DBS: Appoints Piyush Gupta as CEO

DBS announced yesterday that it has appointed veteran banker Piyush Gupta as CEO. He has spent over two-thirds of his 27-year career in South East Asia and Hong Kong, including eight years in Singapore.

Gupta’s experience in the South East Asia-Pacific markets will be a major asset to DBS. Gupta is currently Citi’s CEO for South East Asia-Pacific, covering ASEAN (Singapore, Malaysia, Philippines, Indonesia, Thailand, Vietnam and Brunei), Australia, New Zealand and Guam. In this role, his responsibilities encompass all of Citi’s businesses including Financial Markets, Corporate and Investment Banking, Transaction Services, Credit Cards, Retail Banking and Wealth Management.

DBS valuation pegged to 1.1x 2010 book. The potential benefit from Gupta’s appointment will take time to flow through. In the meantime, we continue to be concerned with DBS’ asset quality, following its strong loan expansion over the past few years. DBS remains a SELL with a S$11.80 target price, which is pegged to 1.1x 2010 book. For investors who want to be exposed to Singapore banks, UOB (NEUTRAL) is our best pick.

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DBS: Better than expected 2Q

Better than expected 2Q09 results. DBS Group posted 2Q09 net earnings of S$552m, down 15% YoY but +27% QoQ, and were above the median estimate in a Bloomberg survey of S$425m. Net Interest Income improved 5.1% YoY or 3.3% QoQ to S$1112m in 2Q09. From the fee income side, the best performers were its Stockbroking (+28%YoY and +79% QoQ), Investment-related (+59% QoQ), Wealth Management (+31% QoQ) and Fund Management (+20%QoQ) units. Cost-to-income ratio also improved from 42.5% in 2Q08 to 38.4% in 1Q09 and then to a significantly lower 35.2% by 2Q09. Non Interest Income rose 22% YoY and 16% QoQ to S$680m.

As expected, impairment charges remained high. This surged from $90m in 2Q08 to $437m in 1Q09 and $466m by 2Q09 (OCBC of S$104m and UOB of S$465m for 2Q09). Net Interest Margin (NIM) was better QoQ, but down YoY. It improved from 1.99% in 1Q09 to 2.01% in 2Q09. The group has declared a dividend of 14 cents for this quarter. For 1H09, the group posted earnings of S$985m or 46% of our revised FY09 forecast.

Upping FY09 and FY10 estimates. With improving economic prospects, we have revised our earnings estimates. While we expect impairment charges to remain high, we believe that 1Q and 2Q were the peak quarters and impairment charges should come off in 3Q and 4Q. We are projecting lower charges of S$567m in 2H09 versus S$903m in 1H09. In addition, with the rally in the equity market, we expect capital market activities and feebased income to improve and we have raised our estimates for 2H09. Overall, we are increasing FY09 earnings from S$1572m to S$2128m. For FY10, we have also upped our estimates from S$1965m to S$2401m.

Maintain BUY, raised fair value estimates to S$14.65. Together with the improved economic outlook, although uncertainty still remains and unemployment is still high in the US, valuations for the three local banking stocks have also moved up higher. To reflect this trend, we are raising our valuation peg from 1.2x to 1.4x book and this in turn raises our fair value estimate from S$12.40 to S$14.65. At this price, valuation is 15.7x FY09 earnings and 13.9x FY10 earnings. Assuming that the group maintains its 14 cents per quarter dividend payout, annual yield is fairly decent at 4.4% based on current price. We are maintaining our BUY rating on DBS.

DBS - 2Q09: Ahead, but issues simmer

Loan growth decelerated in 2Q, flat q-q post-currency adjustment (1Q: +1%) – disappointing considering DBS highlighted market share potential as a driver for the ROE-depressing S$4bn capitalraising in Dec 08. Net interest margin (NIM) saw a positive albeit shallow inflexion (+2bps, following steady decline since 2Q07) as low interbank rates weighed on a liquid, high CASA balance sheet.

