Saturday, 1 April 2017

Banco Latinoamericano de Comercio Exterior (NYSE:BLX): A bit of value?

Banco Latinoamericano de Comercio Exterior (BLX) is principally a trade finance bank based in Panama. The bank was created in the 1970s to finance trade and integration in Latin America and the Caribbean. 

I was looking into the Chilean banks for value and noticed BLX. This is stock I have come across before when I used to work as a Latin American equity analyst. It is a bit off the radar as it doesn't fall into the MSCI EM and doesn't really fit the US market either (where it is listed). However I have not really looked at it in great depth until now. The bank screens cheap at 12.5x trailing P/E, 1x book value and with a generous 5.5% dividend yield. So I want to see, does BLX offer  value?

The Macro; When assessing any Emerging Markets stock and especially a bank the primary thing is the macro. There is not a level playing field between say a Chilean and a Russian bank. Or between an Argentine Telco and a South African one. So where does BLX fit in? 

BLX is based in Panama and funds regional trade primarily for private companies. The principal loan exposures of the bank are Brazil, Mexico, Colombia, Panama and Peru in that order. Therefore the size of the loan book tends to reflect the levels of business activity in those nations. Given that all of these nations are strongly export and generally commodity oriented economies (except Panama which is a tax haven/financial center) we should expect that global growth and demand for primary products tends to drive regional GDP and trade. 

BLX Q4 2016 Results Presentation

This adequately explains why the bank's loan book contracted 10% in 2016 against 2015 after several years of significant growth:

Amiable Minotaur BLX Model: Loan growth & NIM - historical and estimates

[Note that huge turnaround in 2010 and 2011 driven by QE and the great reflation of commodity prices which causes a massive upturn in Latam economies.]

Now today the macro has improved a bit since 2016. Regional economies have stabilised but trade remains depressed principally due to low oil prices and lower commodity prices alongside a significant recession in Brazil (which seems to be abating). I decided to forecast a relatively benign scenario of 8% loan growth in 2017 falling to 5% thereafter - not too aggressive given the 10 year CAGR is 8.9%, low comparison base and the bank guidance of +10% for 2017.

BLX is solely a trade finance bank. The majority of loans represent other financial institutions (39%) and then commodity and energy producers. The loans are principally short term (60%) and medium term. Only around 1-2% of loans are due in > 1 year.

The majority of deposits are from central banks at 77% followed by other private and state owned banks. Time deposits form 46% of the funding structure with short term (25%) and medium term (29%) issues making up most of the difference. Most of the funding sources are either regional central bank deposits or euro area medium term notes.

This means the bank generally lends short and borrows short to medium term. This means the bank has low liquidity risk - the opposite of say Northern Rock in 2007 which was lending long term mortgages and financing lending base via short term money markets. The bank also carries substantial liquid reserves with cash forming 15% of the interest earning balances on average.

Credit risk is limited due to the short term nature of the finance but it also tends to be 'lumpy' with the risk of a single large transaction or counterparty failing being greater than say a consumer credit provider. 

NPLs have risen over the current downturn with 3/4 of them being concentrated in Brazil. At 1.09% of loans this is low by banking standards but quite high relative to history. Cyclical improvements from 2016 into 2017 should see this ratio decline.

BLX Q4 2016 Results Presentation

Market risk is low as assets and liabilities reprice regularly due to the short term nature of lending. The bank is slightly net short rising interest rates due to the pace of repricing on the asset side being lower than the liability side but ultimately this is not material long term.

BLX is a profitable operation with low specific risk and relatively high cyclical risk given the market it operates in which is driven by commodity prices and the global cycle.

Efficiency ratio is excellent! at 26% for the year end. Operating costs are very low which is probably due to the fact that the company only has 200 employees! The main expenses are basically payroll ~ $25m a year ($125k per employee. Seems high but this is a specialized business) and rents, professional and admin expenses at around $15m. There is no real branch network or infrastructure to service. A highly scaleable business.

Fee income is small and volatile as it also includes some trading gains. Most of the fee income is generated by letters of credit and arrangement fees. This area is not particularly material to the bank vs the net interest income generated.

Competition is relatively high. BLX competes with other regional banks and large multinational banks in the trade finance arena. The main competitive advantage would seem to be local knowledge, local central bank support and specialisation. The bank has grown quite successfully for nearly 40 years and it has the advantage that when a cyclical downturn comes and multinationals focus elsewhere then BLX remains in the regional ready to take advantage of the up cycle. 

The shareholder structure has regional central banks owning the key A shares of the company. This is a kind of regional development bank: 

BLX 2015 20-F Report

There are four types of share but only the A,B and E are relevant and the E shares are the NYSE listed shares.

The A shares have the rights with 75% majority to dissolve the bank, amend the articles, merge the bank or change its activities as well as appoint 3 directors. The A and B shares have pre emptive rights in a capital increase. A&B shares form 22.6% of the capital of the bank. A and B shares can only be transferred to qualified holders. These shares are mostly held by regional central banks as can be seen above.

