Fortune REIT proposes acquisition and 1-for-1 rights issue; positive for ARA

ARA-managed REIT, Fortune REIT, has announced 1) the proposed acquisition of three suburban retail properties in Hong Kong for HK$2,039 mn (+23% to FRT’s AUM), 2) securing of debt facilities of HK$3.1 bn to refinance existing term loan facility due in June 2010, and 3) a 1-for-1 rights issue at HK$2.29/right to raise HK$1,889 mn (a 44% discount to the last trading price, a 28% discount to TERP of HK$3.2).

As the manager of the REIT, ARA stands to earn a one-off acquisition fee of HK$20.4 mn (S$3.8 mn, being 1% of the purchase consideration) and also HK$6.3 mn as Advisory Fee.

We leave our estimates unchanged for now as the deal is subject to EGM approval on 11 September and due to be completed around mid-October 2009. The acquisition could boost ARA’s AUM by 3% from S$12.6 bn, and its FY09E EPS by 10% (due to the one-off fees) and FY10-11E EPS by 3% (recurring AUM fees).

We continue to like ARA for its high cash generative and scaleable business model. With positive momentum at both REITs and private funds, it is on track to growing its AUM to S$20 bn from S$12.6 bn by 2012. Maintain OUTPERFORM.

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United Overseas Bank - hold with the results

Results review UOB reported a 21.8% decrease in core net earnings to S$470 mil (- 21.8%yoy, +15.0%qoq, 1Q09: S$409 mil) due to higher impairment charges but largely buffered by a steep decline in taxes. Effective tax rate for the quarter was 4.58% versus 20.1% in 2Q08.

Net interest income grew 3.9% to S$908 mil (+3.9%yoy, -4.3%qoq, 1Q09: S$949 mil) over the year as funding costs fell faster than asset yields. Net interest margin was higher at 2.35% as compared to 2.23% last year.

Non-interest income was unchanged at S$551mil as profit from other operating income, i.e. change in fair value of financial instruments, compensated for the lower fee and commission income.

Operating expenses were capped at S$520mil (+0.4 yoy, +5.9% qoq) as lower staff costs offset higher revenue related expenses. Cost to income ratio declined to 35.7%. Total impairment charges rose 158% over the year to S$465mil as collective impairment of S$321mil was set aside for loans, investments and foreclosed assets. Individual impairments more than doubled to S$151mil as Singapore impairments shot up to S$88mil as compared to a write-back of S$9mil last year.

Loans expansion slowed as gross loans expanded 0.1% in 2Q09 to S$100.3bil (+0.1% yoy, -1.7% qoq), driven by housing loans (+10.1% yoy) and professionals and private individual loans (+8.7%). However, the growth from these industries was negated by loans contraction in financial institutions, manufacturing and general commerce industries. Asset quality deteriorates as the Group recorded higher NPL of S$2.48bil and higher NPL ratio of 2.4% as compared to the 1.5% last year. Total cumulative allowances amounted to 100.0% of NPLs as compared to 128% last year.

Total CAR ratio increased to 17.5% with Tier 1 also higher at 12.6% from the issuance of Class E preference shares, higher retained earnings and lower riskweighted assets. The Bank also declared an interim dividend of 20 cents per share.

Macro economy improves The Ministry of Trade and Industry expects the Singapore’s GDP to contract by 4.0% to 6.0% in 2009, up from the previous estimate of –6.0% to –9.0%. This was largely due to an upward revision of the output estimate in 1Q09. Unemployment rate was also capped at 3.3% in June 2009 as Government introduced many initiatives for the employers to keep and retrain the workers. The two integrated resorts that are slated to open in 2010 will also provide employment opportunities and keep unemployment rate in check. With the property market heating up again and YTD consumer loans in Singapore growing at 3.81%, we are also revising our Singapore system loans growth in 2009 from –4% to 1%.

Recommendation As the economy improves in this Island state, we are lowering the market risk premium in our valuation to 6% from 6.5% we used during the financial crisis. Accordingly we adjust our target price to $17.00, peg to 1.61x FY09 NAV. However, this matrix valuation is a discount to the 5-year average P/B valuation of 1.64x NAV. Maintain HOLD rating.

OCBC - 2Q09 beats expectations

Following a 1.5% q-q decline, OCBC’s loanbook has contracted 2.6% YTD (sector: -0.5%) on a mix of weak credit demand and continuing repayments. Net interest margin was lacklustre, falling 13bps q-q to 2.29% as management moderated gapping activities despite a steepening yield curve (controls are slowly easing now).

Buoyant non-interest income (NII) (+22% q-q) was underpinned by a 25% q-q recovery in fee income (primarily capital market-related) and a doubling in life assurance profit, driven by valuation gains on 87%-owned life insurer GE’s non-par funds. Credit costs sharply undershot, at 76bps on an annualised basis (FY09F: 100bps) and with the bulk being for non-loan assets; gross NPL ratio inched higher (+30bps to 2.1%; mostly from manufacturing and transport in Singapore), while loan loss cover slipped below 100%, to 97%.

Apart from better-than-expected earnings momentum, OCBC should see a pick-up in book value from a S$640mn mark-tomarket gain on AFS securities – this equates to S$0.20/share and could expand over 3Q09F should equity and debt prices continue to rally. With insurance demand likely to gain traction over 2H09, and management indicating the inflow of new NPLs has slowed from 1Q09, our fee and credit cost assumptions are under review.

