2Q - converging to BZ WBK?

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1 BRE Bank Securities ANALYTICAL REPORT Banks ISSN X Warsaw, Q - converging to BZ WBK? PLN untis '000 We asked the question, how does the sector look like following 2Q results. The general trends are well known and much discussed. The incomes of banks are falling as a result of interest margins stabilising on a low level as well as the decline in other income (bonds are yielding smaller capital gains, while smaller differences between Polish and foreign interest rates as well as less market uncertainty are reducing profits on SWAPs, other derivative transactions and trading). Operating costs are slowly being reduced, but despite that the operating profit of the majority of banks is falling We are observing a phenomenon which could be called converging to BZ WBK. Other banks are currently noting similar levels of operating profits and net provisions to those noted by this bank for several quarters. Much lower net provisions than those noted in previous quarters made it possible for Pekao, BPH PBK and Bank Handlowy to note good results, while the weaker result of ING BSK is due to higher net provisions. However, despite everything, there is hope for an improvement in sector results in 2H. A slight increase in volumes can be expected which, should declines in the pure interest margin be halted, could result in an improvement in net interest income. Increasingly less income from SWAP operations means that the potential for a decline in income is increasingly smaller and it can be expected that the decline in income from this source will be compensated by a growth in other income, among others from fees and commissions. Should the economic recovery continue, many provisions will continue to be dissolved, making it possible to maintain a low level of net provisions (although perhaps not as low as that noted in 2Q). In our opinion, volumes will be the most important. Without a growth in the value of extended loans Polish banks will fall all over themselves competing for a handful of clients. However, an increase in loan activity will not occur until enterprises and banks are convinced that the observed economic recovery has a durable character and that it will not be threatened by, for example, a collapse in public finances Recommend Market price Target price Pekao Hold 111,5 115 BPH PBK Sell BZ WBK Hold (*) 83,5 84 Millennium Reduce 3,1 2,58 Kredyt Bank Hold 10,55 9,74 ING BSK Hold Handlowy Reduce 61,5 53 (*) downgraded from Accumulate 0 As three banks (BZ WBK, BPH PBK and Bank Handlowy) are noting a similar level of profitability on assets and ING BSK would note a similar level if it created provisions on a level similar to the sector average, we wonder whether the ROA of banks will converge in the future. Therefore, we thought that investigating the capitalisation/ assets ratio and comparing it to our expectations concerning the long-term ROA of individual banks would be an interesting idea. The result of this analysis confirms our earlier opinions concerning the appropriate pricing of Pekao and the overly high pricing of BPH PBK. Due to the growth in price as well as the fear of a worse 2H, we have downgraded our recommendation for BZ WBK from Accumulate to HOLD. Analyst Andrzej Powierża Investment Advisor Andrzej.Powierza@breinwest.com.pl tel (22) fax (22) Dom Inwestycyjny BRE Banku S.A. ul. Wspólna 47/ Warszawa, skr. poczt P/E ROE P/BV Q (an) 2003F 2004F Q (an) 2003F 2004F Q (an) 2003F 2004F Pekao 24,0 18,5 17,9 16,4 11% 14% 14% 15% 2,6 2,7 2,5 2,4 BPH PBK 73,6 23,4 24,4 17,0 3% 8% 8% 1 1,9 1,8 1,8 1,7 BZ WBK 22,3 24,9 28,9 16,4 12% 1 8% 13% 2,4 2,4 2,3 2,1 Millennium 14,3 169,4-175,4 11% 1% 1% 1,5 1,5 1,5 1,5 Kredyt Bank ,4-22% -55% -11% 2% 0,9 1,1 1,1 1,1 ING BSK 29,1 325,5 34,6 19,5 6% 1% 5% 8% 1,6 1,7 1,6 1,5 Handlowy 33,1 27,3 42,5 23,7 4% 5% 3% 6% 1,4 1,4 1,4 1,4 BRE Bank Securities does not rule out offering brokerage services to an issuer of securities being the subject of a recommendation. Information concerning a conflict of interest arising in connection with issuing a recommendation (should such a conflict exist) can be found on the final page of this report.

