Catalogue

Executive summary 2

Introduction 2

1. SDB’s financial performance 2-5

1.1 Asset quality 3-4

1.2 Earning Capabilities 4

1.3 Capital Adequacy 5

2 Newbridge’s Investment 5-6

Conclusion 6

Appendix 7-9

Reference 10

Executive summary

This report is aimed to assist Newbridge to make mature decisions when it is involved in an investment case associated with Shenzhen Development Bank. Prior to the investment, sensitive issues require sophisticated handling to ensure that the whole project witnesses no flaws. These significant issues include SDB’s asset quality, earning capability and capital adequacy, which are merely parts of this bank’s financial performance. Apart from all these, other key issues related to current situation of Chinese banking industry must also be taken into consideration seriously and comprehensively. To put it briefly, this report is organized to assess whether the 1.6 times book value that Newbridge agrees to pay for its 18% stake in SDB merits this bank’s actual worth.

Introduction

The TPG Capital Newbridge, which was created and operated by TPG Capital, is a joint venture enterprise particularly interested in investing in emerging markets, such as ASEAN countries and Latin America (TPG Capital 2014). After years of practices in arbitrage and speculation, this company shows its expertise in financial services, technology and telecom, healthcare, consumer, and industrials. While Shenzhen Development Bank, a bank based in Shenzhen, Guangdong, People's Republic of China with government background, was founded as a pioneer in procedure of Open and Reform in China (PAB 2014). At the beginning of 20th century, government intervention and low-quality loans put this bank into a real dilemma. In this way, these two seemingly unrelated organizations came together and started bargaining.

SDB’s financial performance

To begin with, it is important to believe that financial performance is a complex and comprehensive concept which is made up of different sub issues. When it comes to outside investment, the three most practical sub issues can be asset quality, earnings capability and capital adequacy. This kind of information should be analyzed together with SDB’s balance sheet, income statement and cash flow statement. Since SDB is a publicly listed bank, all the accounting reports and fiscal data can be found in this company’s annual reports (Jin, Xuan & Bai, 2009).

1.1 Asset quality

The NPL ratio, namely Non-Performance Loan ratio, which equals to NPL divided by Gross Loan. Non-Performance Loan refers to loans that are in default or close to being in default. Many loans become non-performing after being in default for 90 days, but this can depend on the contract terms (Jin, Xuan & Bai, 2009). Apparently, these loans are nothing but a heavy burden to most banks. It is hard to imagine a well-functioned bank with high NPL ratio. As the figure 1 shows, comparing with its industry counterparts, SDB has a much higher NPL ratio. This ratio amounted to 11.6% in 2002, while the average ratio was merely 7.3%. The SDB and BoCom were witness a dangerous situation of heavy non-performance loans, judging from the fact that the NPL ratios of these two banks were higher than 10%. Such kind of absurdly high NPL ratio indicates more conservative provisioning for potential credit losses (Jin, Xuan & Bai, 2009)..

However, it would be ignorant to believe that this bank is completely honest with its NPL figures. The NPL number that SDB reported was low. According to Jin, Xuan & Bai (2009), Shenzhen Development Bank had US$1.2Bn in NPLs, which occupied 11.6% of gross loans. The investor Newbridge also believes that the real NPL ratio is higher than the reported one. Turning to the reason of this phenomenon, it has long been Chinese government’s tradition to inject sheer volume of capital into state banks consistently to write off all the NPLs and bad debts and polish up balance sheets. The SDB is no exception. Another reason lies in the fact that many state banks, including SDB, are mismanaged by bureaucrats and issued many low-quality loans under government’s pressures. The NPL ratio increases in the long-run to a climax as a result of that. Judging from all the facts, the genuine NPL figure and ratio are higher than what the bank reports (Jin, Xuan & Bai, 2009).

.

