Kim Eng on 12 Jan 2012
Maintain Underweight. Having declined 23-25% from their 2011 peaks, Singapore banks appear cheap. We would nevertheless argue that present valuations largely reflect and justify the cyclical downturn in returns that the industry is witnessing, as well as flat earnings this year. The primary risk is of economic growth undershooting expectations while from an operational standpoint, we see little change in the challenging operating environment this year to warrant a more positive stance just yet. We retain our Sell calls on DBS, OCBC and UOB.
In pursuit of returns. Returns are proving more elusive amid i) competitive pressures and NIM compression; ii) capital market volatility; iii) increasing risk aversion; and iv) rising costs. We estimate a blended ROE of 10.5% for 2012 which is not only lower than the long-term mean of 12%, but also below average returns achieved during the GFC.
Challenges remain. Against the backdrop of Singapore’s GDP growth tapering to 3% in 2012 from 4.8% (est) in 2011, we expect cumulative loan growth for the three banks to decelerate to 10% this year from 27% in 2011. NIM compression is likely to persist but we expect a more moderate compression of 3bps this year from 11bps in 2011. Other challenges include potentially higher charge-off rates amid asset quality deterioration, as well as capital market volatility which could impact fee income expansion and fair value reserves.
Flat earnings in 2012. Taking the above factors into consideration, we expect the cumulative operating profit of the three banks to grow by a marginal 5% in 2012. On the back of higher credit charge rates, we expect cumulative recurring net profit to be flat YoY. In contrast, cumulative operating profit for the three banks stalled with growth of just 1.9% back in 2008. With rising credit costs, total net profit contracted by 15.4% in that year.
Valuations not much to shout about just yet. Trading at an average 2012 P/BV of 1.1x presently against a long-term mean of 1.5x, valuations appear attractive from a historical perspective. We would nevertheless argue that this is very much on par with the cyclical downturn in returns for the industry. Moreover, at a prospective PER of 10.7x for 2012, valuations are marginally higher than the regional average of 10.0x ex Taiwan and South Korea. This is not entirely appealing given the fact that earnings are expected to meander along with growth at just about 0.6% versus 7.3% for the region in 2012.
In search of returns
That there are headwinds on the external front is a given fact
. This aside, however, the primary challenge confronting Singapore banks today is that generating returns continues to be a struggle, and we expect ROEs to dip below the global financial crisis (GFC) levels.
A glance back at recent results points to a decent 23% YoY growth in cumulative reported net profit for the first nine months of 2011. Recurring net profit, however, expanded by just 3% YoY. Despite gross loans growing at a breakneck pace of 27% YoY and total assets expanding by 19% YoY, operating income inched up by just 4% YoY while operating profit actually contracted 1% YoY.
Negative JAWS persisting… What is indicative from the table above is that while income generation has been a challenge, profitability has been further impeded by negative JAWS (faster growth in expenses relative to income). Aside from a brief spell in 2009, expenses have generally been increasing at a faster rate than income since 2007. As a result, the aggregate cost/income ratio for the 3 banks has risen from a historical low of about 38% to 43% presently.
…due in part to rising staff costs. That overheads have been rising is largely a function of increasing staff costs, which now account for about 56% of total overheads versus a low of 49% in 2003. DBS, which saw its monthly staff cost/employee dip in 2008 as a result of a retrenchment exercise then, has seen its costs climb back up to precrisis levels.
Returns more elusive. Consequently, while the economy has been expanding post-GFC, returns are proving more elusive and more difficult to generate amid i) competitive pressures and net interest margin (NIM) compression; ii) volatility in capital markets; iii) a shift towards less risky assets; and iv) rising costs.
While DBS has managed to sustain its ROE in recent quarters, income support has come mainly from fees/trading income, which brings into question the sustainability of returns. OCBC, meanwhile, has seen its ROE slip 4.5ppts from a peak of 14% in 1Q10, while UOB has witnessed a 6.3-ppt decline from its peak to 9.3% in 3Q11. Operating profit generated from risk-weighted assets, meanwhile, appears to have peaked as well and is close to pre-crisis lows for OCBC and UOB.
Does it get easier from here?
Probably not yet, particularly amid expectations of slower economic growth ahead. While Singapore has avoided a technical recession, expectations remain tempered as the economy continues to be buffeted by turbulence on the external front.
