PIVOTAL QUESTIONS		return ↑
Q: When will Banco Macro benefit from higher intermediation? UBS VIEW The short answer is: we believe 2016-17 will be years of adjustment, with real growth starting in 2018. Banco Macro will be one of the early beneficiaries, thanks to its large network of 439 branches, presence in the provinces and focus on the underserved SME finance segment. Moreover, its ample liquidity position helped by its payroll product (loans-to-deposits ratio of 76%), and robust capital base (Tier I: 22.6%) will support organic growth. Moreover, we believe Banco Macro will be one of the consolidators in the banking system. EVIDENCE Loan-to-GDP and deposits-to-GDP of Argentine banks are among the lowest in EM at 16% and 13%, respectively. Other measures of banking intermediation are low. Household leverage of 19.3% is well below other countries in the region. Investment-to-GDP of 18.8% over the past five years is also weak. In our Initiation of the Argentine banks from February 2016, we built a proprietary spider chart comparing Argentine banks to EM peers. Argentine banks fare better in terms of solidity of operations and balance sheets. Once the macro situation improves, select Argentine banks should strongly benefit via increased intermediation and acquisitions. Despite the optimist long-term outlook, Argentine banks have evidenced a low penetration for the past 30 years, and we therefore expect only a gradual improvement in banking penetration metrics. In that context, Banco Macro stands out as one of the most solid banks in the system with a loans-to-deposits ratio of 76%, and capitalization ratio of 22.6%, and a strong network of branches, ideally located in the provinces. Moreover, Banco Macro presents a low currency exposure with just 4% of loans and 7% of deposits denominated in USD, and a low net exposure to the public sector at 4.4% of total assets (vs. 9.5% for the system). WHAT'S PRICED IN? Current prices reflect a strong increase in banking intermediation, with net interest income being boosted by both strong loan growth and persistently high margins. Some investors expect banks to boost lending so that the system normalizes to pre-crisis levels (around 24% in loans to GDP). We estimate that going back to the pre-crisis banking penetration level would imply loan growth of 30% p.a. for the next five years. In our view, real gains in banking intermediation will materialize in 2018 only. For investors, real gains are what matters, as inflation will erode nominal growth through currency depreciation.

Loan growth: short term challenge

The control of inflation will involve a combination of wage mass compression and fiscal discipline.

Inflation has distorted the P&L statements of all Argentine banks, both on the revenues and expenses side. For Argentine banks, the impact has been particularly strong and positive on net interest income. Banks have benefited on both sides of the intermediation equation: with cheap funding cost, and high yields on assets, especially securities.

We show below the ROA decomposition (DuPont analysis) of the three large Argentine banks under our coverage. The high level of margins stands out, when compared to LatAm banks, captured under the Latam Bank Inc. summary.

We believe Macro could sustain a slightly higher margin than Galicia and Frances due to its larger share of SME loans. However, we don’t believe that Argentine banks as a whole can maintain such as large gap versus the Latin American average.

We highlight the high sensitivity of earnings to margin assumptions: every 50bps in margins (NIM) represents 10% in earnings growth in 2016 at Banco Macro, on average.

Inflation has had two positive impacts on banks’ revenues, contributing to their high ROAs:

1) Revenues from float are high, yield on securities exceed 30%, driven by low-cost deposits invested in high-yielding public paper. We expect those revenues to normalize to a lower level in 2016-17, as the cost of deposits rises and the yield of securities decreases. However, we expect only limited compression in lending yields. The Argentine banks are in a similar situation to Brazilian banks in the 1990s. As the rate structure normalized in Brazil after 1994, banks’ revenues depended less on securities and more on lending, leading to meaningful structural adjustment for banks.

2) Select balance sheet items are understated and ROA/ROE are overstated, while revenues adjust with inflation, leading to distorted and high ROAs and ROEs. To be clear, fixed assets represent roughly ~3% of total assets and 19% of total equity at Banco Macro. Inflationary accounting is not allowed in Argentina. At the same time, revenues adjust on an annual basis, leading to a distortion and high ROA levels. As fixed assets are marked to market (potentially in 2018 with IFRS implementation), the asset and equity bases of the banks will rise, leading to lower ROA and ROE levels (as well as lower multiples).

We expect margin compression of 250bps for Macro until 2018. After 2018, the lower funding cost will support some margin expansion again.

We detail below the changes for the 3 drivers of margins: yield on securities, yield on loans and cost of funds.

This suggests that high margins are mostly derived from a low funding cost, and not from abnormal lending yields.

Fee income can offset some of the margin compression

Fee income has been constrained in recent years by more stringent regulations. In particular, until recently, the Central Bank demanded that banks standardize and reduce the types of fees they were charging. Banks were also subject to a preliminary administrative authorization to increase fees charged to individuals. That pre-approval is being removed.

At Banco Macro, fees have come mostly from charges on deposit accounts and debit and credit cards. Overall fees represent 28% of total revenues, a level similar to the average of emerging market banks. A healthy level of fee income should partly offset the compression seen on net interest income.

