We retain our NEUTRAL sector call. 1Q15 sector net profit dropped 8% YoY due to a combination of NIM pressure from the funding side and higher overheads, as well as loan impairment allowances (chunky provisioning and lower recoveries). Banks may continue to have a challenging year ahead due to macro conditions, but do not expect any systemic asset quality issues.

• 1Q15 results were below expectations. For the recent 1Q15 reporting quarter, three out of the seven banking stocks that we cover report edresults that were below our and consensus estimates, while the rest booked numbers that were within expectations. The reasons for the earnings disappointment varied from higher-than-expected loan impairment allowances to weaker-than-expected non-interest income as well as sharper-than-expected net interest margin (NIM) contraction and restructuring costs. Overall, aggregate 1Q15 net profit fell 3% QoQ and 8%YoY, with the QoQ decline in net profit due to a combination ofweaker non-interest income and higher loan impairment allowances while the YoY drop stemmed from higher overheads and loan impairment allowances.
• Key takeaways: i) targets and KPIs biased towards downside. During the results briefings, targets and KPIs were guided down or, at best, kept unchanged. Weak macro conditions were common reasonsgiven for the more bearish tone. As for the other banks, better visibility should be available post the 2Q14 results in August, as to whether the targets would be revised.
• ii) NIM pressure still from liability side. Sector NIM continues to remain under pressure from the liability side of banks’ books. The banks cited upward pressure on funding cost stemming from a c ombination of: i) repricing of fixed deposits following Jul 2014’s overnight policy rate (OPR) hike; and ii) competition for retail deposits to meet regulatory requirements. Apart from that, several banks built up liquidity to lower their loan-to-deposit ratios (LDR), which added to the NIM pressure. From a sectorial perspective, LDR as at end-Q15 was marginally lower QoQ at 88.8% (end-2014: 89.1%) but up from 88.1% a year ago.
• iii) Credit cost on the rise as recoveries taper off. Sector absolutegross impaired loans ticked up 1% QoQ (+5% YoY) but it appears that the issues were company/sector specific rather than systemic. 1Q15 annualised credit cost inched up to 29bps from 27bps in 4Q14 (1Q14: 17bps) with the QoQ rise mainly due to lower recoveries. Sector loan loss coverage declined further to 89.5%, from 89.9% as at end-2014 and 95.8% a year ago.
• Investment case. We remain NEUTRAL on the sector, with Public Bank (PBK MK, BUY, TP: MYR21.00) as our top sector pick.

1Q15 Results Roundup Higher overheads and loan allowances dampen sector net profit The recent 1Q15 reporting quarter was disappointing, with three out of the seven banking stocks that we cover reporting results that were below our and consensus estimates. The reasons for the earnings disappointment varied from higher-thanexpected loan impairment allowances - Affin (AHB MK, NEUTRAL, TP: MYR2.70) to weaker-than-expected non-interest income - Alliance Financial Group (AFG) (AFG MK, NEUTRAL, TP: MYR4.40) as well as sharper-than-expected NIM contraction and restructuring costs - CIMB (CIMB MK, SELL, TP: MYR5.20). The remaining results were in line with our and consensus expectations.

In the previous 4Q14 reporting quarter, four out of the seven banking stocks that we cover booked results that were in line with our and consensus estimates. Affin’s and Maybank’s (MAY MK, NEUTRAL, TP: MYR10.00) results came in above our and consensus expectations, aided by lower-than-expected credit costs. On the other hand, CIMB’s 2014 results missed estimates due to a spike in loan impairment allowances (ie its Indonesia coal portfolio and a domestic legacy corporate loan) and goodwill impairment charges.

In terms of dividends, two banks that we cover declared dividends. AMMB’s (AMM MK, SELL, TP: MYR5.70) final dividend was above expectations thanks to a slightly higher-than-expected payout ratio of 43% but AFG’s dividends disappointed, as its full-year payout ratio of 45% came in below our 55% assumption and was at the lower end of its “up to 60% of earnings” policy.

