While we are comfortable with the sector’s FY14 PER valuation of c.13x, as compared to FBMKLCI’s valuation of above 15.0x, we are turning cautious on the Banking Sector. We believe the operating environment is getting tougher with misty growth prospect, NIM continues to be under pressure, credit cost near historical low, which is vulnerable to a rise for both NPL and interest rate. Hence, we are downgrading our rating to NEUTRAL from OVERWEIGHT. We have selected RHBCAP (OP; TP: RM8.75) as our Top Pick as it offers a potential 13% upside from here after the recent sharp price correction. Furthermore, we believe any negative views and concerns are already priced in as per our Regression Study. Furthermore, our targeted price multiples assigned to RHBCAP are based on the 1.2x and 10.2x FY14 PBV and PER, respectively, representing the trough valuation of RHBCAP for the last 3 years.

2QCY13 Results Review. While most of the banks were able to meet consensus expectations and that of ours, certain banks’ profitability, such as AFFIN (MP; TP: RM4.60), AFG (MP; TP: RM5.60), BIMB (MP↓; TP: RM5.00↑) and HLBANK (MP; TP: RM15.20), were boosted by below norm credit charge ratio, which obviously is not sustainable, in our view. Thus far, due to the low interest environment, NPL for the sector in on a declining trend. This favourable trend has been acting as a key earnings driver for the local banks. However, this trend is under pressure as potential cut in subsidies and implementation of GST may hurt consumers’ disposable incomes. Coupled with the near historical high household debts, we would not be surprised to see a reversal in this trend should economic condition take a turn for the worse. This is especially applicable to those banks that have higher impaired loans ratio as well as lower loan loss coverage ratio, i.e. AFFIN, CIMB (MP; TP: RM8.10) & RHBCAP, vis-à-vis the industry average. In fact, we have already seen RHBCAP’s financial performance dragged by higher loan loss impairment in Corporate and Investment as well as Business Banking.

Getting Tougher. On operation front, most of the bank industry’s senior management we met have turned cautious and reckoned that the operating environment is getting more competitive and tougher while the view on interest rate movement is mixed. We also notice that banks have started to diversify their lending directions from the traditional household lending (mortgage and hire purchase) and SME to other segments such as share financing and corporate loans for better growth and asset yield.

Thus far, industry loan growth is recorded at high single-digit (c. 9%-10%) vis-à-vis low-teen (c.10%-13%) last year. Going forward, the prospect of loan growth is also overshadowed by potential introductions of more stringent administrative measures. For instance, there are talks that Loan-to-Value Ratio (“LTV”) for 3rd mortgages onwards could further reduce to 60% from 70% currently. As a result, compression of NIM, say 5%-10% YoY, is likely to continue due to competitive pressure. The volatile equity and bond markets coupled with uncertainty over externalities, could probably pose a threat to banks’ investment banking and treasury earnings prospects. Besides, for banks that have substantial exposure in Indonesia; such as CIMB, they also saw contraction in corporate loan book and rising NPLs as well as depreciation in Rupiah.

Interest Hike: Short-term Gain, Long-term Pain. While some banks with higher CASA and variable rate loans, such as AFG, could benefit from the faster reprising of loans vis-à-vis deposits, in the event that BNM starts to hike the interest rate, we believe this short-term gain may not be sufficient to cushion the erosion of earnings in the long run. This is because the hike in interest may have a stronger repercussion to consumers’ disposable income, hence loan repayment ability. Under such circumstance, asset quality could deteriorate and credit cost is expected to increase, which will eventually hit banks' profitability.

M&A updates. Of late, it was announced that AFFIN has entered into an exclusivity agreement with Hwang-DBS, in relation to the proposed acquisition by AFFIN of a 100% interest in HwangDBS Investment Bank Bhd and HDM Futures Sdn Bhd, 70% interest in Hwang Investment Management Berhad and 49% interest in Asian Islamic Investment Management Sdn Bhd.

While no price tag was mentioned, it was reported in Bloomberg News that both AFFIN and AMMB (MP; TP: RM8.45) bid for approximately RM1.0bn back in June. In terms of business standpoint, we reckon that the acquisition offers a more attractive business proposition to AFFIN as opposed to AMMB. With this acquisition, AFFIN should be able to improve its non-interest income contribution to 38.1% of total income in contrast to 28.5% based on the latest report trailing 12-month numbers. Nonetheless, on a proforma basis, this acquisition could only enhance its net profit by <3% as the cost-to income ratio of AFFIN will also increase from 45.6% to 52.6%. Besides, while the acquisition price tag is manageable to AFFIN’s total common equity of RM6.0bn, this acquisition could potentially reduce its Tier 1 capital ratio of 11.0% (as of end-June13) to 9.1%. Although the Tier 1 capital ratio still above the minimum capital requirement of 8.5%, this will leave little buffer for any potential significant loan loss impairment. As such, we believe the success of this acquisition depends heavily on the cost of acquisition.

Earlier on, BIMB proposed to acquire the remaining 49% stake in Bank Islam Malaysia from Dubai Financial Group (“DFG”, 30.47%) and Lembaga Tabung Haji (“LTH”, 15.83%). In early-September, BNM rejected the group’s proposed move to issue 10-year Sukuk using Bank Islam’s shares as security for the debt. However, it is believed that such issue is likely to be solved following the green light from Bursa Malaysia Securities to list its 2:5 rights (with free warrants) and it was also reported that Bank Islam shares would not be pledged as security for the proposed sukuk. We are positive with such corporate development as it could further enhance BIMB’s profitability despite the larger share base and higher cost of funding post acquisition. In fact, BIMB has the highest loan growth among its peers while being able to contain its impaired loan ratio below industry average and at the same time having higher-than-industry loan loss coverage. However, it is traded at 2.0x to its estimated FY14 book value of RM2.38, which is higher than industry average of 1.7x despite registering a higher-than-industry ROE of 17.4% (vs. industry average of 14.9%). While based on our regression analysis, such ROE is able to justify up to 2.1x (or RM5.00/share), we believe the upside could be limited from here. Hence, we are likely to downgrade our rating on BIMB to MARKET PERFORM from OUTPERFORM.

Source: Kenanga