Hong Leong Finance - DBS Research 2017-04-05: Earnings recovery amidst M&A potential

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HONG LEONG FINANCE LIMITED S41.SI

Hong Leong Finance - Earnings recovery amidst M&A potential

• Initiate coverage with BUY rating, S$3.20 TP; new opportunities abound, M&A a possibility.
• Solid > 50-year track record in property-related financing and SME lending; untapped and unbanked niche financier.
• Expect 44% growth in NPAT in FY2017 due to NIM expansion.
• Attractive M&A target for acquirers looking to expand reach in Singapore SME lending space.
• Trading below book value and >30% discount to banks; TP of S$3.20 offers 18% upside; an additional minimum 43% upside in the event of an M&A over last close.

New opportunities abound; M&A potential. 

• MAS’ rule relaxation on finance companies (fincos) in mid-Feb 2017, which lifted the limits on un-collateralised loans as a percentage of capital funds (from 10% to 25% of capital funds) and liberalised its existing policy to now allow a foreign takeover of a finco (subject to certain conditions), opens new opportunities for Singapore fincos. 
• Hong Leong Finance (HLF), the largest of the three fincos in Singapore, is poised to benefit, in our view.

Strong track record in property financing and SME lending. 

• With over 50 years of lending experience with its SME expertise, HLF dominates the finco lending space, accounting for > 75% of the fincos’ total loans. 
• HLF has the widest branch network among the three fincos with 28 branches and 10 Small-Medium Enterprise (SME) centres across Singapore. 
• HLF’s strength lies in property-related financing (78% of loans) and hire purchase and block financing (16% of total loans).

Expect > 40% growth in NPAT. 

• We estimate 44% growth in HLF’s NPAT, from a multi-year low of S$53.0m in FY2016, riding on higher net interest margin (NIM) due to lower cost of funds. HLF faced higher cost of funds in FY2016 due to expensive deposits collected amidst fixed deposits competition towards end 2015.

Offers 18% share price upside; M&A could provide another 10- 35% upside to last close. 

• Our TP of S$3.20 offers 18% upside potential, based on HLF’s competitive strengths and growth prospects vs its finco peers. This is derived from the Gordon Growth Model with 5.1% ROE, 1.5% long-term growth and 5.8% cost of equity, implying c.0.8x FY17F BV. 
• Under an M&A scenario, we believe HLF should attract a min 1x BV as current shareholders are unlikely to sell out at lower valuations given the prospects of the business under this new regulatory regime, providing a minimum > 43% upside over last close of S$2.70.

Company Background

Singapore’s largest finance company established since 1961.

• Established since 1961, Hong Leong Finance (HLF), the financial services arm of Hong Leong Group Singapore, has since evolved to become Singapore’s largest finance company with over 600 employees. 
• Hong Leong Group Singapore is one of Asia’s largest conglomerates with core businesses in property development, hotels, finance and trade and industry with gross assets of over S$40bn and 40,000 employees.

Widest distribution network in Singapore. 

• Among the finance companies in Singapore, HLF has the widest distribution network with 28 branches and 10 Small and Medium-sized Enterprise (SME) centres island-wide. HLF’s branches can be found mostly in shophouses near the town centres, as well as in shopping malls.

More than 55 years of experience in SME lending. 

• HLF prides itself as a “SME specialist” with more than 55 years of experience serving SMEs locally. Besides providing financial support to SMEs, increasingly, HLF has shifted its focus to provide one-stop financial services to SMEs, for instance through the set-up of SME centres.

Large variety of products and services. 

• HLF provides close to 20 types of SME financial products and services, ranging from commercial/industrial property loan, factoring, trade finance to micro loans. HLF is also one of the participating financial institutions under 
  1. Local Enterprise Finance Scheme (LEFS) administered by SPRING Singapore where SMEs may secure asset-based loans for factory, machinery, equipment purchase or lease/hire purchase; 
  2. Loan Insurance Scheme (LIS) administered by SPRING Singapore for companies who want to secure trade finance loans, and 
  3. Internationalisation Finance Scheme (LFS) administered by IE Singapore for companies looking to secure financing for overseas investments and/or projects.
• HLF also provides deposits and savings, as well as personal loans such as car and housing loans for retail customers. In 2007, HLF was the first finance company in Singapore to offer to chequing account services for corporate loan customers.
• HLF is also the only finance company in Singapore that is a Catalist Full Sponsor, hence offering various corporate finance services such as equity fund-raising and corporate advisory services to its SME customers.

Property loans, housing and HDB home loans account for close to 80% of loan base. 

