OCBC - NPL Formation Has Slowed Across Key Markets

Oversea-Chinese Banking Corp (OCBC) reported a net profit of S$466m for 2Q09, above our forecast of S$398m due mainly to lower provisions for nonperforming loans (NPLs) and higher non-interest income.

NPL formation has slowed. NPLs increased 14.3% qoq to S$1,628m due to the manufacturing, general commerce and transport & communications sectors. By geographical region, new NPLs came from the core Singapore and Malaysia markets. The increases in NPLs came from loans that were not overdue. We take this as a sign of conservative management in recognising NPLs early. In fact, NPLs in the doubtful and loss categories have declined. Management commented that the inflow of NPLs has slowed across key markets.

Benefitting from surge in home sales. OCBC is the prime beneficiary of buoyant sales for private residential properties. Approvals for housing loans doubled qoq in 2Q09. OCBC has so far approved S$600m of SME loans under the Special Risk-Sharing Initiative (SRI) administered by Spring Singapore. We have raised our assumptions for loans growth to 1.6% for 2009 (previous: 2.6%) and 11.7% for 2010 (previous: 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 have assumed NPL ratio will hit 3.8% by end-10 (previous: 4.2%). Our earnings model has imputed allowance for credit losses of 80bp in 2H09 (previous: 95bp) and 60bp in 2010 (previous: 70bp). We have raised our 2009 and 2010 net profit forecasts by 0.9% and 4.1% respectively. Maintain BUY. Our target price of S$9.15 is based on a P/B of 1.72x derived from the Gordon Growth Model (ROE: 12%, payout ratio: 48%, required return: 8% and constant growth: 4.5%).

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OCBC beat consensus by 30%

OCBC reported Q2 net profit of S$466m versus our estimate of S$342m and consensus estimate of S$356m. The main difference was in provisioning, which came in significantly lower than projected despite the increase in non-performing loans (NPL). Management said, “the inflow of new NPLs has generally slowed across the Group's key markets as compared to 1Q09”. We believe this would be welcomed by the market.

OCBC’s fee and commission income was impressive with only a 4% decline YoY and a 25% increase QoQ. It was helped by stock broking, investment banking, and loan-related fees. However, in the core lending business, net interest margin was down 13bps sequentially due to lower gapping opportunity.

While the result beat expectations, we expect Q3 earnings to be muted because of one-off compensation to its insurance customers for the purchase of investmentlinked products that had CDOs. The one-off cost to OCBC is about S$218m, 14% of our full-year estimate.

We plan to revisit our estimates once all the Singaporean banks report their results. We derive our price target of S$8 by using the Gordon growth model; our main assumptions are ROE of 11.3%, COE of 7.6%, and terminal growth of 3%.

OCBC - Short term pain but long term gain for GEH

OCBC posted a 2Q09 core net profit of $466m (+22% yoy, -15% qoq), above market expectations. The 2Q earnings out-performance was led by higher insurance income, trading gains and lower-than-expected provisions. Operating costs rose by 9% qoq due to higher insurance related expenses An interim dividend of 14 cents per share was declared.

While GEH’s contribution surged near 3-fold in 2Q09 along with the sharp rebound in equity prices and improving fixed income portfolio, it remains a swing factor for OCBC. Into the 3rd quarter, a one-time provision charge for Greatlink Choice (GLC) products amounting to about $250m will be taken. This will directly affect OCBC’s 3Q09 earnings by near $218m. Despite the temporary set back, we view this positively in the long run as GEH regains customers’ goodwill ahead of its competitors.

Net interest income slid 4% qoq due to declining loans book (-2%) and narrowing net interest margins. Its loans book has seen weaknesses in the manufacturing and construction sectors, and is likely to remain weak amid the negative economic growth. We also see little catalysts for NIM expansion as its cost of funding is likely to have bottomed with SIBOR at all time lows. Rising competitive pressures will also limit NIM upside.

While specific allowances were halved, NPLs increased by 14%. The NPLs largely comprise of chunky accounts from the manufacturing and transport sectors, which are classified under the substandard category on the group’s conservative stance. Overall, asset quality remained sound as the inflow of new NPLs has generally slowed. The group maintained a strong Tier 1 ratio of 15.4%, highest among its peers.

