Saturday, November 26, 2016

LLoyds Bank

A quick look at Lloyds, the largest bank in the UK.

The only two UK-listed banks serving the UK market are Lloyds and RBS.  Both went under in 2008 and had to accept government bailouts - pages 3 and 4 here give a brief history.  They are slowly mending, though still making large provisions to pay for past misdeeds.  Lloyds is the stronger of the two.

Market Share

The UK banking market is highly concentrated for savings, less so for mortgages:
  • For savings accounts: A UK government report states "The four largest banks (LBG, HSBCG, RBSG and Barclays) in Great Britain (GB) accounted for approximately 70% of active PCAs (Personal Checking Accounts) and 80% of active BCAs (Business Checking Accounts) in 2014".
  • For home loans: Moodys is cited saying that in 2014 the top 5 players had 2/3rds of the market: "Lloyds was the industry leader, controlling 24 per cent1 of the market share, followed by Santander UK with 13 per cent, Nationwide with 12 per cent, and Barclays and Royal Bank of Scotland (RBS) with 10 and eight per cent, respectively."

There are new entrants:
  • There has been new entry into retail banking in recent years. Metro Bank (PCA and SME) was the first organic entrant to the UK banking market in more than 100 years when it received its banking licence in March 2010.  Aldermore Bank (primarily SME but not BCA) entered in 2009. Several other new entrants have their roots in ancillary financial/retail services such as Tesco Bank (PCA 2014), the Post Office (PCA 2013/14), Virgin Money (PCA 2014), and Marks & Spencer Bank (M&S Bank) (PCA 2012). Handelsbanken (PCA and SME) has also significantly extended its UK operations more recently almost doubling its network between 2011 and 2015.
  • There are also a number of banks that have just been authorised or are in the process of being authorised including Atom Bank (authorised in June 2015, digital-only PCA and SME), Starling Bank (digital PCA), Civilised Bank (SME) and OakNorth (authorised in March 2015 SME but not BCA). In addition to traditional bank lending, alternative finance has been growing very rapidly in recent years. It has been estimated that the alternative finance sector had grown by around 160% in the year to 2014. Despite the rapid growth, alternative finance currently accounts for a very small share of SME lending (less than 2% of SME lending). 

Non-Interest Income

Trading and Insurance

Lloyds says that they do "not have a programme of proprietary trading activities".  So why is their "Net Trading Income" so high?

The "Net Trading Income" is tied to its insurance profits 2 , 3.  I can't untie the numbers in any meaningful way, so I add them all together:

This follows the stock market.  Looks like a typical insurance operation where they lose money on insurance and make it up by investing the float.  As expected, a large part of their "Trading and financial assets" held are equities (43%), followed by bonds (33%) and Loans/Advances to Customers (21%) 4.  So the above number is gonna drop when the stock market falls.

Fee and Commission Income

Fees do not seem to be affected by the economy.  Gross fees (i.e.: ignoring their direct costs) are broken down below.  "Other income" includes "Fiduciary and other trust income", Insurance Broking, and others:

Combining all of the above categories, and deducting costs, gives us net fees:

Bank fees in the UK are high, and have been the target of a government inquiry.

Other Operating Income 

Operating Lease income (blue above) is from Lex Autolease.  The increase in 2009 is when Lex Autolease was created from the takeover of HBOS.  Since it happened after the recession, we can't tell if operating lease income is affected by the economy.

Other Income (red above) is very spiky. I have removed one-off items from it 5.  Fortunately its low in 2015, so we can ignore it.


To get an idea of how much of their earnings come from interest vs non-interest, the above income categories are shown for 2015:

This excludes operating costs, and any provisions deducted from interest income.

Other Numbers

The CET1 ratio was 13% at end of 2015, which is OK.   However, RWA does not account for systematic risk.  Tangible Assets were 18.6 times Tangible Equity6, which is too high.

In 2015, (non-interest) operating costs were 2.5% of Deposits.

For Derivatives: The notional amount of derivative exposure is 5.9X total asset value - very high.  Lloyds says that they only hold derivatives for their customers or use them for hedging.


After removing the one-off items from their 2015 results (PPI provisions and TSB sale), their EPS rises from 0.8p to 6.7p.  At a share price of 60p, thats a PE of 9.

Other Risks

The two main risks are:
  • A falling pound, from Brexit
  • UK house prices have been rising for 4 years, and are due for a correction.

The previously rising pound and rising house prices may have fed on each other on the way up, and might unwind now.


I like it because its simple bank which makes most of its profits from deposit, loans, and fees, with a little insurance on the side.  It has minimal proprietary trading.  And operates in one country.  When its legacy problems eventually go away, it will be cheap at today's price.

Its operations are simpler than the Singapore banks.  However, leverage based on the assets/equity ratio is too high...I don't fully trust the CET1 ratio as RWA can be manipulated and doesn't detect systematic falling house prices.  I prefer to use both.

The main risk is the economic and housing cycles: is this the top?

[Edit: 28th Nov 2016: Bought 7191 NYSE:LYG ADRs at USD 2.9192.  1 ADR equals 4 shares.  Total cost USD 21,000.92.]


