Equity analysts are forecasting lower profitability than in recent quarters when Israel’s banks release their financial reports for the first quarter of 2012 next week.
Trading since last summer under the pall of a deepening European debt crisis and uncertainty in the global financial sector, local bank stocks have shed about 30% of their value over the past 12 months and now exhibit depressed price-to-book ratios averaging 0.7 − and as low as 0.4.
Alon Glazer, veteran bank analyst and vice president of research at Leader Capital Markets, expects that the banks will present “acceptable” results, after mostly reporting excellent results at the end of 2011. He bases this outlook on two factors: favorable capital market conditions that are expected to boost performance of their funds and capital market activities, the value of the securities in their portfolios and commission income, and the favorable impact of continued domestic economic growth in the first months of this year.
The big question mark hanging over first-quarter results, Glazer maintains, is the extent of provisions the banks will need to make on doubtful debt − considering damage sustained by borrowers and concern over impairment of their ability to repay their loans. Provisions generally reflect a certain percentage of the outstanding debt based on past experience or an assessment of the amount owing that won’t be recoverable.
“I don’t expect a sharp rise in provisions in the first quarter, but we can definitely expect to see a ratcheting up of provisions resulting from credit losses of several large borrowers,” explains Glazer. “The provision will impact results, so the bottom line for the banks will be merely ‘acceptable.’”
Glazer emphasizes that the greater concern is over the following quarters, or at least the current (second) quarter. “The main worry is over the consequences of the latest capital market declines on the remainder of the year,” he says. “We can already see relatively weak capital market results in the second quarter and further deterioration in the condition of several major borrowers.”
IBI Investment House financial services analyst Adi Scop also thinks credit losses will be the centerpiece of the quarterly results. “The joker of the upcoming reports is in credit losses,” Scop writes in his analysis. “The big questions at hand are how much the banks will set aside in provisions for large borrowers, and how far this amount has already been factored in by the market.”
‘Conservative and appropriate’
Scop estimates that the large write-offs the banks will perform will be a “conservative and appropriate” step to match their assessment of major borrowers’ repayment capabilities with the capital market’s assessment of their repayment capabilities.
“At a price-to-book ratio of 0.7 for Israel’s banks, the market is already pricing in several weak quarters and a jump in the scale of write-offs,” explains Scop. “But banks in Israel are still left with a (price) premium over the worldwide average.”
Psagot Investment House senior analyst Terence Klingman agrees that the bad news for investors still lies ahead, noting that bank shares could be in danger of returning to their nadirs of late 2008 that followed the devastating collapse of Lehman Brothers.
“A short-term deterioration in results, along with a permanent, long-term decline in the return presented on capital could lead to a situation in which the banks will be trading far below their economic value for a long time,” writes Klingman.
Return on equity measures a bank’s ability to translate assets into earnings − at least in theory − and is therefore a key performance indicator. Mizrahi Tefahot Bank led the industry in 2011 with a 14.9% ROE, followed by Bank Hapoalim with 12.0%, First International Bank of Israel (Beinleumi) with 8.6%, Bank Leumi with 8.3%, and Israel Discount Bank with 8.2%.
Klingman thinks banks will henceforth present single-digit ROEs, rather than the double-digit returns shown by a number of them the past few years. He says the impact on business sector profits by last summer’s cost-of-living protests, escalating regulation, the increased leveraging of holdings companies as a result of falling market prices, and an upward trend in unemployment could to lead to increased credit losses for the banks, along with repercussions from a worsening of the crisis in Europe.
Buy for Mizrahi and Hapoalim
Banks may shortly need to sustain a freeze in their revenue levels due to the impact of the economy’s low interest rate environment on deposit spreads, adds Klingman, as well as inter-bank competition over household deposits to meet Basel III capital adequacy requirements.
Klingman points out that the summer protests have also made it difficult for banks to increase their credit margins and fee schedules for households, while the level of activity from business customers remains thin in light of the slowdown in economic growth.
Klingman forecasts annual ROE this year at 12.3% for Mizrahi, 9.5% for Hapoalim, 8.1% for Leumi, 7.7% for First International, and 6% for Discount, giving just the top two − Mizrahi and Hapoalim − Buy recommendations, with target prices of NIS 44.00 and NIS 17.40 respectively, representing upsides of more than 30% over their current trading levels. He rates the other three Hold, with more moderate upside potential.
Scop isn’t rushing to raise his bank share recommendations either, leaving them at Neutral for all but Discount Bank, despite their enticing price-to-book ratios. “We maintain a minority opinion that the potential upside compared with risk factors still doesn’t justify changing the recommendations,” he writes.
Scop nonetheless gives Discount a Buy recommendation after the stock fell 13% over the past month as it faces being dropped from the MSCI index at the end of May.
