Banca IFIS — Update 2 November 2015

The key messages are:

We estimate divisional total loans will rise to €2.8bn by the end of 2015 and €3.6bn by end 2016 (unchanged as noted above). The €0.2bn, 7% increase in Q415 may prove conservative and is a slower rate of growth than seen in Q414 (€0.3bn, up 15% on Q314) and in Q314 (€0.2bn up 9%).

We expect strong growth in the pharma business. On 17 June, IFIS announced the development of a new niche operation to provide finance to the more than 15,000 pharmacies across Italy. It has hired a team of nine specialists, including two credit analysts, who have had relationships with about one-third of this market, and is aiming to initially gain about 500 new pharmacy clients a year. The group will provide not only short-term factoring, but also-medium-term financing.

We expect further steady volume growth in the core business. Management indicates that there has been some competitive pricing pressure on medium and larger corporate customers, but this has not been seen in the smaller and micro enterprise market. IFIS had already been expanding in this area as a way to protect profitability as the Italian government speeded up its payments to suppliers.

The lead credit indicators all continue to be positive but management indicates repeating Q315 levels will be challenging – an annual loss rate of 1% of loans (against 0.79% in Q315) would be regarded as a good result.

The key messages from the DRL division are:

In June 2015, IFIS announced the acquisition of three portfolios and on 4 August announced two further deals. We believe that IFIS's acquisitions will create further economies of scale, collection rates are rising faster than market prices, improving economic returns, and IFIS has the infrastructure to make further acquisitions. The additional c 100k positions took the IFIS portfolio to 883k accounts at the end of September 2015. We understand the existing infrastructure allows the bank to contact more than one million customers per year, meaning that the recently announced deals are well within current operational parameters. We understand further capacity is likely to be added. The tone of management commentary was that there are currently significant numbers of acquisition opportunities across a range of sources and further deals are thus likely.

The tax receivables division has shown good growth on 2014 through 9M15. Specific periods may be affected by the timing of receivable repayments (Q314 unusually high), but the trend is positive.

Historically, bond profits have been a key driver to Banca IFIS results. This is no longer the case (now less than 10% of net result from financial operations) and we expect less focus on this issue in future.

We understand the portfolio is currently being funded at -12bp (after -15bp in Q215 and showing IFIS is making a profit on its funding), which is unsustainable in the long term. Through the money markets, banks are willing to lend to IFIS at a loss because it is a lower loss than they would incur by depositing their funds directly with the ECB. Our estimates assume that funding will be at zero for the forecast period and that the Q2/Q315 benefit will not recur. We also assume no market movements and no impairments in this division.

Our forecast net interest income has been reduced from previous estimates. While the redemption yield on acquisition in April was 1.3%, market movements have seen interest rates fall since that date. While this has not affected coupon receipts, it does affect the interest income earned from unwinding discounts to maturity. There is a capital gain reported in equity changes under the AFS securities valuation reserve (Q215-on-Q315 gain €14.5m).

The G&S division in Q314 also included a €4m (50%) write-down on the investment in Popolare di Vincenza. The stake was taken around five years ago. Q215 and Q115 saw write-downs of the Indian factoring business. We assume no further write-downs in future periods.

Historically, IFIS had raised surplus deposits through its internet offering. In 2014 this portfolio was repriced (from best in class) and the average funding is now around 1.25%. IFIS also pays the stamp duty (0.2%) and has indicated that further pricing improvements could only be achieved by risking significant volumes. We have been surprised by the portfolio's relative resilience during this repricing. We understand that the vast majority of term deposits have now been repriced and management is looking to ensure deposits will grow again and broadly match the loan book. We understand new term products have been launched to stimulate demand. In Q315 we saw a modest growth in deposits (up €17m), in line with the management’s stated strategy.

We use approaches that are based on long-term assumptions and our current forecast period (two years). For a company such as IFIS this is somewhat unfair as we expect meaningful increases in profit beyond this current forecast period. In 2017 we expect lower headwinds from falling bond profits, which means that core business profit (which grew 33% in 2013 and 39% in 2014) is more likely to drop down to the group bottom line. Additionally, a number of its initiatives such as expanding the pharma business will only see full-period benefits in 2017, and the acquisitions in the distressed loan divisions are also likely to have a much greater impact in that year. We have in any case been conservative in our assumptions, with core business profit growth well below recent experience. The average of our valuation approaches is now €20.3 (previously €19.9) driven by modest forecast upgrades.

As we have noted in our previous reports, IFIS does not have any immediate peers in terms of business model. The recently floated Banca Sistema (BST.IM) is the closest comparator, but it only came to market in early July 2015. Investors wishing to consider smaller Italian banks may look at Banca Finnat (BFE.IM), Banca Popolare dell’Etruria e del Lazio (PEL.IM), Banco di Desio e della Brianza (BDB.IM) and Credito Valtellinese (CVAL.IM). In terms of trade finance plays, there is also Tungsten in the UK (TUNG.LN). Looking at comparisons with these banks, we need to bear in mind their very different operations, capital and funding structures.

As a specialist house in a niche area of financing, and with a material element of service income that does not attract the same regulatory capital requirement as lending, we believe IFIS should generate returns above its cost of capital. For the purposes of our valuation, we have assumed a sustained ROE of 15% against a cost of capital of 12% (including a premium for Italian risk, which may be expected to reduce over time). We have assumed long-term growth of 4%, around nominal GDP, generating an expected price-to-book of 1.4x. We have increased our near-term premium from 10% to 30% to better capture the core business growth continuing into 2017 and remaining well ahead of our assumed growth of 4%. While our 2016e ROE is in line with our long-term forecast, higher earnings into 2017 may also be expected to see the ROE above our long-term assumption. This increases our valuation to €21.07 from €20.91 previously with the increase in equity from the revaluation reserve and small earnings upgrades.

We take explicit forecasts for 2015 and 2016. For 2017 we make two adjustments: firstly we make a step change in dividend payout to 73% (reflecting our long-term return on equity of 15%, but growth in equity of 4%). This is unchanged from our previous approach; secondly, we have introduced an incremental 2017 growth of 25% to reflect core business growth in that year carrying on at average historic/forecast rates. We have introduced this new premium to try and capture growth beyond our forecast period. Beyond that we continue to grow this dividend at the expected 4% rate for 10 years. These cash flows are discounted at cost of capital (12%). We also make an upfront payout to bring the initial core Tier 1 down to 10% (value €4.0 per share). This approach indicates a value of €19.5 (previously €18.9).

The net effect of our forecast changes on 2016 is a small upgrade to PBT and EPS forecasts. Revenue has been reduced primarily for the lower interest income on the bond portfolio with a gain in equity in Q315 reflecting the same driver. Our cost assumptions show a small reduction and the continued investment in the group sees the cost income ratio returning to levels seen before the distortion from the bond portfolio. This implies a further deterioration from the level expected in 2015 and we note that our forecasts are conservative with the company targeting a cost income ratio of less than 40%. We have reduced impairments in 2016e from €22.0m to €21m, reflecting continued positive trends in the core business and assumed recoveries in the distressed loans business. We have assumed no recurrence of the €8m AVS impairments expected in 2015. Our bottom-line 2016e ROE of 15% is in line with management guidance.