Pitch Book on China Merchants Bank

1. Introduction

Established in 1987 in Shenzhen, the forefront of

China’s reform and opening-up drive, China

Merchants Bank ("CMB") is China’s first

joint-stock commercial bank and also the first bank

to attend the national experiment for the promotion

of China’s banking industry reform driven by endeavors from outside the government.

Since its inception 24 years ago, CMB has grown with China’s economic progress from a small bank

with a capital of 100 million Yuan, one branch and over thirty employees into a nationwide joint-stock

commercial bank that has a total net capital of 140 billion Yuan, a total asset of 2.6 trillion Yuan, over

800 branches and over 50,000 employees, ranking it among the world’s top 100 banks.

For many consecutive years, CMB has been ranked among China’s top commercial banks according to

comprehensive assessment by CBRC. The Bank was shortlisted as a World-Class Chinese Brand and

ranked No. 1 in the P/B list of the world’s top 50 banks with the largest market value by the British

Financial Times. It was also listed No.60 among the world's Top 1,000 Banks by The Banker.

In 2002, it became publically traded in Shanghai Stock Exchange. In 2006, it went IPO in Hong Kong.

Now it`s traded at 10.45 RMB in SSE, with P/E ratio of 5 and P/B ratio of 0.9 (Chart 1).

Chart 1: CMB Recent Market Value

2. DCF Model

Table 1: The historical financial data of CMB is listed as below (In billions of RMB):

Year Net Income Growth Rate of

Net Income

Book Value

2003 2.2 28.6% 12.6

2004 3.1 41.0% 11.1

2005 3.8 20.4% 11.6

2006 6.8 79.4% 52.0

2007 15.2 124.4% 119.2

2008 21.1 38.3% 130.9

2009 18.2 -13.5% 104.1

2010 25.8 41.3% 139.4

2011 36.1 40.2% 145.9

2012 45.3 25.3% 165.2

2013 51.7 14.3% 244.3

Since we cannot use FCF, as cash flow is not a good metric for banks, here we use net income as an

approximation for free cash flow. From the statistics (Table 1), we can see that over the past 10 years,

the net income of CMB increased over 20 times. Moreover, only through two rounds of equity

financing in 2010 and 2013 respectively that CMB expanded the outstanding shares by 32%, and most

of the growth of net income has been achieved endogenously. However, we need to notice that the

growth has slowed down recently. Therefore, in order to make a conservative valuation, we assume that

within next 5 years, the growth rate would be 7% per year, which is the GDP growth rate of China, and

no growth in terminal value.

Furthermore, in China, the 5-year deposit rate is 3%, and the yield of 10-year Treasury bond is around

4%, so we take 3.5% as the risk-free rate here. In addition, the annual return of Chinese market over the

past 25 years is 13.9%. Beta for CMB is 0.61, which gives us the

WACC=3.5%+(13.9%-3.5%)*0.61=9.8%. We take 2013 as the starting point, and the result is as

follows:

Table 2: Conservative DCF Valuation for CMB

Discount Rate: 9.80%

Year Net Income Growth Rate Discount Factor NPV

2013 51.70 14% 1.00 51.70

2014 55.32 7% 1.10 50.38

2015 59.19 7% 1.21 49.10

2016 63.33 7% 1.32 47.84

2017 67.77 7% 1.45 46.62

2018 72.51 7% 1.60 45.44

Terminal Value 739.92 1.60 463.63

Sum of NPV 754.71

With the total market capital of 754.7 billion RMB, and total shares outstanding of 25.2 billion RMB,

the price should be 29.95 RMB at the end of 2013 (Table 2), but the market priceis only 10.39RMB.

That means that even the conservative valuation gives us a potential rate of return of almost 200%.

