Toshiba: From nuclear renaissance to nuclear nightmare

“There is a chronic culture of lying. We can’t possibly trust such a company. Shame on you.” – An angry Toshiba shareholder at a recent shareholder meeting.

Toshiba, one of the models of corporate governance for Japan Inc until two years ago, stands on the brink of possible failure. Toshiba’s problems began with an accounting fraud identified in FY15 where it was found that the company had overstated operating profits by $1.2 billion. That issue pales in significance to the crisis facing Toshiba today. Significant cost overruns in its Westinghouse Nuclear Power Business (Westinghouse), has meant that Toshiba has had to take a massive Yen 712.5 billion ($6.1 billion) write-off; it is likely to declare a loss of Yen 1 trillion for FY16, the largest ever in Japanese corporate history. Shareholder’s equity stands at a dire negative Yen 540 billion resulting in a shareholder’s equity ratio (net assets / total assets) of -12.6%. If Toshiba doesn’t cure its broken balance sheet soon, it will go bust.

Toshiba’s shares are down ~44% since just before the news of the massive write-off broke in mid-December 2016. 

The situation at Toshiba is of interest because similar situations – large corporate hit by unexpected bad news spooking the market and sparking an overdone sell-off – have made good returns for contrarian investors. To name a few recent examples:

Glencore – In late 2015, the commodity price slump along with high debt load drove Glencore’s shares down by 87% from its 2011 IPO price. However, superior execution by a strong management and recovery in commodity prices has meant that an investor in late 2015 or early 2016 would have made 3x to 4x return.

BP – In 2010 the Deepwater Horizon incident sent BP’s shares down by 50% in just under 2 months. A contrarian investor, having done his due diligence, would have seen value in the shares which subsequently returned 2x in just over 6 months.

Deutsche Bank – In September 2016 when the US Department of Justice hit Deutsche Bank with a $14billion fine, its shares were left reeling and fell below EUR 10 level. The very survival of the bank was put into question. However, a careful analysis would have revealed that the fine was not going to be anything like the $14billion; the shares duly returned ~2x in less than 6 months.

Bombardier – After falling to a historic low of C$0.80 in early 2016 on fears of being taken out of the Toronto Stock exchange which resulted in wide spread sell-off by institutions, Bomardier returned 3x in 2016. Again, a careful analysis would have indicated a buy.

But every fall doesn’t indicate a future recovery and there are cautionary tales too. One can easily ride what appears to be a prospective recovery plays all the way down. Who can forget Valeant, touted as a recovery play by so many only to find that it was a ride all the way down. 

The question is – is Toshiba a Glencore or is it a Valeant?

Toshiba faces multiple headwinds threatening both its immediate survival and its longer term prospects even if it manages navigate the immediate threats:

In the near term Toshiba needs to cure its negative equity and repair its balance sheet. Failing to do so would be catastrophic – there is a real risk of Toshiba getting delisted from the Tokyo Stock Exchange (TSE) if it cannot cure its negative equity by the FY17 (March 2018). And being a capital intensive business with long working capital cycles and significant capex needs, Toshiba relies heavily on its banks (a group of 80+ banks) for lifeline. They will be getting jittery and could pull the plug if they don’t see a cure to the balance sheet woes (shareholders equity ratio is a key metric for Japanese banks and they like to see this ratio being at least above 10%; Toshiba’s negative 12.6% must be alarming).

To add to its balance sheet worries, I don’t think there are any guarantees that the Westinghouse Nuclear issue is behind Toshiba. In spite of the massive Yen 712.5 billion write-off, significant contingent liabilities associated with Westinghouse remain. Toshiba is exposed to an identified parent company guarantee of Yen 650 billion and it can more or less forget being able to recover its Yen 176.5 billion of loans to Westinghouse. The identified contingent liabilities alone add up to Yen 825.6 billion. In addition, two minority partners in Westinghouse holding 13% have a put option to put their shares back to Toshiba – I expect this to cost Toshiba an additional Yen 81 billion. But this is unlikely to be the end of the Westinghouse massacre. As this excellent FT analysis shows, for a project as complex as Westinghouse, the only certainty is uncertainty; escalating costs and prolonged deadlines could deal Toshiba fatal blow. As Georgia Power, a customer of Westinghouse, made it clear in a statement – it has a “firm and fixed” contract with Westinghouse and expects Toshiba to employ “all possible means” to deliver the projects on time or it will hold Toshiba “accountable for their responsibilities under the agreement”. When Toshiba acquired Westinghouse in 2006 for $5.6 billion, nuclear reactors were touted as the future and it was going to be an ear of nuclear renaissance. That dream has now turned into a nightmare for Toshiba.

