back on the earnings growth track*1 october 2018 · 2019f, reversing the trend of margin...

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Research Entity Number – REP-085

Back on the earnings growth track*

We shift to a more bullish view on Pakistan banks after the recent selloff,

and forecast c30% earnings growth in 2019f and medium-term sector ROE

expansion (to 18% n 2022f from 11% in 2018f). Pakistan is one of our

favoured banking markets globally. The share prices of our covered banks

have shed c20% since April 2018, with one-offs such as pension fund top-

ups negatively impacting H1 18 results. Lagged margin expansion leads

us to cut our 2018f EPS forecasts by 3%. We also take a more conservative

stance on loan growth in 2019f, but this should be more than offset by a

c40bps rise in margins. This, together with valuation rollover to Dec 2019,

leads us to raise our TPs by 9-11%. We have 4 Buys and 1 Hold rating (MCB).

We prefer BAFL and UBL, but for differing reasons. BAFL (Buy, TP

PKR60) is showing profitability metrics similar to large banks (c17% 2019f

ROE), but trades at a 13-24% PB/ PE discount to the top three banks. Our

liking for UBL (Buy, TP PKR198) is based on c50% EPS growth in 2019f,

which does not appear to be priced in (2019f P/B: 1.1x, P/E: 7.6x). HBL

(Buy, TP PKR193) and ABL (Buy, TP PKR126) also trade at attractive

valuations, but are lower down the pecking order due to regulatory risk and

low stock liquidity, respectively. We have a Hold rating on MCB, where

positives (margin expansion, superior asset quality, strong capital base)

are balanced by its 25%+ PB and PE valuation premium to closest peers.

Pakistan is in the midst of a macroeconomic adjustment phase that

has seen interest rates rise by 275bps this year (the discount rate is now

9.0%), and the PKR/US$ exchange rate slipped by 18% since mid-Dec

2017. We expect the discount rate to reach 10.0% by Dec 2019. This would

lead to c40bps NIM expansion in 2019f but would negatively affect loan

growth. We trim 2019f loan growth by 1.3ppt to 10.7%. 2019f credit costs

remain at 30bps, but rise to 50-60bps on average over the medium term.

Sector ROEs are at the cusp of an inflection point, in our view, as after

more than four years of steady declines to 11% in 2018f, we expect secular

ROE expansion to 18% in 2022f. Accordingly, P/B multiples should start

to recover given that UBL, HBL and MCB trade more than one standard

deviation below their 5-year historical PB range. However, regulatory risks

are more pronounced for UBL and HBL compared to peers.

Table 1: Investment summary table (PKR)

Target

Price Rating* ETR

2019f

EPS

2019F

P/E (x)

2019F

P/B (x)

2019f

ROE

ABL 126 Buy 35% 13.73 7.25 1.00 14.1%

BAFL 60 Buy 25% 7.62 6.60 1.04 16.7%

HBL 193 Buy 35% 18.19 8.16 1.04 13.3%

MCB 228 Hold 22% 20.36 9.81 1.42 14.9%

UBL 198 Buy 34% 20.30 7.56 1.08 14.6%

Source: IMS Research

* This Pakistan banks update is the fifth in a series of joint reports from Exotix

Capital and its research partner in Pakistan, Intermarket Securities (IMS), as

we bring together our coverage. This report discontinues Exotix’s independent

coverage of ABL, BAFL, HBL, MCB and UBL. The changes in forecasts and

ratings cited are changes from IMS’s previous forecasts and ratings.

PAKISTAN BANKS

1 October 2018

ASIA BANKS

Contact:

Raza Jafri, CFA

+92 213 5155126

[email protected]

Yusra Beg

[email protected]

Rohit Kumar

[email protected]

www.jamapunji.pk

mailto:[email protected]

mailto:[email protected]

https://jamapunji.pk/

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PAKISTAN BANKS

Contents

Executive summary 3

Our recommendations 4

Changes to our recommendations & forecasts 5

Key drivers of the changes in our estimates 5

Sector outlook 6 Pakistan banks in frontier context 7 Strong margin expansion as interest rates rise 8

Loan growth to decelerate but not by much 10

Asset quality is strong and should remain so 12

ROE expansion to drive valuation rerating 14

Valuation methodology 17 Risks 18

Individual banks

BAFL: Turning weakness into opportunity 20

UBL: Back on track from next year 22

HBL: Looks good under a far-sighted lens 24

ABL: Well placed 26

MCB: Positives are in the price 28

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PAKISTAN BANKS

Executive summary

Table 2: Pakistan Banks – Mapping key investment themes

Rising

interest

rates

Slowdown in

loan growth

Rising cost

of risk

Rising capital

requirements

Valuations

ABL

BAFL

HBL

MCB

UBL

Note: green = attractive; yellow = neutral; red = unattractive


Rising interest rates will lead to margin expansion. An ongoing macroeconomic

adjustment has seen interest rates rise by 275bps this year (discount rate is now 9.0%),

and the PKR/US$ exchange rate slip by 18% since mid-Dec 2017. We expect the

discount rate to reach 10.0% by Dec 2019. With asset re-pricing taking place with a 3-

6 month lag, and savings deposits re-pricing almost immediately, the impact of rising

interest rates on margins will be visible in 2019f. We see NIMs expanding by c40bps in

2019f, reversing the trend of margin contraction in place after 2015. We expect UBL

and ABL to record c3.0% NIMs in 2019f vs c4.0% for BAFL, HBL and MCB. ABL should

show the best NIM expansion over the medium-term, while UBL may lag behind.

Loan growth will decelerate but not stall. Private sector credit growth has

accelerated to c19%yoy in H1 18, but pressure points are becoming visible. Long-term

fixed investment loan growth is decelerating to 15% yoy, credit to the SME sector is

now growing at just 6% yoy (vs 27% yoy growth in 2017) and consumer loan growth is

also likely to come off from the current c20% yoy run rate as interest rates rise and

demand slows (e.g. higher auto prices). While we retain our view of long-term credit

expansion in the economy (Loans/GDP is c20% vs almost 30% in 2007), we see loan

growth settling down at a slightly lower clip over the next few years. We now expect 2019f

loan growth for our coverage banks of 10.7% versus our earlier estimate of 12.0%. Our

revised CY18-21f loan growth CAGR is slightly lower at 11%, versus 12% earlier.

A shock to asset quality appears unlikely. The NPL ratio has improved to 7.8% in

H1 18 vs 12%+ in 2014. Importantly, the coverage is more than 85% for the system

and, for banks in our coverage, stands at more than 90% (ex-UBL). We see a fresh

NPL formation cycle from 2019, which should lead to a higher cost of risk over the

medium term. That said, it is difficult to see significant deterioration in asset quality

given: (i) top-tier corporates are resilient; (ii) consumer loans are just 5% of total loans

and tilted towards secured products; and (iii) overall lending standards have improved

with better credit information now available. After reversals in 2018f, we see cost of risk

peaking at 50-60bps (average for covered banks) in 2020f vs 100-150bps across 2008-

11 (aftermath of the global financial crisis). These estimates may be impacted by

potential IFRS 9 implementation from 2019f, but we think our overall thesis of resilient

asset quality will remain intact. We view ABL as being best placed on asset quality,

while BAFL’s SME & Consumer exposure may lead to relatively higher credit costs.

We expect ROEs to depict a secular uptick beginning 2019f. For our coverage

universe, ROE increases from 11% in 2018f to 18% in 2022f, with margin expansion to

counter a higher cost of risk. Projected ROE increases will be driven by ROA expansion

where, in general, we see reduced reliance on leverage. We see the likelihood of lower

cash payouts, due to both higher capital requirements for systemically important banks

(D-SIBs) and changes in tax rules removing tax on bonus share issuances. As a result,

we see banks reverting to a mix of cash and stock payouts.

Valuations have room to expand. Most banks in our coverage trade at 1.0x 2019f PB.

This is lower than justified, in our view, given our projections that ROEs should expand

over the medium term and cross CoE. We note that UBL, HBL and MCB trade more

than one standard deviation below their 5-year historical P/B range. We think the market

has been quick to penalise banks for weak 2018f profitability, but is now ignoring

prospects for profit and ROE normalisation over the medium term.

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PAKISTAN BANKS

Our recommendations

Table 3: Investment summary (PKR)

Target price Rating ETR 2019f EPS 2019F P/E 2019F P/B 2019F D/Y 2019F ROE

ABL 126 Buy 35% 13.73 7.25 1.00 8.0% 14.1%

BAFL 60 Buy 25% 7.62 6.60 1.04 6.0% 16.7%

HBL 193 Buy 35% 18.19 8.16 1.04 5.4% 13.3%

MCB 228 Hold 22% 20.36 9.81 1.42 8.0% 14.9%

UBL 198 Buy 34% 20.30 7.56 1.08 5.2% 14.6%


Bank Alfalah Limited remains our preferred pick given it is well placed to benefit from

rising interest rates (high proportion of current accounts and a domestic-driven book).

Management’s focus on cost control is already showing results, with H1 18 admin

expenses down 3% yoy. At the same time, the capital base has been strengthened by

issuance of PKR7bn Additional Tier 1 capital (ADT-1), which enabled a dividend in H1

18, the first interim payout since 2005. We like the clear tilt towards profit maximisation,

even if it comes at the cost of slower balance sheet growth. For us, BAFL is now firmly

a large bank in all but valuations – a 13-24% PB/PE discount to the top three banks

leads us to upgrade BAFL to Buy from Hold, with a new TP of PKR60 vs PKR54

previously).

