YTD, KLFIN underperformed FMBKLCI by 70bpts as the banking sector still lacks re-rating catalysts; structural and cyclical headwinds such as: (i) muted loans growth, (ii) tight liquidity environment, (iii) narrowing NIM, (iv) weak capital market activities, as well as (v) rising credit costs still plague the industry. Thus, faced with dull organic growth prospects, M&A will continue to be the most talk about theme in the banking space. However, we believe that current weak economic environment is not conducive for domestic M&A exercises. All in all, we maintain our NEUTRAL stance on the sector. Our top pick is MAYBANK (OP; TP: RM10.26) as we like its: (i) superior yield offerings of ~6% and (ii) extensive regional exposure in ASEAN-5.

Banking stocks recovered slightly in 1Q15. YTD, the KL Finance index (KLFIN) advanced by 1.7% (2014: -7.4%) but still underperformed the FMBKLCI index by a mere 70bpts (2014: -170bpts). Essentially, KLFIN’s recovery was led by CIMB (YTD share price: +8.8%) and RHBCAP (YTD share price: +2.6%) as their planned three-way merger (which includes MBSB) was scrapped back in January. However, it failed to outstrip the performance of FBMKLCI as the banking sector lacks re-rating catalysts. All in, most of the banks under our coverage saw positive YTD share price returns, save for AFFIN, AMBANK, BIMB and MAYBANK.

4Q14 results review. Of the 9 banking stocks under our coverage, 5 met expectations (AFG, BIMB, HLBANK, MAYBANK, RHBCAP), 2 above (AFFIN, PBBANK), and 2 below (AMBANK, CIMB). For AFFIN and PBBANK, actual earnings ran ahead of estimates due to higher-than-expected growth in non-interest income. AMBANK, on the other hand, failed to deliver no thanks to a decline in its interest income along with weak income contributions from its Islamic banking unit. Lastly, CIMB disappointed due to a higher-than-expected provision for bad loans. Notable observations during the quarter were: (i) weak earnings growth, (ii) liquidity position remains tight, (iii) net interest margin (NIM) resumed its downward trend, (iv) capital market environment was still weak, (v) cost escalated, (vi) asset quality improved, but (vii) credit cost was on the rise.

Expectations for FY15/FY16: (i) aggregate loans growth is expected to weaken to 8.7%/8.1% (vs. FY14: +11.9%), (ii) sector NIM to contract by 7.5bpts/4.0bpts (vs. FY14: -18.3bpts), (iii) non-interest income growth to pick up some pace (5.9%/4.9% vs. FY14: -3.2%), (iv) credit charge for the sector to increase by 4.1bpts/1.3bpts (vs. FY14: +1.3bpts), (v) cost-to-income ratio (CIR) to fall by 110.1bpts/11.0bpts (vs. FY14: +34.6bpts), and (vi) earnings growth for the sector to remain muted at 7.2%/4.3% (vs. FY14: +0.6%).

In the mood for M&A? Given dull organic growth prospects, mergers and acquisitions (M&A) will continue to be the most talk about theme in the banking space. Hence, in this report, we analyze several M&A permutations, which were explored or speculated in the past: (i) MAYBANK-PBBANK, (ii) MAYBANK-RHBCAP, (iii) MAYBANK-AMBANK, (iv) MAYBANK-AFG, and (v) PBBANK-HLBANK. Furthermore, mid-and smaller-banks could attempt to join forces to build scale and operating efficiency: (i) HLBANK-AFG, (ii) AMBANK-AFG, (iii) AMBANK-AFFIN, and (iv) AFFIN-AFG. Overall, we find that: (i) MAYBANK could be an acquirer while AMBANK and AFG have likelihood to be acquired, (ii) most M&A deals would necessitate a 100% share swap structure to protect capital adequacy ratios (CARs) of the enlarged entity from declining too excessively, (iii) ROE to fall slightly post-merger given issuance of new shares, and (iv) most synergies can only be realized from cost cutting initiatives. Taking a cue and learning from CIMB-RHBCAP-MBSB’s scrapped merger, we reckon that any M&A initiatives must be threaded with care or it will be value destructive for existing shareholders. That said, we believe that current weak economic environment is not conducive for domestic M&A exercises. Instead, large-sized banks like MAYBANK and CIMB may look abroad for inorganic expansion as part of their aspiration to become regional champions.

Maintain NEUTRAL on the sector. Faced with structural and cyclical headwinds such as: (i) muted loans growth, (ii) tight liquidity environment, (iii) narrowing NIM, (iv) weak capital market activities, as well as (v) rising credit costs, we remain NEUTRAL on the banking sector. Hence, we advocate caution and adopt a selective stock picking strategy. Our top pick is MAYBANK (OP; TP: RM10.26) as we like its: (i) superior yield offerings of ~6% and (ii) extensive regional exposure in ASEAN-5. Other stocks under our coverage are MARKET PERFORM.

Source: Kenanga Research - 6 Apr 2015