UOB - 2Q09: within, yet uninspiring

Net interest income was sluggish – the loanbook contracted by 1.7% in 2Q09, for a YTD contraction of -1.7% (sector: -0.5%), with only ex-mortgage consumer finance showing growth. Net interest margin fell 6bps q-q to 2.35%, as narrowing interbank spreads reduced gapping opportunities, overcoming rising CASA share of deposits (+300bps q-q, to 41.3%) and resilient loan pricing.

Key areas of P&L outperformance: 1) for non-interest income, a S$141mn fair value investment gain (1Q: S$29mn) which mitigated 6% q-q fee income contraction; and 2) an effective tax rate of just 5% in 2Q (1Q: 21%) due to recognition of deferred tax assets. Asset loss provisioning rose 23% q-q due to a near doubling in collective impairment charge – while underlying NPLs rose (gross NPL ratio +30bps, to 2.4%), specific provisioning still declined q-q, with UOB now boasting the higher collective impairment buffer as percentage of gross loans at 1.5% (1.2% for OCBC, 0.9% for DBS).

While weak ex-investments operating income momentum and the desire to maintain large provisioning buffer weighs against positive earnings revision, the large AFS securities book revaluation gain (which is reflected directly in equity) over 1H09 (S$1.2bn) means we will be revisiting our book value forecast with a positive bias.

Our existing Gordon Growth-based price target (methodology unchanged, assuming 13% sustainable ROE, 9.5% cost of capital and 5% long-term growth) is S$18.00, implying 1.8x FY10F adjusted book value (1.5x stated book) and 12.5x FY10F earnings. With a large, export-biased SME exposure (25% of group loan book), sustained negative trade data trends would accelerate delinquencies in this portfolio. In a similar vein, UOB’s offshore operations (collectively around 35% of group operating income), being centred on the export-dependent Southeast Asian region, would be vulnerable to related macro events, in our view, adversely affecting sovereign creditworthiness and raising the potential for economic dislocation and sentiment-damaging measures, such as capital controls. This would negatively impact earnings expectations and UOB’s premium P/BV multiple over its less geographically diverse domestic peers.

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United Overseas Bank - 2Q09: A stronger balance sheet

Stable net interest margin. Loans contracted 1.7% qoq to S$100.3b. Growth from housing loans (+2.6% qoq) was negated by contraction for building & construction (-2.7% qoq), general commerce (-4.1% qoq) and financial institutions (-5.8% qoq). By geographical region, the contraction came from Thailand (-4.5% qoq) and Greater China (-12.2% qoq). Net interest margin was slightly lower at 2.35% compared with 2.41 in 1Q09 due to lower gapping income. Customer deposits contracted 2.0% qoq to S$117.0b.

Boost from investment income. Fees & commissions were 6.3% lower qoq at S$225m. Contributions from loans-related activities declined 34.2% qoq to S$50m as the 1Q09 number was boosted by lots of capital restructuring activities. 2Q09 performance was significantly boosted by a net gain of S$34m from trading activities and investment income of S$141m from financial instruments and S$63m from available-for-sale assets.

Huge general provision. Non-performing loan (NPL) ratio increased from 2.1% in 1Q09 to 2.4% in 2Q09 due to large corporations in Singapore and OECD countries. The general provision of S$151m was similar to last quarter’s but United Overseas Bank (UOB) made a large general provision of S$321m (about S$100m for loans, S$150m for investment securities and S$100m for foreclosed assets in Thailand).

Stronger balance sheet. Available-for-sale reserves recovered by another S$1.2b due to the recovery in the equity and bond markets. Thus, NAV/share increased from S$9.37 to S$10.14. Tier-1 capital adequacy ratio (CAR) improved marginally from 12.3% to 12.6% due to a 1.7% qoq decline in risk-weighted assets.

