Description

Kookmin Bank – KRW79,200 (Bloomberg: 060000 KS) or $83.79 (Bloomberg: KB US)(US$1.00=KRW948)

Summary

Buy Kookmin Bank. P/E of 6.7x and P/BV of 1.1x on 2008 estimates for 20% compounded EPS growth 2005-2008 with a 20% ROE. Recently announced acquisition of Korea Exchange Bank plus underappreciated structural growth in retail mortgage lending and asset management should lead to 20-30% upgrades to consensus EPS estimates. Potential for 80% appreciation over two years if the shares trade on a P/E of 12x current year EPS in 2008. Multiple expansion beyond this is possible for further upside.

EPS estimates for 2006-2008 of KRW9,100, KRW10,900 and KRW11,900 respectively. P/E of 8.7x, 7.3x and 6.7x for 2006-2008 respectively.

Description

Kookmin is the largest retail bank in South Korea. The bank recently announced a deal to buy a controlling 70.9% stake in Korea Exchange Bank, the sixth largest bank in the country. The combined group will have a commanding market position with 38% of retail lending and 31% share of deposits, including a 46% share of valuable demand deposits. About 70% of the loan book is retail lending, typically a higher return business than commercial lending. The market is now concentrated with the top three banks controlling roughly a 68% share of retail loans. CEO C.W. Kang, who joined in November 2004, has done an excellent job restoring the bank to health after it (and the entire banking sector) suffered significant losses in credit card lending two to three years ago. He is aligned with shareholders with an incentive plan currently worth nearly $30mm that only fully vests if targets based on share price performance, ROE and capital ratios are achieved by November 2007.

Overall the Korean banking market is fairly developed with lending as a percent of GDP at 109%. For comparison, lending as a percent of GDP is 154% in the US and 133% in Western Europe. However, the retail mortgage market has significant growth potential. Mortgages as a percent of GDP are only 27% in Korea compared to 65% in the US and 56% in Western Europe. Credit quality has been improving since the credit card-related spike in losses in 2003-04. Non-performing loans are now 1.46% of loans for Kookmin/KEB and look set to decline further. The non-performers are 112% covered by loan loss reserves. Outside of the traditional business of lending and deposit gathering, the asset management and pension markets are immature and are on the cusp of a growth boom.

Investment Thesis

· The acquisition of KEB delivers a cash-on-cash after-tax return on investment of 10%+ in 2008, a respectable return for a low-risk, in-market deal. Analysts do not seem to have worked out yet that because of the deal EPS estimates for 2008 need to go up by 15-20%. Kookmin will be buying 70.9% of KEB this year from controlling shareholders, and I have assumed they will buy the remaining minorities next year. Kookmin will not issue its undervalued shares to finance this deal – it will use a combination of surplus capital and debt to pay cash. The purchase will drive Kookmin’s Tier 1 capital ratio down from 10.5% today to a low of 7% next year, but given the bank’s high ROE, capital will rebuild quickly. In a perfect world, Koomin would have just bought back stock to reduce its overcapitalization and create more value per share, but as deals go, this is a good one.

· The introduction of 10-year mortgages in Korea should accelerate mortgage lending growth. Historically, mortgages in Korea have been three-year interest-only bullet loans. In the last year 10-year mortgages were introduced to the market. This should boost mortgage growth for two reasons: first, with significantly reduced refinancing risk, borrowers should be more confident taking out larger mortgages (higher loan-to-value); and second, the lengthening of the amortization period means the outstanding stock of mortgages will be larger because it is less impacted by principal repayment. Assuming 70% of the mortgage stock is 10-year mortgages by 2010 and that house prices rise at 7%, just below nominal GDP growth, the mortgage stock would grow by 14% compounded. This adds about 3% to net profit growth annually compared to market expectations.

· Korea’s asset management market is undeveloped and is about to take off and Kookmin is very well positioned in this market. There is growing interest among Korean households to invest more in equities. Currently household ownership of equities is only 5% compared to the US at 16% and the UK at 12%, for example. At the same time, Koreans are sitting on large amounts of cash with 50% of household wealth in cash and deposits compared to the 33% average in the OECD. Kookmin has a 21% share in the bancassurance market which will allow it to capture a significant share of flows into mutual fund products. In the next few years, growth in mutual fund fees could add 6-7% annual growth to Kookmin’s fee income and this could lift earnings growth by 2-4% annually.

· By 2010 corporate pensions will be mandatory in Korea and early adoption is expected by many companies. Kookmin has a 50% share of the small, early volumes, so should be a significant beneficiary of growth in this market. Much of the benefit of the pension growth will come from beyond 2010 but by 2008 Koomin’s strong position in this market and its growth potential should start to get factored into investors’ assessment of the bank. In outer years, pensions could add 5-7% annual growth to Kookmin’s fee income and boost earnings growth by 1% annually.

· The CEO C.W. Kang has about $30mm of potential compensation riding on the achievement of shareholder-friendly targets. Kang was granted 700,000 options in 2004 at a strike price of KRW37,600 that vest in November 2007. They are exercisable if certain targets are met: 300,000 if ROE of 25% is exceeded in the 12-month period ending November 2007; 200,000 if a minimum BIS total capital ratio of 12% is maintained; and 200,000 if Kookmin’s total shareholder return is at least equal to the rise in the KOSPI banking index from the grant date to the vesting date. So far, Kookmin has outperformed the banking index by 16% and the total capital ratio is projected to remain comfortably above the 12% minimum target. ROE will likely be around 20%, falling short of the 25% target. One would expect Kang to be very focused on trying to increase this figure over the next year and a half.

In summary, this is a well-managed and strong retail banking franchise trading on a low prospective multiple that will benefit from a sound and underappreciated acquisition and a strengthening tailwind from growth in mortgages, asset management and pensions.

Catalyst

Catalysts

Over the next one or two quarters analysts who follow the company should begin issuing upgrades to their earnings estimates after they properly work through the economics of the KEB acquisition. The Kookmin/KEB deal creates a step up in earnings power of 15-20% per share compared to Kookmin stand-alone.

Over the next one or two years the acceleration in growth in mortgages, asset management and pensions will become more evident to investors and should lead to further earnings upgrades plus an overall upward reassessment of Kookmin’s long-term growth potential. These factors should increase Kookmin’s longer-term EPS growth rate by 6-8% annually, potentially leading to some P/E multiple expansion.