Non-interest income (NII) was key positive surprise – fee income grew 13% q-q, primarily on capital market-related revenues, while both trading and investment income surprised with q-q resilience, supporting management’s contention that de-risking of the trading operations over 2H08 will yield more stable contributions going forward. On the other hand, NPLs surprised negatively, rising a hefty +80bps q-q, to 2.8% - while this caused related overshooting in provisioning, loan loss cover has been allowed to further shrivel, declining to 68% (1Q: 85%). Peers remain near the 100% level.

Notwithstanding positive revision bias on NII out-performance, the latter’s underlying dependence on inherently volatile capital market activity sits uncomfortably with broadly weak commercial banking traction i.e. loan growth, margins, NPL formation / coverage. ROE is set to remain depressed and a discounting factor versus peers.

Our Gordon Growth-based price target (methodology unchanged, assuming 10% sustainable ROE, 10% cost of capital and 5% long-term growth) is S$10.80, implying 1.2x FY10F adjusted book value (1.0x stated book) and 14x FY10F earnings. Upside risk lies in faster-than-expected recovery in export demand; this would significantly reduce NPL stress on the balance sheet, particularly from exposure to HK/China SMEs. On the downside, while DBS’ corporate CDO exposure has been substantially provided for, the rapid pace of corporate-directed loan growth over the last two years, coupled with substantial exposure to the HK/China export-dependent SME segment and corporate debt securities, means earnings are highly vulnerable to potential spiking in corporate defaults. Further, any delay or uncertainty surrounding the replacement of DBS’ CEO Richard Stanley, who unexpectedly passed away in April, would be a discounting factor, in our view.

DBS - Loan loss provision higher than expected

Overall, DBS delivered a strong 2Q09 underlying result partly offset by higher than expected provisions. Profit $552m vs. DB $445m and consensus $434m while DPS of 14cps was unchanged and in line. With upside surprise driven by both revenues and expenses it appears the underlying business is perfoming better than we anticipated and given the stock is trading well below our $16.50/share target price we maintain our Buy rating.

Pre-provision profit of $1,161m was 18% above DB forecast with revenue 8% ahead of expectations and expenses down 1% QoQ. Although net interest income grew 3% QoQ (peers -4%) with NIM +2bps, non interest income was the key revenue driver (+16% QoQ). This growth was broad based but pleasingly fees and commissions were up 13% QoQ on higher broking and investment banking fees. Given fee income is still 11% below previous highs we believe this emerging trend has further to go.

The provision expense of $466m (+13% QoQ) was above our $423m while NPLs increased to 2.8% from 2.0% 1Q09, an increase more pronounced than for peers. Although we think this was well anticipated by the market the composition is notable with HK credit quality benign (provision charge -19% QoQ to $71, NPA rate fell to 2.4% from 2.6%) and the Singapore provision charge +65% QoQ to $372m. However the Singapore NPA rate barely moved (1.3% vs 1.2% 1Q09) and given DB economists are forecasting an economic rebound for Singapore in '10e we believe this increase in loan losses is unlikely to be sustained.

DBS - Q 2 beats consensus but provisioning high

DBS’s Q2 net profit beat our estimate by 10% and consensus estimate by 20%. The highlight of its results, in our view, was the higher-than-expected provisioning. The increase came mainly from its shipping and Middle East exposure. However, the credit quality in Singapore was stable while that in Hong Kong and China improved.

DBS’s earnings were ahead of estimates because of stronger trading income that benefited from the improved market conditions, and an increase in its risk appetite as measured by value-at-risk (VAR). In its core business of lending, its loan growth of 8% YoY was ahead of its competitors while its net interest margin remained relatively intact despite inter-bank rate pressure.

While we are positive about the bank growing its business when many of its competitors have taken a more defensive posture, we believe the market will be concerned about the sudden increase in provisioning outside its core markets. We plan to discuss this with management and will want to know whether this is a oneoff and whether there are any other lumpy exposures outside the main markets that could surprise.