Our existing Gordon Growth-based price target (methodology unchanged, assuming 11% sustainable ROE, 9.5% cost of capital and 5% longterm growth) is S$8.10, implying 1.6x FY10F adjusted book value (1.4x stated book) and 12.5x FY10F earnings. Worsening credit conditions and another knock-on drop in property prices and demand would be a key earnings risk, given some 50% of the loan book consists of exposures to mortgages and building & construction loans. While we are relatively comfortable with the Singapore loan book (59% of total book) given the relative strength of domestic corporates and the broad lack of leverage in the system, the Malaysian book (19% of total) looks more vulnerable and could surprise negatively if execution of the sizeable fiscal stimulus measures aimed at cushioning the economy from the downturn is poor, or if commodity prices collapse.

Ready to Sing- upgrading price targets, UOB to Buy

Despite recent share price strength, we see further upside from current levels. A more benign economic outlook suggests earnings upside in '10e and beyond, on improved revenues and falling loan losses. This is only partly captured by our 5-6% EPS upgrades. And given our analysis of historical trends suggests 20%+ upside to current valuation multiples, we think investors should be overweight the sector. DBS is our key Buy (23% TR upside) while we also upgrade UOB to Buy (18% TR upside) with price targets raised across the sector.

Our analysis of historical trends indicates Singapore banks tend to deliver strong absolute and relative share price performance in the year following a trough in GDP growth. The sector typically trades at a premium to average PB and PE multiples post recession, reaching an average 1.9x within one-year post downturns in 1998 and 2001, roughly 27% above current levels. In PE terms, while the premium to average is less pronounced (5% above 15.7x ave. post3Q98 and 3Q01 trough) this still represents 18% upside from the current sector PE of 13.9x.

With the fall in equity markets reducing total sector income by 5% in 2008 we see scope for revenues to rebound materially as a result of improving market conditions. And our analysis suggests loan losses should normalise rapidly as the economy recovers. Within 2-3 years of the 3Q98 and 3Q01 GDP troughs Singapore loan loss rates fell to 16bps and 19bps respectively, well below the 45bps sector’s 2000-08 average (69bps 2008) . Applying the 45bps average rate to 2010e loan forecasts implies earnings 16-22% above our previously published estimates. This upside is partly captured by our 5-6% upgrade to 2010e EPS across the board, but still implies a further 10-16% EPS upside should loan losses return to average levels. And given loan loss rates typically ‘overshoot’ average levels as the cycle matures, medium term EPS benefits could be even greater.

TP’s raised for DBS ($16.50 from $14.50), OCBC ($8.10 from $5.80) and UOB ($20.30 from $14.50). Valuation based on Gordon growth model with COE 7.5% and terminal growth 2% revised up from 0.8% to better reflect long term GDP growth prospects. We now base ROE assumptions on explicit three-year forecasts, compared to previous methodology which reflected estimated sustainable ROEs. Note book value estimates exclude the benefit of unrealised revaluation gains. Key sector downside risks are a downturn in investment markets adversely impacting market-sensitive income, and worsening asset quality as a result of a worse-than-expected global economic slowdown. Key upside risk for OCBC is if there is a further narrowing in CDS spreads, driving higher book values (details pp 14-16x).

Singapore Exchange - FY09: The future is more relevant

Singapore Exchange’s (SGX) FY09 net profit dropped 36% yoy to S$306m. The results were in line with our expectation. ADT dropped 42% to S$1.23b in FY09, leading to 34% yoy decline in revenue from the equity market. Nonetheless, SGX staged a major comeback in 4QFY09 with 65% qoq increase in net profit as ADT surged 84% qoq to S$1.68b.

While our assumed turnover velocity remains largely unchanged at 96.2% (vs 108.1% in May 09), total market capitalisation for shares listed on the SGX rose from S$533b at end-Jun 09 to S$605b at end-Jul 09. Hence, we lift our ADT assumptions for FY10 (from S$2.03b to S$2.24b) and FY11 (from S$2.13b to S$2.31b). As a result, we raise our FY10 and FY11 earnings forecasts by 13% and 12% respectively.

We raise our target price from S$9.50 to S$10.80 (23.6x FY10 PE). The 23.6x PE is the average between the historical average PE and the average of the highest PE for every fiscal year since SGX’s listing. While the A-share and H-share markets have stronger appeal to China enterprises than SGX (due to valuation gap and stronger market liquidity), SGX’s successful diversification strategy, as evident from its non-Singapore derivatives offerings, should ensure long-term growth. As our revised target price represents 27% upside from the current level, we upgrade the stock from HOLD to BUY.

SGX - 4Q09: marginally below

Average securities daily value traded (DVT) in 4Q jumped 85% q-q to S$1.7bn, taking FY09 DVT to S$1.2bn as per Nomura forecasts. Our FY10F securities revenue forecast imputes DVT improvement, to S$1.6bn — this is where FY10F YTD DVT currently stands, which, we believe, is relatively light given the strong rise in benchmark indices, ie, risk of DVT undershooting should the market pull back. We estimate every 10% change in DVT (assuming no change in effective clearing fee) moves forecast earnings by just over 5%.

Derivatives and stable revenues, together 50% of operating revenue, underperformed. Traded contracts saw broad rebound over 4Q but at shallower pace than expected, while stable revenue remains hobbled by weak corporate activity and IPOs, the latter standing at just 15 for the whole of FY09 compared to 60 in FY08.

New products (eg, OTC clearing, single stock futures) and the accompanying infrastructure (ie, new trading, clearing and data engines) are delivering positive, increasingly diversified revenue traction (eg, algo trading is now 21% of derivatives volumes vs 14% in Dec) but progress remains incremental. While opportunities in areas like CDS clearing and dark pools are being explored, SGX will remain hostage to DVT expectations well into the medium term.

