Pakistan’s reform story has been damaged by disruptive politics amidst high commodity prices. Investor interest in equities has accordingly waned, with the KSE100 losing 19% CYTD in US$ and daily turnover reducing to just US$40mn. The new ruling coalition is settling in and taking corrective measures on the economic front, but more holistic reforms are likely on hold until the next general elections due in about fifteen months. That said, the resumption of the IMF programme can be a major catalyst for the market, as has been the case in the past, leading both the KSE100 and the PKR to recover lost ground in the near-term. Politics may remain noisy but this is offset by distressed valuations. More than twenty stocks on the KSE100 already trade at or below their Covid lows. From this list, we like HBL, OGDC and AGP best.
A Budget with an eye on the IMF
Pakistan’s current IMF programme began in 2019 but compliance has been wayward in the last twelve months. The new ruling coalition is now taking the tough steps necessary to resume the programme, including monetary tightening and a reduction in fuel subsidies. The FY23 Budget, due this Friday, is expected to usher in further fiscal discipline, with follow up talks with the IMF likely to conclude in a staff level agreement in our view. As per news reports, the FY23 Budget could include:
Tax collection target of PKR7.25tn, higher by c 20% versus the revised target of PKR6.10tn in FY22
Extra tax on sectors making windfall profits e.g. banks
A fixed and final tax rate on retailers
Personal income tax reforms that could see higher income brackets face more taxation
Luxury tax on immoveable high-value assets and high-end cars
The KSE100 has continued to come down in June, with the market pricing in what it anticipates will be a tough FY23 Budget. We believe there is room for the KSE100 to rebound post budget announcement, as the IMF programme draws near and corporate profitability has greater visibility. More equitable taxation between real estate and other asset classes, as is being reported, may even encourage domestic funds flow towards equities.
Valuations are distressed, mean reversion holds big upside
The KSE100 has shed 7% CYTD (19% in US$ terms) to trade at a market capitalization to GDP of 12.9% (old GDP base). This is the same as the Covid low of 12.9%, when the Index bottomed at 27,229 pts in March 2020. Valuations are higher than the global financial crisis’ trough of 11.7% of January 2009, but this may not repeat as it came about in a burst of heavy selling pressure right after the 4-month Index price freeze was lifted. A market capitalization to GDP of 11.7% would imply a bear-case Index of c 38,000pts, about 8% lower from last close but unlikely to be hit in our view. Instead, we see the coming macroeconomic stabilization as a strong enough catalyst to lift the KSE100 in the near-term. This can also coincide with better PKR performance, with the REER already near 95.
Catalysts are lined up: IMF, Bilateral Support, FATF
Clarity is slowly coming through, with the new PML-N government settling in and taking the necessary tough decisions to stabilize the economy. Pakistan has significantly reduced fuel subsidies in the last few weeks, as required by the IMF, and the upcoming FY23 Budget can help resume the stalled EFF programme in the follow up staff-level talks. This can unlock other funding, including bilateral support from Saudi Arabia and loans from Chinese banks, enabling quick Fx reserves buildup and some respite for the beleaguered PKR. Positive surprises from next week’s FATF review are also possible, given Pakistan has reportedly completed all 27 of its assigned action points. The Imran Khan factor will likely keep politics noisy, but default on international obligations should be avoided and we believe this alone is enough for the KSE100 to recoup some of its CYTD losses.
Stocks at or near Covid lows
More than 20 stocks on the KSE100 trade below or at their Covid lows. From this list, we like HBL, OGDC and AGP best.
· Pakistan’s largest bank by branches and assets but only 4th largest by market capitalization
· HBL maintains leadership in traditional fortress businesses while making digital banking a focal point
· 1Q22 EPS of PKR5.78 (+2%yoy) was inline if adjusted for one-off VSS charges
· Core revenue growth is impressive and next 3yr EPS CAGR is projected at c 20%
· CY23f P/B is 0.4x vs. mid-cycle ROE of c 16%, P/E is about 3x, and the D/Y is nearly 10%
Oil & Gas Development Company
· Pakistan’s largest oil exploration company, owned by the government
· Has suffered from circular debt but can be a key beneficiary of energy reforms under the IMF
· Has continued to focus on its exploration plan, despite the circular debt issue
· 3QFY22 EPS nearly doubled yoy to PKR10.03. Dividend yield is decent despite constraints
· Trades at a forward P/E of 2.5x and EV/EBITDA of less than 1.0x.
· Major pharmaceutical company in Pakistan that has partnered with Mylan USA (generics)
· Revenue growth slowed to 7% in CY21 (possibly reduced Afghanistan sales) but up 52% in 1Q22
· Drug pricing is linked to CPI (with caps). GMs have sustained above 50% despite PKR weakness
· 1Q22 revenue and profits annualize to P/S of 1.5x and P/E of 9.9x
· The discount to 3yr average P/E currently stands at a wide 27%