United Bank Limited is having a very difficult 2018f, but this is due to a large pension

fund top-up as well as an overdue loan book clean-up in the GCC. We do not expect

these factors to spill over into 2019f, implying UBL is well placed to depict more

normalised profits from next year (although the risk of a fine in New York cannot be

ruled out). The new CEO brings with her a strong retail banking background, where we

expect greater focus on both CASA deposits improvement and cross-sell. UBL’s fee

income has taken a hit due to the slowdown in trade and remittance business, but 9%

yoy fee growth in H1 18 indicates a corner has been turned. UBL trades at attractive

multiples (2019f P/B: 1.1x, P/E: 7.6x) and has better earnings visibility compared to

closest peer HBL, in our view. We have a Buy rating on UBL with a target price of

PKR198, up from PKR181 previously.

Habib Bank Limited is also having a tough 2018f but, unlike UBL, may see sub-optimal

profitability extending into 2019f. This follows unhedged exposure on FX borrowing to

settle last year’s US$225mn fine in New York and a bank-wide business transformation

program that is initially adding to costs. The risk of another fine in the New York branch’s

expanded look-back is also there (in addition to the 2017 fine, HBL has had to engage a

consultant to go through the branch’s clearing activity from 1 Oct 2013 to 31 July 2017).

Nevertheless, we believe valuations (2019f P/B: 1.0x, P/E: 8.2x) are very attractive,

particularly as the bank’s domestic franchise is highly profitable. As profitability metrics

normalise across the medium term, HBL’s valuations have most rerating potential, in our

view, given that the stock trades at a 33% discount on P/B to its previous 5-year valuation

range. Our new target price for HBL is PKR193 vs PKR175 previously.

Allied Bank Limited has seen profitability and return metrics deteriorate as interest

rates and hence margins came off. This led to declining earnings (2014-17 CAGR was

-5%) as ABL retained a conservative loan growth policy. However, with interest rates

now rising, this strategy should benefit ABL, through a combination of rising margins

and limited impact on asset quality. We forecast a 3-year (2018-21f) earnings CAGR at

17%. A very strong balance sheet (CAR: 22.3%) also implies prospects for sustained

high cash payouts, which enables ABL to stand out relative to peers. Our revised target

price is PKR126 vs PKR100 previously.

MCB Bank Limited is best-in-class among peers given its: (i) superior asset quality;

(ii) strong capital base; (iii) efficient cost structure; and (iv) growth prospects from its

Islamic banking subsidiary. However, these positives appear to be largely priced in

already, as MCB trades at a 2019f P/B of 1.4x and P/E of 9.8x, comfortably the priciest

valuation set in our coverage. Moreover, the earnings outlook over the next one or two

years depends greatly on recoveries from NIB’s loan book, which will be more

challenging in the new macroeconomic setting (higher interest rates). We have a Hold

rating on MCB with a target price of PKR228 vs PKR207 previously.

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PAKISTAN BANKS

Changes to our recommendations & forecasts

Table 4: IMS target prices and ROE forecasts, new vs old (PKR)

Old rating New rating Old TP New TP % chg

Old 2018f

ROE

New 2018f

ROE

Old 2019f

ROE

New 2019f

ROE

ABL Hold Buy 115 126 9.6% 12.3% 11.8% 13.5% 14.1%

BAFL Hold Buy 54 60 11.1% 16.3% 16.7% 15.9% 16.8%

HBL Hold Buy 175 193 10.3% 9.6% 9.4% 14.2% 13.3%

MCB Hold Hold 207 228 10.1% 13.3% 13.1% 14.7% 14.9%

UBL Hold Buy 181 198 9.4% 9.7% 9.7% 15.0% 14.6%


Table 5: IMS EPS forecasts, new vs old (PKR)

Old 2018f

EPS

New 2018f

EPS % chg

Old 2019f

EPS

New 2019f

EPS % chg

Old 2020f

EPS

New 2020f

EPS % chg

ABL 11.70 11.17 -4% 13.29 13.73 3% 16.24 15.71 -3%

BAFL 6.56 6.70 2% 7.23 7.62 5% 8.09 8.36 3%

HBL 12.45 12.19 -2% 19.44 18.19 -6% 25.39 22.66 -11%

MCB 17.62 17.35 -2% 20.11 20.36 1% 24.74 24.33 -2%

UBL 13.50 13.43 -1% 20.87 20.30 -3% 24.65 23.44 -5%


Key drivers of the changes in our estimates

On average we cut our CY18-20f earnings estimates by 5% for the following reasons:

Higher margins

We expect the DR to average 7.4% in 2018f and 9.5% in 2019f (vs. earlier expectation

of 7.3%/9.0%). This leads us to raise margin forecasts by c.10bps to 40bps in 2019f.

Slightly slower loan growth

Loan growth has averaged 17%pa over the last 2 years but deceleration is now visible,

particularly in the fixed investment and SME segments. Expected GDP growth

slowdown will also push down on loan growth. For coverage banks, we now expect

11% loan growth CAGR over the next 3 years, slightly lower than 12% previously.

Higher cost of risk

Estimates over 2018/2019f remain intact but we raise cost of risk to 50-60bps over the

medium-term to account for a weaker economy.

Higher admin expenses

We build in higher inflation estimates which leads to higher admin expense projections.

Cost CAGR for next 3 years is now 10% vs. 9% % previously projected.

Lower dividend payouts

We reduce our cash payout ratio estimates (especially for UBL), in keeping with higher

capital requirements (D-SIBs) and following removal of tax on bonus share issuances.

Rollover to 2019f & change in valuation methodology

We rollover our target prices to Dec’19, from Dec’18 previously. We also shift our

valuation methodology to modified Gordon Growth [(ROE-g)/(CoE-g)] based on mid-

cycle ROE and 2022f book value, which we discount back, and include the value of

interim dividends. This is now consistent with the Exotix’s global valuation methodology

for banks.

6

PAKISTAN BANKS

Sector outlook

Table 6: Pakistan banking industry forecasts summary

% (yoy) 2017 2018f 2019f 2020f Comments

Income statement growth

Net interest income -1% 4% 20% 15% Rising interest rates to pull NII up 2019f onwards

Total operating income 0% 2% 13% 12%

Loan loss provisions N.M -98% N.M 105% Reversals likely to end in 2019f (ex – MCB)

Net attributable income -27% 3% 32% 18% Banks should post more normalised earnings from 2019f

Balance sheet growth

Net loans 17% 12% 11% 11% Loan growth likely to decelerate over next 1-2yrs

Total assets 16% 4% 8% 10%

Total deposits 9% 9% 11% 12% Trade-off between deposit growth and CASA improvement

Shareholders' funds 4% 1% 7% 11% Retention ratios to rise on higher capital requirements (D-SIBs)

Ratios

Net interest margin 3.7% 3.5% 3.9% 4.1% NIMs to lift from 2019f

Revenues/assets 5.9% 6.4% 7.7% 8.2%

Cost/income 52% 56% 53% 50% Higher revenues to offset higher costs

ROA 0.99% 0.93% 1.16% 1.25% ROA to normalise over medium term

ROE 11.4% 11.5% 14.5% 15.7% ROE to track ROA

Effective tax rate 43% 40% 38% 37% 4% Super Tax to gradually become 0% by 2022f

Dividend payout ratio 74.2% 71.2% 53.4% 51.2% Will reduce as banks revert to a mix of cash & stock dividends

Net loans/deposit ratio 39% 41% 40% 40%

CAR 16.2% 16.8% 16.5% 16.4%


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PAKISTAN BANKS

Pakistan banks in frontier context

Table 7: Pakistan banks relative mapping in frontier

Fundamental

valuation

Valuation vs

history

Macro

environment Growth Margins Risk Profitability

Profit

trajectory Overall rank

Note: green = attractive; yellow = neutral; red = unattractive

Source: Exotix-IMS Research

Valuations

Pakistan banks scan quite well in terms of valuations (compared to fundamentals), with

median ETR of 34% compared to Exotix frontier banks coverage ETR of 20% and

dividend yield of 6.9% in 2019 (5.8% for peers). If compared to valuations for the past

five years, Pakistan banks rank in the middle of the pack as they trade at a 17% discount

to past 5-year average P/B (similar to frontier banks median discount of 17%) but a 6%

premium in P/E terms (our frontier banks coverage is at 14% discount). Sri Lanka banks

valuations are at the highest discount compared to the past five years while Vietnam is

at a significant premium.

Macro environment

Macro environment is tougher in Pakistan compared to other markets in frontier as the

IMF expects GDP growth to drop to 4.7% in 2019 from 5.8% in 2018 and 5.3% in 2017.

This is coupled with high gross government debt (c67% of GDP) and current account

deficit (c6% of GDP) along with declining foreign exchange reserves (less than two

months of import cover). Nigeria scans best in terms of macro environment (strong

momentum in GDP growth, favourable current account) while other East African

countries, Uganda and Rwanda, are facing tough conditions (high current account deficit).

