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In mid-April, I realized it was a full year since I’d last posted about European Islamic Investment Bank (EIIB:LN). No real neglect on my part (EIIB is now a Top 3 holding for me), but simply an undimmed confidence in their underlying story & intrinsic value. A fresh write-up made sense (esp. with 2012 final results due for release), as I suspected EIIB would be a brand new & interesting stock for a lot of (more recent) readers. [The stock actually rallied +15% in the week after my post].

The results speak for themselves, and received an enthusiastic reception from current & prospective shareholders. [EIIB shares are now up +27% since my last post]. These are the first set of results to properly illustrate EIIB’s new asset management strategy, its operational turn-around & progress to date, and the exciting potential of the MENA region. Again, see my prior post, but I definitely encourage you to read the full set of results – or even better, the entire annual report! Let’s divide the rest of this post into four sections:

Highlights:

– Assets under Management (AUM) increased +53% to $922 million, including a mandate win from Norway’s sovereign wealth fund

– EIIB & Rasmala staff/operating expense costs were basically halved – ahead of forecast, with some further efficiencies targeted for 2013

– Underlying business operating near-breakeven (GBP 0.6 mio pre-tax loss, exc. write-downs & discontinued ops.)

– A reduced GBP 13.3 mio in legacy assets targeted for an orderly exit

– Balance sheet risk continues to reduce, with 75%+ of assets invested in cash, deposits & fixed income, and liabilities limited to 25% of total assets

– Wholesale strategy confirmed, with new distribution agreements signed & existing relationships deepened. Re-iterated $3 billion AUM target by 2016

Also, this commitment from the CEO particularly grabbed my attention:

‘Our share price performance during 2012 remained flat; however, we are continuing to deliver the strategic realignment of the Bank and in 2013 we will begin to focus attention on translating our success into improved share price performance.’

The first step is a new GBP 5.0 mio share buyback program.

NAV Update:

My recent 7.2p estimate wasn’t too bad… I anticipated the Arcapita & DiamondCorp (DCP:LN) write-downs, the underlying operational loss, and net outstanding shares fairly well – coming up with a GBP 123.7 mio net equity estimate. However, I couldn’t anticipate further write-downs of 3.2 mio re Accelerator Technology Holdings & 1.3 mio re Carian Bay. [btw Irish readers may be fascinated to see Denis O’Brien is an ATH director!] Which basically explains their actual 2012 yr-end 119.8 mio of net equity, or GBP 6.9p NAV per share.

Hopefully, we’ve reached a point now where further legacy write-downs prove unnecessary. It’s important here to highlight we really can’t blame the new CEO/team for these losses: a) they’re attributable to legacy assets acquired before they arrived (e.g. the original $30 mio Arcapita loan was a ludicrous over-commitment for a bank of EIIB’s size), and b) I suspect a fire-sale of these assets might ultimately have produced similar losses.

But we can definitely blame them for not taking a kitchen-sink approach to write-downs after their arrival. Unfortunately, when it comes to stocks, too many investors prefer to mistakenly dwell on a terrible past, or even a glorious future – which can severely impair their investment opportunities & returns. And EIIB certainly has a terrible past… The constant drip-feed of write-downs has (unsurprisingly) been greeted each time with the same old tired chorus of complaints. And whoever shouts loudest (not smartest) on the message boards often gets far more attention than deserved, cementing EIIB’s old reputation in the minds of many investors.

Hopefully, this over-hang of negative sentiment is now dissipating…

Now, what about today’s NAV? Well, I’ve got comfortable with the valuation of Rasmala (more below), and considering the trajectory in AUM & costs, I’m not going to anticipate a potential 2013 operating loss. We can add-back a GBP 0.2 mio subsequent (FX) gain on the Arcapita loan sale, a likely gain of at least 0.3 mio on the sale of an Egyptian property, and a 0.1 mio increase in their DiamondCorp stake. That increases net equity to 120.4 mio. However, we need to allow for an additional 85.1 mio (as of yr-end – 13.4 mio of this total were issued since, in April) of EIIB share issuance in relation to the Rasmala acquisition – which will ultimately increase net outstanding shares to 1,814.5 mio. But that will also eliminate a 2.9 mio Rasmala deferred consideration liability from the balance sheet, so the actual calculation will be:

GBP 119.8 mio Net Equity + 0.7 mio Gains + 2.9 mio Eliminated Liab. = 123.3 mio Adj Net Eq. / 1,814.5 mio Adj Net Shares = GBP 6.8p Adj NAV per share

I continue to believe EIIB deserves a fair value of 1.0 Price/Book. Based on the current GBP 3.05p share price, I now see an Upside Potential of 123% for EIIB. My holding’s increased to a 7.6% portfolio stake.

