Citigroup Indonesia Banks - Weighing Value and Risks: Upgrade BBCA to Buy

 Buy Selectively: BMRI and BBCA – Indonesia bank valuations at mean multiples represent better relative value, with strong underlying macro economic indicators. Inflation concerns, however, are likely to persist in Q1 (until Bank Indonesia rate hikes), possibly resulting in share prices overshooting on the downside. We see BMRI and BBCA (upgraded to Buy) as offering long-term growth and an inflation hedge due to 1) positive sensitivity to rising rates, 2) strong deposit franchises that can withstand liquidity reversals, and 3) smaller exposure to micro/2w consumer loans that are vulnerable to rising food/fuel inflation. Maintain Hold on BBRI (asset quality concerns) and Sells on BBNI, BDMN and BBTN (likely to disappoint consensus expectations).

 Benign Inflation Forecasts For Now – Citi’s forecast is for a benign environment with 1) peak inflation of 7.2% in Q1 2011, 2) BI rate hike of 75bps starting March/April, and 3) a bond yield of 9% in Dec 2011. Current valuations are pricing in a 10% bond yield. In the 2008 inflation cycle, bond yields shot up to 13% and valuations to -1std (applying current mean and stdev). Earnings remained relatively unaffected, until the post Lehman liquidity reversal. BBCA and BBRI have the least downside if bond yields were to shoot up to 13%.

 2011E EPS Growth = Loan Growth – The consensus 2011 EPS growth forecast of 19% (using Factset) matches BI’s loan growth target of 19-23%. A higher reserve requirement and higher credit cost are the main risks, particularly for BDMN (consensus 2011E EPS growth of 24.5%), BBNI (15.3% on a larger share base) and BBRI (22.6%). The Q4 2010 results (expected end-March) are likely to be in line with expectations, as higher reserve requirements are offset by lower time deposit costs.

 BBCA Upgraded to Buy — Our BBCA upgrade reflects 1) attractive valuations following the correction in the share price, and 2) the stock being a defensive hedge against inflation. The stock is now trading at a mean forward PER, with consensus 2011E EPS growth of 15% below the sector average. A higher reserve requirement related to LDR from March 2011 will compress NIMs and force banks to shed expensive time deposits. This is reflected in lower earning asset growth, while higher interest rates can provide margin upside.