Analyst Note | Apr 22 2020
Narrow-moat Handelsbanken reported a good first quarter considering the coronavirus. Operating profit declined 16% to SEK 5,142 million, which is in line with the 15% decline we modeled for 2020, although we don’t want to read too much into one quarter, especially as COVID-19 primarily affected the latter part of this period. Adjusting for a profit-sharing provision write-back last year as well as currency effects, the decline was only 3%. We maintain our fair value estimate of SEK 107 per share and narrow-moat rating. We believe Handelsbanken is one of the better run banks in Europe with a prudent underwriting process as evidenced in its low loan-loss ratio during the global financial crisis. A performance we believe is more likely, than not, to repeat itself this time around. Shares offer an attractive entry point with about 30% upside.
Net interest income increased 4% year over year on good volume growth while net fee and commission income grew 7%. On a sequential basis, which during the COVID-19 pandemic may be a better gauge, both line items grew 2% and declined 2%, respectively. Corporate volumes saw an increase of 2% versus year-end 2019 as businesses rushed to secure funding while household lending grew about 1%, both supporting net interest income. Net gains and losses on financial transactions were affected by a deferred capital contribution to Handelsbanken Liv, its pension subsidiary, of SEK 152 million as well as credit and derivative valuation adjustments owed to increased market credit spreads. These effects can be directly correlated to COVID-19. Additionally, the bank booked SEK 538 million in loan-loss provisions, of which SEK 440 million are an overlay to account for the COVID-19 impact. Operating expenses declined 1% to SEK 5,506 million on a sequential basis.
Handelsbanken continues to deduct the SEK 5.5 per share from its capital ratios, suggesting it intends to pay out its 2019 dividend, which is a positive given the rout of dividend suspensions for banks under European Central Bank supervision. Additionally, the bank accrued 40% of first-quarter earnings for a 2020 dividend, which is lower than the approximate 60%-70% dividend payout ratio targeted pre-COVID-19, but a prudent measure given the current environment. Loan losses increased to SEK 538 million versus SEK 288 million the same period a year prior and SEK 130 million a quarter ago. Looking at loan-loss ratios puts the increase into perspective, however, as the group remains to post well-contained and low credit costs. The loan-loss ratios were 8 basis points in the first quarter, 5 basis points in the same period last year, and 1 basis point a quarter ago. Out of the SEK 538 million booked this quarter, SEK 440 million or about 7 basis points are related to SHB’s best estimates of the potential COVID-19 impact. We are positively surprised at this low loan-loss charge but remain cautious of what the next quarters will bring. Management indicated they feel the SEK 440 million charge covers full 2020 additional COVID-19-related loan losses with additions possible if the macroeconomic outlook changes materially. We currently have penciled in 19 basis points in loan losses for 2020, which appears high now, given what the company reported, but we prefer to remain cautious and don’t expect to make material changes to our assumptions right now as we don’t think the COVID-19 pandemic has fully played out.
Even so, our fair value estimate of SEK 107 offers about 30% upside to the current share price despite our materially more cautious outlook on loan losses. Capital levels, which are in the spotlight for European banks during the COVID-19 pandemic, are healthy. SHB’s common equity Tier 1 ratio at the end of the quarter stood at 17.6% versus capital requirements of 13.9%. Year over year, the common equity Tier 1 ratio increased by about 120 basis points although it declined about 90 basis points on a sequential basis. The largest moving parts were an increase in the common equity Tier 1 ratio capital owed to the quarter’s earnings after a 40% dividend accrual as well as capital draws from a change in net pensions and higher risk-weighted assets, primarily driven by corporate loan growth. The circa 370 basis points in excess capital are above what the company views as an adequate buffer to requirements of between 100 basis points and 300 basis points in normal times. Common equity Tier 1 ratio requirements have declined from 15.8% previously, as central banks in Europe have reduced countercyclical buffers, which the group would still have cleared at a comfortable margin. We anticipate Handelsbanken to remain profitable through this crisis even in our bear-case scenario, which will add to capital ratios. Nevertheless, the next quarters could see marginal declines in the common equity Tier 1 ratio as risk-weighted asset fluctuations can offset organic capital generation.
