Can Singapore banks achieve post-Asian financial crisis peak P/Bs again?

In May 2007, just before the credit crisis struck, Singapore banks traded at post-Asian-financial-crisis high P/B multiples (DBS 1.9x, UOB/OCBC 2.2x). In a detailed report, we analyse whether Singapore banks can reach those valuation multiples again.

To achieve those multiples again, DBS would need an ROE of 12.8% (CS 2011 forecast 10.2%), UOB 13.2% (CS 12.9%) and OCBC 12.2% (CS 11.0%) using Gordon Growth. So, even in 2011 (a “normalised” year), banks may not reach their recent peak P/B.

Although Singapore banks are enjoying some of the strongest consensus earnings upgrades among the Asian banks, 2011 profits are projected to be only marginally ahead of 1H07 (annualised).

We find bull-case ROEs in 2011 could be 1.5% higher than our base case. In that case, DBS would still fall short of the 12.8% needed to reach 1.9x P/B, while UOB/OCBC would be comfortably ahead.

UOB remains our top pick; while DBS should perform well when rates start rising. UOB is the highest ROE bank in Singapore and has built a sustainable 200-300 bp ROE lead over peers.

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Singapore Banking Sector: Turning the corner

Better set of results. Overall, 2Q09 results were better than expected. OCBC’s strong results were driven by higher non-interest income and lower specific provisions. UOB’s results were mildly better than expectations but still dragged by higher collective impairments. DBS’ results were also above street estimates. All banks declared interim dividends.

Sentiments improving. We gather that loan demand is back. Positive signs in the rejuvenation of housing loan demand were apparent in the Jun-09 banking stats where housing loans grew by 4.1% YTD. We also note that loan spreads for the corporate and SMEs have peaked while loan rates for consumer loans, especially housing loans, remain competitive. Specific provisions are starting to trend down although NPL ratios may still inch up. However, we believe the worst of spiking NPLs are over. We expect NPL ratio to peak at 3% for FY09. Capital ratios for banks remain robust.

Pegged to mid-cycle valuations; further upside depends on sustainability of capital markets and clear signs of macro recovery. Our target prices are still pegged to mid-cycle valuations based on FY10 book value. Further upside to our valuations would depend on the recovery in book values as credit market normalizes. Our preference lies with UOB as its valuation lies in the recovery of its book value. In the longer term, UOB’s ROE stacks up better than its peers. Maintain Buy for UOB with TP at S$18.60. Meanwhile, we have a Hold call for OCBC with TP at S$8.00 as we believe most good news have been priced in.

Singapore Banking Sector - Hold UOB, OCBC, Sell DBS

n the midst of the economic recession, Singapore system loans growth remained lackluster with total loans outstanding higher by 2.2% to S$271.8bn over the year. Business loans contracted 2.1%, as we believe lower economic activities caused many SMEs to reduce their short term financing. However, consumer loans managed to offset some of that contraction as it recorded resilient growth of 8.3%, boosted mainly from the housing loans.

We expect consumer loans segment to expand; especially the mortgage loans (70.3% of consumer loans, 31.0% of total loans) as the number of private properties transacted in Singapore remains elevated in 2009 despite the economic recession. Mortgage loans are usually disbursed over 3 years and thus provide a healthy loans pipeline for the Singapore banks.

However, we currently rate UOB and OCBC as HOLD and DBS as SELL. This is due to the recent run-up in the banks’ share prices and that the risk reward is not as attractive as before. UOB and OCBC are currently trading close to the 5 year average price to book ratio, whereas DBS is trading at a lower P/B valuation. The lower rating of DBS is due to the lower growth assumption, and lower ROE expectation relative to its listed competitors. Moreover, we believe that the increase in non-performing loans remains as a key risk shadowing the banking industry.

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.

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.

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.

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.

Singapore Banking - No major surprises seen

Interim results from 3 August. The 2Q09 results season will kick off with OCBC’s report on 3 August, to be followed by United Overseas Bank (UOB) on 5 August and then DBS Group Holdings on 7 August. We do not expect major surprises. Provisions will be the key swing factor. Overall, net profit (excluding one-off items) should show positive QoQ improvements in 2Q09.
Improvement in QoQ profit expected. Except for OCBC, we expect all three local banks to report a QoQ net profit rise in 2Q09. OCBC is expected to show a lower QoQ 2Q09 net profit because of its one-off S$175mil gain (net of tax and minorities) from the group’s 87%-owned Great Eastern Holdings recorded in 1Q09. Excluding this gain, OCBC should also see higher net profit in 2Q09 compared to the previous quarter. But 1H09 results of the three banks are still expected to show a YoY decline compared to 1H 2008 given much higher provisions made in 1H09.

