Bank Alfalah Limited – BAFL: The bank with a plan

Karachi, January 29, 2015 (PPI-OT): Bank Alfalah Limited tweaks earnings estimates for BAFL to reflect a more palatable macro environment where IFC capital injection (PkR6.67bn) can allow (i) swifter than industry BS growth and (ii) continuation of annual dividends. By this time next year, BAFL will have 700+ branches which should translate into consistent cost efficiency over the medium‐term. The combination of BS size and strong capital base will enable BAFL to post a 14% NPAT CAGR across the next 5yrs, the highest in the AKD Banks Universe with room for +ve surprises if SBP focus on Islamic banking reaches fruition. As a result, BAFL depicts the greatest uptick in Tier‐I ROE in Bank Alfalah Limited’s coverage cluster‐ from an average of 12.6% over the last 5yrs to 18.7% by CY18F. Together with the macro rebound, this should translate into swift valuation rerating where BAFL trades at an average 22% discount to private sector peers that may struggle to expand ROE.

Having shed 4%CYTD, BAFL trades at an attractive valuation set (CY15F P/B: 1.18x, P/E: 7.8x, D/Y: 6.7%) where Bank Alfalah Limited’s revised TP of PkR38/sh (on new no. of shares) offers a 1‐yr total return of 19%. Note, that Bank Alfalah Limited’s TP would rise to PkR40.5/sh upon inclusion of Warid in valuations. Accumulate!

The bank with a plan: Scale pays off in the Pakistan banking sector; to this end, BAFL has increased its branch network from less than 50 in CY02 to more than 600 at present to emerge as the 6th largest bank in the country. This is not easy to replicate, as peers have had to rely on oft‐risky M and A activity to grow. While this rapid expansion has resulted in periods of high earnings volatility for BAFL, Bank Alfalah Limited believes the bank is now positioned to reap scale benefits; across the medium‐term, C/I is projected to drop below 65%, CASA should cross 70% and L/D could expand to above 55%. This should drive a 14% NPAT CAGR across the next 5yrs, with room for +ve surprises (18% NPAT CAGR if C/I drops to 60%).

Stronger capital base: Bank Alfalah Limited ventures that swift BS growth will be a natural consequence of a stronger capital base where IFC capital injection of PkR6.67bn alone (238.1mn shares issued) will bump up BAFL’s CAR by an estimated 180bps (CY13 CAR: 12.1%). Bank Alfalah Limited sees BAFL’s assets growing at a 12%+ CAGR across the medium‐term, with room to support higher risk weights leading to a projected loan growth CAGR of 15%. At the same time, BAFL will likely be able to continue with annual dividends at a ~50% payout ratio. Besides impetus to core interest earnings, Bank Alfalah Limited also likes BAFL’s non‐funded income franchise which can receive a further boost post launch of a branchless banking proposition last year in collaboration with Warid Telecom.

SBP push on Islamic banking: In view of limited asset‐side opportunities, BAFL has consciously pared its Islamic book’s contribution to less than 15% from 20%+ at end‐CY12. While the picture may not change in the near‐term, Bank Alfalah Limited retains Bank Alfalah Limited’s liking for Islamic banking given (i) GoP push for Islamic products (launch of global sukuk), (ii) SBP anticipated push for the same under high‐level appointees and (iii) win‐win situation for the GoP to borrow at cheaper rates from highly liquid Islamic banks. Not for nothing is MCB planning to set up a separate Islamic banking subsidiary where revival in BAFL’s Islamic business over the medium to long term has the potential to result in +ve earnings surprises.

Valuation rerating: Beyond CY15F, BAFL should depict a rising ROE trend with Tier‐I ROE projected to rise from 12.6% across the last 5yrs to 18.7% by CY18F ‐ the larger private banks, coming from a prolonged period of 20%+ ROE, may struggle to replicate the same. This should lead to a compression in BAFL’s valuation discount vs. peers (26%/21%/61% on forward PB/PE/Mkt Cap‐to‐Deposits).

BAFL trades at a CY15F P/B of 1.18x and P/E of 7.8x where Bank Alfalah Limited’s revised TP of PkR38/sh offers a 1‐yr total return of 19%. However, Bank Alfalah Limited flags that increase of 50bps in MDR on savings deposits will compress TP to PkR36.6/sh (total return: 16.5%).