Our price target of S$14 is derived using the Gordon Growth model with the main assumptions being ROE of 9.3%, COE of 7.7%, and terminal growth of 3%.

DBS 3Q09 Results Flash

Net profit of S$552m in 2Q09 (+27% qoq) was above our forecast of S$355m. Net interest income of S$1,112m (+5% yoy) was in line with our expectations. Net interest margin was marginally higher at 2.01% compared to 1.99% in 1Q09. Loans contracted by 1.8% qoq to S$130.4b in line with industry trend.

Fees & commissions were S$358m, up 13% qoq, with strong contributions from stockbroking (+79% qoq), investment banking (+59% qoq) and wealth management (+31% qoq).

Net trading income was a whopping S$234m due to foreign exchange and interest rate activities. DBS also recognised investment gains of S$138m from sale of equity holdings.

Staff cost and other expenses was well under control. Cost/income ratio improved from 38.4% in 1Q09 to 35.2% in 2Q09.

NPL ratio increased from 2.0% in 1Q09 to 2.8%% in 2Q09. The bulk of NPLs came from the "others" category, likely to be a financial institution and currently labeled under the substandard category. Management explained that the increase was from shipping and Middle East corporates and institutions.

Specific provision was S$272m and general provision was S$183m, totalling 138bp on an annualised basis. NPL coverage is 81%. Tier-1 CAR maintain at 12.6%.

DBS declared dividend of 14 cents, unchanged compared to the last quarter.

DBS Group Holdings - Core markets resilient

DBS reported a net profit of S$552m for 2Q09 (+27.5% qoq), above our forecast of S$355m. Fees & commissions and trading income were better than our expectations.

Maintain stable net interest margin. Net interest income of S$1,112m (+5.1% yoy) was in line with our expectations. Loans contracted by 1.9% qoq but grew 8.3% yoy to S$130.4b. Professional & Private Individuals was the only sector that registered positive qoq growth of 3.0%. HK$- denominated loans contracted 3.7% qoq to S$29.1b due to the strength of the S$. Net interest margin was marginally higher at 2.01% on a group-wide basis, compared to 1.99% in 1Q09. Improved credit spreads and lower funding cost were offset by lower SIBOR. Net interest margin for Hong Kong improved from 1.91% in 1Q09 to 1.94% in 2Q09.

Recovery from market-sensitive businesses. Fees & commissions of S$358m were up 13% qoq and above our expectations. DBS benefited from the recovery in market-sensitive businesses with strong contributions from stockbroking (+78.6% qoq), investment banking (+58.8% qoq) and wealth management (+31.3% qoq). Sales of unit trusts started to recover in 2Q09. Net trading income was a whopping S$234m due to foreign exchange and interest rate activities. DBS also recognised investment gains of S$138m from the sale of equity holdings.

Focus on improving productivity. Staff cost and other expenses were well under control. Cost/income ratio improved from 38.4% in 1Q09 to 35.2% in 2Q09, as a result of management’s focus on improving productivity. DBS has started to exploit its advantages in having economies of scale.

Core markets resilient. NPL ratio increased from 2.0% in 1Q09 to 2.8% in 2Q09. The bulk of new NPLs came from the "others" category, likely to be a financial institution and currently labelled under the substandard category. Management explained that the increase was from Middle East corporations and institutions (partly from 50%-owned Islamic Bank of Asia). NPLs from core Hong Kong and Greater China markets declined 10.6% and 10.7% qoq respectively. The proportion of NPLs not overdue is 38.2% (1Q09: 34.2%), indicating that asset quality remains sound.

Specific provisions of S$272m and general provisions of S$183m were significant, totalling 138bp on an annualised basis. However, NPL coverage has dropped from 97% in 1Q09 to 81% in 2Q09.

