We retain our NEUTRAL sector call. We expect another challenging year ahead for the banks amid a softer macro backdrop, tighter liquidity and rising  concerns  over  asset  quality.  That  said,  sector  earnings  should rebound after a weak 2014 performance while banks now appear better-capitalised. Malaysian  banks  have  also  de-rated,  although  we  see  thisas a structural de-rating as sector ROEs shift down a notch.

Another challenging year in store for banks. We see the following key challenges  ahead  for  the  sector:  i)  softer  macro  environment.  We expect real GDP growth to moderate to 5% in 2015 from 5.8% in 2014 as  the  introduction  of  the  goods  and  services  tax  (GST)  and  lower  oil prices will likely lead to a more moderate increase in consumer spending and  private  investment,  ii)  income  growth.  The  softer  macro environment means we project system loan growth to  ease to 8-9% for 2015  from  9-10%  for  2014.  Meanwhile,  net  interest  margin  (NIM) remains under pressure largely from funding cost due to the ongoing re-pricing  of  fixed  deposits,  tighter  liquidity  and  regulatory  requirements. Markets-related income is also a question mark, and iii) asset quality. A weaker  macro  backdrop  coupled  with  higher inflation  and interest  rates should see asset quality remain in the spotlight. Already, gross impaired loans have ticked up while coverage levels have dropped.

But all is not lost. Notwithstanding the above, Malaysian banks are now better-capitalised,  having  raised  an  estimated  MYR12.5bn  in  CET-1 capital in  9M14. CET-1 ratios (fully-loaded) of most banks  are currently above  the  9%  mark,  ie  higher  than  the  minimum  common  equity  plus capital conservation buffer requirement of 7% by 1 Jan 2019. Also, 2015 sector  net  profit  is  expected  to  rebound  with  a  growth  of  9%,  after  a subdued 2014 (2014F sector net profit growth: -1% YoY).  

Malaysian banks have  also de-rated, with the sector currently trading at 2015 P/E and P/BV of 11.1x and 1.4x respectively. These valuations are  around  1SD  below  average  levels,  suggesting  that  the  lacklustre outlook ahead may have already been priced in. In addition, we believe the  sector  de-rating  is  likely  structural  rather  than  cyclical,  and  current valuations may be the “new normal” for the sector. At 1.4x forward P/BV, we  estimate  the  market  is  pricing  in  a  sector  ROE  of  around  12.7% ahead vs our 2015 sector ROE projection of 13%.   

Investment  case.  We  maintain  our  NEUTRAL  sector  stance  as  we believe  the  challenging  sector  outlook  ahead  appears  to  have  been priced  in.  We  like  stocks  with  low  valuations  as  well  as  strong  and predictable  book  value  growth  to  continue  creating  shareholders  value. AMMB  (AMM  MK,  BUY,  TP:  MYR7.45)  is  our  sole  BUY  call  for  its inexpensive  valuations,  while  Public  Bank  (PBK  MK,  NEUTRAL,  TP: MYR20.60)  is  our  preferred  pick  among  the  NEUTRALs  due  to  the group’s ability to deliver above-average book value growth.

Investment Summary

2015 outlook – Another challenging year in store 
Share  price  performances  of  banking  stocks  have  largely  disappointed  this year.  YTD,  the  sector  is  down  13%,  steeper  than  the  9%  drop  for  the  FBM  KLCI. Similarly,  Malaysian  banks  have  underperformed  relative  to  regional  peers,  whose share price performances have generally appreciated by  12-42% YTD.  In our view, the sector’s underperformance boiled down to: i) weak reported earnings as income growth was a struggle amid NIM pressure as well as muted capital markets, among others.  We  estimate  that  2014/2015  consensus  sector  net  profit  projections  are currently 6.5%/7% lower respectively, compared to end-2013  levels; ii) asset quality concerns, both overseas (eg Indonesian coal sector) and domestic (eg the impact of falling crude oil prices on oil and gas-related companies); iii) foreign selling pressure; and  iv)  the  dilutive  impact  from  three  capital-raising  exercises  by  CIMB  (CIMB  MK, NR), Public Bank and Affin Holdings (AHB MK, NEUTRAL, TP: MYR3.30). Challenges  ahead  for  banking  sector  include  growing  income  and  managing credit  cost.  Looking  ahead  to  2015,  we  see  the  sector  facing  another  challenging year.  The  majority  of  these  headwinds  will  be  largely  similar  to  those  this  year, although the macro backdrop has recently turned more volatile. We highlight below the key challenges the sector may face next year:

