In  our  view,  the  key  observation  from  the  recent  CIMB-RHB-MBSB merger  proposal  is  that  M&A  multiples  are  falling.  Retain  NEUTRALsector call. We believe acquirers are no longer willing to pay significant premiums  above  book  values  as  more  stringent  capital  requirements and lack of excess capital  mean local  banks can no longer leverage  up for M&As. Instead, equity-funding M&As are putting pressure on ROEs. This  report  sets  out  three  observations  from  the  recent  CIMB-RHB-MBSB merger proposal.  

Observation  #1:  Acquisition  multiples  are  falling.  The  share  swap exercise under the proposed CIMB-RHB–MBSB merger values CIMB at 1.7x P/BV while RHB is valued at a P/BV of 1.44x. From Figure 1 below, we  note  that bank  M&A  multiples in  recent  years have  generally  been trending  down.  We  believe  this  is  due  to  a  combination  of  declining returns and, in particular, more stringent capital requirements. Malaysian banks do not have excess capital and hence, will not be able to rely on leverage to boost ROEs via M&As. Rather, the need to  fund acquisitions with equity means that major acquisitions are likely to be ROE-dilutive, in the absence of synergies.

Observation  #2:  Cost  synergies  –  key  to  value  creation.  Given  the growth  and  expansion  by  Malaysian  banks  over  the  years,  we  believe there would be a fair amount of overlaps and duplications when bank ing groups  merge.  Therein,  however,  also  lies  the  potential  to  realise synergistic  benefits,  especially  on  the  cost  side  for  the  commercial banking business.  Using a  Maybank  (MAY MK, BUY, TP: MYR11.00)  –AMMB  (AMM  MK,  BUY,  TP:  MYR8.00)  combination  as  illustration,  our numbers suggest that cost synergies could add as much as 6% to the enlarged entity’s net profit and +80bps to ROE.

Observation #3: Deal structure can make a difference  on ROEs. We illustrate in this report a case of  a smaller, lower ROE entity  acquiring a larger, higher ROE entity and show that it is possible for an acquisition to be  ROE  accretive,  at  least,  on  paper,  due  to  accounting  rules.  In substance,  however,  the  deemed  acquirer  (ie  larger  entity)  would  still experience a dilution to ROEs.

Forecasts. No change to our earnings forecasts.

Investment case. While we believe M&A multiples are unlikely to return to  levels  seen  in  the  past,  we  still  see  room  for  a  re -rating  in  stockspecific  prices  amid  M&A  news  flow.  Current  valuations  of  bankingstocks appear decent to us, especially post the recent market correction. That  said,  timing  is  typically  not  easy  to  predict.  Fundamentally,  we remain NEUTRAL on the sector with Maybank and AMMB as our BUYS.

Banking sector consolidation: Three observations

In  this  report,  we  set  out  three  observations  from  the  recent  CIMB-RHB-MBSB merger  proposal.  We then survey  the  banking  landscape  to  identify  potential  M&A candidates and apply the observations for illustrative purposes. Recap of the CIMB-RHB-MBSB merger proposal. To recap, the CIMB-RHB-MBSB merger  proposal  involves  a  share  swap  between  CIMB  (CIMB  MK,  NR)  and  RHB (RHB MK, NR)  at an exchange ratio of 1 RHB share for 1.38 CIMB shares. This is based  on  a  benchmark  price  of  MYR7.27/CIMB  share  (or  1.7x  P/BV)  and MYR10.03/RHB share (or 1.44x P/BV). In tandem, CIMB Islamic, RHB Islamic and MBSB  (MBS  MK,  NR)  will  merge  to  form  a  mega-Islamic  Bank.  The  proposed consideration for the acquisition of MBSB’s assets and liabilities is  MYR2.82/MBSB share (1.9x P/BV).

Observation #1: Acquisition multiples are falling
M&A multiples have been on the decline recently. From Figure 1 below, we note that  bank  M&A  multiples  in  recent  years  have  been  trending  down.  As  mentioned above, the share swap  exercise values CIMB at 1.7x P/BV while RHB is valued at a P/BV of 1.44x. Prior to this, the HL Bank-EON  Capital deal  (2010)  was  transacted with EON Cap being valued at 1.4x book.

