Dragon Capital in Kyiv -

In the first half, Uraine's banking assets surged by 29% on year to $87.4bn (66.3% of estimated 2007 GDP), driven by a 37% increase in retail lending (to $21.0bn) and 26% growth in corporate lending (to $41.7bn). We expect the Ukrainian banking sector to continue to post strong asset growth in the second half driven by retail and corporate lending. Continued sector-wide lending expansion will be led by mid-sized banks. Rodovid Bank, Ukrgazbank, Forum Bank and Megabank led the sector in terms of growth and earnings in first half, boosting lending by 45-79% so far this year, operating revenues by 64%-113% on year and net earnings by 29-212%on year.

Domestic banks reported combined net interest income of $1,827m in first half (up 63% on year), net fees and commissions of $931m (up 48%) and other non-interest revenues of $378m (up 31%), bringing first half operating revenues to $3,136m (up 54%). With operating costs over the period up 54% on year, to $3,136m, net income for the sector in first half increased 41% on year, to $510m, implying ROE of 11.0%.

Despite its impressive asset growth, the domestic banking sector still falls behind its CEE peers in terms of penetration: Ukraine's banking assets/GDP stood at only 66.3% in first half (up from 64.3% as of end-2006) compared with 74-101% in Hungary, the Czech Republic, Croatia, Slovenia and Slovakia, and 224% on average in the European Union in 2006. Domestic retail lending as of end-June stood at 16.0% of estimated 2007 GDP (up from 14.8% at end-2006), rising to $453 per capita (from $330 at end-2006) but remaining low compared to $1,000 to $3,000 per capita for Eastern European peers.

We expect strong lending growth over the next five years, driven by massive demand for retail banking products, to result in further improvement of banking sector profitability and bring the sector's average ROE to above 15%.

We updated our valuation of listed Ukrainian banks based on a comparison with domestic and CEE banks, residual income (EBO) model, modified GGM models and recent M&A deal multiples. Based on the valuation results, Rodovid Bank and Forum Bank are our top picks, offering 35% and 39% upsides respectively from the current market price. Raiffeisen Bank Aval, Ukrgazbank, Nadra Bank and Megabank also look quite attractive. We recommend buying all those stocks.

Sector outlook

Ukrainian banking sector assets expanded at a CAGR of 45% in 2000-06, reaching $67.4bn in 2006 (up 59% on year and 64% of 2006 GDP). Last year's asset growth was fueled by a 71% increase in customer lending (to $48.5bn), as retail lending skyrocketed by 137% on year (to $15.5bn) and corporate lending leapt by 53% (to $33bn), with the share of retail loans in the total lending volume increasing to 32% from 23% in 2005. It should be noted that retail lending penetration in Ukraine, which stood at 14.8% of 2006 GDP, is still relatively low, especially on the per capita basis ($330 versus $1,000-3,000 per capita in Eastern Europe). This definitely implies strong growth potential for the sector. The upside is even more pronounced in mortgages, as Ukraine's end-June total retail mortgage portfolio of $5.4bn represented a mere 4.1% of estimated 2007 GDP (and 5.1% of 2006 GDP) despite surging by 155% p.a. in 2002-2006 and by 28% so far this year in first half. On the per capita basis, retail mortgages in Ukraine amounted to $117 as of end-June 2007, which is much below $700 per capita in Poland and over $30,000 per capita in the EU (2006).

In first half, Ukraine's banking assets surged by 29% to $87.4bn (66.3% of estimated 2007 GDP), driven by a 37% increase in retail lending (to $21.0bn) and 26% growth in corporate lending (to $41.7bn). Total liabilities in the sector rose by 58% in first half, to $58.8bn, driven by a 126% jump in inter-bank funding, to $14.3bn, and a 21% increase in customer deposits, to $48.4bn. The sector's end-June equity was up 190% on year, to $10.0bn. We expect the Ukrainian banking sector to continue to post strong asset growth in the second half driven by retail and corporate lending. The sector's first half interest revenues and interest expenses jumped by 64% on year, to $4,218m and $2,391m respectively, bringing net interest income to $1,827m (up 63%).

Also, banks reported net fees and commissions of $931m (up 48%) and other non-interest revenues of $378m (up 31%) over the period, bringing first half operating revenues to $3,136m (up 54%).

