Long term potential with execution risk on new strategy

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1 Template Friday,8th December 2016 Bank of Ireland Group - Outperform (BIRG ID) Long term potential with execution risk on new strategy Wednesday, 4 th July 2018 Closing Price: 6.68 Key Metrics FY18E FY19E FY20E P/E 10.52x 8.92x 7.86x Revenue ( mln) 2,874 2,986 3,123 Op. Profit ( mln) ,008 EPS Dividend Yield 2.4% 3.9% 5.1% Share Price Return 1 Mth 3 Mth YTD BIRG ID -8.49% -4.16% -5.85% ISEQ -2.61% 7.12% -0.97% Source: Bloomberg, CFI Research Top 5 Shareholders Ownership Ireland Strategic Investment Fund 13.94% The Capital Group Cos Inc 7.88% Blackrock Inc 7.50% Baillie Gifford & Co 4..20% Franklin Resources Inc 3.29% Source: Bloomberg AIB Group 1 year share price Source: Bloomberg Bank of Ireland Group plc attracts deposits and offers retail and commercial banking services. Pierce Byrne, CFA Investment Analyst +353 (1) pbyrne@cantor.com Bank of Ireland Group Bank of Ireland Group is an Irish pillar bank with operations in Ireland, Northern Ireland, the United Kingdom and select international locations. Bank of Ireland primary activities include retail, commercial and corporate banking services as well as Life Insurance activities. Summary Investment Case The investment proposition poised by management at the recent Capital Markets Day (CMD) set the scenario as a business moving from a restructuring to a growth phase. We see managements outlook as overly optimistic, but there is a clear strategy to modernise the bank s business operation through its transformation program which we expect to generate shareholder value over the long term. The question for investors is when will the market begin to price in future efficiencies? In the immediate aftermath of the CMD and in conjunction with a wider European Financials sell off, BOI traded down 10% hitting a low marginally below The market has well founded concerns whether management can achieve 20% loan growth by 2021 while also guiding minimal loan growth in If management do not deliver clear and consistent progress over coming quarters the market will punish the stock by maintaining a discount to the wider sector. However, we are confident that management can deliver the efficiencies outlined on the cost base through both restructuring and the IT spend, achieve robust loan growth (though not quite as strong as guided) and leverage the New Ireland brand to deliver value for shareholders. We believe Bank of Ireland will be substantially better business in 2021, the question that remains for investors relates to timing. Our valuation methodology looks to capture some of the future value that the new strategy should deliver. However, the timing of the investment will be important as the market will look to front run future value once some clarity emerges. We do not think that there is much in the way of clarity or evidence that management can deliver 20% loan growth by FY21 and as a result are using a 20% weighting to our FY21 price target, which results is an overall Cantor price target of 7.73 (15.7% upside). Sector Tailwinds & Headwinds Increases in the ECB s base lending rate would support lending margins across the sector Economic growth should increase demand for credit across Europe and Ireland Resolution of any of the sector headwinds would be supportive Sovereign and political risks pose the largest headwind to the sector. Specifically an Irish election generating populist headlines driving international investors from Irish banks Non Performing Exposures (NPE) continuous to pose a systemic risk to the sector Capital and regulatory requirements dragging on returns Upcoming catalysts More hawkish tones from the ECB will increase the market s rate expectations and support earnings across the sector Sector tailwind from European political tensions easing Half year earnings delivering positive sentiment on the sector Stock Specific Risks Political risk: Particularly exposed to a hard Brexit, which poses significant risks to the balance sheet Failure to deliver on key milestones throughout IT project, including time and budget overruns Significant failures to deliver targets will damage managements creditability 1