The only option open to Toshiba to cure its balance sheet is to sell its crown jewel – the NAND Flash Memory Business (NAND). NAND is Toshiba’s best asset with good growth prospect and margins. Selling NAND and loosing nuclear risks leaving Toshiba with a rump of low growth low margin businesses with little future prospects (the remaining businesses have a projected margin of 1.4% in FY17 and Toshiba’s own optimistic forecasts for FY19 show a margin of 5%). But there is no way out of Toshiba other than a sale of NAND. It is seeking a price of at least Yen 2 trillion from the sale of NAND; if it can achieve this price, it would certainly cure Toshiba’s balance sheet issues and take away its immediate survival threats. A recent bid from Western Digital is reported to be at Yen 2 trillion. This bid has financial support from the Development Bank of Japan and blessings of the Japanese government which does not want NAND to fall into the hands of the Chinese or Koreans and supports Western Digital bid. This news has made the market happy, sending Toshiba’s shares up by ~11.5% in two days (my ~44% fall since December 2016 is after the recent rise without which Toshiba would be down by over 50%).

Given the challenges, a bull case can only be made if it can be established that the sale of NAND will cure Toshiba’s balance sheet, that an exit from Westinghouse can be achieved without any additional liabilities, and that what Toshiba is left with after NAND and Westinghouse has enough value. 

Valuation

Valuing Toshiba is not easy. Given the hundreds of businesses Toshiba operates and the significant distress it currently faces, I don’t think a DCF valuation would return a meaningful result. I have approached the valuation from a balance sheet angle and try to compare market’s implied value with my estimate of value.

The first step in the process is to build the liabilities side of a non-GAAP balance sheet (the GAAP balance sheet is not much use as we want to now all liabilities – including contingent and off balance sheet). The next step is to build the asset side, work out the net asset value and arrive at the value per share.

The liabilities side of Toshiba’s non-GAAP balance sheet

Some of the liabilities are easy to determine – Toshiba has Yen 1389 billion of debt, Yen 633.8 billion of pensions liability and Yen 980.05 billion of net current liabilities. But there are some liabilities which are difficult to estimate – like how exposed Toshiba is on its parent company guarantee to Westinghouse? At present, based on discloses connected with the Westinghouse chapter 11 filings, Toshiba has said that it is exposed to Yen 650 billion on its parent company guarantee; but there is a very real risk that this number could increase. In addition, Toshiba will take a hit on the put options which the two minority partners in Westinghouse who hold 13% will exercise to put their shares back to Toshiba. I estimate this to cost Toshiba Yen 81 billion over the course of FY17. Assuming no additional liabilities on the Westinghouse side other than the Yen 650 billion, the non-GAAP balance sheet looks something like this:

Liabilities	Yen in billions
Debt	1389
Pensions liability	633.8
Net current liabilities	980.05
Westinghouse parent company guarantee	650
Cost of paying out on the Westinghouse Puts	81.9
Total Liabilities	3734.75

For the asset side of a non-GAAP balance sheet, some of the assets are easy to determine – I give full credit to Toshiba’s Yen 804.5 billion of cash balance and ~Yen 221.1 billion of investments (these are securities and loans to affiliates net of the Yen 175.6 billion loan to Westinghouse which I have assumed is a write-off). Then we have the material operating assets of Toshiba which I classify into 3 broad buckets – the NAND business, the remaining nuclear business after Westinghouse, and the rest of Toshiba. As a first step, it is useful to work out the implied value for these businesses based on Toshiba’s current share price. Toshiba currently trades at Yen 258 a share and there are 4.23 billion shares outstanding, giving a market cap of Yen 1091.34 billion. Based on this, I derive an implied market value for Toshiba’s operating assets (NAND, nuclear and rest of Toshiba) of Yen 3800.49 billion. The asset side of this balance sheet looks like this:

Assets	Yen in billions
Cash	804.5
Investments (net of Yen 175.6 billion loan to Westinghouse	221.1
Implied value of NAND, nuclear and the rest of Toshiba based on current share price	3800.49
Total Assets	4826.09
Total Liabilities	3734.75
Net Asset Value	1091.34
Number of shares outstanding	4.23
Current share price	Yen 258

The next step is to try and determine a value for the three Toshiba businesses – NAND, nuclear, and the rest and compare this with the implied value based on current share price.

