Stockwatch: a bank share to own for diversification
4th March 2022 11:07
by Edmond Jackson from interactive investor
UK banks are being affected by events in Ukraine, but this lender with exposure to a relatively strong economy nearby has grabbed the attention of our stock picker.
Why are bank shares plunging if a rising interest environment is meant to strengthen their business models?
It is because financial stocks are inherently sensitive to major market moves; insurers are down similarly since Russia unleashed war.
Also, it reflects uncertainty about how stagflation beckons if wide-reaching sanctions also compromise Western businesses and demand.
- Banking profits boom: the most improved UK banks of 2021
- Bank sector results preview: the profits league table
All this confuses prospects for interest rate rises, which would help banks’ operating models. Loan and mortgage demand could also reduce if a climate of uncertainty sets in.
Yet investors and traders could get lucky - buying leading financials when the market plunges like today. Unless the leading banks’ numbers deteriorate, their valuations are already fair to modest.
Bank of Ireland declares largest profit since 2008 crisis
While most UK investors tend to follow Barclays (LSE:BARC) or Lloyds Banking Group (LSE:LLOY), the contrarian inside me was intrigued by 2021 annual results from Bank of Ireland (LSE:BIRG) earlier this week.
Underlying operating profit (pre-impairment charges) jumped 53% versus 2020 and 25% up on 2019. “We grew income, reduced costs for the eighth consecutive reporting period… as a result of this profitability and strong capital position we are recommencing distributions…”
The news on fundamentals comes in a chart context where the stock declined consistently from €8 in early 2018 to €1.4 in April 2020, then was in an uptrend, reaching €6.8 by early February. The five-year pattern is pretty similar to Barclays and Lloyds, however.
Basic valuation parameters are also broadly in-line with the big UK banks. At €5.55, Bank of Ireland trades on a 12-month forward price/earnings (PE) sub-8x (recent consensus forecasts) and its prospective dividend yield is just over 4%.
Market price also represents a 47% discount to the balance sheet value of €10.5 per share, although management advances its own sense of €9.50 “underlying” value per share – for a 42% discount currently.
All this is broadly in line with Lloyds, however, which at 44p trades on a 7x forward PE and 5.6% prospective yield, and likewise a 41% discount to stated net asset value (NAV). At 163p, Barclays offers an even steeper discount of 61% - on a 6.4x forward PE and 5% yield.
Net interest income shows sensitivity to interest rates
It is up only 5% in context of a 12% rise in operating income to €2.9 billion and a 53% jump in operating profit to €1.2 billion; hence, if rates do rise then net interest income - at 75% of group operating income - can re-rate profit substantially more, given the relative size of its contribution.
The CFO says a 1% rise in interest rates would increase annual net interest income by €274 million.
Obviously, if loans were to contract in a slowdown, then so would the loan interest element.
The bank has benefited from higher loan asset spreads, as a result of lower cost of funds – also longer-term refinancing measures – which makes the prospect of higher rates tricky to quantify.
- When markets fall heavily, here's what to avoid doing
- Check out our award-winning stocks and shares ISA
- Read more articles by Edmond Jackson here
“Other income” benefited from higher business income and valuation gains in wealth and insurance, although the latter have been inflated by loose monetary policy – now tightening.
Operating expenses are down 4% to €74 million due to efficiency improvements, although €0.2 billion net impairment gains, after €1.1 billion of impairment losses on loans etc in 2020, was the chief reason for a €0.4 billion underlying pre-tax loss becoming a €1.4 billion profit.
Reduced losses in non-core items then explain a €0.7 billion net loss becoming a €1.1 billion profit.
It is thus a frustrating aspect of interpreting UK and US banks alike, about how a reversal of Covid-related provisions is swamping headline numbers. Meanwhile, the extent of interest rate rises is now tricky to figure – but the CFO’s guidance is attractive.
