Cash In On Korean Banks' Upcycle And Qualitative Growth

| About: KB Financial (KB)


2017F-18F to see qualitative growth driven by core income.

Household debts improving in quality.

Foreign investor interest in Korean banking stocks is growing.

Three checkpoints for a meaningful stock rebound

Korean banking stocks' recent corrections have to do with their exposure to the ailing Daewoo Shipbuilding and Marine Engineering (DSME) and intensifying geographical risks. To see if the shares can stage a meaningful rebound, we must first address the three major issues facing Korean banks: the possibility of an earnings peak-out, household debt burden, and potential sell-off by foreign investors.

2017F-18F to see qualitative growth driven by core income

We expect banks' net income to record a 6.5% CAGR over the next three years. This is because operating income growth (5%) should outpace the rise in costs of around 2%. In particular, 2017 should see both top- and bottom-line growth on the back of a rise in assets, a moderate recovery in NIM, and lower SG&A costs. Banking stocks move more sensitively to core income and ordinary income than to net income. In 2017F-18F, we see ordinary profit rising 9.2% and 4.8%, respectively, which we find positive because it is qualitative growth led by core income. 1Q17 also experienced qualitative growth characterized by NIM growth (+3bps QoQ), sound loan growth (+ 1.4% QoQ), and higher-than-expected results (10.5% higher than the consensus).

Household debts improving in quality

Household debt has been a chronic burden for Korean banks. The recent increases in mortgage loans and interest rate hikes are likely to boost banks' 2018 debt-to-service ratio (DSR) to 34%. However, we believe the quality of household loans at banks is improving, considering: 1) the growing percentages of fixed-rate mortgage loans and principal & interest home loans (to 45% and 55%, respectively); 2) increased lending to high-income borrowers; and 3) preemptive action to strengthen loan qualifications to slow household loan growth. As a result, banks now have a buffer against interest rate risks and the burdens of lump-sum debt repayment at maturity. We should also consider that Korea's higher household debt ratio vs. overseas stems from its larger number of small office/home office (SOHO) businesses and its relatively larger underground economy. Koreans' wealth also tends to be concentrated in real-estate assets. Korean banks' household loans are unlikely to pose a serious credit risk given the relatively higher proportion of collateral/high-income borrowers and tight lending requirements. However, household debt issues are likely to remain a systemic risk, and Korean banks' household loan growth looks certain to slow.

Key criteria for overseas investors-capital strength, regulatory risk, and cost management-improving

Investor interest in banking stocks is growing, as the capital adequacy ratio, a major investment indicator for overseas investors, is improving and the dividend payout ratio is increasing. We also find it positive that banks have more ability to up their dividends on the back of enhanced capital strength. The issues that have been pointed out as banks' structural problems-1) weak top line (little momentum for growth and margin pressure); 2) high regulatory risks; 3) difficulty in SG&A cost management; and 4) high credit cost ratio stemming from chronically high credit losses-are improving.

I. Earnings growth backed by qualitative growth

1. Core income is the major earnings driver

After falling to a historical low of 0.4x P/B in 1Q16, banking shares once recovered to 0.57x P/B on the back of earnings recovery and the stability of the financial market. More recently, however, banking shares have suffered corrections, weighed on by the restructuring at DSME and intensifying geographical risks on the Korean peninsula. These issues will likely be short-lived but we believe it is time to address the three potential risks facing banking shares before we pursue bargain-hunting opportunities.

We must first consider the possibility of banks' earnings peaking out. While 1Q17 earnings results are likely to come in strong, there are worries that earnings momentum would falter afterwards. Since banks typically enjoy their strongest earnings in 1Q, it is natural that earnings decline in the following quarters. What is more important is to discuss the possibility of an earnings decline on an annual basis: 2017 vs. 2016 or 2018 vs. 2017. In our view, Korean listed banks' earnings should remain on an upward trajectory over the next three years. Earnings growth will be mainly driven by core income (net interest income and net commissions).

