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Hong Kong Banks Sector
SECTOR REVIEW
Survival of the fittest
■ We believe that 2009 will be this credit cycle’s equivalent of 1998. In
this report, we compare the operating earnings power of the Hong
Kong banks to their historical performance on managing asset quality.
The result is a ranking in terms of P&L, dividend and capital resilience.
■ We believe that the “fittest” bank is Hang Seng Bank, due to its strong
(>2%) ROA at the pre-provision profit level and superior historical
performance on asset quality. Even allowing for a weaker outlook for
fee income and margins in our revised forecasts, we estimate a repeat
of 1998 credit costs would only drag down ROE to 19.5%, implying a
dividend yield of 6%. This, in our view, is sufficient to justify
Hang Seng’s premium valuation to its sector peers and a superior
relative performance during 2009.
■ The weakest bank is ICBC Asia, in our view. Its weak (c. 1%) ROA
makes it susceptible to rising credit costs and its tier 1 capital ratio
(8%) is relatively thin. Ironically, this plays into our positive view of the
stock. We believe that conditions may deteriorate to the point that
ICBC Asia needs additional capital. If this turns out to be the case, we
believe that privatisation by the parent company could become a real
possibility.
■ We believe that BOC HK is better placed than BEA, due to its stronger
pre-provision ROA and higher tier 1 capital ratio. However, the credit
cost picture is complicated. BOC HK performed poorly in the last credit
cycle downturn and it remains to be seen how far the new management
team improved risk management. BEA’s credit performance in the last
cycle was by no means the worst, however, the rapid pace of recent
loan growth suggests potential vulnerability.
Company analysis
In view of the asset quality deterioration that we expect to emerge in 2009, we have
analysed the ability of the banks to withstand rising credit costs based on operating returns
and relative performance on asset quality in the most recent credit cycle downturn.
We believe that Hang Seng Bank is the strongest of the domestic Hong Kong banks. Its
earnings power is unrivalled, with ROA at the pre-provision profit level above 2% and a
market-leading credit performance since 1995. To demonstrate Hang Seng’s resilience,
even if we assumed a repeat of 1998 credit costs, we would still expect ROE of 15% (i.e.,
a dividend yield of 4-5%).
In our view, the weakest bank is ICBC Asia. Its low PPOP ROA and moderate capital
strength make it sensitive to a repeat of the extreme credit costs seen in 1998/99.
However, in our view, this sensitivity only serves to increase the chance of privatisation by
its parent company, which is the basis for our OUTPERFORM rating.
BOC HK appears to be better equipped than BEA to ride out the coming downturn, given
its superior PPOP returns and a larger capital buffer. The key question is the extent to
which the new management team’s risk management reforms can prevent the massive
asset quality deterioration seen in the last cycle.
The banks are trading at levels that price in a lot of the bad news. This begs the question:
what could cause the sector to bounce? In our view, for any rally to be sustainable, we
need to see a light at the end of the proverbial tunnel: this implies stabilisation of property
prices, economic activity and corporate profitability. We think that this is more likely a
2H09 or 1H10 proposition, as rising SME delinquencies and higher unemployment in 1H09
would continue to weigh on sentiment.
Accordingly, we believe a capital preservation strategy should continue to be employed.
This supports our continued near-term preference for Hang Seng. While it would not be
immune to the pressures emerging, its P&L and balance sheet power justify the premium
valuation multiple relative to peers, which we believe are still subject to negative news on
financial exposures and Lehman mini-bond buy-backs.
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