The E shares do not have those pre emptive rights so can be diluted but they do have the rights to elect 5 directors.The basic point is the shareholder structure prevents a takeover of the bank. The E shares form the majority of the capitalisation. This is typical of EM companies in general but in particular a quasi SOE like BLX - it is an understandable move though to prevent a hostile takeover of your specially set up regional development bank! I don't see a major problem with the governance structure as far as this goes within EM/SOE norms.

Two quirks of the company: 

(1) BLX pays no corporation tax by a special Panamanian decree. It would still have a very low tax rate without the decree as only income deriving from trade in Panama would be subject to tax. This means a P/E comparison against another bank is comparable but makes BLX potentially more profitable with better ROE than another taxable trade finance operation - a competitive advantage.

(2) BLX has no lender of last resort because Panama has no central bank of its own being a dollarized economy. This may explain the relatively high Tier 1 capital ratio of the bank at 17.9% given that trade finance is generally a low risk, short duration banking activity (leverage ratio 7x).

Note that the dollarisation and lack of a lender of last resort expose BLX to the US Dollar. With the Fed raising rates and potentially even reducing its balance sheet this means that the bank is likely to see a growth hit and it is generally negative for emerging markets. However given the US seems to already be slowing down it is possible that the Fed will hike more slowly than forecast recently. Rising rates would likely improve the NIM of the bank due to better spreads - but in the interim loan growth would slow and/or contract due to monetary tightening. Fed policy is probably the key macro driver for Latam and the global cycle.

I try to keep my analysis relatively bottom up with one eye on the macro to give some perspective as I feel my circle of competence is better on company fundamentals than macro prognostication.

So essentially BLX is a quasi SOE regional development bank engaged in low risk, short duration trade finance with a low cost and highly scalable platform. Therefore if you want exposure to regional growth with relatively limited risk BLX seems to offer a decent formula. 

Now does it offer a good valuation for the value investor?

On a 2017 forward PE basis at 13.5x (Price/10 year average earnings) the bank would have a fair value of $35.60 a share or 28% upside. I use the forward PE as 2016 was likely the bottom of the current cycle. Even applying 13.5x to last year's earnings suggests a value of $30 a share.

The bank pays an attractive dividend especially if you want dollar dividends (US companies typically pay low yields and buyback capital due to the tax advantages). The yield is presently 5.5% ($1.53) and represents a payout of ~65% of earnings. Given the surplus capital of the bank it could raise this in future but I suspect they won't as they have generally held a large surplus of capital historically and don't have a lender of last resort.

A DDM seems appropriate given the company has consistently paid a dividend every year for 10 years with only one cut in 2010 following the financial crisis:

Amiable Minotaur BLX Model: EPS & DPS - historical and estimates

Now at a dividend growth rate of 5.1% (conservative given the 10 year CAGR of 6.5%) and a Ke of 9.6% (Rf 2.4%, MRP 6%, Beta 1.2) alongside a forecast dividend of $1.71 the DDM gives a valuation of $38 per share. A decent 35% upside from the price today at $28.

The bank screens slightly less well on the Residual Income model due I believe to the slightly high capitalisation which increases the capital charge and neuters the residual income. The RI value I get is $27.80 suggesting the bank currently trades at fair value. 

If I raise the payout ratio to 75% these values change to $43.60 for the DDM and $29.33 for the RI model. This would reduce tier 1 capital toward 15% over the medium term. I think the bank could even payout 100% of earnings raising the DDM to $58 a share! This would reduce tier 1 capital to 13% over the medium term and raise the ROE 300bps to 13%. However I believe this is highly unlikely because this bank is being run as much for regional development as for profit - therefore the survival and high capitalisation of the bank are more important than the total return to shareholders. Something to keep in mind with quasi SOE businesses where the state institutions retain the primary control.

On a P/B vs ROE analysis the bank seems fairly valued with a 10% ROAE likely in future and the average ROAE at this level. The low P/B is explained by the low ROE of the bank which is due to the low leverage ratio and low net interest margin generated by this low risk activity. This  is unlikely to change in future and I expect BLX to trade around book value. As stated lowering the capitalisation a bit by increasing dividends could slightly improve the ROE and therefore cause the bank to trade at a greater premium to book.

Amiable Minotaur BLX Model: PB & ROAE - historical and estimates

My opinion is that a fair value range would be between book value of $25 a share and my DDM value of $38. To err on the side of caution I would say around $30-32 which equates to 1.1-1.2x book value.

So does BLX represent good value? I think yes. There is a margin of safety here given the low risk banking model, high capitalisation, consistency of returns and strong dividend. The cyclical downturn seems to be passing but regional macro and especially Brazil may weigh on growth in the medium term. Longer term the positioning of the bank, its low cost model and low risk portfolio should see reasonable growth. As loan growth slows and the bank matures we could see the payout ratio raised a bit further improving the generous dividend.

I may look to add the share to my portfolio around $25-28 a share to give a decent upside to my target fair value estimates above. If nothing else it provides some regional diversity to my rather UK centrist composition at present.

Disclaimer: I have no interest in BLX shares at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

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