2 The banking sector following 2Q is stabilisation a sign of improvement? The period following the publication of quarterly results is a good time to summarise the situation in the banking sector. How did banks do in terms of the most important parameters dynamics of loans and deposits, margins and spreads, total income and costs, costs of provisions as well as the return on assets (ROA) and the return on equity (ROE)? Growth in volume of loans (annual dynamics) Q0 1Q0 2Q0 3Q0 4Q0 1Q0 2Q0 Source: bank, BRE Bank Securities Kredyt Bank (c) ING BSK (nc) Handlowy (nc) Despite all the signs of economic recovery, there is no sign that banks are increasing loan activity. While the chart above does not present data allowing for a conclusive evaluation of loan activity, as it presents the dynamics of net loans, which are declining in some banks (Kredyt Bank and ING BSK) due to increasing provisions, gross loans would probably also show a similar regularity. Only two banks are not following the general trend of a decline in the dynamics of volumes: BZ WBK, which continually notes annual growth of more than 1 and BPH PBK, which has surpassed the competition in terms of the annual rate of loan growth, due to having focused on loan expansion. Bank Handlowy is rebuilding its position following last year s calamity. 1

3 Growth in volume of deposits (annual dynamics) Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 Kredyt Bank (c) ING BSK (nc) Handlowy (nc) Source: banks, BRE Ban Securities Considering the dynamics of deposits, banks are aiming for the average: the dynamics of banks, which against to the general trend increased deposits (ING BSK), is falling, while the situation of banks that noted the most dramatic drops (Millennium) is improving slightly. The declines in Pekao intensified slightly but we should keep in mind, that this bank is one of main beneficiaries of the shift in savings to investment funds. Assets of investment funds as a % of deposits Q0 1Q0 2Q0 3Q0 4Q0 1Q0 2Q0 3Q0 4Q0 1Q0 2Q0 BZ BPH PBK w/ CA Peka Handlo ING Source: banks, hoga.pl, BRE Bank Securities The volume of funds invested by savers in investment funds has remained high in recent quarters. With the stagnation of deposits, the share of investment funds in total savings is growing constantly, and at the end of June 2003 assets of investment funds accounted for more than 1 of Polish banking sector deposits. The leaders in this regard were Pekao and ING BSK, with BZ WBK and Bank Handlowy keeping pace with them. BPH PBK distinguishes itself unfavourably in this matter, not only in terms of the lower value of obtained assets (regardless of whether in comparison with deposits or in terms of dynamics), but also in terms of less favourable settlement terms with the TFI (investment fund). 2

4 Loan, deposit and net interest margins of BPH PBK and Pekao % % % % % 0. 1Q Q Q Q Q Q 2003 Pekao NIM Pekao loan spread Pekao deposit spread BPH PBK NIM BPH PBK loan margin BPH PBK deposit margin BPH BPK and Pekao presented interest margins in terms of deposits and loans (as opposed to Pekao, which described these data as spreads, BPH PBK called them margins therefore, it is difficult to say whether an important essential difference isn t applicable). According to these data, it would appear that, like Pekao, BPH PBK maintained its loan margin at previous level (but higher than in the case of Pekao), and simultaneously noted a smaller decline in the deposit margin. This could explain why the decline in the net interest margin (NIM) excluding SWAP operations was lower in BPH PBK than in Pekao (however, it should be noted that the margin still remains higher in the latter). Interest and spreads in the sector 16% 14% 12% 1 8% 6% 4% 2% jan-02 may-02 sep-02 jan-03 may-03 jul-03 25% 2 15% 1 5% jan-02 may-02 sep-02 jan-03 may-03 jul-03 Spread WIBOR (3M) Loans for enterprises Spread WIBOR (3M) Consumer loans jan-02 may-02 sep-02 jan-03 may-03 jul-03 12% 1 8% 6% 4% 2% jan-02 may-02 sep-02 jan-03 may-03 jul-03 Spread WIBOR (3M) Deposits (3M) Spread WIBOR (3M) ROR-y Source: NBP, BRE Bank Securities 3

