UBS WARBURG Bank of China (Hong Kong) is the second largest bank in Hong Kong in terms of deposits (18 per cent) and loans (15 per cent). It has a loyal customer base of 3.7 million retail customers (more than 50 per cent of the population, including children) and 234,000 corporate accounts (an estimated 60 per cent of active companies). In terms of deposits, its market share is similar to that of Hang Seng Bank (HSB) and Standard Chartered Bank (SCB) combined. For a host of legacy reasons, including the lack of a 'single brand, single culture' before its merger with its 11 sister banks last October, BoC HK has not delivered its full potential in market share, product quality and profitability. With the merger out of the way, it should not be difficult for BoC HK to improve its top line by delivering new and better products over its substantial customer platform, including lucrative bancassurance, investment and equity-linked products. Its retail customer base, for example, appears to be sophisticated enough for these, with an estimated 60 per cent of account holders earning more than the median income. We estimate that BoC HK's 2003 pre-provision profit should be around HK$12.7 billion, which would make it fall marginally short of our estimate for HSB of HK$13.5 billion. That is before further rationalisation of processes delivers estimated efficiency gains of HK$600 million a year by 2005. Following the merger of the group's banks last October, BoC HK has achieved the second lowest cost-to-income ratio of 30.8 per cent in the sector last year. This compares with the Hong Kong industry's average of an estimated 39.8 per cent, HSBC's Hong Kong businesses (excluding HSB) 39.6 per cent, HSB's 26.3 per cent and Bank of East Asia's 54.9 per cent. This suggests to us that revenue, rather than cost structure, is BoC HK's focus. Given its heavy exposure to the corporate sector (66 per cent of total loan portfolio) and real estate (an estimated 80 per cent of collateral behind NPLs), BoC HK has the highest earnings sensitivity to the current cyclical upturn in Hong Kong. UBS Warburg forecasts GDP will accelerate from -0.9 per cent in Q102 to 5.2 per cent by Q402 (full year: +3.2 per cent) and that residential property, after the government's clarification of its policy on sale of public housing on June 5, will rise 10 per cent-plus in the coming 12 months. However, to be conservative, the 'base case' scenario underlying our core equity valuation on BoC HK of HK$114 billion (2.0x 2003E P/BV) has assumed flat GDP and housing market performance this year and next, leaving the 'high case' to reflect our more bullish economic and property sector forecasts. At the end of last year, non-performing loans (NPLs) stood at HK$29.6 billion, accounting for 9.5 per cent of the total loan book. Of NPLs, provisions cover 48 per cent of their gross loan value. Since the market value of the collateral behind the NPLs already represents 58 per cent of gross loan value, a figure that exceeds the 52 per cent of gross NPLs not covered by existing provisions, it would appear that NPLs have been adequately dealt with. Some 70 per cent of NPLs were property or trade related, with the balance being mostly loans to Chinese enterprises, including 'window companies' and investment trust companies of various local government bodies in China. The new, centralised and independent risk-control system, implemented last October, has adopted significantly higher credit evaluation standards than in the past. This should improve the quality of loan origination and subsequent credit performance. Under our base-case scenario, BoC HK's revenue contribution from China-related business is 4 per cent now, and we expect this to double by 2005. Major earnings drivers, in our view, are income from renminbi mortgage loans, Great Wall International Card, Renminbi Card, and other joint projects with BoC Group. Essentially, we think BoC HK can leverage BoC Group's strong franchise and extensive presence in mainland China to offer tailor-made financial products to serve the fast-growing Hong Kong/China business flows (that is, retail mortgage loans, structured trade finance products and cash management business). Furthermore, we believe the bank is uniquely positioned to benefit from regulatory changes, particularly the potential establishment of a renminbi deposit-taking business in Hong Kong. We estimate that BoC HK can potentially earn net interest income of HK$800 million (5.5 per cent of 2003E net interest income) once the People's Bank of China (PBoC, or central bank) allows Hong Kong banks to take and lend renminbi deposits. We estimate that a public listing that raised, say, HK$23.4 billion could generate HK$4.6 billion in demand from MSCI-benchmarked funds and HK$1 billion from the Hang Seng Index-benchmarked Tracker Fund. A listed BoC HK, assuming our core base-case equity valuation of HK$114 billion and free float of HK$23.4 billion (20.5 per cent), should be accorded a free float factor of 25 per cent of market, resulting in an MSCI Hong Kong weighting of only 3.3 per cent, which would put it ninth on the