Equity Group (Buy, TP: KES 46.00) released disappointing Q1 20 results with EPS falling 14% yoy on higher cost of risk (3.2% in Q1 20 vs. 0.5% in Q1 19). This reflected a decline in asset quality in Tanzania, South Sudan and Kenya where the NPL ratio was 40.5%, 40.8% and 10.5%, respectively. In our view, NPL levels are likely to get worse even with Tanzania offering room for write-offs later in the year. Operating expenses increased 16% yoy with salary cost accelerating 23% yoy. This was a surprise considering the bank has already reduced staff numbers back in 2018 and has continued with natural staff attrition both in 2019 and 2020. Meanwhile, non-interest income grew 16% yoy riding on fees income from higher loan issuance and growth in alternative channel income.
Equity Group is trading at a current PB of 1.1x against Q1 20 ROE of 18.7%, which we still consider an attractive discount. We have a Buy recommendation and a target price of KES46.00. The bank is trading at a premium to the sector, which is trading at an average 0.9x. We believe the current premium is justified by the bank’s advanced alternative channel which delivers higher-than-sector fees income to total income contribution of 27.2%. Equity Group also consistently delivers higher-than-sector deposit growth from its large retail market share, which provides a cheap source of funds. Additionally, the bank’s net interest margin post-rate cap is expected to be higher than the sector's with loan yields on SME and retail loans being higher than other loan classes. We note that the premium accorded to Equity Group has fallen from the earlier average of 40% to the current 22%, and we believe this retraction acknowledges the consistent weakening in asset quality, which dampens the bank's outlook.
- Low loan book growth on account of Covid-19 impact. Management's deposit growth target of 6-12% might be achievable on the lower band on account of high retail market share. The risk to achieving the 6% yoy FY 20 deposit growth comes from lower disposable income in the country following the partial lockdown, reduced business hours and job losses.
- NPL ratio is already above management's target of 7.5-9.0% for FY 20. We expect asset quality to remain weak with even write -offs from Tanzania unlikely to be enough to cover expected weakness.
- Though fees and commission income growth for the sector is expected to be dampened by the regulatory cut in fees, we still believe Equity Group is least likely to be affected as the bank already offered a number of free transactions and is the least reliant on Safaricom for transactions. Also, the bulk of transactions are bank-to-bank within it’s own network rather than bank-to-M-Pesa, which is the case for most other banks.
- Net interest margin is expected to decline following recent cuts in the central bank rate on which old loans are priced.
- Non-funded income grew 16% yoy. Notably, mobile banking now accounts for 27% of transaction value in the bank compared to 23% in Q1 19. This boosted the 12% yoy growth in fees and commission income. The bank has sustained transaction and volume growth, which boosted the contribution of fees income to total income by 27.3%, one of the highest levels in the sector. Even with the cut in fees, we expect the bank to glean some transaction growth as clients move away from cash due to Covid-19. This shift in habit is set to deliver income growth in the future as customers are unlikely to revert to cash.
- Strong balance sheet growth with loans and deposits growing 24% yoy and 14% yoy, respectively. We, however, believe this is a one-off for the quarter and is unlikely to be repeated in the coming quarters. Equity Group customers are mainly in the lower-end retail segment and SMEs who have been affected the most by Covid-19. We expect the bank to record minimal loan book growth with deposit growth set to be dependent on income levels of clients.
- High cost of risk of 3.2% from 0.5% in Q1 19, which mirrors the weaker asset quality. There was notable weakness in South Sudan where NPL ratio rose to 40.8% in Q1 20 compared with 15.5% in Q4 19. With much lower trade opportunities on account of Covid-19, we do not expect recovery within FY 20. Elsewhere, Tanzania NPL ratio increased to 40.5% from 38.1% in Q1 19 (we consider Tanzania as the highest-risk country in East Africa in terms of Covid-19, and we expect the situation to worsen, with the current policy or lack of it proving counter-productive) and Kenya NPL ratio rose to 10.5% from 8.2%. While we expect asset quality to weaken further, the regulator has allowed banks to restructure loans, which will soften the impact of weaker asset quality
- Operating expenses grew 16% yoy. Staff costs increased 23% yoy, which was surprising to us considering the bank has been having natural attrition on staff numbers.
- Continued cuts to the central bank rate would impact margins negatively.
- Protracted Covid-19 period would adversely affect business operations.
- Locusts infestation will increase the risk of food shortages.
- Continued floods from heavy rainfall will impact harvests.