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This article first appeared in The Edge Malaysia Weekly, on March 13 - 19, 2017.

IT has been a little over two years since Joel Kornreich, group CEO of Alliance Financial Group Bhd (AFG), came on board the country’s smallest banking group by assets.

Having laid out a clear strategy with his team to build on AFG’s strength in the small and medium enterprise (SME) segment, the group now plans to make substantial investments in the coming financial year in some cutting-edge new products and initiatives in that space.

These include ramping up a loan consolidation service that was launched late last year — it basically consolidates all of a borrower’s loans into one account for convenience — and introducing foreign remittance services through mobile phones.

“These are just two examples but there’s more to come. It’s actually nice to be able to speak about things that are concrete because it’s happening. It’s all coming together now,” Kornreich tells The Edge.

He shares that AFG will incur capital expenditure of “more than RM150 million” on the new technology-based products and initiatives in the financial year ending March 31, 2018 (FY2018) — a move that will take a toll on the group’s profitability and return on equity (ROE) that year.

To put things in perspective, RM150 million is more than what AFG has earned in each of at least its last five quarters. In its latest quarter of 3QFY2017, it made a net profit of RM129.7 million.

“Of course, our profitability [in FY2018] is going to temporarily dip a bit because we’re going to be investing a lot in resources and distribution to get those strategic projects going. We think we’re still going to be doing double-digit ROE … but it is going to be a considerable investment,” Kornreich says.

He guides that the decline in AFG’s net profit in FY2018 will not be significant,  likely coming in at under 10%. Kornreich is however optimistic that revenue will continue to grow at a higher single-digit rate than in FY2017.

As for ROE, the group has abandoned an earlier aspiration to hit 15% in FY2018 as that is no longer realistic. AFG’s ROE stood at 10.8% as at the nine months of FY2017, making it the second-best performing local banking group by that measure after Public Bank Bhd.

“With the investment, coming out of the first year, ROE will be closer to 10%. We are aiming to get it back up somewhere between 12% and 15% but it’s going to take us two to three years to get there,” Kornreich remarks.

He stresses that despite the short-term negative impact on AFG’s profitability, the investments in the strategic projects are meant to be “transformative” and will pave the way for longer-term benefits for the group.

“The essence of our strategy is to help business owners help themselves and other people,” he says. “We call it ‘Building Alliances to Improve Lives’ because it’s really us going to the business owners and saying, look, we can help you, and we can help your employees, family and retail customers.”

The new offerings in AFG’s pipeline basically fulfil this ideal, Kornreich explains. Given that 60% of AFG’s SME customer base comprises retailers, he is particularly keen on a new proposition that he hopes to launch in October for retail SMEs.

“Today, banks’ propositions to retailers are not very sophisticated. They facilitate payments and if they like you a lot, they might lend you some money. That misses a lot of the needs that retailers have,” Kornreich observes. Having done intensive research, AFG hopes to fulfil those needs with its upcoming technology-based solution for retailers.

 

Going it alone

Given its small balance sheet relative to that of other banks, AFG’s sweet spot has long been in servicing small businesses, leaving the large corporations to the bigger banks.

According to Kornreich, it makes sense for AFG to continue to rely on its niche in the SME space to spur future growth. “We’re known in the market for good growth. Right now, growth in the market for SMEs is 6% to 7% but we’re still tracking 12% to 13%, so we’re definitely growing much faster than the market,” he says, adding that asset quality in this segment is stable. It is worth noting that AFG’s gross impaired loan (GIL) ratio in the SME space, at 0.8%, is much lower than the industry’s 2.5%.

However, with an increasing number of banks looking to expand their SME segment more aggressively in recent years, some wonder if AFG’s SME-focused model is sustainable. Some think the group may be better off merging with a rival bank so that it can compete more effectively as the banking environment gets tougher.

Indeed, given its size and recent movements in shareholding, AFG is often singled out as an M&A target.  There was market talk in the past that AFG would make a decent fit with AMMB Holdings Bhd compared with the larger local banks. Acquiring AFG would do little to boost the size of the larger banks. Combined, the AFG-AMMB entity would be the third largest player in the SME space after Maybank and Public Bank.