Closing The Value Gap:

Next, let’s consider some potential measures to reduce/eliminate EIIB’s current 55% discount to (adjusted) NAV. Here’s a copy of a letter I sent to EIIB’s CEO just over a month ago:

‘April 02, 2013

FAO:   Zulfi Caar Hydari, CEO

CC:     H.E. Abdallah Y. Al-Mouallimi, Chairman         

European Islamic Investment Bank plc (EIIB:LN)

Milton Gate

60 Chiswell Street

London EC1Y 4SA

United Kingdom

 

 Dear Zak,

I’ve been an EIIB shareholder for nearly 4 years now. I know you’re already familiar with the Wexboy blog – I’ve posted a number of EIIB articles in the past year & a half (Parts I & II, and here & here). Please find attached a new article which I intend to publish shortly.

To summarize:  I now estimate EIIB’s year-end 2012 Net Asset Value (NAV) to be GBP 7.2p per share. The new asset management strategy offers attractive lower-risk growth potential, and continued progress & success in growing AUM should ultimately prompt a re-rating. I’d consider EIIB shares to be fairly valued at a 1.0 Price/Book multiple (i.e. 7.2p per share). This target offers Upside Potential of 168% vs. the current 2.67p share price. However, even if I project aggressive growth & continued cost control, return on equity (RoE) will be slow to reach acceptable levels. I would blame too much equity, rather than too little return. Noting this sub-par RoE, and EIIB’s long-standing neglected penny stock status, I suspect additional measures are needed to reduce & eliminate the current value gap between the share price & EIIB’s obvious intrinsic value.

I’m therefore writing to you with some suggestions, which I hope you’ll consider. I’m also including a shareholder distribution proposal for your consideration. Please note: I’ve reviewed the content of this letter with Guy Thomas (also an EIIB shareholder, as you know), and he’s generally supportive of each suggestion & particularly the distribution proposal.

Suggestions:

i)          Rasmala Holdings Acquisition:   I’ve estimated Rasmala’s total valuation (at the time of acquisition) to be approx. $38 million, but I’m unable to determine the accuracy of this estimate. Also, extremely limited information’s been provided about Rasmala’s current/historic balance sheet and P&L. I understand your majority stake (approx. $21.5 mio) is a relatively small component of EIIB’s balance sheet, but Rasmala represents a major portion of EIIB’s current/future operating performance & strategy. Since the acquisition cost is mostly recorded as goodwill, I’m also concerned current/prospective EIIB shareholders will apply an undeserved discount to the value of this intangible asset.

            I suggest you consider providing more detailed info. re Rasmala’s pre- & post-acquisition financials, to assist shareholders in performing their own assessment of Rasmala’s intrinsic value.

ii)         Potential Future Acquisitions:   You’ve stated ‘We are also starting to evaluate potential bolt-on acquisition targets that might contribute, on suitable terms, to EIIB’s growth and the consolidation of our chosen markets.’  This strategy makes sense, but the value of asset management businesses obviously resides primarily in people & goodwill – I’m concerned about the potential implications for EIIB’s market valuation. Considering the discount investors now apply to EIIB, with a balance sheet primarily composed of tangible cash/investments, a more severe discount may well be applied to a balance sheet which increasingly consists of intangible assets. Almost inevitably, intangibles are more vulnerable to investor mis-pricing, and to value impairment.

I believe these risks can be countered with: a) a greater level of pre/post-acquisition financial disclosure (as in i) above), allowing investors to better evaluate the underlying intrinsic value of an acquisition, and b) paying acquisition consideration in newly issued shares, rather than cash – vendor/employee ownership of EIIB shares would create far better alignment in newly-acquired businesses. Of course, new share issuance only makes sense if it’s priced at levels near/in excess of EIIB’s own NAV/intrinsic value.