Business Strategy and Outlook | 09 Apr 2020
Much has been said about Handelsbanken's business model, some praising it as the gold standard for retail and commercial banking, while others see it as outdated in a time of ever-increasing digital offerings. Its predominant feature is a decentralised approach to banking which gives higher decision-making power to its branches and reduces the need for middle management. Additionally, it generates stronger customer relationships allowing for better loan underwriting which keeps credit costs low. We believe Handelsbanken is one of the best run banks in Europe and while we acknowledge it has been late to the digital game relative to peers and that its business model does not lend itself to a centralised efficiency splurge, we think concerns that Handelsbanken has seen its best days are exaggerated.
We do not subscribe to the idea that Handelsbanken’s business model and branch network poses a significant disadvantage to the bank. Rather, we are of the opinion that Handelsbanken follows a different path to its peers. We see synergies in Handelsbanken’s approach toward clients and its growing asset management and private banking offering. We expect branches to progressively move away from main streets onto the second floor rather than large-scale branch closings as the bank increases its focus on becoming an advisory service-focused bank. This should not only diversify Handelsbanken’s currently high dependence on interest spread based income but also leverage its existing strength of its customer relationships and solidify its competitive position in an increasingly competitive mortgage and corporate lending markets.
We are also supporters of Handelsbanken's prudent approach in its quest for growth. While Nordic peers have entered primarily Baltic states to participate in the economic upswing, Handelsbanken has entered competitive and saturated markets in the U.K. and the Netherlands. While this may sound odd at first, we believe it speaks to its strength that the bank can replicate its business model in competitive markets and generate organic growth rather than relying on macroeconomic and acquisition driven expansion.
Fair Value & Profit Drivers | 09 Apr 2020
We lower our fair value estimate to SEK 107 from SEK 112 per share after incorporating primarily higher loan losses, lower asset growth and a slightly lower net interest margin as a result of the corona virus pandemic. Our fair value estimate corresponds to 1.3 times book value and 14.9 times earnings based on 2020 estimates and 12.2 times on 2021 earnings. In the medium term, we anticipate an average return on equity of about 11%, which is above our cost of equity assumption of 9%.
Our fair value estimate is primarily driven by net interest margin, provision ratio and operating cost assumptions. We forecast its net interest margin to drop slightly in 2020 to 1.15% from 1.21% in 2019 after which it recovers to about 1.3% at the end of our explicit five-year forecast period. We assume a 13 basis points midcycle provision ratio, up from 5 basis points in 2018. In 2020, we spike our loan loss provision ratio to 19 basis points as a result of the corona virus pandemic and its potential second order effect on Handelsbanken. To put this into context, Handelsbanken booked a provision ratio of 23 basis points in 2009, its highest loan losses recorded in this century. The efficieny ratio declines from 49% in 2019 to about 45% in 2024.
Although we pencil in loan losses close to levels during the Great Financial Crisis, lower asset growth, and a slight margin compression in 2020, Handelsbanken remains profitable. Indeed, all included, we estimate an earnings decline in 2020 versus 2019 of only 16% with a sharp bounceback the year after. Given our current assumption that the corona virus pandemic poses a disruption and not destruction to the economy, this effect has a limited impact on our outlook for Handelsbanken. Additionally, given its high profitability (return on equity of about 9% in 2020) and its solid capitalization (common equity Tier 1 ratio of 18.5% as of 2019), we think a scenario of value destruction via a capital raise is highly unlikely. In our bear-case scenario, which is about where the market is pricing Handelsbanken as of this writing (around SEK 86 per share), the group remains profitable and capital generative.
Scenario Analysis | 09 Apr 2020
In addition to our base-case scenario, we create upside- and downside scenarios for Handelsbanken. Our fair value estimate in the upside and downside scenario are SEK 131 and SEK 86 per share, respectively.