Pick-up in demand. Demand for loans has increased due to improved sentiment and a pick-up in the housing market. Applications for loans increased 50% qoq in 2Q09. However, management mentioned that margins look “toppish” and there is intense competition for housing loans. NPL ratio is expected to increase in 2H09 but likely to be at a slower pace.

UOB 2Q09 Result Highlights

United Overseas Bank (UOB) posted 2Q09 earnings of S$470m during lunchtime, down 22% YoY but up 15% QoQ, and above the median estimate of S$426m based on a Bloomberg poll. This gives 1H09 earnings of S$880m, down 22%.

Its performance would have been better if not for higher collective impairment set aside, which rose drastically from S$180m in 2Q08 to S$378m in 1Q09 and S$465m in 2Q09. This also hurt its 1H09 earnings based on YoY change. Management attributed this to the economic uncertainty, and about S$321m was set aside for loans investments and foreclosed assets in the quarter.

Net Interest Margin (NIM) of 2.35% was better than 2Q08's level of 2.23%, but was down from 2.41% in 1Q09.

Customer loans grew modestly, up 0.4% YoY or down 1.9% from the previous quarter, to S$97.8 bn by end-Jun 2009.

Non-performing loan (NPL) rose from S$1547m in 2Q08 to S$2185m in 1Q09 and hit S$2476m in 2Q09. NPL ratio also increased from 1.5% to 2.1% to 2.4% for the same periods.

Management has declared an interim one-tier tax-exempt dividend of 20 cents (same as 2Q08: 20 cents). The dividend will be paid on 2 Sep 2009.

We currently have a HOLD rating on the stock, but will look to review our earnings and fair value estimates after this evening's meeting with management.

UOB Bank - jump in Tier 1 mitigates dilution risk

UOB’s 1Q09 net profit of S$409 mn (+23% QoQ/ -23% YoY) was slightly ahead of CS (S$399 mn) and consensus expectations.

A strong set of results. Margins were significantly ahead, fee and non-interest income did well, cost control was exemplary, and the bank boosted loan loss reserves through a large general provision. Loan book was flat overall as expected, but within that, UOB grew domestic S$ loans gaining market share in Singapore.

A big positive surprise was that Tier 1 CAR went up sharply (12.3% from 10.9% in 4Q08) thanks to a combination of lower risk weighted assets and a reversal of MTM losses on equities that were hurting Tier 1. This reduces equity dilution risk, in our view.

UOB is trading at 1.5x P/B FY09E versus a 15-year average of 1.6x. Our target price of S$16 (from S$12) is based on 1.6x P/B assuming a 10-11% sustainable ROE and an 8% cost of equity. We have bumped up earnings estimates by 23-24% due to higher revised margin and non-interest income assumptions.

UOB: Collective impairment still up

Q-o-q performance. 1Q09 net profit grew 23% to S$409m, driven by non-interest income and lower expenses. NIM was robust at 2.4% but 4bps lower due to narrower average loan spread. Non-interest income improved 11%, supported by higher investment and fee income. Expenses were lower while cost-to-income ratio was 36%. Specific provisions were lower, but collective impairment continued to rise to S$174m (+64%) as expected. NPL ratio inched up to 2.1% from 2.0%, while absolute NPLs rose 6%; specifically, Singapore and Thailand registered higher NPLs. By industry, increases were seen in Manufacturing and general Commerce. UOB’s Tier 1 and Total CAR rose 1.4ppt and 2.0ppt to 12.3% and 17.3%, respectively.

Expect NIM to hold up, but selective in lending. We expect NIM to hold up as loans get re-priced at higher yields. Loans will grow, specifically from Singapore, but we believe that UOB will be selective about lending. We are retaining our loan growth assumption of 6%.

Upgrade to Buy, TP S$16.50. UOB had underperformed its peers and the market due to impairment to book value. But it should be able to steer away from this setback now, given that credit markets have stabilised. Upgrade to Buy. We roll forward our valuation window to FY10F to derive a higher target price of S$16.50, based on the Gordon Growth Model. This also implies 1.6x FY10F P/BV, which is the normalised mid-cycle multiple.