5 The picture presented by both banks is in line with NBP data, which shows that the loan spread still remains higher than a year ago, while the decline in the margin results from a smaller deposit spread. Annualised interest margins(*) 6% 5% 4% 3% 2% 1% (*) interest margins excluding SWAPs, with the exception of Bank Millennium and ING BSK since 1Q Interest margins stabilised in the majority of banks in 2Q. Margins fell rapidly only in three banks: Kredyt Bank, Millennium and Pekao (in the case of the latter, decline in pure interest margins most likely results from the relatively large share of foreign currency deposits). Commission income (annualised) as a % of assets 2.6% 2.4% 2.2% % 1.6% 1.4% 1.2% 1. Kredyt Bank (c) ING BSK (nc) Handlowy (nc) 0.8% Kredyt Bank (c) ING BSK (nc) Handlowy (nc) The fee and commission income of banks have been growing for some time. The majority of banks (Pekao, ING BSK, Handlowy, BPH PBK) noted an improvement in this regard in 2Q as well. The stagnation in BZ WBK (on the highest level in the sector) and Millennium (on the lowest level in the sector) is noticeable. The good results of Pekao can partly be attributed to sales of investment 4

6 funds, the improvement in ING BSK is due to lower commission costs and in the case of BPH PBK increased loan activity was largely responsible for the result. Other income (annualised) as a % of average assets (*) 6% 5% 4% 3% 2% 1% -1% Kredyt Bank (c) ING BSK (nc) Handlowy (nc) (*) including SWAP operations, with the exception of Bank Millennium and ING BSK since 1Q 2003 The decline in income results most of all from the decline in other income (including SWAP operations). The downward trend is clear, particularly apart from the sale of Polcard (which had a positive influence on the 1Q results of Kredyt Bank and BPH PBK as well as of Kredyt Bank and Millennium in 2Q). As banks do not possess significant capital investments, bonds are yielding smaller capital gains, while smaller differences between Polish and foreign interest rates as well as less market uncertainty are reducing profits on SWAPs, other derivative transactions and trading, other income will play an increasingly smaller role in income generated by banks. In 2Q, BZ WBK defied this phenomenon, but did so due to income from a dividend from CU, an event that will not repeat in 2H. BPH PBK also noted a decline in other income, despite the fact that the bank (due to developing of treasury department) is generating more and more income from financial operations. However, the negative influence of declining income from SWAP operations predominated. Bank Handlowy was hit hardest by the drop in other commission income. This item was an important component of total income. The decline noted by ING BSK in 2003 results from including SWAP income in net interest income. 5

7 Income (annualised) as a % of average assets 1 9% 8% 7% 6% 5% 4% The effect of all these processes (stagnation in volumes, stabilisation of margins on levels lower than last year, slow increase in income from fees and commissions, decline in other income) is a clear reduction in income, which for now only BZ WBK has resisted (partly due to the dividend from CU - a seasonal event). Total costs (annualised) as a % of average assets 6.5% % % % % Kredyt Bank (c) ING BSK (nc) Handlowy (nc) average 2. Kredyt Bank (c) ING BSK (nc) Handlowy (nc) average The potential of simple savings is exhausted in banks. However, costs continue to be optimised. Those banks that recently completed the installation of new IT systems (Kredyt Bank) or the process of integrating systems (BPH PBK), brought costs into line with levels noted before these operations. Other banks, noting higher costs than their competitors, have reduced costs (Millennium) or have planned such activity (BZ WBK). ING BSK, always distinctive in a positive way, announced another round of savings (the effect of which at present was the creation of reserves for severance packages in 2Q). 6

