Friday, February 17, 2017 10:14 AM / Exotix Partners
In this note we roll forward our model and asset quality sensitivity analysis for FBN Holding Limited.
Is FBNH the Rick Grimes of Nigeria?
If there ever was a Nigeria Banks version of the TV series The Walking Dead, we would like to think FBNH would get the role of the lead protagonist, Rick Grimes, who perennially survives a zombie apocalypse against overwhelming odds, despite making some questionable decisions along the way.
One gets the feeling that Rick is simply too big a character to kill-off. Likewise, FBNH began FY16 in a very precarious position (NPL ratio of 18%, capital buffer of only 210bp) and despite overwhelming odds (economic recession, devaluation of the NGN, FX scarcity, runaway inflation) survived the year – contrary to expectations – without raising extremely dilutive capital.
The bank’s capital position was aided by an exceptional FX gain, continued de-risking of the balance sheet and continued low NPL cover on the expectation of a turnaround in asset quality.
Can it continue to survive?
With the odds continuing to stack up against it (and other Nigerian banks), the bank’s capital position remains under the microscope. We think there is almost a 50:50 chance of the bank having to raise capital over the next 12 months, depending on the asset quality trajectory: – Bull case scenario (2% probability): in this scenario, we assume the bank makes a full recovery on three big oil and gas exposures and there is no further NPL deterioration.
Under this scenario, we estimate the bank’s capital adequacy ratio stabilises at c17% in the short term and increases to 25.5% by FY21. – Base case scenario (50% probability): under this scenario, we assume partial recovery on three significant exposures and no further NPL deterioration.
On this path, the bank’s CAR declines to 15.7% in FY17f before gradually recovering to 24.7% by FY21f. – Bear case scenario (48% probability): under this scenario, we assume the bank has to make full provisions on the three significant oil and gas exposures and the NPL ratio further deteriorates to 35%. Under this scenario, we estimate the bank would need to raise additional Tier 1 capital of NGN50bn to maintain its minimum CAR ratios.
Survival may depend on the regulator.
As noted above, we think there is a very high probability of the bank having to raise capital over the next 12 months. This might be complicated by lack of interest from foreign investors (due to a dysfunctional FX rate) and local investors (due to preference for high yielding government bills).
The survival of the bank may therefore be determined by the regulators, either in the form of temporary forbearance or direct capital injection. Like Rick Grimes, we think the bank is too systemically important to fail and will therefore get some form of assistance.
Nonetheless, similar to The Walking Dead killing off important characters in the past, we note that the during the 2009-12 Nigerian Banking crisis, the authorities let several banks which could have been considered “too big to fail” go under (Intercontinental, Oceanic, Bank PHB). We therefore think it is important not to place too much weight on the size of the bank in making any investment decisions.
We cut our target price, maintain HOLD rating on significant financial uncertainty
Our probability-weighted target price of NGN5.9 (down from NGN6.2 previously) suggests an expected total return of 89% at the current market price. Despite the significant upside we maintain our Hold recommendation due to several uncertainties (many of which are difficult to incorporate or predict) which may impact the bank’s fundamentals, and the wide divergence in potential scenarios for shareholders. Our target price is 0.4x its FY17f BVPS based on the base case scenario.
Continues to survive...
The group ended the FY15 calendar year in a very precarious position with an NPL ratio of 18.1% (by far the highest within our universe), NPL cover of 39.5% (the lowest within our Nigeria Banks universe), 46% of loans being FX denominated and a capital adequacy ratio of 17.1% (only 210bp above the regulatory minimum). Given the vulnerabilities, the expectation was that its CAR would drop below the regulatory threshold due to a surge in risk assets following the devaluation and as a result of negligible internal capital generation as it improved its NPL cover.
Contrary to expectations, we forecast the bank to report a capital adequacy ratio of 16.2% at the end of FY16 despite not raising any capital during the year. The continued strong capital position was driven by:
Continued low NPL cover
Despite an estimated cost of risk of 7.5%, we estimate its aggregate NPL cover (including portfolio provisions) of 45.4% will continue to be significantly lower than its historical average of 72.9%.
The low NPL cover is attributed by management to optimism that the bank can recover three significant non-performing assets in the oil and gas sector, thus requiring minimum provisions.
Exceptional FX gains.
Despite the cost of risk increasing to an all-time high of 7.5%, we estimate the group will remain profitable (PBT of NGN38.0bn) largely due to an exceptional FX gain of NGN50bn. Excluding the gain would have resulted in a capital loss for the bank.
De-risking of the balance sheet
As at FY15, c59% of group loans were FX denominated. On that basis, we estimate net loans should have increased by at least 34% following the 58% devaluation of the Naira during the first nine months of 2016.
The reported 26% growth indicates that the bank continues to de-risk its balance sheet in real terms, just like in 2015 when net loans declined by 16.6% yoy. We estimate the continued de-risking of the balance sheet should sustain the bank’s risk-weighted assets to total assets ratio at around 60%, thus easing capital pressure.
...but for how long?
As noted above, we estimate the bank remains in a very precarious position due to its continued high NPL ratio and a capital ratio that just about satisfies the regulatory threshold.
With the macro-environment remaining challenging, we estimate there is an almost 50:50 chance of the bank either continuing to survive or having to raise significant equity capital, which given its current valuation (FY16f P/BVPS of 0.2x) would be extremely dilutive for existing shareholders (not to mention unpalatable for international shareholders given the potential of a significant Naira devaluation).
