HBS Case Report: Shenzhen

Development Bank












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Contents
Executive Summary ........................................................................................................................ 3

Shenzhen Development Banks Financial Performance ................................................................. 3
Shenzhen Development Banks Asset Quality ........................................................................... 3
A Closer Look into Shenzhen Development Banks Earnings Capability ................................. 4
An Analysis on Shenzhen Development Banks Capital Adequacy .......................................... 4

Evaluation of Newbridges Investment .......................................................................................... 5

Conclusion ...................................................................................................................................... 6

Appendices ...................................................................................................................................... 7













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Executive Summary
This report provides an analysis and evaluation of Newbridges proposed investment into
Shenzhen Development Bank. Methods of analysis include an assessment of the banks financial
performance, examining factors such as its asset quality, earning capability and capital adequacy.
It also provides an in-depth analysis into the appropriateness of the price Newbridge must pay
for the stake, given some set circumstances. All graphs, tables and exhibits for the analysis can
be found in the appendices of this report. Our assessment of these key factors show that
Newbridges proposed investment into Shenzhen Development Bank is overall recommended
despite certain negative aspects of it. It should be noted that there are some limitations to the
analysis in this report because of the small scope of data that was given for the analysis.
Shenzhen Development Banks Financial Performance
Shenzhen Development Banks Asset Quality
To begin analysing whether Newbridge investment into Shenzhen Development Bank (SDB) is
appropriate, their performance should be examined first. Firstly, the quality of assets which SDB
has invested in should be taken into consideration. Exhibit 10 highlights SDBs Non-performing
loans (NPL) ratio of 11.6% is higher compared to other industry peers with the exception of
Bocom with 16.7%. Overall, SDB has a higher NPL ratio than the average of its industry peers at
7.3%. This indicates that a higher proportion of SDBs assets are of lower quality, given the
higher credit risk for those loans. It should be noted SDBs NPL ratio may even be higher
because of them likely reporting a low NPL number. This is because these are book values, and
hence the values are subject to the banks discretion, in which they are less likely to recognise
any negative aspects of their bank to continue investor confidence.
Moreover, as highlighted by Exhibit 8, SDB has a loan loss reserves (LLR) level of $391m. This
is lower compared to its own reserve ratio guidelines as shown in Table 1. Simply put, this
implies in the event of a bank run or mass withdrawals, SDB will not have enough capital to
sustain itself from insolvency. Given this, SDBs capital adequacy requirements would also be
affected in the sense the must increase the amount of capital to satisfy the standards to be
adequately capitalised. This has further ramifications, discussed in the capital adequacy analysis
of this report. The industry average LLR is also at a lower level at $386.04 as exhibited by Table

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1 as the average of LLR was 3.8% of gross loans. This implies that the with the exception of
BoCom, other banks in the industry invested into safer loans, further emphasising SDB taking on
more risky loans compared to other banks given poorer credit risk management.
A Closer Look into Shenzhen Development Banks Earnings Capability
To provide additional analysis into Newbridges investment into SDB, SDBs earnings capability
needs to be assessed. As evident by Exhibit 9, SDB has had a decreasing level in Net Interest
Margin from 3.5% to 2.4% in the last three years. In addition to this, the Return on Average
Assets (ROAA) and Return on Average Equity (ROAE) show similar decreasing trends, both
decreasing from 0.9% to 0.3% and 22.4% to 9.1% respectively, as illustrated by Figure 1. SDBs
poor financial performance can also be attributed to its huge decrease in net profits from $56
million to $46 million between 2000 and 2001. In 2002, while its net profits had grown by 1.8%,
this is a significantly smaller figure compared to the profits in 2000.
Overall, these are the factors which drive the differences between SDBs financial performance
in comparison to the other banks. It indicates a poor overall financial performance by SDB.
While the net return on earning assets is similar in comparison to the other banks, it has a lower
ROAA and a significantly lower ROAE compared to the other banks in its industry, as conveyed
in Exhibit 10. Its lower ROAA and ROAE can be attributed to its poorer credit risk management,
leading to an increase in operating expenses, and subsequently decreasing the ROAE. Poorer
investment choices also led to a decrease in ROAA.
An Analysis on Shenzhen Development Banks Capital Adequacy
To further analyse Newbridges investment, the implications of SDBs capital adequacy need to
be examined. Firstly, their total capital adequacy ratio has declined from 10.6% to 9.5% between
2002 and 2003 as shown in Exhibit 9. This can be inferred from the quality of assets that SDB
invests into; as the quality of assets are lower comparatively, as shown in Exhibit 8; there has
been in increase in NPLs, which means that SDBs credit risk weighted assets has also
increased.
These low capital ratios also signify SDB as not being well capitalised but it is adequately
capitalised according to Basel I standards. An adequately capitalised firm is defined as one
having a total capital adequacy ratio of 8%, Exhibit 9 highlights that SDB has a total capital