i)  Economy – GST and crude oil dampener. The implementation of the GST and lower oil prices will likely constrain domestic demand growth, leading to a more moderate increase in consumer spending and private investment. Earlier policies to control rising household debt and  cool down property speculation  as well as the  Government’s  ongoing  fiscal  consolidation  drive  will  also  likely  limit  the
upside  to  economic  growth.  Our  economics  team  recently  lowered  real  GDP growth for 2015 to 5% from an earlier projection of +5.3% (2014F: +5.8%).    

ii)  Loan growth – Further moderation expected. For 2015, we expect household loan growth to continue moderating as higher inflation and interest rates, as well as the GST implementation, take their toll on consumer discretionary spending. Tighter  credit  underwriting  policies  adopted  by  banks  to  preserve  asset  quality would also have an impact on growth. As for the business segment, we expect a pickup largely due to a “low base” effect (Oct 2014 loan growth: +7% YoY). On the whole, in view of the slowing household loan growth, we project system loan growth  to moderate  further  to  8-9%  in  2015, relative to  our 9-10%  estimate  for 2014 and +10.6% in 2013.

iii)  NIM pressure – Focus shifted to funding cost from asset yields. We expect spreads  to  continue  narrowing  in  2015,  largely  as  funding  cost  rises  further. Firstly, the ongoing re-pricing of fixed deposits from July’s overnight policy rate (OPR)  hike  will  likely  spill  over  into  1H15.  Secondly,  liquidity  has  tightened  as deposit  growth  has  lagged  loan  growth.  Hence,  sector  loan-to-deposit  ratio (LDR)  (based  on  group-level)  stood  at  89%  (end-Sep  2014)  from  81%  at  end-2009. Thirdly, new regulatory requirements on liquidity would see banks focus on stable as well as longer-term funding, which could again exert upward pressure on funding cost. Unlike this year, we think Bank Negara Malaysia (BNM) is likely to keep the OPR unchanged in 2015 at 3.25%. Hence, there will be no relief to the NIM pressure next year unless the banks (especially the big banks) opt  for more rational pricing for both assets and liabilities.

iv)  Markets-related  income  still  a  question  mark.  Banks  with  larger  investment banking (IB) franchises are optimistic that prospects would improve ahead, citing healthy  IB  pipelines.  Forex  opportunities  would  have  improved  recently,  given the  depreciation  of the  MYR  against  the  greenback.  Meanwhile, the  Malaysian Government  Securities  (MGS)  curve  has  steepened  recently  and  this  would affect  trading  as  well  as  investment  income.  This  would  be  exacerbated  when the  US  Federal  Reserve  starts to raise  rates in  2015, leading  to further  capital outflows.   

v)  Asset  quality  –  Shifting  from  household  to  corporate.  While  the  focus  on asset  quality  early  this  year  was  on  the  vulnerable,  low-income  household segment, the sharp drop in crude oil prices coupled with a more subdued macro environment  has  seen  focus  shifting  back  to  the  corporate  segment.  Absolute gross  impaired  loans  for  the  sector  have  risen  5%  YTD,  with  the  rise predominantly  driven  by  Maybank  (MAY  MK,  NEUTRAL,  TP:  MYR10.20) (domestic corporate segment and Indonesia) and CIMB (Indonesian operations).  Despite  the  rise,  loan  provisioning  has  stayed  low  (partly  due  to  new  impaired loans being collateralised), causing aggregate loan loss coverage levels to drop to 88% from 94.4% as at end-2013. Our base-case assumption in our forecasts is for credit cost to continue trending towards more normalised levels.

