The focus on risk adjusted returns should pan out to be positive for AFG over the longer term, but near-term, we expect income growth to stay muted as efforts to rebalance the loan portfolio and derisk the balance sheet will need time. Asset quality also appears to be under control, although the current low credit cost is unlikely to be sustainable, in our view. We keep our NEUTRAL call and MYR3.45 TP (3% downside).

Changes require time. The impact from AFG’s ongoing rebalancing of the loan portfolio continues to have a positive effect on average asset yield (3QFY16 (Mar): +8bps QoQ) but the trade-off from the rebalancing, ie moderating loan growth, and tighter liquidity conditions mean that the impact to bottomline has yet to be meaningful. Also, despite FY15’s cost rationalisation exercise, overheads remain under pressure from rising staff cost due to collective agreement adjustments. Asset quality, however, was intact and helped keep 3QFY16 credit cost at a mere 7bps (annualised), but this is unlikely to be sustainable.

Outlook. While 9MFY16 net interest margin (NIM) and credit cost appear to be trending better than the guidance, cost pressures and weaker loan growth are likely to mean FY16 ROE misses the 12-13% target (9MFY16: 11.4%). Looking ahead to FY17, AFG thinks household asset quality could be under pressure from rising unemployment levels and estimates an additional MYR25m in loan impairment allowances would be required from this segment. AFG sees FY17 credit cost moving up to 25-30bps (vs 20-25bps guidance for FY16). Oil and gas exposure is not a concern for management, foming <1% of the loan book. Risks. Softer-than-expected income growth and a significant deterioration in asset quality are key risks, both a reflection of the weaker macroeconomic environment ahead.

Financial Exhibits

3QFY16 Results In Line

Alliance Financial Group’s (AFG) 3QFY16 net profit of MYR136m (+7% YoY, +1% QoQ) was in line with estimates. 9MFY16 net profit stood at MYR392m (-8% YoY, underlying basis) or 76% of our and 75% of consensus FY16 forecasts. Results highlights. Pre-impairment operating profit was weaker sequentially (-7% QoQ) due to a combination of weaker non-interest income (-10% QoQ on the back of lower derivative gains and forex losses) and higher operating cost (+5% QoQ. Personnel cost was higher due to adjustments for collective agreement). The saving grace was the low loan impairment allowances, where 3QFY16 credit cost was just 7bps vs 2QFY16’s 20bps (figures annualised). Other highlights: i) NIM was marginally lower (-1bp QoQ) as higher average asset yield from the repricing and rebalancing of the loan book was offset by higher funding cost due to the issuance of MYR1.2bn in Tier-2 sub debt, ii) cost-to-income ratio (CIR) deteriorated to 48% in 3QFY16 from 45% in 2QFY16 (3QFY15: 45%), and iii) asset quality saw a slight improvement.

Loan and deposit growth. Gross loans expanded 8% YoY (+2% QoQ) but on an annualised basis, the 6% growth was below the high single-digit growth target set for FY16. YoY loan growth was driven by small- and medium-sized enterprise (SME) (+17% YoY) banking, where risk adjusted returns are better. Customer deposits were up 5% YoY (-1% QoQ) while current and savings account (CASA) deposits grew 6% YoY (+3% QoQ). AFG’s loan-to-deposit ratio (LDR) reached 88% in 3QFY16 from 85% in 2QFY16 (3QFY15: 85%), as funding raised from debt securities allowed AFG to shed some of its higher cost deposits.

Asset quality. Absolute gross impaired loans eased 2% QoQ (+3% YoY) with the improvement driven by lower impaired residential mortgages. Gross impaired loan ratio and loan loss coverage were stable sequentially at 1.1% and 93% respectively. Capital. Fully-loaded group common equity tier-1 (CET-1) was 11.3% as at end-Dec vs. end-2QFY16: 11.4%.

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

Forecasts We make no changes to our earnings projections.

Valuation and recommendation We leave our GGM-derived TP of MYR3.45 unchanged. Our GGM assumes: i) cost of equity of 10.3%, ii) ROE of 10.75%, and iii) long-term growth of 4.5%. Our TP is based on fair 2016F P/BV of 1.08x, which is at a discount to the 10-year average P/BV of 1.6x. We believe the discount is fair, given our FY16-18 ROE projections of c.10.5-11.2%, compared with the 10-year average ROE of 12.6%. AFG’s focus on risk-adjusted returns and growing non-interest income should be positive for ROEs if successfully executed, but we think this will take time. Near-term, the rebalancing of the loan portfolio and derisking of its balance sheet are likely to keep income growth muted. Asset quality is also less of an issue for AFG, but credit cost is coming from a low base. As credit cost normalises ahead, this would dampen bottomline growth. We retain our NEUTRAL call, given the muted earnings growth ahead.

SWOT Analysis

Source: RHB Research - 23 Feb 2016