2 Investment spend increases to 275mln per year for the next four years Management addressing profitability by revenue growth as well as underlying efficiency UK remains a core part of the banks strategy despite Brexit concerns New strategy to deliver improved business Capital Markets Day Overview Management announced an additional 500mln spend on its technology program and broadened its mandate to encompass culture, systems and business models. 250mln of the additional spend is to be spent as part of the IT transformation while the remaining 250mln is to be used to deliver the business model and accelerate the reduction in the cost base. The primary benefits of the IT overhaul are expected to deliver on the cost agenda by reducing processing time for applications and removing manual intervention. Management have also stressed the opportunity for cross selling products from better understanding their customers. The IT transformation has reached its first major milestone with delivery of a single view point for a customer s entire interaction with the bank. Profitability and the Cost Base Management have reiterated its medium-term target of a 50% cost income ration (CIR). This is to be achieved by increasing profitability in addition to taking 200mln out of the cost base by Profitability is to be improved by growing the loan book by 20%, which when you consider FY18 guidance of moderate loan growth, it indicates average loan growth greater than 6% from FY19 through to FY21. Management expect growth to be weighted toward the Irish market with 65% originating from its home market. The bank s cost agenda is being implemented across the organisation, generating a portion of the savings while the new core banking platform delivers efficiencies. Net interest margin (NIM) guidance was maintained with expectation that competitive markets and the UK loan book will keep NIM in line with FY17 exit levels of 224bps, despite tailwinds of reduced tracker exposure. Wealth and investment services have been highlighted as an area where management believe the Irish market is underserved. It plans to leverage its current life brand, New Ireland Assurance, along with a better customer understanding from the core banking platform to cross sell products. Management are targeting 2bn in annual premium equivalent (APE) by 2021 up from 1.7bn in FY17 as well as assets under management of 215bn up from 160bn. Management intend to take 200mln out of the cost base by 2021 to help deliver its 50% CIR. Current cost base is c. 1.9bn (includes 110mln in investment spend) with management targeting 1.7bn by This is expected to be delivered by managing costs, simplifying the management structure and the benefits from implementation of the transformation program. The UK Business Management reiterated the importance of the UK business as a revenue diversifier but conceded that profitability of product lines need to be improved. Management are looking to grow products that are generating a return above a target hurdle rate, invest in underperforming products that can generate sustainable returns in the future and exit product lines that are not expected to meet the hurdle rate over the medium term. Management have set a target of doubling return on tangible equity (ROTE) from the low single digits to high single digits by Management plan on exiting the credit card market as they don t believe they have the scale to compete. It intends on pivoting the mortgage business toward the first time buyer and later in life segments of the market, where it sees less competition, better growth opportunities and scale. The auto finance business in the UK has performed well and management see opportunity to offer a larger product suite moving into Personal Contract Plans and Personal Contract Hire. Our take on the new strategy Fundamentally, we believe the Bank of Ireland will be a far superior business by FY21. Management can take a sizable amount out of the cost base to improve efficiency, loan growth will add further profitability (not quite at the level management are guiding). It is best place to leverage its current customer base in the wealth sector and the new IT sector should give management better cost control and a better understanding of its Source: Company Publication 2

3 Model Assumptions We have approached the Bank of Ireland valuation by implementing the guidance as per managements CMD targets. We then weight our 12M price target based on FY19 figures with a discounted 12 month price target based on FY21 figures. The weighting can be used to represent our conviction in management achieving targets. Revenue growth on the back of ambitious lending targets Revenues Our model forecasts a drop in earnings FY18 on the back of lower Non-Interest Income due to lower trading income and exclusion of one off gains from FY17. Given managements focus on growing top line, we are forecasting strong growth in top line from FY19 through to FY21. Chart 1: Projected Group Revenues, Revenue Growth and Net Interest Margin NIM to trend marginally upwards as supportive forces outweigh negative ones Net Interest Margin (NIM) Forecast Management are guiding for NIM to be in line with FY17 exit NIM of 224 bps. Balancing the different factors driving NIM, we see guidance as conservative and have forecast a slight uptick year on year (yoy). We expect earning asset margins to grow on the back of higher new customer lending margins replacing lower margin loans being paid down. The available for sale (AFS) portfolio and cash will continue to be a drag on earnings but we expect the proportion of these assets relative to customer loans to fall which is supportive for reported NIM. We also expect the ECB to introduce tighter monetary policy by increasing rates in FY19 which again should be supportive of wider margins. Competition amongst lenders is expected to keep customer rates lower but we expect the positive factors listed to outweigh the negative impact brought by pressure on headline customer rates. We are also forecasting an increase in funding costs which will weigh on NIM. Given the ambitious loan growth targets we are expecting this to be funded by an increased proportion of wholesale funding relative to customer funds. This will increasing the interest expense yoy and increase the customer loan to deposit ratio to 109% by Net Interest Margin FY17 FY18E FY19E FY20E FY21E Net Interest Margin 2.24% 2.25% 2.26% 2.27% 2.30% Earning Asset Margin 2.62% 2.62% 2.77% 2.91% 2.99% Funding Costs 0.42% 0.41% 0.50% 0.64% 0.67% Loan Deposit Ratio (LDR) 100% 102% 104% 106% 109% As stated ECB policy is expect to tighten in FY19 and we expect rates to increase. However, we expect management to be slower to pass savings through to customer deposit accounts. As demand for deposit grows in an expanding credit market we expect pricing pressures to increase resulting in higher funding costs. 3