Flat QoQ net interest income expected. Local banks are expected to report flat QoQ net interest incomes on the back of stable net interest margins and flat YTD loan growth. While interest spreads have widened on repricing of some loans, net interest margins may be weighed down by low S$ interbank rates in 2Q09. However, given a steepening in the positive yield curve (following the sharp rise in long-dated Government bond yields), there could have been opportunities for gapping profits in 2Q09.

Muted loan growth. We note that while industry housing loan growth has been very encouraging (+2.6% YTD as of May 2009), overall loan growth for the industry up to May 09 is still negative (-0.5% YTD). Lending to the commerce sector is still very weak, with YTD loan growth of negative 10.1% as of May 2009. But we think that with the downsizing in some foreign banks, local banks may have gained market share, particularly DBS. Hence, we think DBS would be likely to show highest loan growth among local banks.

Positive surprise may come from other income. Fees and commissions are expected to show marginal QoQ improvement as a result of higher brokerage income from more buoyant stock markets. One potential positive surprise could come from the banks’ other income or treasury income. We have been more conservative in our assumptions of local banks’ other income, which includes income from customer flows in interest rate and foreign exchange instruments - and the banks’ own proprietary book. Given the improvement in equity prices, these banks could have booked in higher gains from their trading portfolios in 2Q09.

Provisions could be lower-than-expected. Non-performing loans are expected to have risen in 2Q09 although we do not expect a sharp deterioration in the quality of the banks’ loan book. Local banks are expected to continue setting aside substantial provisions in 2Q09. But we think loan provisions for 2009 by DBS and UOB might be slightly lower - QoQ - given hefty amounts set aside in 1Q09. OCBC may report higher a QoQ rise in provisions given its low base in 1Q09.

Positive marked-to-market (MTM) adjustments. With the recovery in capital market prices since the lows in March 2009, we would expect to see positive marked-to-market adjustments for the banks’ available-for-sale portfolios in 2Q09. Note that any positive MTM adjustments to the banks’ AFS portfolios - in the case of UOB, which will be marked-to-model - would be made as a direct adjustment to equity and will help to boost BVs. UOB could possibly be the biggest beneficiary as it has the largest proportion of its AFS portfolio in equities and bonds (UOB: 60.2% as at December 2008 versus slightly more than 40% for the other two local banks).

Loan growth to pick up in 2H 2009. We expect loan growth in Singapore to improve in the second half of the year. One reason is that the buoyant sales in recent primary residential market launches (with 7,367 units sold in 1H 2009) will translate to loan drawdowns from 2H 2009 onwards. We would also expect loans to the manufacturing sector to pick up with the success of the Government’s sponsored SME loans under the SPRING scheme.

Reiterate our OVERWEIGHT call. We maintain our BUY calls on DBS, OCBC and UOB. Share prices of local banks are still below our fair values as derived from the Gordon Growth model. We think that there could be room for an earnings upgrade especially if the banks’ 2Q09 results were to turn out to be better-than-expected - and also if Singapore’s domestic economy continues to recover. We will soon be raising our GDP forecast to between -4% and -5% from an earlier forecast of -6% after Singapore’s positive 20% QoQ GDP growth in 2Q09.

Singapore Banks - 2Q09 results preview

Singapore banks report 2Q09 between 3-7 August. NIMs will improve YoY from better loan pricing and benign funding costs even though gapping profits will be absent from a flat yield curve. Non-interest income should see upside from the revival of capital markets. Yet our checks indicate still rising NPLs, which means credit charges will continue expanding QoQ. Here we expect OCBC to surprise on the negative. Wide Prime-HIBOR spreads should underpin a positive operational surprise for DBS.

