SPAREBANKEN SØR Keep calm and enjoy the yield HOLD TP: NOK87.0

Transcription

1 EQUITY RESEARCH Research report prepared by DNB Markets, a division of DNB Bank ASA Financials Initiating coverage SPAREBANKEN SØR Keep calm and enjoy the yield Sparebanken Sør is market leader in southern Norway, and in terms of profitability we see scope for further operating efficiencies post the 214 merger, as well as credit quality support from minimal direct lending exposure to oil-related industries. We highlight a ~6% dividend yield as the main positive to our investment case, but find the shares fairly valued at a 217e P/B above.7x, with an ROE of ~8% and a P/E of 9.2x. We initiate coverage with a HOLD recommendation and NOK87 target price. Market leader in southern Norway. Sparebanken Sør is Norway s fifth largest savings bank and market leader in Vest-Agder and Aust-Agder, with ~34% market shares. Operating income is skewed towards NII, which has been burdened by falling interest rates and retail margin pressure. However, interest rates look to have flattened out and we expect NII to be supported by lending growth of 4 5% and flat combined margins going forward. Potential for further cost-cutting. While the bank has arguably picked most of the low hanging fruit post the merger (with the number of branches and headcount down 18% and 12% since 213, respectively), its cost base should continue to benefit from further efficiency improvements, in our view. We see potential for a cost/income ratio below 4% towards 218, primarily driven by continued focus on adapting to changing customer preferences and digitalisation. Favourable lending exposure. Despite the bank s dominant position in Vest-Agder, a region with a relatively high share of oil-related employment, it has no material direct lending exposure to oil-related industries. This has supported low loan losses YTD (5bp versus 23bp for Norwegian banks) and the bank expects still-moderate losses in 216. Attractive dividend yield initiating with a HOLD recommendation. We expect a dividend in line with the payout policy of 5% for 216, indicating a dividend yield of ~6%. We initiate coverage with a HOLD recommendation and NOK87 target price, which is based on two valuation methods (fair P/B and peer multiples). Given an ROE of ~8% for 217e we find the shares fairly valued at a 217e P/B above.7x and a P/E of 9.2x versus other large savings banks at 8.5x on P/E. Year-end Dec (NOKm) e 217e 218e Net interest income 1,511 1,521 1,577 1,639 1,71 Net commission income Total revenue 2,2 1,769 1,997 2,3 2,118 Op. expenses Pre-provisions profit 1, ,17 1,25 1,284 Loan losses Pre-tax profit 1, ,84 1,45 1,87 EPS rep (NOK) EPS adj (NOK) DPS (NOK) Revenue growth (%) nm EPS adj growth (%) nm P/E adj (X) P/Book (X) Dividend yield (%) Source: Company (historical figures), DNB Markets (estimates) HOLD TP: NOK87. SOR versus OSEBX (12m) okt des feb apr jun aug okt Sparebanken Sør OSEBX (Rebased) Source: Factset SUMMARY Recommendation (prev.) HOLD () Share price (NOK) 86.8 Target price (previous) (NOK) 87. (N/A) Upside/downside potential (%) Tickers SOR NO, SOR.OL SHARE PRICE PERFORMANCE Abs. 1/3/12m (%) 19/4/-19 Rel. 1/3/12m (%) 14/37/-23 High/Low 12m (NOK) 18/61 NEXT EVENT Q /1/216 ESTIMATE CHANGES (NOK) Year-end Dec 216e 217e 218e EPS (new) Change (%) nm nm nm Total income (new) 1,997 2,3 2,118 Change (%) nm nm nm Source: DNB Markets, ANALYSTS Håkon Astrup hakon.astrup@dnb.no Martin Kaland martin.kaland@dnb.no Niclas Gehin niclas.gehin@dnb.no Please see the last two pages for important information. This research report was not produced in the US. Analysts employed by non-us affiliates are not registered/ qualified research analysts with FINRA in the United States.

2 215 Total income Costs Loan losses 216e Total income Costs Loan losses 217e DNB Markets Sparebanken Sør Investment case overview Share price performance, DNB Markets target price, bear- and bull-case scenarios 115 NOK11 (27%) NOK87 NOK87 (%) NOK6 (-31%) 55 okt 215 feb 216 jun 216 okt 216 feb 217 jun 217 okt 217 Target price methodology Our target price is based on two valuation techniques: 1) a fair P/B multiple based on the Gordon growth model (we used a cost of equity of 1.2% and a 3.% long-term growth rate); and 2) peer trading multiples (217e P/E). Our target price of NOK87 represents a 217e P/E of 9.2x and 217e P/B of.7x. Historical Share Price Performance Price Target (okt 17) Current Share Price Source: FactSet, DNB Markets Source: DNB Markets Downside risks to our investment case Oil prices falling again, which would negatively affect the Norwegian economy. Lower interest rates/increased competitive pressure which would hurt the ROE. Falling house prices, hampering credit growth, fee income-based products and higher loan losses. Increased capitalisation requirements. DNB Markets investment case and how we differ from consensus We expect annual lending growth of 4 5% and underlying growth in its cost base of ~1% over e. We forecast 9 2bp loan losses for We expect a 5% payout ratio for e, implying an end-216e CET1 ratio of 14.5%. Upside risks to our investment case Higher interest rates would improve the bank s ROE. All the banks raise their payout ratios, easing competition in the market. Fee income increases, while loan losses remain at current low levels. Higher oil prices. Source: DNB Markets Source: DNB Markets Source: DNB Markets Pre-tax profit bridge e (NOKm) 1,16 1, ,84 1,45 Source: DNB Markets (forecasts), company (historical data) 2

3 Contents Company overview 4 Company history and structure 4 Financial targets 5 Financial performance 7 Revenue overview 7 Costs realisation of post-merger synergies 9 Asset quality 11 Profitability 14 Capital 16 Funding and liquidity 18 Estimates and assumptions 2 Valuation 22 Computing a fair P/B 22 Peer trading multiples 22 Valuation summary 23 Management, board and shareholders 26 Management 26 Board of directors 26 Shareholders 28 Appendix 29 Pre-merger financial performance analysis 29 Regional macro 31 Unemployment 32 Market overview 36 Risk factors 39 Important Information 48 3

