We issue a HOLD recommendation on Equity group Holdings, with a target price of KES 41.07 representing an 8.9% upside from the current market price KES 37.70 (as at 9th April 2021). The stock is currently trading at a trailing P/B of 1.03x and forward P/B of 1.0x. We remain cautiously optimistic on the bank, expecting an improvement in profitability driven by both funded and non-funded income as well as improved efficiencies. However, we expect asset quality pressures to persist in the short term.
Key Highlights:
- Transactional Revenue Continues to Drive Non-Funded Income: We expect Equity to leverage on its SME customer base to cross sell transactional products with strategic partnerships around diaspora remittances, trade finance and merchant banking.
- Cost optimization through digital banking: While we expect the overall C/I ratio to decline going forward, we note that the rise in operating expenses will be largely driven by the continued reliance on the brick and mortar model by regional subsidiaries, particularly Equity BCDC.
- Cautious lending: We expect the group’s loan book to continue registering growth with a conservative approach to Covid-19 high risk sectors and continued investments in liquid securities.
- Weakening asset quality: We expect the cost of risk to remain elevated with i) new covid-19 regulations that will result in subdued business environment ii) bank’s exposure to high risk sectors such as SMEs (51.0%), Trade (21.0%) and Real Estate (16.0%). We expect this to gradually decline going forward.
FY2020 FINANCIAL RESULTS
Equity Group recorded a 10.9% y/y decline in after tax profits to KES 20.1 billion (-11.8% y/y EPS to 5.24) mainly attributed to a surge in loan loss provisions and cushioned by deferred tax asset of KES 8.2 billion. ROE dipped to 15.3% from 21.8% in FY2019. The group’s board of directors did not declare a dividend payment.
- Declining Net Interest Margin
Net Interest Margin (NIM) declined by 110bps y/y to 7.2% driven by a 120bps y/y decline in yield from interest earning assets. This was however buoyed by cheaper cost of funds (-10bps y/y to 2.8%) supported by mobilization of transactional deposits and concessional funding. Should the CBK permit re-pricing of loans on a risk-adjusted basis, we position Equity to benefit the most, given 51.0% loan book exposure to SMEs. Additionally, alternative channels will continue driving the mobilization of cheaper deposits. We therefore expect to see a gradual escalation of NIMs.
2. Transactional Revenue Continues to Drive Non-Funded Income
Non-funded income grew by 25.1% y/y to KES 38.5 billion boosted by forex trading income (+77.2% y/y). Diaspora remittances contributed 32.0% of the volume of forex traded. Other income grew by 58.6% y/y mainly attributed to mark to market gains of KES 4.0 billion on government securities. Transactional income now contributes 66.5% to non-funded income, mitigating the group from credit related risks. We expect Equity to leverage on its SME customer base to cross sell transactional products with strategic partnerships around diaspora remittances, trade finance and merchant banking.
3. Improved Cost Efficiency
The group continues to reap the benefits of its digitization strategy as the C/I ratio declined to 48.5% from 51.1% in FY2019 (Kenyan subsidiary C/I ratio at 41.5% from 46.4%). As at FY2020, 98.0% of the group’s volume of transactions and 60.0% of transactional value occurred on alternative channels. While we expect the overall C/I ratio to decline going forward, we note that the rise in operating expenses will be largely driven by the continued reliance on the brick and mortar model by regional subsidiaries particularly Equity BCDC.
4. Asset Base Surpasses KES 1.0 trillion
Following the completion of the BCDC acquisition during the year, the group’s asset base grew by 50.7% y/y to KES 1.0 trillion. Customer deposits grew by 53.5% y/y to KES 740.8 billion while borrowed funds from development partners increased 54.1% y/y to KES 87.2 billion. The loan book grew by 30.4% y/y to KES 477.8 billion with exposure to SMEs reducing to 51.0% (59.0% in FY2019) in favor of large corporates 19.0% (13.0% in FY2019). We see this cautious lending strategy persisting, particularly to Covid-19 high risk sectors.
5. Deteriorating Asset Quality
As at FY2020, the group had restructured KES 171.0 billion (32.0% of its loan book portfolio), warranting a significant increase in loan loss provisions, +402.2% y/y to KES 26.6 billion with the cost of risk at 6.1% from 1.3%. Gross NPLs surged 63.7% y/y to KES 59.4 billion leading to an NPL ratio of 11.0%. Of the restructured loans, 33.0% were in real estate, 23.0% in trade, 9.0% in transport, 8.0% in tourism and 7.0% in manufacturing. As at December 2020, KES 20.0 billion of the restructured loans became paying, with KES 9.0 billion downgraded to stage 3. We expect the cost of risk to remain elevated with i) new covid-19 regulations that will result in subdued business environment in the medium term ii) bank’s exposure to high risk sectors.
6. Regional Banking Subsidiaries Support Growth
The regional banking subsidiaries defied the economic challenges to post growth in profitability (except Tanzania). Rwanda and Uganda both recorded ROaE of 22.0% against a cost of capital of 19.0%. Following the acquisition of BCDC, we believe the subsidiary offers the most scaling potential (country’s unbanked population of 28.4% unbanked population against 17% in Sub-Saharan Africa), now contributing 28.1% of the group’s assets. Regional subsidiaries now contribute 28.0% to the group’s overall profitability from 18.0% in FY2019, mitigating the group’s business risk from the Kenyan subsidiary.
7. Capital Adequacy Ratios Boosted by Development Funding
The group propped its core capital by withdrawing dividend payment of KES 9.5 billion (2nd year consecutively) and raising KES 11.0 billion Tier 2 capital from development partners. Core Capital/Total Risk Weighted Assets (TRWA) stood at 16.3% (FY2019: 14.8%) while Total Capital/TRWA was at 19.8% (FY2019: 18.9%).