UOB strong funding position enables asset growth

Target Price - S$19.42



UOB shed 3.5% in the two weeks post-results. Although the headline 4Q was not strong, we think it hid some positives, namely
1) expanding margins ahead;
2) promising build-up in US$ deposit base, and
3) a 4Q earnings that could have been 11-12% higher, ex-EU losses.

We upgrade UOB to Outperform after the stock’s slight underperformance post-results. Our S$19.42 target price (GGM, 1.36x P/BV) is unchanged. We see catalysts from a better 1Q12 when EU debt-related losses no longer impinge on P&L and another quarter of margin expansion drives topline.

1Q12 margins look good
Management has guided that an environment of tight liquidity enables banks that are sound, willing to lend larger quantum at longer tenures, a chance to tweak pricing upwards. Our ground checks suggest that spreads for large corporates are now 160-180bp above cost of funds, vs. 70-80bp nine months ago. Also, the latest update from management confirmed that January margins were marginally higher. We think 1Q12 will serve to confirm that UOB’s margins had bottomed in 3Q11.

Strong funding position enables asset growth
Not only is the margin compression trend arrested, we think that a rapid build-up of US$-deposits confirms management’s comments that strong Singapore banks have benefitted from deposits looking for safe havens. With loads of lending opportunities from trade finance, regional infrastructure projects, an ability to develop funding sources is key. We see more and more signs of the rise in Asian banks. Strong US$-deposit growth in 4Q for the Singapore banks was a start. IFR Asia report on the Marina Bay Sand’s S$4.6bn refinancing deal was also telling for the lack of European names on the syndicate.

No more EU debt-related losses
Lastly, our estimates suggest that UOB’s 4Q net profit (S$558m) could have been S$60m-S$70m higher, if we back out losses related to the EU bank debt divestment in 4Q. Headline profit would have been 11-12% higher if this did not show up. With UOB’s S$2.3bn EU bank debt portfolio (4Q10) whittled down to S$0.6bn (4Q11), we think that UOB will surprise on both trading gains and provisions in 1Q12.

Worth another look on recent underperformance

1. POSITIVE UNDERLYING POINTS IN 4Q RESULTS
1.1 4Q11 results made to look worse than it was UOB’s 4Q headline results (S$558m) at the end of last month did not look strong because provisioning was higher-than-expected. Beneath the weak-looking headline results, pre-provision operating profit (PPOP) was actually above expectations. We note that there were a few positive underlying trends and some one-off effects dousing 4Q results. First, margins have turned up and the guidance about margins was positive. Second, the funding side of the business looks to have been well-taken care off, positioning UOB to go after lending opportunities vs. a more conservative stance a year ago. Third, headline profitability was not bad considering that UOB took a one-off $133m charge to the P&L in 4Q - a good proportion of it due to realised losses from unwinding its portfolio of EU bank debt. All thesse, coupled with the stock’s slight underperformance post-results, make us more positive on share price performance ahead.

1.2 Margins are heading in the right direction First, we were pleasantly surprised by the 6bp increase in margins during 4Q; even more so, when management guided that margin trend was likely to be slightly higher. Management guided that all loans were being re-priced up but the best opportunities were in US$-loans. This was because corporate clients were receptive to paying higher spreads as they sought commitments from banks for credit lines and for loans of larger quantum and longer tenure. Management noted that there were less competitors willing and able to lend large quantum, at longer tenures. Our ground checks suggest that spreads for large corporates are now 160-180bp above cost of funds, compared to 70-80bp nine months ago. The latest update from management also confirmed their 4Q guide; January margins were marginally higher than 4Q.

1.3 Funding is key for asset growth Second, we are impressed with how UOB has built up the liability side of the balance sheet. Ever since the 2008 Global Financial Crisis, management had stressed the importance of funding in today’s world of banking. Over 2011, regional deposits grew 38% while Singapore deposits only grew 13%. UOB said that it was able to price loans, improve asset yields today only because the funding side has been addressed. We agree that any bank that is dependent on wholesale funding is vulnerable today. Post-GFC, UOB has been emphasising that it aimed to grow asset sustainably by matching deposit growth with asset growth in local currency terms. Figure 3 shows that UOB had generally been able to in 2011. In 2H11, we highlighted that dollar funding became one of the more important differentiators for Asian banks. Again, we were pleasantly surprised by UOB’s ability to bring in US$-deposits in 4Q. On a side-note, we note that DBS’s healthy pace of asset growth in the past two years, plus UOB’s emphasis on deposit growth, have combined to move the crown of Singapore’s most liquid bank from DBS to UOB. (Figure 2) We point out that UOB lagged peers in 2010 because it took a more conservative stance towards asset growth but in 2H11, loan growth was accelerating and matching peers. With the liability base now secure, we think UOB will not lag in asset growth in 2012.

