By Gaurav Ghose

While Union National Bank (UNB) succeeded in beating analysts consensus estimates by 8 per cent, with net profits rising by 9.7 per cent to Dh455.7m, in the second quarter, there has been some concern about the deterioration in its asset quality.

Notwithstanding this, the share price of Union National Bank has risen more than 10 per cent in 2012, though one year (52 week) return has only been 1.72 per cent until last week. But, analysts are positive about the outlook for the stock.

But first the concerns. Non-performing loans (NPLs) increased by around 18% in the second quarter, while loans decreased marginally (1.4%) resulting in nearly flat year to date growth. And both these indicators aren’t likely to get better in the remaining quarters of the year.

In a note on the day of the announcement of second quarter results on July 31, Naveed Ahmed, senior financial analyst of Global Investment House said: “It is pertinent to note that UNB’s NPL ratio has already crossed our estimates of 4.5% for 2012, though provisions (when annualized) remain way below our estimates of Dh640m for 2012. What is further disconcerting is the fact that the largest proportion of provisions originate from the retail book, which for most other banks had become less taxing.”

Raja Ghoussoub, vice president, NBK Capital, echoes the same thought. “For the remainder of 2012, we still expect low loan growth. We also expect additional weakening in UNB’s asset quality indicators.”

However, taking into account the various stock indicators, UNB looks a like a good bet in the long term.

Current valuations: It is the extremely cheap valuations that make Union National Bank a compelling investment. At the current prices analysts say it is a bargain as it is at the low end of its historical bandwidth in terms of price to book value and its price to earnings ratio. Currently, its forward P/E is 5.7 times and P/B is 0.7 times, lower than UAE average P/E of 8.0 times and P/B of 1.2 times.

“Asset quality has deteriorated in the second quarter and as a result of that we could see their provisions picking up in the second half. But even if we factor in those higher provisions it still looks attractive. Union National Bank is a value play, in our view, given that its multiples are lower than other UAE banks,” said Shabir Malik, banking analyst at investment bank EFG-Hermes.

NBK Capital agrees. In a note on 31st July they wrote: “We have a “Buy” recommendation on UNB (which offers an upside potential of 22%) driven by its very cheap valuation (P/B of 0.6x) and not from a superior fundamental story.”

On another measure, that of price vs. pre-provisioning earnings, Jaap Meijer, director of equity research, banking and insurance at Arqaam Capital, said UNB is among the cheapest in the UAE, after Emirates NBD.

“So when loan loss charges really come down, UNB could recover faster than the rest of the banks. UNB is trading at P/PPP 2013 (price against operating profits before provisions) of 3.1 times vs. an average of 4.0 times in the UAE banking sector,” said Meijer.

Financial Health: Over the past few years, UAE banks have not done well generally as growth has been subdued and provisions have been high. UNB is no exception.

UNB’s low NPL coverage ratio is still a matter of some concern. “Given the relatively low NPL coverage ratio by the end of June 2012 and our expectation that UNB’s NPL ratio will continue to trend upwards in the remainder of 2012, we expect provisioning charges to increase quarter over quarter in the remainder of 2012,” said NBK Capital’s note.

“The rise in the top-line is a definite positive, though with stagnant loans disbursement and declining benchmark interest rates, the cheer is most likely to be short-lived,” said Ahmed of Global Investment House in his July 31 note . “The decline in non-interest income during the quarter, albeit expected (due to the impact of enforcement of [Central Bank regulations in May 2011 which curtailed fee income) would have been more exacerbated had it not been for the capital gains booked by the bank in the quarter under review.”

However, Meijer feels asset quality concerns have been blown out of proportion. “Given the bank’strongly improved operating profits before provisions against risk weighted assets, [there is deep value once provisioning starts to taper off],” he said. Add an adequate liquidity position and robust net capital generation, and Meijer recommends a “strong buy”.

UNB profitability is still pretty decent despite risk of provisions in the short-term. “We expect ROEs of around 14% on a sustainable basis which we think is decent in context of its valuations,” he noted.

However, Arqaam Capital prefers to look at Return on Risk Weighted Assets (RoRWA) rather than Return On Equity (RoE), as RoE is distorted by the amount of leverage. “UNB scores average in RoRWA among the UAE banks,” said Meijer.

Also, he added: “UNB is generating sufficient additional capital on the back of moderate RoE and pay-out of 18.2%. UNB is one of the best capitalised banks in UAE, with an estimated core equity tier-1 of 13.3% under Basel 3 year end 2011.”

The bank has ample liquidity on its balance sheet, parked in the interbank market and in the form of cash.

Malik of EFG-Hermes agrees. “In terms of dividend yield 2012—UNB is almost at par with the other Abu Dhabi banks. What determines a bank’s ability to pay out dividends is its capitalisation levels. Their capitalisation level is one of the strongest in the sector.”

“Considering UNB’s capital base, we expect UNB’s dividend pay-out to increase in time,” said Meijer.

Risk versus Reward:

UNB’s historical (180 days) standard deviation of the stock, a measure of risk, has been 19.97 per cent. Though it may not have been worth the risk on a five year basis, Meijer says it was worth it in the last three years and year to date.

“I agree it is a bit of laggard in terms of price performance as it has not performed as much as First Gulf Bank and ADCB,” said Malik. “It is a stock for long-term value investors.”

Final call:

Arqaam Capital strongly recommends UNB. “UNB is trading at very compelling multiples of a P/E13e of 5.0x (despite taking into account conservative loan loss forecasts) and 40% discount to tangible net asset value as asset quality concerns have been blown out of proportion. We use cumulative NPLs (non performing loans) similar to the total of NPLs, all past due, but not impaired and restructured loans in our asset quality screen and underlying improvements in profitability are being ignored,” said Meijer. Arqaam has a fair value of Dh4.6 per share.

NBK Capital also has a buy rating on the stock. It expects UNB to record a mid-single digit growth in net profit for FY2012, which is similar to the growth rate witnessed in the first half 2012.

“We have a ‘Buy’ recommendation on UNB (which offers an upside potential of 22%) driven by its very cheap valuation (P/B of 0.6x) and not from a superior fundamental story,” said Ghoussoub of NBK Capital. The bank in a note on July 31 said it’s 12-month fair value of Dh3.9. per share

EFG-Hermes has a fair value is Dh 4.5 per share and has a buy recommendation on it. “It’s based on its bank’s earnings on the next few years,” said Malik.

“For 2012 we expect its earnings to be flat because we are factoring very conservative provisions in our forecast. For 2013, we expect a recovery and expect an earnings growth of 18%.”