4 Management guiding very strong growth in customer loans Asset Growth Management have set ambitious goals to grow assets on the balance sheet through new lending. Our model incorporates 20% loan growth guided by management by FY21 (to be discussed later), while balances are projected to be flat for FY18. From a current trend of flat to marginally negative growth, total assets are expected to produce growth rate above 3% in FY19 rising to above 4% in FY21. Chart 2: Balance Sheet Mix & Growth We expect the AFS portfolio to marginally decrease over the forecasted period as returns on the portfolio weigh on NIM and maturing funds are not fully reinvested. Cash is projected to marginally tick up into FY21 with remaining assets staying largely flat. Life assets are expected to grow strongly as the New Ireland platform becomes the focus of growth for the Non Interest Income line. 250mln investment to reduce cost base by 200mln by FY21 Operating Expenses The cost base remains one of the biggest impediment to sustainable profitability and management have set a target to get the Cost/Income ratio (CIR) below 50% relying on taking out 200mln in costs while improving profitability. Management have yet to provide detailed information on how cost will be taken out of the business. Some of the savings will come through cutting direct costs, which the new management team have Chart 3: Cost Base 4

5 been driving across the organisation. The top team also want to cut some layers of management out of the organisational structure making the bank leaner and more efficient. Implementation of the Transformation Program is critical to achieving a target CIR of less than 50%. The new core banking system needs to deliver on both cost saving efficiencies and support revenue growth to deliver on the CIR target. New lending targets look to focus on the Irish market, however, UK may prove a more challenging environment New Lending Management have set a lofty target of growing the loan book by 20%, assuming a relatively static pay down of the back book of approx. 14bn and new lending levels deliver 20% growth by 20%. Demand for residential housing is expected to drive growth on the retail side, and given the banks position in Ireland it should benefit from continued demand for housing. The UK poses a much different picture, with housing prices cooling demand and Bank of Ireland s position on the periphery of the market providing a more challenging environment to grow its mortgage book. Management s strategy is seeking to target growth in consumer finance in the UK, with particular focus on auto finance. While this segment of the book only represents a small portion of the total customer loans, a significant increase and reliance on these higher risk business lines would be a cause for concern. Growth in the SME & Corporate sector may also be challenging due to Brexit uncertainty in the UK and slower (relative to mortgage) credit growth in the Irish corporate market. Chart 4: New Lending by Division. New Lending FY17 FY18E FY19E FY20E FY21E IRL Retail Mortgage 2,000 2,200 2,332 2,519 2,770 IRL Consumer Lending Retail & Consumer UK 4,905 4,945 5,243 5,540 5,919 SME & Corporate 6,728 6,950 7,228 7,414 7,560 Total 14,033 14,495 15,215 15,899 16,692 Pay down rates on the back book to support loan growth in the medium term Back Book Pay Down Rates Pay down rates on the back book have hampered management s ability to grow the loan book over the past number of years. While we expect these levels to stay broadly in line, two of the major drivers of this should start to abate in the medium term. Firstly, overall levels of credit in the Irish market appear to have bottomed as personal and non financial corporate lending have started to show positive growth trends. Secondly, assuming lending rates have bottomed, refinance and churn within the existing book should reduce. 5

6 NPE under control and getting down to 3% by 2021 Resolution of Non Performing Exposures (NPE) BOI has outperformed its Irish peers on NPE exposures post crisis having not written as many bad loans in the final throes of the Celtic Tiger. With a FY17 NPE rate of 8.3%, we expect continued improvement on this front with NPE levels falling toward 3% by FY21. We are expecting the NPE rate to continue to decline as it has over the past number of years. Management have shown consistent results in restructuring non performing loans and implementing resolutions and we expect this to continue. While BOI has not used portfolio sales as a mechanism to realise value to the extent that its competitors have it remains on option to clear the more challenging cases. Retaining exposure to restructured loans allows the bank to participate in the improving credit environment, however, the flip side of retaining these exposures is the risk associated with relapsing. If credit conditions deteriorate, these loans become particularly vulnerable to losses if the resolution were not suitable. Wholesale market will be need to fund loan growth Capital levels to remain flat as management use capital to grow the business Loan Book Funding Expectations We expect customer deposits to remain the core source of funding for the bank into the future. Given ECB policy and the current rate environment, we are forecasting the current bias towards non interest bearing accounts to remain through to FY19. Post FY19 we expect competition for funds to drive deposit pricing and increase the cost of funding. Considering BOI loan deposit ratio is already at close to 100% we are forecasting an increase in wholesale funding to fund the expansion of the loan book through to FY21. Capital Levels Management have stated a target of maintaining a capital level above 13% on a fully loaded basis. Profitability will generate organic capital but the CET1 ratio is expected to be relatively flat at 13.5%. Increased profitability is expected to be offset by investment in transformation program and increasing risk weighted assets (RWAs) on the back of new lending. Management have committed to distributing capital above 13% to shareholders through share buybacks. However, we do not expect any special distribution pre completion of the IT investment spend in FY21. Chart 5: Risk Weighted Assets & CET 1 Ratio NPE FY17 FY18E FY19E FY20E FY21E Gross Customer Loans 78,487 80,670 84,362 88,249 92,951 NPE 6,521 4,402 3,903 3,516 3,173 % of book 8.3% 5.5% 4.6% 4.0% 3.4% 6