Loan growth picking up in 2H09. DBS has built a strong pipeline in residential mortgages and corporate loans. It has aggressively expanded in housing loans in Singapore, participating mainly in the owner-occupied and upgraders’ market. It offered 90% financing in the early part of 2Q09 but has since “clamp down”. It currently offers 90% financing only on a case-by-case basis. Disbursement for housing loans will be more pronounced in 2H09. Tier 1 CAR was maintained at 12.6%. DBS has declared a dividend of 14 cents/share, unchanged compared to the last quarter.

We have raised our assumptions for loan growth to 5.7% for 2009 (previously 7.8%) and 11.7% for 2010 (previously 8.2%) to factor in increased demand from property developers and housing loans. We have revised our assumptions based on trends in NPL ratios over the last three quarters. We assumed NPL ratio will hit 4.0% by end-10. Our earnings model has imputed allowance for credit losses of 120bp in 2H09 (previously 120bp) and 60bp in 2010 (previously 80bp). We have raised our 2009 and 2010 net profit forecasts by 14.0% and 11.5% respectively.

DBS - Core Profit S$456m: Strong Operating Performance

Reported net profit S$433m (vs. Citi S$400m): Excluding a S$23m impairment charge on TMB, DBS posted a 1Q09 core net profit of S$456m, driven by record revenues and lower costs, leading to a 31%qoq jump in pre-provision profit to S$1,024m. DBS used this good result to raise provisions to S$414m (131bps of loans), conservatively including S$182m general provisions. HK net profit recovered to S$94m (4Q: S$16m) from better non-interest income and lower costs. Tier-1 capital ratio 12.5%; quarterly dividend maintained at S$0.14/share.

1Q09 core profit S$456m (4Q: S$383m), +19%qoq: 1Q09 NII S$1,076m down 3%qoq: Loans +3%qoq, NIM 199bps (4Q: 205bps). Loan-to-deposit spread 2.59% (4Q: 2.61%), LDR 74%. Non-II S$586m, fees S$317m (+21%qoq, higher loan fees), other income S$269m (4Q: S$93m) on higher trading gains. Costs S$638m -7%qoq, as staff costs fell 5%qoq and other costs fell 9%qoq; cost-income ratio 38%. Provisions S$414m (4Q: S$269m), 131bps of loans. NPL ratio 2.1% (NPA: 2.4%). Tier-1 ratio 12.5%, CAR 16.7%. 1Q09 EPS S$0.83, BPS S$10.27.

1Q09 Provisions S$414m (annualized 131bps of loans, 4Q: S$269m): S$225m in specific allowances (flat qoq), S$182m set aside for general allowances (including S$49m GP against corporate CDOs) vs. 4Q08 S$46m, and S$7m for other securities. In addition, DBS took a S$23m impairment charge on its stake in TMB (regarded as a non-core item). DBS has 93% coverage of its S$276m ABS CDO and 36% coverage of its S$736m corporate CDO investment, plus another S$218m CDOs in its trading book for a total of S$1,230m CDO portfolio.

DBS: Downgrade to HOLD though Better than expected 1Q09 earnings

Better than expected 1Q09 earnings. DBS posted 1Q09 net earnings of S$433m, down 28% YoY and 47% QoQ. This was above market estimates (with Dow Jones consensus estimate of S$353m). Net Interest Income rose 2% YoY, but was down 4% QoQ to S$1076m. With Non-interest Income of S$586m, up 63% QoQ, total income improved 6% YoY and 13% QoQ to S$1662m. Net Interest Margin fell from 2.04% in 1Q08 and 2.09% in 4Q08 to 1.99% in 1Q09. This was due to a decline in Singapore interbank rates, but partly offset by higher credit spreads and prime-HIBOR spreads in Hong Kong. Fee and commission income fell 10% YoY (but was up 21% QoQ) to S$317m due to weak capital market activities.