If we become a little more optimistic about valuation, raising the growth rate for the first 5 years to

10%, for the second 5 years to 7%, and the terminal value growth to 2%, the result will be the

following:

Table 3: Optimistic DCF Valuation for CMB

Discount Rate: 9.80%

Year Net Income Growth Rate Discount Factor NPV

2013 51.70 14% 1.00 51.70

2014 56.87 10% 1.10 51.79

2015 62.56 10% 1.21 51.89

2016 68.81 10% 1.32 51.98

2017 75.69 10% 1.45 52.08

2018 83.26 10% 1.60 52.17

2019 89.09 7% 1.75 50.84

2020 95.33 7% 1.92 49.55

2021 102.00 7% 2.11 48.28

2022 109.14 7% 2.32 47.05

2023 116.78 7% 2.55 45.85

Terminal Value 1527.139 2.55 598.88

Sum of NPV 1152.07

Now the reasonable market price should be 45.71 (Table 3),even thoughin 10 years time, the net

income would only double and the growth rate would only be meager compared to what went before.

In the bank’s semi-annual report of 2014, the income growth was 15%.

3. Comparison Valuation

To make the comparison valuation, we choose 4 similar banks globally. ICBC stands for Industrial and

Commercial Bank of China, which is the largest bank in China as well as in the world. HSBC, Bank of

America and Wells Fargo are all systematically important banks in their home markets.

Table 4: P/E and P/B Comparison

2014/10/5 CMB ICBC HSBC Bank of America Wells Fargo

P/E Ratio 5.06 4.72 12.70 27.70 12.86

P/B Ratio 0.92 0.91 1.03 0.81 1.66

P/B Ratio Adjusted to

Tangible Assets

0.95 0.91 1.31 1.66 2.43

Chart 2: P/E and P/B Ratio of CMB

In terms of P/E ratio, the Chinese banks suffer a discount. If the P/E ratio went to 13 as HSBC and

Wells Fargo currently enjoy, the potential rate of return would be 150%. If we look at the P/B ratio, the

Chinese banks are still undervalued (Table 4).

Comparing the ROA and ROE of these 5 banks (Table 5), we could also see that CMB performed much

better than the other three non-Chinese banks, and even outperformed ICBC.

Table 5: ROA and ROE Comparison

2013 Annual

Report

CMB ICBC HSBC Bank of

America

Wells

Fargo

ROA 1.39% 1.41% 0.70% 0.53% 1.51%

ROE 22.22% 21.83% 9.20% 7.13% 13.87%

Adjusted ROE 22.94% 21.83% 11.68% 14.69% 20.25%

Dividend Yield 5.96% 7.40% 5.14% 1.17% 2.72%

4. Stress Test

The profitability ratio of CMB is close to that of the Wells Fargo, which is considered the best banks in

the US by Warren Buffett. However, because of the extremely low price, the dividend yield of CMB is

close to 6% annually.

For global investors, most of them think that there is a huge amount of bad debt hidden under the

financial reports. However, if we compare its stress test result with the other four banks, we could

findthat the result is surprising (Table 6).

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CMB P/E ratio CMB P/B ratio

Table 6: Stress Test

2013 Annual Report CMB ICBC HSBC Bank of America Wells Fargo

Tier 1 Capital Ratio 9.27% 9.95% 10% 9.96% 9.78%

Bad Debt Allowance Ratio 2.22% 2.43% 1.47% 1.90% 1.76%

Loss Reserve Ratio 1.21% 1.29% 0.48% 0.83% 0.94%

Loss Ratio to Terminate

1 Year Income

2.60% 2.70% 1.18% 1.36% 2.45%

Loss Ratio to Terminate

3 Years Income

5.38% 5.52% 2.58% 2.42% 5.47%

Loss Ratio to Bankrupt 8.66% 9.16% 7.17% 4.97% 9.91%

We first calculatethe Tier 1 Capital Ratio based on the Basel III requirement, and shows thatalthough

the ratio of CMB is a bit below the bar in 2013, it has increased to 9.5% in 2014, and reach the Basel

III requirement. Meanwhile, its reserve for bad debt is much higher than the non-Chinese banks.