We derive our price target using a P/E-based method derived from the Gordon Growth model. With market equity risk premium and stock beta pegged at 6% and 1.6x respectively, we estimate cost of equity of 11.5%. We derive a fair P/E of 19x, which when applied to FY10F (June year-end) adjusted net profit of S$415mn, gives a fair value of S$8.0bn. On the current share base of 1,072mn shares, this comes to a price target of S$7.40. Risks include another slump in market sentiment, which would depress trading interest and hence, clearing fees. A pick-up in regional competition for listings and derivatives contracts would stunt SGX’s growth appeal, given its drive to become the region’s primary pan-Asian listing and derivatives market. Finally, an SGX participant defaulting on its obligations could potentially threaten the entire system though this risk is mitigated by imposition of safeguards ranging from position limits and circuit breakers to margin requirements.

UOB: Signs of improvement; upgrade to $17

Net earnings of S$470m were ahead of consensus. UOB posted 2Q09 earnings of S$470m, down 22% YoY but up 15% QoQ, and better than S$426m based on a Bloomberg poll. Earnings for 1H09 fell 22% to S$880m due mainly to higher impairment charge, which rose sharply from S$180m in 2Q08 to S$378m in 1Q09 and S$465m in 2Q09. About S$321m was set aside for loans investments and foreclosed assets in the quarter. Net interest margin of 2.35% was better than 2Q08's level of 2.23%, but was down from 2.41% in 1Q09. Customer loans grew modestly, up 0.4% YoY (down 1.9% from the previous quarter) to S$97.8b by end-Jun 2009. Management has declared an interim tax-exempt dividend of 20 cents which will be paid on 2 Sep 2009.

NPL rose for another quarter. While most ratios were healthy, nonperforming loans (NPL) rose from S$1547m in 2Q08 to S$2185m in 1Q09 and hit S$2476m in 2Q09. NPL ratio also increased from 1.5% to 2.1% to 2.4% for the same periods. With uncertainty still a factor in the market, this ratio is likely to edge up slightly in the current quarter. Economic prospects are improving. The recent pick-up in equity markets should help to beef up fee income and associates contribution for 3Q09. In addition, improving key economic indicators from the US and China are signalling that the world economy is recovering. In Singapore, recent sharp appreciation in property prices is also indicating that loan demand is getting stronger. While we are cautious about impairment charges, we believe that 2Q09 should be the peak and it should start to taper off in the coming quarters.

Retain HOLD, raised fair value to S$17. With the more buoyant outlook, we have raised our earnings for FY09 and FY10 by 15.4% and 10.6%, respectively, to S$1978m and S$2274m. We continue to like UOB for its prudent management stance as seen from its low cost-to-income ratio of only 36%. While demand is showing signs of picking up, sustainability remains unclear. Against this backdrop, we are reluctant to revert back to peak valuation methodology (of more than 1.8x book). However, we do take note of the recent re-rating in the market, and we are raising our peg from 1.5x to 1.7x book, increasing our fair value estimates from S$14.70 to S$17. Maintain HOLD rating on the stock.

OCBC - profit beat from provisions and insurance; already priced in

Event: OCBC reported 2Q09 profit of S$466 mn, up 26% QoQ/22% YoY, ahead of our forecast of S$398 mn and consensus of S$357 mn. Beat came from lower provisions and higher insurance income (from investments), helped by better-than-expected fee income and good control on costs.

View: Key earnings drivers (loan growth, margins, NPLs) remain soft and the main factors behind earnings revision are lower provisions and higher trading income, both relatively inferior quality. 2Q09 performance was robust but boosted by capital markets (fee, insurance) and volatility (trading). In terms of key drivers, OCBC managed to maintain loan spreads but overall margins were down QoQ and are likely to remain at current levels. Loan book is not really growing while NPLs continue to creep up, albeit at a slower pace. Fee income and insurance should hold up in 2H09, but insurance would be hit by a S$218 mn liability in 3Q09 on early redemption of CDOrelated structures sold by insurance subsidiary to retail investors.

Catalyst: CDO-related loss in 87%-owned Great Eastern Holdings could create a drag. Other than that, we do not see any major catalyst near term, unless the economic recovery leads to strengthening of earnings drivers. An interesting angle would be whether OCBC takes this opportunity to make a general offer for the remaining 13% stake in Great Eastern Holdings.

Valuation: OCBC’S 1.6x P/B 2009E and 17.4x P/E 2010E correspond to a range of 10.5-11.0% ROEs, which is what we are forecasting for 2011E and using for our new target price of S$8.0 (from S$6.5), hence the upside is relatively limited, in our view. OCBC has doubled from the March lows but has underperformed peers.

UOB: Stillbuilding up reserves

Mild upside surprise. 2Q09 net profit of S$470m (+15% q-o-q) was driven by non-interest income and one-off recognition of deferred tax assets. Collective impairment continued to rise while specific provisions edged down. Provision charge-off rate up to 1H09 was 87bps (63bps from collective impairment). NPL ratio inched up to 2.4% led by manufacturing, general commerce and financial institution sectors. NIM compressed by 6bps due to lower asset yields and interbank rates, coupled with 2% loan contraction q-o-q. Deposits shrank 2% q-o-q with lower fixed deposits, and loan-to-deposit ratio was flat at 84%. Capital ratios were higher due to lower risk weighted assets. An interim 20 cents DPS was declared.

Lower FY09F earnings, but raised FY10F/FY11F. We raised our collective impairment assumption, which raised over-provision charge-off rate for FY09F to 108bps, from 85bps. We raised NIM by 10bps, but reduced loan growth to 3% for FY09F. Non-interest income is raised to reflect improved capital market activities. All in, we cut FY09F earnings by 4%, but FY10F/FY11F earnings are raised by 13%/27% mainly due to lower provisions. We also revised estimated book value to reflect the adjustments to its AFS portfolio.

Maintain Buy, TP raised to S$18.60. UOB’s result is less impressive than OCBC’s, but we believe the key catalyst to UOB’s valuation lies in the normalization of its book value. In the longer term, UOB’s ROE of 13% stacks up better than its peers, hence our preference for UOB over OCBC. Our revised target price of S$18.60, based on the Gordon Growth Model, implies 1.6x FY10F P/BV (mid-cycle valuation).