4 DNB Nordea Danske Bank Handelsbanken Sparebank 1 SR-Bank Sparebanken Vest Sparebank 1 SMN Sparebank 1 Nord-Norge Sparebanken Sør Others NOKbn DNB Markets Sparebanken Sør Company overview Sparebanken Sør is a Norwegian savings bank focusing on traditional banking services, with its lending book skewed towards retail mortgages and commercial real estate (85% of its loan portfolio at end-q2). The bank is among the largest savings banks in Norway, and ranked number nine among Norwegian banks by gross lending at end-215. Sparebanken Sør has a strong presence in southern Norway and is market leader in the counties of Vest-Agder and Aust-Agder (33% and 36% market shares 1, respectively), while it ranks third in Telemark. The bank s strategy emphasises local knowledge and close customer relations, combined with continued focus on cost effectiveness, digitalisation and adapting to changing customer preferences. Sparebanken Sør Strong presence in southern Norway 9 th largest bank in Norway Lending book tilted towards retail lending and commercial real estate Figure 1: Sparebanken Sør lending split, Q2 216 Figure 2: The largest banks in Norway, gross lending 215 Real estate development: 4 % Social services:4 % Construction: 1% Other:6 % 1,4 1,2 1, Commercial real estate: 19% Retail customers: 66% 2 Source: Company Source: Finance Norway Headquartered in Kristiansand, as of Q2 216 Sparebanken Sør had 36 branches in Aust- Agder, Vest-Agder and Telemark, including offices in the region s largest municipalities such as Kristiansand, Skien and Arendal. Figure 3: Geographical profile, branch offices, Q2 216 Figure 4: Geographical profile, national presence Q2 216 Source: Company reports Source: DNB Markets Company history and structure Sparebanken Sør in its current form is the result of the merger between Sparebanken Pluss and Sparebanken Sør in January 214, both of which had a history of numerous mergers and acquisitions over 19 years, with Sparebanken Pluss dating back to 1824 when Christianssands Sparebank was established as one of Norway s first savings banks. To One of the oldest savings banks in Norway 1 Based on lending to households and non-financial corporations at end-215 by county (Statistics Norway) 4

5 secure lending growth and be compliant with the Norwegian FSA s recommended capital level, Sparebanken Sør completed a fully underwritten NOK599m rights issue in April 216. Figure 5: Sparebanken Sør s history Sparebanken Pluss: Christianssands Sparebank is established Sparebanken Pluss: Sparebanken Agder was formed when Christianssands Sparebank and several other savings banks merged Sparebanken Pluss: Four savings banks from Telemark and Sparebanken Agder merged and changed name to Sparebanken Pluss Sparebanken Pluss and Sparebanken Sør merge and take the name Sparebanken Sør April 216: NOK599m equity certificates issue completed Sparebanken Sør: Arendal Sparebank merged with four other savings banks and formed Aust-Agder Sparebank Sparebanken Sør: Sparebanken Sør was established as a result from a merger of Aust- Agder Sparebank and 11 other savings banks Source: Company As well as providing traditional banking services and products, Sparebanken Sør offers real estate brokerage, insurance, securities trading and leasing through fully- and partly owned subsidiaries. Sparebanken Sør Boligkreditt is a fully-owned mortgage company, to which the loans in the covered bonds pool are transferred. The bank s real estate brokerage services are operated through Sørmegleren, the largest real estate broker in southern Norway. Some of the other partly-owned subsidiaries are companies owned by several stand-alone savings banks (not part of an alliance), including the insurance company Frende Forsikring, the leasing company Brage Finans, and Norne Securities, an investment bank. Sparebanken Sør s equity certificate ratio 2 was 19.8% at end-q2 216, and the 2 largest holders represented 77% of the equity certificate capital. The foundation, Sparebankstiftelsen Sparebanken Sør, was the largest holder of equity certificates with 52% and aims to maintain ownership of at least 51%. Product offering goes beyond traditional banking services Figure 5: Company structure, Q2 216 Sparebanken Sør Sørmegleren 91% Sparebanken Sør Boligkreditt 1% Frende forsikring 1% Brage invest 14% Norne Securities 18% Source: Company Financial targets Sparebanken Sør has a number of short-term financial targets, which to an extent also represent its longer-term ambitions. They include increasing the return on equity (ROE) from 8.4% in 215 to 9% in 216, helped by its cost-cutting ambitions of a cost/income ratio of 42%. As of Q2 the bank had reached its targeted number of branches after the merger of 36 (44 branches pre-merger), and was closing in on its target of 42 FTEs (432 at Q2 216 versus 52 pre-merger). The bank is set to continue to optimise its physical distribution network with further branch closures in Q3 and Q4, while it also announced plans for its first branch in Rogaland (set to be operational from Q1 217). Financial targets for 216: 9% ROE Cost/income ratio of 42% 5% payout ratio 14.5% CET1 ratio 2 4% lending growth 2 The share of total equity attributable to the equity certificate holders and their share of net profits 5

6 Sparebanken Sør has yet to receive its formal Pillar II requirement, but the Norwegian FSA has recommended a CET1 ratio of 14.5% by the end of 216, which is also the bank s target. The rights issue in April was an important contributor to reaching the capital target, and restrained lending growth should support its capital position (the target is 2 4% lending growth for 216). Despite the ongoing capital-building process, Sparebanken Sør aims for a payout ratio of 5% for 216, in line with its long-term payout policy. Yet to receive formal Pillar II requirement, but end-216 target is in line with recommended level Figure 6: Financial targets 215 H1 216 Target Profitability Return on equity 8.4% 1.% 9.% Costs Cost/income ratio 46.2% 42% 42% Dividends Payout ratio 51% N/A 5% Capital CET1 ratio 12.7% 14.1%* 14.5% Growth Lending growth 9.2% 4.% (annualised) 2-4% Source: Company. *The common equity tier 1 capital ratio, including 8% of profit, amounts to 14.1% for the group. 6