Further, we simulate a stress test for the five banks to test whether they have enough capital to

withstand the impact of adverse developments. CMBcan take2.6% loss on total asset,which is

equivalent to its one-yearnet income. This ratio is close to Wells Fargo, and nearly doubles the ratio of

HSBC and BOA. In the 2008 financial crisis, the Bank of America was one of the worst-hit giant banks.

It took BOA 3 years to charge off 8.97% of its bad debt, which is about 5% of its total assets, during

2008 to 2010. If the 2008 financial crisis happened in China, and CMB suffered as much as BOA, it

would still have enough capital to survive the crisis and only take less than 3-years-worth of itsnet

incometo completely recover to the pre-crisis level.

In addition, when we valuate CMB, we also need to take the macro-economic environment andpolices

into account. In CMB’s balance sheet (Table 7), we could recognize that among its assets, only the first

2 categoriesmay be exposed to risks. And among the Security and Other Financial Assets, only 38% are

tradable, in which 99.8% are AAA bonds, including government bonds (27%), commercial bank and

other financial institution bonds (36%) and other large corporate bonds (36%). Since the Chinese

market is relatively closed and commercial banks are heavily regulated, they cannot trade stocks, funds

and risky bonds. In addition, there is no derivatives market in China. As a result, commercial banks can

only invest in high-class bonds. Because of these strict regulations, assets of Chinese commercial banks

are relatively low-risk.

Table 7: Risk of Assets

2013Q4 Amount Percentage

Loan and Leases 2,148,330 53.5%

Security and Other Financial Assets 764,179 19.0%

Cash and Deposits in Central Bank 523,872 13.0%

Lending and Financial Assets Under Resale Agreement 466,952 11.6%

Others 113,066 2.8%

Total Assets 4,016,399 100.0%

Table8: Loans and Leases:

Amount Percentage

Corporate Loans 1,325,810 60.3%

Personal Loans Personal Business 319,722 14.6%

Personal Housing 268,606 12.2%

Credit Card 155,235 7.1%

Others 56,686 2.6%

Total Personal Loans 800,249 36.4%

Others 71,035 3.2%

Total 2,197,094 100.0%

In the respect of the quality of loans (Table 8),we reckon CMB loans are not likely to see a crisis, for

three reasons:

a. Fast-growing economy with a huge market. Despite a cooling of economic growth over the past

few years, GDP growth in China is still well over 7%. At the same time, with a population of

1.3billion, China has a giant market with huge potential. Fast-growing economy coupled with an

immense market ensures that China’s economy isn’t going south any time soon.

b. Heavy regulation. Heavy regulation creates a cushion for the economy against a potential crisis.

For instance, the down payment for house purchase in China is around 30% for the first and

around 70% for the second, which means that home-buyers would default only when the house

prices dropped dramatically, and the same is true with mortgage. As a result, leverage in the

economy is not high enough to cause a crisis.

c. The risk itself. History tells us that real risk rears its ugly head when people least expect it. For

instance, few people saw the subprime mortgage crisis coming in 2008 when the market was

buoyant. That is why the crisis was so catastrophic. In China, however, the risks of non-performing

loans have been laid bare and have been translated into stronger capital cushions and stock price

discounts. Since the stock prices for these banks already reflect the worst-case scenario, even if the

real situation is just a wee bit better, long-term investors of these banks could reap substantial

gains.Just like Warren Buffett said 'Be Fearful When Others Are Greedy and Greedy When Others

Are Fearful'.

5. In-depth analysis

1) Reasons behind undervaluation

a. International investors’ concern about bankruptcy.

Although the non-performing ratio (Chart 3) for the past few years has remained in the low level,

before 2003, the NPL ratio was so high that the CMB was technically bankrupt, and this situation

happened for other Chinese banks, too. If history repeats itself, it will be a disaster for all the Chinese

banks.