In our upside scenario, the net interest margin climbs to 1.4% in the medium term while provisions for loan losses continue to be low at about 8 basis points. In this scenario, Handelsbanken also achieves further efficiency gains from digitizing its core processes, freeing up staff to engange in more client interactions and advisory meetings. As a result, the efficiency ratio declines to 41% in 2024 from 49% in 2019. Our fair value estimate in this scenario is SEK 131 per share and corresponds to 1.6 times 2020 book value.
In our downside scenario, the net interest margin declines marginally just below 1.2% while provisions for loan losses increase to 18 basis points. In this scenario, Handelsbanken's efficiency efforts do not bear fruit as the bank struggles to digitize its decentralised business model. The efficiency declines margianlly to 48% in the medium term. Our fair value estimate in this scenario is SEK 86 per share and corresponds to 1 times 2020 book value.
Economic Moat™
We assign Handelsbanken a narrow-moat rating based on cost advantages and customer switching costs. We believe Handelsbanken's narrow moat stems from its ability to underwrite loans more prudently as is evidenced in its high asset quality and low credit cost metrics the bank has been able to achieve over the last few decades through various cycles. This competitive advantage, which can seem intangible, elusive or even replicable, we believe is defensible by the vast branch network the bank has built in Sweden and the close customer relationships and high customer satisfaction Handelsbanken's branches create, as well as a strong culture focused on low operating and credit costs. Underlying our moat assessment for Handelsbanken is our view of the Swedish banking system, which we rate as good. Handelsbanken also operates in the U.K., the Netherlands, and the remaining Nordic countries, which we rate as fair.
Following our banking moat framework, we analysed potential cost advantages based on operating, credit and funding costs and are confident that Handelsbanken enjoys advantages in operating and credit costs. Nordic banks are dependent to a large extent on wholesale funding to make up for a lack of deposits, which is largely the result of higher adoption of equity products creating a smaller deposit market for Nordic banks. Handelsbanken is no different in this regard to its peers, which is why we believe no Nordic bank has a competitive advantage based on deposit funding.
Handelsbanken has a long track record of costs of risks lower than its peers and healthier asset quality ratios. The driving factor behind this is the ability to grant loans based on customer specific fundamentals rather than via a portfolio approach. Most banks operate on a portfolio approach accepting a certain amount of credit losses if margins compensate for it. Handelsbanken on the other hand focuses purely on default risk per customer following the believe that there is no homogeneous credit portfolio for which outcomes of adverse scenarios can be adequately forecast top-down. In Handelsbanken's model, about 70% of the loan applications are granted on the branch level, with only significantly larger or more complex loan structures requiring approval by the board. As the decision which loan is granted lies mostly with the account manager, the bank can leverage its close customer relationship and better distinguish between low and high-risk customers. As a result, Handelsbanken has experienced significantly lower credit losses than peers, even in sectors which have been in trouble in the past. Given that Swedish banks are price takers, the lower risk cost Handelsbanken can achieve leads to higher and more stable through-the-cycle returns.
The drawback of this more traditional banking model is that it typically comes at a higher cost in the form of branches and staff. This is where we believe Handelsbanken has built a moat around its ability to underwrite loans more prudently. Handelsbanken has shown over multiple decades now that it can run a highly efficient branch network, which is the bedrock of the bank's low-risk performance. This is achieved by creating shared synergies such as IT systems, a centralised treasury department without the need of middle management, and virtually no marketing spending. Further, branch locations are chosen so that customers in any given region are not served by more than one branch reducing the potential for cannibalisation between branches and an oversaturation of regions with staff and locations. Each branch is run with the goal of being profitable as a standalone unit, putting the emphasis on performance rather than just serving as a marketing front at every corner to draw in customers. The banks cost/income ratio is one of the lowest among Nordic peers and lies comfortably below 50%, which we believe is indicative of a well-run bank. In Sweden, where we believe Handelsbanken has the strongest competitive advantage, the bank operates a sub-40% efficiency ratio.