7 NOKm DNB Markets Sparebanken Sør Financial performance Revenue overview Similar to many traditional savings banks, Sparebanken Sør s revenue is skewed towards net interest income (NII), which represented 86% of total operating income in 215 and 75% in 214. Operating income has therefore largely been driven by steadily rising NII on the back of strong volume growth, only partly offset by margin pressure in the past two years. The 12% decline in operating income in 215 was primarily explained by a negative contribution from financial instruments due to increased credit spreads. Operating income skewed towards NII Figure 7: Operating income, Figure 12: Operating income split, 215 2,5 Net financial income: -4 % Other income: % 2, 1,5 NCI:18 % 1, 5 NII:86 % 213* NII Operating Income Source: Company Source: Company Sparebanken Sør reported a fairly muted NII CAGR of 2.7%. Strong lending growth (CAGR of 6.8%) was the main supporting factor, while margins were burdened by a falling interest rate level and fierce competition, in particular in the retail segment. Despite efforts to mitigate lower lending rates by larger cuts in deposit rates, the bank saw underlying net interest margin (NIM) erosion of 24bp from 1.94% in Q1 214 to 1.7% 3 in Q Sparebanken Sør should still have some room on the deposit side to partly compensate for potential future lending rate cuts in our view, with deposit rates on its general savings accounts of.4.6%. However, interest rates in Norway have flattened out in recent quarters and the risk of further rate cuts from the central bank has eased after recent upbeat macro indicators (the key policy rate was unchanged in September). Sparebanken Sør also announced a deposit repricing with full effect from December 216, which should be a supportive factor from 217e. Muted NII CAGR reflects margin pressure 3 Adjusted for the annual guarantee fund charge recognised in Q1 216 and AT1 costs (reclassified as equity from Q1 216) 7

8 NOKm NOKbn DNB Markets Sparebanken Sør Figure 8: NII and NIM, 27 H1 216 Figure 9: Lending volumes and growth, 27 H ,6 2.5 % 1 18% 1,4 1,2 1, H1 216 NII (LHS) Pluss & Sør (LHS) NIM (RHS) 2. % 1.5 % 1. %.5 %. % H1 216 Total lending (LHS) Pluss & Sør (LHS) Lending growth (RHS) 16% 14% 12% 1% 8% 6% 4% 2% % Source: Company, DNB Markets. Note: 213 figures are pro forma, from the company, while premerger figures are the respective banks combined reported figures (27 212). Source: Company, DNB Markets. Note: 213 figures are pro forma, from the company, while premerger figures are the respective banks combined reported figures (27 212). Lending growth has slowed since 213, except for a 9.2% volume increase in 215 on the back of both strong retail lending growth of 7.7% and 12.2% in the corporate segment. The strong corporate lending growth was primarily driven by agreements within commercial real estate with strategically important customers, which reduced the risk profile in the lending portfolio, according to the company. However, the bank has intentionally slowed lending growth slightly in the short term to help secure a CET1 ratio of 14.5% by end-216. Volumes are up 2% YTD, at the upper end of its guided range of 2 4% for the full year. Slowing lending growth short-term in quest for 14.5% CET1 ratio by year-end Figure 1: Quarterly NII and NIM % 2. % 1.5 % 1. % Figure 11: Margins versus 3m NIBOR 3. % 2.5 % 2. % 1.5 % 1. %.5 % 1 5 Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415 Q116 Q216.5 %. %. % -.5 % Q2-15 Q3-15 Q4-15 Q1-16 Q2-16 Lending margin, retail Lending margin, corporate NII, NOKm (LHS) NIM, annualised (RHS) Deposit margin, retail Deposit margin, corporate Source: Company (historical figures) Source: Company (historical figures). Note: average rates to customers versus 3m weighted average of 3m NIBOR In terms of quarterly NII and margins (Figures 1 and 11), margin pressure in the retail segment is clearly visible, with the bank s average retail lending margins down 25bp between Q3 215 and Q However, corporate lending margins were up 21bp over the same period, offering some support to the NIM (the dip in Q1 216 was explained by the annual Guarantee Fund Charge recognised in its entirety in the quarter). As Figure 12 shows, Sparebanken Sør has been one of the more successful Norwegian banks to reprice its corporate portfolio, and despite its relatively low corporate-to-total lending ratio of 34%, we believe the ongoing corporate repricing will continue to be a supporting factor. Among the most successful of Norway s larger banks in terms of repricing the corporate lending book; and we see scope for more 8

9 Q2 216 Target Q111 Q211 Q311 Q411 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 DNB Markets Sparebanken Sør Figure 12: Corporate lending margins (versus 3m NIBOR) Figure 13: Commission income split, % 3.5 % 3. % 2.5 % 2. % 1.5 % 1. %.5 %. % Source: Companies (historical figures) DNB - SME DNB - LCI SRBANK MING NONG SVEG SOR Source: Company, DNB Markets Guarantees Securities Payments Insurance services Commission income, NOKm 99 Real estate broking 15 Other Net commission income represented 17% of operating income in 215 and 14% in 214. The bulk of commission income comprises payment provisions and real estate broking, which represented 48% and 29%, respectively. Costs realisation of post-merger synergies Sparebanken Sør s cost base has been fairly flat after the merger, but was down 2% YOY in 215. As of Q2 216, the bank had reduced the number of branches by 18% and the number of FTEs by 11% from 213, and has arguably realised most of the low hanging fruit from the merger. The bank is steadily closing in on its targeted number of FTEs, but given the significant scale benefits in banking and the two merging banks partly overlapping footprint, we believe Sparebanken Sør has potential for further efficiency improvements. NCI equates to 17% of operating income in 215, up from 14% in 214 Further scope for efficiency gains Figure 14: Operating expenses and cost/income ratio Figure 15: Number of FTEs and branches, 26 Q , * 215 H1 216 Operating expenses, NOKm (LHS) 5% 48% 46% 44% 42% 4% 38% 36% 34% 32% 3% Cost/Income ratio (RHS) Cost/Income-ratio excl. net return from items at fair value (RHS) FTEs (LHS) Target Branches (RHS) Source: Company (historical figures). Note: 213 figures are pro forma, from the company and 214 operating expenses are adjusted for NOK25m in negative goodwill. Source: Company. Note: 213 figures are pro forma from the company, while pre-merger figures are the respective banks combined reported figures (27 213). The relatively stable cost base combined with muted income growth has left the bank s cost/income ratio largely stable at ~42% since 213. However, the cost/income ratio excluding the net return from items at fair value had decreased from 46.6% in 213 to 44.5% in H1 216 (see Figure 14), indicating a positive underlying cost efficiency trend. The 2% decline in total operating expenses from 214 to 215 was primarily driven by lower depreciation and other operating expenses, partly offset by higher wage and IT costs, which represented the largest expense items at 53% and 16%, respectively. Personnel expenses were up 5% YOY despite a reduced headcount, fuelled by wage inflation and pension costs. Largely flat cost/income ratio since 213, while improving by 2%-points if we exclude net return from items at fair value Operating expenses down despite increased personnel and IT expenses 9