We have increased our FY09 and FY10 earnings estimates by 5% and 8% respectively to reflect higher fee based income and lower provisions. We have also taken into account the provision charge on GLC for 3Q. Our target price is raised to $8.80 as we rolled forward to the FY10 PBV of 1.62x (1.53x previously) in line with the sector average. Maintain Hold in view of the lack in earnings catalysts and high earnings volatility.

OCBC - NPL formation has slowed across key markets

Maintains stable net interest margin. Loans contracted 1.5% qoq to S$79.2b due to repayment of short-term loans and term loans by corporate customers (companies repaying loans after equity fund raising). The few areas of growth are general commerce (+3.5% qoq), housing loans (+0.5% qoq) and professionals & individuals (+0.8% qoq). In terms of geographical region, the contraction came from Singapore (-1.3% qoq) and China (-5.1% qoq). Total deposits expanded 4.5% qoq to S$96.6b, driven by savings deposits (+10.5% qoq) and current accounts (+8.2% qoq).

Net interest margin contracted from 2.42% in 1Q09 to 2.29% in 2Q09 due to the following: a) lower gapping income, and b) net interest margin for OCBC Malaysia declined from 2.46% in 1Q09 to 2.35% in 2Q09 after two rounds of cut in the Overnight Policy Rate. Net interest income grew 4.6% yoy to S$710m. Non-interest income better than expected. Fees & commissions grew 25.1% qoq to S$194m with growth from brokerage, wealth management, investment banking and loans-related activities. OCBC benefitted from positive sentiment in financial markets and higher volume of loans syndication and capital raising activities. Life insurance contributed income of S$125m, almost double that of 1Q09 if we exclude one-off items, driven by nonparticipating funds as a result of a rebound in the equity and bond markets.
OCBC recorded positive net trading income of S$61m due to foreign exchange activities. It also recorded gains of S$21m on disposal ofinvestment securities.

NPL formation has slowed. NPLs increased 14.3% qoq to S$1,628m due to the manufacturing, general commerce and transport & communications sectors. By geographical region, new NPLs came from the core Singapore and Malaysia markets. The increases in NPLs came from loans that were not overdue. We take this as a sign of conservative management in recognising NPLs early. In fact, NPLs in the doubtful and loss categories have declined. Management commented that the inflow of NPLs has slowed across key markets.

OCBC made specific provisions of S$44m and general provisions of S$5m in 2Q09, representing total provisions of 25bp on an annualised basis. This is lower than the 45bp in 1Q09 as the bulk of new NPLs were in the substandard category. OCBC also made allowance for investments in debt and equity securities amounting to S$57m. NPL coverage remains healthy at 97.1%.


OCBC is the prime beneficiary of buoyant sales for private residential properties. Approvals for housing loans doubled qoq in 2Q09. OCBC has so far approved S$600m of SME loans under the Special Risk-Sharing Initiative (SRI) administered by Spring Singapore.

OCBC is well capitalised with tier-1 capital adequacy ratio (CAR) at 15.4%. Core equity tier-1 is robust at 11.3% after stripping out preference shares. OCBC recognised gains of S$580m on available-for-sale financial assets, mainly for its investments in Bank of Ningbo and Fraser & Neave. Thus, NAV/share increased from S$4.75 as at Mar 09 to S$4.94 as at Jun 09. OCBC declared interim tax-exempt dividend of 14 cents/share, representing a payout of 44% on core net profit for 1H09.


We have raised our assumptions for loans growth to 1.6% for 2009 (previous: 2.6%) and 11.7% for 2010 (previous: 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 have assumed NPL ratio will hit 3.8% by end-10 (previous: 4.2%). Our earnings model has imputed allowance for credit losses of 80bp in 2H09 (previous: 95bp) and 60bp in 2010 (previous: 70bp). We have raised our 2009 and 2010 net profit forecast by 0.9% and 4.1% respectively.

BUY with target price of S$9.15 based on a P/B of 1.72x derived from the Gordon Growth Model (ROE: 12%, payout ratio: 48%, required return: 8% and constant growth: 4.5%).