Aggregate 1Q15 net profit contracted by 3% QoQ and 8%YoY, with the QoQdecline in net profit due to a combination of weaker non-interest income and higher loan impairment allowances while the YoY drop was due to higher overheads and loan impairment allowances. 1Q15 trends of headline items are as set out below:i) Net interest income (+1% QoQ, +4% YoY). Aggregate loan base expanded by 2.3% QoQ/11.5% YoY vs 4Q14’s 4.3% QoQ/11.3% YoY – mainly driven by retail and SME lending. The wholesale segment got off to a slower start, which was a similar trend in 1Q14. Loan growth, however, was crimped by NIM pressure (1Q15 NIM: -6bps QoQ/-16bps YoY vs 4Q14’s -9bps QoQ/-17bps YoY). QoQ, the average funding cost was down 10bps vs the 15bps drop in average asset yield while YoY, the average funding cost rose 21bps, outpacing the 3bps rise in average asset yield. Reasons cited for the pressure on funding cost include the repricing of fixed deposits following the overnight policy rate (OPR) hike in Jul 2014 and deposit competition to meet regulatory requirements.

ii) Non-interest income (-8% QoQ, +12% YoY). The sequential decline in noninterest income was mainly caused by weaker fee and other (insurance income for Maybank and gains from disposal of assets for CIMB) income. However, these were partly offset by favourable market conditions in terms of bond yield and forex movements, which helped banks to chalk up better realised and unrealised gains from the investment portfolio as well as forex income. YoY, the rise in non-interest income was mainly driven by stronger forex gains.

iii) Overheads (flat QoQ, +14% YoY). Excluding CIMB’s MYR202m restructuring cost, overheads were down 3% QoQ but up 11% YoY. The sequential drop in overheads mainly reflects seasonal year-end spending – such as variable staff compensation. YoY, the double-digit rise in underlying operating expenses appears high. Maybank had cited adjustments to union collective agreements having impacted staff costs and potentially, this may have impacted the industry as well. From the individual banks’ results, staff costs were a factor to the rise in overheads. Overall, 1Q15 cost-to-income ratio (CIR) deteriorated to 51.2% from 50.2% in 4Q14 and 47.9% in 1Q14.

iv) Loan impairment allowances (+13% QoQ, +73% YoY). QoQ, although CIMB’s loan impairment allowances fell 43% from its kitchen-sinking exercise in 4Q14, this was not sufficient to offset the reversal from net writebacks enjoyed in the previous quarter to net charge as reported by Maybank and Affin. Recall that Maybank’s net writeback in 4Q14 was aided by low collective allowances set aside following an update in model parameters and healthy recoveries, while Affin’s net writeback was driven by recoveries. This quarter, recoveries are tapering off while Affin was impacted by chunky provisioning. YoY, the rise in loan impairment allowances was mainly due to CIMB (continued provisioning for its coal portfolio in Indonesia) and Affin

Key highlights from results Below are the highlights from banks’ recent reporting quarter: i. Targets and KPIs biased towards downside. During the results briefings, targets and KPIs were guided down or, at best, kept unchanged. CIMB, for instance, opined that it would be a challenge to achieve its 2015 ROE target of 11%, citing sharper-than-expected NIM contraction in 1Q15 and weak macro conditions. Meanwhile, AMMB lowered its FY16 KPIs (eg FY16 KPI on ROE was revised to 12-12.5% from c.14%), pointing to a softer macroeconomic outlook. For some of the other banks, although 1Q15 results were trending below targets, their targets were unchanged at this juncture due to expectations of seasonally better quarters ahead. That said, these banks also mentioned that visibility should be better post the 2Q results as to whether the targets should be revised.ii. NIM pressure still from liability side. Sector NIM continues to remain under pressure from the liability side of banks’ books. The banks cited upward pressure on funding cost stemming from a combination of: i) repricing of fixed deposits following Jul 2014’s OPR hike; and 2) the competition for deposits, especially for retail deposits, to meet regulatory requirements. Apart from that, several banks raised their liquidity to lower their loan-to-deposit ratios (LDR), which added to the NIM pressure. These include banking groups such as AFG, AMMB and CIMB. On the other hand, we note that some banks continued to manage funding cost by shedding costlier money market deposits and allowing their LDRs to rise. Maybank, especially, saw its NIM expand by 12bps QoQ via this strategy. However, as Maybank continued to guide for a LDR comfort range of 85-90%, we believe it is just a matter of time before Maybank will need to compete and grow its deposits more aggressively given that its LDR has been creeping up over the past few quarters (LDR of 92.2% as at end-Mar 2015). We expect its NIM to be impacted when that happens. From a sectorial perspective, LDR as at end-Q15 was marginally lower QoQ at 88.8% (end-2014: 89.1%) but up from 88.1% a year ago.