As for the LLR level, which refers to the reserve of each loan and is also called loan loss reserve, is also unsatisfactory in this bank. Jin, Xuan & Bai (2009).claims that the loan loss reserve is the most likely loss of loan, and the net loan is the gross amount of the loan minus its reserve. Both Figure 1 and 2 show the actual LLP level and Reserve Ratio Guideline of Shenzhen Development Bank. After calculation, the actual LLR/Loans rate of this bank in 2002 was around 3.9% and the actual LLR figure was US$MM 391(SDP annual report 2003). The actual LLR/Loan rate was slightly higher than the average level in industry (3.8%). However, what is fortunate is that the actual LLR ratio (US$MM 391/ US$MM10159=3.9%) was lower than this bank’s reserve ratio guideline (US$MM603.49/ US$MM10159=5.94%). Much more than this, when it comes to NPL coverage ratio (LLR/NPL), this bank’s actual one is roughly 33.2%(US$MM391/US$MM1200), which is much lower than industry average (55.3%). Such a kind of low NPL coverage ratio suggests that less conservative provisioning for potential credit losses, which is good news for SDB.

1.2 Earning Capabilities

When it comes to the time trends of SDB’s main earning measures, this company’s income statement (Exhibit 6) and other historical financial ratios (Exhibit 9) explain everything. Judging from Figure 3, the trend of this bank’s earning measures can be clearly seen. Comparing ratio of 2000, 2001 and 2002, the first phenomenon is that the net interest margin had been shrinking since 2000, indicating the fact that the traditional income from interests becomes less significant. What is appalling is that this bank’s operating expense rate was also witnessing a huge decline, from 65.6% in 2000 to 58.3% in 2002. However, the proportion of income (58.3%) still makes it the key earning measures of SDB. What is worth mentioning is that the significance of Non-Interest Income is escalating, the proportion of which increased by almost 179% in two years (SDB annual report, 2013). To put it in one sentence, the earning measures of this bank have been diversified. Some of those low-efficient and uneconomical earning modes were knocked out gradually.

In respect of SDB’s overall financial performance comparing its counterparts, it is better to look into the figure 4. The scale of total assets of SDB amounted to US$ MM 19,900 in 2002, which was significantly smaller than its main competitors of China for the average quantity of their assets was over US$ MM 30,000. However, judging from its numbers of staff and branches, which are also much smaller, this bank’s small-scale assets do not count as a major drawback. However, what is fatal is that SDB did have a much higher corporate loan rate, which was roughly 97% and was much higher than the average of other banks, which was 93% (SDB annual report, 2003). This kind of high loan rate lengthened SDB’s fiancé recovery and imposed uncertainties of this bank’s liquidity. What makes things even worse is that this bank’s disastrous market shares. With pathetic market share of 0.5% and 0.6%, this bank was a laggard in both loans and deposits markets. It was unable to catch up with those bellwether banks with over 2% market shares. All these indicate the predicament that SDB was besieged by those big banks. If the Newbridge decides to invest in SDB, the top priority will be issuing a large-sum rehabilitation programme, aimed at winning back market shares in deposits and loans, which is a time-consuming and costly project.

1.3 Capital Adequacy

To begin with, it is necessary to look into SDB’s Tier 1 CAR, Total CAR, Equity/Gross Loans and Equity/Total Assets ratio to assess this bank’s capital adequacy changes over time. From 2000 to 2002, both the numbers of Equity/Gross Loans and Equity/Total Assets ratio declined by roughly 50% respectively. The Equity/Gross Loans ratio plunged from 10.7% to 5.1%, while the Equity/Total Assets ratio crashed from 6.2% to 2.6%. The shrinking scale of equities jeopardized the further development of this bank, especially when Equity/Total Assets ratio declined to only 2.6% in 2002.

Secondly, talking about the degree of capitalization, it is very clear that the Shenzhen Development Bank has not been completely well capitalized. For one thing, several organizations with governmental background still hold significant discourse power among all the shareholders (Jin, Xuan & Bai, 2009). Beyond that, according to be the figure 3, the Tire 1 CAR and Total CAR ratio in 2002 were 5.2% and 9.5% respectively. The truth is, an enterprise can be defined as a well capitalized one only when its Tire 1 CAR is equal or greater than 8% and its Total CAR is equal or greater than 10%. Apparently, SDB did not qualify on these grounds. Hence, it is undercapitalized. Combined with the fact that this bank is now in urgent need of capital, conclusion can be safely drawn that this bank is far from being capitalized. Since SDP is not well capitalized, Newbridge has no choice but keep allocating funds to increase this bank’s Tire 1 CAR and Total CAR ratios. Such kind of action can definitely drive up the price which Newbridge pays for its stake to a new climax (Chen, Lee & Moshirian 2005)