ARA Asset Management: Revving its growth engines

Results showed resilience. ARA Asset Management (ARA) reported a stable set of 2Q09 results. Gross revenues climbed 23% yoy to S$20.6m as a result of (i) a stable AUM base and growing performance fees from higher NPIs from its listed REIT vehicles, (ii) 3rd closing of Dragon fund back in June 2008, (iii) one-off S$2m gain from selling of certain units in its managed reits for working capital purposes. Net profit grew by 35% to S$11.9m due to a lower than expected increase in operating expenses. For 1H09, the board declared an interim dividend of 2.3 Scts (higher than 1H08 of 2.17 Scts), translating to a payout ratio of c60%.

In view of the higher than expected operating margins, we have revised up our FY09 EPS by 14% to 7.6 Scts.

Re-rating catalysts - further possible avenues for AUM growth. ARA is set to resume its AUM growth trajectory. A new PE fund targeted at the healthcare sector may be launched in the near term. We estimate total AUM size for this fund to be US$500m, to close by 1H10. In the REIT space, we could potentially see new developments given the more buoyant and improving liquidity in current capital markets.

Contribution from the new PE fund could add 1 Scts EPS assuming full year contribution. This would increase our EPS estimates to 8.1 Scts in FY10 and 8.5 Scts in FY11.

Maintain BUY, TP adjusted to S$1.02 based on SOTP. Our TP is adjusted higher mainly as a result of new fund contribution in 2010. Further upside potential will derive from ARA (i) launching new REITs & PE funds, (ii) larger than projected AUM for its new PE fund.

OCBC - 2Q09 Profit S$466m Ahead of Forecast on Lower Provisions

2Q profit ahead of Citi 2QE S$400m: Near flat qoq pre-provision profit lifted by sharply lower provisions charges drove a 26%qoq rise in net profit (1Q: S$370m excluding one-time items, reported S$545m). Pre-provision profits saw lower net interest income on a 13bps qoq fall in margins but stronger markets-driven fee income. Provisions charges at an annualized 53bps (1Q: 99bps) of net loans reflecting the bank's view that inflows of new NPLs have slowed. OCBC estimates that it will suffer a negative impact of about S$218m in its 3Q09 result from Great Eastern's decision to redeem S$594m of its "GreatLink Choice" product.

2Q09 profit S$466m, +26%qoq: (1Q recurring: S$370m, less one-time life profit of S$175m net of tax). 2Q09 NII S$710m -4%qoq: Loans -1.5%qoq, NIM 229bps (1Q: 242bps). Loan-to-deposit spread 2.81% (1Q: 2.79%), LDR 82%. Non-II 2Q S$494m (1Q: S$432m excluding one-time profit S$175m) +14%qoq, fees S$194m (+25%qoq), insurance earnings S$157m, other income S$143m (1Q: S$155m) on lower FX/dealing income. Costs S$450m, +9%qoq, on higher insurance-related costs. Provisions S$104m (1Q: S$197m). NPL ratio 2.1%, coverage c97%. Tier-1 ratio 15.4%. 2Q09 annualized EPS S$0.56 (1Q recurring cash EPS S$0.48), BPS S$4.94 (1Q: S$4.75).

2Q09 provisions S$104m: annualized 53bps of loans (1Q: S$197m, 99bps): S$44m specific loan provisions, S$55m other assets impairment, S$5m general. 1Q included S$94m allowances for corporate CDOs.

Total CDO portfolio S$255m (1Q S$305m): ABS CDO portfolio S$95m is 100% provided. The S$160m corporate CDO portfolio has cumulative allowances of S$95m, and including S$65m of cumulative mark-to-market losses previously recognized to the income statement, in effect full provision has been made. Credit rating of total CDO portfolio as of Jun-09: BB: 23%, CCC: 57%, CC:20%.

GreatLink Choice redemption: Great Eastern is making a one-time redemption offer to policyholders of this product. The 5 tranches of this product had invested premiums of S$594m, a Jun-09 NAV of S$217m, and coupons paid of S$48m. Making some assumptions on redemption, GEH will make an estimated S$250m provision (OCBC's share S$218m) to be reflected in 3Q09 results.

Singapore Exchange: Raised fair value to S$8.35

FY09 results came in slightly better than expected. Singapore Exchange Ltd's (SGX) posted FY09 earnings of S$305.7m (-36% YoY) which came in slightly above market expectation of S$297m (from Bloomberg). This meant 4Q earnings of S$91m, flat YoY but +65% QoQ. This was evidenced from the strong trading activities in May. FY09 revenue fell 23% YoY to S$594.8m, with declines in all three key segments; Securities Market Revenue -34%, Derivatives Revenue +0.2% and Stable Revenue -14%.

While IPOs and the average trading value fell in FY09, higher secondary capital raising activities helped to prop up the Securities Market. Total group operating expenses fell 5.6% YoY to S$227.6m, giving FY09 operating profit of S$367.3m. Management has declared a final dividend of 15.5 cents (quarterly base of 3.5 cents and a variable dividend of 12 cents), giving full year dividend of 26 cents (FY08: 38 cents), or a payout ratio of 90%. Based on yesterday's closing price, dividend yield is 3.0%.

Outlook is uncertain, but showing more positive signs. Although average daily trading volume has tapered off from May's peak, the recent rally has boosted interest and is a reflection of the growing confidence in the economy and the equity/derivatives market. IPOs are also slowly tickling back into the Singapore market. With the recent infusion of liquidity into the market, we expect this to translate into more capital market activities which will in turn buoy SGX's revenue. Taking into account improving economic outlook and better sentiment, we have raised our FY10 earnings by 6% to S$333m. In addition, we are also introducing our FY11 forecast and are projecting earnings of S$381m, up 14.5%.