Allowances surged 3x YoY. Total expenses fell 3% YoY and 7% QoQ to S$638m, resulting in cost-to-income ratio of 38.4%, down from 42% in 1Q08 and 46.8% in 4Q08. As expected, allowances surged, up 3-fold YoY or 38% QoQ to S$437m. This comprised of specific loan allowances of S$225m. NPL doubled YoY to S$2721m, while NPL ratio rose from 1% in 1Q08 and 1.5% in 4Q08 to 2.0% in 1Q09. This compares with 2.1% for UOB and 1.8% for OCBC in 1Q09. Management has declared a 1Q dividendof 14 cents payable on 4 Jun 2009.

Downgrade to HOLD, but raising fair value estimate to S$12.40. Management expects NPL to remain high (2% currently), although deterioration appeared to have stopped. We expect impairment charges to remain high for 2Q and 3Q, although at lower level than 1Q, making full year charges of S$1386m. We have revised our numbers and raised net earnings from S$1328m to S$1572m for FY09 taking into account slightly better 1Q09 performance. As the worst appears to be over for the global economy, we have also raised our expectations for FY10, increasing net earnings from S$1723m to S$1965m. Since our last report in Mar 2009, the stock has appreciated some 64% to S$11.90 currently. With the recent re-rating for Singapore banking stocks, with average P/book of 1.4x, we are raising our fair value estimate to S$12.40 (based on 1.2x book, the discount being for the still cautious economic environment). However, until we see clearer increase in regional trades and activities, price upside looks limited at current price level. As such, we are downgrading the stock to HOLD.

DBS - Rising provisions and earnings volatility remain a risk

DBS recorded 1Q09 net profit of $456m (+19% qoq, -24%yoy), above market expectations. Positive surprises come from a $269m gains in trading and sale of investment securities, a 92% surge in loan-related fees and better-than-expected cost efficiencies due to lower staff cost. Robust operating profits, including the sharp rebound of its profits from Hong Kong (>100% qoq) offset higher provisions during the quarter.

Operating profits were lifted by gains in trading and sale of investment securities and loan-related fees, which could be volatile. In addition, rising provision charges remain a bugbear. Specific allowances continue to be hefty at $225m while general allowances doubled against the economic uncertainties. Provision risk is likely to remain high on the back of surging NPLs (+129% yoy) in particular from overseas. Charges for Hong Kong SME loans are expected to remain at elevated levels.

Gross customer loans rose 3% qoq. Excluding the 2% growth from translation effects, loans growth was due largely to Singapore-dollar corporate borrowing for infrastructure projects. DBS increased its market share of Singapore-dollar loans from 20% to 21%. We expect net interest income to remain resilient in view of its strengthening Singapore franchise and easing margin compression as SIBOR hit historical lows. Sufficient capital also put the group in a good position to expand its market share further.

The group maintained its quarterly payout of 14 cents per share. This works out to a dividend payout of above 70% that is way above its past dividend payout of below 50%. With a strong capital strength supported by strong Tier-1 CAR of 12.5% after a $4bn rights issue and a coverage ratio on unsecured NPA of 156%, we believe the group has room to sustain its attractive dividends payout.

We have raised our earnings estimates for FY09 by 8% to reflect the strong quarter and increased our FY10 earnings to reflect better cost efficiencies. At 1.16x FY09 PBV, DBS’s valuation is still very attractive relative to its peers which are trading near 1.5x PBV. We are reiterating our BUY recommendation on DBS with a higher target price of $13.90, pegged to its recovery stage forward PBV of 1.36x.

DBS - Rights come with a price

DBS’s recent S$4bn rights issue has bolstered its balance sheet, but we expect immediate EPS dilution and a big drag on ROE. We do not believe the company can maintain its final-quarter dividend of S$0.14 through 2009, as the payout would exceed 60%. We also believe management’s organic growth focus to expand its loans above (Singapore) system pace and to take market share in 2009 could place additional pressure on asset quality and lower potential dividend payouts.