But all is not lost 
Notwithstanding the above, we see some positives for the sector heading into 2015 as well. Malaysian  banks  now  better-capitalised.  We  estimate  Malaysian  banks  raised  a total of MYR12.5bn in CET-1 capital during 9M14, via a combination of rights issue, private  placement  and  dividend  reinvestment  plans.  As  such,  Malaysian  banks  are now  better-capitalised  heading  into  2015  with  CET-1  ratios  (fully-loaded)  of  most banks above the 9% mark, ie higher than the minimum common equity plus capital conservation buffer requirement of 7% by 1 Jan 2019. We expect the spotlight next year regarding capital to turn to HL Bank (HLBK MK, NEUTRAL, TP: MYR15.90), ie one  of  the  potential  banks that may  need  to  raise  capital. We  estimate  that  it may need  to  raise  about  MYR2.5bn-3.5bn  (10-15%  of  market  capitalisation)  in  order  to raise  its  CET-1  ratio  (at  the  bank  level)  to  10-11%  from  the  estimated  fully-loaded CET-1 ratio of 7.4% as at end-September.

Sector  net  profit  may  rebound  in  2015.  We  project  sector  net  profit  growth  to rebound  to  +9%  YoY  in  2015  (2014F:  -1%  YoY),  underpinned  by:  i)  stable  net interest  income  growth  of  6%  YoY,  amid  loan  growth  of  8.8%  YoY  partly  offset  by 5bps NIM compression, ii) an 11% YoY rise in non-interest income, albeit from a low base effect, iii) positive jaws as banks continue to keep a tight grip on costs, and iv) sector credit cost of 26bps, a milder rise from 24bps in 2014F (2013: 18bps) and up from the low of 16bps in 2012. 2015 sector EPS growth, however, is expected to lag net profit growth at 6% YoY, due to dilution from 2014’s capital-raising exercises.  Malaysia  banks  have  de-rated  and  current  sector  valuations  appear  fair.  The Malaysian banking sector has de-rated this year, with the sector currently trading at 2015 P/E and P/BV of  11.1x and 1.4x respectively. P/E valuations are  around 1SD below  average  levels  while  P/BV  valuations  are  already  below  -1SD  levels, suggesting  that  the  lacklustre  outlook  ahead  may  have  already  been  priced  in.  At 1.4x  forward  P/BV,  we  estimate  the  market  is  pricing  in  a  sector  ROE  of  around 12.7% ahead, vs our 2015 sector ROE projection of 13%. We also note that among regional peers in Singapore, Indonesia and Thailand, the Malaysian banking sector is the only sector currently trading at -1SD levels. 

Risks 
We think the key downside risk to our forecasts still lies with operating income. This could  be  due  to  weaker-than-expected  NIMs  arising  from  competitive  pressures  on both asset yields and funding costs and/or softer-than-expected non-interest income, which  would  be  due  to  adverse  markets  conditions.  Apart  from  that,  deteriorating asset quality may result in higher-than-expected credit cost. 
 
Valuations and recommendations 
Despite the challenging banking environment ahead, we are keeping our  NEUTRAL sector call amid an expected  earnings  rebound next year as well as valuations that appear  fair.  Given  the  challenging  macro  environment,  our  key  sector  picks  are skewed towards a more defensive stance. Generally, we like stocks that offer: i) low valuations,  and  ii)  strong  and  predictable  book  value  growth  to  continue  creating shareholders value. For ii), this would entail a combination of superior returns, sound earnings predictability (eg less reliant on markets-related income) and/or solid asset quality.  Also,  banks  with  relatively  lower  market  risk  should  aid  in  insulating  book value against adverse interest rate/bond yield and foreign exchange rate movements (see page 16 for further details).

AMMB  is  our  sole  BUY  for  the  sector.  In  our  view,  valuations  appear  inexpensive while potential merger and acquisition (M&A) news flow may provide a fillip to share price  performance.  Apart  from  the above, AMMB’s ROA is the highest among the domestic  banks  under  our  coverage.  This  would  be  further  supported  by  the  full synergistic benefits from the Kurnia and MBF Cards acquisitions, which should start to be felt from FY16F.

Source: RHB