Raised fair value to S$8.35. We do not expect the transition to the new CEO at the end of this year to bring about dramatic changes at SGX. We expect SGX's key drivers and objectives to remain on developing new products and growing its existing businesses (including working on more strategic working relationships). With the recent rally in the market, SGX and its regional peers have similarly been re-rated, and are trading at an average PER of 29x (range from 17-50x). We are raising our peg from 20x to 25x (but still below peak valuation of more than 30x), giving a fair value estimate of S$8.35 (previous: S$5.60). At current price, we are maintaining our HOLD rating on the stock.

Singapore Banks - The start of a new credit cycle

Accelerated growth in total deposits. Total deposits in Domestic Banking Unit (DBU) grew at an accelerating pace of 7.9% in Apr 09, 9.1% in May 09 and a double-digit rate of 11.7% yoy in Jun 09. Growth in deposits has been driven by demand deposits (current accounts) and savings deposits, which expanded 17.0% and 23.8% yoy respectively in Jun 09.

Deposit growth leads credit expansion. We surveyed economic cycles in the past 20 years and concluded that expansion in deposits typically leads expansion in loans, normally by 3-12 months. This happened in previous economic recoveries in the mid-80s, post-Asian financial crisis and post- SARS. As such, we expect current strong growth in deposits, a harbinger of a new credit cycle, to lead to stronger loans growth in 2010.

Loans growth a lagging indicator. Overall loans growth remains anaemic at 3.7% yoy. Growth is driven by loans to consumers. Housing loans expanded 1.5% mom and 7.5% yoy due to accelerated drawdown as more private residential projects received temporary occupation permit (TOP). Credit cards loans grew 4.2% mom and 7.1% yoy due to buoyant domestic spending during the Great Singapore Sale (GSS) in May and June. Loans to businesses lag economic recovery and increased only 1.8% yoy in Jun 09.

Strong growth in deposits reinforces our positive view on Singapore banks, indicating the start of a new credit cycle. Singapore banks face less competition as foreign banks retreat while an easing of the credit crunch provides positive industry dynamics. Systemic risk has reduced, paving the way for valuations to recover to pre-crisis levels.

We tentatively keep our earnings forecast unchanged because all three local banks will be announcing their 2Q09 results this week.

OCBC : 2Q09 Results Management Briefing Highlights

OCBC now at 1.6x P/B — A relatively muted price response to a better than consensus 2Q result suggests that the recent price rally had largely discounted a good result, with valuations already close to mid-cycle levels. Revenues were largely capital markets driven, while net interest income dipped on limited loan opportunities and softer margins. Management explained that the qoq rise in NPLs was due to some lumpy accounts, but that generally the new NPL trend is slowing. Rising equity markets lifted AFS reserves by S$580m (S$0.18/share)

Commentary — New NPL inflows have slowed across all key markets. The rise in 2Q NPLs, especially in Singapore, were due to some lumpy loans that were classified as substandard for early recognition but management do not anticipate losses from them. Loan growth is coming from mortgages and SMEs. Loan spreads may have peaked, but the near-term margin squeeze is from lower gapping profits. Management believes that the S$250m provision against the "GreatLink Choice" redemption will prove to be adequate.

2Q09 profit S$466m, +26% qoq — (1Q09 recurring: S$370m, less one-time life profit of S$175m net of tax). 2Q09 NII S$710m -4% qoq: Loans -1.5% qoq, NIM 229bps (1Q: 242bps). Loan-to-deposit spread 2.81% (1Q: 2.79%), LDR 82% (1Q: 87%). Non-II 2Q S$494m (1Q: S$432m excluding one-time profit S$175m) +14% qoq, fees S$194m (+25% qoq), insurance earnings S$157m (1Q: S$122m), other income S$143m (1Q: S$155m) on lower FX/dealing income. Costs S$450m, +9% qoq, on higher insurance-related costs. Provisions S$104m, 53bps of loans (1Q: S$197m, 99bps). NPL ratio 2.1%, coverage 97%. Tier-1 ratio 15.4%. 2Q09 annualized EPS S$0.57 (1Q recurring c ash EPS S$0.46), BPS S$4.94 (1Q: S$4.75).

OCBC - Gesture of goodwill from Great Eastern

OCBC’s insurance subsidiary, Great Eastern, will make a one-time redemption offer to policyholders for investment in GreatLink Choice (GLC), a series of investment-linked products with underlying investments in collateralised debt obligations (CDOs). The product has a built-in loss protection and is diversified across multiple industries and geographical regions. Unfortunately, market values for GLC products are at steep discounts to par (38.9-80.8% discount) due to credit events triggered by the global financial crisis.

Great Eastern will redeem 594m GLC units at $1.00 each. GLC policyholders taking up the offer will receive a refund based on their original investment amounts less total payouts received to-date, and the insurance coverage will cease. Great Eastern will take delivery of the underlying CDOs and will account for the fair value of these instruments at the close of the offer period.

This is a one-off gesture of goodwill to pacify Great Eastern’s loyal policyholders.

We expect investors to focus on the positive outlook for the banking industry. Local banks face less competition as foreign banks retreat while an easing in the credit crunch provides positive industry dynamics. Systemic risk has reduced and this paves the way for valuations to recover to pre-crisis levels.

Latest MAS statistics showed accelerated growth in total deposits of 11.7% yoy in Jun 09, indicating the start of a new credit cycle.

The financial hit will be incorporated in Great Eastern’s 3Q09 results and is estimated at S$250m. The negative impact on OCBC 3Q09 results is expected at around S$218m.