7 Increased issuance required to fund growth Wholesale Funding And MREL BOI currently have approx. 8.4bn in wholesale funding and our estimates expect a Minimum Requirement for Own Funds (MREL) of approx. 4.2bn. We have assumed that issuance will be used to grow the balance sheet, given that the Balance Sheet s loan deposit ratio (LDR) is already at 100% and we don't expect customer funds to grow in line with customer loans. As a result we expect issuance to increase bringing wholesale funding up to 14bn by FY21. This represents a change in the liability mix on the balance sheet with wholesale funding currently representing 7.5% of total liabilities, our forecast see this figure grow to 11% by FY21. FY17 FY18E FY19E FY20E FY21E Wholesale Funding 8,390 8,712 10,512 12,312 14,112 Maturing -1,678-1,200-1,200-1,200 Issuance 2,000 3,000 3,000 3,000 MREL Target % 26.4% 26.4% 26.4% 26.4% MREL Target mln 4,271 4,119 4,200 4,319 Profitability built on the expectations relating to loan growth Earnings and Return Expectation We are forecasting improving profitability beyond FY19 through to FY21. Improved profitability is driven by earning asset growth. In keeping with our NIM forecast, return on assets (ROA) improves year on year despite management not guiding any expansion in margin. We expect ROA to reach 70bps by FY21 on back of efficiencies in the cost base. Our model sees return on tangible equity (ROTE) getting close to 10% in FY20 and pushing past 11% if loan growth and cost base targets are achieved. Chart 6: Forecast EPS & Return Metrics Dividend yield to improve over time but management retain prudent guidance Dividend Yield Management have committed to working towards a prudent and progressive dividend policy. We are forecasting the pay out ratio building towards 50% by FY21, resulting in an FY21 dividend of 52c. At current prices this represents a yield of almost 8%, however, assuming a rerating in the BOI share price the yield is closer to 4.7%. BOI management have repeatedly stated prudence regarding the dividend, as such we do not expect management to increase the payout ratio as profitability improves. We expect excess capital (above 13% FL CET1) that builds up through retained earnings will be used to buyback shares once the investment spend reduces. FY17 FY18E FY19E FY20E FY21E Div/Share Div Yield 1.73% 2.38% 3.93% 5.09% 7.74% Dividend Payout 20% 25% 35% 40% 50% 7

8 We look at weighting a discounted FY21 valuation against our FY19 valuation Valuation Our approach to valuation takes an average across three valuation methodologies. We use two relative value models and a dividend discount model. Our valuation also must take into consideration future value generated by managements investment and restructuring plan. Relative Value Models Our relative value models include a price/earnings (P/E) and a price/book (P/B) valuation. We have a peer group of comparable retail focused banks, how ever Bank of Ireland has consistently traded at a discount to both this group and the wider EURO STOXX 600 Banks Index. As such we have made some adjustments to reflect this observed discount to the market. Divided Discount Model We use an internal dividend forecast to FY21, and apply a Gordon Growth Model using the below assumptions to estimate terminal value at the end of the forecast period. These cash flows are discounted to present value using BOIs cost of equity. Cost of equity is calculated using a CAPM model. Future Value Capture We also generate a valuation using FY21 forecasts. FY21 estimates incorporates managements guidance on loan growth and cost base efficiencies. We then apply a one year multiple that the current peer group trades at under the assumption that if management deliver on its guidance we would no longer expect the stock to trade at a discount to the peer group. We then discount that figure back to a present value, which represents the future value of the business. Final Valuation Our final price target is a weighted average between the FY19 derived price and the FY21 derived price. The FY21 weighing is used to represent our conviction on management achieving the stated targets. Given our current opinion on the difficult management will have in achieving the loan growth aspect of the strategy we have weighed the FY21 price target at 20%. Current Price 6.66 Probability Adjustment 0.75 Irish Ten Year 1.1% Market Risk Premium (ISEQ) 8.4% BOI BETA 1.1 Discounting 9.2% Growth 3.0% BOI Valuation (P/E) 7.80 BOI Valuation (P/B) 7.88 BOI DDM 7.07 Val (FY19) 7.58 Val (FY21) 8.31 Weighting to FY BOI Price Target