index. However, under the Hang Seng Index which does not adjust for low free float, a listed BoC HK should rank seventh and account for 3.5 per cent of the index. We estimate total index-related demand at HK$5.6 billion or 24 per cent of the potential size of the IPO. MACQUARIE RESEARCH Bank of China (BoC) is offering 25 per cent of BoC HK issued share capital for sale. At the indicated price range of HK$6.93-HK$9.50, BoC HK is valued at US$9.4 billion-US$12.9 billion. Valuation: We value BoC HK at HK$7.50 per share, representing 1.5x 2001 book value and 11.4x 2003E earnings, using our discounted economic profit model. This is premised on BoC HK achieving significant asset quality improvements in the medium term. Strong recovery in future earnings and ROE is thus incorporated in our valuation. NPL risks: The key challenge is controlling NPLs. Lowering bad-debt provisions to peer levels should produce respectable ROA of 1 per cent and ROE of 15 per cent. But considerable risks remain due to: (1) a weak track record; (2) uncertainty over the quality of existing loans; (3) further potential weakness in collateral values; and (4) a difficult macro environment. Property exposure: BoC HK is leveraged to declines in property values. Owing to the lack of a revaluation reserve cushion, downward property revaluations will be directly charged to earnings. We estimate that a 5 per cent fall in property values could result in a revaluation equal to 12 per cent of earnings. Other risks: The pre-listing merger of the 10 banks within the BoC HK Group into one entity is arguably one of the most complex mergers ever, and will be a true test of management ability, especially given limited help from outside hires. In addition, the potential for conflict of interest exists, given BoC HK's government ownership. Opportunities: There is room to improve returns and lift valuations; scope to improve retail franchise through unified branding filling product gaps and leveraging its tremendous scale; reducing risk profile by moving away from traditional reliance on corporate lending. BoC HK is uniquely positioned to leverage BoC's huge franchise in China. Reform: The listing marks an important step in the reform of China's state-owned banks. In this context, the strong determination to succeed should be recognised. KIM ENG SECURITIES We are valuing the bank at HK$11.8, based on our FY02E BVPS of HK$5.25, sustainable ROE of 14 per cent (100 bp lower than management's largest of 15 per cent), 10.2 per cent risk-adjusted cost of equity, and a 50 per cent target payout ratio (compared with management's target of over 60 per cent). The upper IPO price limit of HK$9.5 represents a 19.5 per cent discount to our target valuation. We believe the 80 bp increase in NPLs ratio in FY01 was mainly due to the standardisation of stricter NPL classifications for sister banks in October last year, when the bank consolidated. We expect the bank's NPLs ratio to drop by 230 bp to 8.33 per cent in FY02, and reach the 5 per cent level in FY04, due to improving credit quality and NPL carve-out. Bad-debt provision charges will edge down by 44.4 per cent in FY02 to HK$4.1 billion (1.27 per cent of total loans), based on our forecast of HK$520 million in bad debt recoveries (same level as in FY01). Our BD recovery target is achievable, as the bank has already recovered 50 per cent of the HK$7 billion in written-off NPLs post crisis. The bank capitalised US$11.4 billion of property revaluation reserves in October 2001 and treated it as tier one capital. This classification could impact the P&L accounts directly. However, the chance of a sharp decrease in property price levels, in our opinion, is limited. Our view is supported by the strong pick-up in new mortgages approved, which grew by 14.2 per cent in average from March to May, and 99 per cent of new mortgages were related to owner-occupied properties in May. By providing administrative and operational support to BoC's Great Wall international cards (international clearing Visa or Master Cards), BoC HK is sharing 50 per cent of the net merchant fee and interest income. BoC is targeting the number of cards to grow by 3x before YE03. On the other hand, BoC HK's Renminbi Card allows Hong Kong residents to shop across the border, and the bank is targeting numbers of this card to rise by 10x, to 30,000 at YE02. Bancassurance will prosper, given the current low 3.3 per cent penetration rate in Hong Kong. The treasury department has transformed itself into a customer-oriented platform to leverage the opportunities brought about by the leading position of Hong Kong in both the forex and gold markets. Other major mainland-related initiatives include abundant renminbi funding sources to grow renminbi loans, cross-selling both BoC HK's and BoC's treasury product, the potential for running renminbi business in Hong Kong, cross-selling and facilities' sharing opportunities with BoC's branches and business units in China, and asset injection possibilities, such as the high ROE BoC Group Insurance and BoC International. These reasons support our target valuation of HK$11.8.