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Morningstar | Bank of Communications Saw Strong PPOP Growth in 2018; Credit Quality Outlooks Improved

With a 4.9% growth in net profits, no-moat Bank of Communications' 2018 results showed continuous operating improvement since the new management came on board in 2018. As a bank with higher reliance on wholesale funding than large SOE peers, its accelerated core earnings growth in the second half was primarily attributable to net interest margin, or NIM, expansion. This was due to lower interbank rates after the central bank’s liquidity injection. Given the result were largely in line, we retain our fair value estimate at CNY 5.90 per share for A shares and HKD 6.60 for H shares. The bank is fairly valued and shares are trading at 0.6 times 2019 price/book. The bank is trading at lower than peer valuation level given its weaker deposit base. We expect the business restructuring will speed up after the new management is on board in mid-2018. The bank’s strategic focuses on credit card and asset management business are making good progress in 2018, and we expect it will support a continuing mild improvement in fee income in 2019.

Growth in pre-provisioning operating profits, or PPOP, recovered to the highest level at 13.5% since 2014, at the high end of large peers. This was attributable to the 8.5% growth in total revenue and a 35-basis-point reduction in cost to income ratio to 31.5%, the first improvement over the past three years. Furthermore, we are encouraged to see an improvement in credit quality reflected in a contraction in special-mentioned and overdue loans. Core Tier 1 ratio increased to 11.16% from 10.79% in 2017. The upcoming convertible bond issuance is likely to further strengthen its capital position. As a pioneer in mixed-ownership reform in the banking industry, Bank of Communications is undergoing a reform of management mechanism and share-based incentive program for management. This, coupled with the planned convertible bond issuance, is likely to result in increasing management focus on creation of shareholder’s value in the near term.

Net interest margin remained flat from 2017, though it improved during the second half on lower interbank rates. The benefit of lower wholesale funding rate was offset by increasing deposit costs, which saw 21 basis points increase to 2.27% in average deposit costs, at the high end of large peers. Deposit growth was also lackluster at 4.5%, indicating increasing competitive pressure.

Improvement in credit quality was a bright spot of the results, with bad debt ratio declining by 1 basis point to 1.49% and increase in bad debt balance slowed to 6%. More importantly, leading indicators of rising bad debt, including special-mentioned loans and overdue loans, both contracted by 10% from 2017. Balance of overdue loans and loans overdue more than 90 days continued their year-on-year contraction since 2016. It’s worth noting that the bank’s corporate loan bad debt ratio stayed at the low end of industry of 1.78% and further contracted by 11 basis points in 2018. Credit costs climbed to 0.92% from 0.72%, leading to a provision coverage ratio at 173%. We expect its steady credit quality should provide better visibility of future earnings.