Description

I – Introduction
I am recommending purchase of Bank of East Asia (23 HK on Bloomberg or BKEAY for the ADR). BEA is the largest independent bank in HK. The bank is ‘controlled’ by the Li family which owns about 20% of the stock and has David Li as the current CEO.

BEA has been building a large network of branches in China (PRC) for the last several years. ROE and EPS have been driven down by this effort as well as restrictions in place on the types of business that are allowed at those new branches. All this changes at the end of the year when the PRC liberalizes its banking rules which should allow for a significant increase in EPS growth at BEA and a resulting improvement in valuation ratios. As we move towards the end of this year there is also an increasing potential for a larger bank to bid for BEA which would require a significant premium at this point to get a deal done.

BEA has a strong position in Hong Kong with more than 80 locations as well as a solid global network of over 20 branches and offices almost wherever ‘offshore Chinese’ reside (LA, Malaysia, Toronto, Singapore, New York, London, etc). This franchise is profitable and attractive on its own terms, but the real excitement here is that BEA has one of the largest independent branch networks in (PRC). BEA now has offices in 18 PRC cities - all of which will be full branches by the end of the year. In Shanghai, Guangzhou and Shenzhen, BEA has multiple locations with a main branch and ‘sub-branches’.

II – BEA’s Opportunity in China
Foreign bank expansion efforts in China have been quirky for two primary reasons: 1) Non-PRC banks (including those based in HK) are allowed to only open 1 branch per year. 2) Non-PRC bank branches in the PRC can, in general, only do business with foreign companies, foreign nationals and joint ventures of foreign firms.

BEA’s PRC unit is profitable, but not particularly so as 1) significant capital has been reinvested to opening additional branches, sub-branches and offices each year, 2) again, BEA branches can not currently offer services to Chinese consumers and most Chinese businesses. These restrictions of point #2 have significantly reduced growth at these newer locations. This will change dramatically at the end of 2006 as rules promulgated when the PRC joined the WTO stipulate that foreign banks will be able to offer full banking services to all Chinese consumers and businesses by January, 2007.

Imagine Neiman Marcus opened its first store in downtown Chicago and could only sell its wares to customers who were not US citizens or JVs of non-US companies. The competition is a Kmart and a Target across the street but they can sell to anyone who walks in the door. How profitable would that Neiman Marcus be? What happens to profits if all of a sudden one January 1st when the Neiman Marcus can now sell to everyone? I believe the analogy is pretty accurate to what will happen to BEA’s PRC branches come the end of this year.

Chinese customers will want switch their business to BEA (and other foreign banks with local branches) as the state-owned banks are:
- not as tech savvy as BEA (and other foreign banks)
- perceived as being less safe due to their large portfolios of loans to State owned enterprises (SOEs)
- forced to lend on non-risk based metrics and charge the same rate to all borrowers
- forced to increase or reduce lending by government decree as a way to speed up or slow the local economy
- well-known for having poor customer service and limited product offerings, especially for consumer accounts.

Considering the constraints, it is amazing how quickly BEA has been growing its PRC operations

(HK$M)---------------2005------------2004-----------2003
Loans
Hong Kong-----------98,235----------88,598--------81,092
PRC-----------------19,939----------10,911-------- 5,588
Other*--------------20,570----------17,749--------16,228
Total--------------138,744---------117,259-----_-102,909

PRC Loans/Total---- 14.4%-----------9.3%------------5.4%
Total Loan Growth---18.3%----------13.9%

*Other is from the global network – Singapore, US, Canada, UK, etc.

I expect that PRC loans will be 20% of the total by the end of 2006, will jump to 40%-50% by the end of 2007, and be 75-80% by the end of 2008. The margin on loans added in 2007 will also be much higher as BEA is able 1) to bring in low-cost RMB consumer deposits and 2) make higher rate consumer loans. It is certainly possible this extremely fast rate of loan growth will lead to massive charge-offs in the future. However, a rising tide floats all boats and the PRC government is likely to keep economic growth at a fast pace at least through the Beijing Olympics in late 2008.

III – State-Owned Banks all dressed up for the big day
The PRC government knew the negotiated temporary artificial protection of its state-owned banks allowed for a short window to modernize. The execution on this plan to date has been brilliant:
1) Carve off the worst non performing SOE loans from these state-owned banks
2) Sell minority stakes to the likes of Citigroup, HSBC, RBOS, BankAmerica etc. so as to gain western banking skills as well as some deep pockets involved to put in more capital when the current SOE loan book goes bad.
3) Dress the companies up for sale by Goldman and Morgan and raise additional capital in an IPO.

Big Western banks have been doing everything possible to get involved in the potentially giant PRC market in addition to opening their measly one branch per year (which certainly does not move the needle for firms such as Citibank, HSBC, etc.) Thus, the big global banks have been paying billions of dollars to buy minority stakes in the largest state-owned banks in China despite dodgy accounting and the potential for huge loan losses on legacy loans advanced to unprofitable SOEs. In return for the privilege of getting involved, many of these foreign financial firms have had to buy up pools of those carved off bad loans (we’ll see how those investments work out…) The Western banks can only own a significant minority stake in one state-owned PRC bank at a time, there weren’t enough to go around and many well capitalized European/US/Japanese/Singaporean bank missed out on the fun.

