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Are foreigners paying over the odds for Russian banks?

Heiner Klemm
24th November 2006

Pricing banks in Russia has turned into a moving target as the European Bank of Reconstruction and Development (EBRD) and Nordea found out to their cost this month.

Earlier this year the EBRD, which wants to pump more than $2bn into the Russian economy this year, agreed to pay second-tier Russian bank Orgresbank $3,200 per share for 9,400 of its shares, or 15% of its capital.

However, at the eleventh hour Nordic bank Nordea said it was interested in buying into Orgresbank and all the parties returned briefly to the negotiating table.

Nordea is one of Scandinavia’s leading banks and was keen to enter the Russian market after it was pleasantly surprised by the success and quick growth of its investments in Baltic banks a few years ago.

Just how much of a sellers’ market the Russian banking sector has become is painted large in the result of the new deal: the price of Orgresbank’s shares almost doubled with Nordea agreeing to pay $313.7m for an 85.7% stake in the bank.

Orgresbank will issue additional shares after an extraordinary general meeting on December 4. These new shares will be split three ways, leaving Nordea with a 75% stake and both Orgresbank’s management and the EBRD 12.5% a piece.

The new deal saw Orgresbank’s valuation jump from $170m at the start of November to $350m only three weeks later. Not bad for a month’s work.

Still, the surprise is not that the value of the bank almost doubled during the deals, but that the management were asking so little for it in the first place. Analysts say the Nordea deal equates to a price-to-book value (P/BV) of around 3 times, assuming Orgresbank's equity of $141m. Given that banks are going for multiples of 3-4 times book value in Russia and as much as 6 times in Ukraine, the new price looks almost looks reasonable.

«The valuation of any company is considerably based on expectations,» says Ulf Persson, managing partner of Mint Capital, about Orgesbank's soaring valuation.

«Clearly, expectations are to a large extent dependent on capable management, its strategy and execution. That's why the better perception of the company management, the higher valuation the company can get. Although it's clear that it takes time, and corporate governance and other improvements in a company don't happen right away, the arrival of a trusted and experienced manager with a track record is always good for the company value,» Persson says.

Nordea had been actively looking to acquire a mid-sized Russian bank since it sold its 26% stake in International Moscow Bank to UniCredito for $395m in June 2006.

Orgresbank, currently Russia's 67th largest bank based on assets ($690m) with some 35 branches mainly in Moscow and St Petersburg, is seen as a promising acquisition. The bank is particularly strong in corporate banking for small- and medium-sized enterprises (SMEs), while also providing an entry into Russia's booming retail banking sector.

Bank price hype

Did Nordea really get such a good deal' When Central Europe sold off its banking sector to international banks — largely from Austria and Germany — the P/BV multiples were closer to 1.5-2 times. However, Russian and Ukrainian banks are probably not so ridiculously overpriced because the potential upside is mind boggling, even in this the most conservative of all businesses.

Banks are the fastest growing sector across all of Central and Eastern Europe, but Russian banks account for the lion’s share of the growth. Overall, banking assets in CEE grew by a third in 2005 to reach €846bn, the strongest year of growth on record, according to Raiffeisen International. Total banking capital in Eastern Europe almost doubled to reach €331bn, with Russia accounting for 86% of this growth.

Russian banks have embarked on a period of rapid catch-up with their peers in the West, but despite the fast growth they are still at the beginning of a long journey. The total assets of the Russian banking sector were 44% of GDP at the end of 2005 and are expected to reach 49% by the end of this year, compared with 66% in Southeast Europe and 81% in Central Europe.

The Russian ball began rolling in the summer of 2004 when US bank GE Capital bought the US-government funded mortgage bank Delta bank for an estimated $100-120m closely followed by French bank BNP Paribas’ attempt to buy consumer lending pioneer Russky Standart (Russian Standard). The foreign banks in both deals offered to pay a massive P/BV of 3.5-4 times (and the Russky Standart deal failed as its owner Rustam Tariko didn’t think even this was enough).

«While multiples of four-times book and more seem excessive, given the growth potential that foreign banks are buying into and the similar multiples being paid elsewhere in Eastern Europe and Turkey, then they do not appear that extraordinary,» says Andrew Keeley, a bank analyst with Troika Dialog in Moscow.

Comparing banks’ return on equity (ROE) with their P/BV multiples suggests that even the Ukraine’s enormous multiples may mean these banks are still cheap given the size of the returns they offer.

Well established Western banks such as Bank Austria typically come in at about 1.9 times book value for a estimated return on average equity of 14% in 2006- 2008.

Austria's Raiffeisen International is batting above average, but it has invested massively in Eastern Europe and already commands a multiple of 3.6 times book value for an estimated ROE of 18.1% between 2006 and 2008.

By comparison, Russian banks like Sberbank, the national savings bank and largest bank in the country based on assets, promises a 2006-2008 ROE of 27% for a P/BV of 3.8 times: practically the same P/BV as Raiffeisen International, yet earning nearly 10% more as ROE. If the trend line in the chart is extrapolated from the established banks through Raiffeisen, then banks like Sberbank would be reasonably priced with a multiple twice as large.

The reason prices are so high is that Russia’s financial sector is on fire, driven by white-hot lending to consumers. The growth has been given impetus by a raft of reforms introduced by the Kremlin to bolster the sector. The government launched a six-year reform strategy at the start of this year and has introduced dozens of bills to cut red tape and improve the market’s infrastructure.

The reason that prices are not as high as the trend line suggests they should be is because political risks in Russia are still significant. Punters investing into Russia are betting that the worst of the political and economic crises are over and so as time passes the value of their banks will rise even higher to meet this trend line.

Prices are also high, as finding an owner willing to sell his bank is also quite hard. Russian banks are keen to sell small stakes to boost capital however, as their banks are clearly growing so fast most owners prefer to wait a few years until growth slows before putting their banks on the block.

The leading fund specialising in Central and Eastern Europe, East Capital, last year set up a banking fund to buy minority stakes in fast growing small and medium sized banks throughout the CIS and collected $350m of which they have spent some $200m.

«We set up the fund as there is a lack of opportunity to invest into the banking system as there are very few listed banks,» says East Capital’s CEO Karine Hirn. «But most bank owners in Russia are not ready to sell yet. They can see that if they wait a few more years then they can get a much better deal. However, they need capital and they are interested in cooperating to get the most value out of their assets so they are willing to sell small stakes.»

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