• When HLF together with property firm Hong Leong Holdings was set up in the 1960s, the intent was to develop private housing, and through HLF, enable property buyers to finance their property purchases. HLF has since created its niche in property-related lending, from financing residential developments, commercial properties, lending to private residential home owners and HDB home owners amongst others.
• In FY2016, property related loans account for up to 80% of total loans. Housing and HDB home loans account for c.16% of HLF’s total loans, of which 9% are HDB home loans, while other property loans account for c. 64% of total loans.

HLF derives most of its income from interest income. 

• More than 90% of HLF’s income is derived from net interest income on the loans made. Non-interest income is derived from fees and commissions related to the loans and other financing businesses, as well as from fees and commissions from HLF’s non-lending business, including corporate advisory services as well as other trailer fees.

Fee and commission income is largest portion of non-interest income. 

• In FY2016, fee and commission income contributed to 98.3% of non-interest income. Of the fee and commission income, the majority of income (84% of total fee and commission income) is derived from fee income from lending products, such as chequing account services to corporate loan customers.

Non-lending fee income from capital markets. 

• In 2012, HLF achieved full sponsorship status for SGX Catalist Board, and has since been the only finance company locally to provide advisory and fund-raising services to SMEs looking to list on Catalist. 
• In 2013, HLF entered the market with its first Catalist Initial Public Offering. Since then, HLF has acted as Full and Continuing Sponsor for several companies and engaged in roles such as Sub-Placement Agent, Rights Issue Manager and Independent Financial Advisor. The provision of such equity fund-raising and advisory services has helped to distinguish HLF from other finance companies in Singapore. 
• As new listings decline due to broader environment factors, HLF continues to receive steady fee income by acting as Continuing Sponsor for several Catalist companies.

Customer deposits. 

• HLF funds its loans almost entirely through customer deposits and hence competes with other finance companies as well as banks for deposits base.
• Approx. 97% of HLF’s customer deposits are fixed deposits, with the remaining are saving deposits and other balances of customers.
• NIM remains stable amid rising loan yields and increasing cost of funds. Customer loan yields have picked up in FY2016 to 2.5% amid rising cost of funds. 
• HLF’s deposits are mostly fixed deposits which are more expensive than Current Account Savings Account (CASA) deposits. Its cost of customer deposits increased from 1.3% in FY2015 to 1.6% in FY2016, compressing its NIM for the year.

Loan-to-deposit (LDR) ratio at 91%. 

• With deposits growth exceeding loan growth, LDR ratio is now at 91%, which is comfortable and within the range of Singapore banks’ S$ LDR ratio.
• Cost-to-income ratio on upward trend. Its cost-to-income ratio has been on the uptrend, with FY2016’s cost-to-income ratio at 56.4% due to a low base. The increase in expenses was due to the following: 
  1. higher staff cost, and 
  2. higher business promotion expenses and operating lease premises expenses. 
• On top of that, higher depreciation was recorded in FY2016 due to the technology refresh of host computer systems being implemented. This represents HLF’s efforts to continuously innovate and invest in infrastructure and technology so as to enhance internal systems’ capabilities and capacities. It is envisaged that the system refresh would enable faster and more flexible processes.

Asset quality is sound. 

• HLF’s non-performing loans (NPL) position is graded in line with industry standards. HLF’s NPL ratio is the lowest amongst its peers, at 0.8% – comprising secured NPL of 0.7% and unsecured NPL of 0.1%. 
• For secured NPLs, they are fully secured but classified as substandard loans where payments are not kept current for the last 90 days. For unsecured NPLs, they are classified as loss amounts, and are fully covered by specific allowances.

Conservative allowances methodology. 

• HLF sets aside general allowances on a portfolio basis, and provides for specific allowances for all NPLs where the collateral valuation does not cover the outstanding loan amount. As secured collaterals’ valuation exceeds that of the secured NPLs, specific allowances are equal to the amount of unsecured NPLs.

Management & Strategy 

Experienced management team. 

• HLF is helmed by Mr Kwek Leng Beng, who is both the Executive Chairman of Hong Leong Investment Holdings Pte Ltd (HLIHPL) which has c.46% direct and deemed interest in HLF, as well as Board Chairman and Managing Director of HLF. 
• Mr Kwek has helped to set up HLF in the 1960s and grow the original HLF which subsequently acquired and merged with Singapore Finance in 1970s. The merger has positioned HLF as a key finance company through the provision of various financial services to SMEs and consumers. 
• Mr Kwek has been Managing Director of HLF since 1979, and Chairman since 1984.

Dividend policy. 

• HLF has adopted a dividend policy which aims to pay dividends twice a year. Various factors of consideration such as HLF’s operations results, retained earnings sufficiency, cash required for operations, capital adequacy and needs, capital expenditure and future investment plans will determine the actual payout. 
• Between FY2013 and FY2016, the dividend payout ratio ranged from 60% to 76%. We believe this dividend payout range will likely be sustained going forward.