United Overseas Bank - back on its feet

We are upgrading UOB to OW from N as we increase our Dec-09 PT to S$17 (2-stage DDM) from S$13 on back of higher earnings, removal of capital raising risk and solid operating trends. We increase FY09E-11E estimates by 6-13%, primarily on higher margin and revenues. The call essentially is for relative outperformance by the stock in next 3 to 6 months, funded by OCBC within the sector. We also add UOB to our regional financial Long only and Long/Avoid portfolios.

UOB should reverse YTD 10% underperformance against STI as the stock re-rates due to fading away of capital call probability following a 1.4% pt increase q/q in Tier 1 ratio to 12.3%. We continue to believe that the bank gets benefit of regulatory forbearance in form of exclusion of AFS losses from CAR calculations. But given that the benefit has persisted for two of the most volatile quarters, and part of losses are now reversing, we do not expect this issue to remain a concern.

Bank revenues should benefit from better than expected margins and a resilient fee income. Pricing power should lead to consistent increase in loan spreads and higher loan-related charges, while low rate environment should result in further increases in CASA deposit mix. As in the case of 1Q09, a combination of steeper yield curve and buoyant capital markets would also bring about ALM gains, though this remains a volatile revenue source.

We are factoring in a protracted asset quality cycle as staying power of firms would be tested in a low-growth environment, especially SME. We also expect consumer NPLs to rise along with rising unemployment. We assume 135bp of provisions for 2009E, declining to 100bp in 2010.

Significant and sustained decline in interest rates, leading to lower deposit spreads and NIMs, higher than expected credit costs and a negative turn in treasury income are key risks to our view.

UOB - Rights issue risk has diminished

We admit that UOB’s 26% QoQ increase in total NPLs for the final quarter was disconcerting, but we believe it would be premature to conclude that its asset quality will underperform those of its peers, considering that its credit growth has been the most restrained among the local banks. Chairman Wee Cho Yaw (during UOB’s annual meeting with shareholders on 29 April) argued that profitability is more important than having the highest NPLs in the sector. However, he also cautioned that there would be more bad loans.

We believe the possibility of an imminent rights issue has diminished greatly after Wee Cho Yaw said that UOB does not need a rights issue and is comfortable with its current capital and it is being careful with loan growth.

UOB’s NPL rate rose the sharpest quarter-on-quarter, to 2.0% at the end of December, from 1.5% at the end of September. We expect a more gradual increase for 1Q09, but believe UOB shares risk a further de-rating if its NPL growth outpaces that of the sector again.

UOB’s shares trade above our zero-growth DDM value of S$8.98, including a final FY08 dividend of S$0.40 (ex-date: 7 May 2009). Our new target price is equivalent to 1.01x book (December 2008). UOB’s previous PBR troughs occurred in 2003 (1.11x) and 1998 (0.54x).

UOB - 1Q09 profit S$409m inline; improving book value and tier-1 ratio

1Q09 S$409m (vs. Citi S$410m): Net interest income -1%qoq as NIM fell slightly on flat loans, but non-interest income (+11%qoq) was stronger than expected on improved fees and investment gains. Provisions remained high at an annualized 150bps of loans, but due to conservative general provisioning. Rising book value (S$9.37/share) and tier-1 ratio 12.3% should allay concerns of capital raising.

1Q09 profit S$409bn (4Q: S$332m), +23%qoq: 1Q09 NII S$949m -1%qoq: Loans flat qoq, NIM 241bps (4Q: 245bps). Loan-to-deposit spread 3.07% (4Q: 3.19%), LDR 85%. Non-II S$434m, fees S$240m (+5%qoq, higher loan fees), rent, dividends S$38m, other income S$156m (+28%qoq) on higher investment gains. Costs S$491m -8%qoq, as staff costs fell 6%qoq on lower headcount, and grants received under Jobs Credit Scheme, other expenses fell 10%. Provisions S$378m (4Q: S$381m). NPL ratio 2.1%, coverage c100%. Tier-1 ratio 12.3% (4Q: 10.9%, lower risk assets), Total CAR 17.3%. 1Q09 annualized EPS S$1.01, BPS S$9.37 (4Q: S$8.90).