NAND

Given NAND is up for sale and at least a couple of bids have been received, the bid prices are my proxy for value. Bain recently bid ~Yen 1137 billion and the latest bid from Western Digital has come in at Yen 2 trillion. Toshiba too has publicly stated that it wishes to achieve a price of at least Yen 2 trillion. As mentioned previously, the Western Digital bid has the backing of the Japanese government and the market clearly thinks this is the one. Whilst there is no ruling out an insanely high bid from the likes of Hon Hai (there were rumours of Hon Hai bidding Yen 3 trillion for NAND) given the Japanese governments expressed wish of not wanting NAND falling to the hands of any other Asian buyer, such a bid succeeding could be low – Toshiba relies heavily on government support and it may not be able to go against its wishes. Therefore, a reasonable estimate of value for NAND is Yen 2 trillion. My forecast FY17 EBITDA for NAND comes at ~Yen 200 billion giving a 10x EBITDA to NAND which is a reasonable against sector comparables.

Nuclear excluding Westinghouse

The rest of Toshiba’s nuclear business is forecast to generate EBITDA of ~Yen 40 billion for FY17. EDF trades at ~4.7x FY17 EBITDA, but EDF is a superior quality business compared to what will be left of Toshiba post Westinghouse. And Toshiba is likely to fire sell its nuclear remnant once the dust settles down. I assigning an optimistic 4x EBITDA multiple to Toshiba’s remaining nuclear business gives it a value of Yen 160 billion.

Rest of Toshiba

The rest of Toshiba is a myriad collection of businesses from digital services to energy transmission, electronic devices, power transmission, railway and industry systems, printing systems, public infrastructure and building facilities. There are literally hundreds of businesses and it would be impossible to value with any degree of precision without detailed inside knowledge. What we know is that these are highly capital intensive businesses with low growth and low margins (for example, Toshiba’s forecast margins for for this lot for FY17 is 1.4% and even its highly optimistic – entirely unrealistic in my opinion – FY19 forecast shows a margin of 5%).

The best comparable for the rest of Toshiba is Hitachi of Japan which trades at 4.7x forecast FY17 EBITDA. There are strong arguments to say that the quality of Toshiba’s assets and management deserves a meaningful discount to Hitachi’s multiple. Based on Toshiba’s forecast FY17 numbers, I get an estimated FY17 EBITDA for the rest of Toshiba of ~Yen 178 billion. Applying a 4x multiple to this forecast EBITDA gives a value for rest of Toshiba of Yen 622 billion; and applying Hitachi’s 4.7x multiple would give a value of Yen 835 billion. If we take Toshiba’s FY19 forecasts a face value and apply a 4x multiple to FY19 forecast EBITDA of Yen 357 billion, the value for rest of Toshiba would be Yen 1428 billion. Taking an average I assign a value of ~Yen 962 billion for the rest of Toshiba which I believe is more than reasonable.

Based on the above estimates, my estimate of intrinsic value per share for Toshiba comes to Yen 95 to Yen 100 per share which reflects a ~60% downside compared to the current share price of Yen 258.

Intrinsic value estimate

Assets	Yen in billions
Cash	804.5
Investments (net of Yen 175.6 billion loan to Westinghouse	221.1
NAND	2000
Nuclear less Westinghouse	160
Rest of Toshiba	962
Total Assets	4147.6
Total Liabilities	3734.75
Net Assets	412.85
Shares outstanding in billions	4.23
Value per share in Yen	97.60
Current share price (@26/05/2017)	258
Downside to current share price	-62%

In my opinion the market is way too complacent and hasn’t fully appreciated the risks facing Toshiba – it most likely underestimates the risks on the liabilities side and possibly overestimates the value on the assets side. In addition, there are significant risks on a number of fronts – e.g. delisting risk with the TSE, banks pulling the plug, execution risk with NAND sale, getting auditor sign-off on the accounts, and the very real possibility of crippling additional liabilities on the Westinghouse side.

A quick rundown of both downside and upside would read as follows:

Downside risks

1. Liabilities on the Westinghouse Nuclear business turn out to be greater than the estimated ~850billion; this is a real risk in my opinion. Such a scenario could be fatal for Toshiba.

2. Toshiba gets delisted from TSE due to any of the following: if additional write-offs need to be taken due to escalating costs on Westinghouse and negative equity position weakens; if the NAND sale cannot be executed or price achieved is lower than expected; if Toshiba doesn't reach a resolution with it auditor to get its accounts signed off; or if TSE isn't satisfied that Toshiba's internal controls have improved and are adequate (I pity the TSE regulator in charge of checking this given this is a business which failed to notice over $10billion cost overruns on a $25billion original budget on Westinghouse until after 8 years of running the project and all the while reporting positive numbers).

