Banca Sistema — Strong lending growth and capital position

BST’s nine-month results showed net interest income marginally lower, while sharply higher net fee income meant that total income was up 3% compared with the same period in 2017. Customer loans (at amortised cost) increased by 44%, with similar increases for factoring and salary and CQ loans. The disparity with net interest income growth reflects mix changes, both within factoring and towards CQ loans (see further discussion of interest income below). Higher headcount, reflecting the increased scale of the business and investment to support growth, resulted in a 10.8% rise in administrative expenses, leading to pre-tax profits 6.9% lower than 9M17. An increase in the tax rate (34% versus 29%) left net profit 12.4% lower at €19.1m.

Full P&L figures are shown in Exhibit 1 and other points from the results were as follows:

The next exhibit shows the progression of factoring turnover and receivables outstanding over the longer term. This demonstrates the increase in scale of the business, particularly from Q117, together with the normal quarterly fluctuation in turnover driven by seasonal factors and the incidence of larger transactions. Turnover for 9M18 increased 29% y-o-y with tax receivables, as expected, growing in importance. Q4 tends to see larger transactions as customers with calendar year-ends adjust their exposures in the final quarter. The level of turnover in this quarter can therefore be a sensitivity for near-term results as seen in Q416, which was relatively subdued for BST.

Exhibit 3 gives an analysis of interest income, highlighting in particular the details of LPI given by BST. As a reminder, LPI, earned on public sector receivables in legal collection, was accounted for on a cash basis until June 2016. Thereafter, a proportion of LPI outstanding has been accrued; initially this was 65% for healthcare and 15% for other public sector receivables. The accrual rate for other public sector receivables was increased to 31% in Q317 as additional data were fed into the statistical model used to determine accruals. With the third-quarter results, a further annual adjustment has seen the healthcare and other public sector accrual rates rise to 68% and 48%, respectively. The larger increase in the ‘other’ category reflects a shorter existing track record of collections so the incremental data added have a bigger impact. The group average accrual rate has increased from 37% to 44% and is net of a time value adjustment for an increase in the expected collection time. The accrual rate still well below the 86–87% collection rates recorded, suggesting that both the extra collection level and accrual rates are likely to continue to rise over time. While extra collection was lower for the 9M18 period and last two quarters, this reflects seasonal factors and instances of delays in the court process and should be reversed over time; in the meantime, BST earns a return of 8% plus the ECB reference rate on the outstanding balance (€100m at the end of Q318, of which €45m has already been recognised in the P&L).

Reflecting growth in customer balances, interest from CQ and other loans increased by 28% with the annualised interest rate (calculated on period-end balances) stable at c 3.7%. The group interest income and interest plus fee income margin both fell by 150bp, primarily reflecting changes in the asset mix towards tax receivables (13% of factoring outstanding at end-Q317 and 27% at end-Q318), and lower transaction and accrual change elements within LPI. While the return on tax receivables is lower than the average for factoring, the fact that they have a zero regulatory capital risk weighting and a longer duration means that they represent an attractive area of business for BST. The interest margin was also affected by an increase in the proportion of average balances in the CQ business (CQ and other loans accounted for 32% of the total versus 29% in the prior year period).

Turning to asset quality, net bad and unlikely-to-pay loans, at 2.8% of customer loans, and provision coverage of 29% were both at similar levels to those seen in Q317 and H118. Bad loans in isolation increased from 1.6% to 1.8% of total loans between the second and third quarters (Exhibit 4), reflecting one private exposure and the purchase of a portfolio in Q318. Despite some quarterly variation, the overall position has remained broadly stable in the period shown.

Finally, capital ratios for BST remained comfortably above regulatory requirements. At the end of Q318, the CET1 ratio stood at 11.1% and TCR 14.2% compared with 11.0% and 14.1% at the end of H118. The minimum CET1 ratio set by the Bank of Italy is 7.125% and TCR 11.225%.

