Profit Battle Shows Cheap Bank Shares No Bargain: Israel Markets

The rally in Israeli bank stocks that helped reduce their biggest discount to European peers in four years is set to fade as lenders struggle to boost profit as interest rates fall and regulation grows.

The discount of the price-to-book value of Israeli lenders on the Tel Aviv Banking Index, which includes Bank Hapoalim Ltd., the nation’s biggest, and Bank Leumi-Le Israel Ltd., to Europe’s Stoxx 600 Banks Index narrowed to 13 percent today from 18 percent last month, the widest since September 2009. Earnings are under pressure after policy makers cut borrowing costs by 2.25 percentage points since August 2011 to 1 percent and corporate loan growth waned.

New capital requirements, limits on mortgage lending and regulation aimed at lowering fees and increasing competition are hurting an industry with assets of 1.3 trillion shekels ($367 billion). Salaries at Israeli banks as a portion of operational expenses are the second-highest among countries in the Organization for Economic Cooperation and Development. With earnings growth for banks at current levels, there is no reason for them to continue their gains, said Citigroup Inc. analyst Michael Klahr in Tel Aviv.

“Israeli banks are cheap but this reflects diminished profitability,” William Scholes, assistant investment manager at Aberdeen Asset Management Plc in London which oversees $318 billion including Israeli assets, said by e-mail Oct. 1. “We would be cautious on increasing exposure without further signs of improvement in cost-to-income ratios and profitability.”

Earnings Decline

Hapoalim, based in Tel Aviv, may post a 10 percent drop in net income in the fourth quarter and Leumi, the country’s second-largest lender, may report the lowest profit for the period since 2006, according to single analyst estimates on Bloomberg. In the last eight consecutive quarters based on U.S. accounting standards, Bank Leumi posted three declines in quarterly profit including a loss in the fourth quarter of 2012. Bank Hapoalim reported a drop in net income in four quarters of the same period, as well as a loss in the three months ended Sept. 30, 2011.

Lenders refrained from paying dividends last year as they sought to comply with a central bank directive to raise Tier 1 capital ratios, a category of reserves that protects depositors from business losses. Banks need to increase the ratio to 9 percent by 2015 from 7.5 percent, while Hapoalim and Leumi must achieve a ratio of 10 percent two years later.

“I don’t see any significant growth driver for banks over the next 12 months,” Citigroup’s Klahr said by phone on Oct. 2. “Interest rates are low and are not expected to rise in the foreseeable future and banks are just containing costs rather than reducing them significantly.” Klahr recommends investors sell Leumi and rates Hapoalim neutral.

‘Easing’ Tensions

The Tel Aviv Banking Index of the country’s five biggest lenders rose 14 percent since dropping to a nine-month low on Aug. 27, as the U.S. Federal Reserve maintained its bond-buying program last month. Stocks also rallied as Syria agreed to hand over its chemical weapons and the presidents of the U.S. and Iran spoke by phone in the highest-level conversation between leaders of the two countries since 1979.

“An easing of geopolitical tensions in the area is making investors more confident about investing in the local market,” Alon Glazer, an analyst at Leader Capital Markets Ltd. in Tel Aviv who recommends investors buy bank shares, said by phone on Oct. 10. “Israeli banks, which are a reflection of the local economy, are cheap.”

The Israeli banking gauge trades at a price-to-book value of 0.8, compared with 0.9 for Europe’s Stoxx 600 Banks Index, and 1.5 for the MSCI Emerging Markets Financials Index. Leumi, up 15 percent since reaching a 11-month low on Aug. 27, trades at a ratio of 0.8, while Hapoalim is at 0.9.

“Israeli banks continue to offer investors a successful mix of stability and returns,” Ofra Preuss, a spokeswoman for Hapoalim, said in an e-mailed statement to Bloomberg on Oct. 14. An official at Bank Leumi declined to comment on Oct. 14.

Dividend Payments

Banks are reviving dividend payments. Tel Aviv-based First International Bank of Israel Ltd. paid its first dividend in almost three years in June, while Hapoalim got regulatory approval to reintroduce quarterly cash dividends in July.

The shares may also benefit from a possible change in a law that limits investments in banks by institutions to 5 percent, Terence Klingman, the head of research at Psagot Investment House Ltd. in Tel Aviv, said by phone on Oct. 13. A panel charged with finding ways to increase trading volumes on the stock exchange made the recommendation. The central bank said Oct. 13 discussions are in early stages.

‘Rationalizing Costs’

To improve profitability and meet capital requirements, banks are cutting costs and selling assets.

Israel Discount Bank Ltd., the country’s third-largest lender, started a voluntary retirement program and reduced staff since 2011. It’s also considering offers for units in New York and Latin America. Leumi sold a 4.4 percent stake in Migdal Insurance & Financial Holding Ltd. in September for 270 million shekels.

“Encouragingly, there is now a greater focus on rationalizing costs and improving asset quality rather than simple balance sheet growth,” Scholes said. He would re-evaluate bank shares, which he rates underweight, if lenders improved operating efficiency and tackled their cost base.

About 60 percent of operational expenses at Israeli banks stem from salaries, the most of any country in the OECD after Denmark, compared with an average of 47 percent, according to Bank of Israel data published in its 2012 banking report.

Reorganization at companies such as IDB Holding Corp., the Tel Aviv-based company controlled by Nochi Dankner, are forcing banks to pare lending to corporations. In addition, the regulator has prompted banks to cut exposure to business groups and increase consumer credit. Bank lending to businesses fell to 48 percent of the total at the end of last year from 53 percent in 2007, according to central bank data.

Growth Ceiling

The Bank of Israel announced in August new limits on mortgages designed to shield borrowers and the financial system from risk after house prices surged more than 70 percent since 2007. Mortgages accounted for about 28 percent of the balance sheet of the five biggest banking groups as of March 2013, up from 20 percent in December 2007, the central bank said.

“Israeli banks are exposed to one single economy and one single housing market which is over-heating,” Jacob de Tusch-Lec, a London-based money manager at Artemis Investment Management LLP which holds Israeli shares among the $20 billion in assets it oversees, said by phone on Oct. 3. “That creates a ceiling on growth for banks.”

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