3. Longer term, the remaining businesses after the sale of NAND and loss of Nuclear could well turn out to be low growth poor margin businesses which do not justify the current market value.

4. Toshiba's lenders pull the plug and Toshiba is left with no option but to fire sell whatever assets it can, seek government support or go bankrupt. This scenario will mean a complete write off for current equity owners but could prove lucrative for distressed debt investors.

5. If Toshiba manages to navigate the immediate risks by achieving a satisfactory sale of NAND curing its balance sheet, there is a very real chance of a dilutive equity rise at that point. The market seems to be completely discounting this possibility. If I were one of Toshiba's banks, I would certainly be pushing for this.

Upside scenarios

1. Additional liabilities connected with Westinghouse come in at lower than currently anticipated levels in the unlikely event that Toshiba manages to negotiate a better deal. I fail to see how this can happen and why the utilities would ever fall for this given they have Toshiba contractually bound to a fixed price contract.

2. NAND sale generates a more than expected price. Whilst there have been rumours of Hon Hai bidding Yen 3 trillion; given the Japanese government clearly backs the Western Digital bid and has openly expressed its wish for NAND to not pass to a Chinese or Korean owner, the likely hood of achieving a significantly higher price than Yen 2 billion is low in my opinion.

3. Toshiba's remaining business - post NAND and Nuclear- perform better than expected and achieve superior market multiples. Possible but less likely given history.

In my opinion the downside risks trump the upside. While the market is optimistic at present (almost euphoric in the last few days on the back of the NAND bid), there are significant issues Toshiba needs to navigate and more surprises are likely on the downside. It will only take one or two downside surprises for the market to turn pessimistic and dump the stock. This could be an interesting short.

Akzo Nobel: One way or another

Akzo Nobel has fended off a second approach in 2 weeks from PPG.  The improved offer values each Akzo Nobel share at €90 which is a ~8% improvement to the €83 a share bid two weeks ago. Akzo’s rejection of the second approach has not gone down well with its shareholders with at least three high profile shareholders (including Elliott Capital) calling Akzo to engage with PPG this time. A shareholder poll conducted by Bernstein indicates that shareholders want Akzo to engage with PPG and push for a higher price of ~€95 a share.

I believe that Akzo Nobel’s shares have a 15% - 22% upside one way or another. If the PPG deal happens at the current price, there is a ~17% upside to the current share price. Better still would be if the PPG deal doesn’t happen and Akzo spins-off its Speciality Chemicals business as its board as indicated it will; this should unlock a ~22% upside at a much lower risk. The PPG deal has significant political and antitrust risks that the spin-off doesn’t have. 

Valuation

My DCF valuation for Akzo Nobel gives a value per share in the range of €88 - €90 for an upside to current share price of 15%.

In a spin-off scenario, Akzo Nobel’s Speciality Chemicals division could command an enterprise value of €8.8bln based on the sector's average EV/EBITDA of 10.3x; the remaining Paints and Coatings businesses could command an enterprise value of at least €17.5bln using the multiple on which other pure play paints and coatings trade (Sherwin-Williams, Valspar, PPG and RPM International Inc.). Adding the stand-alone enterprise values gives Akzo Nobel a combined enterprise value of €26.3bln and subtracting debt of €2.6bln gives a per share price of ~€94.

The PPG valuation of €90 per share (cum dividend) falls within the range of values derived above. However, as discussed, the PPG deal comes with a significant political and antitrust risk and could take longer to consummate than the spin-off of the Speciality Chemicals division. Even the the PPG deal happens, it is highly likely that PPG will sell off the Speciality Chemicals division as there are no synergies to PPG's core paints business.

As they say in the trade, Akzo Nobel's shareholders would be better off if the board adopted a DIY (Do It Yourself) approach than getting PPG to DIFM (Do It For Me).

Key Energy Services – a punt worth making

Key Energy Services (KEG) is the largest US onshore rig-based well servicing contractor based on the number of rigs owned. Its business consists of helping US onshore oil and natural gas producers get their produce out of the ground. It supports producers throughout the lifecycle of a well – including assistances with drilling and completing new wells, maintaining and working-over producing wells and assisting with plugging and safely abandoning dead wells. However, most of its revenue (~80%) come from production driven services (e.g. maintaining and working-over existing wells). Its services are highly correlated to the WTI crude price because its customers decide their capex commitments based on crude price.