Growth

Growth at Pakistan banks looks better compared to frontier peers as both asset growth

(c9% median in 2020 compared to only 4% in 2018) and revenue growth (median 16%

in 2019 and 13% in 2020 versus only 6% in 2018) momentum is strong on the back of loan

growth remaining resilient and margins expanding. Bangladesh ranks best due to both high

growth levels and momentum over the next few years, while GCC economies look worst.

Margins

Pakistan banks rank in the middle of the pack in terms of margins, the overall levels of

margins are weaker (3.5% for Pakistan banks compared to median 5.3% for frontier

banks) but due to higher interest rates, the margin expansion is expected to be strong

with c40bps rise in 2018-19 compared to our frontier banks median increase of c10bps.

Uganda and Rwanda scan well on margins, while Egypt is the worst.

Risk

In terms of credit risk, we expect Pakistan banks’ median NPL ratio to decline 70bps in

2019 compared to a 40bps dip across our frontier coverage. However, on cost of risk,

we expect Pakistan banks to see a 50bps rise in credit risk costs, as they come off a

low base, where recoveries were high in 2018. Vietnam looks best in terms of credit

risks while Bangladesh is at the bottom of the pack (due to hidden NPLs in the system).

Profitability

Pakistan banks profitability is comparable to frontier peers, with average 2018-20f ROE

at 14.0%, in line with frontier peers, while ROA is lower at 1.1% compared to the frontier

banks average of 1.5%. Other East African countries (Uganda and Rwanda) scan best

in terms of profitability, while Nigeria tier 2 banks appear worst.

Profit trajectory

Profit growth is one of the strongest at Pakistan banks due to the rebound in interest rates

and margins. We expect ROE to expand by 3.5ppt in 2018-19 (frontier banks at 2.3ppts)

and ROA is also likely to expand by 28bps compared to 7bps for frontier peers. Nigeria

tier 2 banks are the best in terms of profit growth trajectory, while Egypt appears worst.

8

PAKISTAN BANKS

Strong margin expansion as interest rates rise

As is usually the case in election years, Pakistan is in the midst of a macroeconomic

adjustment phase that may culminate in entry into an IMF program. The government

has recently raised gas prices, announced a revised FY19 Budget, and is making efforts

to raise financing through bilateral sources, but we think key macroeconomic metrics

will continue to adjust. Inflation was recorded at 5.8% in Aug 2018 (core inflation: 7.7%)

and is expected to keep increasing. Interest rates have risen by 275bps this year

(discount rate is now 9.0%) and the PKR/US$ exchange rate has slipped by 18% since

mid-Dec 2017. Efforts to bring the twin deficits under control (FY18 current account:

5.8% of GDP; fiscal deficit: 6.6% of GDP) will lead to a slowdown in the economy, where

GDP growth (FY18: 5.8%) is likely to decelerate, in turn pushing down on loan growth

and leading to higher cost of risk. For banks, however, we expect these negative effects

to be more than offset by margin expansion as interest rates rise. We see the discount

rate rising to 10.0% by end-2019f.

Figure 1: Core inflation has almost reached the discount rate

Source: PBS, SBP

Spreads have turned the corner

Banks will be key beneficiaries in the rising interest rate environment. Spreads (lending

rate less deposit rate) stand at less than 5% versus almost 8% in mid-2011. However,

data now suggests spreads have turned the corner, improving by 20bps since Mar 2018

to 4.83% in Aug 2018. With the bulk of high-yielding PIBs taken on in 2014 already

matured, and the government introducing floating-rate PIBs, overall NIMs should also

begin to lift from next year. For our coverage universe, we project c40bps NIMs

expansion in 2019f. ABL should show the best NIM expansion on limited PIB exposure,

while we expect UBL to lag behind given its large international book and high PIB

exposure.

Figure 2: Projected NIMs expansion (2018-22f)

Figure 3: Spreads are lifting

Source: IMS Research Source: SBP

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Jan

-10

Ma

y-1

0

Se

p-1

0

Jan

-11

Ma

y-1

1

Se

p-1

1

Jan

-12

Ma

y-1

2

Se

p-1

2

Jan

-13

Ma

y-1

3

Se

p-1

3

Jan

-14

Ma

y-1

4

Se

p-1

4

Jan

-15

Ma

y-1

5

Se

p-1

5

Jan

-16

Ma

y-1

6

Se

p-1

6

Jan

-17

Ma

y-1

7

Se

p-1

7

Jan

-18

Ma

y-1

8

Se

p-1

8

CPI NFNE DR

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

2017

2018f

2019f

2020f

2021f

2022f 4.5%

4.6%

4.7%

4.8%

4.9%

5.0%

5.1%

Jan

-17

Ap

r-17

Jul-

17

Oct-

17

Jan

-18

May-1

8

Aug

-18

9

PAKISTAN BANKS

CA is the new CASA

Our coverage banks maintain high CASA (current & savings a/c) – c90% in MCB’s case

– and even BAFL’s CASA is now approaching 80% vs less than 70% just three years

ago. That said, given there is a rate floor on savings deposits (discount rate less 2.5%),

banks are clearly focusing on growing current accounts. BAFL has the highest

proportion of current accounts in our coverage, while ABL and MCB appear to have the

most potential to tilt their mix away from savings accounts and towards current accounts

over the medium term.

Figure 4: Current a/c to assets Figure 5: PIBs to assets

Source: Company accounts Source: Company accounts

HBL and UBL are the most geographically diversified banks, which should result in a

relatively modest impact from rising domestic interest rates. With both banks taking hits

on foreign operations over the past 12 months, we may see their domestic franchises

taking up a greater share of the business going forward. ABL and BAFL are most

sensitive to rising rates given the domestic concentration and composition of their

books.

Figure 6: Domestic assets (% of assets)

Figure 7: Rate sensitive assets and liabilities gap (% of assets)

Source: Company accounts Source: Company accounts

Margin expansion to counter slower NFI income and rising opex

For our universe, we expect non-interest income to settle at 1.1% of assets, down from

1.4% in 2016. Fee income lines have been affected by the slowdown in home

remittances (+1.4% in FY18), there is less room for realising capital gains on bonds,

FX income will come off from the currency volatility-induced peak of 2018f, and dividend

receipts may be affected by listed companies opting for a mix of cash and stock

issuances after the removal of tax on bonus shares. At the same time, rising inflation

will push admin costs higher while, from H2 18, banks have to separately contribute to

a deposit insurance fund (impact: 0.1% of assets). Nevertheless, the projected pickup

in margins and net interest income should be more than enough to counter slower non-

interest income and rising costs, in our view.

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

ABL BAFL HBL MCB UBL0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

ABL BAFL HBL MCB UBL

60.0%

70.0%

80.0%

90.0%

100.0%

ABL BAFL HBL MCB UBL0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%


10

PAKISTAN BANKS

Loan growth to decelerate, but not by much

Loan growth has averaged 19% yoy in H1 18, building on 18% yoy growth in 2017.

However, given the backdrop of altered macroeconomic dynamics – interest rates have

been raised by 275bps this year and the PKR has slipped 18% vs the US$ since mid-

Dec 2017 – loan growth is set to decelerate. This is already becoming visible in loans

intended for capital formation (17% growth in H1 18 vs 20% in 2017) and, more sharply,

in SME loans (6% growth in H1 18 vs 27% in CY17). Nevertheless, we do not expect

loan growth to stall. Ancillary projects for CPEC will continue to draw financing, export

financing is likely to pick up as the GoP incentivises export-oriented sectors, and

working capital should increase as expansions (e.g. cements, chemicals) come online.

As a result, we now expect 2019f loan growth for covered banks at 10.7% vs our earlier

estimate of 12.0%. Our revised 2018-21f loan growth CAGR is 11% vs 12% previously.

Figure 8: Loan growth vs GDP growth

Source: SBP, Ministry of Finance

We expect Corporate lending to remain resilient, but Consumer lending may slow. SME

lending has already tapered off. Since corporate loans constitute the bulk of loan books

in Pakistan, we expect overall loan growth to stay in early double-digits.

Corporate loans: The corporate loan book accounts for an estimated 60%+ of total

loans in the system. Banks remain open to lend to top-tier corporates, but as the

corporate expansion cycle completes, corporate loan growth may also come off slightly

(fixed investment loans to slow but working capital financing to pick up).

Figure 9: Loan growth trend by type of loans

Source: SBP

0.0%

1.0%

2.0%

3.0%

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30.0%

35.0%

40.0%1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

Loan growth GDP growth - RHs

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Oct-

15

Feb-1

6

Jun

'16

Oct'1

6

Feb'1

7

Jun

'17

Oct'1

7

Feb'1

8

Jun

'18

Total Trade Finance Working Capital Fixed Investment

11

PAKISTAN BANKS

Trade financing: This segment accounts for 15% of private sector credit. Although

import financing may decelerate due to a weaker PKR and administrative measures to

curb imports, we expect export financing to increase as the government takes steps to

support export-oriented sectors.

SME & Consumer: The SME segment has historically seen high NPLs and banks have

become more cautious (6% yoy growth in H1 18 vs 27% growth in 2017). At present,

consumer loans continue to grow at 20%+yoy, but we expect this run rate to also slow

as banks become more cautious, and as demand is affected (e.g. higher car prices).

UBL and HBL have large international businesses that will behave independently of

domestic dynamics. For both, we think the international businesses will gradually come

to occupy a smaller share in the mix, influenced by their losses in 2017/18f. BAFL’s

higher exposure to SME & Consumer may see its loan growth come off more relative

to peers. The mix is tilted towards corporate lending for both ABL and MCB but, given

their conservative strategies, both banks will likely also see loan growth deceleration.