OCBC - 1Q09 net profit S$545m, boosted by S$175m non-recurring profit

Recurring profit S$370m (vs. Citi S$300m): Stronger than expected non- interest income (insurance and FX/securities trading income) drove a 48%qoq rise in net profit (4Q: S$250m), plus fairly robust net interest income and lower operating costs. Provisions charges at an annualized 99bps of loans reflected a conservative stance to fully write down legacy CDOs. Life insurance enjoyed non-recurring profits of S$201m (S$175m net of tax) largely due to the adoption of a risk-based capital framework in the Malaysia business.

1Q09 recurring profit S$370bn (4Q: S$250m), +48%qoq: 1Q09 NII S$740m - 6%qoq: Loans -1%qoq, NIM 242bps (4Q: 247bps). Loan-to-deposit spread 2.79% (4Q: 2.91%), LDR 87%. Non-II S$406m (excluding non-recurring profit S$201m), fees S$155m (-3%qoq), recurring insurance earnings S$96m, other income S$155m (4Q: loss S$46m) on turnaround in FX/dealing. Costs S$413m -11%qoq, lower staff expenses (helped by job credit grants). Provisions S$197m (4Q: S$244m). NPL ratio 2%, coverage c100%. Tier-1 ratio 15.2%. 1Q09 annualized EPS S$0.68 (recurring profit EPS S$0.46 (cash EPS S$0.48)), BPS S$4.75.

1Q09 Provisions S$197m (annualized 99bps of loans): S$88m specific loan provisions, S$2m general, S$94m allowances for corporate CDOs, plus S$13m against other debt securities.

Total CDO portfolio S$305m (4Q S$453m): ABS CDO portfolio S$100m is 100% provided. The S$205m corporate CDO portfolio has cumulative allowances of S$136m, and including S$69m of cumulative mark-to-market losses previously recognized to the income statement, in effect full provision has been made. Credit rating of total CDO portfolio as of Mar-09: A: 2%, BB: 20%, CCC: 45%, CC: 33%.

Valuation now at 1.4x P/B post share rally: OCBC surprised the market with a strong 1Q09 result, up 48%qoq even excluding the large one-time earnings from its insurance business. Robust margins, better-than-expected FX/dealing income and good cost control lifted the bottom line, even though management conservatively decided to make provisions for the rest of its corporate CDO book. At 1.4x P/B there remains a valuation gap to OCBC's P/B cycle mean, with possible upside to consensus. Detailed management briefing highlights are on page 4 of this report.

Outlook: Mgmt remains very cautious on the economic outlook but still sees opportunities for mid-single digit loan growth given govt-assisted loan schemes, refinancing opportunities and the scaling back from foreign banks. While it is difficult to predict NPL growth, mgmt has stressed the importance of being proactive in identifying problems and mitigating losses. Full provision for CDOs will mean no further burden to earnings. Although insurance operations had a poor quarter, mgmt seemed confident of improvement later in the year.

1Q09 recurring profit S$370bn (4Q: S$250m), +48%qoq: 1Q09 NII S$740m -6%qoq: Loans -1%qoq, NIM 242bps (4Q: 247bps). Loan-to-deposit spread 2.79% (4Q: 2.91%), LDR 87%. Non-II S$406m (excluding non-recurring profit S$201m), fees S$155m (-3%qoq), recurring insurance earnings S$96m, other income S$155m (4Q: loss S$46m) on turnaround in FX/dealing. Costs S$413m -11%qoq, lower staff expenses (job credit grants). Provisions S$197m (4Q: S$244m). NPL ratio 2%, coverage c100%. Tier-1 ratio 15.2%. 1Q09 EPS S$0.68 (recurring profit EPS S$0.46 (cash EPS S$0.48)), BPS S$4.75.

OCBC - Lowest equity-fundraising risk

Despite persistently high loan-impairment charges, OCBC’s performance could prove the most resilient in the sector due to a recovery of its insurance business (we forecast the net profit from Great Eastern Holdings [GE SP, S$8.39, Not rated] to rebound to S$356m for FY09 [from S$272m for FY08] on an abatement of marked-to-market losses) and a steady performance from its banking subsidiaries in Malaysia and Indonesia.

