We keep our NEUTRAL sector call. The 2Q15 results season was disappointing, with three out of the seven banking stocks we cover reporting results that missed estimates while the rest were in line. Consequently, majority of the banks now believe that earlier ROE targets set may not be achieved. Public Bank remains our Top Pick and the only bank that escaped unscathed from the earnings downgrades.

2Q15 another disappointing quarter for banks. Four out of the seven banking stocks that we cover reported results that were in line with our estimates. AMMB, CIMB and Maybank all reported results that missed our and consensus estimates. Key reasons were mainly weaker-thanexpected income (NIM compression, soft non-interest income) and higher-than-expected loan provisioning due to the deterioration in asset quality.

Key takeaways: i) Higher LDR to cushion NIM pressure. 2Q15 sector NIM was flattish QoQ (-12bps YoY) despite funding cost pressures. Diving deeper, however, we believe the main reason margins held up well this quarter was because of liquidity management. We note that the loans-to-deposit ratio (LDR) for the sector rose further to 90.2% during the quarter, compared to 88.8% at end-1Q15 (2Q14: 87.8%).

ii) Banks drawing down on coverage levels to cushion impact of deterioration in asset quality Absolute gross impaired loans rose 5% QoQ/+10% YoY. Of note, the deterioration in asset quality was mainly from overseas operations (largely from Indonesia) but domestic asset quality appears to be holding up quite well thus far. Despite the rise in impaired loans, 2Q15 credit cost (annualised) was slightly lower at 27bps vs 1Q15: 29bps. This was because banks were drawing down on coverage levels, resulting in the sector loan loss coverage (LLC) dropping to 83.6% from 89.5% in 1Q15 and 93.3% in 2Q14.

iii) ROEs unlikely to be met and/or downgraded. Amid a soft quarter, more banks now believe the earlier ROE targets set may not be achieved and/or have lowered down ROE targets. Banks that we think will find it challenging to achieve their 2015/FY16 ROE targets include Affin, AFG, AMMB, CIMB and Maybank.

More earnings volatility ahead. Already, the operating environment is challenging while factors such as rising bond yields could give rise to further earnings volatility. We think banks with high LDRs and/or LLCs that have dropped significantly could face additional downside risk to earnings as the need to “normalise” LDRs and LLCs will result in downward pressure on NIMs and higher loan provisioning ahead. These banks include Maybank and CIMB.

Investment case. We remain NEUTRAL on the sector, with Public Bank (PBK MK, BUY, TP: MYR21.00) as our top sector pick.

2Q15 Results Roundup Weak operating income and sticky loan allowances capped earningsgrowth 2Q15 was another disappointing reporting quarter for the banks. Four out of the seven banking stocks that we cover reported results that were in line with our estimates. AMMB (AMM MK, NEUTRAL, TP: MYR4.90), CIMB (CIMB MK, SELL, TP: MYR4.70) and Maybank (MAY MK, NEUTRAL, TP: MYR8.60) all reported results that missed our and consensus estimates. Key reasons were weaker-than-expected income (AMMB and Maybank) and higher-than-expected loan provisioning due to deterioration in asset quality (CIMB and Maybank). Affin’s (AHB MK, NEUTRAL, TP: MYR2.35) results were also below consensus expectations, but in line with ours. In the previous 1Q15 reporting quarter, three out of the seven banking stocks that we cover report results that were below our and consensus estimates. The reasons for the earnings disappointment include higher-thn-expected loan impairment allowances (Affin); weaker-than-expected non-interest income (AFG (AFG MK, NEUTRAL, TP: MYR3.90)) as well as sharper-than-expected NIM contraction and restructuring costs (CIMB). The remaining results were in line with our and consensus expectations.

Underlying 2Q15 sector pre-tax profit: +3% QoQ/+1% YoY YoY, 2Q15 and 2H15 sector reported net profit was down 5-6% due to higher loan impairment allowances. Underlying sector pre-tax profit, however, rose 3% QoQ/1% YoY with pre-impairment operating profit up 2% QoQ/7% YoY. YoY growth, however, was dampened by higher loan provisioning.

Banks that reported strong sequential underlying net profit growth include Affin, AFG, CIMB. Hong Leong Bank (HL Bank) (HLBK MK, NEUTRAL, TP: MYR14.00) and RHB (RHBC NR). Key drivers for the QoQ improvement include: i) lower loan impairment allowances (Affin, RHB); and ii) stronger operating income (AFG, CIMB, HL Bank). AMMB’s core net profit was down 26% QoQ due to combination of NIM squeeze, weak loan- and capital markets-related income and lower loan impairment writebacks.

Forex translation and stable NIMs helped support net interest income 2Q15 net interest income turned in a decent growth (2% QoQ/+6% YoY), on the back of +2% QoQ/+12% YoY loan growth while NIM was stable QoQ (-12bps YoY). That said, we do note that loan growth was aided by favourable forex translation effects (especially for banks with regional operations) while margins were held up by liquidity management, ie banks allowing their loan-to-deposit ratios (LDRs) to rise to help cushion funding cost pressures.

Among the banks in Figure 3 below, AMMB stands out for the drop in net interest income. This was due to a combination of its loan book contracting ( -2% QoQ and YoY amid ongoing portfolio rebalancing efforts and corporate loan repayments) and 18bps QoQ NIM compression due to lower average asset yield from “one-off”adjustments and portfolio rebalancing for both its loans and fixed income books.

Decent non-interest income Excluding lumpy gains from disposal of subsidiaries by AMMB (2Q14: MYR390m; 1Q15: 77m), sector non-interest income would have been down 3% QoQ but up 10% YoY. As seen below, the QoQ decline was mainly due to Maybank, which reported a 80% QoQ drop in forex income as a result of unrealised losses stemming from its foreign currency net liability position. YoY, fee and forex income of banks were generally healthy, partly offset by softer contribution from treasury markets.

Overheads – Need to keep a lid Adjusting for lumpy restructuring cost items (2Q14: MYR90m relating to AMMB; 1Q15: MYR202m IB restructuring cost for CIMB; 2Q15: MYR316m MSS cost for CIMB) sector overheads were down 1% QoQ (+7% YoY). Sector cost-to-income ratio (CIR) was also broadly stable at 49% in 2Q15 and 2Q14, and marginally lower from the 50% recorded in 1Q15. We expect banks to continue keeping a tight lid on cost, especially should income growth pan out to be softer than expected.

Source: RHB Research - 3 Sep 2015