The bank with a plan

Scale pays off in the Pakistan banking sector; to this end, BAFL has increased its branch network from less than 50 in CY02 to more than 600 at present to emerge as the 6th largest bank in the country. This is not easy to replicate, as peers have had to rely on oft‐risky M and A activity to grow. While this rapid expansion has resulted in periods of high earnings volatility for BAFL, Bank Alfalah Limited believes the bank is now positioned to reap scale benefits; across the medium‐term, C/I is projected to drop below 65%, CASA should cross 70% and L/D could expand to above 55%.

This should drive a 14% NPAT CAGR across the next 5yrs, with room for +ve surprises (18%NPAT CAGR if C/I drops to 60%) The importance of scale: Scale matters in the Pakistan banking space. In general, a larger branch network coincides with lower funding costs (higher CASA) and a lower C/I . This arises because a larger, spread‐out branch network tends to attract deposits from untapped areas while better cost efficiency is a natural consequence of scale.

In BAFL’s case, branches have increased from less than 50 in CY02 to ~600 at present, with plans to increase this to 700 by end‐CY15. Although this rapid branch expansion led to high earnings volatility for BAFL, the bank now appears positioned to reap scale benefits across the medium‐term. While the BS has already depicted improvement (CASA has inched up to 70% from 53% in CY09), size has yet to translate into cost efficiency; Bank Alfalah Limited thinks the latter is inevitable – as the staff/branch ratio converges to Big‐5 levels, BAFL’s C/I should decline going forward. This should help drive a 14% NPAT CAGR across the next 5yrs. There is room for +ve surprises – if C/I comes off to 60% over the next 5yrs, the bank’s NPAT CAGR would jump to 18%.

Improved cost efficiency: BAFL’s admin expenses grew by a 22% CAGR over the last 10yrs, outpacing income growth (pre‐provision) CAGR of 20%. This relationship should invert going forward, with income growth projected to outrun cost increases. A comparison of BAFL with private sector peers shows that that while BAFL’s staff is paid on commensurate terms, the bank still has a high staff/branch ratio (18.5 at end‐CY14 vs. 9.8 average for private peer banks). In fact, BAFL’s total staff/branch ratio is almost 50% higher than public‐sector NBP.

Bank Alfalah Limited argues that as BAFL’s branch network reaches optimal size, it will be able to swiftly lower the staff/branch ratio not by a VSS but by reallocating existing staff to new branches. Bank Alfalah Limited sees BAFL’s staff/branch ratio converging onto 15 over the medium‐term, still not as efficient as the larger banks but significantly better than a 40+ ratio in CY06/07.

Stronger capital base

Bank Alfalah Limited ventures that swift BS growth will be a natural consequence of a stronger capital base where IFC capital injection of PkR6.67bn alone will bump up BAFL’s CAR by an estimated 180bps (CY13 CAR: 12.1%). Accordingly, Bank Alfalah Limited sees BAFL’s assets growing at a 12%+ CAGR across the medium‐term, with room to support higher risk weights leading to a projected loan growth CAGR of 15%. At the same time, BAFL will likely be able to continue with annual dividends at a 50% payout ratio. Besides impetus to core interest earnings, Bank Alfalah Limited also likes BAFL’s non‐funded income franchise which can receive a further boost post launch of a branchless banking proposition last year in collaboration with Warid Telecom.

IFC capital injection‐ means to an end: The International Finance Corporation (IFC), the private sector arm of the World Bank has injected capital worth PkR6.67bn in BAFL to acquire a 15% stake in the bank (238.1mn new shares issued at PkR28/share each). The bank has also decided to grant an option to the IFC to purchase additional equity of up to 5.0%, valid till Dec 31’15 subject to applicable approvals. IFC’s equity investment will serve as a means for BAFL to boost its CAR which in CY13 (12.1%) was not providing a significant buffer in case private sector credit ooake sustainably picked up.

CAR boost to allow solid BS growth: All else the same, Bank Alfalah Limited estimates that IFC’s capital injection will boost BAFL’s CY15F CAR by 180bps. While this will be slightly ROE‐dilutive in the immediate‐term, in reality the positive impact is going to be longer lasting and more pervasive. Based on industry leverage of 11.8x, BAFL can potentially grow its assets by ~PkR80bn.

This should lead to incrementally higher profits for BAFL going forward. This is particularly beneficial in a lower interest rate environment with industry NIMs likely to inch lower or, at best, remaining close to current levels. At the same time, BAFL should be able to continue with annual dividends where Bank Alfalah Limited sees an average 50% payout ratio going forward. This should also provide impetus to BAFL’s valuation rerating theme.