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adequacy ratio of 9.5%. While this is currently adequate, this essentially implies if there were to
be sudden changes to regulations regarding holding more capital, SDB would undoubtedly be
required to raise more capital, given they are only just above the minimum capital adequacy
ratio.
If there were to be increases in capital requirement, some methods to increase capital to an
adequate level is to issue more common shares, rights offerings, private placements or through
capital infusions. However, these can have a significantly negative impact on the value of
investments of the issuing company through a problem known as dilution. When any of these
capital raising methods are used, it means previous and existing stakes within the company are
worth less as there would be more capital. Effectively, this in turn implies that the value of
Newbridges stake in SDB would fall, if they were to invest into SDB as their stake becomes a
lower proportion of the company. This also means that the price Newbridge should pay for its
stake should be decreased, given the lower value of the investment.
Evaluation of Newbridges Investment
Given SDBs poor financial performance in our analysis, it would seem Newbridges investment
is completely unjustified. However, another factor needs to be considered before a conclusion
can be reached; the valuation of 1.6 times book value for the stake.
Initially, this value may be seen as inappropriate because the multiplier is 5.5 times as seen in
Exhibit 13, it is the multiplier which can be perceived to be inappropriate. The multiplier is only
this high because SDB has overvalued its shares, because of the supposed increase in investors
wanting to buy a stake into Newbridge and supposedly willing to pay more money for it. Given
this, the 1.6 times book value price seems like an inappropriate valuation.
However, this valuation should be compared with other price to book value ratios of other banks
which have also received foreign investments. CMB Minsheng and SPDB have multipliers of
2.3, 2.2 and 4.9 times respectively. Compared to SDB, these three banks are performing better in
terms of investment decisions and financial performance in some aspects. As shown in Exhibit
10, CMB, Minsheng and SPDB have a lower NPL ratio of 6%, 3.4% and 4.4% respectively
compared to the 11.6% of SDB. Moreover both have higher ROAA values (0.6%, 0.5% and

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0.6% respectively compared to the 0.3% of SDB) and ROAE values (17%, 14.2% and 15.9%
respectively compared to the 9.1% of SDB). Given the relativity of the multipliers, it may even
be plausible to say that 1.6 times the book value could be overvalued given SDBs poor
performance.
Moreover, Newbridge will get a significant controlling stake and the right to appoint CEO and
eight out of fifteen board members, given it receives non-tradable legal person shares. This
means that Newbridge will have a significant say in executive decisions regarding SDBs
investments, and thus the value of their stake may increase significantly if they make the correct
investment choices. The one setback of this is the possibility of stake dilution, capital raising
methods are required. Given that Newbridges stake is non-tradable; it will inevitably decrease in
value unless SDB performs well. Overall, despite the poor performance of SDB, given our
comparison with other banks and Newbridges position of control with the stake, the investment
valuation of 1.6 times the book value for the stake is appropriate.
Conclusion
Despite SDBs declining performance, Newbridges investment of 18% into SDB for the price of
1.6 times the book value is appropriate. Given that Newbridge will have a significant influence
on SDBs decisions; it may be worth their while to invest into it. Given the circumstances of
more people demanding SDBs shares as well, their performance may see improvement. As long
as Newbridge can make the correct decisions regarding investments allowing for higher quality
assets and less non-performing loans, the investment is may definitely be worth it.







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Appendices

Appendix A Tables and Figures
Please refer to the Excel Spreadsheet for how the table and figure were generated.
Table 1
Calculations
SDB's implied LLR level by Reserve Ratios $603.49
LLR level implied by Industry Average $386.04

Figure 1





0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
2000A 2001A 2002A
Historical Trends for ROAA and ROAE
ROAA
ROAE

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Appendix B Exhibits from HBS Case Study: Shenzhen Development Bank
Exhibit 6 SDB Historical Financial Information (Figures in US$ MM)

2000A 2001A 2002A
Income Statement

Total Operating Income 217 313 442

Net Interest Income 209 293 400

Net
SDB's implied LLR level by Reserve Ratios
Fee Income
5 8 9

Other Income 3 13 32

Operating Expense (142) (206) (258)


Pre-Provision Profit 74 108 184

Provisions (14) (40) (116)


PBT 61 67 68

Tax (5) (22) (21)


Net Profit 56 46 47


Balance Sheet

Gross Loans 4,331 6,457 10,159

Reserves (305) (306) (391)

Net Loans 4,025 6,151 9,768

Other Interest-earning Assets 3,497 7,870 9,636

Total Interest-earning Assets 7,522 14,021 19,403

Total Assets 7,522 14,509 19,900


Customer Deposits 6,264 10,442 13,674

Other Interest-earning Liabilities 0 3,200 5,325

Total Interest-earning Liabilities 6,264 13,642 18,998

Total Liabilities 7,058 13,999 19,378


Equity 464 510 521


Source: SDB annual reports.





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Exhibit 8 SDB Historical Loan Breakdown and Reserves

2000A 2001A 2002A
Gross Loans (US$ MM) 4,331 6,457 10,159
Normal 2,915 5,184 8,611
Special Mention 432 285 369
Substandard 338 401 400
Doubtful 627 571 740
Loss 19 17 40

Reserve Ratio Guideline
Normal 0% 1% 1%
Special Mention 0% 2% 2%
Substandard 2% 25% 25%
Doubtful 20% 50% 50%
Loss 100% 100% 100%

Actual LLRs (US$ MM) 305 306 391

Source: SDB annual reports.