Like a number of its peers, KEG ran up too much debt in the lead up to the collapse in the oil price. FY15 and FY16 has been terrible to its finances which resulted in KEG having to enter chapter 11 bankruptcy in October 2016. It emerged from bankruptcy in mid-December 2016 and has since relisted in NYSE.

The rebound and stability in crude price in the past year has meant that the oil capex cycle is finally turning up. The market anticipates this of course - in the US, the S&P 500 oil equipment and services index, which holds some of the world’s largest service companies, has risen well over 20% in the last year. Valuations have hit near historic highs with the sector trading at an EV/EBITDA multiple of 10 to 11 times.

However, the smaller US players emerging out of bankruptcy don’t appear to have benefited from the uptick in market’s sentiment. And herein lies an opportunity. KEG looks particularly appealing.

KEG has emerged a leaner more focused business post-bankruptcy

-        KEG’s balance sheet has delivered significantly with debt falling from $1bln to $250m;

-        KEG has retrenched from almost all non-US operations (bar Russia where a sale is actively being sought) and is now solely US focused. Overseas operations were EBITDA negative and the real opportunity lies in the US onshore market so the retrenchment is EBITDA positive and augurs well for the future;

-        KEG has significantly cut its annualised G&A from $250m to $100m as part of its organisation wide restructuring exercise. For example - its reduced cost structure would have resulted in EBITDA margin of 17.8% on its FY14 revenues (resulting in an EBITDA of $255m from the actual $124m achieved under the old cost structure).  

Oil price rebound and stability offers multiple growth drivers for demand

-        KEG’s revenues are highly correlated with the number rigs active in the US onshore oil sector; the rig count in turn is highly correlated with WTI crude prices.

-        The median crude oil WTI futures forecast for FY17 of 32 banks comes to $55.63. Whilst it’s impossible to forecast oil prices too far down the line, most estimates support a WTI price of $60 from 2018 - 2021.

-        At $55 a barrel the total economic vertical oil wells in the US is forecast at 196,383 (which is a 35% increase in the US population of economic oil wells compared to economic wells at $40 a barrel price). KEG forecast’s an increase in working rig count of 105% at $55 oil compared to the rig count at Nov 16.

-        The rig count increase should have a direct positive impact on revenues for KEG as it is the largest rig based well servicing contractor in the US. The demand for KEG’s services should come from multiple sources – including increase in well activity for existing wells, demand for well maintenance which has been deferred over the last couple of years, and the aging population of horizontal oil wells which should support material incremental rig demand over the next few years.

KEG’s valuation looks appealing

Based on the most recent share price of $25.45, KEG has a market cap of $511.46m; adding debt and other long-term obligations of $301m and subtracting cash of $90.5m, I get an EV for KEG of $722m. My forecast for EBITDA over the next 12 months comes to ~$166m, giving KEG a forecast forward EV/EBITDA multiple of just over 4. This looks cheap compared to the median EV/EBITDA multiple of ~10 to 11 times for the sector as a whole.

The big issue in analysing KEG (as with most commodity companies) is forecasting revenues. As already discussed, KEG’s revenues are highly correlated with rig demand and oil prices (see table below).

I have pulled the above table using information in KEG’s last 5 year financials. The table is revealing and shows how KEG’s revenues have fallen with the fall in rig count due to falling oil prices. The falling rig count and demand has also impacted KEG’s pricing power with revenue per active rig falling to ~$1.3m for FY16 compared to revenue per active rig of ~$1.7m in FY13 and ~$2m in FY14.

The positive for KEG is its lean cost structure post-bankruptcy; therefore any uptick in revenues augurs well for EBITDA.

To forecast next 12 months revenue, I have assumed revenue per active rig of $1.67m and an active rig count of 511 rigs which is the sum of KEG’s active and warm stacked rigs as at December 2016 (warm stacked rigs are rigs which can come to service with limited repair). My revenue forecast per active rig is roughly the average revenue per active rig achieved over the past 4 years; I believe this is a conservative forecast based - KEG has been actively reengaging with customers on pricing as demand recovers and revenue per active rig should recover from FY16 and FY15 levels.

Based on my forecast revenue per rig KEG could hit total revenues of ~$931.3m over the next 12 months, with an EBITDA of ~$166m (at an EBITDA margin of 17.8% supported by KEG’s revised cost structure). Applying a conservative EV/EBITDA multiple of 5x to my forecast EBITDA gives an EV of ~$829m for a 21% return on current share price.