Non‐funded income to play its part: While BAFL retains a decent fee income franchise, core fee income/pre‐provision operating income of 10.4% is the second lowest in the Big‐6 banks. This avenue could enter a new era going forward where BAFL, in collaboration with Warid Telecom, launched its branchless banking product (Mobilepaisa) last year. This remains a fast‐growing segment (industry BB transactions rose by 23%YoY). In this regard, Bank Alfalah Limited builds in an increasing contribution from core fee income in BAFL’s earnings mix. In terms of non‐core fee income, potential for positive surprises remains on capital gains, both on the bank’s own equity porƞolio and its 8.24% stake in Warid Telecom in case the latter is disposed (Warid has been completely written down on BAFL’s books). Recall that in CY13, Abu Dhabi Group bought back 30% stake in Warid from Singtel for US$150mn as well as 7.5% proceeds from any future sale/public offering of Warid. Incorporation of Warid increases Bank Alfalah Limited’s TP to PkR40.5/sh.

SBP push on Islamic banking

In view of limited asset‐side opportunities, BAFL has consciously pared its Islamic book’s contribution to less than 15% from 20%+ at end‐CY12. While the picture may not change in the near‐term, Bank Alfalah Limited retains Bank Alfalah Limited’s liking for Islamic banking given (i) GoP push for Islamic products (launch of global sukuk), (ii) SBP anticipated push for the same under high‐level appointees and (iii) win‐win situation for the GoP to borrow at cheaper rates from highly liquid Islamic banks. Not for nothing is MCB planning to set up a separate Islamic banking subsidiary where revival in BAFL’s Islamic business over the medium to longer term has the potential to result in +ve earnings surprises.

BAFL’s Islamic franchise: With an Islamic network of 148 branches and the largest Islamic window amongst conventional banks, BAFL Islamic division has been one of key importance to the bank with more than 20% contribution to the BS in CY12. However, due to lack of viable asset‐side products, BAFL has had to trim its Islamic business to less than 15% of the book (balanced by shedding of high cost deposits). This foot‐off‐the‐pedal approach can quickly change provided GoP/SBP focus remains on the advancement of Islamic banking in the country. The advantages are clear to see – BAFL’s Islamic CASA is close to 90% vs. overall bank‐level CASA of 65%! Bank Alfalah Limited expects BAFL to continue with Islamic window operations (separate subsidiary would require PkR6bn of capital, to be gradually increased to PkR10bn).

While standalone Islamic banks could provide more competition, Bank Alfalah Limited believes BAFL’s successful efforts to build an Islamic franchise will stand the bank in good stead, notwithstanding window operations. This can lead to +ve earnings surprises for BAFL.

Islamic banking outlook: From small beginnings, the Islamic banking industry has captured a 10% market share with a branch network approaching 1,500 branches. Growth continues to quick (assets: +19.0%YoY; deposits: +20.5%YoY) although Islamic banks have not been able to partake in the recent GoP borrowing from Islamic banks with investment in GoP securities reducing by 23.4%YoY in Sep’14 due to non‐issuance of a new GoP sukuk during this period.

In Bank Alfalah Limited’s view, this stands to change across the medium‐term on a confluence of factors: (i) the GoP/SBP’s continued focus on developing Islamic banking e.g. recent introduction of OMOs for Pakistan Ijara Sukuks and plans to increase Islamic market share to 15% by 2018 and (ii) high prevailing liquidity with Islamic banks (ADR of 28% vs. 37% for the industry) which can fund GoP borrowing requirements. This is backed by banks such as MCB considering to set up separate Islamic banking subsidiaries and FABL, SMBL and BOK reportedly planning to fully convert to Islamic banking.

Valuation rerating

Beyond a slight blip in CY15F (as IFC capital manifests), BAFL should depict a rising ROE trend going forward, with Tier‐I ROE projected to rise from 12.6% across the last 5yrs to 18.7% by CY18F. In contrast, the larger private banks, coming from a prolonged period of 20%+ ROE, may struggle to replicate the same. This should lead to a compression in BAFL’s valuation discount vs. peers; at forward 26%/21%/61% on PB/PE/Mkt Cap to Deposits.

BAFL trades at a CY15F P/B of 1.18x and P/E of 7.8x where Bank Alfalah Limited’s revised TP of PkR38/share offers a 1yr total return of 19% (with‐Warid TP: PkR40.5/share). Higher ROE = Rerating! BAFL’s Tier‐I ROE is projected to rise from 12.6% across the last 5yrs to 18.7% by CY18F with impetus arising from swift BS growth (post IFC capital injection), lower intermediation costs and improvement in asset quality. Regarding the latter, credit costs could average less than 30bps going forward, kept in check by likely low NPL accretion. BAFL trades at a forward P/B of 1.2x, at a 25% discount to average forward P/B of 1.6x for the Big‐5 banks. Over the next 5yrs, Bank Alfalah Limited expects BAFL’s Tier‐I ROE to average at 18.2%, 12% lower than average Tier‐I ROE for the Big‐5.