Maintain BUY. Our target price of S$8.12 is based on a P/B of 1.58x derived from the Gordon Growth Model (ROE: 11%, payout ratio: 48%, required return: 8% and constant growth: 4.5%).

Singapore Banks - June Loans Rise on Mortgage Growth

Singapore mortgage growth rose 4% YTD — Domestic system loans rose by 0.5% MoM (+4.2% YoY, flat YTD) to S$272bn as consumer/mortgage growth offset continued weakness in business lending (down 3% YTD). The completion in 2009 of an estimated 4,560 units under the DPS scheme and another 2,540 units in 2010 is likely driving mortgage drawdowns, with this year's pick-up in property transactions also likely to assist mortgage momentum in 2010. Loan-to-deposit ratio fell to 73.1% (May: 74.3%) as system deposits rose by 2.1% MoM to S$372bn (+11.7% YoY, +7% YTD), suggesting liquidity remains flush.

Sharp rebound in 2Q09 GDP — The 20.4% QoQ SAAR jump in 2Q09 GDP marks the first QoQ increase since 1Q08, and together with the upward revision to 1Q09 numbers will provide a statistical uplift to GDP numbers for rest of ‘09. Economist Kit expects GDP to contract 2.7% for ‘09 (vs. govt. forecast of -4 to -6%).

Banks, STI closing in on mid-cycle P/B levels — Our investment case for the banks is that Singapore will return to positive YoY GDP growth by 4Q09, so banks (and the STI) should normalize towards mid-cycle P/B levels. A rally of c.20% in 3 weeks has brought the banks (and STI) close to those mid-cycle P/B values. While we expect 2Q09 results (out first week of August) to surprise a bearish consensus on the upside, prices already may be factoring in strong 2Q results. If Singapore can pull out of recession in 3Q09, and the banks deliver 2Q numbers ahead of our above-consensus forecasts, then the recent rally might be sustained.

ARA Asset Management: Bagging a trophy asset

Growing its AUM. ARA Asset Management Ltd (ARA) announced its appointment as asset manager and convention and exhibition services provider for “Harmony Fund” post the fund’s purchase of Suntec Singapore International Convention & Exhibition Centre for S$235m. One of ARA’s managed reit – Suntec REIT, is a 20% stakeholder in this fund.

A strategic acquisition. We view this transaction as a strategic move for ARA as it will control both the convention centre and as manger of Suntec REIT - the adjacent office and retail mall. This will give ARA the free role in realizing the full potential of one of Singapore’s iconic asset amidst the re-making of downtown Marina Bay area with the upcoming Marina Bay Sands Resort.

Growing EPS by 10% in FY10. ARA is expected to earn management fees as asset manager & service provider for the fund, we project these fees to increase EPS in FY09 and FY10 to 6.6 Scts and 6.9 Scts respectively.

Maintain BUY, TP S$0.89. We have revised our valuation metrics to sum of the parts (SOTP) valuation, which is likely to reflect fully its strategic equity stakes in Suntec REIT and AmFirst REIT. Our SOTP valuation of S$0.89 offers 31% upside.

Singapore Banks - Firm loan recovery in June on mortgages, back to end-08 levels

While Singapore system S$ loan growth in June continued to slow on a yoy basis, +4.2% vs May’s 5.5% and December-08’s 16.6%, it was positive to see Singapore system S$ loans recover to end-2008 levels for June loans’ sequential growth of +0.5% mom. Growth was largely driven by mortgages, +1.5% mom, on an improved property market with property transactions reaching record highs in June, as well as new loans for completed properties under the Deferred Payment Scheme. Broadly, corporate loans were flattish, -0.1% mom, despite a 2.6%/2.5% mom fall in manufacturing loans/non-bank financial institution loans. For the first time since early 2008 on yoy basis, manufacturing loans fell, -5.2%. Building & construction loans continued to contract at -0.3% mom, down since last April. SME loans fell 0.9% mom, despite continued take-up of new loans under Singapore government’s risk-sharing lending scheme - April: S$1.1bn, May: S$0.8bn, June: S$0.8 bn. Consumer loans remained the most resilient, continuing a positive sequential momentum throughout the downturn, June +1.5% mom. As with the previous 4 months, every consumer sub-segment saw growth except for car loans. Asian Currency Unit (ACU) loans also grew 0.6% mom, but are down 6.6% yoy.

System deposits grew 2.1% mom on broad growth across both CASA (+1.6% mom) and fixed deposits (+2.7% mom). Fixed deposit growth in June was surprisingly strong, for the first time since end-2008 it saw growth on a yoy basis (up 2.6%). We note 3M SIBOR has stayed at 0.69% since February. Loan-to-deposit fell to 73.1% vs. May’s 74.3% on stronger deposit growth. Upside risk to our loan growth forecast; staying positive With the loan recovery in June, system loans are back to end-2008 levels.

While our forecast is for loans to stay flat this year, the recent improved property market, which has been supportive of this year’s mortgage loans, could pose upside risk to our loan forecast. We are maintaining our forecast, pending further evidence of stronger mortgage loan growth momentum. We forecast mortgage loans to grow 5% in 2009E vs ytd 4.1%. We retain our positive stance on Singapore banks, key catalyst to watch is 2Q results, which we expect credit losses to positively surprise in an NPL-light cycle. Our top pick is DBS (DBSM.SI, Buy, Conv List). Key sector downside risks: prolonged global recession; larger-than-expected NPL/credit costs.

OCBC: Most goodies priced in

Better than expected 2Q09. Net profit was S$466m (+26% q-o-q vs 1Q09 core earnings), ahead of street and our expectations due to lower provisions and higher non-interest income. Note that 2Q09 specific provisions fell 50% q-o-q. NPL ratio rose to 2.1% led by the manufacturing and general commerce segments. Loans contracted 2% q-o-q due to corporate loan repayments. The provisions set aside for Great Eastern¨s redemption of its GLC products would have offset the one-off item OCBC booked in 1Q09. Our FY09F net profit of S$1.4bn reflects core earnings. Interim 14.0 cents DPS was within expectation (scrip dividends is an option).