Focus on asset quality and provisions
􀂉 Our checks with the Singapore banks point to rising NPLs, both domestically as well as in their overseas operations
􀂉 Recall NPLs increased 56% YoY in 1Q09 alone; with macro conditions remaining stressed we expect this pace to pick up going in to 2Q09
􀂉 The banks believe this NPL cycle will be drawn-out compared to the Asian Crisis given government backstops. Negative, as this means provisions will also be long
􀂉 Our key concern is OCBC, who saw aggressive SME loan growth in the bull-cycle Also, DBS whose North Asia exposure has been particularly vulnerable.
􀂉 Hence, expect credit charges to expand going in to 2Q. We expect FY09 to see 143bps vs. 65bps in FY08. Recall DBS saw 124bps and UOB 148bps in 1Q09 alone

Resilient NIMs
􀂉 Funding costs remained low in 2Q09, while banks have priced up their corporate/SME books especially in Singapore; positive for NIMs YoY
􀂉 The weak spot is Malaysia for both UOB and OCBC where Bank Negara has aggressively cut benchmark rates. Wide Prime-HIBOR should be a key DBS positive
􀂉 A relatively flat short end in the yield curve means limited gapping opportunities
􀂉 Hence, while we expect NIM growth to remain positive YoY, expect a slower pace
􀂉 Loan volumes should continue to retreat QoQ, with UOB the key laggard given Management’s conservative attitude

Positive on non-interest income
􀂉 With equity volumes up 83% QoQ expect brokerage to post a strong QoQ result
􀂉 Better valuations should also provide upside for fund management fees
􀂉 Rising equity valuations should provide upside in mark-to-market gains at Great Eastern. Recall 42% of the Life fund AUM is equities
􀂉 Volatility in FX, government and corporate securities will support trading income QoQ much like banks globally
􀂉 Yet domestic demand fees, especially wealth management, loan fees and trade fees should remain under pressure
􀂉 High QoQ government securities yields will see mark-to-market pressure on DBS’ and OCBC’s AFS books, although lower corporate yields should somewhat offset this

UOB top pick, SELL OCBC
􀂉 UOB remains our top pick given a better quality loan book. Hence a candidate for an early write-back cycle given the Group’s early provisioning strategy
􀂉 OCBC saw a jump in substandard NPLs in 1Q09 pointing to rising cautiousness. We expect this trend to strengthen driving higher credit charges QoQ. The only positive we see is Great Eastern, but this will not be enough to offset higher provisions. Hence we expect earnings risk to be on the negative for 2Q09. SELL
􀂉 Wide Prime HIBOR spreads and Management’s efforts to price up Singapore loans should see DBS surprise operationally. Provisioning though will be a wildcard

Singapore Banks May loans – still on a downhill

DBU loan growth (Exhibit 1) continued to contract to 5.5% y-y in May (April: 7.6%; March: 8.6%). The decline was attributed to the broad-based drop in business loan growth (Exhibit 10-13) which in the month of May suffered its seventh monthly contraction. Business loans contracted 0.1% m-m but grew 3.7% y-y (April: -0.9%; +7.3%). On the brighter side, consumer loan growth (Exhibit 4) remained resilient at 0.8% m-m or 7.9% y-y (April: +0.6%; +7.9%), largely thanks to solid housing loans following the recent revival of the local property market and more home completions.

ACU loans (Exhibit 2) recorded a 3.1% y-y contraction (March: -1.3%; February: +2.3%), primarily dragged by a continuation of the severe slowdown in consumer loans (May: -21.8%; April: -16.9%). ACU business loan growth also dipped into its first y-y contraction (May: -0.7%; April: +0.6%).

Massive liquidity remains a big plus – the loan-deposit ratio continued to hover around the 74% mark and there was excess deposits of SGD93.7b available in the system. Industry customer deposits have expanded by 4.9% YTD. Continued improvement in the deposit mix is another positive: the fixed deposit (FD) mix has now fallen to an all-time low of 46.8% (Exhibit 15). We expect the trend to persist as depressed FD rates and a buoyant equity market will encourage deposit migration to more flexible and liquid deposits such as current and savings deposits.

Trading close to its historical P/E mean, we think share prices have priced in an earnings recovery scenario and potential reversal of paper losses from investment books. Trading at mid-cycle valuation, banks do not look attractive and the initial re-rating may have run its course, in our view. We would await a pullback to regain entry. UOB remains our top sector pick for its more exciting ROE profile.

