Sep 13, 2015

Following the release of the H1’2015 results by banks, we carried out an analysis on Kenya’s banking sector to decipher any material changes from our Q1’2015 banking report. The aim of the analysis is to answer the question: from an equity investor point of view, which is the most attractive listed bank to invest in for the long-term?

In Kenya there are a total of 42 commercial banks, 12 microfinance banks and 1 mortgage finance institution. The Central Bank of Kenya regulates all banks. The Capital Markets Authority has additional oversight over the listed banks, which are 11 in number.

As at H1’ 2015, the banking sector recorded a slow-down in growth, growing at 8.3% compared to 15.6% in 2014, with the slowdown being attributed to poor economic performance on the back of increased non performing loans and the uncertainty in the interest rate environment. On the PAT y/y growth, National Bank of Kenya (NBK) and Co-operative bank registered the highest growth of 123.0% and 32.3%, respectively. NBK’s growth was due to a robust growth in non-funded income of 227%, driven mainly by sale of property. Net Interest Income (NII) grew by 18.8%, supported by a 30.6% growth in the loan book and 6.4% increase in deposits. Co-operative Bank’s performance was driven by a 19% y/y growth in NII, to Kshs. 11.8 bn from Kshs. 9.9 bn in H1’2014. Total operating expenses declined by 4% y/y to Kshs. 9.0 bn, bringing the cost to income ratio (CIR) to 47%, from 59% in H1’2014.

CfC Stanbic and Standard Chartered registered the largest declines of 42% and 36%, respectively. CfC’s decline was largely attributed to a decline in non-funded income (NFI), which declined by 33% y/y to Kshs. 3.3 bn thereby diluting the effect of the 2.0% increase in net interest income (NII). Standard Chartered banks results were weighed down by a 51.2% increase in loan loss provisions. NII declined a marginal 0.1% y/y, while NFI fell by 31.2% y/y on account of a one off Kshs. 1.2 bn gain last year owing to the bank’s sale of property

On the operating environment, increases in the Kenya Banker’s Reference Rate by 133 bps to 9.87% has resulted in an upward repricing of loans, raising the risk that more loans issued might fall into a non-performing territory. Discussions with various bank management teams indicate that a further increase of 300 bps in the KBRR will see a negative impact on the NPLs in the industry. Other challenges in the banking industry include the Consumer Protection Act, that allows customers to prepay their loans and not be subject to a charge, and the Banking Act that allows customers who had placed term deposits to recall them before maturity and only be charged the foregone interest payment. This has affected commercial bank’s asset liability matching, and poses further risks in the medium term.

Some of the developments in the banking sector include:

1. Increase in interest rates: The KBRR increased by 133 bps to 9.87% largely as a result of an increase in the CBR by 300 bps to 11.5%. This will raise interest on all loans pegged on the KBRR;
2. Lower earnings growth: Banks recorded the slowest year on year growth in 6 years of 8.3% during H1’2015, as compared to 15.6% in H1’ 2014;
3. Core Capital: Rejection of increase in Core Capital Requirements to Kshs. 5 bn as proposed in the 2015/2016 Budget, which would have seen 20 commercial banks make shareholders’ cash calls, merge or sell equity stakes to comply with the law. Parliament rejected the proposal to increase core capital in banks to Kshs. 5 bn by 2018;
4. Dubai Bank Liquidation: Dubai bank was placed under receivership with the Kenya Deposit Insurance Corporation (KDIC) for failure to meet statutory requirements since July and for failure to honour a Kshs. 48.2 mn financial obligation due to Bank of Africa. The KDIC further recommended that the bank be liquidated.

Our banking report examines the health and future expected performance of the bank, by looking at metrics for profitability, efficiency, growth, asset quality, liquidity, revenue diversification, capitalization and intrinsic valuation. In total, we looked at 13 different metrics to rank the banks.

