Stockwatch: Upgrades for this "penny" share

It's easy to be put off by a penny stock, yet this leading retail/commercial bank is capitalised near €12.5 billion (£8.7 billion) despite trading at just over 37 euro cents. This relates to 32.3 billion shares issued, and while Bank of Ireland was indeed high-risk, it has been transformed by a restructuring and the strong Irish economy.

Ireland's largest lender

I initially drew attention as a speculative recovery buy at eight cents equivalent in November 2011, and the five-year chart shows market value nearly quintupling with Irish banks now a play on the country's 5% GDP growth expected this year. Ireland is enjoying an exports resurgence partly helped by the weak euro; also rising employment and confidence are supporting consumer spending and investment.

Bank of Ireland is the economy's largest lender and its UK operations are growing too. There's an aspect of double-edged sword to the UK recovery which attracts criticism for being debt-fuelled when the economy needs better balancing. Yet Ireland's progress with investment and exports is key to what's required. With the 2008 crisis now a distant memory, investors will more likely react to Irish banks benefiting from recovery and becoming more diversified. That loan applications are increasing from smaller businesses implies the upturn is widening.

Surprising on the upside

The bank has now twice beaten expectations when reporting. In 2014 it swung back into a €786 million net profit from a €486 million loss the year before - the cumulative effect of six years' work by a new chief executive to reduce the balance sheet, cut jobs and return some €6 billion to the government after a bail-out. Latest interims show continued improvements with underlying profit doubled to €473 million, new lending up 50% to €6.5 billion as UK mortgages rose from £0.6 billion to £1.3 billion, and defaulted loans down 25% from their peak.

It should all help in the quest to clear a remaining €1.3 billion, 2009 preference stock between January and July 2016: "After that, our intention continues to be to progress towards dividend payments." Besides a milestone in a turnaround, this should enable those institutional buyers prohibited from buying because their portfolio stocks must pay a dividend.

The trailing price/earnings (P/E) multiple appears pricey, testing 20 times earnings relative to about 17.5 for the European banking sector, in context of a return on equity of about 8% relative to 22%. The stock also trades on a significant premium to net tangible asset value (NTAV) per share despite rising from 21.4 cents at end-2014 to 24.0 cents, end-June 2015. So, with a while before dividends, this would appear to convey "high enough" on the stock, although the Irish economy may well help results to continue growing strong - thereby reducing the P/E multiple.

Hence, the chief variable how this plays out is most likely macro. Does anecdotal evidence of rising money supply portend further economic upturn - as monetarists believe - or should you pay more attention to deflationary signals from commodities and risks with China, as to what this implies about global trade? Bank shares tend to be sensitive to changes in the big picture, well before manifest in their financial reports. Possibly, there will be neither boom nor bust, instead a variable on-going improvement as the latest plunge in oil prices and other commodity deflation aids economic activity, quite like a tax cut.

Price target raised

Further to the interim results, broker Cantor Fitzgerald has upgraded its price target for Bank of Ireland to 45 cents from 43 cents, predicting faster-than-expected growth in the bank's UK loan book which will drive interest income. The analysts concede they over-estimated house price recovery in Ireland (helping the bank's write-backs) now the central bank has introduced stricter loan-to-value limits for mortgage lending.

Yet they expect the sharp improvement in the bank's capital position to continue with the Common Equity Tier 1 (CET1) ratio (a key measure of financial strength) rising to 11.1% from 9.3% at the end of last year. This should help the bank to redeem its preference shares (effectively, costly debt) which would provide interest savings and reduce the need to set cash aside - i.e. scope for higher-than-expected dividends, the analysts contend. They reckon on a 60% payout ratio by 2018.

Risk factors reducing

Customer deposits of €79 billion are funding over 90% of customer loans where the net interest margin earned has edged up from 2.15% in the second half of 2014 to 2.21% in the first half of 2015. This margin is expected to continue to grow modestly, helped by lower funding costs (if helped by the current ultra-low interest rate environment). A performance summary on page 10 of the interim results shows impairment charges down from €444 million to €168 million year-on-year, and "other income" up from €335 million to €545 million, which all benefit the risk/reward profile. It justifies why credit rating agencies have upgraded the bank's senior debt to "investment" grade, also helping sentiment towards the equity.

Occasionally "Brexit" is cited as a risk because Bank of Ireland runs financial services for the UK Post Office, with nearly 3 million customers. However, this is a standalone entity fully-funded in sterling. Just recently announced, a ten-year partnership with the AA will offer credit cards, personal loans, savings and mortgages, and further trusted UK brands are sought to extend this approach.

It would therefore take a seriously surprising downturn to jolt underlying progress and expectations. If you are pessimistic about deflation, debt, and how central banks can successfully normalise interest rates - then avoid financial stocks altogether. But assuming the Irish and UK economies continue modest growth, risk looks to remain on the upside as Bank of Ireland keeps raising its financial status.

For more information see: bankofireland.com.