10 H1-16 DNB Markets Sparebanken Sør IT costs were up 9% YOY in 215 due to increased focus on the bank s digital offering, which in the longer perspective should support a lower cost base. Figure 16: Operating expenses split, 215 Figure 17: Quarterly operating expenses and cost/income ratio 25 6 % IT costs: 16 % Other operating expenses: 18 % Salary expenses: 53 % % 4 % 3 % 2 % 5 1 % Marketing expenses: 5 % Depreciation: 5 % Otherpersonn el expenses: 3% Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415 Q116 Q216 Operating expenses, NOKm (LHS) Cost/Income-ratio(RHS) % Source: Company, DNB Markets Source: Company (historical figures) We see potential for a cost/income ratio of below 4% towards 218, primarily driven by continued focus on adapting to changing customer preferences and digitalisation, but also realising further synergies post the merger. Several of the larger banks in Norway have cut branch numbers significantly since 214 (see Figure 19) due to changed customer preferences. Sparebanken Sør s 18% reduction from 213 is broadly in line with the other banks, despite some overlap in Sparebanken Pluss and Sparebanken Sør s branch networks. Hence, we see scope to reduce number of branches further, despite the bank s small expansion into Rogaland with a new branch at Bryne. Figure 18: Cost/income ratio before and after the merger, Figure 19: Number of branches, 9 largest banks, Norway 8% 7% 6% 5% 4% 3% 2% 1% % 214 Q2 216 Change DNB % Nordea % Danske Bank % Handelsbanken 5 5 % Sparebanken 1 SR-bank % Sparebanken Vest % Sparebank 1 SMN % Sparebank 1 Nord-Norge % Total % Sparebanken Sør* % Sparebanken Pluss Sparebanken Sør Sparebanken Sør (pre-merger) Source: Companies, DNB Markets. Note: 213 figures are pro forma, from the company Source: Companies Note: *Sparebanken Sør pre-merger number of branches (213) We also believe Sparebanken Sør is set to benefit from the frugal cost culture at the former Sparebanken Pluss, which had the lowest average cost/income ratio among its peers over at ~39% and half the number of FTEs and branches versus Sparebanken Sør (pre-merger) despite its similar size (see our analysis of the pre-merger banks in the appendix for details). However, we also note that it could be more challenging for Sparebanken Sør to keep up in the digital race as the savings bank is not part of a larger alliance. Set to benefit from cost culture, but a risk it could get left behind in digital race 1

11 Sparebanken Pluss MORG Sparebanken Sogn og SR-Bank Haugesund Sparebank HELG Time Sparebank Skudenes & Aakra Sparebank1 Søre Sparebank1 Telemark Sparebanken Sør BN Bank Fana Sparebank Klepp Sparebank1 Nordvest Sparebank1 Hallingdal Nes Prestegjeld Sparebank1 Oslo Lillestrømbanken DNB Markets Sparebanken Sør Figure 2: Average cost/income ratio , larger Norwegian savings banks Figure 21: Number of FTEs and income per FTE 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Pluss Sør FTEs (LHS) Income/FTE, NOKm (RHS) Source: Companies Source: Companies Asset quality Despite Sparebanken Sør s dominant position in southern Norway, a region with a relatively high share of oil-related employment, the bank has no material direct lending exposure to oilrelated industries (.1% at end-q2 216). Sparebanken Sør s asset quality should therefore benefit from its somewhat more conservative corporate credit strategy and bias towards the retail segment, in our view. The old Sparebanken Sør (pre-merger) historically reported relatively high loan losses versus Norwegian banks on average, while Sparebanken Pluss stands out at the lower end. However, the bank initiated an in-depth review of its corporate portfolio after the merger in January 214. The ensuing clean-up resulted in an increase in non-performing and impaired loans in Q3 214 and a spike in 214 loan losses, but the assessment arguably also resulted in increased credit quality awareness across the two merging banks, as well as improved routines and credit standards. Sparebanken Sør reported low loan losses in the following quarters, with a loan loss ratio of 11bp in 215 and 5bp in H1 216 (versus the Norwegian average of 16bp and 23bp, respectively). The bank expects moderate loan losses in 216. Conservative lending portfolio with low oil and offshore exposure Figure 22: Loan losses, NOKm and as a % of lending Figure 23: Quarterly loan losses 3.35 % %.25 %.2 %.15 %.1 % * H %. % 5 Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415 Q116 Q Loan losses, NOKm (LHS) Loan loss ratio, % of gross lending (RHS) Loan losses, NOKm (LHS) Annualised loan loss ratio, bp (RHS) Source: Company. Note: * 213 figures are pro forma figures and the loan loss ratio is calculated based on net lending at year end 213 Source: Company (historical figures) Sparebanken Sør s retail lending of NOK59bn represented 66% of gross lending in Q2 216 and approximately half of the retail portfolio has been transferred to the mortgage company Sør Boligkreditt. Its corporate lending portfolio is heavily skewed towards real estate, with commercial real estate and lending to real estate development representing 19% and 4% of Retail exposure dominates lending book, while real estate features heavily in corporate book 11