Figure 10: Loan mix by segment for our coverage universe

Source: Company accounts, IMS Research estimates

Long-term credit expansion prospects remain intact

Loans/GDP in Pakistan is c20%, but has been higher in the past – nearly 30% in 2007.

While we forecast below-average loan growth over the next 1-2 years, credit

penetration should increase over the long term. Factors that can push the loans/GDP

ratio higher include fiscal discipline by the government which will prevent crowding out,

development of new industries, e.g. information technology and development of

mortgage finance (this will require better foreclosure laws).

Figure 11: Loans/GDP is still a long way below the peak

Source: SBP, Ministry of Finance

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%


Corporate Commercial & Others Consumer Islamic Overseas

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

22.0%

24.0%

26.0%

28.0%

30.0%

Jun

-02

Jun

-03

Jun

-04

Jun

-05

Jun

-06

Jun

-07

Jun

-08

Jun

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Jun

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Jun

-11

Jun

-12

Jun

-13

Jun

-14

Jun

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Jun

-16

Jun

-17

Jun

-18

12

PAKISTAN BANKS

Asset quality is strong and should remain so

Several banks have been realising provisioning reversals over the past 1-2 years, NPL

ratios have dropped to a decade low (CY17: 8.4%) and coverage is near 90%. Asset

quality will be tested now, but deterioration should be contained. While the

macroeconomic environment is tougher, it is difficult to see a return to the 2008-11

cycle, when the NPL ratio crossed 17%. We see the cost of risk rising to 50-60bps by

2020f, much lower than the 100-150bps levels seen in 2008-11. Our estimates may be

impacted by IFRS 9 implementation, but this should not derail our thesis of resilient

asset quality.

Figure 12: NPL ratio vs provisions coverage

Source: SBP

Cost of risk will rise, but in a manageable manner

Provisioning reversals are likely to end next year, as fresh NPL formation occurs. That

said, we expect only a modest deterioration in asset quality with credit costs likely to

remain under control. The reasons why we see a moderate NPL cycle include:

– Improvement in lending standards with a revamped credit information bureau

(e-CIB), which takes into account consumer, agriculture and SME exposure.

– Consumer lending (just 5% of loans vs 15% in 2007) is more tilted towards

secured products (60%+ of consumer loans vs less than 50% in 2007).

– Corporates are much more deleveraged compared to the past. SME lending

has also become more cautious over the past six months.

High provisions coverage should also shield credit costs. ABL is best placed while BAFL

(SME & Consumer exposure) may see higher credit costs. MCB’s outlook depends on

recoveries from NIB’s loan book, while HBL and UBL will be affected by global dynamics.

Figure 13: Cost of risk projections for individual banks


50.0%

55.0%

60.0%

65.0%

70.0%

75.0%

80.0%

85.0%

90.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

CY

04

CY

05

CY

06

CY

07

CY

08

CY

09

CY

10

CY

11

CY

12

CY

13

CY

14

CY

15

CY

16

CY

17

IHC

Y18

NPL Ratio Coverage - RHS

-0.80%

-0.60%

-0.40%

-0.20%

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%


2017 2018f Average 2018-21f

13

PAKISTAN BANKS

Table 8: Sectoral loan mix of coverage banks

Sectors

Asset quality

direction ABL BAFL HBL MCB UBL

Energy Neutral 34% 18% 24% 7% 20%

Textile Positive 13% 17% 10% 15% 11%

Individuals Negative 3% 10% 9% 8% 9%

Agri business Neutral 16% 2% 12% 3% 9%

Transport, storage and communication Negative 4% 2% 1% 15% 3%

Wholesale and retail trade Neutral 2% 5% 6% 7% 4%

Financials Neutral 5% 2% 4% 2% 8%

Chemicals and pharmaceuticals Negative 5% 2% 3% 11% 2%

Others Negative 18% 43% 31% 32% 35%

Source: Company accounts

IFRS 9 may increase provisions but should not derail asset quality

The SBP has directed banks to assess the impact of IFRS 9 implementation, but has

yet to provide an implementation timeline. So far, banks with international operations

have implemented IFRS 9 in their overseas operations and the impact has been

negligible. Our conversations with banks suggest that those not currently availing forced

sale value benefit (on illiquid collateral) will be better off, as inclusion of this may partially

offset impact on the equities portfolio. Moreover, we think that even if provisions

increase, our thesis of resilient asset quality will remain intact.

14

PAKISTAN BANKS

ROE expansion to drive valuation re-rating

We expect ROEs to depict a secular uptrend beginning 2019f. For our coverage

universe, aggregate ROE increases from 11% in 2018f to 18% in 2022f, with margin

expansion countering a higher cost of risk. The projected ROE increase will be driven

by ROA expansion where, in general, we see reduced leverage in the future (see

below). The ROE pickup should be most resounding for HBL, as profitability metrics

normalise over the medium term. In contrast, BAFL’s ROE may remain relatively range-

bound at 16-17%, albeit still better than previous 5-year average of 14%.

Figure 14: ROE trend for covered banks


ROEs will rise despite lower cash payouts

Our higher ROE projections incorporate likely lower cash dividend payout ratios. This

is due to both higher capital requirements for systemically important banks (D-SIBs)

and changes in tax rules removing tax on bonus issuance. We therefore expect banks

to revert to a mix of cash and stock payouts, compared to just cash dividends over the

past few years. This applies for all banks but particularly for HBL and UBL, which have

been classified as systemically important. Compared to a minimum CAR of 12.5% for

the sector from 2019f, these two banks have to maintain CAR at 14.5% and 14.0%,

respectively, with the incremental requirement filled by CET 1 capital. Within our

coverage, the cash payout for ABL and MCB appears most secure. We think HBL can

sustain a c40% cash payout provided no further fine is imposed in foreign jurisdictions.

Figure 15: Payout ratio projections Figure 16: CAR vs requirement

Source: IMS Research Source: Company accounts

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

2016 2017 2018f 2019f 2020f 2021f 2022f

0.0%

20.0%

40.0%

60.0%

80.0%

2015

2016

2017

2018f

2019f

2020f

2021f

2022f

10.0%

12.5%

15.0%

17.5%

20.0%

22.5%

25.0%

ABL BAFL MCB UBL HBL

Tier-I CAR CAR

15

PAKISTAN BANKS

Margin expansion to be the key ROE driver

As interest rates rise, margin expansion leading to net interest income growth will be

the key return driver. Margins should rebound strongly in 2019f and continue to rise

over the medium term. We forecast a lower contribution from non-interest income, while

costs are also likely to rise more quickly, but the overall impact of margin expansion

should negate these factors. Importantly, ROE should be driven more by ROA than

higher leverage, which we expect will stabilise in the 12-13x range. Risks include: (i)

higher than projected provisions; and (ii) changes in the taxation regime for banks.

Table 9: ROE breakup

As % of average assets 2016 2017 2018f 2019f

2022f Analyst comments

Interest income 6.3% 5.9% 6.4% 7.7% ----- 8.3%

Interest expense 2.7% 2.7% 3.4% 4.4% ----- 4.6%

Net interest income 3.6% 3.1% 3.0% 3.3% ----- 3.7% NIMs to expand from 2019f. Key ROA driver

Non-interest income 1.4% 1.2% 1.1% 1.1% ----- 1.1%

Fee income 0.7% 0.7% 0.7% 0.7% ----- 0.7% Lower remittances contribution but higher cross-sell

Capital gains 0.3% 0.2% 0.1% 0.1% ----- 0.1% Bond revaluation gains will reduce as interest rates rise

Pre-provision income 5.0% 4.4% 4.1% 4.4% ----- 4.8%

Expenses 2.3% 2.3% 2.3% 2.4% ----- 2.4% Admin costs to track inflation

Provisions & impairment 0.1% 0.0% 0.0% 0.1% ----- 0.2% We see higher cost of risk but not a shock

Other Items 0.0% -0.3% -0.1% 0.0% ----- 0.0%

Pre-tax ROA 2.6% 1.7% 1.6% 1.9% ----- 2.3%

1-tax burden 60.1% 57.3% 60.1% 62.0% ----- 65.0% 4% Super Tax is gradually being phased out

ROA 1.5% 1.0% 0.9% 1.2% ----- 1.5%

Leverage (x) 10.7 11.5 12.3 12.6 ----- 12.4

ROE – incl. surplus 16.6% 11.4% 11.5% 14.6% ----- 18.5% ROA expansion to drive ROE


Valuations have room to fill out

Four banks in our coverage trade at c1.0x 2019f PB (MCB is the exception). This is

unjustified, in our view, given projections for ROEs expand over the medium term and

cross CoE. We note that UBL, HBL and MCB trade more than one standard deviation

below their 5-year historical PB range. We think the market has been quick to penalise

banks for weak 2018f profitability, but is now ignoring the prospects for profit and ROE

normalisation over the medium term. As ROEs normalise, we expect valuation multiples

to follow suit. Based on previous 5-year valuation ranges, HBL has the most re-rating

potential, while BAFL now trades higher than its 5-year average.