1.4 Losses from divesting EU bank debt depressed 4Q Third, we think that the reduced association with troubled Europe is good for the stock. UOB’s holding of EU debt securities had been a millstone around its neck for the last two years and UOB had sought to pare down this exposure. Its portfolio of EU bank debt has been whittled down from S$2.3bn (4Q10) to S$0.6bn (4Q11). The divestment accelerated in 4Q11, perhaps as Europe took a turn for the worse. As such UOB took a S$133m loss on the P&L in 4Q which we view as a one-off; 60% of that relates to losses from its EU debt portfolio. We estimate that its headline net profit would have been 11-12% higher, excluding this. Positively, management guides that this should not recur in 1Q.

2. STRATEGY
2.1 Still ASEAN-centric…
The long-term strategy for UOB remains an ASEAN-centric strategy, positioning for cross-geography opportunities in the region. This is similar to OCBC, though the latter has a greater tilt towards wealth management and insurance. UOB’s strategy outside of Singapore is to target niche segments outside of Singapore. For example, UOB is able to provide cross-border loans for corporates to expand overseas after integration of people and platforms in the last few years. In this regards, owning a 100%-stake in its overseas subsidiaries is necessary and helpful. The growth in Southeast Asia is particularly important because these are the markets where UOB garner better net interest margins and achieve higher ROAs. Over the last four years, PBT contributions from Singapore as a proportion of Group PBT, has been decreasing.

The credit card business is another example of successful regionalisation. Part of its success in credit cards is its ability to grow its credit card base in Indonesia in recent years. The attraction for consumers is equivalent merchant privileges when they travel across the region while on the other side of the coin, UOB is able to market to merchants the ability of its card to reach out to the region’s consumers. Meanwhile, moving backroom operations to cheaper central hubs has allowed UOB to bring down backroom costs and reduce the processing cost of a credit card by 60%. UOB guides that it has spent the past few years integrating core banking platforms across the region and the whole integration project would be completed by 2013. We read that as some potential for the jaws to improve in 2014.

In Thailand and Indonesia, UOB recognises that it does not have the heft, the deposit base or the network of the big local players to compete head-on. That said, its presence is not small either. UOB’s strategy is to target the middle segment of both corporates and consumers. UOB tries to service the mid-sized corporates in the region, aiming to cater to the transactional banking needs. For consumer segment, UOB will steer clear of segments like mortgage in Indonesia where recent market pricing has been very competitive. In the wealth management space, we sense that the target segment of UOB Privilege Banking is the mass affluent (US$200k – US$1m) consumer segment.

2.2 …but with China as a new growth component
While ASEAN is important, we reckon that Greater China is fast emerging as an important growth driver for UOB; just as it is for all three Singapore banks. Over 2011, Greater China loans (S$8.4bn) grew by 59% yoy vs. Indonesia (+45%) and Malaysia (+36%). Group loan growth (2011: +25%) would have been far lower, if not for these markets. Though UOB does not seem to have a clear growth strategy for China yet, we expect it to progressively narrate an ‘ASEAN+China’ strategy in the years to come. In the post-results briefing, CEO Wee Ee Cheong said that UOB saw opportunities for trade and infrastructure in the region. We believe this include banking relationships with large China corporates as well. We think that Singapore banks need to consider how to position themselves to benefit from China’s rampant trade flows and its burgeoning, wealthy individuals. We think that this does not necessarily mean that a bank needs a large presence and banking network in China; a bank can just as well cater to the trade flows, the external lending needs of large China SOEs or even service Singapore companies expanding into China. For example, even Singapore-focused City Developments has also started to invest in China in recent years.