12 SRBANK DNB MING MORG NONG NORDEA SEB SVEG DANSKE SWB SHB SOR HELG SPOG DNB Markets Sparebanken Sør gross lending, respectively, at that date (66% of the corporate portfolio). These segments are showing healthy asset quality trends on a national basis (see Figure 25), although the loan loss ratio for the building and construction segment has trended above the average for corporate lending since 26. However, we note that commercial real estate together with construction-related lending stand out as the most overrepresented segments measured by loan losses and write-downs in previous banking crises in the Nordics. Figure 24: Lending portfolio by business area, Q2 216 Figure 25: Norwegian banks loan losses by selected segment as a % of lending Real estate development: 4 % Construction: 1% Other:6 % 3. % 2.5 % Social services:4 % 2. % 1.5 % 1. % Commercial real estate: 19% Retail customers: 66%.5 %. % -.5 % Construction and engineering Real estate management Shipping and transportation of pipes Total corporate loans Source: Company Source: Norges Bank, Norwegian FSA Norwegian banks exposure to oil-related industries remains one of our main concerns given the slump in the oil price and oil-related investments. However, Sparebanken Sør s oil-related exposure equated to.1% of gross lending as of Q2 216, which places the bank at the low end versus Norway s largest banks. Limited oil-related exposure Figure 26: Direct oil-related exposure as a % of EAD, Q2 216 Figure 27: Gross lending by geography, 215 1% 9% 8% 8.6 % 7.8 % Rogaland:2 % Others:5 % Akershus:2 % 7% Oslo:8 % 6% 5% 4% 3% 2% 1% % 4.3 % 4.1 % 2.2 % 1.5 % 1.1 %.8 %.1 %. % Telemark: 1% Aust-Agder: 27 % Vest-Agder: 46 % Source: Companies Source: Company (historical figures) While the Norwegian economy looks to be recovering after a slowdown, we have seen increasing regional differences (see regional macro section in the appendix). While Norwegian banks report a limited spill-over effect from the oil-related lending portfolio to the rest of the lending book, uncertainty remains and in general quantifying each bank s exposure to potential second round effects is a challenge. Sparebanken Sør s lending portfolio is heavily skewed to its home region, with lending to Vest-Agder, Aust-Agder and Telemark making up 83% of gross lending at end-q2. Vest-Agder alone represented 46%, a county at the higher end of the oil-dependency scale, both in terms of employment (17% of total employment versus the national average of 13% in 214) and exports (42% of exports from Expecting minimal oil-related contagion for Sparebanken Sør 12

13 DNB SOR MORG MING SRBANK NONG HELG SPOG Rogaland Hordaland Møre & Romsdal Vest-Agder Akershus Aust-Agder Oslo Buskerud Nord-Trøndelag Sogn & Fjordane Telemark Sør-Trøndelag Vestfold Finnmark Nordland Troms Østfold Oppland Hedmark Norway NOKbn DNB Markets Sparebanken Sør oil, gas and offshore). However, given some upbeat macro indicators recently and improved regional macro, we do not expect this exposure to have a material impact on Sparebanken Sør s loan losses going forward. Figure 28: Employment in oil-related industries (% of total employment), 214 Figure 29: Gross non-performing and impaired loans (NOKbn and % of gross lending) % 21% 17% 13% 1% 8% 8% 7% 6% 3% 2% 1% 13% Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415 Q116 Q % 2. % 1.5 % 1. %.5 %. % Gross other impaired (LHS) Gross non-performing loans, >9 days (LHS) Gross non-performing and impaired loans, % of lending (RHS) Net non-performing and impaired loans, % of gross lending (RHS) Source: IRIS (International Research Institute of Stavanger) Source: Company Gross non-performing and impaired loans as percentage of gross lending increased from 1.5% to 2.% after the bank s in-depth review of its corporate portfolio in Q3 214, but have declined steadily since, and were 1.1% at end-q The aim of the review was to assess and control the quality of the portfolio in relation with the merger, in addition to reviewing and improving credit standards and enhancing focus on asset quality across the organisation. As a result, the bank should have good control of its corporate lending portfolio, in our view, and it expects moderate loan losses going forward. Improving non-performing and impaired loan statistics following review; management expects moderate loan losses going forward Figure 3: Provisions as a % of gross lending for select Norwegian banks, bp Figure 31: Loan loss ratio (bp), select savings banks SVEG SR-Bank NONG MING SOAG SOR Individual Provisions Collective Provisions Source: Companies (historical figures) Source: Companies, DNB Markets Note: 213 data for SOR are based on pro forma consolidated numbers Sparebanken Sør s greater cooperation with Kristen-Norges Interessefellesskap (KNIF) in 215 could be another supporting factor, with the national agreement set to result in increased geographical diversification and a number of new customers in the low risk segment, including corporate clients such as hospitals, schools, healthcare services, kindergartens and church organisations. The KNIF agreement represented ~8% of gross lending in Q Support from KNIF agreement 13

14 NOKm NOKm Loan losses as % of lending, bp Loan losses as % of lending (bp) DNB Markets Sparebanken Sør We note large differences in loan loss levels for Sparebanken Pluss and Sparebanken Sør before the merger in 214 (see appendix for details). Historically, Sparebanken Sør (premerger) reported higher loan losses than the national average, while Sparebanken Pluss had one of the lowest loan loss ratios of the Norwegian savings banks (4bp over ). One explanation could be the difference in lending exposure, both geographical and by sector. Sparebanken Sør had higher exposure to segments such as industry, manufacturing, construction and engineering, where loan losses trended above the Norwegian average for corporate lending between 26 and 213. Sparebanken Pluss corporate exposure was on the other hand skewed towards commercial real estate and organisations. Sparebanken Pluss loan loss level at the low end versus Norwegian banks before the merger Figure 32: Loan losses as a % of lending (bp), Sparebanken Sør and Pluss versus national average Figure 33: Loan loss ratio (bp), 7-year average for select savings banks, Sør Pluss Sør (pre-merger) Norwegian banks Source: Companies (historical figures), Norwegian FSA (Norwegian banks), Statistics Norway (Norwegian banks) Source: Companies Profitability Sparebanken Sør s return on equity (ROE) declined from 12.3% in 213 (pro forma) to 8.4% in 215. This was largely in line with the average ROE for Norwegian savings banks over the same period, but just behind the larger savings banks (see Figure 36). The trend has been driven by slightly higher loan losses (in 214 in particular) and margin pressure. The bank has a ROE target of 9% for 216. Figure 34: Net profit & ROE, Figure 35: Net profit & ROE, Q1 214 Q % 3 16% % 1% 8% % 12% 1% % 4% 2% % * 215 Net profit (LHS) Net profit, Sør & Pluss (LHS) Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415 Q116 Q216 8% 6% 4% 2% % ROE (RHS) Net income (LHS) Return on equity (annualised)(rhs) Source: Companies (historical figures), DNB Markets (estimates). Figure illustrates Sparebanken Pluss and Sparebanken Sør s (pre-merger) combined numbers (27 213). *Note: adjusted for NOK25m negative goodwill in 214. Source: Company, DNB Markets. *Note: adjusted for NOK25m negative goodwill in Q

