Agricultural Bank of China (1288 HK):Leveraging its rural deposit franchise

1Q14 net profit beats consensus. Agricultural Bank of China (ABC) reported 1Q14 net profit of RMB53.4b, up 13.65% YoY, much higher than the Bloomberg consensus estimate of RMB48.6b. This was due to stable NIM and lower credit costs. Annualized ROE and ROA were 24.47% and 1.43%.

Funding advantages lead to better NIM trend. ABC reported 1Q14 NIM of 2.96%, up 18bp YoY led by cheap funding from county area banking, which contributed 42.2% of the bank’s deposits and 32.6% of its loans. The bank’s funding costs are low because of rural depositors’ preference for traditional deposits over WMPs. Demand deposits and retail deposits accounted for over 50% of the bank’s total deposits, resulting in lower funding costs than peers.

Normalized credit costs a boon to earnings. Credit costs were 72bp in 1Q14, down 3bp YoY. The bank’s credit costs fell from 117bp in 2011 and 90bp in 2012 to 76bp in 2013. We project stable credit costs ahead (81-83bp in 2014F-2016F), which will help stabilize bottom-line growth.

Preference shares to boost Tier-1 capital ratio. Tier-1 CAR ended 1Q14 at 9.48%, still below the regulatory requirement of 9.50% to be met before the end of 2018. ABC is likely to be among the first banks to issue preference shares.

Maintain Outperform rating and HK$4.00 target price, equivalent to 1.05x 2014F P/B. Rural area banking will continue to provide higher priced loans and abundant cheap funding. ABC’s NPL prospects are also better than its peers becaus