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Friday, March 4, 2016

Sector Update: Financial Services (Bank) - Sector ROE Yet to Bottom Out



Maintain Neutral, Public Bank as top pick

The 4Q15 results season, while mixed, reinforces our view that sector ROE has yet to bottom out with most banks guiding for lower ROEs ahead. We continue to see a challenging environment ahead for banks with: i) asset growth likely constrained by tighter liquidity and soft macroeconomic conditions, ii) NIMs still under pressure, iii) capital markets yet to recover meaningfully, and iv) higher credit costs ahead – all of which should keep bottomline growth muted, in our view. We keep our NEUTRAL sector call.


Banking sector

4Q15 a mixed quarter for the banks. Three out of the seven banking stocks that we cover reported results that were in line with our estimates. Affin and Hong Leong Bank (HL Bank) both missed our and consensus estimates with the main variances being weaker-than-expected associate contribution (Affin and HL Bank) and lower-than-expected net interest margin (NIM) (HL Bank). CIMB’s results were in line with our expectations but missed consensus estimates. Public Bank’s results exceeded our and consensus forecasts on the back of lower-than-expected credit cost.

Key takeaways:

i) ROE targets missed/lowered. For non-FYE Dec banks, Alliance Financial Group (AFG) said that its earlier ROE target would likely be missed, while AMMB and HL Bank lowered their ROE targets for FY16 by 100-150bps. For banks that reported 4Q results, expectations are for further ROE dilution ahead with 2016 ROE targets set at 100-200bps lower relative to 2015 targets.

ii) Credit costs set to rise ahead. 2015 credit costs for the larger banks, ie Maybank and CIMB, were both higher than our estimates due to the deterioration in asset quality for their overseas operations. For banks that are predominantly domestic-based, asset quality was relatively more benign. That said, we note from the guidance provided that expectations are for credit costs to rise ahead, in line with our expectations. Banks’ oil & gas exposure varied with retail-focused banks at less than 1%, while corporate-focused banks cited a 3 - 5% range. At this stage, the banks appeared comfortable with their exposure.


iii) Surprise improvement in capital ratios. Both Maybank and CIMB reported a surprising 100-130bps sequential improvement in their common equity tier-1 (CET-1) ratios. Reasons provided for the improvement include risk-weighted assets (RWA) management, asset disposals as well as favourable market trends (eg forex).

Bottomline growth remains challenging. We project underlying sector net profit to rise 4% YoY in 2016 (2015: flat YoY), led by stronger operating income. That said, banks earnings had generally disappointed in the past two years. Banks’ earnings are more sensitive to credit costs and NIMs, and we think downside risks to earnings would likely stem from these two factors. Key upside risks include benign asset quality, an upturn in capital market activities, and better-than-expected NIMs.

Investment case. We remain NEUTRAL on the sector, with Public Bank as our top sector pick.

4Q15 results dampened by higher tax rate

Three of the seven banking stocks that we cover reported results that met our and consensus estimates. Affin (AHB MK, SELL, TP: MYR1.80) and HL Bank (HLBK MK, SELL, TP: MYR11.00) both reported results that missed our and consensus estimates due to weaker-than-expected contribution from their respective associates (insurance associate for Affin while HL Bank was dragged by its China operations). HL Bank was also weighed by lower-than-expected NIM. CIMB’s (CIMB MK, NEUTRAL, TP: MYR4.50) results were in line with our expectations but missed consensus estimates. Public Bank (PBK MK, NEUTRAL, TP: MYR19.40) reported a strong set of numbers that was ahead of our and consensus estimates thanks to lower-than-expected credit cost.

Sector 4Q15 net profit was flat QoQ and YoY, mainly due to a higher effective tax rate during the quarter. At the pre-tax level, profit rose 3% QoQ and YoY with the QoQ increase aided by lower loan impairment allowances while YoY, net interest income rose 9% driven by balance sheet expansion. Stripping out staff separation costs, 4Q15 pre-tax profit was down 1% QoQ (seasonally higher opex) but up 6% YoY. 4Q15 trends of headline items are set out as below:

i) Net interest income: flat QoQ, +9% YoY. Loan growth ended 2015 on a weaker note – flat QoQ/+10% YoY vs 3Q15: +5% QoQ/+15% YoY – a reflection of weaker macroeconomic conditions, less favourable forex fluctuations and a deliberate slowdown of asset expansion due to tighter liquidity conditions and to preserve asset quality. Meanwhile, NIM was down an estimated 3bps QoQ (+2bps YoY) with the sequential drop due to higher funding cost (+10bps QoQ/-1bps YoY) from the seasonal competitive pressure on deposits in 4Q, together with issuances of capital qualifying debt securities.

ii) Non-interest income: +5% QoQ, +2% YoY. The QoQ growth was driven by stronger fee income but YoY, fee income fell 5%, reflecting weak capital market activities as well as loan-related fee income for some banks. YoY, the modest rise was from better trading income.

iii) Overheads: +2% QoQ, +7% YoY. Excluding costs relating to mutual separation schemes, underlying overheads rose 6% QoQ and 5% YoY. The QoQ trend reflected seasonal patterns while the YoY rise was partly due to adjustments for collective agreements. Underlying cost-to-income ratio (CIR) stood at 49% in 4Q15, vs 3Q15’s 47.3% (4Q14: 49.8%).

iv) Loan impairment allowances: -14% QoQ, +58% YoY. The significant YoY rise was due to higher provisioning made by Maybank and RHB during the quarter coupled with the swing from a net writeback in 4Q14 to a net charge in 4Q15 for banks such as HL Bank and Affin.