15 As illustrated in the figure below, prior to the merger, Sparebanken Pluss reported an average ROE of 1.5% over , above Sparebanken Sør s 7.7% and the sector average. According to our profitability analysis of the two banks (see appendix for details), this outperformance was primarily driven by superior cost efficiency and asset quality as highlighted above. Sparebanken Sør s volatile ROE has largely been driven by loan losses. Focus on cost efficiency and asset quality helped Sparebanken Pluss to above-average ROE over Figure 36: ROE, largest savings banks 16% 14% Figure 37: ROE, Sparebanken Pluss and Sparebanken Sør 16% 14% 12% 12% 1% 8% 6% 4% 1% 8% 6% 4% 2% 2% % SRBANK SVEG MING NONG SOR MORG % -2% Sparebanken Pluss Sparebanken Sør (pre-merger) Sparebanken Sør Savings banks average Source: Companies Source: Companies, Statistics Norway 15

16 Capital Sparebanken Sør targets a CET1 ratio of 14.5% by end-216, in line with the FSA s recommendation. The bank s Pillar I CET1 ratio requirement is 11.5% as of June 216, leaving the bank with a combined Pillar II and management buffer of 3.%-points. The bank has yet to receive its official Pillar II requirement, but it is expected by year-end in relation with its Supervisory Review and Evaluation Process (SREP). Tier 1 and Tier 2 capital requirements together add up to 3.5%-points. Hence, Sparebanken Sør s total capital target is 18% by end-216. Its leverage ratio was 7.5% in Q Sparebanken Sør targeting a CET 1 ratio of 14.5% Figure 38: CET capital requirements 16% Figure 39: Total capital ratio and requirements 2% 14% 12% 1% 8% 6% 4% 2% % CCB (- 2.5%); 1.5 % Systemic buffer; 3.% Conservation buffer; 2.5 % Minimum requirement; 4.5 % CET1 Pillar I requirements June 216 Pillar II and management buffer; 3. % Pillar I requirements June 216; 11.5 % Sparebanken Sør 18% 16% 14% 12% 1% 8% 6% 4% 2% % 2. % 2. % 1.4 % 1.5 % 14.1 % 14.5 % Actual Q2-16 Target Q4-16 CET1 Tier 1(hybrid capital) Tier 2(supplementary capital) Source: Norwegian FSA, Company Source: Company (historical data) As illustrated in Figure 4, Sparebanken Sør added ~1bp to its CET 1 ratio as of Q1 216 by raising NOK599m in a fully underwritten rights issue in April 216. The aim of the equity issue was to be compliant with the regulatory requirements and expectations, in addition to having capacity for profitable growth. As of Q2 216 its CET1 ratio was 14.1% (including 8% of YTD profits), and Sparebanken Sør should be well positioned to reach its targeted 14.5% by the end of the year, in our view, helped by continued internal capital generation (i.e. retained earnings) and controlled lending growth. Rights issue adds ~1bp to CET 1 ratio; bank looks well placed to meet its target ratio of 14.5% by end-216 Figure 4: Q4 215 Q2 216 common equity Tier 1 ratio 15% 14% 1. %.2 % 14.1 % 13% 12.7 %.2% 12.9 % 12% 11% 1% Q4 215 CET1 Internal capital generation Q1 216 CET1 Equity issue Internal capital generation Q2 216 CET1 Source: Company 16

17 Figure 41: CET 1 ratio, 212 Q1 216 Figure 42: CET 1 ratio select Norwegian banks, Q % 14% 13% 13.2 % 13.7 % 13.1 % 12.7 % 14.1 % 16% 14% 12% 1% 15.2 % 13.5 % 14.1 % 13.7 % 14.1 % 14.1 % 12% 11.5 % 11.9 % 8% 6% 11% 4% 1% Q2 216 Sparebanken Pluss Sparebanken Sør(pre-merger) 2% % DNB SRBANK MING NONG MORG SOR Sparebanken Sør FSA's recommendation Reported Q2 216 CET1 ratio Source: Companies Source: Companies 17

18 Funding and liquidity Sparebanken Sør has a diverse funding mix, with deposits as its main funding source. Deposits represented 47% of total liabilities in Q2 216 and are dominated by smaller balances, with 7% of total deposits being less than NOK8m. Wholesale funding, amounted to NOK43bn (4% of liabilities), of which 59% were covered bonds. Funding mainly consists of senior debt and deposits Figure 43: Funding split, Q2 216 Figure 44: Funding Q1 214 Q2 216 Subordinated debt:1 % Equity: 9% Wholesale funding:4 % Other:2 % Deposits:48% 12 % 1 % 8 % 6 % 4 % 2 % 3 % 3 % 2 % 2 % 2 % 2 % 2 % 2 % 2 % 2 % 7 % 7 % 8 % 8 % 8 % 8 % 8 % 8 % 8 % 9 % 41 % 4 % 38 % 38 % 4 % 39 % 4 % 41 % 43 % 4 % 48 % 49 % 51 % 51 % 5 % 5 % 49 % 48 % 47 % 48 % % Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415 Q116 Q216 Deposits Senior debt Equity Subordinated debt Other Source: Company (historical figures). Source: Company (historical figures). Sparebanken Sør s deposit-to-lending ratio has been fairly stable at 57 59% since 214 and the merger, although it reported a slight decline towards the end of 215, primarily due to lower deposit rates to mitigate lending margin pressure. As of Q2 216, the deposit-to-lending ratio was 57%, largely in line with the average for the Norwegian savings banks. The deposit rates offered on the bank s general savings accounts are competitive versus its closest peers, ranging from.4.6% (DNB.55%, Nordea.2% and Danske.3%). Sparebanken Sør s deposit portfolio is equally split between corporate and retail customers, with 51% and 49% respectively, at Q2 216, and has been broadly stable in recent years. Deposit-to-lending and deposit split remain fairly stable Figure 45: Deposit-to-lending ratio, 214 Q2 216 Figure 46: Deposit split, 214 Q % 6 % 1 % 57 % 9 % 55 % 8 % 55 % 7 % 52 % 49 % 51 % 6 % 5 % 5 % 4 % 3 % 45 % 2 % 48 % 51 % 49 % 1 % 4 % % Q Q2-16 Deposits-to-lending ratio Retail Corporate Source: Company (historical figures) Source: Company (historical figures) Sparebanken Sør and other Norwegian banks faced higher credit spreads on funding in 215 (see Figure 48), putting pressure on margins and driving weaker net financial results due to negative marked-to-market effects in the liquidity portfolios. Some of the increase in 215 could arguably be explained by the slump in oil prices, weakening the outlook for the Norwegian economy, but other Nordic banks also saw corresponding increase. However, spreads stabilised in Q1 216 and have come down to around 64bp and 87bp for banks with assets above NOK2bn on 3Y and 5Y senior bonds, respectively. Covered bond spreads Credit spreads narrow again after widening in

