Turkish Banks: What Went Wrong?

Turkish banks which have spent years with high profits generated in the past, only managed a ROE of 10.6% (10-year average was 16.1%), well below the business’ cost of capital of at least 15% and the returns which investors aspire. Unlike their peers around the world, financial institutions in Turkey are not in a regulatory cycle either. We have mentioned recurrently the rising risks of earning recession in Turkish banks. Not surprisingly, today only two of the six major bank stocks trade with a premium to its book value in Istanbul. Additionally, in January 2016, systemwide ROE was up by only 6 bps to 10.7% from 10.64% and did not no improvement is in on the horizon.

Turkish Banks - Valuations

Below is the trend in ROE versus COE which is estimated with monthly average yield of 10-year Turkish government bonds, equity risk premium of 5.5% and 1.0x beta. Simply, banks’ earnings do not justify premium valuations since they are capable of adding economic value.

Turkish Banks - ROE v COE

We previously published sufficient number of articles mentioning the declining profits in banks, and now think it is better to look beyond the metrics and try to analyze what actually went wrong and what are the underlying factors that drove earnings downside.

Turkish Banks - Summary Financials - 2015-2005

Above is a financial summary of Turkish banking universe for the last ten years. 2010 was the year when the industry started to experience ROE deterioration, the same period when Turkish central bank lowered interest rates to historic low levels in order to support the recovery process following the global financial crisis. Remember that Turkey was the second fastest growing major economy in the world after China in 2010-11 when the country recorded high single-digit digit real GDP growth rates. The strategy paid out well in the short-term, however, caused concerns around overheating thereafter. Turning back to the banks’ financial performance, NII posted for those two fiscal years in the industry was even lower than that for 2009. Banks seemed to struggle to price the loans desirably in a low interest rate environment. But more importantly, they needed new funding sources to finance the lending growth as keeping cash deposited in a bank was less attractive. That was the time the industry began to issue bonds and it had a new line on the interest expenses side. Interestingly, Turkish banks did not fully benefit from the zero-interest policy rates implied in developing economies until the very first phase of extreme money printing known as quantitative easing. Borrowing costs had remained relatively high until the liquidity injections of the Federal Reserve were in progress.

Banks enjoyed the QEs effect until mid-2013, when the Fed Governor Bernanke signaled a downshifting of his printing press. That meant a massive sell-out in emerging markets, and Turkey had environmentalist uprising to boot (Murphy’s Law). Then, the second source of profit erosion showed itself, the melting down in local currency. Banks recorded a loss of TRY7.1 billion due to the volatility in foreign exchange rates in 2013. That being said, they also were obliged to borrow via the repurchase agreements this time since the capital started to flow out of emerging markets this time. In a recent post, we shared our views on the funding challenges of the banks with warnings about the Turkish central bank doubling its overnight lending. This type of funding is also not cheap needless to say, and ultimately putting pressure on the bottom-line across the board.

Interestingly, banks have failed to grow their fees from loans over the past two years which led weaker revenues. During the same period, total non-interest income increased by 12% which was below the long-term growth rate of 15%. This has been partly due to the new regulations that have restricted fees.

A simple analysis of trends in income statement presents the key findings to walk through as to what actually went wrong. On the other hand, having investigated the sector-level balances, a bigger picture is easily seen. “…And then like a lot of dreams, there’s a monster at the end of it.” After a quote from a beloved TV series, let us present the crucial point at the end. The real trouble with Turkish banks is the leveraging ending up with lower gains, in other words, taking more risks for earning less, which is also an ominous data point for the economy in general. “Cautiously lowering our guidance” is the kind of a key phrase you might hear in earnings calls this year.

Do Turkish Banks Add Economic Value?

Time and time again I have been directing sharp criticism for the relatively poor financial performance, and more importantly, for the industry’s lack of focus on low profitability. In September, return on equity, or ROE, for the whole industry, came down to a level that made it even lower yielding than the riskless Treasury bonds (September RoAA was at 10.41% versus average 10Y bond yield at 10.44%). The situation is even more severe once the other elements of costs of equity such as equity risk premium are considered. These all reveals an important finding: Turkish banks are deeply struggling to add economic value.

The chart above shows the return on equity for the industry and the cost of equity. Return on equity is derived from 12-month trailing net income and 12-month average total shareholder’s equity. On the other part, the cost of equity, the threshold for generating positive economic value, is derived from average Turkey 10Y government bond yield, an estimated equity risk premium of 6%, and beta of 1.0x. Importantly, the chart reveals why we have seen lots of discount to book value valuation in the equity market and M&A deals.

Turkish Banks - RoE versus CoE

However, it is also worth to point that October data may be signaling a turning point for banks as RoE and CoE both showed signs of convergence. RoE was up by 4 basis points to 10.45% m/m as well as 10Y bond yield significantly decreased 46 basis points to 9.98%. The industry posted 5.6% and 15.5% growth in earnings and total equity, respectively.

The important part of earnings growth came from the net interest income that were up by 18.5% y/y to 62.8 million liras. The growth is fees was relatively slower with 12.2% increase while expenses grew by 19.2%. On a negative note provisions extended significantly in October.

With banks’ 3Q financial statements and first month of 4Q stats at the table, Akbank (BIST:AKBNK) seems to be a good candidate to be an outperformer in my view, as the bank is poised for fast loan growth due to its strong liquidity and core liabilities.

Are Turkish Banks Undervalued?

Turkish banks had outperformed European peers over the course of last year. However, rising risks around Turkish central bank’s independency depressed the asset prices in the country as well as the share prices. Therefore, the gap between Turkish banks and their European peers began to close starting late January. Since then, we have seen Turkish banking index performing in line with MSCI European Financial Index.

Turkish Banking Index vs MSCI European Financials Index

To be more specific, following is an analysis of most traded Turkish banks stocks and their CEEMEA peers. Simply, Eastern European and Middle Eastern stocks seem to be the most overvalued ones while Nigerians remain exceptionally cheap. This should be mostly due to country-specific risks. In broad strokes Turkish banks along with their Russian peers are traded at reasonable multiples. At this stage my recommendation to investors looking into CEEMEA financials would be forming a list of stock picks supported by a strong investment theme and key fundamental data.

CEEMEA Banks Multiples

Below is a list of top-traded Turkish banks with fundamental indicators.

Turkish Banks Key Fundamentals

ROE generation has appeared to be the key theme in Turkish banking sector. Halkbank which delivered the strongest profitability metric has been the best performer in year-to-date terms. Isbank, Yapi Kredi, and Vakifbank are traded at a discount to their book values. Growing fee income in the industry has built a supportive case for Garanti and Akbank due to their exposure consumer banking and credit cards.

The consensus has a neutral view on Turkish banks in general, and more specifically on the stocks excluding Akbank and Halkbank. However, there are key risks to be watched including the economic growth on a slowing path and higher unemployment leading higher credit card fails.