Is inflation good for banks stocks?

We analyzed the stock performance of Argentine banks in 2000-2004 when inflation decreased significantly. Needless to say, it is impossible to isolate the impact of inflation alone. We derive three main conclusions for the data on Argentine banks:

We observed a similar spike in inflation in 2014 at 41%, according to Banco Galicia and local experts. M2 growth reached 30% in 2014. Argentine banks ADR performance was among the strongest in EM at +79% in 2014 and +47% in 2015.

2016 is different from the 2001-2003 episode insofar as inflation is largely driven by the removal of subsidies and one-off adjustments in prices. Moreover, 2016 normalization in inflation should go hand in hand with GDP contraction.

PIVOTAL QUESTIONS				return ↑
Q: What external events could impact banks’ stocks? UBS VIEW The short answer is: flow events could have a positive impact on stocks, while we expect limited new news on the banking regulatory front. Banking regulations have been meaningfully relaxed in the past months, removing some distortions implemented under the previous administration. We expect a limited impact from new bank regulations (or relaxation thereof). Meanwhile, external flow events could impact bank stocks, such as the MSCI re-inclusion of Argentina into the EM index, and the potential sale of ANSES shareholding. Among forthcoming measures, we would watch for a removal of dividend restrictions, now that the situation with the holdouts is normalized. The new administration that took office on December 10, 2015 lifted a number of restrictions on banking activities that had been implemented in the past few years, such as caps on lending rates and minimum remuneration on deposits. Other restrictions remain: directed lending for SMEs, restrictions on dividends, and restrictions on fees. EVIDENCE In less than 100 days, the new administration removed two emblematic restrictions on banking activity: caps on lending rates for consumers (38-47%) and minimum remuneration on time deposits (24%). This narrows the gap between Argentina and best-in-class countries in the region (Mexico, Peru) for a sound business environment for the banks. Exposure to public assets is low at the privately owned banks at ~15%, while USD assets are also low at 4.8% of total assets. Argentine banks have diversified their revenues, with fee income representing 21% of total revenues. Further relaxation of banks rules could involve dividend distribution or directed lending to SMEs, although we find those changes less likely and less impactful. Flow events such as the MSCI consultation for potential re-inclusion could start in June 2016, for an inclusion in 2017. The potential sales by ANSES (public pension fund) would require the passing of a Law in Congress and could help finance part of the pension deficit. ANSES currently owns 31% of Banco Macro shares, an event we do not expect in the short term. WHAT'S PRICED IN? Current stock prices incorporate a market friendly stance from the new administration. That said, further regulatory normalization and positive flow events could be a positive surprise for markets.
Figure 20: Share of public assets is low			Figure 21: High capital base suggests potential for dividend distribution once restrictions are relaxed
Source: BCRA, UBS			Source: UBS, Company data

Regulations: Moving fast to market-friendly stance

Conclusion: Accounting and capital policies as well as regulations applicable to Argentine banks are mostly in line with other countries.

Accounting policies applicable to Argentine banks are generally in line with LatAm practices. We estimate that risk weights are conservative for the purpose of calculating capital ratios in a LatAm context. In particular we note that all corporate loans have a risk weight of 100% and all consumer loans weigh 75%.

On the flip side, we find that provisioning policies are not as conservative as in other countries. In particular, loans in past due status above one year (classified as unrecoverable) require just 50% in provisions in many cases. Loans need to be 100% provisioned once they have been classified as unrecoverable for at least six months. In contrast, Brazilian regulations require banks to provision 100% of loans in past due status above six months (Resolution 2682).

Regarding BIS III agreements, the Central Bank is still to define the details of the BIS III implementation. We expect no meaningful impact for the private sector banks in terms of capital or liquidity. BIS II was implemented in 2013.

Argentine banking regulations include restrictions to banks. In the past few months, the new administration revoked some emblematic restrictions, namely caps on lending rates (which were set at 37.7%-46.8% depending on the type of borrower), and a minimum rate on deposits (23.6% on CDs with a 30-day maturity). We expect limited new news on the other regulations that still hold:

WHAT'S PRICED IN?		return ↑
		Banco Macro trades on 9x earnings.

Based on conversations with investors, markets have a positive view on the long term potential of structural reforms in Argentina. For banks, most investors expect a strong pickup in loan demand when inflation normalises. While markets expect some normalization in margins, we believe consensus sees high profitability at sustainable in the high 20%. We flag that consensus is not very reliable as coverage remains scarce and there is a wide variation on FX forecasts.

Share price performance and multiples

The table below shows the relative performance of Argentine banks in a Latin American context, as well as the MSCI LatAm Banks and MSCI GEM Banks.

Compare to its own index of the Argentine exchange, Argentine banks (local tickers) also underperformed meaningfully.

Prior to 2016, Argentine ADRs have been among the best performing globally both in 2014 and 2015.

Historical multiples

We indicate below the historical P/E and P/BV multiples of Banco Macro. Similar to other Argentine banks, Macro experienced a strong rerating.