19 Basis points NOKbn DNB Markets Sparebanken Sør have also come down to the levels seen in September 215 (51bp for the largest banks covered bond programmes). As of Q1 216, around ~89% of Sparebanken Sør s funding had a maturity above 12 months and the average maturity was 3.4 years. Figure 47: Wholesale funding, maturities (NOKbn) as of Q Figure 48: Indicative secondary spreads, benchmark/large cap Norwegian banks >224 Senior- and subordinated bonds Coverd bonds Covered 5Y Senior 5Y Subordinated 5Y Tier 1 5Y Source: Company (historical figures) Source: DNB Markets (estimates) Sparebanken Sør had a liquidity coverage ratio of 153% at end-q Hence, the bank has a comfortable liquidity position and the liquidity portfolio 4 amounted to 16% of net lending in the quarter. Covered bonds represented 74% of the liquidity portfolio at end-q Comfortable liquidity position Figure 49: Liquidity portfolio as a % of lending, Q % 16 % 14 % 12 % 1 % 8 % 6 % 4 % 2 % % 14 % 12 % 16 % Q2-16 Liquidity portfolio as % of lending Figure 5: Liquidity portfolio split, Q % Norwegian gov.bonds 1 % Gov. Guaranteed (AAA / AA) 5% 74 % Coverd bonds Financials, utilities & other Figure 51: Liquidity portfolio ratings Q % 89 % AAA AA A BBB Source: Company Source: Company Source: Company 4 Liquidity portfolio: cash and deposits with central banks and certificates, bonds and other fixed income securities 19

20 Estimates and assumptions We forecast a net profit CAGR of 9%, driven by 6% growth in revenues and moderate cost inflation of 1% on the back of a continued focus on cost efficiency. We expect the cost base to be supported by the planned headcount reduction and gradual digitalisation of processes. We estimate a cost/income ratio below 4% from 218e. We forecast a net profit CAGR of 9%, driven by 6% revenue growth and moderate cost inflation Figure 52: Sparebanken Sør P&L (NOKm) P&L NOKm e 217e 218e Net Interest Income 1,511 1,521 1,577 1,639 1,71 Net Fee and Commission Income Net result from items at fair value Other operating income Total Income 2,2 1,769 1,997 2,3 2,118 Staff costs Other admin expenses Total Expenses Operating profit 1, ,17 1,25 1,284 Loan losses Pre-tax profit 1, ,84 1,45 1,87 Net profit excl. AT1 contribution Non-recurring items Net profit adj. 1, EPS reported EPS adjusted DPS Payout ratio 38 % 51 % 5 % 5 % 5 % CET1 ratio 13.1 % 12.7 % 14.5 % 14.8 % 15. % Source: Company (historical figures), DNB Markets (estimates) We forecast a lending CAGR of 4.3% as lending growth gradually normalises after somewhat muted growth in 216 due to the ongoing capital generation process. We estimate an expansion in net lending to NOK91.8bn in 216e, up 3.9% YOY and largely in line with the bank s targeted range of 2 4%. Expecting a return to normalised lending growth beyond 216 Figure 53: Lending volumes (NOKbn) Figure 54: Loan loss provisions (NOKm and bp) e 217e 218e e 217e 218e Loan losses, NOKm (LHS) 1 5 Net lending (NOKbn) Loan losses in % of lending, bp (RHS) Source: Company (historical figures), DNB Markets (estimates) Source: Company (historical figures), DNB Markets (estimates) We expect margins to remain relatively stable at Sparebanken Sør as competitive pressure in the retail segment is largely offset by corporate repricing. The bank s adjustment to deposit rates (effective December 216) should also be supportive for net margins going forward. While we believe the bank should continue to benefit from its insignificant oil-related lending exposure in the short term, we nonetheless expect loan losses to gradually approach more normalised levels towards 218. We estimate a loan loss ratio of 9bp for 216e (5bp YTD as of Q2 216), trending up to 2bp in 218e. 2

21 Figure 55: Sparebanken Sør key data and ratios Key balance sheeet data NOK e 217e 218e Lending volumes (NOKbn) Deposit volumes (NOKbn) Total shareholders' equity excl. AT1 (NOKbn) Intagible assets (NOKbn) Risk-weighted assets (NOKbn) Key data and ratios ROE 12.4 % 8.3 % 9.6 % 8.1 % 8. % RONAV 12.5 % 8.3 % 9.6 % 8.2 % 8. % RORWA 1.65 % 1.2 % 1.3 % 1.18 % 1.17 % CET1 ratio Transitional rules 13.1 % 12.7 % 14.5 % 14.8 % 15. % Tier1 capital/assets 8.3 % 7.7 % 7.2 % 6.9 % 6.6 % RWA/Assets 57.4 % 59.9 % 57.1 % 57.5 % 57.5 % Net interest Margin on loans (%) 1.87 % 1.8 % 1.75 % 1.75 % 1.74 % Cost/income 31.4 % 46.2 % 41.4 % 4.7 % 39.4 % Cost YOY growth. % 29.9 % 1.3 % -.2 % 1. % Lending YOY growth n.a 9.24 % 3.9 % 4.21 % 4.92 % Deposits/lending 59.6 % 54.7 % 56.7 % 56.4 % 56.4 % Loan loss ratio (bp) Source: Company (historical numbers), DNB Markets(estimates) We expect Sparebanken Sør to reach the recommended capital level of a CET1 ratio of 14.5% by end-216 and maintain a payout ratio in line with its policy of 5%. 21