Singapore Banks Big Picture - Thoughts on Interest Rates and Margins Outlook

Tightening unlikely until 2010: The recent bond sell-off saw SGD 10-year prices fall 18% into mid-June, 10-year yields rising to 2.8% (end-June 2.6%), while short-term SGD rates remain near record lows. Our economists view this sell-off as overdone with limited inflation fears and the US Fed unlikely to tighten until well into 2010E. Low short-term rates hurt margins for DBS (less so for OCBC, UOB), but rising lending spreads and higher loan growth should add to DBS' margins as we progress through the year. Top pick remains DBS on relative valuation.

DBS most sensitive to rates changes: While a positive sloping yield curve implies gapping opportunities for all 3 banks, historic trends show persistently low short-term rates hurt margins for DBS (see Figure 1), due to a low LDR and higher holdings of low-cost CASA funds. We think the recent 18% fall in bond prices implies AFS (book value) adjustments rather than any direct earnings impact.

GDP recovery swifter than expected. With IP rising 1.2%yoy in the Apr-May period, Citi Economist Kit suspects 2Q09 advance GDP estimates could come in close to minus 4%, with a qoq saar jump in the high teens, reversing the 14.8% qoq saar plunge in GDP in 1Q09. Continued positive momentum in May NODX may suggest upside risk to our base case of Singapore coming out of recession by 4Q09.

May-09 monetary data. Domestic lending rose marginally (+0.3%mom, +5.5%yoy) to S$271bn. Weaker business lending (-0.1%mom) was offset by stronger consumer lending (+0.5%mom) on steady mortgage growth. Loan-to-deposit ratio fell to 74.3% as total deposits rose by 0.5%mom to S$365bn (+9%yoy).

Singapore Banks - Mortgages holding the fort, business lending declines in May

May-09 loan growth came in at 5.5% y/y for the industry, with personal loans clocking 7.9%. Business loans grew at a slower 3.7% y/y pace, while these loans contracted 0.1% m/m and 1.2% q/q. Details of loan growth are on page 2. Total loans, however, grew 0.3% m/m and 0.1% q/q.

Mortgages grew 8.8% y/y, 1.5% q/q and 0.8% m/m. In $ terms, loans grew by S$810mn m/m, with mortgages contributing S$627mn or 77% of the total growth. This is due to an increase in property transactions and completion of construction of apartments that were sold on a deferred payment basis in last few years.

Business loans have become a drag on overall loan growth this year, as against driving growth till late last year, per chart below. This change is due to continued risk reduction by banks as operating leverage becomes a concern for business credit.

Financials leverage related risks on business loans have diminished due to increased liquidity and revival of risk appetite. But we expect banks to remain in the risk reduction mode and closely ration business loan growth as operating cash-flows may remain sub-trend for an extended period of time.

We continue to expect DBS to lead industry loan growth, while OCBC may scale back mortgage loans due to low spreads. We expect UOB may reduce loans with higher capital charge (Asean, SME), while increasing mortgage loans (lower risk weight).

Singapore Banks - Differentiating Returns

Retain Cautious Industry View: While fundamentals are less bad, we see no reason to expect a sharp snap back in global growth. This makes Singapore vulnerable given its small, open economy and lack of domestic story. Our concerns over asset quality remain – credit cycles usually last at least two years and Singapore is still optimistically pursuing its over-build. We also have the inflation debate and US debt concerns. We missed this strong bounce, but from the risk reward on offer today, we see no reason to be more constructive on the sector. Moreover, with limited meaningful growth/ return options outside of Singapore, the sector looks to be headed back to the low return/ low growth phase.

Re-visiting return/ earnings power: Since 2001, the sector RoE has averaged 11.5% and peaked in FY07 at 13.3% with buoyant investment market related fees, wide margins and very low loan loss charges – the zenith of the global debt super cycle. Looking forward we see two years of elevated credit charges, as the recovery in growth is weak and troubled, and lower normalized RoEs with a less buoyant global economy. RoEs look set to trough at around 6% in FY10e.

Upgrade UOB to Equal-weight: Our analysis showed a structurally higher and more stable return profile – mean RoE of 12% with a standard deviation of 1%. We assess normalized RoE at 12%, 2% pts better than peers. UOB deserves a premium rating. Rudimentary investment arithmetic suggests 1.7x book vs 1.3x for DBS/ OCBC. We see UOB as a structurally higher return franchise less reliant on low quality investment markets.

