We assume coverage of Philippine banks, with a recommendation to take selective positions. We are OW on MBT and PNB; and Neutral on BPI, BDO, and SECB.

We expect 8.7% average RoE over the next two years vs. 10.7% during 2014-19.

These low returns could limit stock price upside, despite muted YTD performance (-7% vs. PSEi -3%) and reopening expectations. We have three main concerns: (1) intensifying digital competition will force banks to increase spend, limiting operating leverage; (2) asset quality risks persist, particularly in middle market and consumer; and (3) we do not expect mean reversion on PB, given lower expected RoE vs. history. MBT is an exception. Valuations look undemanding, while asset quality and capital management outcomes should deliver a positive surprise, and drive a re-rating.

 We expect the banks to increase operating expenses, despite low profitability, as digital competition forces their hand (details on pages 9-18).

We expect ~30% tech spend CAGR over the next 2Y, leading to 8% overall cost CAGR vs. 3% in the last 2Y. High cost density with 2.6% cost/assets (vs.

ASEAN at 2.1%) and low PPoP RoA of ~190bps has limited the ability of banks to spend in the past. This is now changing, with six digital banks approved to launch and compete, and more to follow. FinTechs have also moved to offer deposits, loans, and insurance, with various partners.

 We expect 8.7% RoE for the banks in 2022-23 vs. 10.7% during 2014-19.

During this period, the banks delivered just 4% EPS CAGR on a 15% loan CAGR. Going forward, we expect lower returns driven by higher digital spend, while structural factors remain: (1) excess liquidity limits pricing power, primarily on corporate; (2) inadequate operational infrastructure leads to manual and personnel-driven processes, and higher costs; and (3) lack of data from credit bureau drives higher underwriting, monitoring, and collection costs.

 Philippine banks are a consensus buy, as the stocks are trading ~1SD below 5/10Y averages on PE and PB, with expectations of mean reversion as the economy reopens. We disagree. We believe the stocks are fairly valued at current levels, in most cases. Banks traded at 1.45x PB for 11.7% RoE in the last 10Y, due to the promise of multi-year growth, with no asset quality issues. This is no longer the case, given risks to asset quality following prolonged lockdowns, higher costs, and limited NIM expansion. Furthermore, we see limited upside to Street EPS estimates, despite improvements in 2022-23.

 MBT is our preferred pick, as we expect asset quality and capital management to drive a re-rating. BPI and BDO should see meaningful increases in digital spend over the next 2Y. This offsets the revenue upside potential in the near term, but could lead to improved efficiencies beyond our forecast horizon.

Further, higher restructured loans at BDO suggest risks to asset quality. In our view, SECB offers value, but consistent disappointments on asset quality and a potential increase in bond yields limit re-rating catalysts, for now. We hold OW on PNB as a deep-value play.