22 Cost of equity Long-term growth DNB Markets Sparebanken Sør Valuation We have used two different methodologies to derive a fair value for Sparebanken Sør, calculating a fair P/B multiple based on the Gordon growth model and a peer-based multiple analysis. Computing a fair P/B We calculate a fair P/B for Sparebanken Sør at end-218e based on the Gordon growth valuation approach [P/BV=(ROE-g)/(COE-g)]. Our estimate of normalised RONAV is based on our formal forecasts, adjusted for a normalised loan loss ratio and normalised tax rate. As Sparebanken Sør has limited intangible assets, ROE is approximately equal to RONAV. A normalised ROE of 8.1%, a cost of equity of 1.2% and a 3.% long-term growth result in a fair P/B multiple of.71x at end-218e. The fundamental value at end-218e is discounted back to the present with the present value of net dividends included. Our fair long-term P/B approach indicates a value of Sparebanken Sør s equity certificates of NOK1.4bn or NOK88 per equity certificate. Figure 56: Valuation, fair P/B NOKm Q2 216 SOR Current equity attributable to EC-holders 1,731 Intangible assets 4 Current NAV 1,727 - per share P/NAV.79x Aggr. net profit to EC-holders -218e 376 Aggr. dividends -218e -229 Net capital build-up % of current NAV 8.5% Other capital adj. 34 NAV 218e 1,97 Source: DNB Markets Figure 57: Valuation, fair P/B continued Gordon growth assumptions Normalised loan loss ratio.2 % Normalised RONAV 218e 8.1 % Long term growth 3. % Cost of equity 1.2 % Fundamental P/NAV 218e.71x Fundamental value ECs 218e 1,363 Distributable excess capital 218e 17 Net present fundamental value 1,112 Present value of dividends -218e 14 Fundamental value 12m forward (NOKm) 1,38 Fundamental value per share 12m forward (NOK) 88 Source: DNB Markets Figures 58 and 59 show the sensitivities of the estimated value per equity certificate by stressing our assumptions for the cost of equity, long-term growth, ROE and loan losses. Figure 58: Fair P/B valuation sensitivity (NOK) Long-term return on equity 4 % 5 % 6 % 7 % 8 % 9 % 1 % 11 % 12 % 8.2 % % % % % % % % % Source: DNB Markets (estimates) Figure 59: Fair P/B valuation sensitivity (NOK) Normalised loan loss ratio p.a.. %.5 %.1 %.2 %.3 %.4 %.5 %.6 %.7 % 1. % % % % % % % % % Source: DNB Markets (estimates) Peer trading multiples Our main peer group consists of the large Norwegian savings banks, in addition to DNB and Skandiabanken. Although we have selected the peers that we believe fit best, there are key differences worth highlighting. For example, different banks have a different expected growth trajectory (in particular Skandiabanken) and the savings banks generally trade at a discount to commercial banks due to a less shareholder-friendly corporate governance structure. 22

23 The large savings banks are trading at an average 217e P/E of 8.5x versus DNB and Skandiabanken at ~1.3x. 217e P/E indicates a valuation range of NOK7 11 per share for Sparebanken Sør, with an average of NOK86 per share. Figure 6: Peer group multiples P/E P/B ROE Div. yield 216e 217e 218e 216e 217e 218e 216e 217e 218e 216e 217e 218e Norwegian savings banks SRBANK 7.7x 7.3x 7.1x.6x.6x.6x 8.7% 8.6% 8.2% 3.2% 5.1% 6.1% SVEG 8.x 8.3x 8.2x.8x.8x.7x 1.5% 9.6% 9.4% 5.9% 7.% 7.6% MING 8.3x 8.2x 7.8x.8x.7x.7x 9.9% 9.4% 9.3% 4.3% 5.8% 6.9% NONG 8.1x 7.9x 7.7x.9x.8x.8x 11.1% 1.7% 1.3% 5.7% 6.6% 7.% MORG 8.x 9.x 8.8x.7x.7x.6x 9.6% 7.5% 7.2% 5.9% 5.7% 6.% SPOG 9.3x 9.9x 9.7x.9x.8x.8x 9.5% 8.6% 8.7% 7.6% 7.6% 7.7% RING 9.1x 9.5x 9.5x.9x.8x.8x 9.8% 8.8% 8.3% 5.4% 5.2% 5.2% HELG 6.6x 7.7x 8.x.7x.7x.6x 11.3% 9.% 8.3% 6.2% 6.3% 6.4% Average savings banks 8.1x 8.5x 8.3x.8x.7x.7x 1.% 9.% 8.7% 5.5% 6.1% 6.6% Sparebanken Sør 7.5x 9.2x 9.5x.7x.7x.7x 9.1% 7.8% 7.3% 6.2% 6.1% 6.6% Nordic and Norwegian banks Danske 11.1x 1.6x 9.8x 1.2x 1.2x 1.1x 11.3% 11.2% 11.6% 4.5% 4.8% 5.1% DNB 1.7x 1.2x 9.1x.9x.9x.8x 9.% 8.8% 9.5% 4.5% 5.6% 6.8% Nordea 11.x 1.5x 9.7x 1.2x 1.1x 1.1x 1.7% 11.% 11.6% 7.2% 7.2% 7.3% SEB 13.5x 12.x 11.2x 1.4x 1.3x 1.3x 1.2% 11.3% 11.7% 5.8% 6.1% 6.4% Handelsbanken 14.7x 14.9x 14.1x 1.7x 1.6x 1.6x 11.6% 11.1% 11.2% 4.3% 4.6% 4.9% Swedbank 12.5x 12.6x 12.x 1.7x 1.7x 1.6x 14.% 13.5% 13.8% 6.3% 5.9% 6.3% Skandiabanken 1.2x 1.4x 9.3x 1.4x 1.3x 1.2x 14.5% 12.6% 13.% 3.4% 3.2% 3.8% Source: Bloomberg Valuation summary The two valuation methods we applied suggest largely the same fair values. Our fair P/B approach results in a fair value of NOK88/share and peer multiples suggest NOK86/share. The average of the two is NOK87, which also is our target price. Figure 61: Valuation overview Fair P/B Low Mid High Low Mid High Peer multiples Total valuation range Low Mid High Sparebanken Sør valuation per share (NOK) Source: Company reports, Bloomberg, DNB Markets 23