GDP momentum to taper off
GDP growth of 3% for 2012. Being a very open economy, the whipsawing of Singapore’s economy epitomises the state of the external environment. Singapore’s 4Q11 real GDP shrank 4.9% QoQ (3Q 2011: +1.5%), the second QoQ contraction in the year, but not on a consecutive basis, as the technical definition of a recession requires. YoY growth slowed to 3.6% (3Q2011: +5.9%).
Our in-house GDP growth projection for 2012 stands at +3% (2011: +4.8%), supported by the services sector (especially non-financial services), pharmaceutical industry, public housing and infrastructure (MRT upgrade and extension), although external factors such as the prolonged Eurozone debt crisis, sluggish US growth and China’s economic slowdown, will be a drag on manufacturing – especially E&E – on top of the recent additional measure to cool property prices.
As it stands, there is a fairly strong 0.8 correlation between the general business expectations manufacturing) index and Singapore’s GDP growth, with the latter lagging the former by about 3 months. The former turned negative in 3Q11, portending slower growth ahead, and this was eventually borne out. We await the release of 4Q11 numbers. The official GDP growth forecast for 2012 is currently 1-3%, and the primary risk at this stage is of economic growth under-shooting expectations.
Slower loan growth ahead
US$ loans swell. Loan growth in the first nine months of 2011 has been robust, with cumulative gross loans for the 3 banks expanding at an accelerated pace of 27% YoY. What is evident from the charts below is that much of this growth has been driven primarily by US$ loan growth, which jumped 69% YoY in 3Q11 versus a more paced increase of 16% YoY for S$ loans. By end-September 2011, US$ loans accounted for 25% of total loans versus 16% in 3Q09.
Trade finance loans. The surge in US$ loans has been largely driven by demand from Chinese companies for US$-denominated trade financing lines.
31% of DBS’ total loans. US$ loans have grown at the fastest pace for OCBC (+90% YoY in 3Q11 versus 62% for DBS and 59% for UOB) but make up a larger proportion of DBS’ total loan portfolio (31% of total loans) compared to OCBC (26%) and UOB (15%).
US$ trade finance loans carry low risk and low yields. While US$ trade financing loans have expanded at a rapid pace, they are typically of short duration (< 1 year) and usually secured against goods/deposits from the borrower. As such, they are relatively low risk (and low yielding), which would partially explain why DBS’ and OCBC’s riskweighted assets (RWA) have expanded at a much slower pace of 14% YoY (20% for UOB) despite the more rapid growth in such loans.
US$ lending is likely to taper off in 2012 as global trade cools and as US$ funding cost rises. An added inhibiting factor, in our view, is the lack of corresponding US$ liquidity to fund such lending. As it stands, DBS’ US$ loan/deposit (L/D) ratio is already at an all-time high of 171%, while OCBC’s is 166% and UOB’s is just above 100%.
Property lending likely to come off too. We expect the recent imposition of the additional buyer’s stamp duty to take some wind out of property (particularly private residential) demand. Mortgages account for about 25-30% of the banks’ Singapore loan portfolio, with private residential loans making up 80-90% of such mortgages. Property development loans, meanwhile, account for a further 10-20% of total domestic loans.
Overall loan growth to moderate to 10%. Taking the above factors into consideration, we expect sector loan growth to moderate into 2012 and expect cumulative loan growth for the three banks to moderate to
10% from 27% in 2011.
NIM compression has had a negative impact on earnings. The singular factor that has had the most dampening impact on earnings is NIM compression, which has persisted over the past two years. 2010 saw average NIMs of the 3 banks contract by about 23 bps, and we expect another 11 bps squeeze in 2011.
Nevertheless, we expect some NIM stability into 2012, and impute a marginal 3 bps compression.
Positively:
a) Anecdotal evidence suggests that while pricing in the retail market remains tight, some pricing power has returned to corporate lending, as foreign banks cut back on their lending activities.
b) Interbank rates are stabilizing. Interbank rates have been declining over the past two years, but appear to have bottomed out at about 0.34%, with some recovery to 0.40% presently.
c) The Singapore Swap Offer Rate (SOR) has recovered. Having temporarily slipped into negative territory in September 2011, the 3- month SOR has since bounced up to close to 0.6%, and is higher than the 3-month SIBOR of 0.40%
On the flip side, funding costs are unlikely to ease anytime soon. Cheaper CASA deposits are proving harder to come by these days, while L/D ratios have been rising rapidly. We would expect the banks to cap their L/D ratios at about 90% and with L/D ratios already at 87-88% presently, there is less room to manoeuver in this regard.
