Agricultural Bank of China (ABC) is the largest bank in China in terms of number of outlets and employees, the third largest in terms of asset size and deposits, and the fourth-largest bank in terms of loans, as of end-2009. It is a full service, nationwide, state-owned bank, providing a range of commercial banking (retail, corporate & treasury), investment banking and services. China state investment arm Central Huijin Investment Ltd, and Ministry of Finance of China are currently the biggest shareholders of ABC, holding 40% and 39% stakes respectively, and Social Security Fund is the strategic investor with 3.9% stakes.

A snapshot of the bank’s size and reach as of 2009
• RMB8,883 billion (~US$1,300 billion) in assets, 11.3% of domestic market share;
• RMB4,138 billion (~US$606 billion) in loans, 9.7% of domestic market share;
• RMB7,498 billion (~US$1,100 billion) in deposits, 12.3% of domestic market share;
• 23,624 domestic branches, down from nearly 45,000 in 2000, among which 12,737 were located in the county or below level areas;
• 441,144 employees, down from ~600,000 in 2000; and more than 2.6 million corporate customers and 320 million retail customers.

ABC has achieved significant improvement in financial performance in the past few years. As of 1H10, ABC reported the highest net interest margin and ROE (return on equity) among peer state banks. Nonetheless, its pre-provision ROA (return on asset) and ROA were the lowest among peers, due mainly to the relatively weak non-interest income contribution, high cost-income ratio, and high credit cost. Its NPL (non-performing loan) ratio remained to be much higher than peers, and NPL coverage remained below sector average.

Domestic corporate and retail loans accounted for 74% and 22% of ABC’s loan book respectively as of 1H10, broadly in line with peers. Nonetheless, it is more geared towards the more risky segments:

-     Manufacturing and property development, which are the more cyclical and risky sectors, accounted for 21.9% and 11.6% of its total loans respectively, both the highest among peer state banks.

-     Its retail lending is more geared towards unsecured retail loans, with mortgage loans accounted for 63% of its total loans, compared to 65%-80% at peers. Moreover, 2.5% of total loans, or ~11% of its retail loans, were to “rural households”, which suffered high historical NPL ratio at more than 86%.

Deposit mix: Superior funding base from retail demand deposits
ABC enjoys high proportion of retail demand deposits, which made up 26.6% of its total deposits as of 1H10, much higher than 13%-19% at peers. Consequently, demand deposits accounted for nearly 56% of its deposits base, also the highest among peers (46%-55%). As The People’s Bank of China (PBoC) has kept demand deposit rate largely stable during the previous cycles of rate hikes and cuts, ABC should be well-positioned to enjoy margin expansion in a rising rate environment, and be worse-off in a rate cutting environment.

Retail deposits accounted for nearly 58% of ABC’s total deposits, much higher than 45%-47% at other big banks, and ~42% in the sector. Retail deposit franchise is commonly regarded as a key competitive advantage, as retail funding is more stable and cheaper than wholesale funding. However, ABC’s retail deposit cost was 1.42% in 1H10, much higher than its corporate deposit cost of 1.08%. Retail deposit is more expensive than corporate deposit at many Chinese banks, mainly due to the longer maturity of retail time deposits and also the absence of pricing differentiation on retail deposits.

Geographical exposure: broader and deeper footprint in inland China
ABC is more exposed to the relatively less developed inland China (Central, Northeast, and West China). As of 2009, inland China accounted for more than 60% of its outlets, ~44% of its deposits, and ~37% of its loans. Moreover, as ABC has by far the largest branch network among peers, it is more deeply involved in the lower tier governments and poorer areas.

Rural banking has always been the key component of ABC’s strategy and business mix since its establishment. County Area Banking Business Unit accounted for half of ABC’s staff and branch outlets, 35%-40% of asset and deposits, 30% of its loans, and ~40% of its operating income and costs. Moreover, ABC is required by the banking regulators to maintain and increase the focus on rural banking.

Despite the favourable government policy support, we reckon that rural banking remains a relatively less proven business model, which offers potentially high growth, high yield, but also high operating cost and high credit risks. The challenge remains how to achieve profitability and sustainable growth.