We expect a slightly better net profit (quarter-on-quarter) for 1Q09 from a decline in operating expenses and slightly lower provisions. DBS’s net-interest income should improve as a result of higher lending margins, but we expect the low SIBOR to keep its overall NIM flat. We forecast a sharp quarterly dividend cut to S$0.10 (compared with S$0.14 for 4Q08).

DBS’s shares are trading above our zero-growth DDM value of S$6.16 (excluding final-quarter dividend for 2008). We have assumed a CAPM-derived cost of equity of 7.69%. Our new target price is equivalent to 0.60x book (December 2008, adjusted for the rights issue). The stock’s previous PBR troughs were in 2003 (0.84x) and 1998 (0.39x).

DBS - Bad news priced-in

DBS has been trading at a PBV of 0.6-0.9x YTD - a steep discount to its peers that have been trading at above book values. The group’s earnings are relatively more vulnerable in this downturn due to its high-risk exposure to SMEs in Hong Kong, depressing NIMs and its huge trading book comprising $5.8bn in debt and equities. However, we view that the stock’s prolonged discount to peers would have reflected the potential earnings disappointment over the next few quarters.

In fact, the market consensus has already factored in an average 30% yoy decline in FY09 core earnings. Such bearish earnings expectations for FY09 have taken into account high provision charges of $1.2bn on average (a significant 61% surge from FY08), flat loans growth, a more than 10bps-decline in NIM and a 12% yoy dip in fee income. Lower market expectations will minimise earnings downside risks going forward.

The group’s recent $4bn rights issue will boost its CAR from 14% to a pro-forma 16.2% with tier-1 at 12.2% (way above regulatory requirements). As a result, we estimate its excess capital will double to $5.8bn or $2.50 per share. Post-rights, the group has emerged as the Singapore bank with the strongest capital strength that is essential to ride through the downturn and tap on growth opportunities.

The spike in Prime-Hibor spreads in 1Q09 bodes well for the group’s NIM in Hong Kong. The Prime-Hibor spread bounces off its lows in 4Q08 and has widened by 152 bps. This could signal the beginning of a recovery for its Hong Kong business that plunged 90% yoy in 4Q08 when the Prime-Hibor spreads narrowed along with rising provisions and operating costs.

The sharp 11.5% contraction in 1Q09 GDP - the steepest decline since 1976, suggests that the economy is bottoming out. Likewise, we reckon the valuations of the Singapore banks are near their trough valuations. In view of the improved economic outlook, we have turned most positive on DBS in view of its superior capital strength and attractive valuations. Upgrade to BUY at a higher target price of $11 (pegged to 1.1x PBV).

DBS - Margin squeeze

Possible slowdown in reforms: DBS’ CEO, Richard Stanley, was unfortunately taken ill in late January 2009, and is expected to be off work for 3-6 months. While this is unlikely to impact the group’s day-to-day operations, we suspect any reform momentum that was building post his appointment in May 2008 may slow.

Margin squeeze: The 3-month SIBOR has fallen by 26bp to 0.69% since end-December 2008. We expect this to put a squeeze on DBS’ NIMs and add additional downward pressure on prospective earnings.

Asset quality proves to be more resilient than expected: We think this is the key risk to our call. However, we think the risk of this materializing is low considering the rapidly deteriorating economic conditions.

DBS - Government link importance

We maintain our Outperform recommendation on the DBS Bank (‘DBS’) US$725m Tier 1 perp note, lower our recommendation on the 19c14 to Market Perform from Outperform, and maintain our Market Performs on the other three US$ notes. DBS’s US$ perps yield 17% to call and we forecast a one year total return of 23%. We believe much of the value in these notes reflects an overstatement of the likelihood that the bank will not call the notes at the step-up coupon date in March 2011 and the problems at major international banks that are dragging bank capital prices lower globally. We view DBS as one of the strongest bank credits in Asia ex-Japan. This strength stems from its ownership link to Singapore’s investment arm Temasek, its ability to raise additional capital, and its current financial position. We believe the key risks are 1) a sharp hike in NPLs in the coming 18 months (we forecast NPLs to peak at 6.7% next year), and 2) ongoing weakness in global bank capital prices.