Analysts whom The Edge spoke to reckon that AFG can continue to stay as a standalone bank for now.

“It can still survive [on its SME niche]. The SME space is big enough. If you look at the final quarter of last year, most banks recorded double-digit loan growth in the segment, which shows that there is still room to grow,” says Imran Yassin Yusof of MIDF Research.

He notes that competing in this segment is not just about reaching out to SMEs but also about having close relationships with them. On this front, AFG is known to have the edge over the larger banks.

“The reality is that it is a very tough playing ground for the smaller banks in this industry. For now, AFG will survive, but in the longer term, consolidation is inevitable. Having said that, there are boutique banks everywhere in the world, and there could be space for that in Malaysia,” another banking analyst says.  

Last April, Singapore hotelier Ong Beng Seng and two others — Ong Tiong Sing and corporate adviser Seow Lun Hoo — bought the entire equity interest in Langkah Bahagia Sdn Bhd, which holds a 51% stake in Verticle Theme Sdn Bhd, which in turn has a 29.06% stake in AFG.

Singapore’s sovereign wealth fund Temasek Holdings, through its unit Duxton Investments Pte Ltd, holds the remaining 49% in Verticle Theme. This means that Temasek and the three individuals, whom analysts believe to be parties friendly to the sovereign fund, collectively own a major 29.06% stake in AFG.

This sparked market talk that the move would eventually lead to Singapore banking group DBS Group Holdings Bhd, of which Temasek is the single largest shareholder, or some other suitor merging with AFG.

Kornreich declines comment on such speculation. “Frankly, from our perspective, we’re really focused on trying to improve the bank. The plan is to grow organically within Malaysia,” he says.

 

Small but strong

AFG fared decently in the first nine months of FY2017 with net profit growing 1% to RM394.7 million, which was within analysts’ expectations. Positively, it had better control of costs and its net interest margin (NIM) widened in the third quarter — by nine basis points from the preceding quarter to 2.31%.

On the downside, loan loss provisions in the nine months grew 57.5% year on year to RM67.4 million.

“We’re now No 2 in terms of ROE in the market. We’ve been able to slow down ROE erosion quite substantially by optimising and choosing the portfolios that we go after,” says Kornreich.

The group plans to continue its focus on higher  risk-adjusted return (RAR) loans, namely working capital and SME and personal loans. Over the last nine months, higher RAR loans grew 14.6% while lower RAR loans — mortgages, hire purchase and some segments of corporate banking — contracted 1.4%.

Kornreich says that AFG is aiming for overall loan growth of between 5% and 6% in FY2018. “We had slowed down considerably in the mortgage space. Our plan is to restart that but in a slightly different way, using innovation,” he says, adding that a good portion of mortgage growth will be through the loan consolidation service.

The group’s overall GIL ratio remains sound at 1% — much lower than the industry’s 1.6% — despite making higher provisions in the third quarter for residential and personal loans. “Our ballpark range for GIL ratio in FY2018 is between 1.1% and 1.4%,” Kornreich says.

On AFG’s plan to transfer its listing status to its banking unit Alliance Bank Malaysia Bhd under a corporate reorganisation that involves a simple share swap, he says the exercise will likely be completed in the third quarter of this year instead of the second. The delay is “just administrative”, Kornreich clarifies. The reorganisation is meant to improve cost and corporate efficiency.

As for dividends in FY2018, amid higher investment costs, the group is aiming for “a stable payout ratio” of between 40% and 60%, which is its stated policy.

Bloomberg data shows that out of 15 analysts who track the stock, most, or eight, of them have a “neutral” call on it while only three have a “buy” recommendation. Their average 12-month target price is RM4.01. The stock closed at RM4.05 last Thursday.

“While we are positive on the improvement in the group’s NIM as well as its focus on a better RAR strategy, in the near term, credit cost is expected to normalise with lower recoveries. Also, its expenses on its IT-related investments to offer new value propositions to its customers will impact its earnings in FY18 as it will raise its operating expenditure before longer-term benefits to revenue can be realised,” says Kelvin Ong, banking analyst at AmInvestment Bank Research, in explaining his “hold’ call on the stock.

