We downgrade our stance on Pakistan Banks to Market weight following the acute impact of Covid-19 on the economy and the sector. There are significant risks on revenue, particularly from tighter margins after the 425bps rate cut, while asset quality headwinds may persist for the next few years. A step increase in digital banking is possible, but this will not offset the weak near-term outlook.
The SBP has acted quickly to protect borrowers, but stress on banks looks unavoidable. We have cut CY20/21f EPS estimates by 23/29%, with TPs coming off by 24% on average. The cuts to estimates are less acute from CY22f onwards as we build in gradual normalization. The existing capital buffers imply largely defendable cash payouts, but we still build in slight cuts (after the SBP moratorium ends).
The sector has shed 31%CYTD to trade at a CY20f P/B of 0.76x and P/E of 7.05x (CY21f: 0.72x and 6.29x). A lot of risk has been priced in, but banks may not outperform given the significant uncertainty to earnings outlook. In general, we prefer the large banks over medium banks given their (i) less reliance on spread income, (ii) more conservatively structured loan books and (iii) more defendable cash payouts.
Tough times ahead for Pakistan Banks; downgrade to MW
The impact of the Covid-19 outbreak on economic activity is already severe and still unfolding. Despite recent relief measures by the SBP, we expect a widespread impact on Pakistan Banks, particularly on margins and asset quality; we have thus cut our EPS estimates by 23%/29% for CY20/21f. The cuts have been driven by (i) lower interest rates leading to NIM compression, (ii) slower loan growth, (iii) a sharp increase in the cost of risk, and (iv) a decline in fee income led by lower trade and remittance income. We have built in EPS cuts beyond CY21f as well, but these are less severe compared to the near-term estimate revisions.
Sharply lower interest rates to compress NIMs
The SBP has cut the Policy rate by 425bps since mid-March to 9.0%. Going by the SBP’s revised FY21 inflation range of 7-9%, and low aversion for zero real interest rates, further rate cuts are possible, in our view. We now incorporate an average Policy rate of 9.5%/7.5% for CY20/21f, down from 12.3%/10.5% previously, which reduces NIMs by 46bps/75bps compared to previous estimates. Non-funded income is also likely to be affected – trade and remittances account for more than 20% of fee. Pakistan banks have historically been able to offset margin compression by growing loans or realizing capital gains on bonds, but it is difficult to see earnings growth in CY20.
Asset quality stress is inevitable
Despite relief measures for borrowers, including deferring principal repayments by 12mths, asset quality pressures appear inevitable. For our covered banks, we see the cost of risk rising to 88/86bps in CY20/21f, up from 23bps over the last five years. This is, however, still lower than c 170bps pa across 2008-11, where we draw comfort from (i) much lower ADRs of c 50% vs. 75% in 2008, (ii) Consumer & SME having 12% share in the loan mix, down from a peak of c.30%, (iii) loans to the public sector having 17% share in the mix vs. single-digit exposure earlier and (iv) provisioning coverage at c. 90% (with room to take FSV benefit on illiquid collateral) vs. 70% in 2008.
Larger banks appear better positioned
The IMS Banks Universe now trades at a CY20f P/B of 0.76x and P/E of 7.05x (CY21f: 0.72x and 6.29x). Multiples are at a 37%/35% discount to the previous 5yr average on both P/B and P/E, respectively for CY20f. A few banks continue to offer double-digit dividend yields (once the SBP moratorium on dividends ends) but there are downside risks. In general, we prefer the large banks given their more defendable earnings and cash payouts compared to medium banks, as well as more attractive valuations relative to long-term sustainable ROE. (Intermarket Securities Limited.)