9 Appendix - Accounts BOI Group Forecast Forecast Forecast Forecast Income Statement Net interest income 2,235 2,229 2,307 2,392 2,552 Life Margin Other income Total operating income 3,040 2,874 2,986 3,123 3,339 Total operating expenses -1,904-1,842-1,802-1,763-1,741 Operating profit (before bank levies, provisions) 1,136 1,032 1,184 1,360 1,598 Bank levies and regulatory fees Impairment Group operating profit 1, ,008 1,214 Other Income (JV) Profit before exceptionals 1, ,048 1,255 Restructuring & Other Profit before tax ,175 Profit after tax NIM % 2.24% 2.25% 2.26% 2.27% 2.30% CIR % 63% 64% 60% 56% 52% Dividend Div / Share Dividend Payout % 20% 25% 35% 40% 50% BOI Group Forecast Forecast Forecast Forecast Balance Sheet Gross loans to customers 78,487 80,670 84,362 88,249 92,951 Provisions 2,359 2,120 2,056 1,803 1,582 Net loans to customers 76,128 78,550 82,306 86,446 91,369 Interbank 3,061 2,969 2,821 2,651 2,492 Financial investment AFS 13,223 12,562 12,059 11,456 11,113 Cash 7,379 4,812 4,674 5,052 6,186 Life Assets 14,421 15,539 16,744 18,042 19,441 Non Earning Assets 7,234 6,970 6,573 6,098 5,639 Other assets 1,108 1,129 1,145 1,158 1,171 Total assets 122, , , , ,411 Customer accounts 75,869 77,379 79,101 81,640 84,151 Deposits from CBs & Banks 4,339 4,556 4,419 4,243 4,073 Debt securities in issue 10,497 10,846 12,700 14,555 16,402 Other liabilities 5,538 2,849 2,599 2,335 3,733 Insurance Liabilitites 16,644 17,016 17,398 17,792 18,198 Total liabilities 112, , , , ,557 Equity 9,503 9,885 10,279 10,697 11,125 Total liabilities & equity 122, , , , ,682 Outstanding Shares 1,078 1,083 1,089 1,094 1,100 BVPS LDR % 100% 102% 104% 106% 109% Source - CF Research & Bloomberg Source - CF Research 9

10 BOI Group Forecast Forecast Forecast Forecast Metrics NIM (Net Interest Margin) % 2.24% 2.25% 2.26% 2.27% 2.30% CIR (Cost Income Ratio) % 63% 64% 60% 56% 52% CIR (Cost Income Ratio) % (ex. IT spend) 59% 60% 57% 53% 49% No of Ordinary Shares in Issue (mln) 1,078 1,083 1,089 1,094 1,100 EPS (Earnings per share) cents (adj) DPS (Dividend per share) cents Dividend Payout % 20% 25% 35% 40% 50% LDR (Loan to deposit ratio) % 100% 102% 104% 106% 109% RWA (Risk Weighted Assets-FL) bn 44,960 46,845 47,771 49,218 51,512 RWA intensity % 37% 38% 38% 38% 37% CET 1 (Fully Loaded) bn 6,253 6,057 6,166 6,462 6,812 CET 1 (Fully Loaded) % 13.5% 13.2% 13.5% 13.8% 13.6% Leverage ratio % 5% 5% 5% 5% 5% RoE (Reported) % 6.69% 5.90% 6.73% 7.37% 8.67% ROTE 7.29% 7.53% 8.58% 9.40% 11.04% Return on assets % 0.52% 0.48% 0.55% 0.60% 0.70% Non-performing exposures bn 6,521 4,402 3,903 3,516 3,173 P/E P/B Source - CF Research 10

11 Wednesday, July 4 th, 2018 Regulatory Information Issuer Descriptions: (Source: Bloomberg) Bank of Ireland: Bank of Ireland provides a range of banking, life insurance and other financial services to customers in Ireland and United Kingdom Historical Record of recommendation Bank of Ireland: We have reinstated an outperform rating on Bank of Ireland as of 13/07/2016 None of the above recommendations have been disclosed to the relevant issuer prior to dissemination of this Research. Date of distribution The first date of distribution is the same date as this report unless otherwise specified. All regulatory disclosures pertaining to valuation methodologies and historical records of the above recommendations can be found on the Cantor Fitzgerald Ireland website here: This material is approved for distribution in Ireland by Cantor Fitzgerald Ireland Ltd. 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