Merkur Bank (XETR: MBK)
Merkur Bank (MBK) is a small regional bank located in Munich, Germany. In 1986, MBK was acquired by a group of private investors led by Mr. Siegfried Lingel. At this time MBK had total assets of €14 million and 7 employees. Mr. Lingel refocused the bank’s business on financing residential real estate developers in Leipzig, Berlin and, to a lesser extent, Munich. In 1995, the bank extended its business to the financing of leasing companies and SMEs. In 1999, MBK went public on the Munich stock exchange. In 2002, Mr. Lingel’s son, Mr. Marcus Lingel, joined the company’s management team and, after a six-year transition phase, he finally became CEO. Mr. Lingel refocused MBK’s real estate business to Munich (beginning in 2002) and, in 2005, to Stuttgart. MBK operates five branch offices and since 2009 the company has also been offering online retail banking solutions to its clients. Currently, MBK has total assets of approximately €1 billion and 200 employees.
The following are the main arguments for investing in the company:
- MBK’s business model is easy to understand.
MBK could serve as a text book example of how banks used (?!) to operate. MBK collects deposits from its clients and uses these funds to provide loans to real estate developers, leasing companies and SMEs. The difference between the cost of taking in clients’ deposits and the interest rate MBK demands from its borrowers is MBK’s most important revenue stream. The second revenue stream are commissions earned by providing various consulting services to clients and borrowers.
MBK is not engaged in any sort of proprietary trading or investment banking. This allowed MBK to survive the financial crisis of ’08-’09 and the “Euro crisis” unscathed because it did not have to record any write-downs. In fact, MBK has been profitable during these times of financial turmoil. MBK also refrains from performing maturity transformation as far as possible.
MBK’s business model, i.e. focusing on the “traditional” banking business, makes the bank quite insensitive to the prevailing low interest rate environment. From 2009 to 2016 the bank’s interest rate spread fluctuated between 3.24% (2010) and 2.78% (2016) and the average (= median) interest rate spread being 2.92%. The main factor affecting MBK’s profitability are competitive pressures, i.e. when its competitors demand lower interest rates on new loans to gain market share. These pressures have intensified in the last three years, as the interest rate spread declined from 2.94% to 2.78% (2016).
- Focus on Munich’s housing market should provide potential for further growth.
MBK’s most important business segment is real estate financing and, here, the bank is particularly focused on Munich.
Munich is an attractive city for real estate developers because of a chronic scarcity in housing. This situation will probably not change as Munich’s population is likely to grow in the future, as it has done in the past. This is due to the high quality of living the city offers (it constantly ranks among the top ten cities in the world) and its economic strength (e.g. nearly a quarter of all companies listed in the DAX have their headquarters in Munich). With a high demand for new housing and new construction still lagging behind Munich should provide real estate developers and, on the other hand, MBK with ample opportunities for further growth.
- Growth in retail banking provides additional funds to expand MBK’s core business and strengthen commission revenues.
MBK began offering its retail banking solutions to private clients in 2009 and could grow its deposit base to €250 million. Management expects to be able to grow deposits to up to €400-500m within the next five years. MBK has already expanded its service personnel in anticipation of this growth, so there seems to be some room for margin improvement in the future.
It should be noted that MBK focuses on individuals who own and operate SMEs (German “Mittelstand”), demand consulting services and, most important, are willing to pay for the bank’s services. For example, MBK does not offer checking accounts for free to lure in new customers. In fact, MBK’s policy is that if you are not willing to pay adequately for the bank’s services you shouldn’t open an account in the first place and MBK is happy to refer you to a bank that can better serve you. This might seem harsh, but I think it is a good way to build long-term relationships with the “right” customers. Additionally, MBK does not offer any own products to avoid conflict of interests.
- MBK is run by an owner-operator.
Mr. Lingel owns 20% of the bank through one registered share with restricted transferability. Additionally, due to the bank’s rather unusual corporate structure, he’s a personally liable partner. So it’s no overstatement to say that he has “skin in the game”.
Mr. Lingel admits that this sometimes causes him sleepless nights but it also forces him to limit the bank’s business on things that he truly understands. Says Mr. Lingel, “That’s why we did not invest in the US real estate market before the crisis, and we generally do not invest in government bonds because we can’t judge the creditworthiness of whole countries”. Instead, he stays within his circle of competence, i.e. a very limited number of regional real estate markets as well as leasing companies and SMEs whose owners he often knows on a personal basis.
- MBK’s true earning power is disguised by the use of German GAAP.