1 Lloyds market share will have dropped since then, as TSB was 50% owned by Lloyds in 2014 and sold off in 2015.

2 See table 1.35 in 2015 AR: Of the 140,536m of "Trading and other financial assets" on the balance sheet, almost 2/3rds (63%) is held for insurance. 

3 From the A lot of their insurance products are ILPs, whose value rises or falls based on some underlying investment. The rise/fall in value of previously sold insurance products is recorded under "Insurance Claims" (See 2015 AR's footnote 10, the entries "Change in insurance and participating investment contracts" and "Change in non-participating investment contracts"). However this is offset by LLoyds holding the underlying investment, and the offset is recorded under "Net Trading Income".

4 2015 AR footnote 15

5 See the text in footnote 9 in the ARs. Lists costs for restructuring, or managing liabilities for their past misdeeds.

6 I am including the "Other Equity Instruments" (Convertible notes issued in 2014 - see footnote 45) as part of the Shareholders Equity.  Otherwise it jumps to 20 times.

Friday, November 25, 2016

Bought OCBC

Bought 3,400 shares of OCBC @ SGD 8.74 on 23rd Nov 2016.  Total cost SGD 29,887.70.  Thats a a TTM PE of 9.6 (or 11, excluding "Trading Income"), and a yield of 4.1%.

I'm buying bank stocks cause I'm holding lots of cash, and they're still reasonably cheap, after 7 years of ZIRP.  Which looks like its ending now.  But they could still get cheaper if theres a recession or crisis.

I am still more than three-quarters in cash:

Thursday, November 17, 2016

Singapore Banks and Rising Rates

If US rates go up, how much will Singapore banks benefit?

SIBOR tends to follow the fed funds rate:

And the banks' Net Interest Margins (NIM) roughly follow it:

Its hard to tell, because the correlation is not direct, and there is probably a lag.  I'll assume that NIM goes back up to 2%, which is about halfway back to the highest level, and roughly what it was in 2010.  If this happens, I estimate that all three banks would increase their earnings by 15-20%.

Tuesday, November 15, 2016

US Drug Wholesalers


Part 1: The Good

Drug wholesalers handle the logistics of buying, warehousing and transporting drugs from manufacturers to retailers.  Three companies: McKesson (MCK), Cardinal Health (CAH) and AmerisourceBergen (ABC), form an oligopoly with an estimated 90% of the US market.

Its a low margin business where you make money on turnover.  Operating margins average around 2%.  All three companies are profitable, generate free cashflow, and have low debt1.  As expected in a business like this, their main costs are inventory (COGS) and SGA.

Most of the growth in this industry is by acquisition, which consumes part of the free cashflow.  This industry was previously fragmented, and over time consolidated into the oligopoly it is today.  Even in today's concentrated industry, all three companies make acquisitions every year to expand their offerings and move into new fields, such as specialty drugs and oncology.

The long term trends look good.  The population is getting older and weaker.  Drug usage is expected to grow 5% pa.  As the middleman, these companies take their small cut off the drugs passing through their pipelines.  When analysing them, we don't have to worry about patent expiry, competition from other generic suppliers, or the intricacies of insurance payments in the US health system.  We just sit back, let the drugs flow through, and collect our money.  Whats not to like?

Part 2: The Bad

When we look at the details of this industry, there are some issues.

First: retailer consolidation.  Distributors are most profitable when they work in "barbell" model.  That is: a small number of distributors in between a large number of suppliers and a large number of customers.  Giving pricing power to the distributor.  But one side of the barbell is shrinking.  The pharma retail industry has consolidated, with more and more sales going to the largest players (Walgreens and CVS) - see point 2 here.  This gives two problems:

  • Distributors margins for their small customers, such as independent pharmacies, are a lot higher that for their large ones.  Distributor operating margins average around 2%, but this is estimated to drop to 0.5% for their large customers.  Even these large customers make up 20-30% of a distributor's revenue, most profits come from their many smaller customers.
  • When retailers are taken over, they usually switch their drug distributor to the acquirer's one.  This makes it harder to project future revenue and profits.  For example, Walgreen's first indicated it will takeover Rite Aid in the middle of the year. Rite Aid's distribution contract with McKesson expires in March 2019, but will probably be terminated before then.  McKesson still does not know when, except to say that they will probably service Rite Aid at least till March next year.

To overcome this, all three companies have started franchises to help independent pharmacies start up.  They provide a broad range of services to help the viability and profitability of their smaller customers.  They have also been acquiring the smaller distributors that supply the independent pharmacies.

Second: pricing is complicated.  Distributors do not earn a fixed fee, like a postage rate.  Instead they buy drugs at some discount to the manufacturer's list price ("buy side profit") and sell at a profit ("sell side profit"), which may still be less than the list price.  See here for a good diagram of payments.  The distributors also benefit from price inflation when the price of items in their inventory increases, though less than before2.  