Tweaked assumptions. We raised our NIM assumptions by 4bps for FY09F and 5-7bps for FY10-11F, to reflect normalized SIBOR rates by end 2010. We lowered loan growth to 3% for FY09F (from 6%), but left FY10-11F loan growth at 6%. We also lowered our provision estimates by 3-10% for FY09-11F, leading to provision charge-off rates of 47-55bps for the same period. All in, earnings are revised by 4-23% for FY09-11F. We also revised our estimated book value to reflect the adjustments made to its AFS portfolio.

Goodies priced in. We believe the good news for 2009 has been priced in and to some extent 2010, too. We are downgrading OCBC to Hold, despite raising target price to S$8.00 after incorporating our revised earnings and book value. Our target price, based on the Gordon Growth Model, implies 1.6x FY10F P/BV (mid-cycle valuation).

DBS - Competitive advantage from strong deposit franchise

With huge base of savings deposits and largest exposure to the interbank market, DBS is prime beneficiary of recovery to positive GDP growth and higher SIBOR. Well positioned to expand in home base Singapore. Maintain BUY.

DBS Group Holdings (DBS) is a high-beta play on the eventual economic recovery, which is usually accompanied by higher interest rates. High-beta play on eventual economic recovery. DBS derives the bulk of its funding from savings accounts (DBS: 42.5% of customers’ deposits, OCBC: 19.2% and UOB: 22.0%), a stable and low-cost source of funding. It was the largest lender with S$28.3b parked in the interbank market as at Mar 09 (OCBC: S$14.5b and UOB: S$12.3b), equivalent to 10.5% of total assets. Current earnings have already factored in a depressed SIBOR. Net interest margin (NIM) will rebound when Singapore recovers to positive GDP growth, bringing about a higher SIBOR.

Streamlining for greater efficiency. DBS has cut headcount, streamlined its organisational structure and “de-risked” its treasury operations. There is latent growth potential in Singapore as the bank’s Singapore-dollar loan/deposit ratio (LDR) was only 57.4% as at Mar 09. It is a leader in providing financial services to large corporate and institutional clients and could expand market share in SME and consumer lending. DBS has instilled discipline in cost management and its cost/income ratio fell from 44.3% in 2006 to 38.4% in 1Q09.

Conservative classification of NPLs. DBS adopts a conservative approach in recognising non-performing loans (NPL) and taking provisions early. About 34.2% of its NPLs are not overdue (still current in interest and principal) compared with 16.7% for OCBC and 17.1% for UOB. This indicates that DBS is more stringent and conservative in the classification of NPLs.

We have raised our assumptions for loans growth to 7.8% for 2009 (previous: 6.4%) and 8.2% for 2010 (previous: 4.9%) to factor in increased demand from property developers and housing loans. Demand from general commerce should also improve as confidence returns, particularly in Asia. We have assumed the bank’s NPL ratio will hit 4.0% by end-10. Our earnings model has imputed allowance for credit losses of 120bp in 2009 (unchanged) and 80bp in 2010 (unchanged). We raise our 2010 net profit forecast by 3.1% to S$1,934m.
Valuation is attractive with P/B at 1.18x, the lowest among Singapore banks (OCBC: 1.47x, UOB: 1.67x). Our target price of S$14.43 is based on a P/B of 1.36x, derived from the Gordon Growth Model (ROE: 9.5%, payout ratio: 55%, required return: 8% and constant growth: 4.0%).

OCBC 2Q09 Results Flash

OCBC reported net profit of S$466m for 2Q09. The results were higher than our forecast of S$398m due mainly to lower provisions for NPLs and higher trading income.

Loans contracted 1.5% qoq to S$79.2b due to repayment of short-term loans and term loans by corporate customers. Net interest margin contracted from 2.42% in 1Q09 to 2.29% in 2Q09 due to lower gapping income.

Fees & commissions grew 25.1% qoq to S$194m with growth from brokerage, wealth management, investment banking and loans-related activities. It also recorded positive net trading income of S$61m.

NPLs increased by 14.3% qoq to S$1,628m due to manufacturing, general commerce and transport & communications sectors. By geographical regions, the new NPLs came from core Singapore and Malaysia markets. It is important to note that the increases in NPLs came from loans that are not overdue. We take this as a sign of conservative management and prudence.

OCBC made specific provision of S$44m and general provision of S$5m in 2Q09, represeting total provision of 25bp on an annualised basis. This is lower that provision of 45bp in 1Q09. OCBC also made provision of S$57m for investment in debt and equity securities. Preserved healthy NPL coverage of 97.1%.

Management commented that the inflow of NPLs has slowed across key markets.

OCBC remains strongly capitalised with tier-1 CAR at 15.4%. Core equity tier-1 is 11.3% after stripping out preference shares.

OCBC declared interim tax-exempt dividend of 14 cents/share, representing payout of 44% on core net profit for 1H09.

UOB 3Q09 Results Flash

Net profit of S$470m in 2Q09 (+14.9% qoq) was above consensus estimate of S$421m.

Performance was boosted by net gain of S$34m from trading activities and investment income of S$141m from financial instruments and S$63m from available-for-sale assets.

NPL ratio has increased from 2.1% in 1Q09 to 2.4% in 2Q09. General provision of S$151m was similar to last quarter but UOB made a large general provision of S$321m for loans, investments and foreclosed assets.

Tax was only S$23m (1Q09: S$112m) due to deferred tax assets.

Available-for-sale reserve recovered by another S$1.2b. Thus, NAV/share increased from S$9.37 to S$10.14. Tier-1 CAR has also improved marginally from 12.3% to 12.6%.