iii. Loan growth – Uncertainties ahead for retail and corporate lending activities. As mentioned above, 1Q15 loan growth was mainly driven by the consumer and SME/commercial segments. Possibly, demand for credit from these segments could have been due to some pre-GST spending activities. On the other hand, the corporate segent appears to have had a slow start – similar to last year. Factors causing the soft corporate lending market include chunky loan repayments as well as weak macro con ditions. Going forward, some banks have mentioned the possibility of a moderation in consumer lending, in line with the expected slowdown in consumer spending post-GST. As for the corporate segment, much will still depend on macro conditions.

iv. Credit cost on the rise as recoveries taper off. Sector absolute gross impaired loans saw a mild uptick, up 1% QoQ (+5% YoY), but the gross impaired loan ratio was stable QoQ at 1.7% (1Q14: 1.8%) due to an enlarged loan ase. The sequential rise in absolute impaired loans came mainly from corporate focused banks such as Affin, CIMB, Maybank and RHB. Nevertheless, it appears that the issues were company/sector specific issues, rather than a systemic deterioration in asset quality. On he other hand, retail-focused banks generally saw asset quality continuing to improve – AFG, HL Bank (HLBK MK, NEUTRAL, TP: MYR15.00) and Public Bank reported a sequential drop in absolute gross impaired loans of 5-6% (5-22% decline YoY). 1Q15 annualised credit cost inched up to 29bps from 27bps in 4Q14 (1Q14: 17bps). We note that the QoQ rise in credit cost was mainly due to lower recoveries (-37% QoQ). Individual and collective allowances, however, were down 19% QoQ and 5% QoQ respectively. Given that individual and collective allowances remained benign, sector loan loss coverage declined further to 89.5%, from 89.9% as at end-2014 and 95.8% a year ago.

v. Markets-related income – Decent start but visibility still cloudy. Treasury –fixed income as well as forex, had a good start to the year while 2Q15 appears to be shaping up to be a better quarter for the equity capital market. That said, we had factored in a rebound in non-interest income for the banks in 2015, after a poor 2014. We see potential risks with respect to the rebound, especially if macro conditions turn out to be weaker than expected.

Risks The risks include: i) slower-than-expected loan growth, ii) weaker-than-expected NIMs, iii) a deterioration in asset quality, and iv) changes in market conditions that may adversely affect investment portfolios.

Forecasts Our 2015F/2016F/2017F sector net profit projections were revised down by 5%/3%/3% respectively, with the steeper downgrade in 2015 mainly coming from CIMB (2015 net profit forecast cut by 16%) and AMMB (FY16F earnings down by 14%). On the whole, the earnings disappointment together with downward revisions to targets and outlook led us to cut our 2015F-2017F numbers for five out of the seven banking stocks that we cover. There were only two banks whose forecasts were unscathed from the downgrades – Maybank and Public Bank.

Valuations and recommendations

Maintain NEUTRAL on the sector. Given the challenging macro environment, our key sector picks are skewed towards a more defensive stance. We like banks that offer strong and predictable book value growth to continue creating shareholders value. 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. In our view, Public Bank meets the criteria above and is our sole BUY stock for the sector.

Source: RHB Research - 1 Jun 2015