Post-meeting with management yesterday, we upgrade CIMB to OUTPERFORM while maintaining its TP at RM7.15 as we see value emerging from its current price. Key takeaways from the meeting were: (i) explanation on the accounting treatment of MFRS 3 Business Combination which considers the economic substance over its legal form where CIMB is deemed the acquirer instead of RHBCAP, (ii) more reasons were given to why CIMB, RHBCAP and MBSB should merge, and (iii) how CIMB intends to move forward if the merger succeeds.

Substance over form; CIMB is deemed the acquirer. Management provided more clarity on the accounting treatment of MFRS 3 Business Combination. Essentially, this accounting standard considers the economic substance over its legal form where CIMB is deemed the acquirer instead of RHBCAP because the former is a larger banking outfit vs. the latter. As a result, (i) the group’s ROE should fall by only 90bpts while (ii) CARs of the enlarged CIMBRHBCAP group is expected to fall 50-250bpts compared to what was computed previously (ROE: -300bpts, CARs: -200-400bpts). That said, EPS of the combined CIMB-RHBCAP entity is still projected to be enhanced by 2% (please see Table 1).

More reasons to merge. Management claims the following: (i) the combined entity has the scale to stabilize earnings, (ii) ability to strengthen its domestic presence, (iii) RHBCAP was too inexpensive to ignore, (iv) synergies are controllable since 86% are from costs, (v) as a whole, RHBCAP and MBSB should only need 60% of their total existing costs to be fully functional.

CIMB Group is looking to pare down its stake in CIMB Islamic to about 51%-55%. We understand that if EPF were to accept CIMB Islamic shares while minority shareholders opt to receive cash in exchange for MBSB’s assets and liabilities, CIMB Group will in turn, hold approximately 65% stake in the newly created mega-Islamic bank. Here, management plans to transfer some of the conventional banking’s resources over to its Islamic arm to grow this segment of the business but this will come at the expense of the latter which will likely face a gestation period over the short-term. As such, CIMB is looking for a strategic partner to pare down its stake in CIMB Islamic to about 51%-55% to share the initial pain of integration.

Valuation & recommendation. All in, we upgrade CIMB to OUTPERFORM (from MARKET PERFORM) while maintaining its TP at RM7.15 based on 1.6x FY15 P/B. Reasons to upgrade the stock include: (i) it is currently trading at -2SD below its 5-year mean, (ii) CIMB’s foreign shareholding is near its 8-year low and our regression analysis suggests that CIMB should trade at 1.6x Fwd P/B, (iii) its share price has plunged 13% relative to FBMKLCI since the beginning of Oct-14, (iv) the stock’s RSI is below 30-mark, indicating an oversold technical condition, and (v) cheaper entry cost to the enlarged CIMB-RHBCAP-MBSB entity.

Risks to our call. (i) Further selldown by foreigners and (ii) a sharp decline in RHBCAP’s share price which could in turn results in direct purchase of RHBCAP shares becoming a more attractive investment proposition.

Key takeaways from yesterday’s meeting with management

Substance over form; CIMB is deemed the acquirer. Management provided more clarity on the accounting treatment of Malaysian Financial Reporting Standard 3 (MFRS 3) Business Combination. Essentially, this accounting standard considers the economic substance over its legal form where CIMB is deemed the acquirer instead of RHBCAP because the former is a larger banking outfit vs. the latter, although the current proposal put forward to BNM indicates that RHBCAP is set to acquire CIMB’s assets and liabilities via a share swap exercise. As a result, (i) the group’s ROE should fall by only 90bpts on the back of lower P/B valuation attached to RHBCAP while (ii) CARs of the enlarged CIMB-RHBCAP group is expected to fall 50-250bpts due to lower acquisition goodwill compared to what was computed previously in our Banking report titled “Moving On With The Proposed Merger” dated 10-Oct-14 (ROE: -300bpts, CARs: -200-400bpts). That said, EPS of the combined CIMB-RHBCAP entity is still projected to be enhanced by 2% given that MBSB is not acquired directly at RHBCAP level, entailing lesser issuance of new RHBCAP shares (please see Table 1).