As of 2009, ABC’s rural business had relatively high loan yield (+35 basis points), low funding costs (-6bp), but low LDR (loan-deposit ratio), and high cost-income ratio compared to its urban business. Moreover, asset quality in rural banking is clearly worse, with relatively high NPL ratio and Special Mention Loan ratio, high credit cost, and low NPL coverage. In our view, the gaps between rural banking and urban banking, especially in operating cost and credit risks, are unlikely to close in the short term. Rural financial institutions have to identify unique rural banking strategies and develop the loan pricing capabilities in order to survive and thrive in the rural business.

Challenges in transforming the current strategy
One strategy ABC adopted so far in its rural banking business is to gather low-cost rural deposits and redeploy them to the more developed urban areas. This is evident in the significant gap in its LDRs between rural and urban business, and between different geographies. Rural banking LDR was only ~40% in 2009-1H10, and “inter-segment asset” (funds transferred for urban area use) accounted for nearly 60% of the rural assets. Interest income paid by urban banking for such “inter-segment assets” accounted for 41%-49% of total interest income for ABC’s rural banking in 2008-1H10, up from 26% in 2007, and was a key driver to the improved profitability of rural banking in the past two years. The strategy helped to reduce the credit risks in lending to the less developed rural areas, and the transfer pricing paid by the urban banking also supported (or “subsidised”) the growth of rural business. However, ABC is facing regulatory pressure to change the strategy and fight the hard battle. The central government had in recent years required financial institutions to use (or invest) majority of the new deposits gathered in rural areas in the local communities, and had designed performance metrics to ensure the execution.

Operating costs: Limited room for operational leverage
ABC’s cost-income ratio has been higher than state bank peers, mainly due to its decentralised organisation structure, partly required by the nature of rural business. With stronger-than-peer level margin expansion in 1H10, ABC is on track to reduce cost-income ratio significantly this year. However, due to the potential weakening in credit demand and loan pricing, and the lengthening of deposit maturity, we expect ABC’s cost to income ratio to show gradual and limited improvement in the next few years, and to remain higher than state bank peers.

Good near-term earnings visibility
ABC is well-positioned to report strong near-term earnings growth, in our view. With the recently completed financial restructuring and relatively “new vintage” loan book, it could report good asset quality trend and reduce the high pre-IPO credit cost to boost bottom line earnings. Moreover, it has room for increasing the low LDR by rapid loan growth (especially in rural areas), and cost-income ratio could decline as a result of the strong revenue growth. We forecast its earnings growth to be ~36% in 2010E, and decelerate to mid-teens as net interest margin (NIM) stabilises and credit cost rebounds. Mid-term (2010-12E) average ROE is estimated to be ~19%.

Key earnings drivers
Loan growth — With the restructuring and enhanced capital position post listing, we forecast ABC to accelerate loan growth to a CAGR (2009-12E) of ~18%, one of the highest among state banks. Rural loans should grow faster at more than 20% pa. ABC’s loan-asset ratio and loan-deposit ratio were at 47% and 55% respectively by end-2009, both the lowest among peers, mainly due to the large amount of NPLs carved out in 2008. As loans are the highest yielding asset class, the asset mix is negatively impacting its NIM and profitability.

While ABC plans to increase the ratios significantly, we factored in a modest 1.5ppt rise in its LDR to 56.7% by 2012E, mainly due to the regulatory control on loan growth, and the deposit growth corresponding to loan growth.

Net interest margin better positioned than peers
We expect ABC to enjoy better-than-peer-level margin trend. We factored in 6bp half-on-half (h-o-h) net interest margin improvement in 2H10, and another 3bp year-on-year (y-o-y) in 2011. On the positive side, ABC faces less funding pressure from competition, as 40% of its deposits are from rural areas. In addition, its rapid growth in rural lending will increase its loan yield, due to the potentially higher risk profile and less competition in rural areas. On the negative side, upside in treasury yield enhancement may be smaller than peers, due mainly to the gradual decline in its high yield restructuring bonds (MoF receivables yielding at 3.3%).