Table 10: Bank’s 2019f P/B relative to 5-year range

P/B (x) ABL BAFL HBL MCB UBL

2019f 1.00 1.04 1.04 1.42 1.08

5yr low 0.80 0.62 1.04 1.38 1.07

5yr high 1.83 1.17 2.39 2.82 1.97

5yr average 1.15 0.87 1.58 1.92 1.37

5yr average less 1 sd 0.93 0.75 1.30 1.55 1.19

(Disc)/prem to 5yr avg. -13% 20% -33% -26% -21%


16

PAKISTAN BANKS

Regulatory risks should not impede ROE expansion

The regulatory environment has tightened over the past few years, where central bank

steps to limit margins and raise capital requirements have coincided with the Supreme

Court’s directives to increase minimum pension payments. We see these risks as

having largely played out already. That said, IFRS 9 may be implemented over the next

1-2 years; this will likely lead to higher provisions but will also improve earnings quality.

We also flag high-impact legal risks. We cannot entirely rule out a further fine for HBL

in New York (UBL also faces this risk), while meeting global Financial Action Task Force

(FATF) guidelines is also crucial for Pakistan and its banking system.

Table 11: Regulatory risks

Risk Current requirement Analyst comment

Capital

Paid-up capital PKR10bn (paid-up capital net of losses) Limited weak banks; need for consolidation not as acute

Capital adequacy 2019f CAR minimum is 12.5% (14.5% for HBL/14.0% for

UBL)

CAR requirement for D-SIBs now quite high

Margins & asset quality

Spread compression Min. savings a/c rate is DR less 2.5% SBP steps to curb margins are unlikely in next few years

Deposit insurance Annual premium is 0.16% of eligible deposits Annual impact is 0.1% of assets, incorporated in our

models

Directed lending Only agriculture lending has indicative targets Does not appear to be on the cards

IFRS 9 Banks working out impact. May be implemented in next

1-2yrs

Provisions to rise, but earnings quality will improve

Legal

Pension Large banks (ex-NBP) are compliant with Supreme Court

directives

We expect no increase in pension fund top-ups for private

banks

Foreign fines HBL undergoing a lookback in New York. UBL & NBP

strengthening compliance

Risk of further fine for HBL is there. UBL and NBP also at

risk

Tax rate Normal rate for banks is 35%, Super Tax is add-on Continuation of Super Tax is a risk

FATF Pakistan is presently on FATF grey list. Has until Sep

2019 to comply

Banks at risk in case of blacklisting

Others

Demonetisation PTI's manifesto wants to take deposits/GDP to 50% from

30% at present

Unlikely but, if it happens, may benefit large banks and

Islamic banks


17

PAKISTAN BANKS

Valuation methodology

We value banks on a modified Gordon Growth methodology [(ROE-g)/(CoE-g)] based

on mid-cycle ROE and 2022f book value which we discount back, and also include the

value of interim dividends. This approach serves to reduce the impact of short term

fluctuations on valuations.

Key assumptions include:

We use tangible book values as opposed to Tier-1 book values previously.

We employ mid-cycle ROE (2022f) vs simple average of ROEs projected over

next five years.

We use a risk-free rate of 10% (similar to 10-year PIB yield), the same as

before.

Our equity risk premium is 6%, the same as before. This is based on the

average KSE-100 return over and above the risk-free rate since the KSE-100

Index was introduced in 1992.

To derive COE, we employ 5-year betas available on Bloomberg (ranging from

1.04-1.12). Our COE range for our banks universe thus comes to 16.2%-

16.7%.

Terminal growth of 9%, the same as before. Average nominal GDP growth for

Pakistan is in early double-digits but we choose to be conservative.

Target prices are for a time horizon of December 2019.

Table 12: Key valuation inputs

Risk free rate 10.0%

Equity risk premium 6.0%

Beta 5-year average

Terminal growth rate 9.0%


Table 13: Sensitivity of target prices to risk free rate & terminal growth

Risk free rate 8% 9% 10% 11% 12%

Terminal growth 7% 8% 9% 10% 11%

ABL 168 143 126 112 101

ABL 123 124 126 127 130

BAFL 82 69 60 53 47

BAFL 59 59 60 60 62

HBL 261 222 193 171 153

HBL 187 190 193 198 205

MCB 305 260 228 203 184

MCB 217 222 228 236 248

UBL 269 228 198 175 157 UBL 191 194 198 203 209


18

PAKISTAN BANKS

Risks

Downside risks include:

We assume the discount rate to be 10.0% at end-2019f. If interest rates are lower

than expected, our projections for margins in particular may be missed.

We expect a moderate NPL uplift cycle. If asset quality deterioration is more

severe, the cost of risk will be higher and affect return metrics for our coverage

banks.

Regulatory risk is balanced by what has already transpired (higher capital

requirements for D-SIBs, deposit insurance, pension fund top-ups) and what may

come through going forward (IFRS 9, potential fines in overseas jurisdictions). We

think IFRS 9 implementation will not derail our outlook for banks. However, if

further overseas fines are imposed, then our investment cases for individual

banks may be affected. Furthermore, any FATF blacklisting (unlikely in our view)

may pose a risk for the entire banking sector.

We assume a gradual reduction in cash payout ratios. However, it is possible that

there is a step reduction in cash payout, particularly for UBL, now that tax on

bonus share issuances has been removed. This may lead to a mix of cash &

stock issuances, as was the case in the past.

We assume the Super Tax gradually reduces to 0% by 2022f, in line with the

government’s latest instructions. Given the high fiscal deficit, there is a chance

that the government considers imposing Super Tax again, particularly on banks.

Upside risks include:

If the government wishes to lengthen the maturity profile of its domestic debt, it

may have to offer higher yields on PIBs, similar to the case in 2014. In this case,

there may be a step increase in margins.

We incorporate a mild rebound in fee income given pressures on home

remittances and trade-related income. A quicker than expected normalisation

may lead to positive surprises.

The new PTI-led government has commenced a program of encouraging fiscal

discipline. If the government is successful in its objectives, it could lead to

sustainable improvement in the government’s finances which could, in turn, allow

greater room for private sector credit.

19

PAKISTAN BANKS

Individual banks

20

PAKISTAN BANKS

BAFL: Turning weakness into opportunity

BAFL is one of our top picks. We upgrade our rating to Buy from Hold,

with an increased target price of PKR60 (up from PKR54). The bank is

in a position to enjoy swift margin expansion over the next 1-2 years. Other

reasons for our positive view include: (i) improved cost control; (ii) better

loan growth than peers; and (iii) improved capital strength that allows 30-

40% payout to be sustainable. BAFL trades at a 2019f P/B of 1.0x and P/E

of 6.6x, a 13-24% discount to the rest of our coverage banks despite

similar ROE projections (BAFL’s discount has been higher in the past but

there was an ROE gap vs peers, which is not the case now).

Focus on cost control is evident under the new CEO. Over the past ten

years, BAFL has run a high cost/income of 65% which subdued the bank’s

return metrics. This is now very clearly a focus area, with admin expenses

down 3% yoy in H1 18 (C/I at 55% vs 59% in H1 17) with the bank

streamlining operations at the head office (merging segments) and also

looking at greater branch level efficiency. We expect the cost/income ratio

to reduce from 65% in 2017 to 50% by 2022f. This alone will add an

estimated c2ppt to BAFL’s ROE, all else being the equal.

BAFL is more leveraged to rising interest rates. A CASA weight near

80% is not as high as MCB (90%) but BAFL’s deposits carry a lower cost

due to a higher proportion of current deposits (45% vs 37% for MCB).

Greater sensitivity to rising interest rates also arises from: (i) domestic

focus (90%+ of assets); (ii) limited PIB exposure (12% of assets); and (iii)

relatively high loans/deposits ratio (H1 18: 68%). Despite a more

challenging macroeconomic backdrop, BAFL’s loan growth guidance

remains relatively upbeat. While asset quality is strong (NPL ratio < 3.5%,

coverage > 95%), we build in higher cost of risk for BAFL (75bps in 2020f)

compared to other banks to reflect its higher SME & consumer exposure.

Return metrics are now similar to the large banks, driven by ROA with

reduced reliance on leverage. This has coincided with improved capital

strength (after the issuance of a PKR7bn ADT-1 instrument earlier this

year) that enabled BAFL to announce a cash dividend of PKR1/share with

Q2 18 results, the first interim payout since 2005. BAFL’s ROA now stands

above 1.0% and we think this the new normal. Rising ROA should enable

BAFL’s ROE to expand to 17% by 2022f vs 14% in the past five years.

Downside risks include: (i) greater than expected fallout on asset quality;

(ii) failure to maintain the improvement in cost efficiency; and (iii) any

inconsistency in cash dividend payout trend.