MBK uses German GAAP instead of IFRS. German GAAP allows banks to set up reserves called “fund for miscellaneous banking risks” (this is probably a poor translation but I hope it becomes clearer in the following paragraphs). These reserves don’t have to be related to any specific loan portfolio risk but can be set up by management (theoretically) arbitrarily. This results in MBK’s “true” earning power being understated.
The effect of this accounting feature is best demonstrated by Ben Graham’s “comparative balance sheet approach” which he described as follows:
“You take the equity for the stock at the end of the period, you subtract the equity at the beginning of the period, and the difference is the gain. That gain should be adjusted for items that do not relate to earnings, and there should be added back the dividends paid. Then you get the earnings for the period as shown by the balance sheet”.
In the case of MBK the final stock equity (excluding Mr. Lingel’s share) for 2016 was €58,541,000 of which €4,680,000* had come from the sale of stock, so that the adjusted equity would be €53,861,000. The beginning equity in 2012 was €37,168,000. So the indicated earnings were €16,693,000 or €3.23 per share. Dividends added back of €1.04 give earnings per balance sheet of €4.27. But if you look at the reported figures, you see that EPS add up to only €2.90 for the five years, so it appears that the company lost €1.37 (or 32% of earnings per balance sheet) somewhere along the line.
The reason for this difference lies in the “fund for miscellaneous banking risks” which I added back to shareholders’ equity as reported on the balance sheet. In my opinion and unlike usual reserves for loan losses, the “fund for miscellaneous banking risks” does not constitute a real future liability. Therefore, the corresponding provisions should not be charged to current earnings but rather be seen as a result of management’s decision to allocate, i.e. retain, earnings. So, when considering MBK’s true earning power I prefer to add them back to operating income.
The balance sheet also gives an indication that both kinds of reserves should be treated differently. While reserves for loan losses are treated as a contra asset account for the loan portfolio (similar to e.g. accumulated depreciation for PP&E) and don’t show up on the balance sheet, the “fund for miscellaneous banking risks” appears right above the equity section of the balance sheet. In fact, regulators accept these reserves as “core capital”, i.e. the minimum amount of capital a bank must have on hand.
These adjustments, of course, have an effect on the valuation of MBK which brings me to my last point.
- Valuation and expected return
Making the necessary adjustments due the “fund for miscellaneous banking risks” and using the average interest margin that MBK earns on customer deposits results in pre-tax earnings of €1.23. Using a pre-tax multiplier of 9 (equal to a “normal” after-tax multiplier of 15, given MBK’s statutory tax rate of 40%) results in an intrinsic value of €11.07.
Given the fact that MBK’s earns a positive interest margin on customer deposits, MBK should be worth at least book value. Again, adjusting reported book value for the “fund for miscellaneous banking risks” result in a book value per share of €11.20.
At a rounded intrinsic value of €11.00 and with the current price at €7.43 this results in a margin of safety of 32%.
MBK’s dividend yield is 3.25%. MBK retains approximately 65% of net income and the average (mean and median) RoE for the last 9 years was 10%. If the future equals the past this should give investors an additional 6.50% return, through growth in intrinsic value. Assuming that the valuation gap closes during the next five years, investors could make an additional return of 6% p.a. All in all, if these assumptions materialized investors could expect a satisfactory return above 10% p.a.
In summary, I think MBK’s stock offers a good opportunity to partner with an owner-operator whose financial wealth is being tied to the bank’s future performance. This should provide outside investors with the comfort that Mr. Lingel will not take on any undue risks. MBK is a well-run bank that does business quite differently than most of its competitors; it focuses on a few attractive markets that it understands well and values long-term partnerships with its clients. At the current price, investors can expect a satisfactory return on their investment without paying for any potential growth in the coming years.
* In October 2016, MBK announced a secondary offering of 517,000 shares (10% of shares outstanding) to raise capital to finance the anticipated growth in its real estate financing business. I usually don’t like if a company needs to issue stock to fund its growth and it is no different for MBK. But I think the capital raise at least provides some clues about what Mr. Lingel thinks the company to be worth. The price of the new shares was set at €7.80 while the stock was trading for €6.10 at the time of the announcement. At the new price Mr. Lingel not only raised his share in the company by 10% but also guaranteed to acquire any shares that existing shareholders did not subscribe to. In the end, he acquired about 70% of the newly issued shares. I think Mr. Lingel would not invest nearly €3.5 million of his own money if he thought the stock was not worth at least €7.80. In fact, I believe Mr. Lingel, being a Swabian which are known for their thriftiness, was sure that he still struck a good deal while raising the maximum amount of capital for the company. Therefore, one could use €7.80 as the lower limit for what MBK should be worth.