JP Morgan Indo : Indonesia - Underweight (update 1)

Investment Summary

Key Issues/Drivers
• Issue 1 – Margins – playing the cycle as well as longer term impact of Indonesia transitioning to lower rates
• Issue 2 – Looking through accounting changes and reclassification to underlying trends in 2010 and into 2011.
• Issue 3 – Valuations, as linked to long bond rates.
Catalysts – 1) Capital Raising, 2) 4Q earnings and revisions, 3) compression/expansion in discount rates.

Operating Outlook
• Loan Growth: We expect that loan growth may be just about 20% in 2010, and currently expect credit to expand rapidly in 1H, but end the year up about 14-16% or so.
• Fees: Fee incomes remain dominated by account maintenance fees, but J.P. Morgan expects a weaker external environment which may limit trade and fee income growth
• Capitalization: Indonesian Banks are generally well capitalized, however growth potential in the market means that banks look to have a buffer above a 12% CAR.
Risks – 1) We see risks from policies aimed to curb hot money flows having a collateral impact on banks. 2) Margins remain a risk, as well as if credit quality proves less benign in 2011. 3) Valuations leave little room for disappointments.

Key issue 1: Margins
• What is happening: As Indonesia makes the transition to lower interest rates – asset yields are being compressed.
• Impact: Over the last 18 months lower credit costs and tax rates have meant that RoE has not been diluted by NIM pressure. In FY11 neither may help further. A low for long rates environment could put RoE at risk.
• Risk to our view: The volume opportunity in an under penetrated market is the biggest offsetting factor to margin compression. We also see the possibility that a cyclical increase in rates could lift margins within a longer term secular trend lower.

Key issue 2: Looking through Accounting changes
• What is happening: BI has mandated a closer alignment of bank accounting with IFRS. Additionally banks have also reclassified several line items leading to distortions in building meaningful comparisons.
• Impact: Reporting and accounting changes are complicating analysis of underlying provisioning trends, as well as margin analysis.
• Risk to our view: Our basic view is that credit quality is benign, and we have seen a gradual decline in margins – which is exaggerated by accounting changes, and banks trying to set aside as much as possible under the new system. If this view is wrong – there could be risks (upside/downside) to our
perception of earnings potential.

Key issue 3: Valuations linked to discount rates
• What is happening: The massive decline in long bond rates over the last 18 months has driven a substantial re-rating of the banking sector – risks emanate from inflation and overseas risk appetite for Indonesian assets.
• Impact: The risk free rate decline, if reversed, could have a negative impact on overall sector valuations.
• Risk to our view: The potential for a) further sovereign credit rating upgrades, b) recent benign inflation prints, and c) accommodative western monetary policy leaves open the risk that portfolio flows could drive yields lower and valuations higher.

Operating Outlook
• Loan Growth: A touch above 20% in FY10E, growing by about 15% next year.
• NIM: NIM pressures remain in 1H, with some succor if overseas markets become choppy, and local rates move higher.
• Fees: 10-15% growth in fees seen in FY11E.
• Costs: Costs are not a focus area in a growth market and we see wage costs and expansions driving costs higher.
• Asset Quality: FY11E could see a peaking of the credit cycle, although no signals are visible yet, we would brace our selves for some deterioration in asset quality perhaps towards 2H11.
• Capitalization: Capitalization is not an issue relative to BI’s 8% CAR norm. However growth will consume capital and increasing operating risk charges will mean that banks continue to be opportunistic in looking to raise capital where possible.