That said, L/D ratios have been skewed upwards by tight US$ liquidity. US$ L/D ratios range from just over 100% for UOB to 171% for DBS. S$ liquidity meanwhile remains adequate while liquidity in other major regional currencies is manageable, in our view. As such, the reining in of US$ loans would improve liquidity conditions.
Higher credit costs ahead?
Asset quality healthy. To date, asset quality continues to strengthen and there is little indication of stress to the loan books as yet, except for an uptick in 3Q11 NPLs for UOB, which has been attributed to lumpy corporate loan exposure to some clients in the transport sector. NPL ratios are respectable at less than 1.5% across the 3 banks, with commendable loan loss coverage of 120-140%.
However, the prospect of an economic slowdown brings this concern to the fore, for during the GFC, average gross NPL ratios across the 3 banks rose 14 bps in 2008 and 62 bps in 2009. Credit charge-off rates, meanwhile, jumped from 34 bps in 2007 to 72 bps in 2008 and 94 bps in 2009.33
Downside risk. What we have factored in to date is a 10 bps increase in NPL ratios in 2012 and 6 bps rise in 2013, while our credit charge-off rate estimates would appear fairly benign at this stage at 30-31 bps for 2012-2013 versus 27bps in 2011. Downside risk therefore is of a greater-than-expected deterioration in asset quality.
The impact of capital market volatility
Impact on two fronts. Capital market volatility is unlikely to abate anytime soon, and impacts the banks on two fronts: a) a hit to fee income; and b) potential write-downs in available-for-sale (AFS) reserves which dampen book value.
Fee income contraction expected. Fee income is susceptible to fluctuations in capital market activity. This revenue source contracted by 11% in 2008 and a further 1% in 2009 on a cumulative basis. On expectation that volatility will persist, we have factored in a 5% contraction in 2012.
Little differentiation in impact. We see little differentiation in the fee income structure across the 3 banks, with capital market-related fees (fund management, futures broking and investment-related) accounting for 24-25% of total fee income and trade-related fees making up 18- 19%. Fee income, meanwhile, accounts for about 21-23% of total income.
A drag on book value. The other risk amid market volatility is that of potential write-downs to investment values, which in turn would be a drag on book values. 2008 saw a significant write-down in AFS reserves, largely from the banks’ exposures to collateralized debt obligations (CDOs). 3Q11, meanwhile, saw a dip in the shareholders’ funds of UOB and OCBC, with the former’s AFS reserve turning negative on the back of a S$492m mark-to-market provision against its overseas investments. OCBC saw a S$228m decline in the value of its AFS investments in 3Q, primarily on Bank of Ningbo.
No CDOs but some Eurozone exposure this time round. UOB’s total European debt exposure stood at S$2.1b as at end-Sep (9.4% of shareholders’ funds), a tad lower than DBS’s S$2.4b (8.5% of shareholders’ funds). The difference, however, is that while DBS’s exposure to European banks (excluding European government debt) is just S$211m, or 0.7% of shareholders’ funds, UOB’s European bank exposure is S$1.2b, which is a larger 5.4% of shareholders’ funds.
OCBC’s investment portfolio appears more resilient at this stage. Negligible exposure to the Eurozone aside, OCBC’s investment portfolio appears more resilient at this stage, with a lower 45% exposure to non-government securities (corporate debt and equities), versus 50% for DBS and 55% for UOB.
Earnings forecasts
Flat earnings in 2012. Taking the above factors into consideration, we expect the cumulative operating profit of the 3 banks to grow by a marginal 5% in 2012. On the back of higher credit charge rates, we expect cumulative recurring net profit to be flat YoY.
This compares against a 15% contraction in 2008 earnings. Back in 2008, cumulative operating profit for the three banks stalled with growth of just 1.9%. Including rising credit costs, total net profit contracted by 15.4% during the year.
Valuations
2011 – a year of underperformance. The banking sector generally underperformed in 2011. Against a loss of 17% for the STI, OCBC’s share price declined 20.7% YoY while DBS’ share price dropped 9.6%
YoY. UOB eked out a slight out-performance though there was little to cheer about, with its share price down 16.1% YoY.
A function of the economy. That the banks underperformed last year is probably not too surprising, given their lacklustre earnings and the uncertain state of the economy. As the chart below shows, there is some correlation between economic growth and banks’ share prices, albeit a relatively weak one at 0.4.