1Q09 Provisions S$378m (annualized 150bps of loans). S$169m in specific allowances (-7%qoq), S$174m set aside for general allowances (+67%qoq), and S$34m impairment for other investments. Although provision charges remain high, 1Q09 has a higher proportion of general provisions, which we regard as conservative.

Investment securities portfolio and CDOs. As of Mar-09, UOB had S$15.8bn in investment securities, with (86%) in debt securities, and 14% in equities. Of the S$13.6bn debt securities, about 53% comprised of bank capital securities, of which 1.5% exposed to US banks. Total Mar-09 CDO exposure S$142m; S$19m ABS CDO (100% provided), while S$123m corporate CDO book is 99% provided.

Price spike to 1.47x P/B post good 1Q09 result: while cautious on the economic outlook, UOB seems confident on navigating the downturn, capturing loan opportunities on robust margins, while managing modestly rising NPLs through conservative provisioning. A strong book value and tier-1 capital pickup should allay investor fears of capital raising. UOB spiked 29% so far this week; its valuation now just shy of its 1.53x P/B cycle mean, suggesting greater evidence of economic recovery may be needed to justify a stronger re-rating.

Outlook. With overseas markets suffering from yield pressures, UOB is likely to focus on Singapore for growth. Corporate/SME loan spreads have improved over the last six months, and govt-scheme SME loans will likely draw down in 2Q/3Q. NPLs are rising but on a modest up-trend; mgmt remains comfortable with property exposures. A change in valuation of debt securities to mark-to-model and firmer equity markets have reduced concerns of further AFS losses.

1Q09 profit S$409bn (4Q: S$332m), +23%qoq: 1Q09 NII S$949m -1%qoq: Loans flat qoq, NIM 241bps (4Q: 245bps). Loan-to-deposit spread 3.07% (4Q: 3.19%), LDR 85%. Non-II S$434m, fees S$240m (+5%qoq, higher loan fees), rent, dividends S$38m, other income S$156m (+28%qoq) on higher investment gains. Costs S$491m -8%qoq, as staff costs fell 6%, other expenses fell 10%. Provisions S$378m (4Q: S$381m). NPL ratio 2.1%, coverage c100%. Tier-1 ratio 12.3% (4Q: 10.9%, lower risk assets), Total CAR 17.3%. 1Q09 annualized EPS S$1.01, BPS S$9.37 (4Q: S$8.90).

UOB 1Q09 Results - Muted increase in NPL ratio, rebuild tier-1 CAR

Loans were flat qoq but 5.9% higher yoy to S$102.0b. Growth came from housing loans (+7.7% yoy) and loans to private individuals (+12.9% yoy). Net interest margin unchanged at an attractive 2.41% but management indicated there was lower average loan spread for some overseas centres. Net interest income was flat qoq but increased 11.4% yoy to S$949m.

Fees & commissions rebounded 5.0% qoq to S$240m due to huge jump in loan-related activities. UOB also booked gains of S$98m for financial instruments and available-for-sale assets, compared to S$45m for 4Q08.

Staff costs reduced by 5.5% qoq due to lower headcount and cash grants from government's job credit scheme. Other operating expenses was cut 9.7% qoq with reduction in revenue related and IT related expenditure. Cost-to-income ratio improved from 39.4% to 35.5%.

UOB made specific provision of S$169m, similar to last quarter. It also built buffer with general provision of S$174m. NPL ratio increased only marginally from 2.0% in 4Q08 to 2.1% in 1Q09. Management commented that there is no major signs of deterioration. We believe Special Risk-Sharing Initiative from government has helped to reduce NPL formation for SME loans.