We think Handelsbanken's narrow moat is supported by implicit switching costs based on its high customer satisfaction scores, which create longer lasting relationships with a more loyal customer base. The bank does not only have stable and high market shares in both deposit and lending volumes in Sweden, which can be indicative of switching costs, but also ranks high in customer satisfaction surveys in Sweden and the U.K., and has been able to keep market shares relatively steady despite new entrants offering lower priced mortgages in Sweden.
Strong customer relationships are a form of implicit switching cost which can be costly in the form of staff and fixed costs for branches and therefore are often believed to be suboptimal in the age of digitalisation. Although digitalisation has its perks, such as lower costs through leveraging fixed IT costs on a large customer base, we don't think a fully digitised product offering is the be all and end all. Swedish banks are front-runners when it comes to offering online and mobile banking solutions to customers leaving little room for banks to carve out a competitive advantage on the digital side. Customers seem to be largely agnostic to the minor digital differences in banks' offerings. On the other hand, Swedish customers continue to rank regional banks with local branches highest in satisfaction metrics. As a result, we believe that banks able to connect their digital offerings with a regional branch network can enjoy implicit switching costs through closer client relationships to customers who value such services. Handelsbanken operates the largest branch network in Sweden and repeatedly scores highest of all large Swedish banks in customer satisfaction surveys. Its large branch footprint and customer centric business model allows Handelsbanken to achieve customer satisfaction ratings close to local community savings banks, although running an efficient large-scale banking group. Outside of Sweden, in the U.K., the Netherlands, and other Nordics, Handelsbanken ranks in the top three, if not in the first spot, for its services as well. We believe that better customer-orientated service which Handelsbanken can offer to its clients generates loyal customers which are then exposed to the bank's pallet of product offerings including mortgages, loans, mutual funds, debt and equity underwriting services, as well as brokerage and securities services.
Although not a moat source, we believe the low risk and high efficiency culture Handelsbanken has built over nearly half a century supports our view that the bank enjoys a narrow competitive advantage. While each aspect of the bank's culture seems replicable, we believe the interconnection between the bank's cultural traits as well as its long history of adhering to these principals creates a significant hurdle for competitors to replicate Handelsbanken's success. Handelsbanken incentivises long-term thinking of employees by deferring any bonuses in the form of retirement savings reinvested in the bank's own stock. This not only ensures that employees adopt a low risk approach to safeguard their retirement, but also shields the bank from shareholder pressure to pursue short term gains, as the pension fund is the largest shareholder in Handelsbanken (10.5%). Branches operate with great autonomy. The bank does not operate any volume targets but forces branch managers to adhere to a rigid risk policy, which allows branches to decide which sectors to lend to and which customers to decline, without following a trickle-down strategy set by the board. Employees are tasked to collect bad debt on each of their underwritten loans rather than being able to offload it to a separate department, further increasing the focus on each loan on a standalone basis rather than a portfolio perspective. Internally, branch managers with the lowest ratio of bad loans rather than the highest profitability attract the largest praise. Overall, decision outcomes are closer aligned with decision-makers, lowering internal moral hazard problems a centralised bank can face.
We believe the strongest evidence of how difficult it is to replicate a culture is Handelsbanken's own expansion strategy. Its business model forces the bank to open branches from scratch, hire the right talent and incentivise its staff to focus on prudent underwriting. In the U.K. it typically took about 1.5 years for a new branch to become profitable and we believe it took multiple more years to recoup its investment outlay and create adequate returns on capital. Although acquisitions would bring Handelsbanken the branch footprint as well, the bank knows that it is much harder to change a culture than it is to build it.
From an operating environment point of view, we rate the Swedish banking system as “good” under our banking system framework, thanks to its stable economic environment and good regulatory setup (which has been on an increasing trend in recent years). Finansinspektionen (the Swedish FSA) and the Riksbank (Sweden’s central bank) are primarily responsible for monitoring compliance and maintaining financial stability in the country. These supervisory bodies are strong believers in tougher capital and liquidity requirements for the system, and they monitor banks closely.
