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SUNCORP-METWAY LTD (SUNCORP)

12 April 2010

Executive Summary

• Suncorp is working through operational problems successfully with the banking division's bad debts now likely to have peaked. The significant losses from the insurance arm encountering increased claims due a number of weather related events in 2009 should also decline this year.
• However, subsequent to the $1,046m capital raising undertaken in February 2009, the capital position is sound. If banking bad debts and insurance claims are more problematic than expected, this capital should provide Suncorp with a sufficient buffer to further re-capitalise, or sell off assets in a controlled manner.
• The diversified nature of Suncorp is also an advantage – banking, insurance, and wealth management. This gives the company the option of selling off individual divisions, an option that is typically easier and more beneficial to stakeholders than attempting to sell the entire operation.
• Suncorp has taken advantage of the government guarantee on term deposits and wholesale funding to substantially improve its funding profile.
• Overall, despite the operational problems, Suncorp is a solid credit risk due to its sound capital position subsequent to the equity raising. With credit spreads on the company's debt still trading at wide margins, opportunities exist to pick up Suncorp at attractive levels, particularly longer dated subordinated debt issued by the insurance arm.

Company Background

Suncorp is a financial services conglomerate providing banking, insurance, investment and superannuation services. The company was formed by a Queensland government instigated merger of Suncorp, QIDC and Metway Bank.

In recent years the company has increasingly focussed on its insurance assets. In 2001 it purchased AMP's general insurance assets followed by the much larger acquisition of Promina in March 2007 for $7.4bn. The company is now a diversified operation with banking, insurance and wealth management businesses.

Trading Update (For the half year ended 31 December 2009)

Key results include:

• Profit from ordinary activities increased 41% to $364m on the prior corresponding period. Profit before tax was $567m.
• Total assets decreased $2.0bn from $97.5n to $95.5bn. Lending assets decreased slightly to $55.5bn.
• The Bank's Tier 1 capital ratio at 31 December 2009 was 11.96% with the total capital ratio 13.70%.
• Deposits and short term borrowings decreased from $37.9bn to $34.6bn.
• 2009 final dividend of 15 cents per ordinary share.
• The contribution before tax of the banking division, including treasury, increased to $224m due to having negligible impairment losses.
• The contribution before tax from the combined general insurance division was $491m, an increase of 53.4% on the half year ended 30 June 2009. The contribution before tax of other divisions totaled a loss of $211m which is largely a result of a $272 impairment loss.

Recent Events

Subsequent to the 31 December 2009 result, Suncorp notified the market of the following events:

• Suncorp has recently approved 2,500 claims from Cyclone Ului in North Queensland and around 11,000 claims from the Perth storm earlier this week. Both these events will contribute towards the group's aggregate reinsurance programs, which aggregates the cost of claims events above $10m until $250m is exceeded.
• Suncorp has reported that claims costs from the Victorian storms would reach $200m, which is the maximum event retention under the Group's property catastrophe reinsurance cover.
• The group has also received 1,600 claims with an estimate cost of $25m to $30m from recent flooding in Southern Queensland.

Capital Structure and Liquidity

The bank has a strong capital position with a Tier 1 capital ratio of 11.96% at 31 December 2009. It has also significantly increased its proportion of retail funding over the past year.

Suncorp should also benefit from the run-off of the non-core portion of its lending book. As these loans mature or are called in, this will reduce the lending assets of the company and hence its risk weighted assets, improving the capital ratios of Suncorp. The current run-off of the non-core part of the lending book was $0.3bn ahead of schedule at 31 December 2009.

Overall, Suncorp is soundly capitalised. The high prima facie capital level of the bank should be more than sufficient to absorb any future losses from write-offs in the banking book and insurance related events. If these operational issues turn out to be more problematic than expected then the capital position should provide a sufficient buffer to allow for a further re-capitalisation, or, a controlled disposal of assets.

Sale of Business

While the chances of asset sales have diminished with the capital raising and stabilisation of operational problems, there is still the possibility that some of the businesses will be offloaded and consideration needs to be given to what impact that will have on the debt securities of Suncorp.

A sale of the wealth management is highly likely to be a positive development for Suncorp debt holders. The proceeds of such a sale would likely be used to bolster the balance sheet of the company – there is little chance that APRA as regulator would allow the company to conduct a capital return or special dividend to shareholders given the current market environment.

Divesting either the bank, (most likely), or the insurance division would prove more complex, but again this is expected to be an overall positive for debt investors of the company. Again, APRA would likely require Suncorp to retain most of the funds within the company due to current market conditions. This would likely leave the company over-capitalised although capital would be expected to be returned at some point.