Tier-1 CAR improved from 10.9% in 4Q08 to 12.3% in 1Q09, above regulatory requirement of 6%. This was achieved through reduction of risk-weighted assets and retained earnings.

UOB: Downgrade on valuation grounds

UOB rallied 40% from 2009 trough. Since our last report on 2 March 2009 where we recommended accumulating at less than $9.30, UOB hit a 2009 low of S$8.07, but rallied 40% recently to a high of S$11.32. While the worst appears to be over for the equity market, the same cannot be said about the local economy. Recently, Singapore's 2009 growth was revised down to a range of -6% to -9%. Over in the US, while equity prices rallied in recent weeks, the economic numbers continued to show weakness, and high unemployment rate remains a concern. Valuations for the STI are also starting to look a bit stretched, especially in view of expected dismal 1Q and 2Q earnings. Recently, there was also a spate of smaller-cap companies in Singapore issuing profit warnings and all these point to still bearish operating environment. Against this backdrop, we expect provisions for banks to be a key item to watch out for in the upcoming results of the three banks. UOB and OCBC will be releasing 1Q results on 6 May 2009, while DBS will be issuing its 1Q report card on 8 May.

High impairment charges. In 4Q08, UOB posted higher than expected impairment charges of S$381m, more than doubled 3Q08's level of S$158m, and the highest of the three banks. For 1Q09, we expect impairment charges to remain high for the three banks, and project charges of S$280m for UOB, +215% YoY and -26% QoQ. Overall, we are expecting 1Q net earnings of S$316m, down 40% YoY and 5% QoQ.

Maintain fair value of S$9.30, but cutting to SELL. We continue to like UOB for its healthy asset quality and its continual profitability. However, with the global economic recession and the resultant weakness in the Singapore economy, trading activities will decline sharply and hurt earnings for the banks. This will be seen in higher NPLs and high impairment charges. This will also mean that for the medium term, share price appreciation may be capped until a more convincing return to sustained profitability and a bottoming-out is seen for new NPLs. We are maintaining our earnings estimates and retaining our fair value estimate of S$9.30, but downgrading to SELL purely on valuation as we see limited near term price upside and possible near term weakness at the current level.

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.

UOB - Disappointing results due to high impairment charges

UOB’s 4Q08 net profit of $332m (-30% qoq, -34% y/y), was below expectations. Earnings disappointed mainly due to huge impairment charges taken in the quarter. However, the group’s business remains strong operationally, as operating profits recorded double-digit growth led by resilient net interest income and tight cost controls.

Weak fee-based income, which fell by 38% yoy, was offset by the resilient lending business and a $92m net gain from trading and investment activities. Net interest income grew on the back of margin expansion and loans growth across regions. Going forward, we remain upbeat on UOB’s lending business as it will be one of the key beneficiaries of the government’s recent initiatives to boost SME lending.

Impairment charges in 4Q08 more than doubled to $381m due to specific losses on loans and debt securities from overseas. At the same time, higher collective impairments were provided to buffer against the global economic uncertainty. While impairment charges are set to rise, the management is confident to survive the downturn as stress tests indicates that their portfolio are resilient. Moreover, with a strong CAR that was well above regulatory requirements, the management sees no compelling reasons for capital raising at this juncture.

Book value has shrunk from $10.91 to $8.90 over the year, mainly due to a near $3bn decline in available-for-sale reserves. Any further mark-to-market losses of its investment-grade bonds investments (which is worth some $16b) that will be taken into the reserves could continue to reduce the book value in the near-term.

We have lowered our FY09 and FY10 earnings estimates by 5-9% to reflect higher provisions. Our target price is cut to $9.10 based on FY09 book value per share (assuming lower magnitude of mark-to-market losses in 2009). The group recommended a final dividend of 40 cents per share, in line with its regular dividend payout. UOB’s earnings remain at risk as credit deterioration deepens. Maintain Hold.