GEM Financials - Turkish banks: Two elephants in a small room
/Results slightly beat estimates; margin outlook is poor but asset quality and fee business are looking good
The December quarter results came in marginally better than consensus. The sources of positive surprise to earnings include higher-than-expected yields on CPI-linkers, NPL reversals and somewhat better-than expected F&CI. Core spreads were otherwise weaker, both QoQ and YoY. Loans originated in 2015 do not appear as profitable as the historical loans do. The good news is that the bad loans are not looking too bad; and the outlook for credit quality has moderated. Unlike their counterparts in Europe, Turkish banks do not have material exposure to energy sector. Fee business should also help banks partially offset margin shortfall in 2016; and the volume growth may just be good enough for earnings to deliver growth after all, over a relatively low base of 2015.
The two elephants in the room
The positive surprise to December quarter financials and moderation in operating outlook hide a more secular trend: deceleration in earnings power across the industry. The 2015 full year results indeed demonstrate Turkish banks continue to struggle to deliver earnings growth. The sector earnings fell two-years in a row now. We have discussed the underlying reasons why earnings growth is proving increasingly more challenging in a separate research commentary (Turkish Banks earnings conundrum, Global Emerging Markets Monitor, 23 February 2016). There we identified two sources dragging earnings, namely lower inflation and macro prudential regulations curbing credit demand. Neither of these two factors is likely to change course in any meaningful way in 2016. We would expect the level as well as the volatility of consumer price inflation to remain subdued throughout 2016 dampening the outlook for trading income. It is similarly premature to expect the Central Bank of Turkey to relax any of its prohibitive measures over consumer credit.
Idiosyncratic valuations
We have looked at valuation merits and demerits of 7 Turkish banks, the 6 money center banking majors and TSKB. The chart provided up front in the note plots price-to-book-equity multiples (PB) against return on common equity (ROE) on a scatter diagram. The current market values show Akbank, Garanti Bank and TSKB are trading above, albeit slightly, their book equity as at December 2015. These three banks form the upper end of Turkish banks valuation range. Market values of Halkbank, Isbank, Vakifbank and Yapi Kredi lie considerably below book with price to book multiples ranging between 0.65x (Vakifbank) and 0.76x (Yapi Kredi).
We see two reasons why Garanti and Akbank are trading at a premium to the rest of the banks. The first reason is obvious: they both have stronger ROE outlook than their peer group do. Yet, the ROE differential between those two and the rest of the group is not wide enough to justify the valuation gap. There is something else going on. The second reason, probably less obvious, has to do with shareholders. The majority shareholders of Akbank and Garanti are perceived to have drives and motivations other shareholders can identify themselves with, especially when earnings predictability is low. We are not entirely convinced that Akbank and Garanti necessarily deserve this treatment because there is no clear evidence to back this up. Nevertheless, this valuation gap has been there for some time now.
TSKB trades at a premium to the industry for all the good reasons. It is set to earn an ROE superior to everybody else's as shown in the chart we have put up front, not only in 2015 but also 2016. TSKB does not have deposit re-pricing risk, an advantage in a rising rate environment and not necessarily a disadvantage in a down cycle. The assets are funded by long-term loans with maturities well in excess of 5 years. TSKB's duration mismatch is in fact positive in that its liabilities re-price far less frequently than those at mainstream banks, which improves earnings predictability irrespective of what stage of rate cycle we are in.
Risks in bullet form
Global credit market conditions remain volatile, to say the least. There is risk of contagion across credit markets.
European banks including those with exposure to Turkey, have exposure to oil and gas industry, which could be a source of potentially damaging write-offs across Europe.
Turkish banks do not have material net open positions considering off-balance sheet protections; but cost of hedging (swap costs) may go up and drag earnings significantly.
In the unlikely event Fed tightened its monetary policy any more than it communicates, Turkish banking sector shares would come under selling pressure.
Finally, there are geopolitical risks. Syrian conflict could get a lot worse before we see any improvement. We are not making any strong assumption on the future of Syria here; but it is fair to say Syrian crisis will not be solved to any satisfaction until after the next U.S. president is sworn in.
All these risk sources we cite here make earnings predictability all the more difficult. The analysts may have to go back to drawing board more than once this year.