DBS and OCBC remain Underweight: Our analysis showed structurally lower and more volatile return profiles. We assess normalized RoE at 10% for both banks. Lower core return power means a higher reliance on lumpy investment gains and very low loan loss charges … low quality and higher risk best suited to the halcyon days of the global debt super cycle.

Target prices increased for a reduction in the recession/ credit cycle discount: However, no change to earnings estimates. Asset quality remains critical.

DBS: TP - from S$8.00 to S$9.50
OCBC: TP - from S$4.10 to S$4.60
UOB: TP - from S$9.50 to S$12.50

Singapore Banks - Wait to pull the trigger

Banks performed in line with the market in June with stock prices falling by 5% vs a 4% decline in the FSSTI. We think there could soon be opportunistic entry points into the sector. At this stage, our top pick in the sector remains UOB. We see better entry points into DBS at 1x Dec 10E BV (S$10.65) and OCBC at 1.2x Dec 10E BV (S$6.15).

Recent checks suggest that the sector has held up well in the past 2-3 months. Specifically, revenues are still robust while overall asset quality has remained fairly stable. As a result, we raise our earnings forecasts by 6%-20% to adjust for higher non-interest income to reflect stronger fee income and capital market activity. Consequently, we adjust our price targets up by 1%-5%.

Recent financial market stability relative to the last two quarters should result in positive BV adjustments as banks mark-to-market their securities portfolios. While difficult to quantify, we think that a 30% write-back from what was written down last year is highly plausible, which could lead to a 2%-6% increase in BV.

Asset quality was stable QoQ in 2Q09 (1Q09 gross NPL: 1.8%-2.1%). At this rate, our gross NPL forecast (Dec 09: 4%) would seem too conservative. Nevertheless, provisioning charges will remain elevated as banks are likely to provide more for the sake of prudence. We still expect net provision charge of 1.5% of avg net loans in 2009E and 1.3% in 2010E. We think this is the key reason why our forecasts are 4%-11% below 2009-2010 consensus for OCBC and DBS.

With a stable SIBOR since Dec 08 (3-mth SGD SIBOR: 0.68%), we think NIMs have troughed. NIMs should remain stable to positive as loans are repriced on higher credit spreads. However, we believe this phenomenon is already largely expected by market watchers. Meanwhile, we continue to expect anemic growth in 2009 with low single digit loans growth at best.

DBS Group
Our S$12.50 PO (ADR PO: US$34.33) is derived using a modified Gordon Growth dividend discount model (DDM) that assumes an 10.5% sustainable ROE, 9.8% cost of equity and 4% long-term growth rate. At our PO, DBS would trade at 1.1x 2010E BV. Risks: (1) a slowdown in the Singapore and/or Hong Kong economies, which would depress loan growth, and (2) a sustained low SIBOR, which would compress its net interest margins. Upside risk would be a faster than expected upturn in Asian economies and markets.

OCBC BANK
We have set our PO at S$7.25 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.

United Overseas Bank
Our PO of S$15.55 (ADR PO: US$21.36) for UOB is based on 1.5x Dec 10E BV using a Gordon Growth dividend discount model. The fair-value PBV multiple reflects an 11.5% sustainable ROE, 4% long-term growth rate and 9.1% cost of equity assumption. Risks: (1) Regional macroeconomic and specific credit quality risks from its banking operations in Thailand, Indonesia and Malaysia, (2) banking franchise in Thailand could take impairment charges if the political and economic environment were to deteriorate, and (3) expansion into SE Asia represents a move out of its traditional core markets of Singapore and Malaysia.

Adjusting forecasts to DBS, UOB and OCBC

DBS

We adjust our FY09 and FY10 earnings forecasts upwards by 5% and 13% respectively, on an improved NIM and mortgage growth outlook (see Singapore banks: Bettering record margins; Well placed for property upswing dated 22nd Jun. 2009 for more details). We also marginally adjust upwards our market-sensitive income sources, given improved equity and creditmarkets. Our new 12-month target price, which is based on a Gordon growth model (ROE-g)/ (COE-g), is S$14.00, from S$12.80 previously.

