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.

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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.

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.

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%).

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).

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.

OCBC Malaysia to sell Great Eastern products

OCBC Bank has launched a partnership with insurer Great Eastern in Malaysia to sell life insurance products through the bank's branches there. The deal will expand the reach of Great Eastern - a subsidiary of OCBC - in Malaysia. Under the partnership, OCBC's Malaysian subsidiary will distribute insurance products developed by Great Eastern Life Assurance (Malaysia) through its 29 conventional banking branches. Initially, OCBC Malaysia will distribute two insurance products from Great Eastern Life Assurance (Malaysia) - MaxMoney Plus and MaxMoney Back. 'Bancassurance is an important segment of our consumer banking business,' said Andrew Lee, OCBC Bank's head of global consumer financial services. He hopes to duplicate the success the bank has had in Singapore, through its cross-selling of insurance products from Great Eastern. Until recently, OCBC Malaysia was not allowed to sell Great Eastern's products - regulations there did not permit a foreign bank and a foreign insurance company to work together.

In late April, however, Malaysian Prime Minister Najib Razak announced several broad changes aimed at liberalising the country's financial services sector, including greater flexibility for foreign financial institutions to operate within the country. In particular, the government removed a restriction that prevented locally incorporated foreign insurance firms such as Great Eastern from working with banks there to sell insurance. 'Following the implementation of the new liberalisation rules, we can now work with our subsidiary, Great Eastern, in Malaysia to grow our bancassurance business there,' Mr Lee said. 'We look forward to transferring successful business models and product solutions from Singapore to Malaysia.' At OCBC's first-quarter results briefing in May, chief executive David Conner told reporters that Malaysia's plan to open up its financial services sector further to foreign players would open up new opportunities for the bank and its subsidiaries. He said then that Great Eastern would apply for a takaful or Islamic insurance licence in Malaysia, while OCBC would be keen to add to the 29 bank branches it has there.

OCBC is the most well capitalised bank in Singapore

OCBC is a prime beneficiary of the rebound in sales of private residential properties. It has the largest exposure to property developers, with building & construction accounting for 20.8% of total loans in 1Q09 (DBS: 14.1%, UOB: 12.5%).

We expect low probability of negative surprises from marked-to-market losses for non-participating funds at Great Eastern given an improvement in sentiment in the equity market. In Malaysia, Great Eastern will be able to distribute insurance products through OCBC’s extensive branch network due to the liberalisation of the financial sector.

OCBC is the most well capitalised bank in Singapore with tier-1 capital adequacy ratio (CAR) at 15.1%. Given that the worst is likely behind us in terms of a Gross Domestic Product (GDP) contraction, OCBC could utilise surplus capital for reactivation of its share buyback programme.

OCBC - as solid as gold

Benefitting from surge in home sales. Sales of private residential properties have surged 240.7% yoy to 2,596 units in 1Q09 with buyers taking advantage of low interest rates and interest absorption scheme (IAS). Buying momentum continued unabated in 2Q09 and has reduced the risk of default by property developers. OCBC has the largest exposure to property developers with Building & Construction accounting for 20.8% of total loans in 1Q09 (DBS: 14.1%, UOB: 12.5%).

Steady contribution from life insurance business. We expect low probability of negative surprises from marked-to-market losses at Great Eastern for nonparticipating funds given improvement in sentiment in the equity market. In Singapore, domestic consumption has normalised and we expect sales of life insurance products to improve going forward. In Malaysia, Great Eastern will be able to distribute insurance products through OCBC’s branch network due to liberalisation of the financial sector.

Solid as a rock. OCBC is the most well capitalised bank in Singapore with tier-1 CAR at 15.1%. Given that the worst is likely behind us in terms of GDP contraction, OCBC could utilise surplus capital for reactivation of its share buyback programme or exercise option to redeem 5.1% non-cumulative class B preference shares of S$1b in July 2013. Management focuses primarily on organic growth and will expand regionally in Indonesia and China.

OCBC’s P/B of 1.42x is one standard deviation below its long-term average of 1.82x. BUY with target price of S$8.12 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%).

