Japan megabanks remain cheap on the market despite recent rally

There's doubt on their growth potential.

Even after a rally in the past few months, Japanese megabanks remain cheap on the market, as skepticism of the companies' growth potential keeps their share prices in check.

According to a research note from SNL Financial, shares in both Mitsubishi UFJ Financial Group Inc. and Sumitomo Mitsui Financial Group Inc. traded at 86.66% of book value as of May 8, while Mizuho Financial Group Inc. was at 83.69%.

The figures represent the lowest valuations among the 25 largest Asia-Pacific bank stocks, far below an SNL Financial index of 173% for banks based in the region with market capitalization of more than US$5 billion each.

Mitsubishi UFJ Financial's stock jumped 32.85% year-to-date through May 8, outperforming an 11.05% gain in the Nikkei 225 index, while Sumitomo Mitsui Financial shares gained 22.45%. Mizuho Financial rose 15.60%.

The rally accelerated after the companies, all of which reported the largest-ever annual net profit in the year ended March 31, 2014, posted financial results showing they are well on track to exceed the banks' forecasts for full-year earnings.

Japanese banks in the past two years have benefitted from a weaker Japanese yen, which boosts the values of foreign-currency assets, and gains from stock holdings, the effects of ongoing monetary easing in the country.

But loan demand in Japan has not picked up much; a chronic challenge Japanese banks are facing in a mature, stagnant economy.

Here's more from SNL Financial:

And even in their record-breaking year, the megabanks, known for their conservative approach to putting capital to use, have lagged far behind their regional peers in profitability, as measured by ROE.

"There are only a few growth opportunities in Japan," Naoko Nemoto, a senior banking analyst at Standard & Poor's Ratings Japan KK in Tokyo, told SNL. "Executives haven't got enough ideas and they are also losing a risk-taking spirit."

The returns on average equity of Mitsubishi UFJ Financial and Sumitomo Mitsui Financial slipped during the 12-month period through March 2014, as Mizuho Financial managed to boost the metric to 9.60% from 9.55%.

Sumitomo Mitsui Financial had the highest ROAE among the three megabanks as of March 31, 2014, but its 10.78% return falls far short of the regional median of 16.28%, according to SNL data. As of the end of 2014, the megabanks' ROAEs ranged from 8.94% at Mizuho Financial to 10.82% at Sumitomo Mitsui Financial.

To survive in a graying society with a low birth rate, such as Japan, companies should focus on profitability and growth, but Japanese companies traditionally prefer stability, Bank of America Merrill Lynch said in a February 2014 report.

"Regarding the megabanks in particular, the most negative aspect is that return on equity is low. Yieldability and capital efficiency are not good. Although their assets are large, profitability is relatively low. Because profitability is quite weak as a bottom line, their valuations remain low. Power to make profit is not strong enough," Takashi Miura, a banking analyst at Credit Suisse Securities in Tokyo, told SNL.

Regional banks generate better returns, partly because they buy back shares frequently. Their price-to-book ratios are also higher than those of the megabanks, Miura said. As of May 8, the SNL Japan Bank index measuring the share prices of SNL-covered Japanese banks relative to book value was 97%, higher than the ratios of the megabanks.

But on the flip side, active share buybacks by regional banks suggest they do not see much growth potential in themselves.

"Regional banks have been always very active when it comes to share buybacks. This is because they are not expecting to grow," Miura said. "What's more, buybacks are the best way to keep stock prices up."

Mitsubishi UFJ Financial also bought back shares for the first time since 2008 from November 2014 through March.

Bank valuations tend to be high in countries where appetite for capital is strong, such as Australia, a developed market underpinned by real estate demand, Miura said. Australian and New Zealand bank stocks as a whole command the second-highest premium to book value, when compared to their peers in South Asia, Southeast Asia, China and Japan, according to SNL indexes.

The top three Japanese banks have been expanding overseas, and earnings outside Japan made up more than 20% of total revenue at all of them at the end of the previous fiscal year. But back home, they are up against a shrinking and aging population, coupled with low interest rates, which cast a shadow on the outlook for banks.

"They are all negative factors for a long-term business model of banks," Miura said.