Alfa Bank in Moscow -

Ukrainian banks seem to have adopted their strategy for the next few years from neighboring CEE countries, appearing ready to sell stakes to foreign institutions. On this expectation, Ukrsotsbank is currently showing the greatest upside potential. Trading at 3.7x P/BV for 2007, we rate it as a BUY, given its retail market penetration. Two other banks we cover - Bank Forum and Raiffeisen Bank Aval - have become expensive on their P/BV multiples and have thus been assigned HOLD recommendations.

Beginning January 1, Ukraine simplified the process for banks to raise capital, which opens a number of banks, such as Nadra Bank and Rodovid Bank, to possibly holding an IPO. In particular, Nadra offers a good opportunity to play on Ukrainian retail growth and high banking valuations.

Ukrainian banking sector outlook for 2007

In 2007, we forecast a slowdown in banking sector growth to 40%. This year growth in this category appears to be directly correlated to banks' access to external funding. In addition, lending appetite remains strong in Ukraine, given that escalating prices for gas imported from Russia has pushed a number of industries, especially metals producers, to install energy efficient equipment, which is fueling demand for loans. The Ukrainian market has also shown an abundant appetite for retail loans.

In contrast to Russian commodities exporters, which are flush with cash and investment from within their respective financial-industrial groups, Ukrainian companies continue to borrow heavily from local banks. Overall, corporate deposits are 2x lower than corporate loans. Moreover, as of the end of 2006, retail deposits were relatively equal to retail loans, suggesting that the Ukrainian population is no longer a net deposit holder in the banking system.

Insofar as domestic sources of financing are running low, we expect Ukrainian banks to show greater interest in international markets, which includes issuing Eurobonds, attracting syndicated loans and securitizing mortgage assets. We also believe more Ukrainian banks will seek foreign strategic investors as a means of getting better access to cheaper foreign resources. For example, Italy's Banca Intesa should soon complete its purchase of Ukrsotsbank, while Bank Forum is currently negotiating with multiple potential buyers. The owners of Ukraine's largest bank, PrivatBank, are also in deliberations with a potential strategic investor. A number of local banks have already been sold to foreign investors and growth for these banks is financed by foreign capital.

In 2006, retail lending in Ukraine showed spectacular growth of 138%, albeit starting from a relatively low base. As a result, retail loans accounted for 15.4% of Ukraine's GDP last year. This figure suggests that the market remains under-penetrated, implying ample upside potential. In 2007, growth in the banking sector will continue to be driven by Ukraine's retail consumption boom. The retail sector should grow by 80% and reach 23% of GDP this year.

Ukrainian retail market

In October 2006, Ukraine's retail market reached $15 bln. Compared to markets in Russia and Kazakhstan, Ukraine's retail sector is more diversified.

In Russia, personal loans for unspecified uses account for 60% of market volume, while in Kazakhstan mortgages account for 30%. In Ukraine, the share of personal loans remains modest, while mortgage and auto loans together cover more than half of the total retail market.

At more than 200% y-o-y growth, consumer finance was the fasted growing segment in 2006. As in Russia, this market niche delivers strong returns for Ukrainian banks, even though banking services remain underutilized overall.

We expect this market sector will deliver the strongest gains for banks in 2007.

Overall, the mortgage market grew by 60% in 9M06, with PrivatBank leading the pack with 16% market share. Ukraine's other four major mortgage providers are Pravex-Bank (13% market share), Raiffeisen Bank Aval (12%), Ukrsibbank (12%) and Ukrsotsbank (10%).

PrivatBank has a decisive lead on the cards market. As of mid-2006, the bank issued 10.6 mln cards, or 34% of the total number of cards given out in Ukraine. Bank Aval and Nadra Bank are the second and third largest players, respectively. The card market remains rather concentrated, with the top three cards issuers controlling 60%. In Ukraine, there are 8.3 mln credit cards in circulation, or 25% of the total number of cards issued. As the Ukrainian economy still primarily cash-based, we do not expect the credit card market to show rapid growth in 2007.

One major positive observation of retail lending in Ukraine is that it remains highly specialized. The share of personal loans remains just below 10%. We expect this segment to grow in line with market averages in 2007, maintaining its modest share of the total retail market.