2QCY21 results reinforce our positive stance on Pakistan Banks. Pre-tax profits were up a modest 11% qoq and 8% yoy but were mostly beats, led by a significantly lower cost of risk with reversals in some cases, rebounding net interest income and normalized fee.
We raise our CY21/22f EPS estimates by 7% on average as we incorporate improved revenue (margins + balance sheet growth) and stronger asset quality. Interest rate increases now appear to be closer on the horizon and can be a key trigger for the sector.
Pakistan banks are at cyclical troughs in terms of margins, loan growth and ROEs. This gives significant room for valuation expansion with the IMS Banks Universe at a c.30% discount to its 5yr average P/B). Top picks are UBL and BAFL.
Multiple positives in 2QCY21 results
2QCY21 results represent a strong beat relative to expectations. Pre-tax profits for our coverage banks are up 11% qoq and 8% yoy, despite currently standing at the bottom of the rate cycle. Margins for our covered banks have flattened at 4.1% in 2QCY21 and the annualized cost of risk remains in check at c. 20bps. This, together with strong balance sheet growth (loans and deposits, up 13% yoy/19% yoy), has lifted ROEs from c.15% in CY20 to c.17% in 1HCY21. The remainder of CY21f should see a continuation of this trend, with room for quicker-than-expected margin expansion if interest rates begin to rise in CY20.
Revenue growth is picking pace
Net interest income has troughed (up 6% qoq), despite margins still facing the effects of the sharp monetary easing in CY20. Sequential NII growth is a function of sharply higher deposit growth of 18% yoy this year vs. previous 5yr average growth of 13% yoy. With Pakistan’s economy moving from stabilization to growth, loan growth has also picked up to 16% yoy from just 2% yoy in CY20. We expect revenue to continue growing quickly, particularly as margin expansion comes through. Normalized fee income – in the absence of strict lockdowns – should offset any reduction in realized capital gains.
Asset quality fears have been unfounded
Most banks in our coverage chose to build discretionary general provisions in CY20 at the outset of Covid-19 and raised asset quality concerns. However, with the government and SBP taking swift measures encompassing targeted lockdowns and liquidity infusion, these fears proved unfounded. A single large account had an industry-wide impact, but this was unrelated to Covid. There has been no new NPL formation in 2QCY21, total coverage stands at 101% and banks are now gradually reducing their stock of Covid-related provisions (0.7% of gross loans). We estimate a modest c.20bps cost of risk for CY21f.
Valuations are at trough levels
All three of margins, loan growth and ROE are projected to expand through the cycle, which should have a positive impact on valuations. The IMS Banks Universe trades at a c.30% discount to its 5yr average P/B; this discount increases to c.45% ex-MEBL. Forward P/E of 5.4x also stacks up well against 3yr projected earnings growth of 14%, while several banks offer double-digit D/Ys. Our top picks are UBL and BAFL. The former’s earnings and return metrics should significantly improve, as its Middle East portfolio stabilizes, while the margins for BAFL are more sensitive to rising interest rates. HBL and MCB may see selling from foreign passive funds near-term, due to the reclassification to FM, but this would be an opportunity to add these names, in our view.
Regulatory risk has greatly materialized
Pakistan banks already face an effective tax rate of c 40% (35% normal tax + 4% super tax + higher marginal tax depending on investments and ADR). Directed lending has been mandated for Construction (5% of private sector credit), and the introduction of the Single Treasury Account and IFRS 9 – although implementation is still pending – are no longer surprises and in line with global standards. From this vantage, it is difficult to see further regulatory tightening coming through, such that it impedes ROEs and valuation rerating.
(i) Inability for the economy to sustain the transition from stabilization to growth, (ii) Covid resurgence, (iii) punitive regulatory tightening.
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