More reasons to merge. Management claims the following: (i) the combined entity has the scale to stabilize earnings by cushioning volatility from capital markets and its Indonesian operations, (ii) the ability to strengthen its domestic presence, (iii) RHBCAP trading at 1.1x-1.2x P/B was too inexpensive to ignore and it immediately provides further penetration into the Singaporean market, (iv) synergies are controllable since 86% are from costs and is just a matter of proper execution to reap the low-hanging fruits of the merger (possibly shutting down 40-50 branches and retrenching < 9k-10k employees; the enlarged entity has a total estimated 1.6k branches and 60k workers), and (v) as a whole, RHBCAP and MBSB should only need 60% of their total existing costs to be fully functional.

CIMB Group is looking to pare down its stake in CIMB Islamic to about 51%-55%. We understand that if EPF were to accept CIMB Islamic shares while minority shareholders opt to receive cash in exchange for MBSB’s assets and liabilities, CIMB Group will in turn, hold approximately 65% stake in the newly created mega-Islamic bank (CIMB Islamic + RHB Islamic + MBSB). Here, management plans to transfer some of the conventional banking’s resources over to its Islamic arm to grow this segment of the business but this will come at the expense of the latter which will likely face a gestation period over the short-term. As such, CIMB is looking for a strategic partner to pare down its stake in CIMB Islamic to about 51%-55% to share the initial pain of integration. For now, management do not have any intention to list its Islamic banking business but in the future, if opportunity permits, they may consider this route. Separately, the Ministry of Finance has yet to advise on whether MBSB’s Angkatan Koperasi Kebangsaan Malaysia (ANGKASA) code can be retained post-merger.

Operational headwinds in Indonesia. Management continues to paint a bleak outlook for its 98%-owned subsidiary, CIMB Niaga. This is expected given the tough operating environment in Indonesia where: (i) intense competition for deposits will continue to compress NIM as funding cost increases, (ii) rising inflation along with higher cost of borrowing may further exert pressure on asset quality, (iii) loans growth may be tepid going forward given uncertainties on the country’s policies as businesses and consumers adopt the wait-and-see approach before investing into the future. Recall, back in August, management had already toned down its loans growth expectation to +8-9% YoY vs. its original target of +15% YoY. Furthermore, they had reiterated its 80-90bpts credit cost guidance, suggesting higher loan loss provisions in the next two quarters (1H14: 70bps). We are leaving our forecasts unchanged for now since CIMB Niaga will be releasing its 3Q14 results later today.

Valuation and recommendation

Upgrade to OUTPERFORM, TP unchanged at RM7.15. All in, we upgrade CIMB to OUTPERFORM (from MARKET PERFORM) while maintaining its TP at RM7.15 based on 1.6x FY15 P/B. Reasons to upgrade the stock include: (i) it is currently trading at - 2SD below its 5-year mean of 2.0x Fwd P/B, (ii) CIMB’s foreign shareholding is near its 8-year low (3ppts away) and our regression analysis on foreign shareholding vs. Fwd P/B suggests that CIMB should trade at 1.6x Fwd P/B, (iii) its share price had plunged 13% relative to FBMKLCI since the beginning of Oct-14, (iv) the stock’s RSI is below 30-mark, indicating an oversold technical condition, and (v) based on the predetermined exchange swap ratio of 1.38 for the mega-merger between CIMBRHBCAP-MBSB, investors stand to save 2% by converting CIMB shares to 1 RHB shares (at current price) vs. directly purchasing RHBCAP shares to gain entry to the enlarged entity.

Risks to our call. (i) Further selldown by foreigners – CIMB’s foreign shareholding as at Sept-14 is 34.4% vs. its low of 31.6% as at Mar-09. The stock is currently priced at 1.4x FY15 P/B while back then, it was traded at Fwd P/B of 1.2x, (ii) a sharp decline in RHBCAP’s share price which could in turn results in the direct purchase of RHBCAP shares becoming a more attractive investment proposition.

Source: Kenanga