By: Next Capital Limited
Initiate with Outperform- We initiate our coverage on the Pakistan banking sector with an Overweight stance. The recent fall in banking stocks (down 19% on avg. in the last two months) has created an excellent entry point, where P/B’s, P/E’s and dividend yields are now at their cheapest in the last two years.
Investment Case: We forecast that medium-term pressure on NIMs is non-existent; upto July 2016, lower DR will actually increase profitability for most banks, due to heavy investment in Pakistan Investment Bonds (PIBs). Infact, we expect strong earnings growth of 19% in CY15. However, where we differ more significantly from consensus is in earnings momentum beyond CY15; the market expects earnings to decline in CY16 and CY17, whereas we estimate CY16 to be a low growth year, with resumption of growth in CY17. Our estimates are premised on two crucial insights. Firstly, some banks have built up a large portfolio of longer term 5 and 10 year bonds, which limits the maturities in July 2016. Secondly, the re-investment risk post July 2016 is greatly exaggerated; we estimate that CPI inflation will revert to around 8.0% levels by July 2016, even if inflationary pressures remain below historical norms. With CPI inflation at 8.0%, DR would revert to around 10% levels by 3QCY16. And the fiscal deficit continues to expand, banks to be able to reinvest their maturing PIB holding into freshly issued PIBs at double-digit yields by that time.
Catalysts: As strong earnings come through in the quarters ahead, we expect the market to recalibrate its view on the banking sector. Furthermore, as focus on yield stocks intensifies and broadens, we believe investors will begin to appreciate that banks should now form the mainstay of a dividend yielding portfolio; selected banks are now offering close to double digit dividend yields.
Valuation: We have valued banks using a justified P/B approach. On multiples, Pakistan banks are now trading at P/B multiples well below their historical averages. On a forward P/E basis, selected banks are now trading below 5x, offering strong value in an improving macro environment.