8 Operating profit before provisions (annualised as a % of average assets 6% 5% 4% 3% 2% 1% We are observing a phenomenon which could be called converging to BZ WBK. In 2Q, an almost 2% annualised operating profit in relation to assets was noted by BZ WBK (the bank has maintained a similar operating margin since 1Q 2002), BPH PBK (a decline from a level of more than 2% noted in previous months), ING BSK (growth from the low level at the turn of 2002 and 2003, but still much lower than at the beginning of 2002) as well as Bank Handlowy (a drop from approximately 3% noted in 2002). Kredyt Bank and Bank Millennium (which as a matter of fact generated a positive financial result only due to the profit from the sale of Polcard) stand out in negative way. Pekao continues to note a higher than average profitability, but observing the dramatic decline in operating profit in recent quarters, one can only wonder for how long. Quarterly net provisions as a % of average loans 2.5% Pekao (c) BPH PBK (nc) BZ WBK Millennium (c) Kredyt Bank ING BSK (nc) Handlowy (nc) % % 0. Pekao BPH PBK BZ WBK Millennium Kredyt Bank (c) ING BSK (nc) Handlowy (nc) In regard to net provisions, we are observing a similar phenomenon as in the case of operating profit. In 2Q, three banks (BPH PBK, Pekao and BZ WBK) achieved very similar net provisions/ average loans ratios (respectively, 26 bp, 22 bp and 24 bp), while the ratios for Millennium (33 bp) 7

9 and Bank Handlowy (15 bp) differed only slightly. We were surprised how quickly they reached this level. It appears that maintaining the ratio in this area is possible, but with the current condition of the Polish economy we see no chance for a further reduction of net provisions. ROA return on assets (annualised) 3% 2% 1% -1% -2% -3% -4% Kredyt Bank (c) ING BSK (nc) Handlowy (nc) Regarding return on assets, Pekao leads the sector, traditionally noting a ROA of 1.5%. BZ WBK, which has been the only bank since the beginning of 2002 not to note a substantially worse quarter and has a ROA of 1%, is second after Pekao. BPH PBK and Bank Handlowy, which due to reducing the costs of provisions quickly increased ROA from approximately 0.2% to about 1%, recently caught up with BZ WBK. Millennium, which has problems with obtaining a positive result on the operating level, and ING BSK, which as opposed to other banks creates high net provisions, are noting a profitability close to zero. Kredyt Bank, which was again forced to create additional provisions, noted a huge loss. ROE return on equity (annualised) 35% 3 25% 2 15% 1 5% ING BSK (nc) Handlowy (nc) The return on equity of individual banks appears similar, while banks with greater capital leverage 8

10 rank higher. Despite only a slightly higher ROA, BZ WBK has a clearly higher ROE than BPH PBK or Bank Handlowy. Results of individual banks in 2Q were more disappointing (dynamics of the balance sheet and income in Pekao, the decline in income in Kredyt Bank, Millennium and Bank Handlowy) than pleasing, and the improvement in the net result was due to the low base and a reduction in net provisions. However, despite everything, there is hope for an improvement in sector results in 2H. A slight increase in volumes can be expected which, should declines in the pure interest margin be halted, could result in an improvement in net interest income. Increasingly less income from SWAP operations means that the potential for a decline in income is increasingly smaller and it can be expected that the decline in income from this source will be compensated by a growth in other income, among others from fees and commissions. Should the economic recovery continue, many provisions will continue to be dissolved, making it possible to maintain a low level of net provisions (although perhaps not as low as that noted in 2Q). In our opinion, volumes will be the most important. Without a growth in the value of granted loans Polish banks will fall all over themselves competing for a handful of clients. However, an increase in loan activity will not occur until enterprises and banks are convinced that the observed economic recovery has a durable character and that it will not be threatened by, for example, a collapse in public finances. Investment Conclusions We will return once more to the analysis of return on assets. Three banks (BZ WBK, BPH PBK and Bank Handlowy) are noting a similar level of profitability on assets. ING BSK would also note a similar level if it created provisions on a level similar to the sector average. Therefore, it can be considered whether the ROA of banks will converge in the future and whether comparing the capitalisation/ assets ratio would not be the best approach to valuation. Capitalisation to assets and return on assets (2Q, annualised) Pekao (c) BPH PBK (nc) BZ WBK (c) Millennium (c) Kredyt Bank (c) ING BSK (nc) Handlowy (nc) Price for assets Return on assets Due to the negative or close to zero results of Kredyt Bank and Millennium, we used only ratios for the remaining five banks in calculating the median. The relation of operating profitability (operating profit before provisions to average assets), ROA as well as prices for assets of individual banks to the median of these ratios is presented in the chart below. 9