Capital and falling returns likely causing the decline. In our view, the key reasons for the downtrend in acquisition  multiples of late is due to a combination of: i) more stringent capital requirements; and ii) declining returns.

Malaysian  banks  are  not  carrying  excess  capital  and  hence,  need  to  finance acquisitions with equity. Malaysian banks have spent the last few years shoring up capital,  eg  rights  issue,  private  placement,  dividend  reinvestment  plan,  due  to  the more  stringent  capital  requirements  that  banks  have  to  adhere  to  under  Basel  III.While current capital levels  largely  appear adequate, they are not in excess and still lower than the capital levels of peers in Singapore.  Hence, for any sizeable M&As, Malaysian  banks  will  need  to  fund  the  bulk  of  the  acquisition  cost  with  equity  to ensure  that  capital  levels  do  not  get  eroded  significantly.  The  combination  of:  i) financing  acquisitions  with  equity  as  compared  to  the  use  of  leverage;  ii)  paying above book  value for M&A, given that  Malaysian banks are generally trading  above 1x P/BV; and  iii) ROEs of banking groups are rather similar, ie 12-14%,  we think it would generally be a challenge for banks to do an ROE-accretive acquisition.

Meanwhile, sector  return on assets (ROAs)  is likely to have peaked.  Secondly, ROAs for banks have peaked and we expect them to trend down ahead.  Two factors causing the downtrend are net interest  margin (NIM) compression and normalisingcredit cost. While NIMs have been on a decline  for a while now, this was more than compensated for by falling credit costs, thus, lifting ROAs. We see a reversal in this trend  as  credit  cost  moves  towards  more  normalised  levels  ahead  and  this  would exert pressure on banks’ ROAs.

Overall,  trend  of  declining  acquisition  multiples  likely  to  stay.  Thus,  due  to  a combination of the need to preserve capital, manage ROEs  and falling returns,  we believe  these  will  keep  a  lid  on  book  value  multiples  that  potential  acquirers  are willing  to  pay  for  and  the  trend  of  declining  acquisition  multiples  will  likely  remain going  forward.  This  is  notwithstanding  the  shrinking  number  of  domestic  banking groups.

Looking  back  at  the  HL  Bank-EON  Bank  experience,  this  was  widely  viewed  as  a good deal for HL  Bank from the perspective of valuations, among others. In addition, the MYR5bn acquisition of EON banking group was only part funded by equity, ie via a MYR2.6bn rights issue. While there was an uplift in ROE post acquisition, ROEs have since trended below pre-acquisition levels.

Observation #2: Cost synergies – key to value creation
Duplications  and  overlaps  among  Malaysian  banks  provide  opportunities  for cost rationalisation in M&As.  Given the growth and expansion by Malaysian banks over the years, we believe there would be a fair amount of overlaps and duplications when  banking  groups  merge.  Therein,  however,  also  lies  the  potential  to  realise synergistic benefits, especially on the cost side for the commercial banking business.At  CIMB’s  recent  analyst  briefing  on  the  proposed  CIMB-RHB-MBSB  merger, management expected  86% of synergies  from the merger  to come from cost while revenue synergies would only make up 14% of the total. The realisation of synergies should help  to,  at  least,  cushion  the  dilutive  impact on  ROE  and,  possibly, lead  to further shareholder value creation.

Taking a look back again at the HL Bank-EON  Bank deal, HL Bank had guided for total synergies of MYR400m  over a three-year period, 55% of which  were related  to cost synergies. As a proportion of combined overheads, the expected cost synergies were about 12%. Meanwhile, the integration cost guided then was MYR200m or 91% of expected cost  synergies.  We use these broad numbers in our illustrations below (see  Figures  13-20)  to  show  how  synergies  can  help  create  value,  if  successfully realised.

Observation #3: Deal structure can make a difference, on paper

Putting  aside  the  difference  in  shareholder  approval  threshold  required  for  the acquisition or sale of assets and liabilities if an entity, the deal structure in certain instances may be able to make a difference on ROEs. We set out  in Figures 17-19 below  an  example  of  a  smaller,  lower-ROE  entity  acquiring  a  larger,  higher  ROE entity and show that it is possible for an acquisition to be ROE-accretive – at least, on paper due to accounting rules. In substance, however, the deemed acquirer (ie larger entity) would still experience a dilution to ROEs.

