Thursday, November 23, 2017 04:30PM /ARM
Which club will get to top 4? It’s an interesting tale in the EPL as three rivals, Chelsea, Liverpool, and Arsenal continue to struggle for a place in the top four. While Chelsea started the season weak, it seems to have stepped up its pace and has pulled away from its rivals after beating Manchester United at Stamford Bridge. The question now arises, will the rivals catch up with Chelsea or will Chelsea sustain its form?
A tale in the Tier 2 space. Across our Tier 2 coverage banks, the valuations of three comparable banks are showing an interesting pattern just like the EPL. Fidelity Bank Plc (Fidelity) has pulled away from its peers – FCMB and Diamond Bank (Diamond), returning 90.48% YTD relative to 0.91% and 30.68% for FCMB and Diamond respectively.
Fidelity currently trades at a price-to-book value (P/B) of 0.3x compared to 0.1x for its peers, commanding a premium relative to peers which has widened to 92% from 14.3% in FY 16. Price movement in recent trading appears like FCMB and Diamond are currently playing catch-up and in this note we look to determine if this premium will widen or shrink in the short term.
Why the valuation gap?
Looking at the recent earnings reports of these three banks (9M 2017/H1 2017 for FCMB), Fidelity outperformed consensus expectation with ROE of 9.6% compared to 3.3% for Diamond and 3.5% (est.) for FCMB with a higher Net Interest Margin (NIM) and improved asset quality as the key drivers for the better than expected result. Despite higher funding cost (WACF: +3.1pps to 8.1%), NIM expanded by 76pps YoY to 7.1% as growth in asset yields (14.6%) outpaced funding cost pressures.
The foregoing, alongside FX gains of N4.9 billion as well as 8% decline in loan loss provision to N7.3 billion (cost of risk: 1.3%) supported earnings with a 65% rise in EPS to N0.50. Furthermore, asset quality improved with NPL ratio markedly declining to 5.9% (FY 16: 6.6%) even as CAR improved 50bps relative to prior year at 17.3%.
Though like Fidelity, Diamond reported improvements in earnings (with EPS growth of 68% YoY to N0.26) on the back of lower loan loss provision (-12% YoY), the Q3 2017 reading was a loss after tax of N3.4 billion reflecting significant funding cost pressures, lower non-interest revenue (NIR) as well as elevated loan loss provision in the quarter. Consequently, despite improved performance in 9M 17, deterioration in ROE (6M 17: 7.9%, 9M 17: 3.3%) could be said to account for the valuation gap relative to Fidelity.
For FCMB, though 9M result are delayed1, H1 17 results illuminates two key reasons why investors have been lukewarm towards the stock. First, EPS of N0.15 is down 81% YoY largely on the back of a weighty decline in non-interest income (-50% YoY). In addition to this, the bank faced sizable funding cost pressure (interest expense: +24% YoY) in the review period.
On the former, despite an over three-fold expansion in trading income, lower FX gains (-97% YoY) dampened non-interest income2. Adjusted for FX gains, H1 17 non-funded revenues are 83% higher YoY. Furthermore, NPL ratio tracked higher to 4.7% (FY 16: 3.7%).
Value in the Gap
We think the drivers for earnings performance over the short to medium term are lower yield environment, impact of the adoption of IFRS 9, deposit base, asset quality, CAR, and liquidity. Though similar impact cuts across the three banks, scale and direction of impact seems to signal some clues to where the value lies.
Lower yield sensitivity come into play. In our recent macro and fixed income note – Pathway in a turning tide – we projected that the confluence of inbound macro play guides to a lower yield environment (~200bps) in the near term. On this note, we analyze the impact of a lower yield environment to support the pass-through on valuation.
First off, the higher interest rate environment has driven expansion in asset yields among the three banks with share of interest income from investment securities rising by an average of 3.8pps for Fidelity and Diamond relative to 2016, while FCMB’s relatively illiquid balance sheet constrained its ability to capture the high yield environment over H1 17. The scale of impact thus differed due to variation in loan re-pricing, capital buffer and liquidity.