Risks to this stock include the prospect of a dilutive acquisition, external shocks or operational risk such as DBS's hedging strategy and management's positioning on the bank's currency mix/duration of its bond portfolio relative to the yield curve. Another downside risk is the possibilty of losses on DBS' trading and investment portfolio, especially given the current volatile investment environment.

OCBC

We adjust our FY09 and FY10 earnings forecasts upwards by 6% and 6% respectively, on an improved NIM and mortgage growth outlook (see Singapore banks: Bettering record margins; Well placed for property upswing dated 22nd Jun. 2009 for more details). We also marginally adjust upwards our market-sensitive income sources, given improved equity and credit markets. Our new 12-month target price, which is based on a Gordon growth model (ROE-g)/ (COE-g), is S$5.80, from S$5.30 previously.

A downside risk is if economic growth significantly slows and asset qualityworsens, resulting in a rise in bad debt expense. Loan growth could also be hampered. An upside risk is if investment markets recover earlier than expected, thus benefitting OCBC's insurance income. Net interest margins could also rise by more than expected as corporate lending spreads rise.

UOB

We adjust our FY09 and FY10 earnings forecasts upwards by 9.8% and 7.3% respectively, on an improved NIM and mortgage growth outlook (see Singapore banks: Bettering record margins; Well placed for property upswing dated 20 Jun. 2009 for more details). We also marginally adjust upwards our market-sensitive income sources, given improved equity and credit markets. Our new 12-month target price, which is based on a Gordon growth model (ROE-g)/ (COE-g), is S$14.50 from S$11.30 previously.

Key downside risks to our valuation and target price are an adverse impact on loan growth and asset quality from a stronger-than-expected slowdown in the global economy and risk that asset quality problems will continue to adversely impact global financials. Key upside risks to our valuation and target price are an earlier-than-expected economic recovery, if regional governments start to guarantee the credit risks of SME loans, and if confidence starts to return to investment markets, with this benefiting market-sensitive income sources

What is the cost of a recession to Banks?

In a downturn, the main issue for banks is the cost of the recession—the level of provisioning necessary, and whether the banks can cope with that level. We studied 753 companies for this report. Our findings suggest upside risk to consensus earnings estimates, as provisioning is likely to be significantly lower than it was during the 1998 Asian financial crisis, despite this being a global recession. We believe this is a potential catalyst for further rerating.

To estimate the level of provisioning, we compared the 2008 balance sheets of companies listed on the Singapore stock exchange with 1996. We identified the stronger companies and the weaker ones using a scorecard we designed based on net debt-to-equity and interest coverage ratios.

We found that only 4% of companies were in the ‘stressed’ category in 2008 and 29% were in the ‘strong’ category. This contrasts with 7% and 16%, respectively in 1996. We believe the significantly smaller percentage of stressed companies, plus the current low interest rates, will cap provisioning to only 2.6% of loans. This compares with 5.2% during the 1998 recession. However, as in 1998, we expect the most stressed companies to be SMEs.

We expect all the Singapore banks to comfortably absorb the provisioning, but our top pick is DBS Group Holdings (DBS) as: 1) it offers exposure to the more dynamic Greater China region; 2) we expect it to take market share by using its new capital; and 3) it trades at only 1.11x P/BV.

Singapore banks: Rising NPLs will take a toll on earnings

Regionally, Singapore banks compare well on balance-sheet safety, boasting low gearing and high liquidity. However, for investors looking to reward growth, we believe the banks will disappoint as non-performing loans (NPLs) rise to levels similar to emerging economies resulting in negative earnings momentum, falling ROEs and an impetus to preserve capital. We Underweight Singapore banks with UOB our top pick.

Safe, liquid balance sheets. Regionally, Singapore banks’ balance sheets offer relative safety. Balance sheet liquidity is strong (77% loan-to-deposit ratio) compared to other developed markets such as Australia (118%), Taiwan (98%) and Korea (140%). Similarly, gearing levels are low with equity-to-assets at a healthy 8%, compared to peers in Australia (5%) and China (6%). But these ratios are particularly vital only for growth which is important in a recovery, but current macro conditions mean the medium term will be defined by the provisioning cycle.