For new acquisitions, I suggest you consider adopting an ongoing policy to: i) evaluate the pros & cons of an all/part-share vs. a cash consideration, and ii) provide more detailed pre/post-acquisition financial disclosure to shareholders.

iii)        UK Banking Licence:   The reduction in EIIB’s head-count & annual operating costs since 2011 has been admirable. However, I presume there’s a continued incremental cost (and less balance sheet flexibility) associated with satisfying the regulatory requirements of a UK banking licence. The licence remains relatively un-utilized & is clearly beyond what’s required for your new asset management strategy. On the other hand, a banking licence is an unrecorded intangible asset that’s potentially very valuable – it could be monetized, for example, via low-cost/low-capital joint ventures with interested third parties, or even perhaps via some type of sale.

            For shareholders, I suggest you consider disclosing more of your plans for better utilization and/or monetization of your UK banking licence.

iv)        Investor Relations:   With EIIB’s share price at such a substantial discount to obvious intrinsic value, I believe more time & energy devoted to investor relations (IR) could prove very rewarding. A re-rating of EIIB’s shares obviously demands new shareholders, and/or a broader investor awareness of the value, exposure & strategy EIIB now offers.

EIIB provides Sharia’a compliant products & services, has broad exposure to the Middle East & North Africa (MENA) region, and now holds a majority stake in Rasmala Holdings (a Dubai-based institution). A specific IR focus on the following potential investors could prove very effective: a) your own customers & counterparties, b) Islamic institutions, charities, (ultra) high net worth families & individuals etc., and c) perhaps most promising – emerging/frontier markets & MENA investment fund managers.

            I suggest you consider increasing your IR activities, and seeking out potential new investors who might better appreciate EIIB’s unique Sharia’a focus & geographical exposure.

Proposal:

i)          Tender Offer:   Following last year’s transfer of GBP 20 mio from EIIB’s share premium account to distributable reserves, you stated ‘We are now reviewing options for possible future capital returns to shareholders and expect to reach a conclusion early next year after having finalised our long term capital requirements in consultation with the regulator.’ Considering your likely 2012 results, I’ve estimated year-end 2012 distributable reserves will be a little over GBP 10 mio – hopefully, the balance will prove well in excess of this estimate.

It’s clear EIIB’s new asset management strategy requires far less capital (even with bolt-on acquisitions) than the current GBP 129.8 mio of net equity. A return of capital will reward existing shareholders, attract new shareholders, and can be generally expected to: a) support & boost the share price, b) highlight EIIB’s substantial discount to intrinsic value, c) improve future return on equity, and d) enhance NAV per share.

At the current GBP 2.67p share price, EIIB trades at a colossal 63% discount to my year-end GBP 7.2p NAV estimate. Considering this discount & the maximum distribution possible, a tender offer appears to be the most efficient & value enhancing way to return capital. Assuming my NAV estimate, and (say) GBP 10.3 mio available for distribution, a GBP 5.34p tender offer would reward investors with a 100% premium for some/all of their shareholding. [If investors over-subscribe the tender, a simple pro-rata reduction in shares repurchased is by far the fairest option. If for some reason the tender’s under-subscribed, share buybacks and/or a special dividend could then be utilized]. The tender price would also be at a 25% discount to NAV – I calculate post-tender NAV would increase 3.2% to GBP 7.4p.

            Please consider the timely implementation of a tender offer (plus share buybacks and/or a special dividend, if necessary), priced at (say) a 25% discount to year-end 2012 NAV, to distribute EIIB’s entire year-end 2012 distributable reserves.

Of course, this letter reflects my own views as a shareholder, but I believe the great majority of shareholders will be supportive of any measures you might consider to increase EIIB’s share price and/or intrinsic value. I’d like to thank you in advance for your consideration of these suggestions & proposal, and any commentary & response to shareholders would be greatly appreciated. Also, both Guy & I would welcome the opportunity to meet with you in the near future (after your final results).

Please note I intend to publish this letter on the Wexboy blog in due course.

Kind regards,

Wexboy

wexboy.wordpress.com’

Follow-Up Comments:

Suggestions

i) Rasmala Holdings Acquisition:   It’s somewhat difficult to reconcile all the pre/post/adjusted profit figures, but Rasmala looks like it’s running near-breakeven at a GBP 0.5 mio operating loss (continuing ops. basis). As I mentioned above, current AUM & cost trajectories suggest a 2013 move into profitability.