Core income growth should become even more pronounced in 2017. This year, banks are guiding 4% asset growth and a slight increase in net interest margin (NIM). Under these assumptions, it is easy to forecast a net interest income increase of 4% but we expect to see 6% growth on the back of growth in the average balance. Listed banks displayed robust top-line growth in 2016, as evidenced by an 8.1% rise in interest-bearing assets (based on ending balance). If the ending balance of interest-earning assets grows by an additional 4.4% this year, the average balance of interest-bearing assets should increase by 6%. Considering the slight improvement in NIM, net interest income should increase by 7.3% in 2017. In 2016, commission income fell YoY due to lower credit card merchant commission fees and a change in the bancassurance fee recognition system. However, in 2017, sales commissions on financial products will probably grow thanks to the base effect and improving global/domestic stock/financial environments. KB Financial Group's (NYSE:KB) consolidation of Hyundai Securities should also help, resulting in 8.9% growth in net commission income for 2017F. In all, we estimate core income will grow 7.6% YoY in 2017.

From 2017 to 2019, operating income (net interest income plus non-interest income) should increase at a CAGR of 4.9% while expenses (provisions plus SG&A costs) grow just 1.8%. This will result in net profit growth of 6.5%. Loan growth should normalize to 4% (close to the nominal GDP growth rate), and the 2018F-19F NIM should decline slightly from the 2017F figure, based on our conservative forecast. In 2017, banks will need to realize their massive valuation gains to make provisions for nonperforming loans (NPLs) related to DSME and KCI. Through this preemptive provisioning, banks should be able to keep their earnings on the growth path in 2018 while reducing credit costs. After 2018, the voluntary retirement programs and streamlining of branch networks, which have been underway for some time, should start to bear fruit, helping to mitigate SG&A cost increases.

Historically, banking shares have been highly correlated with core income rather than net income. This is natural because core income mirrors the fundamentals of a company. We are encouraged by banks' continued earnings upcycle since 2015 but we also find it very meaningful that company fundamentals-characterized by top-line growth (led by core income growth), stabilization of credit costs in the mid- to long- term, and efficient SG&A cost controls-are improving. We believe that earnings sustainability has improved and qualitative growth is progressing.

2. Quarterly earnings forecasts

In 1Q17, sharper-than-expected NIM growth (+3bps QoQ) and loan growth (+1.4% QoQ) likely helped bolster core income. Net interest income growth was somewhat limited due to reduced number of business days (-1 day YoY and -2 days QoQ), but 2Q17 is expected to see visible QoQ growth thanks to the increased number of business days. Non-interest income should be strong thanks to an increase in dividend income, securities-related gains, and FX-translation gains as well as last-minute sales hike for savings-type products before the end of tax benefits. Meanwhile, credit costs remained favorable as there were no special credit events during the quarter and ordinary credit costs were on the decline. However, there could be an additional provisioning related to DSME which we expect to happen in 2Q17. SG&A expenses are typically low in 1Q and thus we believe 1Q17 earnings were overall strong for most banks. In particular, we believe Woori Bank (NYSE:WF), DGB Financial Group, and Hana Financial Group enjoyed significant improvement in 1Q17 results. Our 1Q17 earnings forecast for the eight listed banks exceed the consensus by 10.5%.

In 2Q17, the big three Korean banks-Shinhan Financial (NYSE:SHG), KB Financial, Hana Financial-should feel the burden from additional provisions for DSME. However, we believe they have enough buffers to ease the burden as they have considerable amounts of unrealized securities-related gains and one-off gains. Of note, our 2017 earnings estimates of the banks in our universe is 1.4% above the consensus (see Fig 63).

3. Key earnings drivers

The strong NIM movements in 1Q17 are attributable to: (1) interest rate hike; (2) proper setting of the interest rate spread; and (3) strong inflows of low-cost deposits. We expect a modest recovery in margins to continue throughout this year as management's focus is more on margins than on the top line. In addition, the loan mix is expected to help widen the NIM as low-margin mortgage loans decline and high-margin SME loans increase. The loan-to-deposit (LTD) ratio, which has turned downward, should also help boost margins. Since declining NIM was the biggest factor weighing on earnings and stock performance, the rebounding NIM should serve as a catalyst for stocks.

Last year, Korean banks' loan growth reached 8% buoyed by robust household loans (especially mortgage loans), but this year it is expected to normalize to the 4% level, close to the nominal GDP growth rate. By segment, household loan growth will likely slow to 3% while small and medium enterprise (SME) loans grow by 5%. We estimate loans by large businesses and public institutions will rise by around 1%. By bank, IBK and regional banks, which have greater exposure to SME loans, should show relatively higher growth.