While Diamond bank largely rode on income from investment securities with income from loans losing steam, asset yields on loans (excl. FX impact) remained resilient for Fidelity and FCMB, rising faster than growth in asset yields on investment securities to drive record overall yield on assets of 14.6% and 12.9% respectively. Fidelity’s growth in loan income mirrors the increase in loan book of 1.1% to N753.8 billion (+4.9% inclusive of FX impact) with CAR increasing to 17.3% – FCMB (17.3%) and Diamond (15.8%).
Going forward, we think Diamond will suffer the most impact from a lower yield environment given its heavy reliance on higher yields on investment securities while improved liquidity for Fidelity and FCMB (Eurobond issuance and reversal of excess CRR debit) as well as loan portfolio is expected to temper moderation in asset yields.
Elsewhere, Diamond bank’s higher share of cheap deposit (81% vs. 72% average for Fidelity and FCMB) continues to keep funding cost tempered relative to its peers and provided support for NIM. Consequently, a lower yield environment is expected to moderate funding cost pressure for FCMB given re-pricing of term deposit while we expect a 45bps increase in Fidelity’s funding cost on the back of Eurobond issuance of $400 million at 10.5% coupon.
On balance, we forecast a 60bps and 43bps increase in NIM for Fidelity and FCMB respectively on the back of resilience in asset yields while we expect a slight moderation (-1pps) in NIM for Diamond weighed by lower asset yields.
IFRS 9 should impact loan-loss provision. Although the adoption of IFRS 9, from January 2018, will impact of banks from the perspective of classification and measurement of financial assets, hedging and impairment (loan-loss provision), we think immediate impact on profit will stem from impairment. Basically, IFRS 9 adopts a forward-looking view on asset quality and introduces expected credit losses relative to incurred losses approach under the current IAS 39. Banks are expected make provision based on a 3-stage credit approach;
Stage one. For performing assets that are not subject to significant deterioration in quality, banks are expected to recognize one-year of expected credit losses upon recognition even as interest income reflects the gross carrying amount of assets.
Stage two. For non-impaired assets whose credit risk has significantly increased since initial recognition, banks are expected to recognize expected credit losses on lifetime basis (i.e. estimated lifetime losses from default events that are possible over the entire residual life of the asset) even as interest income reflects the gross carrying amount of assets.
Stage three. For impaired/incurred-loss asset, banks are expected to recognize expected credit losses on a lifetime basis while recognition of interest income reflects the net carrying amount of assets ((i.e. the difference between the gross carrying amount and the loss allowance).
Based on the foregoing, we are quite cautious on loan-loss provision despite our expected moderation in Cost of Risk largely underpinned by improvement in macro space. Irrespective, the scale of moderation differs. We think banks with coverage ratio of at least 100% implies less pressure to make provision even as subsequent re-classification of provisioning is not expected to impact on earnings.
Among the three banks, FCMB and Fidelity reported coverage ratio (excl. regulatory reserve) of 111.2% and ~100% respectively while Diamond’s coverage ratio of ~78% implies more room for impairment in the near term. Consequently, we think Cost of Risk for Diamond will remain elevated in the near term.
Exposure to vulnerable sectors buttresses concerns. In recent times, asset quality concerns stemmed from high-risk Oil & Gas, and Power sectors due to well documented issues that clouded the overall sector. However, given improvement in these sectors on the back of higher production and crude oil prices, FG’s power sector intervention and improved dollar liquidity, we see little scope for further impairment in these sectors.
That said, following subsisting economic contraction in the non-oil sector, we foresee concerns in vulnerable sectors – General Commerce, Manufacturing, Real Estate & Construction, and ICT. On General commerce and Manufacturing, Diamond bank has the highest exposure of 14% and 10% respectively, followed by Fidelity (7% and 10% respectively) and FCMB (7% apiece).