Competitive Strengths Market leader of Singapore fincos with approx. 75% of fincos’ market share. 

• HLF has been a reputable finco for more than 55 years locally and is the market leader with approx. 75% of Singapore fincos’ loan market share totalling c.S$12bn. 
• With HLF’s wide branch network across the neighbourhoods, we believe that HLF is well-positioned to serve its SMEs as well as garner retail deposits.

Strong niche and expertise in property loans. 

• Property-related loans account for ~80% of total loans. The Hong Leong Group and HLF have deep expertise in the property sector and HLF has, through the years, amassed deep expertise in financing property developers. 
• HLF stands out clearly from the other fincos as a well-regarded lender in the property sector and participates in syndicated lending with other banks for big property development projects.

Strong SME relationships and comprehensive suite of SME products and services. 

• HLF is known for its strong SME relationships, for instance, reaching out to SMEs in the HDB neighbourhoods, through its HDB SME loan which aims at helping HDB business owners. 
• HLF is also the only finco to offer all three loan programmes administered by various government statutory boards: 
  1. Local Enterprise Finance Scheme (LEFS), 
  2. Loan Insurance Scheme (LIS), and 
  3. Internationalisation Finance Scheme (LFS), placing it in the “league” of local and foreign banks alike, in terms of product offerings. 
  We believe this further helps to differentiate HLF from the other fincos. 
• HLF has intention to participate in government-initiated programs such as “SMEs Go Digital” programme announced in Budget 2017, aimed at helping SMEs use digital technologies to build up their capabilities.

Deep relationships with partners, e.g. car dealers. 

• HLF is also known to have deep and exclusive relationships with car dealers, which adds to its healthy pipeline of car and hire purchase loans. 
• Notably, in 2012, HLF has appointed the first Porsche financial partner in Asia and has crafted various financial schemes for Porsche car owners.

Full sponsorship status for SGX Catalist Board. 

• HLF is the only finance company locally to provide advisory and fund-raising services to SMEs looking to list on Catalist. The provision of such equity fund-raising and advisory services has helped to distinguish HLF from other finance companies in Singapore and adds to HLF’s non-interest income continuously. 
• HLF also piloted a SME Connector Programme to provide several SMEs with first-hand one-to-one corporate advisory services in 2016, aimed at increasing its corporate finance and advisory suite of services.

Sound asset quality with low NPL ratio and conservative provisioning. 

• HLF has the lowest NPL ratio of 0.8% for FY2016, well below SIF and SF with NPL ratios of 1.7% and 2.4%, respectively, for FY2015. 
• HLF has a conservative approach when it comes to general allowances provisioning and as a result, HLF’s loan loss coverage is also the highest among the finco at over 120%, well above those of its peers as well as Singapore banks. We believe that HLF is well-positioned to absorb any sudden deterioration in asset quality.

Strong capital position. 

• HLF’s total capital adequacy ratio (CAR) has been on the downtrend but its capital position remains strong at 16.4% for FY2016, well above the statutory requirements of 12%. This compares with SIF’s CAR of 14.3% (FY2015) and SF’s CAR of 24.8%.

Growth Strategies 

Opportunities from MAS’ rule relaxation. 

• HLF was already the first finco to be allowed to offer business current accounts, subjected to various conditions prior to the MAS’ rule relaxation. 
• Going forward, positive catalysts could also come from cheaper funding if HLF is able to hold institutional deposits like the banks, thereby allowing HLF to act as the “go-to-bank” for various transactions for the SMEs. 
• There could also be further opportunities in unsecured lending, however, we think caution should be exercised on unsecured lending to smaller-sized SMEs due to risk concerns. 
• We note that the new MAS rules have not been implemented, and we look towards its full implementation and more clarify in 2Q2017.

Fincos may be allowed to further expand its role in providing SME financing. 

• We believe fincos play an irreplaceable role in providing financing to niche customer segments, as demonstrated by the increasing amount of loans and advances provided by the fincos. Fincos may be further allowed to further expand its role in providing SME financing, for instance, increased risk-sharing from government-related entities in relation to unsecured lending. This would be in line with the government’s objective of providing more support to the SMEs and local start-ups scene as reiterated in the recent Budget.

NIM set to recover after 2016’s decline. 