Indicative returns for a number of revenue per active rig count and EV/EBITDA scenarios is shown in the table below. 

There is high uncertainty no doubt – the oil price could be any number. But most forecasts support an improvement from the lows of last two years which should support increased rig service demand from US onshore producers. Add to this KEG’s significantly delivered balance sheet and low cost structure post-bankruptcy, and things start to look appealing from a risk:reward perspective. While the wider oil services sector has been swept up in the euphoria of forecast demand, KEG continues to be unloved and trades at deep discounts to the sector. It offers a decent bet on a recovery in US domestic oil market.

A Short History of Financial Euphoria - lessons for a value investor

Those who learn the lessons of history are saved the doom of repeating its mistakes; for history repeats itself. And as John Kenneth Galbraith lays out in entertaining detail in his magnificent book, financial history is no different. The one constant which can be taken for granted in the free-enterprise economy is that speculative insanity and its associated financial devastation will reliably recur. From the Dutch Tulipomania and John Law’s infamous Banque Royale scheme of the 15^th century, to the Great Crash of 1929 and the dot com bubble of late the 19^th century, to the more recent devastation heaped by the subprime mortgage crisis and the resulting credit crunch, and the numerous episodes of financial insanity in between, financial history has repeated itself time and again in reliable fashion. But the value of John Kenneth Galbraith’s book comes not from its fascinating description of all the major episodes of insanity, from the Tulipomania to the October 1980 stock market crash, and the entertaining stories from each episode. The value of his work comes from his analysis of the features common to these episodes and the things that signal their certain return. Knowing this has great practical value for an investor – firstly, in terms of being able to preserve ones wealth, and secondly, in terms of being able to profit from the insanity of the markets. I must note here that this is by no means easy and almost everyone is prone to disillusion and insanity.

The common features of financial euphoria (and the ones which ensure their recurrence in the future)

1.      Some artefact or development, new and desirable, captures the financial mind. For examples: Tulips in Holland (Tulipomania of the 1630s), Gold in Louisiana (John Law and Banque Royale in 1700s), the untold riches of Americas which The South Sea Company was all set to exploit in the 1700s, the stock market which was always set to raise in the late 1920s, the enormous economic lift to be provided by the Regan administration in the 1980s, the great dotcom companies which signalled the arrival of the new digital economy of the late 1990s, and the amazing power of securitisation to make risk disappear in the mid-2000s. By the way, Trumponomics could be the new and desirable development in today’s market.

2.       The price of the object of speculation goes up; this increase in price and prospect attracts new buyers and ensures a further increase in price; more are attracted and the increase continues. This process is only clearly evident after the fact – i.e., after the doom.

3.       The basic attributes of the participants in such episodes of financial insanity take two forms:

a.       Those who wholeheartedly believe in the new artefact or development and its price-enhancing characteristics; and,

b.       Those who believe that they have the ability to perceive the speculative mood of the times and profit from it by riding the momentum and somehow magically get out just before the crash.

4.       Both the price and the participants are sustained by their vested interests. They are experiencing an increase in wealth and no one wishes to believe that this is undeserved; they all wish to think that it is the result of their own superior insight or intuition. To directly quote John K Galbraith – “Speculation buys up, in a very practical way, the intelligence of those involved.” This is particularly true of the first group of participants discussed above.

5.       The other common feature is the condemnation heaped on doubters and dissenters. There is a general tendency in such times to ignore the sceptics and suspend disbelief.

6.       The financial world also suffers from brevity of memory, a feature which ensures that it cannot learn the lessons of history. Again, I must quote John K Galbraith on this – “Let it be emphasized once more, and specially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius.”

7.      The public and the market believes that intelligence and wisdom are closely associated with possession of wealth and/or control of money. In consequence, possession or control of wealth creates a lack of self-scrutiny and the general belief in one’s superiority. Again to quote John K Galbraith’s rule – “Financial genius is before the fall.”

8.     Almost all episodes of financial insanity have involved debt in some fashion; debt that became dangerously out of scale in relation to the underlying means of payment. Again, there is a tendency by participants to view each episode as being unique, a new normal, where debt take a form which is considered perfectly reasonable if not innovative and genius. As John K Galbraith notes – “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets”. And in episodes of financial insanity, the scale of this debt goes awry.

9.      Built into each episode of financial euphoria is its eventual fall. It doesn’t matter what triggers this fall – however much the cause of the fall gets debated – what matters is that it always comes and comes with a bang. At some point in the cycle, the participants who had been riding the upward wave decide to sell; and those who had up until then believed that the increase was forever get their confidence shaken and also decide to sell. When everyone decides to sell, a collapse ensues. As John K Galbraith notes – “The rule, supported by experience of centuries: the speculative episode always ends not with a whimper but with a bang.”

