the bank taking provisions of ~70% against pre-provision income (consistent with provisions taken during 9M to Sep16). If the positive trend in 90+DPD formation and NPL’s continue provisions as a percentage of pre-provision income should come down. There is no doubt that provisions will stay high given the level of NPEs, but the bank should be able to generate a 1% ROA even where provisions stay as high as 50% of pre-provision income.

If the bank hits ROA of 1%, I calculate value per share of €0.052 (~169% upside to current price). Even in a scenario where provisions stay as high as 60% of the pre-provision, per-share value could rise to €0.041 for a 135% upside. The above assumes no growth in pre-provision income.

Downside risk

The biggest challenge is the risk of dilution owing to the bank having to rise additional equity to cover further write-off’s in the loan book. NPE’s currently stand at an alarming ~55% of gross loans with accumulated provisions covering ~42% of the NPE’s.

But the trend in NPE’s and 90+DPD formation has been positive, with both falling consistently over the past 12 months consistently every quarter.

Source: Bank of Cyprus investor presentation 11 Jan 2017

Based on my calculation, the bank will most likely need to rise additional equity if TBV falls by 
~€750mn; such a fall will take its capital ratio from the current ~14.5% to 10.75% which is the minimum required by the ECB for the bank. For TBV to fall by €750mn, the default rates would need to increase from the current ~55% of loan book to ~69% at constant coverage of 42%. To put this into context, At its peak in Dec14, NPE stood at 63% of gross loan with coverage at 34%; currently NPE is at ~55% of gross loan and coverage is at 42%. 

In the table below, I have calculated downside under 3 scenarios - if default rates rise to 63%, 69% and 80%. Per my estimates, even if default rates rise to 63% (last peak), the bank won't loose €750mn in TBV if allowing for 3 years' of pre-provision income and won't need equity issuance. Default rates need to rise to 69% for the bank's TBV to fall by €750mn; assuming the bank issues new equity at 35% discount to TBV, downside to current equity holders will be ~35% in this scenario. Default rates need to rise to 80% with loss given default going up to 50% for current equity to be wiped out.  
 

I think the current downward trend in NPE and 90+DPD formation, including the fact that the bank has achieved healthy recovery rates on restructured loans make the downside scenarios discussed above less likely.

Finally, there are a couple of elements that offer considerable upside with virtually no downside for a long-term investor. The first is the potential of Cyprus’s offshore natural gas fields. The recent auction of another block of concessions attracted the participation of some major international companies and recent drilling activity suggests that there could be decent level of natural gas offshore Cyprus. The second game changer is the possible reunification of north and south of Cyprus after more than 50 years of divide – both sides have recently held positive talks. The bank has significant property assets in the north which is currently valued at zero in the books and any reunification will mean the bank getting the assets back or being owed compensation for expropriation. None of the two elements above form part of my thesis but provide a decent upside if they come to fruition.