Table 14: Bank Alfalah Limited investment summary

(PKRmn) 2016 2017 2018f 2019f 2020f

Operating income 38,510 39,868 43,840 50,830 56,762

Operating expenses 23,973 25,717 24,810 26,750 29,033

Net income 7,890 8,515 11,888 13,520 14,840

EPS (PKR) 4.45 4.80 6.70 7.62 8.36

P/E (x) 11.3 10.5 7.5 6.6 6.0

BPS (PKR) 34.3 37.7 42.9 48.3 54.0

P/B (x) 1.5 1.3 1.2 1.0 0.9

DPS (PKR) - 1.36 2.50 3.00 3.50

Dividend yield 0.0% 2.7% 5.0% 6.0% 7.0%

ROA 0.87% 0.89% 1.20% 1.31% 1.34%

ROE 13.72% 13.33% 16.63% 16.72% 16.37%


Price (PKR) 50.3

Target price (PKR) 60.0

Expected share price return 19%

Expected dividend yield 6%

Expected total return 25%

Market cap (mn) 89,215 401

Market cap (US$mn) 718

Avg. daily volume (US$mn) 0.60

21

PAKISTAN BANKS

Table 15: BAFL – Financial statement

PKRmn 2016 2017 2018f 2019f 2020f 2021f 2022f

Income statement

Net interest income 28,991 29,288 31,866 38,677 43,473 47,626 53,135

Other operating income 9,519 10,580 11,974 12,153 13,289 14,405 15,570

Total operating income 38,510 39,868 43,840 50,830 56,762 62,031 68,705

Operating expenses 23,973 25,717 24,810 26,750 29,033 31,736 34,686

Pre-provision profit 14,537 14,151 19,031 24,080 27,729 30,295 34,019

Loan loss provisions 1,083 (434) (821) 2,011 3,855 3,764 3,693

Extraordinary expense - - - - - - -

Pre-tax profit 13,354 14,410 19,765 21,973 23,725 26,367 30,122

Net attributable income 7,890 8,515 11,888 13,520 14,840 16,763 19,462

Balance sheet

Net loans 378,724 400,660 446,112 487,062 538,021 599,776 666,887

Interest-earning assets 808,039 856,046 886,947 952,639 1,031,240 1,137,919 1,268,473

Total assets 919,443 991,027 995,833 1,063,498 1,148,285 1,279,888 1,427,000

Total deposits 640,854 653,346 691,647 767,027 860,833 948,263 1,054,366

Total interest-bearing liabilities 840,770 877,366 888,597 946,743 1,021,117 1,139,988 1,273,608

Shareholders' funds 60,925 66,830 76,131 85,615 95,748 108,021 120,918

Per share data (PKR)

EPS 4.45 4.80 6.70 7.62 8.36 9.45 10.97

BVPS 34.3 37.7 42.9 48.3 54.0 60.9 68.1

DPS - 1.4 2.5 3.0 3.5 4.0 5.0

Ratios

Revenue generation

Net interest margin 3.73% 3.62% 3.71% 4.19% 4.34% 4.37% 4.43%

Revenues/assets 4.23% 4.17% 4.41% 4.94% 5.13% 5.11% 5.08%

Operating efficiency

Cost/ income 62% 65% 57% 53% 51% 51% 50%

Risk management

NPLs/gross loans 4.8% 4.2% 3.7% 3.8% 4.2% 4.5% 4.5%

Coverage ratio 90% 94% 92% 92% 91% 91% 93%

Loan provisions/Advances 0.30% -0.11% -0.19% 0.43% 0.75% 0.66% 0.58%

Profitability

ROA 0.87% 0.89% 1.20% 1.31% 1.34% 1.38% 1.44%

ROE 13.72% 13.33% 16.63% 16.72% 16.37% 16.45% 17.00%

Effective tax rate 41% 40% 39% 38% 37% 36% 35%

Dividend payout ratio 0% 28% 37% 39% 42% 42% 46%

Liquidity and solvency

Net loans/ deposits 59% 61% 65% 64% 63% 63% 63%

Tier 1 ratio 9.9% 11.3% 14.3% 14.8% 15.1% 14.9% 14.8%

CAR 13.3% 13.8% 16.6% 16.9% 17.1% 16.7% 16.5%


22

PAKISTAN BANKS

UBL: Back on track from next year

UBL is the second of our top picks. We raise UBL to Buy from Hold,

with a target price of PKR198, up from PKR181 previously. UBL trades

at a 2019f P/B of 1.1x and P/E of 7.6x, with better earnings visibility than

HBL. Valuations reflect current challenges but ignore the bank’s strong

franchise and true earnings potential, in our view. UBL is having a difficult

2018f due to a large pension fund top-up and a GCC loan book clean-up

that will see credit costs approach 1% this year. Importantly however, we

do not see these factors spilling over into 2019f, implying UBL should

deliver normalised profits from next year. Cash payout ratio may drop to

40% from 2019f (despite an ADT-1 issuance), but higher earnings

retention should not impede the swift ROE recovery.

We think regulatory risk has already been priced in. The bank has taken

a pension fund top-up of PKR8.4bn and a further charge looks unlikely.

Note that earlier this year, the bank’s New York branch entered into a

written agreement with authorities to strengthen compliance. This new

agreement follows the termination of a previous agreement pertaining to

international remittances. The Supreme Court’s investigation into accounts

allegedly used for suspicious transactions on behalf of politically exposed

persons is a manageable risk, in our view, given its domestic dimensions.

Provisions should peak this year as UBL undergoes a GCC loan book

clean-up. Increase in overseas provisioning coverage levels will likely

result in elevated provisions in H2 18 even if there is no fresh infection.

However, given that losses on foreign advances will no longer be tax

deductible in Pakistan from next year, we strongly believe the clean-up will

be completed in 2018f and not extend into 2019f. This means credit costs

should be lower over the next few years compared to 2018f’s c90bps.

UBL’s retail franchise is delivering more with current accounts now 39%

of the deposit mix vs less than 35% at end-2016. If this continues, UBL’s

sensitivity to rising interest rates can increase (currently it is the lowest in

our coverage). Fee income stagnated in 2016 and 2017 (slowdown in

remittance & trade lines and increased competition for Omni) but appears

to have turned the corner (+9% in H1 18). Cross-selling e.g.

bancassurance, greater consumer focus and a stronger branchless

banking proposition (Omni) can lead to further improvement in fees.

Downside risks include: (i) continued high provisions in the GCC; (ii)

potential fine in New York; (iii) failure to better leverage the retail franchise;

and (iv) greater competition in the digital banking space.

Table 16: United Bank Limited investment summary

(PKRmn) 2016 2017 2018f 2019f 2020f



Net income 27,783 26,190 16,437 24,851 28,697

EPS (PKR) 22.69 21.39 13.43 20.30 23.44

P/E (x) 6.8 7.2 11.4 7.6 6.5

BPS (PKR) 133.7 142.5 135.7 142.0 159.9

P/B (x) 1.1 1.1 1.1 1.1 1.0

DPS (PKR) 13.00 13.00 12.00 8.00 10.00

Dividend yield 8.5% 8.5% 7.8% 5.2% 6.5%

ROA 1.77% 1.39% 0.79% 1.17% 1.24%

ROE 17.40% 15.49% 9.65% 14.62% 15.53%


Price (PKR) 153.5






Market cap (US$mn) 1,512


23

PAKISTAN BANKS

Table 17: UBL – Financial statement

PKRmn 2016 2017 2018f 2019f 2020f 2021f 2022f

Income statement






Loan loss provisions 609 1,877 6,079 3,591 5,588 5,656 5,230

Extraordinary expense - - 8,405 - - - -

Pre-tax profit 47,154 41,131 27,666 40,175 45,656 54,144 66,228


Balance sheet

Net loans 537,782 642,507 731,008 813,246 910,836 1,020,136 1,147,653

Interest-earning assets 1,443,796 1,838,871 1,791,352 1,932,490 2,141,971 2,376,207 2,651,879

Total assets 1,661,742 2,105,361 2,050,582 2,198,888 2,430,899 2,695,042 2,993,929

Total deposits 1,245,792 1,366,158 1,487,003 1,658,643 1,847,111 2,060,448 2,308,808

Total interest-bearing liabilities 1,463,416 1,896,633 1,838,508 1,977,308 2,189,271 2,427,846 2,694,576



EPS 22.69 21.39 13.43 20.30 23.44 28.24 35.09

BVPS 133.7 142.5 135.7 142.0 159.9 179.3 204.1

DPS 13.0 13.0 12.0 8.0 10.0 12.0 14.0

Ratios

Revenue generation


Revenues/assets 5.40% 4.40% 4.15% 4.30% 4.45% 4.54% 4.68%


Cost/ income 43% 47% 50% 52% 50% 48% 46%

Risk management

NPLs/gross loans 8.0% 7.7% 7.5% 7.2% 7.2% 7.1% 6.9%

Coverage ratio 90% 83% 86% 85% 84% 84% 84%

Loan provisions/Advances 0.12% 0.32% 0.89% 0.47% 0.65% 0.59% 0.48%

Profitability

ROA 1.77% 1.39% 0.79% 1.17% 1.24% 1.35% 1.51%

ROE 17.40% 15.49% 9.65% 14.62% 15.53% 16.65% 18.31%





Tier 1 ratio 10.7% 11.0% 12.5% 12.4% 12.6% 12.8% 13.2%

CAR 14.9% 15.1% 16.7% 16.1% 16.2% 16.2% 16.3%


24

PAKISTAN BANKS

HBL: Looks good under a far-sighted lens

We raise our rating for HBL to Buy from Hold, with a new target price

of PKR193 (up from PKR175). HBL is also experiencing a difficult 2018f

but, unlike UBL, profitability may take until 2020f to normalise given

disruption to fee & FX income lines as well as higher compliance and

business reorganisation costs. However, we believe this is already priced

in; HBL trades at a 2019f P/B of 1.0x, a 33% discount to the 5-year

average. We draw attention to HBL’s domestic franchise (80%+ of assets),

which should help drive HBL’s ROE to 18%+ by 2022f, from c10% in 2018f.

