GEM Financials - Turkish banks earnings conundrum or ripe for a rebound?

History of Turkish banks earnings

We all monitor corporate earnings paying particular attention to periodic changes in net income, be it year on year or quarter on quarter; but do we ever look at what the trend actually looks like over a longer horizon? The past decade has made all the difference. Turkish banks' earnings growth (nominal Lira based) has declined rather significantly since 2005. The EPS growth first dropped to mid-teens by 2010 from 40-50% range, which was the norm in mid 2000s. The growth then slowed to low single digits from 2010 onwards and actually turned negative in 2014 and 2015. There is no ambiguity about the trend with all the banks we have looked at displaying massive erosion in earnings growth/power. The decline in EPS growth would have looked more pronounced had we used "real" earnings instead of nominal or restated earnings in a hard currency such as the dollar.

Data and actual results

We are interested in how inflation has shaped banking sector earnings in Turkey. With that in mind, we have gone back and looked at earnings growth at three major Turkish banks, namely Akbank, Garanti Bank, and Isbank, since 2000. We have excluded Yapi Kredi as this bank had to report massive net losses several years following the seizure of its assets by the government, which distorted the statistics. We have also excluded Halkbank and Vakifbank as their GAAP financials do not go as far back. To smooth out the time series of earnings growth, we have plotted 3YR moving averages against time reducing the number of observations effectively to 11.

Below we list the growth rates in net income generated by the three Turkish banks in the 11 years to 2015. What we report here again is the average earnings growth rates at the three banks, which form our sample, calculated as the 3-year moving average from 2005 onwards.

• 2005: +53.5%;
• 2006: +33.7%;
• 2007: +45.0%;
• 2008: +22.1%;
• 2009: +34.1%;
• 2010: +18.3%;
• 2011: +19.1%;
• 2012: +7.4%;
• 2013: +3.1%;
• 2014: -4.0%
• 2015: -3.1%

Positive correlation between inflation and earnings

We have found reasonably strong positive correlation between earnings growth and consumer price inflation, in line with our a priori beliefs. We have also observed that, not only the actual level of CPI but also its volatility has played a role in dragging earnings growth at banks. Reduced inflation volatility, especially after 2011, has indeed slowed the pace of earnings growth via reduced income from trading.

The behavior of return on common equity displays a similar pattern. The mainstream Turkish banks have generated ROEs exceeding 20% only in those years inflation itself was in double-digits. In 10%-or-below inflation years of mid-2000s to date, the ROEs have first declined to low teens and then towards 10% mark or below, consistent with the earnings growth trajectory we have reported here.

Prudential regulations and earnings

Falling inflation explains majority of the decline in Turkish banks' earnings power over the past decade. We also see the Central Bank's implementation of prudential regulations as a reason for earnings erosion. The low-inflation episodes of late have indeed coincided with adverse regulatory changes, which have exacerbated the slowdown in earnings growth. The CBT's tougher credit regulations aiming to curb consumer loans have had their fair share in reducing bank earnings, in particular during the last two years. Nevertheless, inflation appears as the most sensible factor explaining the erosion in sector's earnings. 

The caveats

We would like to flag three particular reservations about the arguments we make in this note.

1. First, we know all too well earnings power of banks around the globe has eroded significantly, over the past decade, for secular, cyclical and regulatory reasons most of us are familiar with. Most money-center banks do not any more earn the ROEs they did 10 years ago. Turkish banks are no exception there.
2. Second, there is very little, if any, discussion of company or industry fundamentals. There may well be other explanations for such earnings using idiosyncratic fundamentals of these banks which could make perfect sense. However, we have a strong view that fundamental company research will only confirm our conclusion that inflation is the single most important reason for erosion in earnings power.  
3. Third, the results (growth rates) we report here are (may be) statistically inconclusive because they fail the-law-of-large-numbers test. Yet, that does not hold us from drawing conclusions because the trend is visually strong. Moreover, analyst conclusions are seldom significant statistically.

And the silver lining...

The impact of declining inflation and interest rates on net interest margins and hence earnings is well documented. However, one would expect earnings growth to "bottom out" and start gaining pace gradually. We are not yet seeing that with Turkish banks.

The silver lining, if there is one, is that earnings growth rate may have hit the bottom.