Pakistan Banks Sector
SECTOR REVIEW
Riding a tiger
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Pakistan banks’ margins expanded in 3Q08, as a sharp rise in asset
yield offset the impact of the minimum saving deposit rate imposed by
the SBP in May. While rising margins are positive for banks’ earnings,
we remain concerned about the impact of higher lending rates on asset
quality. We raise our earnings estimates for CY08 and CY09, due to
higher margins, but lower our target prices, as we factor in a 100 bp
hike in the risk-free rate and higher minimum CAR in our valuation
model. We maintain our UNDERWEIGHT on Pakistan banks, as
valuations are above our target levels, but we may revise estimates for
NBP, UBL and HBL if prices fall 20-30% once the KSE floor is removed.
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Margins have once again started to improve, as KIBOR and risk
premiums are rising. We have raised our three-month KIBOR estimate
to 14.6% for CY09E and adjusted aggregate NIM for CY09E upwards by
149 bps to 6.8%. Interest rates are likely to remain firm until the middle
of next year and margin contraction could be pushed back to CY10.
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We view rising interest rates and robust loan growth in this challenging
economic environment as worrying. Under these circumstances, risks
to asset quality remain high and, taking a conservative view, we
estimate the aggregate NPL ratio for our coverage banks will rise from
7.7% in 3Q08 to 9.0% in CY09. We estimate P&L provisions will rise
from 103 bps of loans in 9M08 to 216 bps of loans in CY09.
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We cut our target prices by 12-37%, to incorporate a 100 bp hike in the
risk-free rate and raise the minimum CAR to 11-12% for CY09-10E due
to new capital adequacy rules. We maintain our UNDERWEIGHT on
Pakistan banks, downgrade UBL to UNDERPEFORM from Neutral with
a revised target price of PRs68, but maintain our ratings on the
remaining four banks. Banking stocks have corrected 50-60% from
their peaks, but valuations remain unattractive and rerating catalysts
are missing. The outlook for the next six months is encouraging, but
earnings visibility beyond 1H09 is low and we would wait for the stocks
to fall by 20-30% before revisiting them.

Riding a tiger
Pakistan banks’ margins continued to expand in 3Q08, as a sharp rise in asset yield offset
the impact of the minimum saving deposit rate imposed by the SBP in May 2008. Latest
system lending and deposit rate data indicate MoM interest spread continues to expand on
the back of a higher KIBOR and rising risk premiums. While rising margins are positive for
banks’ earnings, we are uncomfortable that higher lending rates raise risks for asset
quality, especially given the challenging economic environment. We raise our earning
estimates on the back of higher margins, but cut target prices by 12-37%, due to a 100 bp
hike in the risk-free rate and higher minimum capital adequacy ratio (CAR). We maintain
our UNDERWEIGHT on Pakistan banks, as valuation multiples are expected to contract in
response to the higher risk-free rate and lower returns on equity (ROE) once the price floor
is removed.
Margins improve as KIBOR continues to rise
Margins have once again started to improve, as KIBOR and risk premiums are rising. We
believe KIBOR will average 15% in 4Q08E, up by 129 bps over the previous quarter and
average at 15.5% during 1H09E, due to inflationary fears and the liquidity crunch, before
declining to an average of 13.6% by 2H09E. Loan growth is still robust at 17% YTD,
according to the latest data, while YTD deposit growth lags at 3.3% and is exacerbating
the liquidity problem. Based on our revised estimate of 14.6% for KIBOR for CY09, we
have adjusted the aggregate net interest margin (NIM) for CY09 upwards by 149 bps to
6.8% and now expect margin contraction to be pushed back to CY10.
Risks to asset quality are rising
We are concerned about widening margins and robust loan growth in the current
challenging economic environment. Higher lending rates could potentially push marginal
borrowers towards delinquencies and non-performing loans (NPLs) may rise in coming
months. Three of the five banks that we cover show signs of asset quality deterioration,
with the NPL ratio rising by 40-130 bps over 9M08. We maintain our conservative view
and estimate the NPL ratio will rise from 7.7% to 9.0% in CY09E. We estimate P&L
provisions will jump from 103 bps of loans in 9M08 to 216 bps of loans in CY09E.
Valuations are not attractive yet
We maintain our UNDERWEIGHT on Pakistan banks despite them having corrected 50-
60% from their peaks, as their valuations remain unattractive and rerating catalysts are
missing. We have adjusted our target prices for a higher risk-free rate of 15%, while
raising the minimum CAR to 11-12% for CY09-10E, as we factor in new capital adequacy
requirements based on CAMELS rating applicable from 2009. We downgrading UBL to an
UNDERPERFORM from Neutral with a revised target price of PRs68 (from PRs77), while
maintaining our previous ratings for the other four banks. Although the outlook for the next
six months is encouraging, earnings visibility beyond 1H09 is low and we would wait for
our stocks to fall by 20-30% from the price floor level before revisiting them.