Loan quality risks . . . Emerging-market style credit growth over the past two years means Singapore NPLs (3.7% FY09) will be akin to developing market levels (for example 4.1% in Indonesia and 5% Philippines). This is even higher than China (1.9% FY09) where lending growth is resilient (especially towards state-owned enterprises (SOEs)) underpinning a low NPL ratio. There are no such backstops for Singapore, where lending is focused on large corporates and small- and medium-enterprises (SMEs). Here banks have to take on individual credit risks rather than sovereign risk; hence the appetite for loan growth is limited. But FY08 total provisions to loans is at 2.3% for the sector; lower than countries with similar NPL levels.

Indeed provisioning levels in Indonesia (4.4%), Philippines (4.0%) and Malaysia (3.5%) are significantly stronger. As macro conditions continue to deteriorate, expect banks to aggressively build up provisioning. Note UOB (UOB SP - S$14.34 - BUY) and DBS (DBS SP - S$11.68 - SELL) were adding to provisioning from 2Q08 when macro conditions were significantly more benign. Even then we expect the FY09 provision cover to fall below 100% for the first time since 2006. Compare this with Indonesia which will see a provisioning cover of 147% and Korea at 133% in FY09. Hence, expect Singapore credit charges to be in the higher end regionally.

. . . will disappoint growth. While improving net interest margins and trading income are structural positives, regionally Singapore fares poorly in pre-provision operating profits to equity (19% versus HK: 25% and Indonesia: 38%). This is driven off low interest rates and a corporate biased lending book versus a higher margin consumer book in developing regional peers. In addition, expect headwind to fee income, which has a strong capital market component at c. 45% of non-interest income (excluding insurance). While in cost management Singapore is top-of-the-class, this isoffset by high credit charges (recall DBS saw 124bps and UOB 148bps in 1Q09 alone). This means FY09 earnings will contract -29% YoY vs. HK (+16%), Australia (+8%). While FY10 will see a modest recovery (+8%), this will still lag HK (+14%).

Remain Underweight. The sector trades at 1.3x FY09 PB, cheaper than history, but FY09-11 ROEs are 250bps lower than history, too. UOB is our only pick in the sector given proactive provisioning since 2Q08 which can potentially support an early write-back cycle. Similarly, the group’s asset quality is the strongest compared to peers based on recent Pillar 3 disclosure. With the lowest provisioning level amongst peers (2.2% vs. 2.5%) and a loan book which is c. 20% exposed to construction lending, we remain negative on OCBC (OCBC SP - S$6.78 - SELL).

Singapore Banks - Probability-of-default is at the high end

Pillar 3 disclosures by the Singapore banks show the probability-of-default on corporate/SME exposures is at the high-end, especially for DBS and OCBC. Credit risk mitigation, on the other hand, does not lower risks to the same level as the likes of StanChart. Together with worsening macro data (April bankruptcies and liquidations are at record highs), this does not bode well for asset quality. Hence expect credit charges to rise further, while ROEs will remain depressed. Maintain UNDERWEIGHT.

Probability-of-default is at the high end
- All three Singapore banks have provided Pillar 3 disclosure for the first time
- Other bank exposures and mortgage exposures are benign coming in at the lowest probability of default bucket for all three
- However, on corporate/SME exposure a dichotomy exists, with UOB having 82% of exposure in the lower risk bucket, while this is 40% and 35% for DBS and OCBC
- Their aggressive expansion in to SME lending during the boom years is a likely cause here. Recall OCBC grew SME customers by 15% YoY each in FY07 and FY08

Risk mitigation good, but not great
- Credit risk mitigation (CRM) lowers risk for assets under the foundation IRB category by 5-9% for the three banks
- Similarly, risks for assets under the standard approach are lowered by 4-11%
- While good, there is significant room for improvement to catch up with the likes of StanChart who is seen as far more aggressive than the Sing banks
- We believe this spells a more conservative lending attitude from the Singapore banks going forward

NPL cycle set to get worse
- The NPL cycle has only just started and hence will get worse as the cycle progresses; hence rising credit charges (143ps in FY09)
- Bankruptcies have risen 38% YoY in April; the worst since the data series began
- Pawn broker loans are up 16% MoM in February signifying rising levels of indebtedness away from the formal banking sector; this is a concern

Stay UNDERWEIGHT
- The sector is now at 1.4x 12-month forward PB vs. 1.7x long term, but long term ROE was 11%; we expect just 8.5% for FY09-11CL
- UOB is our top pick for the sector, based on stronger asset quality vis-à-vis peers. SELL OCBC given low provisioning levels.

