We issue a LONG-TERM BUY on KCB Group. The counter is currently trading a trailing P/B multiple of 0.84x (at a price of KES 35.05), a 28.2% discount of over its 3-year P/B average of 1.17x. The company has a return on average equity (ROaE) of 20.7% (second highest among listed banks) and a dividend yield of 10.0% above the industry average of 5.1% (as at 3rd July 2020).
Our recommendation is based on the following long-term factors:
NIM Expansion on Interest Rate Cap Repeal: We expect KCB’s Net Interest Margin to benefit from repeal of the rate cap. Since KCB did not materially alter its lending strategy on enactment of the rate cap, we expect the NIM expansion to be driven mainly by repricing of loans (i.e. higher loan yields) rather than loan book growth.
A portion of the loan book is still pegged on the interest rate cap regime (CBR + 4.0%). We expect these loans to be repriced downwards in line with the CBR cuts. This puts more downward pressure on NIM. However, based on management guidance, we are likely to see a much faster maturity in these loans than initially anticipated. Our model initially assumed that 50.0% of these loans would mature by the end of FY2023. However, at the FY2019 results call, management alluded to 50.0% of the loans maturing within one year. Additionally, we see the opportunity to restructure loans to the new interest rate regime. This will benefit the bank over the long term as economic prospects improve.
In light of bleak economic outlook, banks will likely be more cautious in lending. We therefore do not expect higher loan book growth to make up for the lower yields.
Due to the lower interest rate environment we expect the bank to lower its cost of deposits to mitigate the decline in NIMs.
Strategic Partnerships and Investments in Digital channels: We expect strategic partnerships and investments in digital channels (particularly the mobile channel) to play an important role in growing NFI. Notable products from these partnerships include KCB MPESA (with Safaricom) and Fuliza (with Safaricom and NCBA).
In the 1Q2020, alternative channels accounted for 97.0% of the volume of transactions with the mobile channel alone accounting for 73.0%. Through the strategic partnerships, the mobile channel has facilitated saving and lending. By the end of FY2019, KCB had cumulatively lent KES 212.1 billion (KES 157.7 billion of this amount was lent in FY2019 after addressing capacity constraints with a revamped mobile platform). An additional KES 49.8 billion was lent in the 1Q2020. Due to the COVID 19 pandemic, management intimated that demand for credit on these platforms is likely to weaken, contrary to our previous expectations. We also anticipate that the bank will likely be more stringent to preserve the quality of borrowers, potentially leading to lower disbursements.
We expect the initiative by banks to provide free mobile transactions to lead to lower non-interest income growth. These measure which were initially meant to last for 3 months have now been extended to 33rd December 2020. KCB expects to forego about KES 500.0 million on KCB to MPESA transfers for the FY2020.
Moreover, with lower economic activity we expect lower transactions and lower credit related fees and commissions income.
Lower Loan Book Growth: For the FY2020, we expect the bank to be more cautious in lending on asset quality concerns.
Asset Quality Deterioration: We anticipate that asset quality deterioration on the adverse economic outlook brought about by the pandemic. Its highest sector exposure (36.9% as at 1Q2020) is in personal/household segment. Although the pandemic has brought about income losses following job losses, management intimated that they have a large exposure in the public sector (e.g. Teachers Service Commission) which we view as more job secure. During the 1Q2020 results call, management said that most of the restructured loans (c. KES 80.0* billion at 1Q2020) were in the corporate segment followed by mortgages. The personal segment was the best performing segment due to the aforementioned reason. We therefore expect KCB’s NPL ratio to deteriorate at a lower rate compared to some SME focused banks like Equity Group.
In the short term, we expect a higher a cost to income ratio to lead to lower profitability for the bank. Over the long term, we see a strong investment case for a buy and hold investor driven by the aforementioned drivers which will outlive the pandemic.
*According to the Business Daily, this figure has since increased to over KES 120.0 billion as at the end of May 2020.
1Q2020 Results Commentary
KCB Group posted an 8.5% y/y growth in after tax profits for 1Q2020 to KES 6.3 billion (1Q2019: KES 5.8 billion). The growth in profitability was predominantly attributed to a 22.4% y/y growth in total operating income to KES 23.0 billion. The performance also reflects consolidation of NBK first quarter results.
Total interest income rose by 20.4% y/y to KES 20.2 billion. This growth was mainly driven by a 63.3% y/y increase in income from government securities to KES 5.3 billion (+20.3% q/q), due to a 52.8% y/y growth in the Group’s holding of government securities to KES 203.7 billion.
Interest income from loans and advances grew by 9.5% y/y to KES 14.7 billion as loans and advances edged up by 19.3% y/y to KES 553.9 billion (+3.5% q/q) with the yield on loans falling to 10.8% (1Q2019: 11.6%).
Total interest expenses declined by 26.6% y/y to KES 5.2 billion owing to a 31.0% y/y dip in interest expenses from customer deposits to KES 4.7 billion. The lower interest expenses from customer deposits were owing to a marginal decrease in the cost of customer deposits to 2.7% (1Q2019: 2.8%) as customer deposits rose by 31.4% y/y to KES 740.4 billion (+7.8% q/q).
Despite an 18.5% y/y growth in net interest income to KES 15.1 billion, the net interest margin (NIM) fell to 7.6% from (1Q2019: 8.5%).
Non-funded income grew by 30.5% y/y to KES 7.9 billion mainly due to a 44.8% y/y rise in other fees and commission income to KES 2.7 billion. The contribution of non-funded income to total income grew to 34.4% (1Q2019:32.3%). According to management, the growth in non-funded income was supported by additional income from National Bank.
Despite a 22.3% y/y increase in operating expenses (excluding provisions) to KES 11.1 billion, the cost to-income ratio (excluding provisions) remained flat at 48.5% owing to the faster rise in total operating income (+22.4% y/y to KES 23.0 billion).
Loan loss provisions surged by 149.1% y/y to KES 2.9 billion as gross nonperforming loans edged up by 70.5% y/y to KES 66.2 billion. According to the bank this was to cover for downgraded facilities, with an expected growth in defaults across key sectors of the economy attributable to the Covid-19 pandemic that has negatively affected the country’s, regional and global economy.
Cost of risk increased by to 2.1% from 1.0% in 1Q2019 owing to the rise in loan loss provisions. Asset quality deteriorated as the NPL ratio (gross NPL/ gross loan book) rose to 11.1% (1Q2019: 7.7%). This was attributed to consolidation with National Bank. We expect asset quality to be adversely impacted by the Covid-19 pandemic due to loan defaulting.
National Bank of Kenya (NBK) posted a profit before tax of KES 233.0 million from loss of 961.0 million in the 1Q2019. Its loan book grew by 3.1% y/y to KES 47.3 billion over the same period.