1. Net interest margin: We used the net interest margin as a bank’s measure of core profitability;
2. Return on average common equity: We used the return on average common equity as a measure of profitability that flows to equity holders;
3. Price/Earnings growth ratio: We used the price/earnings growth ratio to determine relative valuation considering each bank’s expected growth rates;
4. Loans to deposit ratio: We used the loans to deposit ratio as a bank’s measure of liquidity;
5. Cost to income ratio: We used the cost to income ratio as a bank’s measure of efficiency;
6. Deposits per branch: We used a bank’s deposits per each branch as a measure of efficiency and proficiency in deposit gathering;
7. Price to tangible book value: We used a bank’s price to tangible book value as a measure of relative valuation;
8. Tangible common equity ratio: We used the tangible common equity ratio as a measure of a bank’s permanent capitalization levels;
9. Non-performing loans to total loans ratio: We used a bank’s non-performing loans to total loans ratio as a measure of a bank’s asset quality and credit risk;
10. Provisions to NPLs: We used a bank’s provisions to non-performing loans as a measure of a bank’s credit risk;
11. Non-interest income to revenue: We used the ratio of non-interest income to revenue as a measure of a bank’s revenue diversification;
12. Camel rating: We used our own camel rating system to assess the overall safety and soundness of the banks;
13. Intrinsic Valuation: We used our analyst’s projections of the future performance of the banks to derive their intrinsic valuation.

Based on these metrics, we were able to rank the listed banks from number 1 to number 11, and get the bank that is likely to deliver the best return over a long term period of 3 to 5 years, based on the best franchise value and future growth opportunities.

It is notable that CFC Stanbic registered the biggest ranking deterioration in the H1’2015 Cytonn Banking Report. The bank declined from Rank #1 in Q1’2015 to Rank #8 in H1’2015 because of a high cost to income ratio of 60.0% vs. an industry average of 48.1%, and low net interest margin of 5.3% vs. an industry average of 8.3%.

CYTONN’S H1’2015 BANKING REPORT RANKINGS
Banks	Franchise Value Total Score (a)	Total Return Score (b)	Weighted H1’2015 Score (c)	H1’2015 Rank (d)	Q1’2015 Rank (e)
Equity	55	2	23.2	1	4
Standard Chartered	54	3	23.4	2	3
KCB	70	1	28.6	3	5
Barclays	67	4	29.2	4	9
Co-operative	68	8	32	5	7
NIC	73	5	32.2	6	8
I&M	67	9	32.2	6	2
Diamond Trust	73	7	32.8	8	6
CfC Stanbic	75	10	36	9	1
National Bank	92	11	43.4	10	10
Housing Finance	98	6	43.4	10	11

 Source: Cytonn Investments

Notes

1. Franchise Value Total Score: In this ranking, the banks are ranked by health, by looking at metrics for profitability, efficiency, growth, asset quality, liquidity, revenue diversification and capitalization. Banks are assigned scores ranging from 1, which is the best performing bank in the metric, till 11, which is the worst performing bank. The scores from each bank are then summated, with the bank with the lowest total score emerging on top, and that with the highest score emerging at the bottom.
2. Total Return Score: Potential upside for each bank based on the intrinsic valuation, and the current market price. The bank with the highest upside was ranked 1^st, and that with the lowest upside, or greatest downside, was ranked last. Cytonn’s Analysts carry out this valuation, arriving at the actual value of each bank based on an underlying perception of its true value, including all aspects of the business, in terms of both tangible and intangible factors, and future growth expectations. This value may or may not be the same as the current market value.
3. Weighted H1’2015 Score: Using the Franchise Value and Total Return, banks are given a score. Franchise value was assigned a weighting of 40%, while the intrinsic value was assigned a 60% weight.
4. H1’2015 Rank: The bank with the lowest Weighted H1’2015 Score was ranked first, and that with the highest score was ranked last.
5. Q1’2015 Rank: The Q1’2015 rank was based only on franchise value.

The full release of the rankings and how each bank performed across the metrics is in the Cytonn Banking Report H1’2015. See link: Cytonn Banking Report H1'2015

We will be discussing this report tomorrow, September 14^th 2015 at the Nairobi Serena at 7.00 AM.

 

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Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted- as the facts may change from time to time. This publication is meant for general information only, and is not a warranty, representation or solicitation for any product that may be on offer. Readers are thereby advised in all circumstances, to seek the advice of an independent financial advisor to advise them of the suitability of any financial product for their investment purposes.