Guotai Junan International's revenue fell 23 per cent in the first half of 2020 compared with the same period last year, but net profit fell only 5 per cent year-on-year, due to a significant reduction in impairment charges associated with margin financing.

Affected by the COVID-19 epidemic, corporate financing revenue fell 46% year-on-year, but management expects it to recover in the second half of the year.

Our earnings per share forecast for fiscal year 20-22 increased by 17.6-18.6% as a result of an increase in the assumption of average daily turnover and a lower forecast for impairment charges.

To reiterate the "overweight" rating, the new target price is HK $1.58. It is believed that the slight decline in net profit in the first half of 2020 has dispelled concerns about the impact of the epidemic, and the recovery in the second half of the year is expected to be the main catalyst.

Income was dragged down by COVID-19 epidemic in the first half of 2020

Guotai Junan International's revenue in the first half of 2020 fell 23 per cent year-on-year to HK $1.798 billion, of which corporate financing income fell 46 per cent and investment income fell 27 per cent, mainly because these revenues were affected by the epidemic in the first quarter. However, driven by a rise in average daily turnover in the Hong Kong stock market as a whole, the company's transaction commission (excluding placing commission) rose 21 per cent year-on-year.

Net profit fell 5 per cent year-on-year to 605 million yuan, significantly less than income, due to a 92.5 per cent decline in net impairment charges, which are mainly related to margin financing.

Impairment charges are expected to remain low in the second half of the year.

In the past few years, Guotai Junan International has shifted the focus of margin financing from small and medium-sized stocks to large-cap stocks to reduce potential risks. As the adjustment process has been largely completed and the company made substantial impairment expenses last year to solve the problems that have existed in the past, the net impairment charge for the first half of 2020 was only HK $38 million, compared with HK $512 million for the first half of 2019. Due to the improvement in asset quality, management expects impairment charges to remain low in the second half of the year.

Wealth management business promotes margin financing business

Despite the extremely volatile Hong Kong stock market due to the COVID-19 epidemic in the first quarter, Guotai Junan International's margin financing balance increased from HK $11.7 billion at the end of 2019 to HK $13.5 billion at the end of June 2020. Growth is driven by margin financing demand from high-net-worth clients for high-quality stocks and bonds. Although the decline in interest rates caused the interest income of margin financing business to fall by 3.3 per cent year-on-year to HK $350 million, the overall return improved due to the reduction in impairment expenses.

Corporate financing business is expected to recover in the second half of 2020

Revenue from bond underwriting and equity underwriting fell 37 per cent and 78 per cent respectively from a year earlier, as the epidemic in the first quarter affected market transactions. Based on the company's current projects, management expects both bond underwriting and equity underwriting to improve month-on-month in the second half of the year. In particular, full-year performance of the bond underwriting business is likely to be close to 2019 levels. In addition, we believe that as more Chinese stocks go public, the equity underwriting business will benefit.

Some of the market's worries have been alleviated, reiterating the increase in rating.

We believe that before the company reports interim results for 2020, some investors may be worried about the company's market-making and investment business, as the fixed income market fluctuated sharply in the first quarter. As for the fact that the business eventually fell 30 per cent year-on-year to HK $513 million in the first half of 2020, we think it has performed well, given the extreme volatility of market conditions in March. The target price of our Gordon growth model is HK $1.58 (1.04 times 2020 market-to-market ratio; figure 5). With the current price-to-book ratio of 0.77 times lower than the historical average by more than a standard deviation, shares have the potential to receive higher valuations as the company's business is expected to recover in the second half of 2020.