Singapore Exchange - Strong recovery in the final quarter

Singapore Exchange (SGX) will announce its FY09 full-year results on 5 August. We expect net profit to drop 33% yoy to S$319m mainly due to a contraction in average daily turnover (ADT) from S$2.12b in FY08 to S$1.26b in FY09. Derivatives revenue was largely stable as the number of derivatives contracts traded on SGX was largely unchanged at 55.5m in FY09 vs 53.5m in FY08. Nonetheless, SGX staged a major comeback in 4QFY09 with an estimated 76% qoq increase in net profit as ADT surged 90% qoq to S$1.73b.

While our assumed turnover velocity in FY10 remains largely unchanged at 96.2% (vs 76.8% in Jun 09), total market capitalisation for shares listed on SGX went up from S$377b as at end-Mar 09 to S$533b as at end-Jun 09. Hence, we have to raise our forecast market turnover. We raise our ADT assumptions for FY10 (from S$1.43b to S$2.03b) and FY11 (from S.1.46b to S$2.13b). As a result, we raise our FY10 and FY11 earnings forecasts by 35% and 39% respectively.

We raise our fair price from S$7.00 to S$9.50 (23.5x FY10 PE). 23.5x PE was the average between the historical average PE and the average of the highest PE for every fiscal year since listing. As the current price represents only 10% upside, we recommend investors buy at a lower price. Entry price is S$8.20. Maintain HOLD.

SGX - more upside

We initiate coverage of Singapore Exchange Limited (SGX) with a BUY call. Our fair value of S$10.42/share implies an upside of 22.3% based on DCF - assuming a discount rate of 10% and terminal growth rate of 2%.

SGX’s sizeable derivatives business (35% of operating revenue for 9MFY09) differentiates it from other exchanges and gives it a more diversified and stable earnings stream. SGX’s futures & options business has been remarkably resilient even in the current slowdown.

Quarterly securities turnover bottomed in 3QFY09 and we expect a recovery in volumes in FY10. Turnover velocity rose to 88.2% for 4QFY09, higher than averages of 76.5% and 70.9% for FY08 and FY09 respectively. Increased algorithmic trading and higher retail participation are expected to drive future growth.

SGX now has a stable revenue stream (from membership fees, terminal & connection fees, price information fees and others) that is less susceptible to market trading volumes. This is expected to account for 22.4% of total operating revenue in FY10.

The appointment of a new CEO Magnus Bocker may accelerate SGX’s push into forming strategic partnerships and alliances with other exchanges. Currently, SGX has a 5% stake in Bombay Stock Exchange and Tokyo Stock Exchange has a 4.99% stake in SGX.

SGX’s advanced trading engines for securities & derivatives are a key competitive advantage. Its clear technology roadmap will ensure that it can support the increased needs of algorithmic and high velocity traders.

SGX has a strong balance sheet with substantial cash hoard (estimated at S$739mil as at June 2009). Given its strong operating cashflows and rising cash reserves, we will not be surprised if SGX pays a special dividend to shareholders in the near future.

SGX’s valuation is attractive on a regional basis. SGX’s prospective PEs of 23.8x and 20.3x for FY10 and FY11 respectively are below the averages of 28.1x and 24.5x for its regional peers even though its two-year EPS CAGR of 21.2% is higher (versus regional peer average of 9.6%).

Key risks include a possible decline in securities turnover. We estimate that an every 10% fall in securities volume will impact FY10 net profit by 7.7%. The threat of ECNs (including dark pools) should not be discounted but its impact is expected to be limited.

Singapore Financials Strategy - How Much 2Q09 Results Upside Is in the Price?

Banks, STI closing in on mid-cycle P/B levels: Our investment case for the banks is that Singapore will return to positive yoy GDP growth by 4Q09, so banks (and the STI) should normalize toward mid-cycle P/B levels. A rally of c.20% in 3 weeks has brought the banks (and STI) close to those mid-cycle P/B values. While we expect 2Q09 results (out first week of August) to surprise a bearish consensus on the upside, prices already may be factoring in strong 2Q results. If Singapore can pull out of recession in 3Q09, and the banks deliver 2Q numbers ahead of our above-consensus forecasts, then the recent rally might be sustained.

2Q09 results—consensus too bearish: Bloomberg consensus estimates for 2009E remain bearish on the earnings prospects for the 3 Singapore banks, implying a quarterly profit trend that is flat or lower than what was reported by the 1Q09 results. We see upside surprise for 2Q in two main areas: lower provisions as the NPL cycle appears to be far more benign than first thought, and a lift to book value/share from positive revaluation of AFS investments. We predict 2Q profits of DBS S$470m (+8%qoq), OCBC S$400m (+8%qoq vs. 1Q recurring profits) and UOB S$460m (+12%qoq). UOB should see the most AFS gain and BV/S lift.

Bank price rally may have factored in stronger 2Q expectations: With the banks closing in on our price targets (UOB surpassing), we believe the market is already factoring a strong 2Q earnings performance, particularly for UOB and to a lesser extent DBS. Our analysis suggests that if our 2Q forecasts are achieved, they are being priced in PER terms at the +1SD level for UOB and DBS, and at the +1SD P/B level for UOB. Only OCBC would be trading closer to mean PER and P/B levels based on Citi's 2Q09 profit estimates.

Singapore Exchange (SGX)—4Q09 (June) forecast profit S$89m (+61%qoq): From a cycle-low Mar 2009 qtr net profit of S$55.3m on ADT of S$900m/day, we expect 4Q09 (June) results to reach S$89.3m (annualized EPS: S$0.34) driven by the recent surge in May ADT to S$2.1bn. We expect the ADT for the June quarter to reach S$1.7bn/day, or near double that of the previous quarter.