The annual report also provides a good break-down of the Rasmala acquisition. My prior estimates are confirmed – EIIB’s 56.8% stake cost $21.5 mio, which pegs Rasmala’s total valuation at $37.8 mio. But I can now confirm net assets of GBP 12.1 mio ($18.7 mio) were acquired, while AUM was $603 mio at the time – which implies an underlying 3.2% of AUM price tag. This might look a little steep for a currently unprofitable business, but the timing of the deal was perfect, and the price tag’s now reduced to approx. 2.3% of (current) AUM. The re-energized boom in the MENA/GCC economies & stock markets, plus Rasmala’s wholesale distribution strategy, also promises another year of AUM growth.

Anyway, as I’ve highlighted with many of my posts/holdings, the metric ultimately for asset managers is % of AUM – not (necessarily) profitability. I think shareholders can be satisfied Rasmala’s turned out to be a reasonably priced acquisition, and it’s clearly been a resounding success in terms of execution & integration.

ii) Potential Future Acquisitions:   Funding any new acquisition (primarily) with shares will be clearly dependent on the seller(s) accepting EIIB’s London-listed shares priced at a level near/at NAV. The (continued) success of the Rasmala acquisition makes that a far more likely & attractive proposition in the future, and will be a great calling card for EIIB.

iii) UK Banking Licence:   The strategy for EIIB’s London operation & banking licence has been clearly articulated – to provide in-house product structuring capability, and to act as a natural conduit between the MENA region & the London market. Synergies with Rasmala should now also improve prospects. However, news of tangible progress is required here, plus a substantial acceleration in revenues & profits, if EIIB is to justify a dual strategy of asset management & financing solutions.

A pure-play asset management business, and the implied release of capital from EIIB’s banking operations & licence, may still ultimately offer a superior return.

iv) Investor Relations:   Realistically, any IR activity in the past couple of years would probably have yielded little reward. Now, on the back of their 2012 results & continued progress in 2013, EIIB management has an exciting and successful turn-around & growth story to tell. And with 2013 GCC growth rates predicted to be 3.7% (with even higher non-oil GDP growth of 5.5%), versus just 1.5% G7 growth, selling EIIB as a London-listed MENA/frontier markets play is now a compelling IR strategy.

Let’s remind ourselves of this commitment from the annual report: ‘…and in 2013 we will begin to focus attention on translating our success into improved share price performance.’ I fully expect that will include an enhanced level of IR activity. Frankly, a top-class investor presentation is de rigueur in the finance industry anyway. If you’ve sat through as many client meetings as I have, on both sides of the table, you’ll already know that client pitch book can easily double up as an IR presentation!

Proposal

i) Tender Offer:   Unfortunately, the additional write-downs in 2012 mean the net amount available for shareholder distribution is closer to GBP 6 mio, rather than the 10 mio+ I previously estimated. Which basically explains the limited size of the GBP 5 mio share buyback program that’s actually been announced since. [Which is obviously only meaningful if the full amount’s actually spent on buybacks]. This is obviously a disappointment to shareholders vs. the original 20 mio share premium a/c reduction. However, it still represents over 9% of EIIB’s current market cap.

In my opinion, with an unfortunate halving of the expected distribution amount, a buyback probably does offer more bang for the buck than a tender. In recent months/years, we’ve often seen how a relatively low volume of selling can cause a precipitous decline in the share price – this bodes well for the potential price impact of a buyback. It may also offer greater NAV enhancement. For example, if we presume the full buyback’s executed at a 15% premium to today’s price, adjusted NAV would improve from GBP 6.8p to 7.1p per share.

However, the real beauty of a share buyback program is the constant market feedback. Taken to its extreme, we have three post-buyback outcomes:

– Ideally, the share price rallies substantially (to/near NAV) & maintains its gains. Shareholders are obviously happy, and EIIB continues to grow its business & increase intrinsic value.

– The share rallies sharply, but quickly loses some/all of its gains post-buyback. A re-load & another share buyback/tender are the obvious solution.

– The share price barely budges. Again, a re-load & another share buyback/tender will take advantage of the continued cheap price/discount to NAV, and may prove a better success second time around.

While further acquisition(s) may raise the level of capital required, the current regulatory capital surplus of GBP 36.3 mio certainly offers plenty of scope for further returns of capital. And in terms of its balance sheet, it’s worth highlighting the announced GBP 5 mio program is less than 3% of EIIB’s total assets!

I look forward to further news of the announced share buyback program.

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