Chart 3: Non-Performing Ratio of CMB

However, we could expect that this scenario was just a one-off, becauseall the banks in China were

branches of the governmentbefore 2000,and the government didn’t care about their profits or losses.In

the past, the government could easily get loans and did not need to repay them. But things changed

after the Premier Zhu Rongji conducted a series of financial reforms. He peeled away the

non-performing loans from these banks’ balance sheets and put them in a special state-owned company,

thus creating clean and profitable banks for domestic and international investors. The government then

loosened its grip and these banks became publicly traded companies in Hong Kong and Shanghai.

Though the state remains the majority shareholder, it can no longer directly harm the interests of the

shareholders and the banks. Therefore, what went before 2003 simply will not happen again.

b. Chinese investors lack a long-term investment philosophy, and do not want to invest in large groups

like CMB.

In Chinese stock exchanges, 98% of the accounts hold less than $20,000 worth of stocks, and these

small investors also dominate mutual funds. Traditional long-term large investors like pension funds are

prohibited to buy stocks, insurance companies are also constrained in their stock-trading activities.

These individual investors tend to invest in small, volatile companies, with the hope of making a fortune

overnight by taking huge risks (Chart 4).

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NPL Ratio of CMB

Chart 4: Weighted Average P/E Ratio

In addition, there is a significant psychological speculation called ―Long Bear and Short Bull‖ among

Chinese investors. Here, long and short stand for time duration. Chinese investors do not expect to

establish long-term investment relationship with the company, which means that speculative

opportunities, rather than dividend are what investors are looking for.

2) Reasons to invest in CMB

1. The fluctuation of Chinese stock market is huge, which can help long-term investors to buy at

a lower price and sell at a higher price. As Chart 3 shows, the volatility of Shanghai

Composite Index is much higher than that of S&P 500, which creates arbitrage opportunities

for long-term investors.

Chart 5: Volatility of Shanghai Composite Index and S&P 500

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2. Outstanding Growth Rate

If we set the year 2006 as the baseline (Table 9 and Chart 4), we can see that in the 2008 financial crisis,

all the US banks were badly hit, but CMB maintained a high growth rate, and outperformed the other

banks.

Table 9: Growth Rate Comparison

Net Income Growth CMB ICBC HSBC Bank of America Wells Fargo

2006 1.00 1.00 1.00 1.00 1.00

2007 2.24 1.66 1.21 0.71 0.96

2008 3.10 2.27 0.36 0.19 0.32

2009 2.68 2.63 0.37 0.30 1.46

2010 3.79 3.38 0.90 -0.11 1.50

2011 5.32 4.27 1.14 0.07 1.93

2012 6.66 4.89 0.97 0.20 2.30

2013 7.62 5.38 1.13 0.54 2.64

Chart 6: Growth Rate Comparison

3. Excellent Historical Performance

As shown in Chart 5, in the past 10 years, the bank’s net income and book value have dramatically

increased. Net income grew by 22.5 times, 36.5% annually. And the return on equity has hold up

steadily at around 20%. CMB has beenquite profitable with a healthy growth rate, and we believe that

it will remain so in the future.

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CMB ICBC HSBC Bank of America Wells Fargo

Chart 7: Historical Performance of CMB

4. STOW Analysis

Strengths

a. Innovation. CMB established China’s first bank-wide IT platform and first telephone bank and became

the first to offer nationwide deposit and withdrawal, and real-time fund transfer services. CMB also

launched a large number of innovative products that are highly competitive, such as All-in-One Card

(the first bank card managed based on customer numbers), the Dual-currency Credit Card (the first

dual-currency credit card compliant with international standard in China), the Sunflower Finance

(China’s first financing product for high-end customers), and private banking services.

b. Rapid Expansion. Since its inception 24 years ago, CMB has grown with China’s economic progress

from a small bank with a capital of 100 million Yuan, one branch and over thirty employees into a

nationwide joint-stock commercial bank. Currently, CMB has 82 branches and 763 sub-branches in 96

cities, 2 branch-level specialized agencies (the Credit Card Center and the Small Enterprise Credit