Despite the restructuring of several conglomerates, the new nonperforming loan (NPL) formation ratio has stabilized downward. Thus, we expect credit costs to continue to decline in 2017. Proactive provisionings in 2016 should also help. It is also impressive that the banking sector has been reducing its exposure toward the cash-stricken industries. The big three banks have reduced their exposure to the shipbuilding/shipping sectors by 45% since 2012. We believe that banks will continue to make proactive, additional provisions this year too on the back of massive one-off gains expected for this year. Accordingly, credit costs should increase YoY, but the credit cost ratio will likely rise only slightly thanks to asset growth.

The additional provisions for DSME are unlikely to be too much of a burden. Assuming that five major banks (three banking majors plus Woori Bank and IBK) cover 50% of their DSME exposure as provisions, their additional credit costs should be about 3.5% of this year's net income. For Hana Financial Group whose DSME exposure is high, it could be burdensome as it has to set aside 10.5% of its annual net income as provisions. Even so, we believe its valuation gains related to SK Hynix (OTC:HXSCL) and KEPCO (NYSE:KEP) can help offset the burden.

Since 2015, large banks have been streamlining their workforces, by encouraging their employees to apply for voluntary retirement programs. During this period, eight commercial banks reduced their total headcount by 10.6% through voluntary retirement programs. The number of branches decreased by 5.5%, which is outstanding. The restructuring pace is bound to slow from the peak seen in 2016 but efforts to transition to organizations that are more efficient should continue, in line with the online trend of the financial industry. These efforts will be especially visible at Hana Financial Group and Woori Bank over the next three years. These banks, following a merger and privatization, are likely to shed weight more easily as sizable portions of their workforces that face retirement are subject to the wage peak system. As such, Korean banks' SG&A cost should increase by around 1.5% YoY in 2018-19F after growing 0.5% YoY in 2017.

4. Overall earnings outlook

Looking at the combined net income of the eight listed banks, net interest income growth slowed from 2011 to 2014 due to NIM declines and in 2013-2014, it finally saw negative YoY growth. It rebounded in 2015 but it was not until 2016 that net interest income recovered to the 5% level. This year, we expect net interest income to grow at a meaningful pace of 7.3% YoY. In 2018-19F, the growth rate should again slow to 3.7% under our conservative NIM assumptions (-2bps YoY in 2018 and -1bp YoY in 2019) but 4% growth is also a plausible scenario if NIM turns moderately upward.

II. Overview of Korea's household debt issue

1. Household debt status

As household debt growth accelerates led by mortgage loans, household loans' credit and regulatory risks are growing. Household debt has long been a key risk in Korea. The main issues can be characterized as: 1) household debt ratios that are higher than those of benchmark countries; and 2) deterioration in debt service ratios due to increased household debt. The high household debt ratios are attributable to several factors that are unique in Korea.

First, Korea has especially high numbers of self-employed persons. The Korean financial authority classifies SOHO loans as SME loans, but by international standards (e.g., Organisation for Economic Co-operation and Development (OECD)) they are classified as household debt. Additionally, the size of the underground economy is bigger in Korea compared with other advanced countries (KRW290tn as of 2012 according to Hyundai Economic Research Institute), which makes Korea's disposable income appear smaller than it really is. The higher household debt ratio is also attributable to Koreans' tendency to concentrate their wealth in real estate. Indeed, real estate represented 70% of individual assets in Korea as of 2015, far higher than 42% in Japan and 36% in the US. This works to raise the household debt ratio and at the same time deteriorate the household financial asset-to-household debt ratio, another indicator of the financial soundness of households. Considering these conditions that are peculiar to Korea, Korea's relatively higher household debt burden may be smaller than it appears. In addition, we find it positive that household loan delinquency rates have been stabilizing downward despite a rise in household lending and the portion of principal & interest repayments in recent years.

2. Banks' SOHO loans: healthy borrowers, high mortgage ratio

What is more serious than the household debt ratio that is higher than benchmark countries is the growth rate of household debts and deteriorating debt-to-service ratio (DSR). In 2016, SOHO loans at three major banks rose 10% YoY (vs. total loans + 5.1%). Meanwhile, the number of self-employed workers is declining from the peak seen in 2012, which seems to be the result of the growth of SOHO businesses while smaller businesses falter. This suggests that banks that work closely with healthy SOHO have comparatively lower credit risks. In addition, the high mortgage ratio of SOHO loans is over 70%, which works to reduce credit risks. Meanwhile, the financial authority announced plans to lend further support to the self-employed and strengthen loan requirements in order to prevent SOHO loans from going default.