11 Operating profit, ROA and Capitalisation/Assets as a % of the median of these ratios Pekao (s) BPH PBK (ns) BZ WBK (s) ING BSK (ns) Handlowy (ns) Operating profit ROA Capitalisation/Assets The comparison shows that the higher in relation to the sector profitability of Pekao average was partially reflected in a higher valuation. In our opinion, the bank will manage to maintain a higher than average ROA over the long term (in our long-term model we forecast that this ratio will be 34% higher than the sector average), therefore we believe that the current premium in valuation is justified. As a result, we are maintaining our HOLD recommendation. Simultaneously, it appears that in the near future, Pekao could be the Polish bank that most pleasantly surprises investors: the first steps taken by President Bielecki will dispel investor fears regarding his presence with the bank, and the new offer of mortgage loans together with stopping the decline in the corporate portfolio will increase balance sheet items and reduce fears about the bank losing further market share. We do not believe that in the long-term BPH PBK will maintain profitability on the average level noted in the sector (in the long-term model, we assume a ROA 1 lower than the sector s). The bank will have a larger than average market share of low-margin loans (mortgage loans and loans for large corporations), it will lose share in the market of retail client accounts and therefore will generate commission income on a lower level than the sector average. We fear that costs of provisions (despite the relatively large share of safe mortgage loans) will be higher than the sector average. For this reason, we believe its current valuation is too high and are maintaining our SELL recommendation. The valuation of BZ WBK is fully justified by current results. We believe that in the longer term the bank will achieve a return on assets higher than the sector average (in the long-term model, we forecast a ROA 12% higher than the sector average), as it will maintain its advantage in relation to competitors regarding income and supervising the credit risk, and thanks to savings and the growth in the scale of activity, its cost base will decline. However, we fear that 2H results could disappoint investors (increased business activity will be unable to compensate for the lack of single and seasonal profits noted in 1H), therefore in reaction to recent increases in the share price, we are downgrading our recommendation from accumulate to HOLD. The share price of ING BSK reflects the hope for a reduction in net provisions and ROA approaching average levels in the sector, which can be expected due to the bank s operating profitability being similar to the median. We believe that in 2004 ING BSK will join the group of banks noting a ROA of approximately 1%, and in the long-term model we assume a ROA for the bank similar to the sector average. We see growth potential here, but due to the fact that we do not expect an improvement in results this year, we are maintaining our HOLD recommendation. 10

12 The results of Millennium are oscillating around zero, as the bank is having problems with generating an operating profit. Without an increase in income, the bank will stay close to the breakeven point of profitability, and because the source of the weakness is the structure of the bank s income (among others, a very low share of income from commissions and fees), we do not believe that recovery in the sector will improve the situation. Of course, this would require a more thorough analysis and eliminating the value of the share in PZU from market pricing, but this would not change the overall picture. Therefore, we are maintaining our REDUCE recommendation. In the case of Kredyt Bank, including current results in the pricing would produce a negative pricing. However, we believe that after completing the process of cleaning out the portfolio the bank will regain the ability to generate a profit, for which hopes gives the positive operating profit (despite considering the negative influence of the planned reduction of the tax rate on operating costs). In the long-term model, we assume that Kredyt Bank s ROA will be approximately 28% lower than the sector average. The current discount in the pricing is higher, but fully justified by uncertainly whether the process of cleaning out the portfolio was completed as well as by a prospective new issue of shares. Therefore, we are maintaining our current HOLD recommendation. 11