Center), 1 rep-office, 1,917 self-service banks and 1 wholly-owned subsidiary (CMB Financial Leasing

Co., Ltd) in mainland China. For overseas market, CMB has 2 wholly-owned subsidiaries — Wing

Lung Bank Ltd. and CMB International Capital Corporation Limited and 1 branch (Hong Kong Branch)

in Hong Kong, a branch and a rep-office in New York, and two rep-offices in Taipei and London.

c. Modern Management Structure.With respect to corporate governance, CMB separates ownership from

management and is one of China’s banks that have established a modern corporate governance

structure with clear division of work and mutual balance and supervision between the board of

directors, the board of supervisors and the management team. In terms of HR management, CMB was

the first to abolish the "three-guarantee mechanism" (guaranteed job, guaranteed position and

guaranteed salary) and adopt a flexible system, under which employees can be dismissed, managers

can be promoted or demoted, and remuneration can be flexibly adjusted.

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Historical Performance of CMB

Net Income Book Value ROE

Weaknesses

a. Relatively Small Scale. Compared to the big five state banks in China, CMB is relatively small and

thereforeharderto achieve economies of scale. Established only in 1987, the development of CMB is in

the primary stage with only 2.6 trillion Yuan of total assets, which even lags behind the smallest bank –

Bank of Communications -- among the big five state banks.

b. Inadequate Branches. Although CMB has 82 branches and 763 sub-branches in 96 cities currently, they

are still severely inadequate compared to the big five. The smallest one, Bank of Communications, has

2,600 branches, which are about three times as many as CMB’s. The Largest one, Agricultural Bank of

China, has 23,461 branches, which are 26 times as many as CMB’s.

c. Lack of Policy Support. Compared to other local commercial banks, CMB cannot enjoy the preferential

policies for the development of finance issued by local governments. At the same time, compared with

the big five, who have their own asset management companies provided by the national government,

CMB does not have the state's credit support, and has to handle bad loans by itself.

Opportunities

a. IT New Area. Given that all banks in China were initially at the same level in terms of internet-related

businesses, CMB aggressively developed electronic banking channels, including online, telephone and

self-service banking services, which offset the disadvantage of inadequate banking network and won a

large number of high-value customers.

b. Financial Liberalization in China. China’s new leadership has unveiled plans to accelerate financial

liberalization that offer significant potential opportunities to domestic and foreign financial institutions.

The measures include interest rate liberalization and the development of bond market,

internationalization of RMB, the China (Shanghai) Pilot Free Trade Zone, and other regulatory reforms.

CMB need to be ready to take thisopportunity to expand further.

c. New Policy Adjustment. In recent years, CBRC adjusted the operating policies, easing intermediate

business restrictions. Since then the trend for the banking sector to develop intermediate business,

business structures and profit model is gaining momentum. We could expect that CMB will explore this

broad new market and increase net profit.

Threats

a. Growing Competition from Local Commercial Banks.

Except for big 5 traditional state owned banks,local commercial banks have proliferated in recent years,

such as Bank of Beijing, Bank of Shanghai, Bank of Dalian, and so on. All of these banks are

developing rapidly in their local markets as they enjoy local governments' strong policy supports, and

are familiar with local culture.

b. Growing Competition from Foreign Banks.With the liberalization and internationalization of Chinese

financial market, 47 foreign banks so far have established branches in China. They have tremendous

advantages in innovation, marketing, and capital management. Thus they might be powerful

competitors to CMB

c. Talent Competition

Since the emerging of local banks and foreign banks, there is now intense talent competition among

banks. Excellent managers, sellers, and representatives are the key to build a bank's core

competitiveness.

5. Conclusion

Based on our DCF model, comparison valuation and its historical performance, CMB has been

undervalued to a large extent. As a result, we would recommend a buy position of its stock, and expect

healthy long-term growth of the company.