Moat Trend
We believe Handelsbanken's moat trend is stable. Contrary to many critics of Handelsbanken's business model, we believe that the company’s competitive advantage has held up well against threats of digital banking. We acknowledge that Handelsbanken is not the most efficient Swedish bank anymore, owed mostly to the digitalisation efforts of its peers, but we do not believe that this is an apples-to-apples comparison. Handelsbanken remains one of the most efficient Swedish banks despite operating a larger branch footprint which creates cost advantages in lower credit costs as well as a loyal customer base. We view it as less and less likely that competitors switch course and start expanding their branch network to replicate Handelsbanken's close customer relationships. Also, we do not think that the efficiency ratios of peers, which are based on a declining branch footprint and higher digitalisation, would be sustainable in a scenario in which peers try to replicate Handelsbanken's model by expanding branches. Overall, we think the close customer relationships Handelsbanken has can shield the bank from threats such as fully digital and mobile banks as well as new market entrants offering lower prices on mortgages.
Risk & Uncertainty
Handelsbanken has built a reputation of being a safe haven in times of trouble, being the only large Swedish bank that has never required government subsidies and guarantees or fresh equity from shareholders to cover for bad loans. More importantly, the bank has in the past managed to remain highly solvent and liquid in times of economic hardship because of its low risk profile, allowing the bank to grant loans and gain market shares when credit spreads widen. The flip side is that the bank accepts to forgo market shares in expanding credit cycles. Our uncertainty rating is medium.
Handelsbanken generates about three quarters of its income from its lending business, most if of it tied to mortgages and in particular the Swedish mortgage market. The Swedish real estate market frequently ranks in the top three of potential asset bubbles ripe for rebalancing. This is a significant risk to Handelsbanken's profitability outlook, and equally so for its Swedish peers, although current market fundamentals, regulation and demographic trends are likely to support elevated real estate prices short to medium term.
Outside of Sweden, Handelsbanken operates primarily in well regulated and mature markets such as the U.K., the Netherlands and the remaining Nordics reducing potential legal, regulatory and also economic risks.
Financial Strength
Handelsbanken’s loan/deposit ratio stood at 205% as of 2019. As a result, the group is highly dependent on wholesale funding, especially covered bonds, which are correlated to money markets and will impact the funding costs when a bond requires rolling. While Handelsbanken experienced no problems accessing funding even during the 2007 global financial crisis, in the event of a more severe financial crisis than those experienced in the 1990s or 2007, Handelsbanken may have difficulty funding its balance sheet.
That being said, Handelsbanken is in good financial health. The company is well capitalized with a common equity Tier 1 ratio of 18.5% as of fourth-quarter 2019 while its liquidity coverage ratio and net stable funding ratio stand 147% and 113%, respectively.
Stewardship | 03 Jan 2020
We award Handelsbanken an Exemplary stewardship rating. Following the Morningstar methodology, we primarily focus on capital allocation decisions and alignment of such decisions with shareholder interests. We believe Handelsbanken scores exceptionally well in this category.
Handelsbanken has refrained from large acquisitions in the past. The only notable exceptions are asset managers Heartwood (2013) in the U.K. and Optimix (2016) in the Netherlands, which we believe are strategically well-placed add-ons to an increasingly advisory service based business model. The bank has instead opted to build new branch networks from scratch in mature and saturated banking markets within good regulatory and stable economic environments such as in the U.K. and the Netherlands. This has kept credit costs and shareholder value destructive impairment charges low and allowed Handelsbanken to brush through the financial crisis of 08/09 unscathed. Additionally, the absence of large acquisition sprees allows for stable excess capital distributions to shareholders mostly in the form of dividends.
Handelsbanken aligns employee actions to long-term shareholder value creation through a profit-sharing scheme called Oktogonen in which a yearly contribution is made if the company achieves its target of outperforming its peers. The funds are reinvested in the bank's stock and paid out to employees at retirement. This not only de-incentivises short-term thinking on the part of employees, which can result in adverse scenarios in the long-term. Oktogonen also is one of the largest shareholders in Handelsbanken (~11%) shielding the bank to some extent from short-term focused investors.
