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Morningstar | BOC's 1H Result Saw NIM Expansion, While Credit Quality Outlooks Were Mixed. See Updated Analyst Note from 29 Aug 2018

Narrow-moat Bank of China's, or BOC's, first-half results posted 5.2% year-on-year growth, relatively flat from the first quarter and well on track to deliver our full-year projection of 6.5% growth. We retain our CNY 4.40 fair value estimate for A-shares, but lower our fair value estimate to HKD 4.90 from HKD 5.40 for H-shares to reflect the latest Chinese yuan/Hong Kong dollar exchange rate. Trading at a 26% discount to our fair value estimate, and 0.64 times 2018 price/book, the H-shares appear undervalued as the market is pessimistic about BOC's anemic top line growth and modest net interest margin, or NIM, expansion. We believe the former was largely attributable to the high base in 2017 and impact of foreign exchange rate movement. We retain our thesis that BOC's ongoing business restructuring, rising interest rates, and the Belt and Road initiative will benefit its overseas business, which now represents over 25% of its total assets.

Revenue growth accelerated to 5.5% in the second quarter from a negative 2.5% in the prior quarter. Excluding one-off impacts including exchange rate gains and the sales of subsidiaries in 2017, revenue growth would reach 4%. However, we're a bit disappointed to see growth in both net interest income and fee income slowing in the past quarter, indicating weaker growth momentum than larger peers. Other positives include tighter expense control in the second quarter when compared with a two percentage point increase to 26% in the first quarter, with cost/income ratio falling to 25.8%, up 39 basis points from the first half of 2017.

Second-quarter NIM climbed about six basis points, supporting 5% growth in net interest income and contributed to 70% of total revenue. Total assets grew 4.3% with increasing allocations to bank loans which posted a 4.7% growth as a result of RRR cuts. Such growth was prudent and in line with the 4.4% deposit growth. We believe BOC's better-than-peer NIM expansion was attributable to BOC's efforts in assets and liabilities adjustments, to take advantage of changing interest rate environment. This included shifting asset allocation to loans from interbank assets and replacing high-cost structured deposits with interbank liabilities and bonds issuance as interbank rate gradually fell in the first half.

Posting a 2% decline in the first half, fee income growth faced mounting challenges due to structural change in asset management market after the new rules. Investment bank and consulting-related services contracted 40% as both supply and demands for shadow bank credits were cramped. Asset management related income was flat but improving from decline in the past two years. Bank card-related fee income was the major growth driver with 14% growth. We expect low-single-digit growth for the full years given weaker-than-peer growth and smaller fee income contribution of BOC's credit card fee when compared with peers.

Credit quality was mixed in our view, with bad debt ratio declining two basis points to 1.43%. Provision level improved, with provision coverage rising 6 percentage points to 165%. Bad debt classification became stricter, as bad debts covered 124% of loans overdue more than 90 days. However, leading indicators for credit quality trend turned less optimistic. Special-mentioned loans rose two basis points to 2.93% and loans overdue within 90 days rose 60 basis points to 1.25%. Credit costs reached 0.51%, flat with the year-ago period and we expect a slight increase in full-year credit costs given higher credit quality risks.