Key highlights from results

Below are highlights from banks’ recent reporting quarter:

i) ROE expected to trend lower
For banks that reported 4Q results, we note that 2016 ROE targets and guidance are about 100-200bps lower, when compared to respective targets for 2015. For the non-FYE Dec banks, management of these banks either guided that the FY16 ROE target will be missed or revised down targets. We set out in Figures 4-5 below a comparison of the numbers. Possibly, rising credit cost ahead could suppress ROEs.
ii) Credit costs on the rise
2015 credit costs for the larger banks, ie Maybank and CIMB, were both higher than our estimates due to the deterioration in asset quality for their overseas operations. For banks that are predominantly domestic-based, asset quality was relatively more benign. That said, we note from the guidance provided that expectations are for credit costs to rise ahead, in line with our forecast.
iii) Domestic asset quality still holding up well, for now
Banks’ oil & gas exposure varied with retail-focused banks at less than 1%, while corporatefocused banks cited a 3 - 5% range. At this stage, the banks appeared comfortable with their exposure. In terms of soft spots, opinions varied ranging from low-income individuals to property developers but so far, the banks do not expect the issue to be systemic.

iv) Surprising improvement from capital management initiatives
Both Maybank and CIMB reported a surprising 100-130bps sequential improvement in their CET-1 ratios. Reasons provided for the improvement include RWA management, asset disposals as well as favourable market trends (eg forex). As at end-Dec 2015, AMMB appeared light on the capital front but we believe there is scope for capital management initiatives. We believe the ratio of the group’s RWA-to-total assets is in excess of 70%, vs above 60% for CIMB and 53% for Maybank.

Risks

We think the key downside risk to our forecasts lies in sharper-than-expected deterioration in asset quality, which could impact credit costs. Apart from that, income growth is also a risk and this could be due to: i) weaker-than-expected NIMs arising from competitive pressures on both asset yields and funding cost, and/or ii) softer-than-expected noninterest income due to adverse market conditions.

Key upside risks include benign asset quality, an upturn in capital market activities and better-than-expected NIMs, which could be due to loan repricing and/or a surge in liquidity.

Forecasts

On a sector basis, the impact from the various revisions to earnings and updates post the full-year results were not significant (less than 1%)

We project underlying sector net profit to rise 4% YoY in 2016 (2015: flat YoY) on the back of operating income growth of 4% YoY.

2016 net interest income is expected to rise by a modest 4% YoY, with loan growth of 7% partly offset by 7bps NIM compression. Non-interest income growth is expected to be at a slower clip of 3% YoY as last year’s strong forex income (partly unrealised from forex positions) is unlikely to be repeated. We project loan-related fee income to moderate, in tandem with the slower loan growth ahead.

We expect 2016 operating expense growth to ease to 3% YoY, as the impact from the cost restructuring exercises in 2015 kicks in. This ought to result in the CIR ratio trending down to 47.2% in 2016F from 47.8% in 2015.

These, however, would be partly offset by higher loan impairment allowances (+21% YoY), as we project sector credit cost to rise to 40bps from 36bps in 2015. We expect 2016 sector EPS, however, to rise by a more modest 2%. This is due to dilution from 2015’s capital-raising exercises and ongoing capital preservation initiatives. Similarly, 2016 sector ROE is expected to be diluted further to 10.7% from 2015’s 11.3%, as sector leverage continues to trend lower due to the Basel III capital requirements

Investment case

Despite the challenging banking environment ahead, we are keeping our NEUTRAL sector call. The sector currently trades at 2016F P/E and P/BV of 11.7x and 1.2x, below their respective -1SD levels of 12.3x and 1.6x respectively.

While valuations may appear undemanding (sector P/BV is close to the global financial crisis (GFC) low of 1.17x), we believe that this is fair. This is as our 2016F-2017F ROEs of 10.6-10.7% are lower than the 12% ROE recorded during the GFC period.

Given the challenging macroeconomic environment, we like banks that offer strong and predictable book value growth to continue creating shareholders value. This would entail a combination of superior returns, sound earnings predictability (eg less reliant on marketsrelated income) and/or solid asset quality.

Also, banks with relatively lower market risk should aid in insulating book value against adverse bond yield and foreign exchange rate movements. Public Bank meets the criteria above and is our preferred pick, although we think upside potential may be capped by valuations that appear to have priced in much of the positives. Our least preferred pick is AMMB. The bank’s NIMs have fallen significantly (currently 1.97%) due to its portfolio rebalancing efforts, and are likely to continue drifting lower. We are concerned on the levels to which its NIMs have dropped, especially amid soft capital market conditions and a turn in the impaired loan cycle.

Source: RHB, 04 March 2016

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