We issue a LONG-TERM BUY on KCB Group. The counter is currently trading a trailing P/B multiple of 0.94x (at a price of KES 39.05), a 19.7% 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 9.0% above the industry average of 6.0% (as at 8th May 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).
For the FY2019, alternative channels accounted for 97.0% of the volume of transactions with the mobile channel alone accounting for 78.0%. 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). We expect demand for credit to increase in light of the COVID 19 pandemic. We anticipate that the bank will likely be more stringent to preserve the quality of borrowers.
We expect the initiative by banks to provide free mobile transactions to lead to lower non-interest income growth. For instance, KCB expects to forego about KES 150.0 million on KCB to MPESA transfers in the 3 months. It’s not clear whether banks are willing to extend the time period.
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 (37.8%) 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.
Apart from the personal segment, the tourism and manufacturing sectors have been key loan book drivers. This is a cause of concern as these sectors have faced significant income losses and have recorded the highest proportion of restructured loans. Should the pandemic continue and measures to restrict spread of the virus extended there is a high risk of default for these restructured loans.
In sum, 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.