2011 was a defining year for the rapid growth of trade finance loans it brought; we don’t think the momentum will slow. General commerce loans became the most significant business loan category for DBS (17% of Group loans) and OCBC (15%). It was not so big for UOB (12%) only because UOB had been reining back its US$-loan growth earlier the year and 4Q11 was somewhat distorted by large repayment of such short-term trade finance loans. As a group, UOB is guiding 15% loan growth for 2012; we will not be surprised if regional growth opportunities push loan growth up to 20% instead at the end of this year.

3. RISKS
3.1 Credit costs will act as earnings headwinds
Although CEO Wee Ee Cheong expressed confidence over the balance sheets of Asian corporates and individuals (due to the Asian savings culture), we still expect credit charges to pose the most challenging headwind to earnings growth over the next two years. We reckon that we are at the cusp of a credit cycle downturn that will largely spurred by global events and global trade. We cannot ignore the impact on global trade from Europe’s deleveraging efforts and signs that certain commodity inventory is building up. We are already hearing slowing trade flows on the Asia-Europe route, which will inevitably impact businesses in the region. SMEs will be particularly vulnerable in a downturn - a segment that UOB is typically strong in. Although UOB’s loan loss coverage ratio is not the lowest, the sector’s NPL ratio (1.2%) is very low and any spike in NPLs will see provision coverage slip quickly. We note total credit costs went above 100bp (of loans) in 2009. This compares against our assumptions of 46bp and guidance of 30-50bp.

3.2 Competition in overseas markets
The other risk for UOB is overly aggressive competition in its key overseas markets. The two key reasons for UOB’s (previous) superior NIMs (vs. Singapore peers) has been its traditional strength in higher margin SME loans and its established regional branch network to gather cheaper deposits. In Singapore, SME competition has been intense in the last five years because under Basel II, SME loans drew a lower capital charge and attracted lots of competition. Meanwhile, the low-interest rate environment negated UOB’s advantage in gathering cheap deposits. With the negatives from these two trends already baked into current operating margins, the issue is about dealing with bouts of competition in each of their key overseas markets and reaping the benefits of higher corporate lending spreads.

In Malaysia, we expect UOB’s NIMs to remain flat in 2012. Although our Malaysia bank analyst, Winson Ng, expects another 5-10 bps compression from the progressive release in low margins-loans granted in the last two years, this is not really UOB’s business. UOB is largely tilted towards consumer and SMEs in Malaysia. In Indonesia, we think UOB cannot escape further margin pressure. Despite reference rate cuts in Indonesia, fierce competition for deposits has led to rising deposit costs in a low-liquidity environment. The situation is exacerbated by pressures on lending yields led by BCA. According to our channel checks, BCA, galvanised by its strong deposit base, has capped lending rates by pricing loans 2% pts lower than the market. While all these are negative, we think it will be offset by better pricing to regional corporates.

4. VALUATION AND RECOMMENDATION
4.1 No change to our estimates, maintain target price We make no changes to our estimates. Our target price is also unchanged at S$19.42, based on 1.36x CY12 P/BV (GGM, ROE 11.1%, CoE 9.28%, g 4.3%). The stock is relatively cheap at 1.15x CY12 P/BV 10.2x CY13 P/E.

4.2 Upgrade from Neutral to Outperform
UOB shed 3.5% in the two weeks after its relatively poor 4Q results. The results were poor on the headline, but pretty decent beneath. We liked three things in the results:- 1) margin expansion and positive margin guidance; 2) promising build-up of its liabilities base, particularly in US$-deposits; and 3) much reduced EU bank debt exposure and a bottom-line that still met expectations after enduring losses from the divestment of its EU bank debt. Back then, we refrained from upgrading as the stock had already done well leading to the results announcement and we think the higher credit costs announced could dampen share price. With the stock having pulled back, we think it is timely to upgrade it from Neutral to Outperform. We see short-term catalysts from a better 1Q12 as 1) EU debt-related losses no longer impinge on the P&L; 2) improving margins add to confidence that UOB had seen a trough in margins in 3Q11; and 3) credit costs stay muted at least in 1H12. After a period of underperformance post-results, UOB outperformed peers and the FSSTI yesterday. We think it is just a start.