The drag from the US$225mn New York fine is likely to extend into

2019f. The risk of another fine in the look-back exercise aside, HBL faces

FX losses on the income statement each time the PKR weakens

(estimated hit of cPKR1bn for every 5% depreciation; however, translation

gains lead to a book value increase on a net basis). The remittance

business has also been disrupted. This has led to widespread changes –

a new CEO is in place, compliance staffing has increased, a bank-wide

business transformation project is underway and the entire foreign

business is being scrutinised. Gains will be slow though, with business

reorganisation costs possibly continuing into 2019f.

The domestic business is performing well and should gain in

importance. In H1 18, domestic operations generated pre-tax ROA of

1.7%, which is decent given: (i) pension fund top-up of cPKR1.9bn; and (ii)

PKR1.4bn spent on a business reorganisation project. Support is

emanating from double-digit loan growth and strong asset quality that

should result in provisioning reversals in full-year 2018f. In 2019f, HBL

should experience c50bps expansion in NIMs to 4.2% (higher than even

MCB, albeit temporarily) which should help drive c50% earnings growth.

This high growth trajectory can extend over the medium term, where we

project 2019-22f earnings CAGR at 25%.

Earnings normalisation will be gradual, but it will happen. Over the

medium term, we project: 12% overall loan CAGR and 13% fee CAGR.

Together with the phasing out of extraordinary costs and a likely focus on

cost reduction (we see C/I falling from almost 70% in 2018f to 55% by

2022f), HBL should depict consistent improvement. This should take ROE

from c10% this year to more than 18% by 2022f.

Downside risks include: (i) Another fine in New York, which in a worst-

case scenario might necessitate capital raising; (ii) greater than expected

deterioration in asset quality; and (iii) continued pressure on NFI lines.

Table 18: Habib Bank Limited investment summary

(PKRmn) 2016 2017 2018f 2019f 2020f



Net income 34,070 7,829 17,880 26,689 33,246

EPS (PKR) 23.23 5.34 12.19 18.19 22.66

P/E (x) 6.4 27.8 12.2 8.2 6.5

BPS (PKR) 133.8 128.7 129.9 142.7 160.2

P/B (x) 1.1 1.2 1.1 1.0 0.9

DPS (PKR) 14.00 8.00 5.00 8.00 10.00

Dividend yield 9.4% 5.4% 3.4% 5.4% 6.7%

ROA 1.44% 0.30% 0.65% 0.92% 1.04%

ROE 17.98% 4.07% 9.43% 13.35% 14.97%


Price (PKR) 148.5








25

PAKISTAN BANKS

Table 19: HBL – Financial statement

PKRmn 2016 2017 2018f 2019f 2020f 2021f 2022f

Income statement






Loan loss provisions 491 (50) (496) 4,095 7,284 6,863 6,237

Extraordinary expense - 23,717 1,852 - - - -

Pre-tax profit 56,525 28,813 30,702 43,633 53,357 64,928 80,903


Balance sheet

Net loans 748,466 851,502 942,920 1,055,577 1,188,493 1,340,673 1,510,617

Interest-earning assets 2,172,878 2,301,015 2,416,298 2,665,426 2,976,660 3,294,620 3,678,909

Total assets 2,507,182 2,684,102 2,779,062 3,034,617 3,384,516 3,750,994 4,179,464

Total deposits 1,885,959 1,998,935 2,175,733 2,423,020 2,714,223 3,025,714 3,389,349

Total interest-bearing liabilities 2,259,976 2,440,484 2,521,211 2,756,365 3,078,904 3,416,996 3,809,228



EPS 23.23 5.34 12.19 18.19 22.66 28.07 35.59

BVPS 133.8 128.7 129.9 142.7 160.2 178.3 201.8

DPS 14.0 8.0 5.0 8.0 10.0 12.0 14.0

Ratios

Revenue generation


Revenues/assets 4.80% 4.47% 3.89% 4.44% 4.66% 4.73% 4.87%


Cost/ income 50% 55% 70% 63% 59% 57% 55%

Risk management

NPLs/gross loans 9.2% 8.2% 7.6% 7.4% 7.4% 7.2% 6.8%

Coverage ratio 91% 92% 92% 91% 91% 90% 90%

Loan provisions/Advances 0.07% -0.01% -0.06% 0.41% 0.65% 0.54% 0.44%

Profitability

ROA 1.44% 0.30% 0.65% 0.92% 1.04% 1.15% 1.32%

ROE 17.98% 4.07% 9.43% 13.35% 14.97% 16.59% 18.73%





Tier 1 ratio 12.0% 12.0% 12.3% 12.6% 12.5% 12.7% 13.1%

CAR 15.5% 16.0% 16.1% 16.0% 16.0% 15.9% 16.0%


26

PAKISTAN BANKS

ABL: Well placed

We raise our target price for ABL to PKR126 (from PKR115) and

upgrade our rating to Buy from Hold. An investment mix tilted towards

short-term tenors should hold the bank in good stead in a rising interest

rate environment, and we see c60bps NIMs expansion in 2019f. Strong

asset quality should lead to provisioning reversals in 2018f, and limited

credit costs going forward. We project 3-year profit CAGR at 17%, which will

lift ROE from 12% in 2018f to 17%+ by 2022f. ABL trades at a 2019f PB/PE

of 1.0x/7.3x. Valuations are in line with the past 5-year average and, in our

view, do not adequately reflect the strong prospects for ABL as rates rise.

ABL should achieve the quickest lift in margins in 2019f due to: (i)

limited exposure to longer-term bonds (9% of assets for ABL vs 17% on

average for peers); and (ii) an improving deposit mix where current

accounts now have 37% share vs 31% at end-2016. To allow for greater

benefit from rising interest rates over the medium-term however, ABL

(similar to MCB) needs to focus on further improving current account

generation to reduce reliance on savings accounts, while increasing

consumer lending. The latter can add to ABL’s fee franchise as well, which

is relatively weak (fee contribution is 0.4% of assets vs 0.7% for peers).

Asset quality is very strong and ABL is on track to post net

provisioning reversals for the fourth straight year. This this due to a

more secure corporate-centric loan portfolio with limited SME & Consumer

exposure. While reversals may not extend into 2019f, cost of risk for ABL

should be one of the lowest among our coverage over the next few years.

We also see improved cost efficiency over the medium term, even though

costs are likely to stay elevated across 2018/19f as the bank is adding 95-

100 branches pa. As new branches become profitable, we expect ABL’s

cost/income to converge towards 45% by 2022f vs a high 55% in 2018f.

ABL’s balance sheet strength is exceptional with 22.3% CAR. This is

by far the highest among our coverage and will allow ABL to meet loan

growth targets without compromising on dividends. ABL may look to revert

to a mix of cash and bonus issuances, but this will be out of abundant

caution, as the balance sheet can easily sustain a 50-60% cash dividend

payout ratio. Room for positive surprises on dividends remains.

Downside risks include: (i) continued weak fee franchise with peers

increasing the gap in digital banking also; (ii) greater than expected

deterioration in asset quality; and (iii) greater than expected slowdown in

dividend income from the equities portfolio.

Table 20: Allied Bank Limited investment summary

(PKRmn) 2016 2017 2018f 2019f 2020f



Net income 14,700 12,926 12,791 15,720 17,994

EPS (PKR) 12.84 11.29 11.17 13.73 15.71

P/E (x) 7.7 8.8 8.9 7.2 6.3

BVPS (PKR) 88.9 94.4 95.2 99.9 110.1

P/B (x) 1.1 1.1 1.0 1.0 0.9

DPS (PKR) 7.25 7.00 8.00 8.00 9.00

Dividend yield 7.3% 7.0% 8.0% 8.0% 9.0%

ROA 1.42% 1.12% 0.96% 1.10% 1.18%

ROE 15.32% 12.32% 11.78% 14.07% 14.96%


Price (PKR) 99.5






Market cap (US$mn) 917


27

PAKISTAN BANKS

Table 21: ABL – Financial statement

PKRmn 2016 2017 2018f 2019f 2020f 2021f 2022f

Income statement






Loan loss provisions (335) (1,967) (1,376) 1,146 2,146 2,743 2,299

Extraordinary expense - - 265 - - - -

Pre-tax profit 24,178 21,144 21,035 25,356 28,561 32,273 38,043


Balance sheet

Net loans 330,272 372,081 418,464 456,539 505,702 561,456 631,274

Interest-earning assets 932,390 1,080,748 1,229,165 1,267,076 1,378,672 1,523,861 1,665,569

Total assets 1,071,044 1,247,323 1,407,464 1,460,490 1,586,552 1,750,351 1,912,977

Total deposits 805,090 883,702 973,171 1,093,506 1,218,559 1,361,105 1,521,143

Total interest-bearing liabilities 941,308 1,115,094 1,274,764 1,322,991 1,437,722 1,591,227 1,741,028