Present valuations are decent… The sector as a whole trades at a prospective 2012 PER of 10.7x, which is a 22% discount to the longterm sector PER average of 13.7x. The sector also trades at a prospective 2012 P/BV of 1.09x, a 26% discount to its long-term average of 1.47x.
…but largely reflect the cyclical downturn in returns and earnings momentum. While valuations have come off, this is to a large extent representative of, and justified by, expectations of flat earnings this year as well as the cyclical downturn in ROEs, in our view. As per our estimates, the blended ROE for the sector currently stands at about 10.5% for 2012 versus the long-term average of about 12.1%. Moreover, ROEs have started trending below the levels recorded during the GFC itself.
Still some distance from trough. Current PER and P/BV valuations are about 34% and 33% away from the trough PER and P/BV (in March 2009) valuations of 7.1x and 0.73x respectively.
Not entirely appealing from a regional perspective. While admittedly P/BV valuations for Singapore banks rank low, so do their ROEs, which are the third lowest in the region after Taiwan and South Korea. PER valuations for Singapore banks, at 10.7x for 2012, is marginally higher than the regional average of 10.0x ex Taiwan and South Korea. This is not entirely appealing in view of the fact that earnings are expected to meander along with growth at just about 0.6% versus 7.3% for the region (ex Taiwan and South Korea) in 2012.
Recommendations
Valuations appear cheap from a historical basis but as we have pointed out above, they do not appear compelling from a regional perspective, not with expectations that earnings will likely stagnate this year and with ROEs trailing levels recorded even during the GFC.
The primary risk as it stands is of earnings under-shooting expectations on slower-than-expected economic growth while from an operational standpoint, we see little change in the challenging operating environment this year to warrant a more positive stance. Our Underweight call on the sector is retained, as are our Sell calls on DBS, UOB and OCBC.
DBS (Target price: S$11.50, target P/BV: 0.9x, 2012 ROE: 9.7%)
On the plus side, DBS’s valuations are the cheapest among the Singapore banks with a low P/BV of 0.9x. Nevertheless, valuations are low for a reason, with its single-digit ROE of 9.7% in 2012 lagging the industry average.
With exposure to two highly open economies (Singapore and Hong Kong), DBS’s earnings are more vulnerable to economic headwind relative to its peers, in our view. Moreover, as earnings growth in recent quarters has largely been supported by fees/trading income, sustaining this momentum could be a challenge.
With more of a corporate focus than its peers, DBS’ domestic NIMs are likely to benefit from improved pricing on corporate (as opposed to retail) loans. At the group level, however, any improvement is likely to be capped by its high HK$ and US$ L/D ratios of 132% and 171% respectively.
OCBC (Target price: S$7.30, target P/BV: 1.1x, 2012 ROE: 10.8%)
Our favourite of the 3 banks for its strong credit risk management (impeccable asset quality and highest loan loss coverage/lowest credit charge-off rates) and burgeoning wealth management franchise. At this juncture, however, valuations do not warrant entry just yet, in our view.
We expect the bank’s investment portfolio to be least impacted by market fluctuations, but the overall effect is likely to be amplified by volatility in Great Eastern’s portfolio, which is only to be expected. Great Eastern, nevertheless, has a solid franchise and its business continues to expand at a stable pace.
Also a positive is that Bank of Singapore continues to grow and contribute to group earnings, with assets under management totaling US$29b at end-September 2011. Since buying ING’s Asian private banking business in 2009, OCBC’s fee income has expanded from 15% of total income in 4Q08 to 23% in 3Q11. Separately, we expect OCBC’s Malaysian operations (which made up 25% of pretax profit in 9M11) to provide some buffer to group earnings.
UOB (Target price: S$14.20, target P/BV: 1.0x, 2012 ROE: 10.8%)
Our least favoured Singapore bank at present. Of the 3 banks, we expect UOB to see higher NIM compression in 2012, mainly from its regional operations in Indonesia, Thailand and Malaysia. The clampdown on the property sector, meanwhile, is likely to take the wind out of loan expansion, particularly for UOB, which has a larger exposure to the private residential property market compared to the other two banks.
That it bucked industry trends with an uptick in NPLs in 3Q11 is reason to be cautious, while its Eurozone debt exposure could further dampen book value expansion through mark-to-market losses.
