When I conducted a Local Bank Sector Seminar in late 1996, there were 13-listed local banks in Hong Kong. When the dust finally settles after the conclusion of the current spate of privatizations, there will be only eight local bank groups still listed (with only five survivors from the seminar). One of the latest banks to leave the list is Wing Lung Bank, which has been sold to China Merchants Bank for 2.91x book value. Here’s why I believe both sides of this latest deal will be reasonably happy.
Hong Kong’s evolving listed local bank sector
Others parties that should be feeling happy could include: bank analysts, who will have less to do these days (less company visits and presentations to attend), and, generally speaking, they should be pleased because the quality of listed banks now is better than 1996. The HKMA must also be very pleased with the response to its constant calls, since the Asian Financial Crisis, for a restructuring of the sector into larger groups. The regulator’s reasoning is that fewer banks will result in fewer mistakes (from both sides of the regulatory fence).
CITIC’s upcoming privatization will reduce some of the duplication between the listed local bank sector and the China banks that are listed here. However, ICBC (Asia) and Bank of China (HK) still represent considerable confusion to investors. I have already suggested in the past that the parents of locally listed subsidiaries should privatize their Hong Kong offshoots (particularly Bank of China) – but that’s another story.
The main topic of this week’s newsletter is the price paid by China Merchants for Wing Lung Bank. Did they overpay? Should the share prices of local, family-run banks, command a bid premium? The answer in both cases is no.
I’m not sure where the CEO of ANZ was coming from when he raged publicly that China Merchants is paying over the odds for Wing Lung Bank. I suspect it was a pressure tactic designed to save his bank a bit of money (because his main target is the much smaller Chong Hing Bank).
My reading of the Wing Lung deal is that China Merchants and the Wu family should both be happy campers. The only related parties that are upset would be China’s regulator, which seemed to support ANZ’s view that China Merchant had offered too much, and other families such as the Liu’s of Chong Hing, the Li’s of Bank of East Asia, the Wong’s of Dah Sing and the Fung’s of Wing Hang. The families would be a grumpy right now because 1) another potential buyer has passed them by 2) minorities of their banks, and the press, are constantly bugging them with the same question: “when are you going to sell?” This must be very distracting, particularly when you are eying up the 18th hole, and a large wager is at stake! And 3) the pressure of topping Wing Lung’s 2.9x - after all, the remaining families, I’m sure, all believe that their banks are superior in every way to Wing Lung.
But they are missing the point regarding the usefulness of the price to book valuation yardstick. Of all the measurements used to determine the value of a retail bank, none is more important than the deposits to market value ratio. In the end, it was this ratio which determined the price of Wing Lung, and will probably determine the price of CITIC Ka Wah too.
The big daddy of local retail deposits is Hang Seng Bank, and, even without any sign of a bid premium in its share price, its deposit to market value ratio is only 1.76x. Wing Lung was sold for 1.94x, while the sector average is currently 3.8x.
Summary of local bank valuations
Why are deposits so important? A retail bank’s franchise is determined by its deposit base. Deposits represent the investing public’s trust in the institution. Their importance can be shown in the correlation between rankings of the ratio and those of “do-nothing” banks – which is a very tight 0.80. The correlation between price to book and “do-nothing” banks is looser at 0.70.
What is a “do-nothing” bank? It’s a hypothetical bank that only receives deposits. It makes no loans. It receives deposits, and pays 3 month deposit rates. It takes the deposits, puts 25% aside for liquidity purposes, and the rest goes into 10-year EFNs. The bank’s equity is also plopped into EFNs. Also, one should assume that 10% of deposits are non-interest bearing. As fee income should match operating expenses in an ideal bank, the result is net interest income equal to pre-tax profits. No credit proposals, no provisions: no nonsense. In effect, this is historically what banks such as Hang Seng Bank and Wing Lung Bank did for a living.
Last year, the 3-month HK$ deposit rate averaged 2.52%, while the 10-year EFN averaged 4.18%. The “do-nothing” net interest margin for the sector averaged 1.81%. Apply the same rules to each banks’ deposits and equity, and the results are quite illuminating. They show, for instance, that the three banks whose share prices have risen the most since the year low of March 17, all failed to match the net interest income from “doing-nothing”. Those that produced the most income compared to “doing-nothing” are the least likely to be take over candidates, with this prospect reflected in their share price performances since March 17.
“Do nothing” net interest income vs actual – 2007
In effect, a “do-nothing” bank only generates deposit spread. What most bankers are trying to achieve is something better than deposit spread, by generating loans with higher yields than the EFN benchmark. Those that produced a premium over the deposit spread deserve a pat on the back, with bonuses going to the loan officers.
The performance of Wing Lung last year may have been the final straw for the Wing Lung Bank business model. Chong Hing’s performance confirms that the family run retail bank model is breaking down. Why the two red chip banks (CITIC and ICBC) performed so poorly last year may be simply down to inexperienced China bankers. Whereas Wing Hang, Hang Seng and the like have been through many crises unaided, PRC bankers have been hand-carried through them, and are not equipped to handle disruptions such as the sub-prime crisis.
Local bank share price performance, bid candidates, do-nothing performance
The price performance of the candidates in the table seems to make sense, in that the two +60% gainers are being taken over, while ICBC may be taken over by its parent because of its inability to produce profits above its deposit spread, while Dah Sing is a candidate because of its family-run business model. The most curious price performance has come from Wing Hang, which is everybody’s best bet to be taken over next, but whose price performance (+9%) does not reflect this expectation.
So the Wu family sold a franchise that was starting to show signs of breaking and wasn’t even meeting basic performance measurements, while China Merchants got a valuable deposit brand, and a decent franchise that can be fixed, if only it can get Wing Lung to follow the Hang Seng model of hiring professional loan/credit officers/managers. China Merchants did not pay over the odds from a deposit/market value point of view, as Hang Seng’s bid free 1.76x is a good benchmark to pay under.
As for the price that CITIC Bank will pay for CITIC Ka Wah, the range is anything from HK$7.43 to HK$10.26, assuming that CITIC Ka Wah’s 15% stake in CITIC Bank is priced at market, and the Hong Kong business is priced at 2-3x book value. Bearing mind its poor performance last year, 2x would appear to be a good price. The blended price to book using the lower price would be 1.7x, which is in line with the average deal price of the past 10 years (see the first table). HK$7.43 would also lower the deposit/value ratio to 1.96x, in line with Wing Lung. Bearing in mind, the buyer is friendly and there are no synergy gains to be had, an average priced deal sounds about right. The price also matches CITIC Ka Wah’s all-time high price. Which would be a nice way to round out this little chapter in Hong Kong’s banking history.
As closure to another long running situation, I am selling the China Unicom (0762.HK – HK$15.18) position from the Model Portfolio – after seven long years. The 25% gain represents a pretty pathetic CAGR of 4.0% (4.88% con-dividends – compared with the average 10-year EFN yield during the period of 4.46%). I’m taking Unicom out because I don’t understand how the recently announced restructuring of China’s telecom industry will be of benefit to anyone – except Unicom’s customers.