Government link and systemic importance: Temasek (Aaa/AAA) effectively owns 28% of DBS and is an investment arm of the Singapore government (AAA/Aaa). We believe Temasek has both the ability and the inclination to support DBS’s future capital issues. Should DBS not be able to get finance from the capital markets and/or Temasek, we believe the government would provide capital support to the bank. DBS is the largest of three domestic banks in Singapore and hence is systemically important. Moreover, Singapore is a regional financial center and the perceived financial health of its banks is important to attract international investors.

Sound financials: DBS’s current capitalization seems sound, with an estimated tier one of 12% and total CAR of 16% post the SGD4bn rights issue. As at end-FY08, the NPL ratio was 1.5% and provisions fully covered these for losses. The bank also maintains a very strong liquidity position. The loan deposit ratio was a low 77% at end-FY2008. We believe the bank also has a sound reputation among depositors in its two key markets of Singapore and Hong Kong. This stability in deposit funding is augmented by deposit guarantees from both governments.

Call risk mis-priced: On our estimates, the market is pricing the chance of DBS not calling the notes at 30%. We see this risk as less than 10%. We believe much of this is driven by international investors’ fear of bank capital due to large losses at many large banks. There also is a large disconnect with comparable local currency notes that trade at far lower credit spreads. Management has said it values the trust investors place in DBS when investing in these securities. While the bank has not explicitly stated it will call the notes at the first step-up date, we believe that only if it faces severe financial stress at the time of the call would it not exercise its call option. Given its liquidity strength and relatively strong ability to raise capital, we see a non-call as unlikely. We also see the chance of a missed coupon in the interim as remote.

UOB or DBS?

UOB has underperformed the index YTD from mark-down concerns on investment securities. These are balance sheet charges, while we believe the more critical issue for the sector is NPLs and P&L credit charges. With unseasoned loans nearly half that of peers and the slowest loan growth during the bull years, the potential for a negative surprise on asset quality is lower for UOB relative to peers. With strong capital and a liquid balance sheet, UOB remains our top-pick. For traders, we recommend a switch from DBS to UOB as the PB differential here is reverting to mean.

Amidst emerging market style credit expansion in Singapore where system loans grew 40% between FY06-08, UOB saw a more modest 29% increase. Of the loans during this period 23% of credit was for mortgages in UOB. Compare this with ~40% for construction at OCBC or 12% for manufacturing at DBS. Indeed, unseasoned loans as a percentage of total loans make up just 7% for UOB vs. a sector average of 11%. While NPLs saw the largest QoQ expansion for UOB in 4Q08 this was mostly driven off higher substandard NPLs whereas peers saw higher doubtful NPL classifications.

UOB’s tier-1 ratio of 10.9% is amongst the highest regionally. Management claims there are no plans to raise additional capital. We estimate that NPLs will need to reach 24% before MAS tier-1 minimums are reached. Separately, UOB has one of the most liquid balance sheets regionally (11% cash).

60% of UOB’s available-for-sale securities are corporate bonds and equities (<45% for others). With ~68% of this biased towards financial institutions further mark-to-market charges on equity is a significant concern (FY08 equity contracted by 19% YoY). Another risk is goodwill at nearly one-third of equity for all three banks. We believe the risk here is higher for DBS who bought Dao Heng for 3x PB vs. UOB who purchased OUB for 1.1x PB in 2001.

UOB has been a consistent relative outperformer during past US recessions. With a strong balance sheet and conservative management this should be no different in this cycle, we believe. Separately, the PB premium between UOB and DBS is rapidly approaching historical mean and as a result we expect the short term LONG DBS, SHORT UOB trade to reverse.