With operating costs over the period up 54% on year, to $3,136m (implying an average Cost/Income ratio of 58.6%), net income for the sector in first half increased 41% on year, to $510m, implying average ROA and ROE of 1.3% and 11.0%, respectively. Publicly traded banks reported impressive growth of 37-122% on year in operating revenues over the period, improving their Cost/Income ratio from 69.4% to 66.3% on year.

Higher Cost/Income ratios reported by traded banks compared to the sector average can be justified by their high investments into continued aggressive retail expansion.

We expect strong lending growth over the next three to five years, driven by massive demand for retail banking products, to result in further improvement of banking sector profitability and bring the sector's average ROE to above 15%.

Despite its impressive asset growth, the domestic banking sector still falls relatively short compared with CEE countries in terms of penetration: Ukraine's banking assets/GDP stood at only 66.3% in first half (up from 64.3% as of end-2006) compared to 74-101% in Hungary, the Czech Republic, Croatia, Slovenia and Slovakia, and 224% on average in the European Union in 2006. Domestic retail lending as of end- June stood at 16.0% of estimated 2007 GDP (up from 14.8% at end-2006), rising to $453 per capita (from $330 at end-2006) but remaining low compared to $1,000 to $3,000 per capita for Eastern European peers. It should be noted that the actual banking penetration in Ukraine could be even lower taking into account the shadow economy (estimated at 30% of official GDP).

Despite the robust growth in lending over the past years, the Ukrainian banking sector has managed to keep the good quality of its loan portfolio. As of end-first half the sector's non-performing loans amounted to just 1.8% ($1.1bn) of its total gross customer loan portfolio (under UAS). At the same time, loan loss reserves (LLR) stood at 4.8% of the gross loan portfolio in first half, implying NPL coverage ratio of 264%. The low NPL and high coverage ratios are explained by the NBU's strict loan collateralization and provisioning policy rules.

The sector's end-first half funding base was rather stable and diversified by source, with inter-bank funding accounting for 26% of the end-June total funding base, corporate deposits contributing 26%, retail deposits 29%, equity accounting for 12% and debt securities for 3%, with the remaining 4% represented by other liabilities. In the first half the sector's capital adequacy ratio (CAR) stood at a sound 14.0% and we expect it to remain above 12% in the following years.

Although the sector's net interest margin (NIM) and net interest spread (NIS) have inched down over the past five years, driven by competition from foreign players coming to the market, they remain rather healthy compared with other countries in the region. In first half the sector's NIM stood 4.93%, down 0.37pp from end-2006. At the same time, although the cost of foreign borrowings for Ukrainian banks may rise by 0.5-1.0 percentage points next year, we expect the sector's NIM to remain stable thanks to a gradual increase in the share of hryvnia loans in bank loan portfolios (especially in retail lending) in the coming years.

Robust demand, favourable interest rate environment and funding base diversification (through heavy foreign borrowings) will continue to drive local banks' lending and profitability, keeping them on investors' radar screens. Branch network maturity, further growth in retail lending penetration and development of new retail banking products, increasing the overall share of retail loans, will support healthy interest spreads and robust lending growth.

To capitalize on Ukraine's retail lending boom, foreign investors have jumped into the Ukrainian banking sector with both feet since 2004 when the first two foreign acquisitions were registered. Since then more than 20 acquisitions of Ukrainian banks by foreign strategic investors have been completed for a total value of $6.1bn, with UniCredit Group's recent acquisition of Ukrsotsbank for $2.2bn becoming the largest to date. As a result, as of end-first half, foreign-owned banks accounted for 33% ($28.3bn) of Ukraine's total banking assets, 42% ($8.9bn) of retail loans and 31% ($13.1m) of corporate loans. The acquisition of Ukrsotsbank by Italy's UniCredit Group (announced in July) should lift the respective ratios to 38%, 52% and 35% upon transaction closing.

These acquisitions in the local banking sector confirm continued strong interest towards Ukrainian banks among foreign strategic investors. Besides being highly positive for the banking sector as a whole, these developments are also supportive for traded banking stocks, particularly Raiffeisen Bank Aval, Forum, Nadra, Rodovid, Ukrgazbank, Megabank and Ukrinbank. Despite their solid growth this year, Ukrainian banks still trade at attractive estimated 2007-2008F P/BV of 3.58 and 2.77, implying discounts of 15% and 28% to their CEE peers' average, which grow much slower. Although smaller domestic banks still report much lower profitability (due to expansion-driven cost growth), their profits are set to improve from 2009 as their networks mature and they attain the targeted market share.

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