2. Newbridge’s Investment

Judging from figure 5 that the book value per share and earnings per share of Shenzhen Development Bank was experiencing a slight increase from 2002 to 2003, it is still tempting to invest in this bank and gain more shares of this bank. However, whether the 1.6 times book value that Newbridge pays is appropriate or not highly depends on the future trend of several key ratios, including SDB’s book value per share, earnings per share, price to book and price to earning rates. On the basis of figure 5, the earnings per share of SDB in 2003 were nearly 1.15 times as much as that in 2002 (increased by 15%). The book values of this company decreased by 7% in 2003. Hence, it is suggested that the appropriate valuation range is around 1.15 times of the book value. That is to say, if Newbridge pays 1.1 times of its stake, it can recover its initial investment and make profits in around 3 years (Chen, Lee & Moshirian 2005)

Another thing which is thought-proving comes from other Chinese banks’ cases of receiving foreign capital. These cases can provide reference values for Newbridge. For instance, in 2006, Goldman Sachs, Allianz Germany Financial Services and American Express spent US$ 3.78Bn to take over 10% of Industrial and Commercial Bank of China’s shares. The price per share was 1.16 RMB, 1.5 times of the book value. After two years, the price per share jumped to 6.77RMB, which is over 3.8 times as much as that in 2006.The net earnings of these foreign investors came to over US$ 40Bn (Ho, Lee & Baer 2013). However, such kind of successful investment cases have their particularities, which do not apply to Newbridge completely. As the first shareholding system bank in China, SDB has its strategic advantage, despite the fact that its current profitability and capitalized procedure are far from satisfaction. It is still worth Newbridge’s attention and investment in the long-run.

Conclusion

By injecting capital into this bank, Newbridge can gain a significant controlling stake to appoint chief executive officer and other board members. The business of SDB can flourish with assistance of Newbridge’s investment and professional guidance, hence finish its capitalizations and compete with industrial giants. All in all, such kind of investment can achieve mutual benefits and win-win situation in the long-term, as long as both sides reach a consensus on a reasonable acquisition price.

Appendix

Figue1 Benchmarking SDB Against Other Joint-Stock Banks 2002 (SDB Annual Report 2003, p5)

Figure 2 Loan Breakdown and Reserves 2002 (SDB Annual Report 2003, p9)

Figure 3 SDB Historical Financial Ratios (SDB Annual Report 2003, p26)

Figure 4 Selected joint-stock banks data in China (Goldman Sachs Research, 2005)

Figure 5 Comparable Company Valuation (China Stock Market & Accounting Research Database,2005)

Reference

Chen, Z, Lee, D & Moshirian, F 2005, ‘China’s financial services industry: The intra-industry effects of privatization of the Bank of China Hong Kong’, Elsevier, vol.29, no.8, pp 2291-2324, viewed 2 September 2014,

<http://www.sciencedirect.com/science/article/pii/S0378426605000567>

China Financial Market Data Base 2005, Comparable company valuation, no.487, viewed 30 August 2014,

<http://www.gtadata.com/products/plist.aspx>

Ho, P, Lee, Y & Baer, J 2013, ‘Goldman Sachs Selling ICBC stake’, Wall Street Journal, 20 May, viewed 3 September 2014,

<http://online.wsj.com/news/articles/SB10001424127887324787004578494632098998150>

Jin, L, Xuan, YH & Bai, XB 2009, ‘Shenzhen Development Bank’, Harvard Business School Case, case 9-210-020, pp.1-27, viewed 1 September 2014,

<http://www.hbs.edu/faculty/Pages/item.aspx?num=37769>

PAB 2014, Ping An Bank, ACT, viewed 2 September 2014,

<http://bank.pingan.com/about/en/index.shtml>

Shenzhen Development Bank 2004, Annual Report 2003, viewed 31 August 2014,

< http://bank.pingan.com/ir/gonggao/baogao/index.shtml >

TPG Capital 2014, Texas Pacific Group, ACT, viewed 1 September 2014

<https://tpg.com/global-reach>