Singapore Bank - too early, not cheap enough

Large system reliance on foreign banks: As with most aspects of the Singapore economy the provision and availability of foreign capital is critical. The banking system is no different. Foreign banks now provide ~42% or ~S$115bn of system credit. In our opinion, this is not an ideal position in the current global macro setting. The Singapore economy could confront a credit shortage, which could further exacerbate the macro stresses, should the foreign banks retreat/exit and/or scale back commitments due to capital constraints, pro-cyclicality and intensifying risk aversion. The local banks do not have enough capital to fill any credit void, in our opinion.

Complete exit is a S$9bn capital hole: In the unlikely event the foreign banks made a complete exit tomorrow, but for illustrative purposes, the local banking system would need to find ~S$9bn or ~27% of their current market capitalisation to provide the same level of system credit in support of the economy. We believe a large reduction in foreign bank balance sheets is foreseeable.

Depressed organic capital generation … dividend cuts look like a certainty: We forecast a 50% reduction in the capital generating capacity of the Singapore banks … i.e. RoRWAs falling from ~150bps to ~75bps. This means, cet par, maintaining current dollar dividends leaves capacity for only 1% RWA growth. A loss position (LLP charges > 240bps loans) would likely trigger capital action depending on the severity of the loss, the degree of pro-cyclicality (hard to forecast) and the extent of buffer erosion. Sector core tier one is 10%.

Retain Underweights, despite the Singapore banks being at or just below our target prices (DBS S$7.50, OCBC S$4.00, UOB S$9.00). While we may see a technical bounce, downside to our bear case scenarios (0.7x NTA with losses in FY10e) is still ~30%. We are only in the first of generally three phases to a credit cycle … visibility is poor and the economy appears some way from a bottom in our view. Add the heavy reliance on foreign capital and hence further domestic capital strain. Current valuations – P/NTA of DBS 0.9x, OCBC 1.1x and UOB 1.3x may appear reasonable … but they were 0.7x in the Asian Crisis … too early, not cheap enough.

DBS - Valuations close to trough levels

Weakness in banking stocks. Banking stocks have taken a severe beating this week. The market capitalisation of the three local banks fell 21%, where about S$11.2b was wiped off since the start of the year (or doubled the combined FY08 net profits of S$5.6b for the three local banks). As the unceasing spate of negative news continues to hit, the rapid deterioration in recent weeks, including dismal economic indicators and comments, are signals that provisions will go up. One key area of concern is the exposure to the SME segment, which could translate into more loan provisioning in the months ahead.

Higher impairment charges in 2009. DBS mentioned recently at the results briefing that it has about S$15b of SME loans in Hong Kong and about S$9b in Singapore. In terms of its loans breakdown, the manufacturing sector accounted for about 12% of total loan, and this could pose an issue in terms of loan defaults and bankruptcies. While some market watchers are expecting the NPL rate to go back to the Asian Financial Crisis high (which was around 8-9%, see Exhibit 1), we believe that it was due to the inclusion of DBS Thai Danu Bank (DTDB) then. DBS's NPLs stood at S$1958m as at end 2008 or a NPL ratio of 1.5%. If it were to reach 8%, this would mean an increase in NPLs of S$8.5b and we think this situation is unlikely although the market seems to have priced in a certain portion as DBS's market cap fell $2.7b YTD.

In 4Q08, the specific allowances for loans amounted to $224m or an annualised 70bp (more than double the 33bp for the full year). Taking into account DBS's core exposure to both the Singapore and Hong Kong markets, we have upped the provisions for FY09 and FY10, lowered other expenses, and fine-tuned some of the income estimates. We are now going for FY09 earnings of S$1328m, with a more than doubling in provisions to S$1386m (up from S$561m previously), as we expect another 2-3 quarters of high provisions to the same tune or higher than what was reported in 4Q08 of S$316m.

Upgrade to BUY. Since our last report, the stock has dropped 14% to S$7.24 (with yesterday's low at S$6.94). At current price level, we are raising our rating to a BUY with fair value estimate of S$8.20 (prev: $8.60) based on same 0.8x book.