An exceprt from the interview with Kornreich follows.

 

‘We see a great deal of opportunity to develop our retail bank’

 

 

The Edge: Are there plans to sell non-core assets of the bank?

Joel Kornreich: There are no immediate plans, but I think that you are touching on an interesting topic, which is the relationship between the complexity and the size of a bank. The bank is small. Either we find ways to reduce complexities, which is not out of the question, or we find a way to increase the size, so we can handle the complexities.

It is true that while we have a very efficient bank, that is, great return on equity (ROE), great positioning with the SME, good prospects and obviously the bank is quite profitable, very good cost-to-income ratio and asset quality, it is also true that everybody is dealing with pressures that increase either complexities or cost.

So this is a good question, to see how we can make sure that the ratio of complexity to our size doesn’t grow so much that it becomes an impediment to the development or to the profitability of the bank. We do take it seriously.

We do not have immediate plans to sell core assets, but I will say this: for us to figure out what we want to develop and do more intensively, and what we would like not to do, is an important question.

 

At this point, what would you like to focus less on? What would you consider non-core?

For sure, what we know and will continue to focus more on is SME. We are going to focus more on the business owners and we are going to significantly develop our retail bank.

We have, in fact, made a lot of progress. Our wealth management business has grown quite substantially over the past year, around 21% year on year. It is still small, but we see a great deal of opportunity to develop our retail bank. Clearly, it has been under-powered.

Do you see stress bubbling in the SME space?

It’s true that things have been more difficult in the last couple of years than they were before. I don’t think that they’re going to be significantly more difficult in the year or two ahead. In fact, I think that there’s a good chance that as the economy benefits from the infrastructure projects that trickle down, there might actually be an improvement. At least, that’s the hope.

You know, the economy goes in cycles. So if you have a down cycle, at some point you’re going to have an up cycle, right? The question is, when does that up cycle happen?

 

So, at what point of the down cycle are we in now? Are we more than halfway through?

Listening to the people (entrepreneurs and business folks) who speak to us, we see a lot more optimism among our business partners. Clearly in some sectors, things have recovered already. Palm oil and steel have risen very significantly over the past 12 months, and the risk of a hard landing by China has receded. Things are getting better. There are restrictions. The market is not flooded anymore by some of these goods from China which was creating pressure for folks. Commodity prices have overall recovered, so that is quite a big (part) of the sector.

Clearly, the retail real estate development sector is still very much under stress because of current consumer sentiment, but at the same time, developers and people involved in construction are seeing a lot of opportunities from the infrastructure projects, displacing these issues as well.

There are at least some sectors in which you can see improvements; for example, anything that is infrastructure related. There is definitely hope coming down the pipeline, and obviously that would trickle down to other sectors in the economy.

Manufacturing is always spotty. There is never a time where it is completely bad or completely good. Some manufacturers are doing okay, and some manufacturers are having a tougher time.

For example, exporters had a great run in the second half of 2015 and a good part of 2016. They are now finding that there is a little bit of additional pressure in the system where their input costs have risen because of imported inflation, and so those advantages have kind of eroded a bit. So they need to think about things a little differently but they are still doing quite well.

That is why we think that things haven’t turned yet for consumers. That is very obvious, but there could be good reason to think that it will in the not too distant future.

 

Within the next 12 months?

Yes, I am hoping so. It takes time to work its way through the system.

 

What is all this going to mean for your asset quality? Have provisions already peaked?

There is always a lag, so we think that next year (FY2018) we will still see incremental increase in credit cost. I am hoping not, but that is what we have planned for. If what we think is correct, things are going to start to improve again.

A lot of our competitors have had to make very large provisions, because of exposure to oil and gas and other things in the past 12 months. We don’t quite compare the same way.

Our loan loss coverage ratio is 137%, which is high. I don’t think we are going to see a big rise in provisions, except for one thing — IFRS 9, the new financial reporting standard. When that comes up, depending on the portfolio, we will have increases of 25% to 50% of the current collective allowance level.

Since our provision level is not very high in relation to our capital (it is quite modest), it is fine. It will not have a huge impact on us.

 

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