Bank of Ireland Group - financial summary
Year ended 31 Dec
2016 | 2017 | 2018 | 2019 | 2020 | 2021 | |
Total revenue - € million | 4,975 | 4,867 | 4,028 | 5,854 | 4,578 | 6,314 |
Operating margin - % | 20.8 | 17.5 | 20.7 | 11.0 | -16.6 | 19.3 |
Operating profit - €m | 1,035 | 852 | 835 | 645 | -760 | 1,221 |
Net profit - €m | 799 | 664 | 620 | 386 | -742 | 1,048 |
Reported EPS - € | 0.67 | 0.59 | 0.58 | 0.36 | -0.72 | 0.91 |
Normalised EPS - € | 0.71 | 0.63 | 0.64 | 0.41 | -0.45 | 1.04 |
Cash flow/share - € | 1.22 | 2.10 | 1.83 | 3.07 | 3.87 | 18.4 |
Capex/share - € | 0.26 | 0.26 | 0.26 | 0.28 | 0.26 | 0.30 |
Free cash flow/share - € | 0.96 | 1.84 | 1.57 | 2.79 | 3.61 | 18.1 |
Dividend/share - € | 0.0 | 0.12 | 0.16 | 0.0 | 0.0 | 0.1 |
Earnings cover - x | 0.0 | 5.1 | 3.6 | 0.0 | 0.0 | 18.2 |
Return on capital - % | 0.8 | 0.7 | 0.7 | 0.5 | -0.6 | 0.8 |
Cash - €m | 8,541 | 10,440 | 8,658 | 11,653 | 13,406 | 34,110 |
Net debt - €m | 3,599 | 64.0 | 2,354 | -589 | -5,107 | -23,194 |
Net assets/share - € | 8.7 | 8.2 | 8.6 | 9.0 | 8.9 | 10.5 |
Source: histroric company REFS and company accounts
Strong balance sheet and capital ratios
Loans are yet to rise; they actually eased over 2021 from €77 billion to €76 billion. My suspicion about how monetary stimulus has benefited asset values more than economic activity, looks to have supported a 61% rise in liquid assets to €50 billion and a 15% rise in wealth/insurance assets to €23 billion.
Total assets thus rose 16% to €155 billion versus €144 billion liabilities, with an 82% loan to deposit ratio.
The common equity tier one ratio – a measure of the bank’s equity capital versus its total assets, hence financial strength – improved from 15% to 17%. This was around 70% due to organic capital generation, and in principle benefits the stock’s rating.
Glowing narrative, as you might expect
Bank of Ireland asserts its ambition as a “national champion bank”, also with UK and selective international diversification. By this it means championing consumers and driving economic growth with a strong market share.
Cost-cutting has however meant 88 branches closed last year besides 1,585 redundancies and a 15% reduction in office space which continues.
Lengthy parts of the annual report are devoted to improvements, but, for example, I find “over 171,000 customers targeted through behavioural campaigns to improve financial wellbeing” rather wishy-washy. Cutting to the chase: how much can interest rates rise and how might loan demand pan out?
Examining the profile of loans and mortgages in note three to the accounts, “management of key group risks”, some 55% of total loans and advances are mortgage-related – 52% of which are in Ireland and the remainder UK – yet may be substantially Northern Ireland.
A majority element of Bank of Ireland’s prospects therefore relates to confidence in the housing market, which effectively means the authorities not raising interest rates too much.
It underlines the challenge for central banks to find a sweet spot after years of monetary stimulus since the 2008 crisis, that can tame inflation without seriously harming mortgage or general lending.
A means of exposure to Ireland’s ‘supercharged’ GDP growth
Just over a month ago, Davy Group, which is Ireland’s largest stockbroker and wealth manager, estimated a phenomenal 15.5% rate of Irish GDP growth in 2021 – driven by multinational sectors especially IT and communications, pharmaceuticals and medium-tech manufacturing companies.
Notionally, it affirms my concern during the 2016 EU referendum about how a big risk of Brexit – despite the UK unshackling politically from Brussels – was compromising inward investment by global firms.
- 10 shares to give you a £10,000 annual income in 2022
- Covid crash anniversary: the stocks to own since February 2020
While that can seem a bit disconnected from plain vanilla mortgage demand, it does help explain Ireland achieving employment 6% above pre-pandemic levels, and consumer spending just 1% below pre-pandemic levels during last summer.
While that may now be compromised by higher energy costs and consumer inflation, Davy points to Ireland having the second-highest household savings rate in the OECD in 2020. I figure that should provide a cushion for Bank of Ireland’s various services.
Davy also expects residential property inflation to slow from 13.5% late last year to 4.5% this year, but Irish wage strength should support ongoing mortgage demand – amid a lack of housing supply. The average mortgage approval rose 8% on the year, in late 2021.
A ‘buy’ for Irish exposure and capitalising on higher rates
Financial shares are likely to remain pressured as the Ukraine crisis festers, but unless expectations tilt towards recession, then Bank of Ireland offers a means of diversification from UK-oriented banks. Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.
Disclosure
We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.
Please note that our article on this investment should not be considered to be a regular publication.
Details of all recommendations issued by ii during the previous 12-month period can be found here.
ii adheres to a strict code of conduct. Contributors may hold shares or have other interests in companies included in these portfolios, which could create a conflict of interests. Contributors intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. ii will at all times consider whether such interest impairs the objectivity of the recommendation.
In addition, individuals involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.