Bank of Cyprus (BOCH LN) – Sunny skies ahead?

Bank of Cyprus is the clear market leader in an otherwise deeply fragmented Cypriot banking market. Within Cyprus it accounts for 42% of lending; 35% of deposits; and its insurance businesses have 25% and 13% shares in life and general insurance respectively. In recent years it has shed many of its overseas exposures as it concentrates on lending to a country which has some of the most attractive long-term fundamentals within the European Union. Eurostat population projections show that Cyprus’ population is expected to grow by 26% between 2020 and 2100, which compares to an expected decline of 7% across the total EU in the same period. Cyprus’ projected population growth is the 4th highest across the bloc, behind only Malta, Ireland and Sweden. This growth has obvious implications for future credit formation (demand for mortgages etc.).

As with every other bank on the planet, COVID-19 has been weighing on activity, but the recent signs are more encouraging. BOCH reported new lending of €487m in Q121, +30% q/q. As of 21 August, 57% of the population of Cyprus had been fully vaccinated against COVID-19 (a further 7% were partially vaccinated), slightly ahead of the EU average. The Group also returned to (modest) profitability in Q121 of €8m at the net income line, helped by a step-down in impairments.

At the end of Q121 the Group had net assets (excluding minorities) of €2.1bn. Its market cap of €500m puts it on a P/B of <0.25x, making it (optically) one of the cheapest banks in Europe on this measure – the sector is trading on c. 0.73x – although returns goes a long way towards explaining this muted multiple (not helped by heavy credit losses in recent years). Happily, the Group has a clear and coherent strategy to uplift returns which, in my view, could lead to at least a doubling in the share price over time, assuming successful execution.

BOCH’s medium-term targets are: (i) ROTE of c.7%; (ii) Total OpEx of sub-€350m; (iii) NPE ratio of c.5%; and (iv) Cost of Risk of c.70-80bps; supported by a CET1 ratio of at least 13%.

BOCH had net loans of €10bn at end-March, of which €0.8bn were legacy loans. Over time the latter should run off (or be refinanced elsewhere) and replaced with new lending. So taking €10bn of net loans as the starting point, the mid-point of BOCH’s cost of risk guidance implies an annual impairment charge of €75m. Add to this total OpEx of (say) €350m and this (simplistically) gets you to €425m of costs. BOCH defines ROTE as net income divided by (shareholders’ equity less intangible assets). BOCH had tangible equity of €1.7bn at end-March, so a c.7% ROTE implies net income of €116m. Adding back OpEx and impairments means that BOCH will need total income of (at least) €541m to meet this ROTE target. Annualised Q121 income was €544m, so BOCH’s target return looks reasonable. Yes, I know that this is very crude analysis, but there are other levers to propel ROTE higher on the capital side that BOCH should be able to pull in time.

Drilling down into the accounts, BOCH has been under some margin pressure in recent quarters. Its NIM tumbled from 195bps in Q120 to 163bps in Q121 as tailwinds from falling funding costs were offset by drags from a declining stock of legacy high risk high yield NPEs; the low interest rate environment (on both core lending and liquid assets) and TLTRO effects. Non-interest income has been more stable (at €60m in Q121 it was flat on year-earlier levels) and this line contributes 28% of BOCH’s total income. BOCH sees scope to grow its insurance businesses in particular.

On the cost side, while the Group’s targets are to reduce the cost/income ratio to 50% in the medium term, in the short term this ratio is expected to rise (Q121: 64%, pro-forma for disposals) due to investment in digital and income headwinds. In common with a lot of other banks across Europe, the Group is seeing increased digital adoption and product delivery, which will deliver tangible cost (and also revenue) benefits.