As mentioned above, banks will need to raise equity to fund significant acquisitions these days. Between raising equity via a rights issue and a straight share swap, we show below that a rights issue would be more dilutive on EPS and  book value per share (BVPS) as compared to a share swap. This is because rights shares tend to be issued at a discount to market prices (ie more shares need to be issued) whereas in a share swap, shares tend to be swapped at or close to fair values (ie fewer shares issued). However, the impact to ROE and valuations under both fundraising methods is the same.

Who’s next?
AMMB  –  a  potential  M&A  candidate  in  the  next  round?  Lately,  the  press  has speculated  that  AMMB  could  be  the  next  M&A  candidate.  According  to  reports, Australia  and  New  Zealand  Banking  Group  (ANZ)  (ANZ  AU,  NR)  may  look  to  sell down assets in Asia due to the need to bolster its capital levels, among others. Other potential  M&A  candidates  that  have  been  mentioned  before  include  Public  Bank (PBK MK, NEUTRAL, TP:  MYR19.85) and Alliance  Financial  Group (AFG) (AFG MK, NEUTRAL, TP: MYR4.95).

If  reports  are  accurate  that  ANZ  is  looking  to  dispose  of  its  stake  in  AMMB,  we believe Maybank  could be interested in the deal. We do not discount the possibility that Affin (AHB MK, NEUTRAL, TP: MYR3.50) may also enter the fray, as we believethat  it  remains  interested  in  scaling  up  its  operations.  We  set  out  below  possible structures that a Maybank-AMMB deal and Affin-AMMB deal may occur, although the emphasis here is to provide investors with an illustration of the observations above.

Maybank-AMMB – reclaiming the no. 1 spot

Maybank-AMMB combination to reclaim market share top spot. The combination of Maybank-AMMB would fortify Maybank’s domestic presence and  see the enlarged group regain its position as  the largest banking group in the country  with total assets of  MYR709bn  (13%  larger  than  the  combined  CIMB-RHB-MBSB  group).  Within Asean, it would rank fourth, behind the Singapore banks.

The  enlarged  Maybank-AMMB  entity  would  also  become  the  market  leader  in  a number  of  retail  segments  domestically,  bringing  Maybank  closer  towards  its aspiration  of  becoming  the  undisputed  top  retail  financial  services  provider  in Malaysia by 2015.

Apart  from  the  above,  AMMB’s  lack  of  a  regional  presence  should  mean  less overlaps  and  complications  for  Maybank,  although  all  these  would  have  to  be balanced  against  factors  such  as  AMMB’s  weaker  deposit  franchise  (relative  to Maybank), among others.

We  set  out  below  in  Figures  13-16  our  estimated  impact  of  a  Maybank-AMMB scenario. Some key takeaways from our analysis are as below:

• As expected, an all-equity financed acquisition is ROE-dilutive (up to 150bps), at least in the near term. Synergies can help cushion the dilutive impact, adding an estimated 80bps to ROE (see below);
• Cost synergies, if successfully executed, can add significantly  to bottomline. We assumed  potential  cost  synergies  amount  to  10%  of  the  proforma  enlarged group’s  overheads  from domestic operations, which adds  6% to net profit.  We have  not  assumed  any  potential  revenue  synergies  that  may  arise  from,  eg cross-selling  opportunities  to  AMMB’s  wholesale  clients  by  leveraging  on Maybank’s regional platform;
• Equity  funding  for  acquisitions  via  a  rights  issue  is  more  dilutive  on  EPS  and BVPS  as  compared  to  a  share  swap  exercise,  but  does  not  impact  ROE  and valuations (all else  being  equal). However, existing Maybank shareholders face a  trade-off  between  having  to  inject  capital  into  the  group  (rights  issue)  or accepting a dilution in their equity stake (if acquisition via share swap);
• Gordon Growth Model (GGM)-derived valuations  point to enhancements in fair values, after taking into account  the  synergistic benefits. Assuming there is no change in parameters such as cost of equity and long term growth, the dilution in ROE would be more than compensated for by an enlarged BVPS, after taking into account the synergies.

