In the early 2000s, Argentina was undergoing a major economic depression that had caused widespread unemployment, negative GDP growth, the fall of the government, a default on the country's foreign debt, the rise of alternative currencies and the end of the peso's fixed exchange rate to the US dollar. Grupo Financiero Galicia S.A. (GGAL), the fifth largest financial services group based in Argentina, was also one of the direct affectees as it had lent 50% of its loan portfolio to the public sector. Back then, government default was the issue creating problems for the investors of Galicia and today, the high inflation prevailing in Argentina creates the new hurdle. I believe that investors will soon realize that the positive changes at the micro level are insufficient to cover up for the macro level problems and that investing today in this stock is likely to result in a negative return of 41.8%. Therefore, I recommend shorting this stock.
Why Mispricing Exists?
Presently, investors are giving more weight to the high interest yield and ultimately, returns generated by the bank. They are not accounting for the repercussions that result from a high inflationary environment. This has led to the price of this stock to rise above its intrinsic level. What investors fail to realize at this point in time is that the return is attractive in the base currency and once they account for the currency devaluation due to the high inflation environment in Argentina, the price bubble will burst and the stock price will plunge.
Investment Thesis
- At micro level, things may seem good but it is not the case when analyzing from a macro level.
- The bank operates in a high inflation environment. Therefore, interest rates are also quite high.
- Although Galicia offers an attractive return in terms of Argentine pesos, the returns in dollar terms do not seem attractive.
- Repatriation of investable funds to dollar eats up all the return earned and also part of the principal investment due to currency devaluation that results from the high inflation.
- Market based valuation clearly highlights this factor.
- The bank has yet to adhere to the new capital regulations for banks introduced in Argentina. Until then, it is unable to distribute dividends to shareholders.
- If the sovereign debt lawsuits filed by hedge funds are decided against the country, it is likely to result in immediate devaluation of the Argentine peso and at the same time, the dollar will appreciate. As a result, the stock price of Galicia's ADR will fall.
Linking Asset Composition With Returns
Source: Investor Presentation
Over the last decade, the bank has effectively reduced its exposure to public sector debt. From its highest ever levels in 2003, where 50% of the total assets were lent to the public sector, it now only represents 10% of the loan portfolio. Then, real GDP growth in the Argentine economy was negative 10.9% and the Argentine government was struggling with a fiscal deficit. As a consequence, the bank saw its non-performing loans shoot up when the government defaulted on local debt along with sovereign debt. Also, this episode made the bank realize that it ought to maintain higher loan loss reserves in advance to be able to handle such events smoothly.
As the asset composition was changed to incorporate more proportion of private debt disbursement, the bank's asset quality began to improve as revealed by the declining non-performing loans as a percentage of total credit. Reduced dependence on a single borrower was a major reason. The bank also has a significant buffer reserve at hand compared to its non-performing assets which ensures its future safety.
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Source: Investor Presentation & Form 20-F
The net interest yield has taken on an upward trend and has been increasing drastically. This has contributed to the expanding revenue base of the bank over the years. The bank has also focused on decreasing its efficiency ratio which was at its highest back in 2002-2003. The efficiency ratio is currently at its lowest level. Decreasing trends in this ratio indicates that the bank has been quite effective in controlling and managing its expenses. Combining the effect of these two factors has ultimately led to the increase in the return of stakeholders from negative 10.1% to 3% in 2013, an improvement of over 1300 basis points.
With every passing quarter, the bank stands at a better position to reward its investors by working on operational efficiency.
Liquidity Position
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Source: Form 20-F
Loan-to-deposit ratio, a bank's key liquidity statistic, has dropped considerably from almost 100% to 62% in the last five years. A high ratio can have disastrous effects, especially in the case where borrowers begin to default. This creates a serious problem for the financial institution which will still remain obligated by law to pay back the deposits on its balance sheet. Thus, the bank is now trying to play it safe and maintain a liquidity cushion by lending less than deposits at hand so it has the capacity to absorb an unforeseen event or losses as in the early 2000s.
Argentine Banking Regulations
As the regulator of the Argentine financial system, the Argentine Central Bank requires financial institutions to submit information on a daily, monthly, quarterly, semiannual and annual basis.
Minimum Capital and Legal Reserve Requirements
The bank is required to maintain minimum capital requirements equivalent to Ps.26,000,000. The Argentine Central Bank also requires that every year the bank set aside 20% of their net profits to a legal reserve. This reserve can only be used during periods of bank losses and after all other allowance and reserves have dried up. Distribution of dividends is also not allowed if the legal reserve has been impaired.