As at the half-year stage, BST indicates that there has been no change in the factoring market background with yields, on a like-for-like basis and including fees, showing a slight increase in recent quarters. As noted earlier, changes in business mix will also affect the trend in reported yield in this area with increased tax receivables and purchases of portfolios with a higher proportion of receivables going straight to legal collection, potentially lowering the yield.

During its conference call, BST highlighted that it has secured a two-year factoring contract with a large pharmaceutical company, which is due to begin next year. This is set to generate factoring turnover of €700m per annum. This will help the group generate the growth envisaged in its three-year plan. The turnover will comprise three roughly equal components: payments that are expected to be on time, those likely to see a slight delay in payment and a tranche that will go into legal collection and will accrue LPI and consume regulatory capital.

The uncertain political and economic background in Italy has had a negative impact on the valuation of the Italian bank sector and has pushed up the yield on Italian government bonds. While this has resulted in a small negative valuation impact on BST’s short-dated portfolio of government bonds and is unhelpful for BST’s share price, in terms of credit risk the bank’s main credit exposure is to the public sector and factoring volume and yields may be strengthened by increased appetite among international corporations to reduce their exposure to Italy.

On the CQ side of the business, the prospects for growth in this niche area remain good. The pace of growth will be augmented by the acquisition of Atlantide announced in September with an initial consideration of €2.4m. This is a registered financial intermediary operating in this area and will provide BST with more direct access to business flow, enhancing its yield on business sourced in this way from a current rate of c 3.5% to over 4%. Atlantide may contribute up to €60m in turnover, potentially contributing approximately half of the targeted purchases for CQ. The acquisition, expected to complete in Q219, would affect the CET1 by the equivalent of 15bp (based on the June 2018 balance sheet). The group continues to monitor progress of the proposal in the European Parliament to lower the risk weighting applied to CQ loans from 75% to 35%, where loans are secured by one-fifth of salary or pension payments. If agreed, the change could add about 150bp to the CET1 ratio, facilitating expansion of the CQ business.

As a reminder, the financial targets set out in BST’s three-year strategic plan announced in April this year are summarised in Exhibit 3 with further detail and discussion in our note published in May.

As before, our estimates are aligned with these targets. We have reduced our estimate for the current year (-3.7% at the EPS level) to allow for the results year-to-date, with a slightly lower figure in total for net interest income and fee income and a higher assumed tax rate, partly offset by lower assumed costs. Although there are small changes in the make-up of the estimates for FY19 and FY20, at the EPS level there are only marginal reductions.

Suggesting a cautious view on BST’s financial targets, we note that consensus estimates for FY19 and FY20 (company-collected) are noticeably below our own with net earnings of €29.4m and €34.7m, respectively, compared with our estimates of €35.9m and €41.8m. Sensitivities in achieving the bank’s financial plan include the phasing of turnover in both factoring and CQ, changes in competitor behaviour, the timing and level of changes in LPI accrual and the delivery or otherwise of changes in risk weighting for CQ assets. Further detail on our estimate is shown in the financial summary (Exhibit 9).

We have updated our valuation comparison table in Exhibit 7. In a period that has seen markets correcting in the face of heightened macro concerns, the peers shown here have seen a 30% decline in share price over 12 months, in line with the fall in BST’s share price. This has left BST trading at a P/E multiple of close to 5x, the lowest in the group; Encore and Arrow also trade below 6x.

Our chart showing ROEs versus price to book for the same group of companies (Exhibit 8) also suggests that Banca Sistema is conservatively valued and we would need to assume a ROE of below 15% to place the company more in line with peers. As noted earlier, consensus estimates for BST have been reduced that would potentially pull the prospective ROE in this direction although probably still above 15%. On modestly reduced estimates, our ROE/COE points to a valuation of c €3.30 (€3.40 previously) using assumptions including a 20% ROE, long-term growth of 4% and cost of equity of 12.6%.