(HK) China Banking Sector - Bank on eventual re-rating

In Singapore, this research report or research analyses may only be distributed to Institutional Investors, Expert Investors or Accredited Investors as defined in the Securities and Futures Act, Chapter 289 of Singapore. www.dbsvickers.com Refer to important disclosures at the end of this report ed-JS / sa- DC Bank on eventual re-rating • Capital raising and asset quality concerns will limit upside in the near term. • However, sector EPS and ROE outlook is still bright even with rising credit costs and dilution from issue of new shares. • Resume coverage of sector with CCB as our top pick Near term hurdles. We are cautious on the Chinese banks in the near term for several reasons. For one, the sector’s capital raising activity could spike up; we estimate around Rmb183bn – 233bn will be raised in July alone. Expected property price declines in China are also raising asset quality fears. Meanwhile, the market has been banking on the sector to re-rate on the back of several positive drivers. Unfortunately, two of these key re-rating drivers, Rmb appreciation and policy interest rate hikes, are likely to be delayed. Longer-term outlook is still attractive despite near term challenges. In our view, the sector’s EPS and ROE for FY10-11 will be marred by dilution from capital raising and increased provisions for asset quality risk. However, earnings growth outlook is still sound; we believe positive earnings drivers will be able to eclipse higher credit costs and help grow H-share banks’ EPS by 21% CAGR over FY09-12. Key positive drivers are very much intact, and these include NIM recovery, moderate asset growth, continued fee income growth and improvements in operating cost efficiency. Catalysts for sector re-rating. We believe the sector is undervalued with the H-share banking universe currently trading at 2.04x P/BV, or 0.6 standard deviations below the three year mean of 2.58x P/BV. But, capital raising and asset quality concerns may limit capacity to re-rate in the near term. In our view, the sector has potential to re-rate strongly once policy interest rates increase and there is meaningful appreciation of about 3+% p.a. in the Rmb. As we expect both these events to eventually occur, we are positive on the longer-term share price outlook for the banking sector. Other key re-rating drivers, being ROE improvement and completion of capital raising, will also support the sector’s re-rating. Based on closing prices as at 23 Jun 2010 HSI: 20,857 ANALYST Alexander Lee, CFA · (852) 2971 1930 · alexander_lee@hk.dbsvickers.com ClosingTarget Upside Stock price PBVPER yield ROEPrice(%) rating(HK$)(X)(X)(%)(%)(HK$)ICBC (1398)5.93 2.21 10.83.7 22.16.6912.8 BuyCCB(939)6.68 2.16 10.14.3 22.58.1522.1 BuyBOC(3988)4.10 1.658.94.5 18.84.366.3 Hold BoCom (3328)8.75 1.93 10.32.7 20.09.447.9 Hold CMB (3968)19.42 2.71 14.41.7 21.722.1414.0 BuyCNCB (998)5.26 1.569.92.5 16.46.0715.3 BuyAverage2.04 9.21 2.78 20.313.1FY10F Chinese banks: Valuation & recommendation Source: DBS Vickers, Bloomberg Action ideas: Long CCB, our top pick. We foresee CCB will have lower credit cost risk than its peers. CCB’s NIM also has the highest upside among large cap banks and CCB will be the strongest beneficiary of Rmb appreciation. Long CNCB as a laggard play. CNCB has fallen 21% YTD vs. rest of the sector’s 1% decline. We believe the counter is oversold and a clearer capital raising road map will be the stock’s key catalyst. Short BoCom in early July. We expect BoCom’s share price will begin to weaken against the sector shortly before July 19, when BoCom’s rights issue shares start trading. BoCom’s new H-shares from the rights issue will equal to 14-15 trading days worth of turnover, and will likely cause BoCom to underperform peers for several weeks. Note: ICBC, BOC, CCB, BoCom, CMB, and CNCB stand for Industrial Commercial Bank of China, Bank of China, China Construction Bank, Bank of Communications, China Merchants Bank, and China CITIC Bank respectively DBS Group Research . Equity 24 June 2010 Hong Kong / China Industry Focus China Banking Sector Industry Focus China Banking Sector Page 2 Table of Contents Cautious in the near term 3 Delay of re-rating driver – policy interest rates 3 Delay of re-rating driver – Rmb appreciation 4 Peak time for capital raising activity 6 Property market jitters 9 Earnings outlook is still sound 12 Average EPS CAGR of 21% 12 Valuation and recommendation 20 Action ideas 22 Stock Profile 32 ICBC (1398 HK) 32 China Construction Bank (939 HK) 34 Bank of China (3988 HK) 36 Bank of Communications (3328 HK) 38 China Merchants Bank (3968 HK) 40 China CITIC Bank (998 HK) 42 Industry FocusChina Banking Sector Page 3 Cautious in the near term We are cautious on the Chinese banks in the near term for several reasons. For one, the sector’s capital raising activity is likely to spike up in the near