BUY OR SELL-Will Korea banks reflect M&A hope or earnings risks?

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* Top four S.Korea bank shares up 40 pct from March lows

* M&A speculation provides new life to potential target banks

* Valuations near lows, but earnings seen at risk

By Kim Yeon-hee

SEOUL, June 1 (Reuters) - Just as it seemed that South Korean bank shares are set for a sharp pullback after racking up gains of 40 percent over a two-month period, talk of M&A in the sector and a relaxation of capital rules have pushed them higher.

The top four banking firms, KB Financial (105560.KS), Shinhan Financial (055550.KS), Woori Finance (053000.KS) and Hana Financial (086790.KS), have been hot favourites of foreigners. But will the spectre of weakening earnings spoil the party that is being fueled by M&A hopes?

'PAST THE WORST'

Supporters point to their ultra-cheap valuations, despite the recent gains, and stabilising financial markets as reasons why they still offer upside potential. The new rules also reduce the threat of earnings-diluting capital raises, they say.

The top four banks are trading near historical lows of between 0.6 and 1 times their estimated book values. That is lower than the valuations for the top Japanese banks, including Mitsubishi UFJ Financial (8306.T), but higher than those of Citigroup (C.N) and Bank of America (BAC.N).

Seo Young-soo, Kiwoom Securities analyst, said stabilising financial markets mitigate negatives such as weak interest margins and bad loans weighing on South Korean banks by slowing the pace of their formation and prompting companies and households to borrow for investments and home purchases.

A string of better-than-expected economic data lately has fueled optimism that the first quarter was the trough for the banks' earnings and that delinquency ratios and net interest margins will bottom out in the current quarter.

"Their earnings will recover from the second quarter and loan delinquency ratios will start showing signs of improvement," Seo said, adding bank stocks had room to go up further.

South Korea last week lowered its guideline for banks' total capital ratios to a maximum 10 percent from 12 percent. [ID:nSEO342367]. Banks meet the new capital levels comfortably.

The Financial Supervisory Service, the nation's financial services regulator, said South Korean banks had raised enough capital by now and do not need to restrain lending.

"The fact that banks are in no need to raise additional capital indicates they are past the worst," said Han Jeong-tae, Hana Daetoo Securities analyst.

Consolidation in South Korea's crowded banking sector, where 18 banks compete, would help some to gain heft.

State-owned Korea Development Bank (KDB) has said it would buy a rival bank to boost its retail base. A local newspaper reported in May that KDB was interested in Korea Exchange Bank (KEB) (004940.KS), which is 51 percent owned by U.S. private equity firm Lone Star [LS.UL].

There has also been speculation that Hana Financial could be a target for KDB, which is keen to expand its retail base prior to the sale of a stake by the government. There was also talk last week that KB Financial might buy a majority of KEB, currently valued at $3 billion.

TOO EARLY FOR M&A?

Critics say the bad economy will push up bad loans and provisions for them will haunt banks' earnings for many quarters to come. The boost from the M&A fervour is only temporary and shares have only one way to go -- down -- they say.

"It is still too early for an M&A to materialise in the sector given the unfinished corporate restructuring process and high provisioning requirements for the forseeable future," said Grace Oh, an analyst at CLSA Asia-Pacific Markets.

Some also questioned if valuations were as enticing as they seemed to be.

"From a historic standpoint, South Korean banks look cheap, but such a view cannot be justified until profitability reaches the (pre-slowdown) level," said Scott Seo, head of research at J.P.Morgan in Seoul.

"We now believe the sector may go through a few more quarters of depressed earnings before earnings visibility improves. We expect net interest margins to recover very slowly from the bottom and it will take long for them to revert to their level of the fourth quarter of 2008," J.P. Morgan's Seo added.

South Korean banks' net interest margins plunged by 47 basis points to an average 1.91 percent in the first quarter of 2009.

Prudential Investment & Securities analyst Sung Byung-soo said banks' current valuations already reflected an eventual economic recovery. "The sector does not have strong ground to go beyond 1 time book," he said, of bank valuations. (Editing by Muralikumar Anantharaman)