Exhibit 9 Selected SDB Historical Financial Ratios

2000A 2001A 2002A
Asset Quality

NPL/Gross Loans 22.7% 15.3% 11.6%
LLR/Gross Loans 7.1% 4.7% 3.9%
LLR/NPL 31.0% 30.9% 33.2%

Capital Adequacy

Tier 1 CAR N/A N/A 5.2%
Total CAR N/A 10.6% 9.5%
Equity/Gross Loans 10.7% 7.9% 5.1%
Equity/Total Assets 6.2% 3.5% 2.6%

Earning Capability

Net Interest Margin
a
3.5% 2.8% 2.4%
Non-Interest Income/Operating Income 3.4% 6.5% 9.5%
Operating Expense/Operating Income 65.6% 65.6% 58.3%
ROAA
b
0.9% 0.4% 0.3%


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ROAE
c
22.4% 9.4% 9.1%

Growth

Gross Loan 17.7% 49.1% 57.3%
Total Asset 45.8% 92.9% 37.2%
Customer Deposit 42.1% 66.7% 30.9%
Net Interest Income 37.6% 40.1% 36.5%
Non-Interest Income -23.8% 171.7% 106.7%
Pre-Provision Profit 67.0% 44.9% 70.8%
Net Profit 246.6% -17.8% 1.8%

Liquidity

Gross Loans/Deposits 69.1% 61.8% 74.3%
Avg. Gross Loans/Avg. Interest-Earning Assets 67.5% 51.1% 49.7%

Source: Compiled from SDB annual reports.

Exhibit 10 Benchmarking SDB Against Other Joint-Stock Banks (2002)



Bank
NPL/
Loans
LLR/
Loans
LLR/
NPL
Tier 1
CAR
Total
CAR
Equity/
Loans
Equity/
Assets
BoCom 16.7% 7.4% 44.5% 6.2% 8.8% 2.2% 2.0%
CMB 6.0% 3.3% 55.0% 8.4% 12.6% 8.1% 3.7%
Huaxia 6.0% 3.3% 56.0% 3.6% 8.5% 4.1% 2.1%
Minsheng 3.4% 1.9% 56.8% 6.8% 8.0% 5.4% 2.9%
SPDB 4.4% 2.8% 64.0% 5.0% 6.2% 4.8% 3.0%
Average 7.3% 3.8% 55.3% 6.0% 8.8% 4.9% 2.7%
SDB 11.6% 3.9% 33.2% 5.2% 9.5% 5.1% 2.6%


Bank
Net Int.
Margin
Non-Int. Inc. /
Op. Inc.
Op. Exp./
Op. Inc. ROAA ROAE
Loans/
Deposits
Loans/
Earning
Assets
BoCom 2.3% 8.6% 55.5% 0.7% 59.2% 62.2% 55.6%
CMB 2.5% 7.7% 53.6% 0.6% 17.0% 68.0% 55.6%
Huaxia 2.5% 5.9% 59.2% 0.5% 27.8% 59.3% 50.2%
Minsheng 2.1% 7.1% 56.8% 0.5% 14.2% 66.9% 52.6%
SPDB 2.4% 12.8% 51.5% 0.6% 15.9% 66.6% 60.1%
Average 2.3% 8.4% 55.3% 0.6% 26.8% 64.6% 54.8%

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SDB 2.4% 9.5% 58.3% 0.3% 9.1% 74.3% 49.7%

Source: Compiled from company annual reports; Goldman Sachs Research, October 6, 2004, May 28, July 29, 2005; Morgan Stanley
Research, August 16, September 30, 2004.

Exhibit 13
Comparable Company Valuation






Market
Cap.
a

Book Value
Per Share
(RMB)
Earnings
Per Share
(EPS)
(RMB)
Pre-
Provisi
on
Profit
(PPP)
(US$
MM)
Price to
Book
(P/B)
Price to
Earnings
(P/E)
Price
to PPP
(P/PPP
)
Bank
(US$
MM)
2002
A
2003E
2002
A
2003
E
2002A
2002
A
2003
E

2002
A
2003
E
2002A
CMB 8,032 2.50 3.20 0.29 0.39 457 2.3 1.8

19.6 14.6

17.6
Minshe
ng
4,338 1.52 2.66 0.19 0.38 216 2.2 1.2

17.5 8.7

20.1
SPDB 5,610 2.25 3.07 0.34 0.40 355 4.9 3.6

32.7 27.8

15.8

Averag
e


3.1 2.2

23.3 17.0

17.8




SDB 2,921 2.22 2.06 0.20 0.23 184 5.5 5.9

61.2 53.2

15.8

Source: Compiled from China Stock Market & Accounting Research Database (CSMAR); Goldman Sachs Research, October 6, 2004, January 5, 2005;
Morgan Stanley Research August 16, September 30, 2004; CICC Research, March 4, 2004.

a
Based on average daily market value in April 2003.