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Bank of Ireland reported a profit before tax of EUR 80 million for the six months ended September 30, but only because it benefited from a EUR 1,037 million gain on the repurchase of its own debt and other one-time items. The struggling bank's underlying loss before tax was EUR 979 million. We are leaving the bank unrated, as it continues to face substantial uncertainties, especially surrounding the potential impact of Ireland's proposed National Asset Management Agency and business restructurings that may be required by the European Union.

Bank of Ireland had a difficult quarter across the board, but especially in its commercial property and construction segment, where provisions for loan losses increased to EUR 1.135 billion, or an annualised 6.4% of these loans, compared with just EUR 125 million in the year-ago half. For the bank as a whole, loan-loss provisions increased to EUR 1.787 billion, or an annualised 2.6% of loans, from EUR 267 million in the year-ago half. The net interest margin fell 10 basis points to 1.61% as competition for deposits intensified, and loans to customers fell to EUR 131 billion from EUR 144 billion a year ago. As a result, net interest income fell 24% to EUR 1.477 billion.

The bank has made some progress addressing its many problems, but we think it still has a long way to go. Bank of Ireland reduced its loan/deposit ratio to 152% from 161% in March, but it remains well above the 100% level we'd prefer to see. Tier 1 capital increased to 11% but we remain concerned that it may not be enough to absorb the losses ahead.

Thesis (Last updated 29-05-2009)

Bank of Ireland's profits sank in fiscal 2009 as Ireland's economy shrank and property values plummeted. While actions taken by the government promise to help stabilise the bank, they will come at great cost to shareholders. We're leaving BOI unrated, as it remains difficult to assess how much more capital the bank may need and whether it will be able to survive as a publicly held firm.

Until the economic meltdown, BOI enjoyed a comfortable position in Ireland, where it and its primary competitor, Allied Irish Banks, control some 70% of the country's concentrated retail banking market. BOI earns about 60% of its profits in Ireland, and we think this protected position, rapidly rising property values, and the bank's constant focus on efficiency were largely responsible for its historical ability to generate returns on equity at or above 20% year after year.

Now, however, falling property values and rapidly rising unemployment are pummeling commercial and residential property values in Ireland and forcing BOI to accept multiple rounds of government assistance. In March, shareholders approved the sale of EUR 3.5 billion of preferred shares to the government, which increased Tier 1 capital to 9.5%. In exchange for this assistance, BOI gave the government warrants to buy between 15% and 25% of the company at a deep discount to book value. When it became increasingly clear that this recapitalisation would not be enough to soak up loan losses, even with the additional EUR 1.5 billion BOI has agreed to raise, the government announced plans to create a "bad bank," the National Asset Management Agency, which will buy loans at a significant discount. While this will almost certainly help stabilise loan losses, it has created deep uncertainty about the banks' futures. The discount at which the loans will be bought will not be determined until midsummer, but the resulting losses are likely to drive the banks' need for more capital. While BOI is in slightly better shape than AIB, since only one quarter of its Irish loans are commercial and property loans compared with one third at AIB, we think both banks will probably need additional capital to absorb the losses and may have little choice but to turn, once again, to the Irish government for assistance.

We think the outlook is grim for BOI. While much of its lending looked conservative during the boom years by traditional measures such as loan/value ratios, Ireland's rapid deterioration means that its population may shrink and its property market may never fully recover. Moreover, clawback provisions in the bad-bank plan may leave BOI on the hook for larger-than-anticipated losses, even once discounts are agreed upon this summer. If BOI does need to turn to the markets or the government for more capital, the cost to shareholders is likely to be great.

Valuation

We are not rating Bank of Ireland at this time because of significant uncertainty about its future in the wake of falling asset values in Ireland. BOI recently accepted a EUR 3.5 billion investment in preferred shares from the government, while giving up warrants to buy 15%-25% of the firm, which increased its Tier 1 capital ratio to 9.5%. However, BOI plans to sell loans to NAMA at a discount that will not be determined until midsummer but that promises to be significant. We think that the resulting losses are likely to be high enough to force BOI to raise additional capital, either in the public markets or by turning to the government for additional assistance. Whichever route it chooses, existing shareholders are likely to be significantly diluted.