3. Households' ability to repay debts

Despite the decline in long-term interest rates, Korea's DSR has risen steadily, reaching 34% by the end of 2016. This is because the pace of household debt growth was faster than disposable income growth, and the portion of loans that require principal as well as interest repayments increased as guided by the financial authority. If the percentage of principal & interest repayment of loans increases and market interest rates rise further, we may see an additional rise in the DSR. Meanwhile, banks' household loan DSR growth was slower than the overall financial sector, due to a fall in interest amid interest rate declines.

The rising DSR is a cause for concern but we cannot overlook the change in the quality of household loans. First, we note that the quality of household loans is improving as the proportion of fixed-rate loans and principal & interest repayment loans is increasing. This is because the volatility of the interest burden due to interest rate changes is reduced and the principal & interest repayment scheme constantly test borrowers' ability to repay debts and provide hedges against the risk of paying off debts at maturity. We also find it positive that household loan growth (mainly mortgage loans) in recent years has been driven mainly by high-income households. We believe banks' credit risks are not high since the portion of low-income borrowers is low. Non-bank asset quality indicators have been stable so far. Nonetheless, if non-banks start to show signs of household debt bankruptcies, banking shares may fall too amid concerns that it may spread to the banking sector. Since banks are not free from this systemic risk, it should remain a discount factor for bank stocks until the household debt problem has a soft landing. Having said that, we believe the issue is mostly priced in, and the soft landing of the household debt problem will help shares to re-rate further. Meanwhile, we think household loan growth will slow and overall loan growth will be led by SME loans going forward.

III. Global comparison and valuation

1. Foreign investors welcome stronger fundamentals and fewer structural challenges

Foreign investors investing in Korean banks tend to be long-term, value investors. As such, they have a keen interest in identifying any structural changes that may be taking place in the banking sector. For such foreign investors, the CET1 ratio is traditionally one of the most important investment indicators because dividends are especially important for low-growth stocks like banks. In the past, it was difficult to expect dividend growth from Korean banks because of their lower capital adequacy ratio vs. global peers. There were concerns that several Korean banks would even attempt to raise additional capital. In addition to the lackluster dividends (less than 20% dividend propensity), there were also regulatory risks, with the financial authority encouraging banks to keep their profits as reserves.

However, through various efforts over the past two years, Korea's listed banks have managed to boost their group CET1 ratio to 12.2% by end-2016, thanks to profit growth, risk-weighted assets (RWA) management and favorable regulatory changes over capital. Korean banks' capital adequacy ratio is now better than the average of that of major foreign countries. In addition, the financial authority's intervention over dividend policy has eased, which enabled Korean banks to raise their dividend payout ratio steadily. Their average dividend payout ratio in 2016 was 21%, which is still far lower than the global average of 42%. However, due to low valuations, their average dividend yield is quite handsome at 3.0%. For foreign investors, the fact that Korean banks' dividend propensity has ample room for growth could be a very attractive point. Considering the high correlation between the P/B multiples and dividend payout ratios of overseas banks, we believe Korean banks' increased dividend payout ratio will lead to a stock re-rating.

Some of the unique weaknesses of Korean banks are regulatory pressure which is severe given the maturity of its economy and little flexibility in SG&A spending. Foreign investors thought the problem was a structural one and did not expect things to improve. However, since the inauguration of the new Financial Services Committee (FSC) chairman, deregulation of the overall financial system has made progress, and Korean banks have secured considerable autonomy in determining their interest rates and dividends. SG&A cost growth has slowed to around 2% through limited wage increases and the execution of voluntary early retirement program (ERP). Given the staff composition of Korean banks (e.g., higher percentage of experienced workers), the early retirements of bank employees should continue over the next few years. Additionally, as the financial sector increasingly focuses on online platforms, the number of branches is declining, and we expect SG&A cost reduction, already a visible phenomenon in developed countries, to become visible in Korea in a few years.

Korean banks' structural problems have been described as: 1) little loan growth momentum and declining NIM caused by a protracted period of low growth and low interest rates; 2) chronically high credit cost ratio; and 3) absence of major shareholders who can be held accountable and concerns over government interventions. However, over the past two years, bank loans grew at an unexpectedly solid rate of 8% YoY on the back of the healthy real estate market and SME loan demand. Although the loan growth rate is expected to normalize to around 4% this year, solid asset growth in the past two years has cemented a base for earnings growth. Besides, NIM should recover this year, and net interest income, which is the basis of banking operations, will likely grow 7.3% YoY. Credit costs, which were chronically high in the past, have plummeted since the peak of 2013 and worries over corporate bankruptcy should be limited after the DSME crisis is resolved this year. Corporate governance issues are also improving, through the privatization of Woori Bank and the internal promotion of CEOs at listed financial holding companies.