On a forward P/E basis, BMA trades on 9x forward earnings, above its historical average at 6x.

On a P/BV basis, BMA trades on 2.3x book, above its historical average of 1.6x.

The country risk of Argentina has normalized from the very high levels seen in 2013, to be close to 500bps currently.

Argentina currently has the lowest rating in the region together with Venezuela and Brazil.

Markets already price in a sharp adjustment in cost of equity for Argentine banks. In fact in 2015, Argentine banks saw the most improvement in their implied COE, according to UBS proprietary model (based on consensus estimates and the Gordon growth model). The implied cost of equity decreased to close to 11% currently from more than 25% in early 2014. The cost of equity increased to 14% recently.

While earnings and P/E multiples are distorted by current inflation (which boost earnings), book value multiples also have their shortcomings and can be overestimated. We view the equity value of Argentine banks as undervalued, since part of their assets do not adjust with inflation and are carried at historical cost. In a country with high inflation, this can cause large distortions in the balance sheet of the banks and in ROE/ROA measures.

Fixed assets represented 3% of total assets and 19% of total equity at Macro.

IFRS mandates that all assets be booked at their current market value and could be implemented in 2018. This suggests that fixed assets would be revalued at Argentine banks.

Sensitivity. If we had assumed that the value of fixed assets was 50% higher in 2015, the ROE of Banco Macro would have been 34.6% (instead of the reported 36.6%).

UPSIDE / DOWNSIDE SPECTRUM		return ↑
Value drivers Loan growth NIM LLP as % of Average Loans EPADR change from base Sustainable ROE $84 upside 35.9% 13.0% 1.5% 14.7% 24.0% $77 target 27.9% 12.2% 1.6% - 22.0% $55 downside 23.9% 12.0% 1.7% -5.0% 22.0% Source: UBS		BMA is trading at 9x PE16e (as of 30 May).

Our scenarios depend on assumptions in three key lines: loan growth, net interest margin, loan loss provisions

Upside (US$84): Our upside scenario for 2016 assumes loan growth of 35.9%; NIM being increased by 80bps above our base case estimate, to 13.0%; and loan loss provisions (as a percentage of average loans) decreasing by 10bps, to 1.5%. We estimate upside risk to 2016E EPADR of 14.7% to US$7.81, while the derived valuation per share would be US$84.

Base (US$77): Our base scenario for 2016 assumes loan growth of 27.9%; NIM at 12.2%; and loan loss provisions (as a percentage of average loans) at 1.6%. We estimate base to 2016E EPADR at US$6.81, with price target of US$77.

We have a Neutral rating on Banco Macro (BMA) and a US$77 price target for the next 12 months. We derive our price target from a residual income methodology, using a sustainable ROE of 22%, long term earnings growth of 6% and cost of capital of 12%.

We forecast upside of 23% for BMA, which is consistent with our Neutral rating, considering the high risk assigned to Argentine assets. In fact, we assume a market risk premium of 27.9% for all Argentine stocks under UBS coverage (consistent with short term rates). Our cost of equity is based on a risk free rate of 7%, a beta of 1.1x and a market risk premium of 5%.

We forecast all our financials for Argentine banks in local currency, and then translate our valuation into USD to find the fair value of the ADR. We note that the ADR factor is 10x for BMA.

Downside (US$55): Our downside scenario for 2016 assumes loan growth of 23.9%; NIM being decreased by 20bps below our base case estimate, to 12.0%; and loan loss provisions (as a percentage of average loans) increasing by 10bps, to 1.7%. We estimate downside risk to 2016E EPADR of -5.0% to US$6.47, while the derived valuation per share would be US$55.

COMPANY DESCRIPTION	return ↑
Market Cap US$3.6bn Shares Outstanding 58.5mn (ADRs) Industry Banks, Financials Region Americas Website www.macro.com.ar Banco Macro is the sixth-largest bank in Argentina, with nearly 7% market share of loans as of 2015, and a large branch network mostly outside the city of Buenos Aires. The bank's main businesses are retail, especially payroll loans, and SME finance. Macro also offers products to large companies, distributes insurance products, and holds a sizeable credit cards portfolio. The bank has grown over the past decade via organic growth and acquisitions, and is the financial agent of four provinces. It is 39% owned by major shareholders (founding families Brito and Carballo), 31% by Anses and the other 30% corresponds to free float. Banco Macro focuses on low & mid-income individuals and SME finance. The company counts close to 9,000 employees and 439 branches. The bank has a strong presence outside of Buenos Aires, where 93% of its branches are located. Industry outlook 2016-17 will be transition years for the Argentine economy and the banking system, with slight GDP contraction in 2016 followed by a rebound in 2017. We expect real loan growth (above inflation) only after 2017, while the yield curve normalization should lead to lower net interest margins for banks. Argentine banks have strong balance sheets and report some of the highest ROAs globally. We would wait for signs or economic normalization as entry point into the sector.	Loans by type (%) Source: Company data