Risk

BOI has agreed to raise EUR 1.5 billion of new Tier 1 capital by the end of 2009 but has not announced how it plans to do so. Selling additional shares at today's depressed prices would dilute existing shareholders significantly. If the bank instead chooses to sell noncore assets, it would probably have to do so at depressed prices, thereby destroying value. Property values are deteriorating rapidly in Ireland, and about one quarter of the bank's Irish loans are in the especially troubled commercial property and construction sectors. BOI plans to sell many of these loans to NAMA at what will probably be a very significant discount. The resulting losses may eat deeply into BOI's capital cushion and force it to raise even more capital, possibly by turning to the government and significantly diluting existing shareholders' stake in the firm.

Strategy

Historically, BOI's core strategy has been to maximise profits from its strong position in Ireland, where it generates about 60% group profits, by offering a wide range of services and carefully controlling costs. Now, however, it is focusing on shoring up its financial health as its loan portfolios rapidly deteriorate.

Management & Stewardship

The management team is undergoing dramatic changes as the bank struggles to survive. We think BOI is in need of strong leadership and hope that the new management team will be able articulate a clear strategy shift for the bank. Chairman Richard Burrows has announced that he will not seek re-election in July; a successor has not yet been announced. Richie Boucher was appointed CEO in February after Brian Goggin, CEO since 2004, resigned. Boucher had been CEO of BOI's Irish retail bank, and we wonder whether an external candidate would have been a better choice. We're pleased that compensation has been cut dramatically for senior executives in 2009 and 2010 and that their bonuses have been eliminated. The company's directors currently own just under 1 million shares of BOI, about 0.1% of shares, which we think may not be enough to align their interests with shareholders'.

Profile

Along with its chief rival, Allied Irish Banks, Bank of Ireland dominates banking in Ireland. Through its 250 branches there, it offers an array of financial services, including retail and corporate banking, mortgages, and insurance products. In the United Kingdom, BOI offers mortgages and business banking and operates a consumer finance joint venture with the Post Office. BOI-UK specialises in niche businesses, such as nonprime mortgage and small-business lending.

Growth

BOI's loan book grew an average of 22% annually between 2003 and 2007 as Ireland's economy boomed. As part of the bailout, BOI has agreed to increased lending availability to small business and first-time home buyers, but we expect growth to be tepid though 2013.

Profitability

BOI's financial performance was impressive though fiscal 2008, with returns on equity averaging 22% annually, before tanking in fiscal 2009. We expect the bank to take large losses in fiscal 2010 and 2011 and do not expect it to revert to its historical profitability.

Financial Health

After the government's EUR 3.5 billion capital infusion, BOI's Tier 1 capital ratio was 9.5%, and the bank has agreed to raise another EUR 1.5 billion by the end of the year. However, we doubt that will be enough to absorb the losses BOI will take when it sells loans to NAMA and think it may need to raise even more capital.

Bulls Say

1. Ireland's rock-bottom 15% corporate tax rate makes it an attractive place to build businesses, which will help the economy to recover.

2. A smaller commercial and property loan portfolio means that BOI is in better shape than Allied Irish, its largest competitor.

3. BOI is poised to gain even more market share as Ireland's economy recovers from competitors that have been nationalised.

4. Selling loans to NAMA, Ireland's "bad bank," will allow BOI to start with a clean slate.

Bears Say

1. Bank of Ireland's competitor Anglo Irish was nationalised in early 2009, leaving shareholders with nothing, making this once unthinkable possibility seem very real for all Irish banks.

2. Property prices have fallen sharply in Ireland and the UK, and further increases in delinquencies are inevitable. At best, the bank will be forced to take large losses; at worst, it may be nationalised.

3. Ireland's unemployment rate is increasing rapidly, which may cause positive immigration trends to reverse. If the population falls, property values may fall further.

4. Ireland's rapidly growing fiscal deficit will limit the government's ability to stimulate economic growth.

Erin Davis is a Morningstar senior stock analyst. Morningstar's editorial policies prohibit analysts from owning stocks they cover.

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