This article is authored by MOI Global instructor Patrick Brennan, Portfolio Manager of Brennan Asset Management, based in the San Francisco Bay Area.
Recent selling has battered the financial service sector and arguably there is a plethora of undervalued names. That said, we find two names to be particularly attractive on a relative and absolute basis. While Irish bank Permanent TSB (TSB) generates more than its fair share of ugly headlines, we think the risk/reward is heavily skewed in investors’ favor.
Ireland was one of the housing markets hardest hit by the global financial crisis, and TSB was one of several banks nationalized in the wake of a housing collapse. Ireland’s macroeconomic outlook has strengthened considerably since the financial crisis with its economy likely among the strongest in Europe. This economic strength, combined with increased migration levels and an acute housing shortage, has driven significantly higher housing prices and increased demand for additional mortgage financing.
The Irish government sold shares in TSB in 2015 at €4.50 per share but retains a nearly 75 percent interest. TSB is down nearly 60 percent from the IPO and trades below 40 percent of book value. The government ownership stake greatly limits the size of the tradeable float and this, combined with the higher headline non-performing loan (NPL) levels (26 percent), makes the name untouchable for many investors.
However, TSB has already announced two securitization transactions that will take NPL levels below 10 percent pro-forma for the deals. Further NPL reductions (we project NPL levels below 8 percent by the end of 2019) could actually allow asset write-ups from current marks, especially given the strong recovery in the Irish housing market, but we assume no benefit. TSB’s capital levels should continue to rise well above target levels throughout 2019. Dividends would be welcomed by TSB’s largest shareholder (the Irish government), so we believe the bank has an incentive and the ability to return meaningful capital by the end of 2019. This capital return story can deliver meaningful returns and help rerate the stock.
While a low interest rate environment and higher capital requirements could limit TSB’s standalone return on equity, the bank’s pro-forma capital position, combined with current valuation levels, likely limits downside from current levels. Conversely, asset write-ups and capital return should provide some more immediate upside for shareholders. Additionally, the Irish housing market remains red hot as there continues to be a shortage of housing supply relative to current demand. This situation could be exacerbated by a continued migration to Ireland as companies hedge the “Hard Brexit” risk.
Most importantly, TSB is a logical merger candidate. With the liquidation of Anglo Irish Bank, Ireland lacks a natural number three bank behind Allied Irish Bank (AIB) and Bank of Ireland (BOI), and there could be a couple of suiters for TSB. It is not difficult to believe that 20-30%+ of TSB’s costs could be eliminated in a merger and that a valuation closer to book value could provide over 100 percent upside. The government’s desire to monetize its stake could serve as a catalyst for a deal. But, absent a deal, even modest multiple improvement combined with capital returns can drive considerable upside from current levels.
Back stateside, Jefferies (JEF – formerly known as Leucadia) has been neglected by investors since the 2013 Leucadia/Jefferies merger, despite CEO Richard Handler’s long-term track record. Inconsistent results at Jefferies, initial struggles at National Beef and a complicated corporate structure have all curbed investor enthusiasm.
In early April of 2018, JEF simultaneously announced the following:
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