13 Previous recommendations issued for Pekao S.A. recommendation Hold Hold date issued price on day of recommendation WIG on day of recommendation Previous recommendations issued for BPH PBK S.A. recommendation Reduce Sell Sell date issued price on day of recommendation WIG on day of recommendation Previous recommendations issued for BZ WBK S.A. recommendation Accumulate Accumulate date issued price on day of recommendation WIG on day of recommendation Previous recommendations issued for Millennium S.A. recommendation Hold Reduce Reduce date issued price on day of recommendation WIG on day of recommendation Previous recommendations issued for Kredyt Bank S.A. recommendation Hold Hold date issued price on day of recommendation WIG on day of recommendation Previous recommendation issued for ING BSK S.A. recommendation Hold date issued price on day of recommendation WIG on day of recommendation Previous recommendations issued for Bank Handlowy S.A. recommendation Hold Reduce Reduce date issued price on day of recommendation WIG on day of recommendation

14 EV net debt + market value (EV economic value) EBIT Earnings Before Interest and Taxes (operating profit) EBITDA EBIT + Depreciation and Amortisation PBA Profit on Banking Activity P/CE price to earnings with amortisation MC/S market capitalisation to sales EBIT/EV operating profit to economic value P/E (Price/Earnings) price divided by annual net profit per share ROE (Return on Equity) annual net profit divided by average equity P/BV (Price/Book Value) price divided by book value per share Net debt credits + debt papers + interest bearing loans cash and cash equivalents EBITDA margin EBITDA/Sales Recommendations of BRE Bank Securities A recommendation is valid for a period of 3-6 months, unless a subsequent recommendation is issued within this period. BUY we expect that the rate of return from an investment in a company s shares will be at least 15% higher than the WIG ACCUMULATE we expect that the rate of return from an investment in a company s shares will be 5%-15% higher than the WIG HOLD we expect that the rate of return from an investment in a company s shares will be within +/-5% in relation to the WIG REDUCE we expect that the rate of return from an investment in a company s shares will be 5%-15% lower than the WIG SELL we expect that the rate of return from an investment in a company s shares will be at least 15% lower in relation to the WIG The present report expresses the knowledge as well as opinions of the authors on day the report was prepared. The present report was prepared preserving principles of methodological correctness and objectivity, on the basis of sources available to the public, which BRE Bank Securities considers reliable. However, BRE Bank Securities, in no case, guarantees the accuracy and completeness of the report, in particular should sources on the basis of which the report was prepared prove to be inaccurate, incomplete or not fully consistent with the facts. BRE Bank Securities bears no responsibility for investment decisions taken on the basis of the present report nor for any damages incurred as a result of investment decisions taken on the basis of the present report. BRE Bank Securities has rendered fee-based services for Bank Millennium within the last 12 months. It is possible that BRE Bank Securities renders, will render or in the past has rendered services for companies and other entities mentioned in the present report. Copying or publishing the present report, in full or in part, or disseminating in any way information contained in the present report requires the prior written agreement of BRE Bank Securities Strong and weak points of valuation methods used in recommendations: DCF still acknowledged as the most methodologically correct method of pricing; it consists in discounting cash flows generated by a company; its weak point is the significant sensitivity to a change of forecast assumptions in the model Multiple based on a comparison of valuation multipliers of companies from a given sector; simple in construction, reflects the current state of the market better than DCF; weak points include substantial variability (fluctuations together with market indices) as well as difficulty in the selection of the group of comparable companies 13