Our target price for OCBC is S$8

OCBC is Singapore's third largest bank by group assets (S$181.4bn as of Dec 2008). Its primary business focus is Singapore (67% of profit before tax) and Malaysia (25%), but in recent years OCBC has made investments in Indonesia, China and Vietnam. OCBC is a balanced corporate, SME and consumer bank, with a leading position in life insurance and public housing ("HDB") mortgages, plus an orientation towards the mass market consumer.

We rate OCBC Buy/Low Risk, with a target price of S$8 (from S$6.50). We are positive on all of the Singapore banks given our view that the Singapore economy is passing its point of worst contraction, and our strategist expects the Singapore STI could recover to the 2400 level. Past market cycles suggest that banks tend to lead an STI recovery as valuations normalize from trough levels, P/E multiples expanding in anticipation of earnings recovery. OCBC is typically viewed as the least operationally leveraged of its peers to economic recovery and rising interest rates, and conversely it has greater earnings resilience in a less favourable outlook and falling short-term rates, in part due to its capital strength and diversified earnings.

Our target price for OCBC is S$8. (1) Using a dividend discount model (DDM), assuming a 2009E net DPS of S$0.28, cost of equity of 9.8%, and a long term growth rate of 6.3%, gives a fair-value P/E of 15.8x 2009E, which when applied to our 2009E EPS of S$0.51 derives a fair value of S$8, which equates to a 2009E P/B of 1.6x (vs. 10.7% ROAE). We use DDM as a primary valuation tool, as we view it reflects sustainable earnings, dividend growth and excess returns relative to cost of equity, and also factors in liquidity/sentiment impact on valuations. It is also consistent with the methodology underpinning our P/E investment cycle analysis framework. (2) Using our P/E cycle analysis, which suggests an average trough-peak P/E range for the Singapore banks of 11-18x (for OCBC 12.4-17.6x, average 15.0x) on one-year forward consensus estimates, our target price P/E is above the cycle mean for OCBC.

We rate OCBC Low Risk to reflect the capital strength and financial regulation of the Singapore bank sector. This is in-line with our quantitative risk-rating system, which tracks 260-day historical share price volatility. Possible downside and upside risks to our target price include: 1) the extent of impact of the US/global economy on Singapore's domestic economy and job growth; 2) the level of short term interest rates and shape of the yield curve (generally lower S$ SIBOR is at the margin positive for OCBC, and conversely); 3) changes to the (currently benign) asset quality position and in turn provision charges; 4) market liquidity risk appetite; and 5) dividend policy and capital mgmt. These risks could impede the stock from achieving our target price.

OCBC - Strong pre-provision profit growth

Management remains cautious on the outlook and is still selective on lending activity. OCBC will focus on government-sponsored SME loans and high grade corporates in its lending business. Meanwhile, it has de-risked its securities portfolio by trimming exposure to corporate bonds and equities in favor of government bonds. We raise our price target to S$6.90 after rolling over our valuation base to 2010E. Our price target implies 1.4x Dec 10E BV and reflects 11% sustainable RoE, 9.1% cost of equity and a 4% long term growth rate.

1Q09 core pre-provision profit rose 24% YoY on robust net interest income and trading profits. But core net profit fell 26% YoY to S$ 325mn as provisions rose dramatically. Still, core recurring earnings were ahead of expectations, accounting for 25% of Reuters consensus estimates and 29% of BAS-ML forecasts.

Gross NPL rose to 1.8% (Dec 08: 1.5%) on weakness from manufacturing and building & construction loans. Most of the weakness came from abroad, especially from Indonesia and China. Management revealed that the spike in NPLs came mainly from two loans in the building & construction segment. Although the borrowers are still meeting their debt servicing obligations, they were reclassified as NPLs as one of them breached a loan to value covenant while the other missed a repayment, which has already been recovered. Loan loss coverage remains strong at 112% (Dec 08: 129%).

We have set our PO at S$6.90 using a modified Gordon Growth dividend discount model (DDM). Our PO equates to 1.4x 2010E P/BV, wherein we have assumed a 11% sustainable ROE, 4% long-term growth rate and 9.1% cost of equity. The key risk is volatility from exposure to the emerging markets of Malaysia and Indonesia. Also, OCBC has greater mass market consumer exposure compared with its Singapore peers for which it may suffer comparatively higher credit losses during economic downturns.