Equity Analysis /
Pakistan

Pakistan Banks – Switch to large banks

    Raza Jafri
    Raza Jafri

    Executive Director, Research

    Yusra Beg
    Yusra Beg

    Senior Investment Analyst

    Intermarket Securities
    29 May 2019
    • Q1 19 results reinforce our positive outlook on the banking sector. Pre-tax profits are up by 35% yoy on strong margin expansion, while the cost of risk remains in check. Reported profits are flat, but this is due to the one-off retrospective impact of the super tax on 2017 earnings. Share prices of our covered banks have turned the corner since last week, and we remain bullish.
    • In this report, we incorporate Q1 19 results, new interest rate assumptions, 1ppt increase in the risk-free rate to 12%, and a target price rollover to Dec’20. Our 2019 and 2020 EPS estimates are up by 7% and 2%, respectively but our target prices see little change due to the offsetting impact of the higher risk-free rate. We have three Buys and three Neutral ratings, with our preference tilted towards large banks. 
    • Adjusted for the 2017 super tax, the ROE for our covered banks comes to 14.3% in Q1 19, up from 9.5% in H2 18. We believe this represents a key inflection point, ahead of a secular uptick in ROE to 19%-20% by 2023f. HBL, UBL and MCB offer the strongest lift in ROEs across the cycle, which stack up well against their valuations (28%-56% discount to previous five-year multiples on both PB and PE). 

    Multiple positives in Q1 results
    Q1 19 results represent a strong beat of expectations, except for MEBL which posted in-line earnings. Pre-tax profits are up by 35% yoy and support our theme of margin expansion more than offsetting a higher cost of risk. Margins for our covered banks have increased by c40bps to 4.25% and the annualised cost of risk remains in check at just 7bps (12bps ex-MCB). This has helped to counter a slowdown in both loan and deposit growth, at 14% yoy and 8% yoy, respectively, in Q1 19. Normalised ROE rose to 14.3% in Q1 19 from 9.5% in H2 18, which represents an important turning point, in our view. We expect ROEs to build on the platform set in Q1 19 and expand to 19%-20% by 2023f.  

    Higher interest rates lead to revised estimates
    The 150bps increase in interest rates earlier this month has brought rate hikes in the last 18 months to 650bps, with the discount rate now standing at 12.75%. Given that real interest rates stand at +3.5% to +4.0% (measured against April 2019 CPI), monetary tightening may be over. However, interest rates may not begin to come off in the next 9-12 months. We thus raise our average discount rate assumptions for 2019/20f to 12.0%/11.8%, from 11.0%/10.7% previously. This feeds into our 2019/20f EPS estimates rising by 7%/2%, with stronger margins more than offsetting the impact on loan growth (slower), cost of risk (higher) and admin expenses (higher). We also increase our risk-free rate by 1ppt to 12% and rollover our target prices to Dec’20. These offset each other, leading to only a small change in our target prices. 

    Larger banks are positioned better
    The margins of medium-sized banks such as BAFL and MEBL are most sensitive to rising interest rates. However, with interest rates at a cyclical high and the margin expansion theme already priced in, large banks such as HBL, UBL and MCB appear to be in a much better position, in our view. This is due to (i) better outlook for domestic asset quality, (ii) strong deposit franchises that should shield CASA, and (iii) alleviating bank-specific issues of the last few years. With the larger banks trading at a 28%-56% discount to their previous five-year valuation multiples, in contrast to a premium for the medium-sized banks, we recommend switching to the larger banks for the rest of the year. 

    Regulatory risks appear manageable
    The income tax rate is already 39% (a 4% super tax has been made permanent for banks) and a further increase is not our base case scenario. Similarly, with conventional savings deposits now offering at least 10.25%, we believe there is no need to increase their rate floor. IFRS 9 and TSA may come through in the next few years, but phased implementation is likely.