Southwest Securities:Decent performance in brokerage,but reliance on investments needs to be addressed

In brokerage, a shift to wealth management; investments under pressure.

    In response to intensifying competition, Southwest Securities has been actively buildingup its wealth management franchise with an emphasis on high-end bespoke services.

    Since 2014, its market share in brokerage and margin lending has held steady at~0.80%. Meanwhile, its commission rate has fallen by less than the industry average,coming in at 0.043% in Q116. With its focus on Chongqing and its shift toward wealthmanagement, we think the company can successfully defend its market share.

    However, investment income accounts for a high share of revenue (2015: 46%). InQ116, the company recorded Rmb1.37m in investment losses, and held-for-trading andavailable-for-sale financial assets represented 42% of total assets. We believe thecompany must swiftly address its high reliance on proprietary trading investments.

    Received notice of CSRC investigation, but direct penalties likely to be minor.

    Despite Southwest's strength in investment banking, the company was notified of aCSRC investigation on 23 June. According to SINA Finance, the investigation may berelated to information disclosure violations in a transaction involving Dayou Energy.

    Southwest and Central China Securities were joint lead underwriters for Dayou Energy'sprivate placement in 2012. The total amount underwritten was Rmb7,539m, withRmb159m in issuance costs. Based on the CSRC's Rmb23.6m fine imposed on DayouEnergy in 2015, we expect direct penalties to be minor, but indirect losses could totalRmb100-200m due to the temporary suspension of its investment banking activities.

    Lowering 2016-18E earnings on weak market activity and fiercer competition.

    We are downgrading our 2016-18E EPS 35%/23%/16% to Rmb0.29/0.39/0.46 basedon the following: 1) we are lowering our 2016-18 core sector assumptions (ADT andaverage margin lending balance); 2) we are lowering our 2016-18E investment yield forthe company, given an overall drop in investment yields; and 3) the aggregate NPAT (atthe parent company level) of Southwest was Rmb605m in 5M16.

    Valuation: New Rmb7.94 price target; upgrading to Neutral.

    We are changing our valuation method to PB/ROE given industry characteristics.

    Assuming a stable market, we estimate average ROE of 10.6% in the next 5 years andlong-term sustainable ROE of 11.0%. We derive our new Rmb7.94 price target byapplying 2.30x P/B to our 2016E BVPS, implying 20.3x 2017E PE and 2.08x 2017E P/B.

    We believe Southwest is fairly valued and upgrade the stock to Neutral.