Fee income
Fee income contributed to around 16.5% of ABC’s operating income in 1H10, up from 11%-13% in 2007-08, but still lower than other state banks at 20%-22%. Fee income grew by 32% y-o-y in 1H10, broadly in line with peers. We forecast ABC’s fee income growth to be broadly in line with state banks peers at around 27% CAGR during 2009-2012E. Nonetheless, its fee income could suffer greater volatility than peers due to its concentrated revenue sources.

Cost-income ratio structurally high, but room for decline
Cost management should not be the top priority for ABC, given it is still focusing on revenue growth. We forecast ABC to achieve positive operating leverage over the next three years, with cost growing slower than revenue growth, and cost-income ratio declining from 49% in 2009 to <46% in 2012E. Nonetheless, we expect its cost-income ratio to remain higher than peer state banks, due to its structurally high costs rural business.

NPL ratio and credit cost trough in 2010-11E
ABC recently completed financial restructuring and carved out the worst quality NPLs in 2008. The bank also downgraded 293bp of total loans into NPLs in 2008, much higher than the 100-150bp of gross formation in 2007 and 2009, probably due to tightened NPL classification criteria prior to listing. Consequently, ABC’s remaining NPLs were more concentrated in the higher quality tiers (ie substandard and doubtful), which offer better opportunity for upgrade and recovery. Moreover, as 25% of its loan book was carved out in 2008, it has a relatively new vintage loan book. By end 2009, ~93% of its loans were “new loans” (loans made for the first time after Jan 1, 2004).

We expect ABC to report better asset quality trend than peers in the next six-12 months. The bank will face increasing challenges in asset quality management in 2H11-12, as the benefit of financial restructuring gradually fades and loan book seasons. ABC’s credit costs were 122bp and 121bp in 2009 and 2008 respectively, much higher than H-share bank average at 47bp and 87bp respectively. In 1H10, peers further reduced credit costs to 41bp on average, while ABC maintained relatively high credit cost at 90bp (149bp and 65bp at rural and urban banking respectively). We were pleased to see its prudent provisioning strategy. Given the high credit risks in its rural business, we expect ABC to maintain significantly higher-than-average level of credit costs in the next few years.

1H10 results review
ABC 1H10 net profit rose 40.1% y-o-y to RMB45.8 billion, accounting for ~52% of our and consensus FY10E. Quality was solid, with the 10bp quarter-on-quarter (q-o-q) net interest margin rebound being a key highlight. Loan and deposit growth were well balanced at 11.4~11.7% h-o-h, leading to a stable LDR. The sharp rise in operating costs may raise some concerns, although management attributed it to the smoothing of cost allocation within the year, and expected lower cost growth in 2H10. Asset quality continued to improve, with NPL ratio down to 2.32% and NPL coverage rose to 136% by end-1H10. The bank prudently increased credit cost in 2Q10, and 1H10 annualised credit cost was ~90bp, much higher than peer average at ~41bp. As of 1H10, ABC reported the highest net interest margin (2.47%) and ROE (26.3%) among peer state banks.

However, with the relatively weak non-interest income contribution, high cost-income ratio, and high credit cost, its pre-provision ROA and ROA were actually the lowest among H-share banks. It still lagged behind peers on asset quality metrics, with NPL ratio much higher than peers at 2.32% (down 59bp h-o-h), and NPL coverage ratio below average at 136% (vs sector average: 186%). ABC’s net profit growth in 1H10 grew 40.1% y-o-y was the highest among peer state banks. Its loan growth at 11.7% h-o-h was broadly in line with sector average, while deposit growth at 11.4% was slightly weaker than average. With the balanced loan and deposit growth, LDR maintained largely stable h-o-h. Asset quality showed continued improvement, with NPL volume down 10.9% h-o-h or 2.2% q-o-q in 2Q10, broadly consistent with peer state banks.

Price objective basis & risk
Our price objective of HK$3.70 (RM1.48) assumes an average ROE of 18.7% for the next three years, a sustainable long-term growth rate of 8%, cost of equity capital of 14%, and RMB/US$ exchange rate of 1:6.6 in next 12 months. At HK$3.70, ABC would be trading at 10.3 times average FY10E-11E P/E, 1.8x average FY10E-11E P/BV, or 6.2x average FY10E-11E P/PPOP (pre-provision operating profit).