Luzhou Bank's profit growth looks sweet, but could mask souring loans

Key Takeaways:

• Luzhou Bank’s profit rose 23% last year, buoyed by investment gains, even as its net interest income shrank
• While the company’s bad-loan ratio declined, its loans at the greatest risk of default increased

By Warren Yang

Headline numbers often don’t tell the whole story when it comes to a company’s financial performance. This is especially true for Chinese banks, whose earnings reports often require a bit of unraveling to understand what’s happening. Things can be even trickier for China’s hundreds of regional banks, which are often at the confluence of a wide range of competing forces, including serving local powerbrokers while also trying to operate profitably.

Luzhou Bank Co. Ltd.’s (1983.HK) latest financial results are a prime example. A quick glance could lead one to think this regional lender, based in its namesake city in Sichuan province, is faring pretty well, particularly in light of China’s economic headwinds. But a deeper dive into its latest annual report shows it’s hardly immune to the challenges facing its peers.

Luzhou Bank’s net profit totaled 994 million yuan ($138 million) last year, up 23% from 2022, according to the report released last Friday. That looks quite enviable for a Chinese bank, especially in the current economic slowdown that is causing default rates to creep up at many lenders.

Among its peers, Bank of Tianjin (1578.HK) posted far slower 6% growth in its 2023 profit. National giant ICBC (1398.HK; 601398.SH) has yet to disclose its latest annual results, though its bottom line barely improved in the first half of last year from a year earlier.

Granted, ICBC is China’s biggest bank, and Bank of Tianjin is also much larger than Luzhou Bank, making it harder for both to post big growth. But Luzhou Bank actually lagged Bank of Tianjin in terms of total asset growth last year. This leads to questions about how Luzhou Bank still posted such strong profit growth.

Luzhou Bank’s net interest income – typically one of a bank’s main revenue sources – actually decreased about 5% last year, even though the size of its loan portfolio grew. That’s because rates it charges to borrowers declined as China lowered interest rates. But those rate declines improved bond yields, driving up bond prices and the value of Luzhou Bank’s bond holdings. Resulting gains in the value of its investments helped to drive the bank’s operating profit up more than 20%.

The way a bank treats its investment assets in this case worked to Luzhou Bank’s advantage. The bank includes changes in the value of more than half of its investment assets in its operating income, which flows directly into its net profit. Another option for recognizing changes in asset values under international accounting standards is to classify them as “other comprehensive income,” which isn’t included in bottom-line net profits. Banks have some leeway in how they classify their investment assets, which can have a big influence on their net profit.

Bank of Tianjin, for example, took a different approach by excluding a far larger share of changes in the value of its investment assets from its operating profit last year. As a result, its investment income increased far less dramatically than Luzhou Bank’s. All this means Luzhou Bank’s big profit jump last year owed mostly to factors unrelated to its core banking business.

Doubtful loans

In what looks like a similar sleight of hand, the company’s loans seem to be holding up quite well despite China’s weak economy. But a deeper dive into the numbers shows it’s still standing on the same shaky ground as most of its peers.

The bank’s non-performing loan (NPL) ratio declined to 1.36% at the end of 2023 from 1.53% a year earlier. To put that in perspective, the latest figure is much lower than 1.6% for the whole banking sector and 1.7% for Bank of Tianjin, and is on par with ICBC’s ratio at the end of last June. Luzhou Bank’s ability to improve this important metric, even as most lenders’ NPL ratios rose, should also inspire confidence.

But there are some red flags. For starters, Luzhou Bank took a 1.6 billion yuan charge for expected losses for loans last year. That’s up 60% from 2022 and equal to more than half of its net interest income for 2023, suggesting the bank’s outlook isn’t quite as rosy as some of its headline numbers might imply.  

Another warning sign is the big jump in Luzhou Bank’s loans classified as “doubtful” last year, even as its “substandard” loans decreased substantially. The spike means the bank’s volume of souring loans may be growing, possibly as more “substandard” loans were downgraded to the lower “doubtful” category. The bank’s actual loan losses also grew sharply. All told, it’s hard to tell if the quality of Luzhou Bank’s loan portfolio improved last year, and the opposite could quite possibly be true.

Luzhou Bank is focused on business lending, which makes up about 85% of its total loans. More than 35% of its loans come from companies in the construction and real estate sectors, which are coping with a prolonged downturn. That’s reflected in the bank’s 4.8% NPL ratio for real estate loans at the end of last year, which is notably higher than its overall NPL ratio.

Luzhou Bank’s reserves against loan losses are ample, amounting to more than three times the total volume of its NPLs. So it should be able to cope with defaults on its loans without further boosting its provisions for potential loan impairments. That fact, combined with Luzhou Bank’s relatively muted loan growth last year, does seem to point to prudent risk management.

Luzhou Bank’s situation highlights the fine line Chinese lenders are walking these days as they are often forced to give up profit growth to maintain healthy risk levels. Its shares have lost about a third of their value from their 2018 IPO, joining many other Chinese stocks that have fallen out of investor favor. Still, their price-to-earnings (P/E) ratio of 7.5 is ahead of 3.8 for ICBC and just 2.6 for Bank of Tianjin.

At the end of the day, Luzhou Bank is not only profitable but also has been growing its earnings over the years, even if some of that growth may owe to non-operational factors. That sets it apart from a growing field of troubled regional peers like Bank of Jinzhou, which has been bailed out by the Chinese government after years of troubles. But despite its strong profit growth, Luzhou Bank’s latest earnings show the company could also be headed into the same choppy waters as its peers.

This article is from an unpaid external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.