Considering the ROE differential will not be significant, Bank Alfalah Limited believes BAFL’s valuations are set for accelerated rerating; both as Pakistani banks in general are assigned higher multiples in an improved macro seƫng and as BAFL’s valuation differential to the Big‐5 contracts. Ignoring sector‐wide rerating for the moment, if BAFL’s P/B discount to the Big‐5 contracts to 12%, its share price will rise to PkR40/share!

Rerating can be swifter:

The five most profitable banks in Pakistan all have a few things in common particularly, capital strength and a large branch network. With a target network of 700+ branches and a boost to CAR by the recent IFC capital injection, BAFL is now part of the A‐league. While Bank Alfalah Limited’s sample of top 5 banks are expected to witness stable ROEs, BAFL will catch up quickly on ROE terms due to the fastest projected growth in the AKD Banks Universe. With this to be driven by more efficient operations/intermediation, Bank Alfalah Limited opines that BAFL stands to catch on Market‐Cap‐to‐Deposits basis. In this regard, BAFL has a forward Mkt Cap/Deposits of 7.9%, 61% lower than the comparable average of 20.3% for the Big‐5 (51%discount ex‐MCB) where Bank Alfalah Limited believes this hefty discount is due to BAFL’s high admin cost base eroding its deposit franchise potential. As scale efficiencies emerge, Bank Alfalah Limited believes the market will start assigning a higher value to BAFL’s inherent deposit franchise, hence contracting BAFL’s discount to peers on this metric.

Investment Perspective: Having shed 4%CYTD (vs. 7.0% CYTD return for KSE‐100 Index), BAFL trades at a CY15F P/B of 1.18x, P/E of 7.8x and D/Y of 6.7%. While Bank Alfalah Limited sees limited immediateterm ROE dilution on the IFC equity injection, Bank Alfalah Limited believes this is a significant medium‐term positive. Scale gains arising from the bank’s large size (700+ branches by CY15F) are expected to be another medium positive trigger, enabling the bank’s deposit franchise to come to the fore. Bank Alfalah Limited’s revised TP of PkR38/sh (with‐Warid‐ TP: PkR40.5/sh) offers a 1yr total return of 19%. Accumulate!

Risks:

Politics/ Law and Order: While political noise has clearly reduced after the sharp escalation in Autumn 2014, pressure points remain. At the same time, while the civil/military leadership appears committed to the ongoing military operation, law and order concerns persist. Any disruptive developments on both fronts could respectively impact the operating environment for banks including BAFL.

Macroeconomic risk: Pakistan’s Economy is on an uptick, underpinned by soft inflation, lower interest rates and a much improved BoP position. This stability can potentially manifest in higher GDP growth going forward, which can unlock valuation rerating for Banks besides leading to likely lower NPL accretion. Banks including BAFL will likely be adversely affected if the macro growth theme fails to sustain.

Competition from other Islamic banks: Despite the recent slowdown, BAFL’s Islamic operations still comprise ~15% of the bank’s BS. Bank Alfalah Limited expects the bank to continue with window operations (due to capital requirements for standalone Islamic banking operations). This could lead to peers, with focus on standalone Islamic banking, overtaking BAFL.

Regulatory moves to tighten interest rate margins: The SBP Governor has recently stated that the central bank will look to review the banking industry’s spreads in Jun’15, with appropriate regulatory steps to be taken if necessary. The Governor has also stated that the present level of spreads (Dec’14: 6.0%) is too high and that the industry’s spreads should ideally be at 4.5%. While Bank Alfalah Limited flags this as an unrealistic target where commercial banks can point to fresh spread (on loans on deposits extended/taken during the month) that has averaged 4.6% over the last 6m.

That said, Bank Alfalah Limited concede that the SBP could realistically look to slightly tighten rules; at present the rate floor on savings deposits (~40% of sector’s deposit base), is 300bps below the DR, this could conceivably be tightened to 250bps below the DR in 2HCY15 and beyond. In case this happens, it will lead to a downward revision in Bank Alfalah Limited’s earnings estimates for BAFL by 4%‐8% across Bank Alfalah Limited’s investment horizon, lowering Bank Alfalah Limited’s TP to PkR34.5/sh (with‐Warid TP: PkR36.6/sh), all else the same.

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