Affin-AMMB – how a ROE-accretive acquisition may be structured
Smaller bank buys bigger bank to lift ROEs.  The Affin-AMMB deal below serves as an example as to how a deal  structure may still lead to ROE  accretion, if certain conditions are met. As mentioned above, pre-requisites are: i)  a smaller, lower-ROE entity  –  in  this  case,  Affin  (market  capitalisation  of  MYR4.8bn  and  FY15F  ROE  of 8.9%),  ii)  a  larger,  higher-ROE  entity,  ie  AMMB  (market  capitalisation  and  FY16F ROE of MYR20bn and 13.8% respectively), and iii) a deal structure which sees Affin acquiring  AMMB.  Affin  would  be  the  legal  acquirer,  but  in  substance  and  for accounting purposes, AMMB would be the deemed acquirer.

Based  on  the  reverse-acquisition  accounting  treatment  for  the  acquisition,  our analysis  suggests  that  the  enlarged  entity  could  see  ROE  rise  to  12%  from  our current  projection  of  8.9%  on  a  standalone  basis,  excluding  synergies.  Including synergies, ROE rises further to an estimated 13.2%. If these materialise, Affin’s share price should see a significant rerating from current levels, where it only trades at  a 2015 P/BV of 0.7x.

From  the  perspective  of  the  deemed  acquirer,  ie  AMMB,  the  acquisition  would  beROE-dilutive  –  from the currently-projected 13.8% to 12% (13.2%, after synergies). This is consistent with what we mentioned above, about the difficulties in  enhancing ROEs via M&As.

Other potential M&A candidates?

Other potential M&A candidates that have surfaced in press reports include AFG and BIMB  (BIMB  MK,  NEUTRAL,  TP:  MYR4.70),  with  Maybank  touted  as  a  potential suitor. As mentioned above,  the purpose of this report is to provide investors with an application of the observations above. Hence, we do not go into details regarding a Maybank-AFG or a Maybank-BIMB potential deal.
Nevertheless, some quick thoughts:

• Maybank-AFG: We are doubtful that size and scale would be the objectives of such a deal. This is because the enlarged entity would only be 1% larger than the  CIMB-RHB-MBSB  entity.  That  said,  we  acknowledge  that  AFG  has  its strengths  that  it  can  bring  to  the  table,  namely,  SME  banking  and  a  strong deposit franchise.
• Maybank-BIMB:  As  the  only  pure  listed  Islamic  bank,  we  believe  BIMB  is perceived  to  be  the  country’s  flagship  Islamic  bank  (despite  it  not  being  the largest Islamic bank). M&As with any of the listed banking groups may erode this perception.

Forecasts

We make no change to our earnings forecasts.

Risks
The  risks  include:  i)  slower-than-expected  loan  growth.  This  could  be  caused  by business  lending  activities  remaining  muted  and/or  household  lending  growth decelerating  in  a  sharper-than-expected  manner  due  to  the  various  regulatory measures  imposed  to rein in household debt, ii) weaker-than-expected NIMs, which may  stem  from  dilution  in  average  lending  yields  and/or  rising  funding  cost,  iii)  a deterioration  in  asset  quality,  and  iv)  adverse  market  conditions  that  may  crimp markets-related non-interest income.

Valuations and recommendations
While we believe M&A multiples are unlikely to return to levels seen in the past, we still  see  room  for  a  re-rating  in  stock-specific prices amid M&A  news  flow.  Current valuations of banking stocks appear decent to us, especially post the recent market correction.  AMMB  has  been  in  the  spotlight  in  recent  weeks  as  a  M&A  candidate. While plausible, we highlight that  the  timing  of a deal like this  is typically not easy to predict.

Fundamentally, we remain NEUTRAL  on the sector.  For big-cap stocks,  our pick is Maybank,  which  offers  investors  a  well-balanced  exposure  to  both  the  retail  andcorporate segments,  and  is  also  a major  beneficiary  when  capital markets  pick  up again. In our view, dividend yields are attractive while valuations are also decent. Among  the  mid-sized  banks,  we  like  AMMB  for  its  focus  on  profitable  and  viable segments,  healthy  current  account  savings  account  (CASA)  growth  and  efforts  to grow recurring non-interest income. AMMB’s  ROA is the highest among the domestic banks under our coverage. Finally, the full synergistic benefits from the recent Kurnia and MBF Cards acquisitions should start to be felt in FY16F.

Source: RHB