In effect from the end of 2011, the Argentine Central Bank has implemented new regulations regarding dividend distribution. These new regulations established that after paying dividends, financial institutions must still have an excess of computable capital over the new minimum requirement of 75%, an increase from the previous requirement of 30%. As a consequence of these regulations, Banco Galicia, a major subsidiary of the group, was unable to declare dividends for the fiscal year 2012, and thus, the ability of Grupo Financiero Galicia to pay dividends has been negatively impacted.
Peer Comparison
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Source: Investor Presentation
Galicia is one of the leading banks in Argentina as shown by the market share it has captured in the private sector loan and deposit market as compared to its active peers.
Valuation Insight
*I have selected Bank of America (BAC) as the benchmark in my analysis.
Normally, a company's return on equity "ROE" is calculated based on the book value of its equity. My computations, based on book value, clearly highlight the exuberantly high return that Galicia is offering as compared to its American peer. However, return potential based on book value is not an accurate measure. This can be explained by the difference in the ROE that has been calculated based on market value.
Based on the market valuation, the bank is offering a return on equity (ROE) of 16% in dollar terms. However, for a US investor, this may be an incomplete return analysis if I stop here. Exchange rate movements carry immense importance for a foreign investor. The purchasing power parity explains that the current inflation rate of 25% in Argentina compared to 2% in the United States is likely to result in 23% devaluation in the Argentine peso on an annual basis. Therefore, a US investor who has invested in this bank will be ableto earn 16% but when the investor repatriates the money back to his/her currency, the devaluation will result in a net negative return of 7% after one year. Conversely, investing in Bank of America is providing ROE of 5%.
Although the bank is one of the best return generating stocks based on fundamentals in Argentina, it may not be feasible for an American investor to move investable funds in this country due to its extraordinarily high inflation rate. For this very reason, the bank is generating a much higher ROE backed by the high prevailing interest rates compared to Bank of America which is operating in a low inflation environment and thus, has a much lower net interest yield to back its ROE. Argentina has been subject to hyperinflation multiple times in the past as well.
Why market value is better?
Clearly, the above tables show that the difference between ROE based on market value is lower than the difference between ROE on book value basis because Galicia has twice the price to book value (1.6) of Bank of America (0.8). If I were to go forward with book value based ROE, the bank may have still seemed to be an investable option as then the bank's exaggerated ROE (32%) would have greater than the breakeven ROE (28%) required by an American investor.
Breakeven Price Analysis
Considering this fact, an investor will turn indifferent between investing in Galicia's stock and Bank of America if the share price falls to $7.36 from its current level of $12.65, at which point it would generate ROE of 28% in peso terms.
Risks
The above analysis is, by the nature, subject to a number of risks and uncertainties.
Currency devaluation
The economic growth of the Argentine economy may improve which may lead to lower currency devaluation than the 23% as projected in the above valuations. A materially lower inflation rate is likely affect the target price that has been calculated and thus, my recommendation.
Non-performing loans
Non-performing loans may continue to decline further despite being at a historically low level. This is likely to provide a boost to the bank's bottom line and enhance its ROE. ROE may increase to 28% where my recommendation may need revision.
Interest rates
On the monetary front, the Central Bank of Argentina may decide to raise the borrowing rates charged by banks which may increase the bank's financial income and positively impact its net profit position.
Efficiency ratio
A further major improvement in the efficiency ratio of the bank could mean lower expenses and an increase in the portion of revenue being passed on to the shareholders. This may increase the ROE to a level where the investment in the bank's stock turns attractive even after adjusting for the currency devaluation.
Correction Points
If actual inflation turns out to be higher than expected inflation, the Argentine peso will depreciate more than expected. This is likely to reduce the returns translated in dollar terms which will provide gains to a short position holder.
Secondly, the Argentine government is facing a lot of lawsuits regarding the sovereign debt that the country defaulted on back in the early 2000s. Hedge funds have filed lawsuits against the country demanding their money back. What needs to be considered here is that if the court decides in the favor of the hedge funds, a lot of money will flow out of the Argentine economy. The debt will be paid in dollars which means the supply of Argentine pesos will increase and cause an immediate devaluation of the currency. Moreover, if the case is decided in the favor of hedge funds, other bond holders that had agreed to rescheduling of their debt and haircuts proposed by the government at that time would also stand up to demand their money to cause further depreciation of the base currency. All in all, this will appreciate dollar and reduce the price of Galicia's ADR. Once again the expected fall in the price of Galicia's ADR will benefit the short position holder.
Disclosure: I am short GGAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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