With the highest Tier-1 ratio and management practically dismissing (in our opinion) the possibility of raising common equity, OCBC’s slight premium valuation to the sector is partly justified, in our opinion.

We do not believe the 4Q08 NIM of 2.47% (from 2.18% the previous quarter), is sustainable, due to one-time factors, and expect subdued results due to persistently high loan-related provisions. The insurance business offers potential to surprise positively.

OCBC’s shares trade above our zero-growth DDM value of S$4.31 (excluding the 2008 final dividend). We have assumed a CAPM-derived cost of equity of 6.58%. Our new target price is equivalent to 0.89x book (December 2008). The stock’s previous PBR troughs occurred in 2003 (1.04x) and 1998 (0.58x).

OCBC 1Q09 Results - Non-recurrent boost from life insurance

Net profit of S$545m in 1Q09, significantly above our forecast of S$299m and consensus estimate of S$335m.

Loans contracted 1.2% qoq but was 6.5% higher yoy to S$78.8b. Loans to Building & Construction has started to taper off, declining 2.8% qoq. Singapore dollar-denominated loans contracted 3.6% qoq. Net interest margin maintained at an attractive 2.42%. Net interest income expanded 16.0% yoy to S$740m primarily due to expansion of credit spreads for corporate loans.

Fees & commissions declined 2.5% qoq to S$155m. The only area of improvement was investment banking, rebounding from a low base to S$13m. Profit from life insurance more than doubled to S$266m. Great Eastern Holdings booked non-recurring profit of S$213m mainly from valuation surplus for Malaysia insurance business after implementation of Risk Based Capital framework starting Jan 09. OCBC also benefitted from trading gains of S$87m from foreign exchange, compared to losses of S$17m in 4Q08.

Staff costs reduced by 4.8% qoq due to control on headcount and salary increases and cash grants from government's job credit scheme. Other operating expenses was cut by 18.0% qoq with reduction in business promotions and travel expenses. Cost-to-income ratio fell from 42% in 1Q08 to 30.7% in 1Q09.

NPL ratio has edged slightly higher from 1.5% to 1.8% due to corporate and middle-market loans in manufacturing, building & construction and general commerce sectors for overseas markets. NPL ratio for Singapore remains relatively unchanged at 0.9% but increased from 3.3% to 3.6% for Malaysia. OCBC booked specific allowance of S$88m for loans in 1Q09, much lower than S$159m in 4Q08. However, it made allowance of S$94m for its corporate CDOs in 1Q09 and has fully written down its entire portfolio of ABS and corporate CDOs.

Tier-1 CAR remains robust at 15.1%, the highest among local banks.

OCBC - Key risk is loans growth

Economic outlook unfavorable The Ministry of Trade and Industry announced recently that it expects Singapore’s GDP to contract by 6.0% to 9.0%. According to our PSR economist, we are looking at -7.2% sa. One of the key factors impeding the recovery of Singapore’s economy is the reduction of global trade as WTO estimates that the volume of trade is projected to decline 9% in 2009. As a result, most countries in the region have also seen their exports collapsed as global tradesdwindle. Singapore’s total exports declined 23.7% in March 2009, Japan’s and China’s export registered a contraction of 49.4% and 25.6% respectively in February. This financial crisis is a mood of unwinding 30 years of global excesses and it willbecome clearer that US consumption will no longer be consumer of the first and last resort. This process will impact the bank earnings significantly due to weak demand of loans, lower margins and higher provisions. We trim our earnings by another 5.0% to S$1.45bil and reduce our call rating to sell with target price of $4.61.

Key risk is loans growth Singapore total loans contracted for the 4th time in February to –0.24% mom. Just for the two months of January and February, YTD total loans contracted 0.61%. There were only two occurrences in the last 20 years that we saw loans contract, -2.9% in 1999 and –1% in 2002 and since loans growth is closely tied to the economy, it is probable that loans will contract for the third time since 1999. We are projecting system loans to contract 4%. In fact, we expect loans growth to remain weak in 2010 going into 2011 even as the economy recovers. Borrowers draw down credit lines to tide over liquidity crisis rather than capital expansions and growth. We need to see the economy to resume growth and absorb the loan excesses from 2008 (loans growth of 16.6%) before system loans begin to expand.