• FY2016’s dip in NIM was caused by expensive fixed deposits taken in towards the end of 2015 due to competition for fixed deposits among banks alike, in lieu of the pending rate hike. HLF’s cost of deposit was 1.6% for FY2016. 
• According to our channel checks, fixed deposit rates have since fallen from the highs in end-2015 to beginning 2016 (some banks were offering as high as 1.8% - 1.9% for 12-month fixed deposits) to < 1.3% currently. We believe that with expensive deposits now out of its system, HLF can focus on managing cost of funds going forward. 
• There will also be a NIM uptick should Fed rate hikes translate into rising SIBOR yields in 2H2017. We estimate HLF’s NIM for FY2017 to normalise to levels that are above FY2015’s.

Loan growth outlook. 

• With the exception of FY2012 which saw expansion in balance sheet with loan growth of 19.3% and customer deposits growth of 29.4%, HLF’s loan growth has been in the mid-single digit range between 2014 and 2015. 2016’s loan book shrank due to lumpy development projects attaining Temporary Occupation Permit (TOP). 
• We expect loan growth to be in the range of low single digits in FY17F due to the slower overall loan momentum in Singapore. HLF remains selective in writing loans for private residential properties due to the unattractive yield, and remains cautious about the commercial property market.

Highly selective key areas of growth. 

• We remain optimistic about selected growth industries for HLF, such as medical and equipment financing, which continued to see high growth rates in the last few years. 
• We also expect to see continued vehicle loan growth given the relaxation of rules on loan-to-value ratios and loan tenure, and unwavering interest in the luxury cars segment. HDB financing, in contrast to private residential properties, remains a key focus for HLF. The relaxation of unsecured lending limits could catalyse further lending.

Earnings recovery in 2017. 

• With loan growth returning back to positive territory, improved NIM, amid a recovering property outlook in Singapore for the coming years as signs are pointing to a bottoming out of the property cycle, as well as growth in non-interest income arising from corporate and advisory related services, we believe HLF will see stronger earnings in 2017. 
• Our forecasts translates into > 40% increase in net profit, and accordingly, higher dividends per share to be declared.

Valuation 

Initiate coverage with BUY and S$3.20 TP. 

• Our TP of S$3.20 offers 18% upside potential, based purely on HLF’s competitive strengths and growth prospects vs its finco peers. This is derived from the Gordon Growth Model with 5.1% ROE, 1.5% long-term growth and 5.8% cost of equity, implying approx. 0.8x FY17F BV.

Fincos are trading at c. 0.7x P/BV; potential re-rating on potential M&A newsflow. 

• The share prices of the three fincos have surged by 10% to over 20% following the MAS announcement, and are currently trading at c.0.7x P/BV, with PEs of above 17x. 
• From a P/BV perspective, these fincos are trading at a 30% discount to the banks. However, on a PE basis, it is considered lofty compared to banks given their sub-par ROEs.

HLF an attractive takeover target. 

• We believe that HLF is an extremely attractive takeover target for foreign banks that are keen to expand their reach in the Singapore SME lending space, for the following reasons 
  1. its strong asset quality, 
  2. its niche lending expertise in property-related loans, 
  3. its extensive branch network.

Further 43% upside potential over last close on M&A possibility. 

• We believe any takeover for fincos should be launched at above 1x P/BV, providing >43% upside over last close of S$2.70 and an additional 21% upside over our TP of S$3.20.

Key Risks 

Asset-quality deterioration. 

• There are still concerns over Singapore’s sluggish economy outlook and that SME loans may turn sour, which could tilt HLF’s asset-quality position.
• As most of HLF’s loans are secured, together with HLF’s conservative provisioning methodology and high loan loss allowance coverage, we believe that HLF is well-positioned to absorb any deterioration in asset quality.

Concentration in property-related loans. 

• HLF has high exposure to the property sector. However, we are of the opinion that the worst is over for the Singapore property sector and we expect further government initiatives in the near term, which bode well for the sector and property developers at large.
• In our view, catalysts to HLF’s share price going forward are: 
  1. HLF’s competitive strength and growth prospects versus its finco peers. Stronger loan growth, higher loan yields and lower cost of funds should contribute to higher net interest income and NIM for HLF. We observe that from 2010 to the beginning of 2012, HLF’s share price was on a downward trend, in line with its full-year NIM.
  2. Between 2013 and mid-2015, HLF’s share price was largely range bound due to flattish NIM of 1.3%. Thereafter, HLF’s share price was on a downward trend due to lower full -year NIM. We believe our fair value of S$3.20 offers a 18% upside potential, based purely on HLF’s competitive strengths and growth prospects vs its finco peers.
  3. M&A newsflow. We believe that HLF is an extremely attractive takeover target for foreign banks that are keen to expand their reach in the Singapore SME lending space. Any M&A-related newsflow would further catalyse HLF’s share price.
  4. An M&A premium could further see HLF’s share price run up by another 25%.

Sue Lin LIM DBS Vickers | Singapore Research DBS Vickers | http://www.dbsvickers.com/ 2017-04-05

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