This leads to three more points:

  • The industry is hard to analyse.  Contract terms are not disclosed, so analysts have to estimate the revenue and profitability of each customer.  When analysing profitability, we end up making estimates based on other peoples estimates.  Its not modelling, just guessing.
  • In the past few years, wholesaler profits have been artificially boosted by price inflation in generic drugs.  This "generics bubble" was caused by few generics being approved for use - this pipeline is now clearing.  So those excess profits have gone down.
  • Theres a risk that the whole pricing model will have to change, so its no longer based around the manufacturer's list price.  Or medicaid may eventually be extended to everyone as a "single payer" system, like in a civilised country.  Even though drug wholesalers are performing an essential task in the system, with sustainable (that is, low) margins, any uncertainty associated with an industry overhaul could play havoc with healthcare stock prices.

Part 3: The Ugly

In October, McKesson said in their conference call that AmerisourceBergen has started a price war in the independent segment.  The stock fell 22% overnight.

I think the price war is temporary,and won't last in a market with 3 players.

Still, the level of stock volatility is sickening.  I may hold a smaller amount.

Comparing the companies

The companies are pretty similar in terms of cashflows generated, debt and the industry they serve. There's no point comparing their profit margins, since they vary so much between the large and small customers.  The main thing I want to look at is valuation.  How much would I be willing to pay for them?

I'm leaning towards McKesson or Cardinal.  Among independent pharmacies - the most profitable segment - AmerisourceBergen's market share has been falling, and they have a lower estimated margin3.  And they are the ones starting the price war.


All three companies report both GAAP and non-GAAP earnings.  Non-GAAP is supposed to exclude one-off items.  Guidance is only provided for non-GAAP.

The differences are:

  • Changes to LIFO Reserves: Stock is sold on a FIFO basis, as with any perishable good.  But the accounting is done on a LIFO basis.  When prices are rising, this lowers profits and taxes.  In other words, the profits on paper are lower than the cashflows.  The difference is added back to their non-GAAP earnings.  I think this is makes sense, and the amount is objective and easily calculated.
  • "Acquisition costs" and "Amortisation of acquisition related intangibles"4.  This is the largest part of the difference.  Since all three companies are serial acquirers, then do we ignore this by considering it a one-off cost that should be excluded from earnings?  Not sure, but I can probably accept it - its better than leaving the costs on the balance sheet as goodwill.
  • Litigation costs.  McKesson has such large and frequent litigation costs which makes me wary.  I'm wondering if they can conduct their business for another 5 years without getting their asses sued off.  Cardinal's litigation costs are small enough to ignore.

Earnings Estimates

For MCK, after accounting for:
  • the loss of OptumRx, Omnicare, Target, Rite Aid, partially offset by Rite Aid and Safeway
  • less generics price inflation than in FY2015.
  • a price war for supplying independent pharmacies, assuming operating margins are halved.
I get an EPS reduction of $3.84. This would give an non-GAAP EPS of $8.51.  At 12X earnings, thats a target price of $102.12.  At 15X, its $127.65.

If we exclude the price war, its $112.24 (12X earnings) and $140.31 (15X earnings).

For CAH, after accounting for:
  • the loss of Safeway, plus the potential loss of Pharmerica
  • less generics price inflation than in FY2015.
  • a price war for supplying independent pharmacies, assuming operating margins are halved.
I get an EPS reduction of $1.12. This would give an non-GAAP EPS of $4.24.  At 12X earnings, thats a target price of $51.03.  At 15X, its $63.78.

If we exclude the price war, its  $58.39 (12X earnings) and $82.87 (15X earnings).


1 Less than 2X EBIDTA
2 McKesson2Q17 Conference call: "90% of our [branded] income is fixed, 10% is variable."  And Cardinal 1Q17 Conference call: "about 15% of our branded margins are based on a contingent basis, which means that generic or a branded inflation is a piece of the driver of the value that we receive."
3 From the DrugChannels 2016-17 Wholesalers and Specialty Distributors Report.  All my estimates are calculated from the estimates in the report. 
4 Defined in Supplemental non-GAAP information here.

Bought UOB

Bought 1500 shares of UOB at SGD 18.81 on Friday 11th Nov, total cost SGD 28,378.03.  Thats a TTM PE of 9.8 (or 12.5 if we exclude "Trading Income"), and a trailing yield of 3.7% (excluding their special "80th Anniversary" dividend).

Singapore banking stocks are quite cheap.  One reason is because of seven years of falling interest rates.  After Trump won and gained control over two houses, the market narrative is that US inflation and US interest rates will go up.  Bonds jumped on the news:

 As did banks:

So the market believes ZIRP is dead.  Lets see if it comes true.  The Singapore banks are cheap enough to buy anyway, even without that.

Monday, November 7, 2016

Sold Seaspan

Sold Seaspan at USD 9.57 yesterday.  The stock was still falling in a rising market.  The market is now valuing the common shares as though the dividend will be cut, possible eliminated.  Loss of USD 5311.62 (incl. dividend).

The shipping sector is still interesting, and I'll look at Maersk or Seaspan again later for a cyclical recovery.  But its a long way off.

When I'm so far underwater on a position, better to sell and realise the loss first.  It helps me to clear my head when thinking about whether I would buy the stock at the current price.