Sector net profit expanded 12.0% yoy in 1Q18, driven by strong forex income and cost discipline. However, key revenue drivers were weak, with fee income expanding just 1.4% yoy while net interest income fell 1.0% yoy and 0.7% qoq despite a 25bp OPR hike. Sector valuation at 1.35x 2018F P/B is fair against ROE of 10.6%. Maintain MARKET WEIGHT as modest top-line growth is mitigated by stable asset quality and healthy capital buffers.

WHAT’S NEW

• More muted sentiment in 1Q18. The ratio of banks delivering positive earnings surprise in 1Q18 declined to 22% (RHBBank, HLBank) vs 44% in 4Q17. Overall, 67% of banks in our universe reported earnings that were in line with expectations. Post 1Q18 reporting season, we fine-tuned our 2018-19 sector earnings by +0.7% and +0.5% respectively.
• Lower provisions, cost discipline and strong trading gains underpinned earnings.
• 1Q18 sector net profit expanded 12% yoy, driven by lower provisions (-10%), strong forex income growth which helped underpin an 11% yoy growth in non-interest income, and strong cost discipline (-0.1% yoy), partly on the back of the deconsolidation of CIMB Securities international stock brokerage business (ex-CIMB, sector cost rose 2.0% yoy). However, key revenue drivers were lacklustre, with fee income expanding just 1.4% yoy while net interest income fell 1.0% yoy and 0.7% qoq despite the benefits of a 25bp OPR hike in 1Q18 due to higher-than-expected deposit competition.
• Moderating earnings growth ahead. We forecast sector net profit growth to moderate from 14.3% in 2017 to 9.7% in 2018 with sector ROE expected to register a marginal 3bp yoy improvement to 10.6%. Our earnings growth assumption is driven by prevailing positive operating JAW, underpinned by well controlled opex growth of only 3% vs revenue growth of 6% but partially offset by a mild increase in net credit cost to 35bp in 2018 vs 32bp in 2017. If 1Q18 strong forex and trading related non-interest income reverses, this could place downside risk on our 2018 non-interest income growth forecast of 7%, judging from 1Q18 lacklustre net fee income growth of 1.0% yoy.

ACTION

• Maintain MARKET WEIGHT. Post-GE14 macro policy uncertainty could have a slight dampening effect on the banking sector’s growth. As such, we believe the sector is unlikely to chart the same degree of outperformance prior to GE14. However, earnings downside risk is partly mitigated by strong cost discipline (+2% to +3%) and a manageable credit cost growth environment. Given this scenario, we reckon the sector could mirror the FBMKLCI performance in 2H18 with a slight upward bias as asset quality remains stronger than expected. Upside risk to our call could come from an additional OPR hike in 2H18 that would be positive for NIM.
• Current sector valuation is fair. Sector valuation has declined 7% post GE14 to 1.35x 2018F P/B, which is fair against a forecast ROE of 10.6%. Although P/B is at -0.5SD below the 10-year historical mean of 1.60x, we note that structurally, the ROE has compressed significantly from a high of 16.0%. CIMB (BUY/Target: RM7.40) remains our top pick, given its valuations at -1SD to P/B and PE valuations. A potential Hyflux-related provision remains an overhang for Maybank (HOLD/Target: RM10.20). For Public Bank (2.4x P/B) and Hong Leong Bank (1.6x P/B), we believe their stable and defensive franchises have largely been reflected in their premium valuations, which prompts us to maintain our HOLD call.

ESSENTIALS

• Banks guiding for only a mild recovery in loan growth in 2018. It is too early to gauge the impact of loan growth post GE14 as potentially stronger automobile and consumer durable loans growth from the new government’s mandate to raise disposable income will be partially offset by slower construction and government-related corporate loan growth and the multiplier effect on SME loans within the construction value chain. As such, most banks have continued to set a modest average domestic loan growth target of 5.0% yoy for 2018 (2017: +4.1%).
  Automobile loans (10% of total loans) could experience a temporary uplift in 3Q18m driven by the three-month “tax holiday” before the sales service tax kicks in which should result in higher car prices and hence downward normalisation in demand post the “tax holiday” period. This could provide a mild 20bp uplift in overall loan growth, assuming a 2% growth in automobile loans vs the current -1%. However, this positive uplift will be partially offset by slower construction loan (3% of total loans) growth (currently: +11%).
• Manageable impact from MFRS9 but still early days. Six of the nine banks under our coverage (December year-end) have adopted MFRS9 which resulted in an average 30% increase in day 1 provision taken through the balance sheet. Overall impact on CET1 was manageable, averaging -40bp, with Public Bank the only bank with zero impact on its CET1 given its large regulatory reserve buffer which it can utilise to offset the increase in provisions required. Post MFRS9, the average CET1 for banks under our coverage is expected to remain relatively healthy at 12.5%, with Maybank having the highest at 13.7%.
  As for net credit cost, the combination of MFRS9 and lower recoveries will lead to a 9% qoq increase in provisions with net credit cost coming in at 27bp. We are expecting sector net credit cost to gradually normalise upwards to above the 30bp level over the course of the year as lower recoveries and MFRS9 continue to play out. 
• Focusing on cost discipline. Given the rather benign loan and fee income growth, banks will continue to focus on cost discipline to sustain a positive operating JAW. Cost-to-income ratio improved to 47.2% in 1Q18 (4Q17: 48.1%, 1Q17: 49.5%). Strong cost discipline (-0.1% yoy) was seen in 1Q18, partly driven by the deconsolidation of CIMB Securities international stock brokerage business (ex-CIMB, sector cost: +2.0% yoy).
• Room to further optimise cost-to-income ratio for GLC banks. The advent of fintech should help drive banks’ productivity and hence the need to maintain a lower number of branches and with that, potentially lower operational headcount. We note that non-GLC banks tend to have higher productivity as measured by pre-provision operating profit per headcount at an average of RM279,000 per year vs GLC banks at RM203,000. If we exclude AMMB, the average PPOP per headcount of non-GLC banks is even higher at RM320,000, which is nearly 60% higher than that of GLC banks.
  On this note, we think the new government’s mandate to drive reforms and performance across government agencies could filter down to GLC banks with further cost rationalisation being a potential low hanging fruit. Even if we assume a 20% reduction in staff cost for GLC banks in the longer term in tandem with the downsizing of branch network, average PPOP per headcount for GLC banks would still be 20% lower than non-GLC banks ex-AMMB.
  Based on our earnings sensitivity, we estimate every 15-20% improvement in overall staff cost could translate into a 100-150bp improvement in ROE, assuming all things equal. Sector ROE could re-rate to 11.4-11.9% vs our current 2019 forecast of 10.7%, which in turn could drive sector P/B closer to 1.60x vs 1.35x currently.

Source: UOB Kay Hian Research - 6 Jun 2018