Later this year and into 2007 we will see a mad scramble as the big US investment banks take the big Chinese state-owned banks public and we will be told by Goldman Sachs and Morgan Stanley how great these stocks will be. If there is any truth to the sales pitch that these big Chinese banks will be very profitable, it is hard to see why BEA’s PRC operations on a now more level playing field won’t see a major increase in earnings as well.

IV– Why is BEA a potential M&A Target?
I see three potential groups of buyers for BEA:

1) Many a large bank and insurance company in Europe, Japan and the US have missed out on gaining a foothold in China as all the PRC state-owned banks already have found their minority-interest partners. How can a global bank like JPMorgan, ING, Santander, Deutsche, etc. claim to be global and not have anything significant in China? The answer to this problem - buy BEA.
2) Big banks such as Citibank already have a small network of branches in the PRC and want more under their own control (in addition to their non-controlling stake in the big state-owned players). How do they get more branches to gain scale? Buy BEA.
3) Finally the big Chinese banks will soon be public, flush with IPO cash, and interested in gaining more professional managers as well as an international network of offices to service their increasingly global clients. What’s the easiest way to do this? Buy BEA.

V – What’s about the Hong Kong operations?
Hong Kong is no longer a hyper-growth emerging market but it isn’t doing all that poorly either. After +7% GDP growth in 2005, the Economist Intelligence Unit expects +4% GDP growth in both ’06 and ’07 which isn’t all that shabby a tailwind for a banking operation. BEA has easily beaten expectations the last 2 years even while it has poured significant cash into new PRC branches that can only service a small fraction of the local population.

There is also the potential that the next 12-24 months will finally see a significant acceleration of the long-expected revaluation of the Chinese RMB (RMB) vs. the US$ (and thus the HK$ as well). Last year the PRC authorities changed the monetary regime to allow for some limited appreciation. However, to date the RMB has only moved up a couple of percent vs. the US$. Many market watchers expect the RMB to appreciate by about 4% a year in both 2006 and 2007. The Chinese government is under significant pressure to allow for a greater amount of appreciation to avoid significant political backlash from the US. When/if China’s currency finally appreciates:

1) Everything in Hong Kong (including real estate) gets cheaper to more than a billion people in the PRC. One would imagine that HK real estate would do pretty well as would BEA’s home market banking operations.
2) BEA’s EPS in HK$ would soar due to translation from the PRC RMB operations.
3) A change in the currency regime would make BEA even more attractive as a takeover target to PRC state-owned banks whose stock is now worth more in HK$, and for western banks hungry for appreciating RMB profits.

VI- Is this still a value stock?
Most investors have ignored BEA’s PRC expansion for the last few years or, worse, downgraded the stock as the expansion weighed on EPS, ROE and cost/income ratios. Finally the sell-side has started to perk up to the opportunity here and the stock has been rising. Yes, the stock recently moved up fast from HK$23 to HK$26 on the back of better than expected 2H05 earnings and a growing understanding that the stock could be a ‘China play’. However, I don’t think that this move means BEA isn’t a ‘value’ play any more. Note that:

1) the stock has only recently broken out of the range it got to back in late 2003-early 2004
2) BEA is still 20% under its all-time high from ten years back before the Asian currency crisis and EPS is higher now than it was back then.
3) The stock is at the same level where it was at the start of 1997 and since that time BEA has seen its BVPS has increase from HK$9 to over HK$15 while also building a significant PRC and global branch network.

The valuation is pretty darned reasonable for such potential EPS growth and/or premium buyout bid. P/B is under1.8X, and the dividend yield is a healthy 4.7% (record date for the big annual payout is March 10th). The stock is on 14X ’06 and 13.3X ’07. Sell siders are taking a wait-and-see approach to the impact of the liberalization of PRC banking rules after 1/1/07 and currently forecast only 6% EPS growth in 2007. This seems much too low.

I see BEA as a win-win situation. Either management executes and EPS comes in much higher than expected, Or the company stumbles and the controlling family can sell out in an auction for a significant premium to the current price.

My target price is 16X the Street high 2007 estimate of HK$2.32 over the next 12 months yielding a price of HK$37. Adding in the 4.7% yield this would result in a 43% one year return on the investment.

VII – Risks
I see four major risks to an investment in BEA:

1) The upcoming IPOs of the big PRC state-owned banks may drain liquidity from all the HK banks stocks, especially ‘China-play’ BEA.

2) As the HK$ is pegged to the US$, HK imports US monetary policy. Most sell side estimates for BEA already incorporate a flat yield curve through 2006. However, a significantly inverted yield curve would be negative for BEA just as it would be for US banks.

3) A large increase in the yield on the US 10-year bond would hurt the HK real estate market which would be a negative for all banks in HK.

4) BEA has been growing its loan portfolio in the PRC at a rapid percentage pace. So far loan quality has been very good, risk-based pricing is employed and most loans are to international companies operating in the PRC or JV’s of such firms. Of course, the present situation could deteriorate which would be a significant negative for BEA shares.

Catalyst

1) Positive mix and margin shift and payoff on PRC investment = ROE growth & P/B expansion
2)2007 Estimates are too low
3) Value of franchise and EPS to rise as Chinese RMB (RMB) appreciates vs. the US$/HK$
4) Increased M&A speculation from Western Banks wanting PRC footprint or PRC banks wanting to increase EPS and gain global franchise