EPS 12.84 11.29 11.17 13.73 15.71 18.04 21.60

BVPS 88.9 94.4 95.2 99.9 110.1 119.2 130.4

DPS 7.3 7.0 8.0 8.0 9.0 10.0 12.0

Ratios

Revenue generation


Revenues/assets 4.37% 3.54% 3.36% 3.76% 3.99% 4.08% 4.17%


Cost/ income 47% 53% 55% 51% 49% 48% 47%

Risk management

NPLs/gross loans 5.9% 4.6% 4.3% 4.0% 4.0% 4.0% 4.0%

Coverage ratio 92% 93% 81% 86% 88% 91% 89%

Loan provisions/Advances -0.10% -0.56% -0.35% 0.26% 0.45% 0.51% 0.39%

Profitability

ROA 1.42% 1.12% 0.96% 1.10% 1.18% 1.24% 1.35%

ROE 15.32% 12.32% 11.78% 14.07% 14.96% 15.73% 17.30%





Tier 1 ratio 16.5% 17.0% 15.3% 15.6% 15.5% 15.2% 15.2%

CAR 20.9% 22.4% 19.1% 19.1% 19.1% 18.5% 18.3%


28

PAKISTAN BANKS

MCB: Positives are in the price

We raise our target price for MCB to PKR228 (from PKR207) but retain our

Hold rating. MCB is best-in-class among peers given its: (i) high-spread model;

(ii) superior asset quality; (iii) strong capital; (iv) efficient cost structure; and (v)

growth prospects from Islamic banking subsidiary. However, these positives

appear to be largely priced in already, with MCB trading at a 2019f P/B of 1.4x

and P/E of 9.8x, comfortably the priciest valuations in our coverage. Earnings

outlook over the next 1-2 years depends to a large extent on recoveries from

NIB’s book which will be more challenging in the new macroeconomic setting.

Our expected share price return of 14% keeps it in Hold territory.

NIB’s loan book is generating net provisioning reversals, but there are

risks to the outlook. Initial recoveries were soft but Q2 18 reversals in excess

of PKR1bn are in line with management guidance. However, given the much

tougher macroeconomic backdrop, sustaining this pace of recoveries will be

difficult, in our view. We build in 30% recoveries from NIB’s book over the next

three years (less than the 40-50% that management is targeting). If our

conservative expectations are met, this should still result in net provisioning

reversals for MCB in 2019f and, possibly, also in 2020f.

Post-merger cost synergies have been slow in coming. We estimate MCB’s

cost/income at 53% in 2Q 18, compared to 47% in 3Q 17 (when NIB was

incorporated into MCB’s books). MCB’s own cost structure is efficient but

synergies from NIB have been slow due to: (i) a contractual obligation to retain

NIB’s staff for a period of at least 12 months after the merger; and (ii) set-up

of a dedicated Islamic banking subsidiary that has yet to breakeven

(management targets breakeven in 2019f). Given MCB’s track record, we are

confident that the cost/income ratio will fall below 45% by 2022f; over the next

few years however, the cost/income ratio may be near 50%.

NIM expansion will be slow, which will limit earnings growth in 2019f. This

is because MCB’s deposit mix is heavily tilted towards savings accounts (52%

of deposits) that attract a minimum rate linked to the discount rate and that are

re-priced almost immediately following benchmark rate changes. Within our

covered banks, we see MCB experiencing the slowest NIM expansion in

2019f. Over the medium-term however, as asset re-pricing catches up, MCB’s

NIM expansion will be greater than that of HBL and UBL.

Downside risks include: (i) slower than expected recoveries from NIB’s

books; and (ii) higher than expected admin costs. Upside risks include: (i)

higher than expected NPL recoveries from NIB; (ii) higher than expected loan

growth; and (iii) positive surprises on dividends.

Table 22: MCB Bank Limited investment summary

(PKRmn) 2016 2017 2018f 2019f 2020f



Net income 22,063 21,963 20,560 24,133 28,833

EPS (PKR) 18.62 18.53 17.35 20.36 24.33

P/E (x) 10.7 10.8 11.5 9.8 8.2

BPS (PKR) 123.2 132.1 133.5 140.5 150.0

P/B (x) 1.6 1.5 1.5 1.4 1.3

DPS (PKR) 16.00 16.00 16.00 16.00 16.00

Dividend yield 8.0% 8.0% 8.0% 8.0% 8.0%

ROA 2.10% 1.79% 1.42% 1.50% 1.63%

ROE 15.31% 14.52% 13.07% 14.87% 16.75%


Price (PKR) 199.8








29

PAKISTAN BANKS

Table 23: MCB – Financial statement

PKRmn 2016 2017 2018f 2019f 2020f 2021f 2022f

Income statement






Loan loss provisions 1,205 (2,895) (3,469) (1,523) 222 1,547 3,094

Extraordinary expense - - 1,903 - - - -

Pre-tax profit 36,721 30,614 34,008 39,062 45,903 52,902 62,740


Balance sheet

Net loans 364,334 500,966 560,213 616,762 677,300 758,586 856,664

Interest-earning assets 931,115 1,173,658 1,331,774 1,475,572 1,600,965 1,750,669 1,963,594

Total assets 1,076,690 1,373,430 1,526,086 1,695,153 1,841,743 2,011,575 2,239,224

Total deposits 795,690 1,001,146 1,114,852 1,245,984 1,389,334 1,556,074 1,748,294

Total interest-bearing liabilities 886,420 1,168,496 1,318,590 1,478,835 1,613,581 1,772,431 1,972,537



EPS 18.62 18.53 17.35 20.36 24.33 28.50 34.34

BVPS 123.2 132.1 133.5 140.5 150.0 163.7 185.4

DPS 16.0 16.0 16.0 16.0 16.0 16.0 18.0

Ratios

Revenue generation


Revenues/assets 5.83% 5.05% 4.54% 4.68% 4.95% 5.17% 5.42%


Cost/ income 41% 50% 51% 51% 48% 46% 43%

Risk management

NPLs/gross loans 5.6% 8.9% 7.5% 6.8% 6.4% 6.1% 5.7%

Coverage ratio 91% 94% 93% 91% 89% 88% 88%

Loan provisions/Advances 0.35% -0.67% -0.65% -0.26% 0.03% 0.22% 0.38%

Profitability

ROA 2.10% 1.79% 1.42% 1.50% 1.63% 1.75% 1.91%

ROE 15.31% 14.52% 13.07% 14.87% 16.75% 18.17% 19.67%





Tier 1 ratio 16.8% 14.2% 15.4% 14.3% 13.9% 13.8% 13.8%

CAR 19.7% 16.3% 16.9% 15.8% 15.3% 15.2% 15.0%


30

PAKISTAN BANKS

We, Raza Jafri, CFA, Yusra Beg and Rohit Kumar, certify that the views expressed in the report reflect our personal views about the subject securities. We also certify that no

part of our compensation was, is, or will be, directly or indirectly, related to the specific recommendations made in this report. We further certify that we do not have any beneficial

holding of the specific securities that we have recommendations on in this report.

Ratings Guide* Upside

Buy More than 15%

Neutral Between 0% - 15%

Sell Below 0%

*Based on 12 month horizon unless stated otherwise in the report. Upside is the percentage difference between the Target Price and Market Price.

Valuation Methodology: We use multiple valuation methodologies in arriving at a Target Price including, but not limited to, Discounted Cash Flow (DCF), Dividend Discount

Model (DDM) and relative multiples based valuations.

Risks: Please refer to page 18.

Disclaimer: Intermarket Securities Limited has produced this report for private circulation only. The information, opinions and estimates herein are not direct at, or intended for distribution to or use by, any person or entity in any jurisdiction where doing so would be contrary to law or regulation or which would subject Intermarket Securities Limited to any additional registration or licensing requirement within such jurisdiction. The information and statistical data herein have been obtained from sources we believe to be reliable where such information has not been independently verified and we make no representation or warranty as to its accuracy, completeness and correctness. This report makes use of forward looking statements that are based on assumptions made and information currently available to us and those are subject to certain risks and uncertainties that could cause the actual results to differ materially. No part of the compensation of the author(s) of this report is related to the specific recommendations or views contained in this report.

This report is not a solicitation or any offer to buy or sell any of the securities mentioned herein. It is meant for information purposes only and does not take into account the particular investment objectives, financial situation or needs of individual recipients. Before acting on any information in this report, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Neither Intermarket Securities Limited nor any of its affiliates or any other person associated with the company directly or indirectly accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein.

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Investing in any non-U.S. securities or related financial instruments (including ADRs) discussed in this report may present certain risks. The securities of non-U.S. issuers may not be registered with, or be subject to the regulations of, the U.S. Securities and Exchange Commission. Information on such non-U.S. securities or related financial instruments may be limited. Foreign companies may not be subject to audit and reporting standards and regulatory requirements comparable to those in effect within the United States. The value of any investment or income from any securities or related financial instruments discussed in this report denominated in a currency other than U.S. dollars is subject to exchange rate fluctuations that may have a positive or adverse effect on the value of or income from such securities or related financial instruments.

Frontier and Emerging Market laws and regulations governing investments in securities markets may not be sufficiently developed or may be subject to inconsistent or arbitrary interpretation or application. Frontier and Emerging Market securities are often not issued in physical form and registration of ownership may not be subject to a centralised system. Registration of ownership of certain types of securities may not be subject to standardised procedures and may even be effected on an ad hoc basis. The value of investments in Frontier and Emerging Market securities may also be affected by fluctuations in available currency rates and exchange control regulations. Not all of these or other risks associated with the relevant company, market or instrument which are the subject matter of the report are necessarily considered.

back on the earnings growth track*1 october 2018 · 2019f, reversing the trend of margin...

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