The issues mentioned above are partly structural problems and unlikely to improve dramatically. Thus, we would be satisfied only to see gradual improvements. What is more important is that Korean banks have finally steered in the right direction regarding these issues, and that progress is being made simultaneously. This phase of quality improvement has not occurred suddenly; we believe it is the result of the banks' efforts, good-willed competition among financial institutions, and the macro and regulatory environment changes over the past several years. Taken together, the banking sector should experience qualitative growth as their structural problems gradually dissipate over the next few years, following the earnings upgrade phase of 2015-16. These changes seem to be enough to attract foreign investors' attention, and as such, it is unlikely that foreign investors will switch to a sell-off position as they did in 2013.

The three major banks' foreign ownership has been growing since 4Q16, recovering to the pre-downcycle level of 68%. During the previous buying spree of banking shares, which lasted from 2H13 to 1H14, expectations were high that the Bank of Korea would freeze the benchmark interest rate and the rate-decline cycle would come to a close. Since then, interest rates were cut further, and foreign ownership of Korean banks declined. At the time, banks' profits were recovering but it was not meaningful as declining NIM suppressed the top line and margin improvement happened only thanks to non-recurring profit and lower credit costs. On the other hand, the upcycle that we see of late is mainly driven by: 1) the possibility of an end to the base rate cut cycle and the cautious mood of expecting a rate hike in 2018; and 2) top-line growth driven by a modest recovery in NIM and solid asset growth. As such, we believe the current upcycle could be stronger and last longer than the previous cycle. Furthermore, the valuation gap between Korean and overseas peers has widened after Korean banks' recent corrections, which makes Korean banks' valuations appear more attractive.

The current undervaluation of Korean banks vs. their fundamentals is more evident when we look back at 2013. In 2013, Korean banks faced negative factors inside and out. The decline in interest rates accelerated the NIM decline and the loan growth rate stood at just 1.3%. The regulatory authority's downside pressure on interest rates and commission rates was strong. The household delinquency rate surged on the slumping real estate market and sluggish economy. The global financial market was also unstable, which created an added burden. Foreign investors rallied to sell off Korean banking stocks. Nevertheless, banking shares' valuations were significantly higher than now, trading at 0.72x P/B and 8.4x P/E with a dividend yield of 1.6% (vs. 4.9% ROE). Considering the favorable cycle that Korean banks face now, it is safe to say their investment appeal has grown significantly higher compared to the past.

2. Valuation

Within the financial sector, we prefer banking stocks the most. Insurance companies are enjoying a favorable earnings cycle, but they are not free from capital issues in the short term due to the adoption of IFRS 17 and the financial authority's plan to strengthen the RBC standard. On the other hand, banks do not seem to have big issues in the medium term. Compared with brokers, they have superior earnings visibility. In addition, while investors are increasingly interested in dividends, banks currently produce attractive dividend yields and are likely to pay out even higher DPS going forward. In the meantime, banking stocks' valuations remain the lowest in the financial sector. Since we believe banking stocks' growth and ROE will become similar in the long term, banks are an attractive investment in the long term, in our view.

Our 2017-2018 net income forecasts of Korean banks exceed the consensus forecasts by 1.4% and 3.3%, respectively. Despite the stock rally since 2H16, we think banking stocks' valuations-0.56x 2017F P/B, 7.4x P/E with a dividend yield of 3.2%-is attractive considering its 8% ROE. In the short term, large banks will likely gain investor attention but small/medium-sized banks also merit attention for they are likely to have stronger upside potential in the coming year. This is because small/medium-sized banks have structurally higher ROE but their valuations are lower than those of large banks due to relatively weaker share price rally. In addition, SME loans, the major source of earnings for smaller banks, are expected to be robust while the burdens from household debt issues are relatively small for smaller banks. We expect to see a stock rally this year as concerns over the local economy ease and the relatively low capital adequacy ratios of small/medium-sized banks improve (especially BNK Financial Group and JB Financial Group).

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