Sustainable interest margins to compensate loans contraction OCBC’s efforts in improving margins via innovative saving products are commendable as net interest margins improved significantly from 2.14% to 2.47% in 4Q08. We think products like Mighty Savers deposit schemes are able to secure regular long term, low cost fundings and thus be able to mitigate the effect of lower interest rates in Singapore. Despite 3MSIBOR has been low of 0.675%, we are projecting net interest margins to soften but not deteriorate significantly.

Provisions to remain high The Group provided net allowances of S$447mil for loans and other assets. Although this amount is more than 10 times last year, we note that this was due to successful efforts in loan recoveries, repayments and upgrades in 2007. However, we expect allowances to remain elevated in 2009 through 2010 due to the weak economic conditions. We forecast NPL ratio to rise to 2.0% in 2009 and 2.4% in 2010.

Recommendation As with lower operating profits and higher allowances, we are trimming our 2009 earnings by another 5.0% from S$1.53bil to S$1.45bil and cutting our long term ROE assumption from 10.0% to 9.5%. Accordingly, our target price has been reduced to S$4.61, pegged to 1.02x FY09 NAV as we input the lower ROE and growth assumption in our Gordon growth model. Downgrade to SELL on revised fair value. We think the 42.3% run up within 30 trading days is a little excessive, as economic turnarounds do not happen within such a short span of time.

OCBC: accumulate on weakness

In the wake of undershooting 4Q08 earnings and a worse-than-expected GDP growth trajectory, as underpinned by our recent Singapore FY09F GDP growth downgrade, from -1% to -5%, we have cut FY09F-10F earnings by 16-23%. This reflects the net effect of the following revisions: increase in the group net interest margin (NIM) estimate for FY09F, from 2.15% to 2.37% (FY08: 2.27%), reflecting the positive combination of broadly rising average loan spreads, steeper yield curve and more favourable deposit mix; ii) a sharp increase in net asset (loan and securities) loss provisioning for FY09F, from 60bps to 100bps, as asset quality deterioration reflects reduced GDP growth forecasts; iii) reduction in loan growth expectations, from +6% to +2%, primarily reflecting the weaker GDP environment and reduced working capital requirements, particularly for export-related industries; and iv) a reduction in growth expectations for reported non-interest income (NII) over FY09F, from -3% to -12% (core NII flat y-y, helped by stabilising insurance contributions), as capital market-related weakness extends even as commercial banking fee-related volumes come off.

Supported by ample capital and sustained profitability, management has guided that the absolute dividend payment (FY08: 28 cents net) is unlikely to decline by the same pace as earnings. We are conservatively forecasting that dividend payouts will decline to 20 cents net in FY09, equivalent to an earnings payout of 50%, which is similar to the payout for FY08 – should the dividend for FY09 be maintained at 28 cents a share, the effective earnings payout would be closer to 70% of forecast earnings.

In line with the reduction in forecast book value formation over FY09F and a cut in our sustainable ROE input for the Gordon growth-based valuation model, from 10% to 9%, to reflect the relatively cautious forecast deployment of an overflowing capital base, our Gordon growth-based target price (methodology unchanged: assumptions being 9% sustainable ROE, 9% cost of capital (from 10% previously to reflect the interim decline in risk-free rates as derived from the five-year government bond yield), 5% long-term growth) is adjusted lower, from S$5.60 to S$5.30, or 1.0x stated book value, or 13x FY09F earnings (see Exhibit 6 for the regional valuation comparison).

OCBC fits the bill as a quality low-beta exposure to the Singapore banks sector, underpinned by a tight operational footprint and ample capital reserves. While larger-than-peer property sector exposure is a concern, risk management appears robust and, unlike the Asian Financial Crisis, credit assessment has had substantial lead time to adjust to expectations of declining property prices. The life insurance operation via GE, notwithstanding a volatile 2008, is fundamentally a low-beta business and with capital markets stabilising, investment returns should flatten out in parallel and reaffirm this reality – a move to privatise GE should be positively received given attractive valuations. With high-conviction yields exceeding 4% and well-supported, investors seeking a relatively low-risk exposure to the sector should look to accumulate on weakness.

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.