10.   After every collapse, anger and recrimination ensues. This always focuses on individuals who were previously admired for their financial ingenuity. Some end up in jail and others in financial obscurity. New regulations are brought in to tackle the financial excesses of the times. But what is always forgotten is the speculation itself or the insane optimism behind it. To quote John K Galbraith – “Those who are involved never wish to attribute stupidity to themselves”.

To avoid being caught up in an episode of financial insanity is no easy task. The crowd’s force is a strong pull and it is by no means easy to sit on the side watching the masses get rich. At the height of financial euphoria it is easy to buy into the euphoric belief, especially when it seems to be supported by superior financial opinion at all fronts. The only remedy, as John K Galbraith states, is an enhanced skepticism that would resolutely associate too evident optimism with probable foolishness and that would not associate intelligence with the acquisition, the deployment, or, for that matter, the administration of large sums of money.

Strong adherence to the philosophy of value investing comes to the rescue. A true value investor must never be caught up in episodes of financial euphoria. At its core, value investing requires a contrarian mindset and a long term investment horizon; the first quality inspires skepticism and the second quality inspires respect for the lessons of history. By always being disciplined; carefully measuring intrinsic value; constantly challenging and updating ones measure; and only buying at a discount to ones measure of intrinsic value, a value investor can not only preserve his wealth but also look to profit from episodes of financial euphoria.

UK's student loan book sale

Earlier this month (6 Feb 2017) the UK Government announced it will commence the process to sell a part of the pre-2012 English student loan book through securitisation. The plan is to sell the loan book which entered repayment between 2002 and 2006, with the reminder of pre-2012 loan book to be sold over the next 4 years. A bunch of investment banks are working towards bringing the initial tranche to market and the sale is expected to close in the second quarter of 2017.

There has been a lot of press over the last few days – mostly negative for the Government and its plans. But what caught my eye were the numbers.

The total pre-2012 English loan book stands at ~£45.4bln as at April 2016; and the Government expects to raise £12bln through the sale of this loan book over the next 4 year. This equates to a ~74% discount to the outstanding loan book. Given these numbers, this opportunity is worth a look. 

Valuing the student loan book is not easy. This is not your typical fixed income instrument where you have a defined cash flow and you apply a discount rate based on your cost of capital after taking account of credit and interest rate risk. These student loans are income contingent where repayment is triggered based on the income of the borrower. Broadly, each student pays 9% of the difference between his/her income over a set threshold. Currently, for the pre-2012 loans, this threshold is £17,495; therefore, a borrower earning £25,000 would pay £675.45 per annum. On top of the income contingent nature of these loans, default rates tend to be very high – current average default rate on the loans granted between 2002 and 2006 is ~50%. The high default rate reflects the fact that there is no credit or other checks needed to be eligible for these loans which means that almost any student enrolled in any university course is eligible. Before getting to my estimate of value for the 2002 – 2006 loans, here is a brief table showing the key terms for these loans:

Key terms of the English student loans granted between 2002 and 2006

Type of loan	Income Contingent -current annual repayment threshold - £17,495
Payment terms	9% of income above annual threshold
Annual Interest rate set on 1 Sep each year	Retail Price Index (RPI) in the previous March, or 1% above the base rate, whichever is lower. It is worth noting that as the graduates only pay 9% of the income above threshold, interest rates only change the duration of the loan and not the amounts repaid.
Cancellation	Any outstanding balance on the loans taken between 2002 and 2006 is cancelled when the borrower reaches the age of 65; the loans are also cancelled upon death or disability of the borrower
Collection process	For most borrowers, payments are collected by the HMRC through the UK tax system by employers taking amounts from their salary through the Pay as You Earn (PAYE) system. Borrowers who are self employed pay through the tax self-assessment process by filing returns with the HMRC. Borrowers living abroad pay direct to Student Loan Company

Valuation

There is some data available from the Student Loan Company (SLC) which I have used to estimate future cash flows and to value the loans which entered repayment between 2002 and 2006. It is by no means easy to do and requires some big assumptions. I see this exercise as a bit of homework before I can get my hands on the pitch book from the banks when they bring these loans to market. By doing some homework and knowing the difficulties / assumptions required in valuation, I should be better prepared to review the sales pitch from the Government and its advising banks when it becomes available.