However, FCMB’s higher exposure to real estate & construction of 13.5% compared to 8% and 7% for Diamond and Fidelity raises some concern in that space. Lastly, while Fidelity is more exposed to ICT (5.2%) followed by FCMB (3.3%) mainly due to Etisalat’s exposure, we recognize ample provision made on this loan.
On balance, we think concerns in vulnerable sectors, mainly General commerce, Manufacturing, and Real estate posit scope for elevated provisioning for these banks with Diamond Bank leading the pack.
Diamond Bank – FVE: N1.22
We maintain our NEUTRAL rating on Diamond while we increase our FVE by 4% to N1.22. Given its high share of CASA deposit relative to peers, we expect decline in funding cost to moderate the impact of lower asset yields on NIMs. Further down, we slash our NIR forecast to reflect lower fee income and FX trading income.
To add, while we think Diamond is at the rack in terms of loan-loss provision and expect to see some moderation on Cost of Risk, we think relative concerns in vulnerable sectors as well as below average coverage ratio relative to peers will limit the scale of moderation and thus expect impairment to be relatively elevated in the near term.
Irrespective, we think expect sizable improvement in earnings over 2018 driven by lower funding cost and lower impairment. Net impact to our adjustment, brings PBT for FY 17E and FY 18F to N10.8 billion and N26.5 billion respectively with EPS of N0.41 and N0.97 accordingly.
FCMB – FVE: N1.34
We maintain our FVE of N1.34 for FCMB which is 18% upside from current market price and thus rate the stock NEUTRAL. In our discussion with FCMB, management revealed plans to address balance sheet inflexibility by focusing on asset creation on its investment securities portfolio to harvest the current high yields on government treasury bills.
Furthermore, FCMB expects a CRR refund of ~N23billion in H2 2017, which would improve its balance sheet and earnings capacity. Furthermore, FCMB recently completed 60% acquisition in Legacy pension managers which brings its total stake to 88.2%, thus making Legacy a subsidiary of FCMB. Given ~3% contribution of legacy to FCMB’s PBT in H1 17, we think the acquisition is expected to improve FCMB’s earning with Legacy’s contribution to PBT expected to hit ~7%.
Therefore, with a focus on capturing higher yields on the naira curve, no plans to grow risky assets, lower loan-loss provisioning, increased prospects of recoveries, operational efficiency, and adequate capital buffer, downside risk to 2017 earnings now seems moderated than was earlier expected. Overall, we forecast 2017E EPS of N0.55 (-22% YoY) and DPS of N0.11. However, excluding FX gains in prior year, FY 17 EPS should be four-fold higher YoY.
FIDELITY – FVE: N1.88
In framing our outlook for FY 2017, we forecast loan book growth to be 6% YoY (9M 17: +4.9%). Following 9M 17 run rate, we expect interest income to increase 19.4% YoY to N147 billion (9M 17: N110.4 billion) and asset yield to expand 2pps YoY to 14.5%. Elsewhere, we forecast WACF to be 8.1% (+1.6pps YoY) to reflect funding cost pressure.
This brings our NIM to 6.9% (+60bps YoY). Although there are still concerns over Fidelity’s exposure to manufacturing, general commerce and transport sector, Fidelity has made sizable provisions so far, this year with coverage ratio at 97.3% (FY 17E: 130%). We forecast annualized cost of risk at 1.1% (FY 16: 0.5%, 9M 17: 1.3%). Consequentially, we forecast loan loss provision to decline 6% YoY to N8.2 billion. On balance, we forecast EPS to increase 79% YoY to N0.60.
Beyond 2017, we see more upside for loan growth as the economy continues to improve. Importantly, we expect funding cost - which has been a major concern to tier 2 banks – to subside as yields begins to moderate. Compared to other tier 2 banks, Fidelity has proven to be resilient with average ROE for 2017 at 9.4% second only to Stanbic. Net impact of our estimates puts our FVE at N1.88, 18% upside to the last market price of N1.60.
Summary of Results and Forecasts - Naira (N)