Debts would be expected to remain with the company that issued them, (the insurance or bank), and assume the rating of the acquirer. As suggested above, the company remaining in the Suncorp structure would be expected to benefit from the improved capital position assuming a cash consideration was paid.

Overall however, a sale of any of the businesses is likely to a positive development for debt holders. It is difficult to think of a scenario where debt investors would be placed in a worse position with the most likely outcome that would be at least as well off, if not better placed than before.

Strengths

• Suncorp has a diverse range of businesses and the various sources of income reduce risk and provide a stable of saleable assets if needed to meet commitments.
• The capital position has improved significantly due to the $1.046bn capital raising undertaken in February 2009. This capital buffer provides the company with sufficient flexibility to raise further capital or undertake calculated, not forced, sales if operational issues deteriorate further.
• It is possible that subsequent to the appointment of Snowball as the new chief executive that Suncorp will look to sell businesses to improve the financial position of the company. If asset sales are made, due to current market conditions, it is highly unlikely APRA would allow Suncorp to undertake a substantial capital management initiative such as a share buy-back or special dividend.
• The company's access to the government guarantee on deposits and wholesale lending is easing funding pressures. With several billions dollars in government guaranteed wholesale issuance plus significant government guaranteed deposits, the company has essentially brought itself insurance as the government can't afford for Suncorp to fail.
• Suncorp has a strong brand name in its home state of Queensland.
• The bank continues to improve its liquidity position although it is still low when compared with its banking peers.

Risks

• Suncorp is highly exposed to the Queensland market in both banking and general insurance.
• The banking operations have a high exposure to property developers and significant impairment losses are already being incurred on select loans.
• Management risk – a number of key executives brought over in the Promina acquisition have since left the company. Also, at the senior executive level, there is a new chief executive and chief financial officer.
• It is possible the company will sell its banking operations and/or its wealth management division. There is a risk that Suncorp will not be able to achieve the desired price given current market conditions.
• There is some refinancing risk, (as with all banks at the moment), however, as a regional bank Suncorp is more exposed than the major banks.
• While Suncorp has significantly improved its liquidity profile, these funds have been raised at significant additional cost. This places Suncorp at a competitive disadvantage to the major banks and may in the long-term affect the profitability of the banking operations.

Debt Securities

Suncorp offers numerous fixed income products ranging from term deposits to hybrid securities. The current spreads for each of the major type of securities is listed below, in general order of increasing credit risk. The red section represents the range of returns for each asset class depending on maturity and other factors. The levels detailed are spread over applicable swap rates to expected maturity.

As the above chart illustrates, the subordinated debt of both the bank and insurance operations of Suncorp are trading at spreads higher than most of the company's other fixed income products, and similar to that of its hybrids which are higher risk securities. Investors in the hybrids should consider switching into the higher ranking subordinated debt.

It also demonstrates the difference in returns between the bank subordinated debt (i.e. 10 year legal maturity with a 5 year call date) and the insurance subordinated debt (i.e. 20 year legal maturity with a 10 year call date).

Our credit assessment of the subordinated debt issued by the two divisions is that they are viewed as broadly in line from a risk perspective, with the insurance subordinated debt possibly deemed as slightly less risk.

While many of the above investments are not directly comparable due to differing terms to maturity, the chart clearly illustrates the significant value available in subordinated debt issues. From a risk/reward perspective, FIIG Research believes the insurance subordinated debt represents the best value (despite the longer duration) due to:

1. the superior rating of the issuer;
2. the possible capitalisation improvement and resultant positive rating impact should the banking arm be sold-off;
3. the risk assessment detailed in the previous paragraph regarding the subordinated debt of the two arms;
4. our assessment that the insurance arm is seen to have less long term risks than the banking division which is expected to have cost of funding/refinance issues once the government guarantee is removed and credit impairment concerns for some time.

Summary

Suncorp is working through operational problems successfully with the banking division bad debts now likely to have peaked. The significant losses from the insurance arm encountering increased claims due a number of weather related events in 2009 should also decline this year.

However, subsequent to the $1,046m capital raising undertaken in February 2009, the capital position is sound. If banking bad debts and insurance claims are more problematic than expected, this capital should provide Suncorp with a sufficient buffer to further re-capitalise, or sell off assets in a controlled manner.

The latest update from Suncorp indicated that while bad debts were still an issue, the impairments had stabilised. Unless the economy significantly deteriorates from here we would expect that the banking division has already experienced its nadir in this financial cycle.

Overall, despite the operational problems, Suncorp is a solid credit risk due to its strong capital position subsequent to the equity raising. With credit spreads on the company's debt still trading at wide margins, opportunities exist to pick up Suncorp at attractive levels especially the subordinated debt of the insurance operations.

Brad Newcombe
Senior Research Analyst