Singapore Banks - Could We Be Heading for a V-shaped GDP Recovery?

Top picks DBS, UOB — Banks still trade 8-27% below mid-cycle P/B despite rising 75-82% from March lows (STI +57%). Banks outperform the STI in the first 9-12 months of a new cycle as the economy moves from recession to recovery. Our economist Wei Zheng Kit models a U-shape profile in his recently upgraded GDP of -5.2% in 09E and +6.4% in 10E, but concedes that strong April Industrial Production data (+24.7% mom sa) presents further GDP upside risk. Consensus bank forecasts rose 4-13% since 1Q results. More upgrades could come from improving loan growth, margin expansion and lower than expected provisioning.

Upward revision to 1Q GDP — Singapore MTI revised 1Q09 GDP to -10.1%yoy (from -11.5%), better than our (-10.7%) and consensus (-10.9%) numbers. Our economist noted that while there was no change to official GDP forecast of -6 to -9%, the tone of the press statement noted that the revised estimates present a less pessimistic picture than the advance estimates, and that “things have stopped getting worse”. He maintains his view that that the economy will be out of recession by 4Q09, returning to pre-recession levels by end 2010 or early 2011.

April-09 loan data — Domestic loans fell 0.3% mom to S$270bn, but 7.6% higher versus a year ago. Business lending dropped by 0.1%mom with greatest declines in manufacturing, non-bank FIs and others. Consumer lending rose by 0.8%mom, with mortgages growing by S$0.5bn (+0.6%mom, +6.3%yoy). IE Singapore data shows that 1,834 SME-related loans, with total value of $1.06bn, were approved in April, bringing the total value of loans approved since Dec-08 to S$2.5bn.

Singapore Banking: 1Q09 loan spreads widened but provisions surged

Stripping out trading gains and non-recurring items, banks’ 1Q09 net profits are generally in line with expectations. Both DBS and OCBC reported 1Q09 net profits that were above ours and market expectations, whilst UOB’s was in line. DBS recorded a jump in trading income, due to interest rate and foreign exchange rate activities, whilst OCBC had non-recurring gains from the implementation of the new Risk Based Capital framework in Malaysia effective 1 Jan 09. Stripping out these, DBS and OCBC earnings were close to our expectations.

Expect OCBC and UOB 1Q09 outperformance in NIM to persist, whilst DBS NIM to remain squeezed due to soft SIBOR. OCBC and UOB recorded 1Q09 YoY NIM widening to 2.42% and 2.41% respectively, due to better lending spreads, the consequence of reduced competition from foreign banks. On the other hand, DBS’ 1Q09 NIM of 1.99% is sharply lower than peers, due to its low Singapore loan deposit ratio of 57% amidst the soft SIBOR environment. We expect this variance in NIM between DBS and its peers to remain for the remaining quarters of 2009.

DBS and OCBC non-interest income boost not sustainable. We do not expect the surge in 1Q09 DBS’ trading income and OCBC’s non-recurring life assurance gains to be repeated in the subsequent quarters. Although the recent pick-up on stockmarket activity offers hope, we do not believe this can be sustained for long and hence expect fee and commission income to be relatively subdued. Hence, we do not expect much excitement from non-interest income going ahead.

Asset quality to deteriorate further, with DBS at higher risk. All three banks recorded higher NPL ratios, and also significantly higher provisions in 1Q09. NPLs typically lag the deterioration in economic growth, and we are forecasting Dec 09 NPL ratios of between 3.7% and 4.2%. As DBS was the most aggressive in lending over the past 3 years, with a 18.3% CAGR loan growth, versus OCBC’s 12.4% and UOB’s 13.3%, it faces the risk of a higher NPL ratio. We are assuming 2009 provisions to loans of between 114 and 126 bps, sharply higher than 2008’s 59 to 84 bps range.

UOB is our preferred pick within the sector. With the share price surge of the banks over the past 2 months, valuation has become stretched. We are NEUTRAL weight the sector. For investors interested in the Singapore banking sector, UOB (NEUTRAL call) is our preferred pick on the back of its higher-quality loan asset.