In terms of the balance sheet, BOCH had assets of €23bn at end-March 2021, of which €9bn were core loans and a further €1bn in legacy net loans. Central Bank balances of €7bn partly reflects the TLTRO drawdown from the ECB. The Group had a 14.6% pro-forma CET1 ratio at end-March, well above its minimum requirement of 9.7%. The Group has signposted a 44bps regulatory headwind for Q221 but there should be tailwinds in the future from the normalisation of an abnormally high RWA density (the Group had €11.5bn of RWA as at end-Q121, equivalent to nearly half the size of its total assets). New lending carries a much lower associated RWA than the back book.

In April 2021 the Group refinanced its Tier 2 instrument, raising €300m at a 6.625% coupon and retiring the legacy €250m instrument (9.25% coupon). The tighter coupon and breadth of investor interest (nearly 4x oversubscribed with more than 140 investors) were very welcome.

I mentioned earlier the elevated credit charges in previous years. Asset quality has been a huge area of focus at BOCH and management should be lauded for the steps they have taken. The gross NPE ratio was an eye-watering 47% in December 2018, but this has steadily reduced (helped by disposals) to a pro-forma 16% as of March 2021. This is still massive in a European context – EBA data show that the weighted average for European banks is just 2.2% – but the direction of travel is positive and BOCH has 59% coverage on its stock of NPEs. BOCH intends to pare the NPE ratio to a single digit percentage by 2022 en route to the c.5% medium term target.

Staying with resolving legacy issues, BOCH has €1.4bn of property-related assets in its Real Estate Management Unit (REMU) where disposals in Q1 were (on average) 13% ahead of net book value (management has hinted that it expects the pace of disposals to quicken from here).

At the simplest level, the Gordon Growth valuation model, a common metric for valuing banks, says that the P/B multiple that one should pay for a business is derived from this formula: (ROE-g)/(COE-g), where ROE = Return on Equity, COE = Cost of Equity and g = a nominal growth rate. If you plug in the BOCH ROTE target of 7% for ROE, assume an 11.4% COE (this equates to the yield on BOCH’s perpetual AT1 securities) and assume a nominal 2% growth rate this suggests that BOCH should re-rate to 0.53 P/B over time, more than double the multiple it trades on today (all else being equal).

Of course, this won’t happen overnight. Execution will be key, particularly in terms of de-risking the balance sheet (which will surely have associated COE benefits) and this will take time. The Group is under a regulatory prohibition for equity dividends, although one suspects that will be lifted if NPEs get down to a single digit percentage. So, anticipating a maiden BOCH dividend in (or perhaps in respect of) 2023 is not unreasonable. Sustained profitability and RWA reduction will also lead to a widening of BOCH’s capital surplus to a point where management may also consider buybacks – which would be very accretive if the Group is still trading at (say) 25-50% of book value once the regulatory prohibition is lifted.

On a (say) two year view, the blue sky case for BOCH is that the Cyprus economy (overweight sectors that were badly mauled by the pandemic such as tourism) roars back, driving stronger new lending and underpinning a step change in asset quality, while in the background BOCH’s digital and efficiency drives pare OpEx further, facilitating elevated returns, including from distributions. That should, in theory, lead to the sort of illustrative re-rating discussed above.

As a footnote, we have seen consolidation take place in a number of European markets in recent quarters and this is a welcome development. The Central Bank of Cyprus’ Register of Credit Institutions lists a remarkable 30 firms in a country with a population of less than 1m people. There has been some modest M&A activity in recent years, but there is clearly scope for more. Greece’s Eurobank, which has a subsidiary in Cyprus, recently took a 9.9% stake in Cyprus’ second largest bank, Hellenic, with an agreement in place to increase this to 12.6%. Eurobank recently merged its Serbian unit with another bank in that market, explaining this move as being “consistent with Eurobank’s strategy to further strengthen its position in the countries where the Group retains presence and further grow with bolt-on acquisitions and friendly mergers”. BOCH may also elect to act as consolidator in time, although it may be more interested in deals that will bring its insurance market shares up to levels that are commensurate with the rest of the Group’s businesses.

Disclaimer: I have shares in BOCH – my interest in this, alongside details on the rest of my holdings, is provided on the ‘Portfolio’ tab.