Data available from the SLC

The SLC has some good data from which can get the following information for each repayment cohort:

a)       number of students paying their loans each year;

b)       number of students who were liable to repay each year (borrowers become liable to repay the April after graduating or otherwise leaving their course and are required to make payments if their income is above the threshold);

c)        implied default rate (number of students repaying divided by number of students liable to repay);

d)       total amount outstanding (liable to repay) at the end of each year;

e)       total amount paid each year;

f)        average amount paid by each paying student (total amount paid divided by number of students paying);

g)       income threshold for each year;

h)       interest rate for each year; and,

i)         implied average income per paying student (on the basis that each paying student pays 9% of his/her income above the income threshold, this can be calculated as – [(f) average amount paid per paying student divided by 9% plus (g) income threshold per year]

The below tables show the trend in above variables, from the first year when they entered repayment, for each of the repayment cohort currently earmarked for sale. 

Projecting future cash flows                 

Projecting cash flows for these student loans is more art than science. I have used the following variables to arrive at my projected future cash flows for each repayment cohort:

1.       I have assumed that the number of students repaying will fall by ~10% each year for the reminder of the payment period. The trend over the last 5 years for each repayment cohort indicates that the number of students repaying has fallen by ~10% each year.

2.       I have assumed that the implied annual income per paying student increases by 1% each year. Again, the trend over the last 5 years is consistent with this assumption.  

On the basis that the repayment cohorts above are fairly mature – these repayment cohorts include students who would have finished their education between 2001 and 2004 – I believe that the last 5 year trend in number of students repaying and implied annual income should be a reasonable estimate to use in projecting future cash flows. For example, if the average implied income over the past 10 years has been ~£28k and growing at ~1% over the past 5 years, it is unlikely to change materially in future given the amount of time it has been since the student graduated and any uncertainty should be to the upside.

3.       I have assumed that each repayment cohort will pay for 30 years from the year it entered repayment. I believe this is a conservative estimate – e.g. these loans pay till the borrower turns 65 and assuming an average age of 25 when the borrower becomes liable to pay, these loans should pay for 40 years from the year they entered repayment.

4.       The other key assumption required to forecast cash flow is the income threshold for each year. This variable has a significant impact on the cash flows as the payments are set at 9% of borrowers’ income above the income threshold. This is a difficult one to predict and I am sure will be a key focus for investors when they see more detail on the sale. This will be a political hot potato for the Government – for example, freezing the annual income threshold could maximise the proceeds from sale as there is less uncertainty for the investors but will likely invite severe rebuke for the Government; similarly, any uncertainty on this variable (e.g. if a future socialist Government is able to increase this threshold materially to the detriment of the private investors but playing well to its constituents) will mean reduced proceeds. Based on last six year trend, average increase has been ~2.5% and I have used this as the basis for my cash flow forecast.

5.       Interest rate is another key variable which is difficult to forecast. As discussed earlier, this is the lower of RPI or base rate plus 1% each year. Given the low base rate in the UK over the last several years, this rate has hovered around the 1.5% mark over the last several years and is at 1.25% at present. I have assumed a rate of 1.25% for my forecast cash flow. As discussed above, the interest rate does not impact the amount of cash a student has to repay but only impacts the duration of the repayment – e.g. the amount repaid each year is fixed at 9% of the income earned above the income threshold with the interest being added each year to the outstanding balance. On the basis that I am assuming cash flows coming in for the next 30 years only, interest rate should not impact my valuations and any uncertainty should be for the upside.

Using the above variables to project cash flow for each repayment cohort and discounting cash flow at a rate of 10% gives a present value of ~£1bln for 2002 – 2006 repayment cohort, implying a discount of 75% to estimated £4bln outstanding amount on these cohorts. 

The assumptions I have made in arriving at the above valuation are fairly conservative and provide a decent chance for an upside. If the Government does decide to sell these loans at a ~74% discount, it definitely merits a detailed look. The other point of interest will be how the securitisation is structured – e.g. will it be by repayment cohort where earlier years merit a higher discount than later years, or will it be by quality of borrowers.

From the UK Government’s perspective one could ask why sell at such a heavy discount?; clearly these loans should be worth more than 25p in a pound to the Government given its low cost of capital. Apparently, for the Government, immediate cash is worth more than cash coming in over a number of years in future; this is because it can then use this cash to fund near term needs (like making more student loans) instead of borrowing which impacts on its commitment to reduce public sector net debt in the near term. 

It appears that we have a situation where the seller is selling for reasons other than pure economic value which should present an opportunity for the buyer. 

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.