Note, we assume any capital injection will be in the form of Tier 1 capital as we estimate the bank’s Tier 2 capital will contribute 25% of total FY16 capital, which is the maximum limit set by the CBN.
In our view, the key determinant for the bank will be the recoverability of the three large oil and gas exposures and potential further asset quality deterioration (or recovery), which forms the basis of the stress test analysis we first introduced in 2014 and updated last year (available on request). Before we articulate our updated stress test analysis, we would like to recall the three significant and concentrated bad debts, which management says are behind its above-industry-average NPL ratio.
As highlighted above, our discussions with management indicate all three loans are within the oil and gas sector and the aggregate exposure is US$550-600mn (c27% of end-FY16 NPLs). Of this, the largest exposure (US$400mn) is in the upstream segment and on this management remains hopeful that the government (which took over the asset following a dispute with the previous strategic investor) can find another strategic investor who will take over the amount owed to the government (believed to be in the region of US$1.2-2.0bn) as well as FBNH.
Regarding the other two loans, our discussions with management indicate that one of the loans has been successfully restructured and the loan should be re-classified as a performing loan (assuming it continues to remain performing during the period), while the bank has reached agreement with the owners of the third loan to liquidate the collateral (high value commercial real estate estates) which should cover any further losses on the exposure (and therefore does not require further provisioning).
The successful restructuring of these three loans is therefore a key determinant of the bank’s profitability and capital adequacy trajectory. In the following sections, we hypothesise three potential scenarios:
Bull case scenario
Under this scenario, we assume the bank successfully restructures and/or recovers the significant exposures detailed above in FY17. We further assume no further significant deterioration in asset quality.
Under this scenario, we estimate the group NPL ratio will decline to 15% by the end of the current financial year, and to 5% by FY19. Further, we assume the cost of risk declines to 3% (bringing the aggregate cost of risk to 15.2% between FY15 and FY17) which should boost the NPL cover to 77.1%.
Based on our profitability estimates (average ROE of 18.6%) and dividend payout assumptions (6.2% in FY17 increasing to 26..4% by FY21) under this scenario, we estimate the bank will generate sufficient internal capital and will not require further significant de-risking of its balance sheet; we estimate its gross LDR will decline by 7ppt to 70% in FY17 and remain at that level through FY21, and that should improve its CAR to 19% in FY17 and 25.5% by FY21.
As per our update on Guaranty Trust Bank and Zenith Bank (see Zenith vs GTB: mind the valuation Gap, it could get bigger), we attach a very low probability to our Bull case scenario (2%) given the continued macro-economic headwinds in the country, especially the dysfunctional FX policy which we believe is creating significant asset quality pressures for the banks.
Under our base case scenario, we assume no further significant deterioration in asset quality in the short term and that the bank makes partial recoveries on the three significant oil and gas exposures (especially the US$400mn exposure).
Under this scenario, we estimate the cost of risk will remain relatively elevated in the short term as the bank makes provisions on the rest of its bad book (as noted above, the three significant exposures account for only 27% of its FY16 NPLs) and builds it NPL cover.
The continued high cost of risk combined with the decline in exceptional gains will result in the ROE dropping to 3.0% in FY17 before recovering to 11.6% in FY18 and 24.4% by FY21 as the risk charge moderates.
The low internal capital generation will require the bank to continue de-risking its balance sheet more aggressively to maintain its capital ratio; we estimate the bank’s gross LDR will have to decline to 68.5% in FY17 and to 60% by FY19. Based on our LDR estimates, we estimate loan growth will be in the single digits in FY17 and FY18 (5.0% in FY17 and 5.5% in FY18) before accelerating to a CAGR of 13.9% through the rest of our forecast period.
Apart from moderating risk asset growth, we estimate the bank will also need to sustain a low dividend; we estimate an average payout ratio of 21.2% over the five-year period between FY17 and FY21. Based on our assumptions, we estimate the bank’s CAR will drop to 15.7% in FY17 before gradually recovering to 24.7% by FY21.
Given its systemic importance, we believe the bank will be given sufficient time by the regulator to resolve its core NPLs. We therefore attach a 50% probability to this scenario.
Bear case scenario
Under this scenario, we estimate the bank not only has to make full provisions on its current bad debt portfolio (including the three large exposures), but also on a further deterioration of the NPL ratio to 35%.
Given the current macro-environment, we think a further deterioration in asset quality is feasible, especially in the manufacturing and general commerce sectors which account for almost a quarter of its portfolio.
As mentioned above, under this scenario, we envisage its NPL ratio to peak at 35% before gradually declining to 4% by FY21 as the bank gradually makes provisions and writes-off the bad debt.
Unlike the base and bull case scenario, we assume the cost of risk will remain significantly elevated in the short term as it makes full provisions on the bad debts; we estimate an average cost of risk of 8% between FY16 and FY18, declining to 3% by FY21.
A persistently high cost of risk combined with decline in exceptional FX gains will result in a loss making position in FY17 and FY18, which will negatively impact the bank’s precarious capital position (which we estimate will drop below the regulatory threshold in FY17).
In order to meet its regulatory capital requirements, we believe the bank will have to aggressively cut its dividends (we assume it pays no dividends until FY20), de-risk its balance sheet (we estimate the bank will have to cut its loan-todeposit ratio from 77.5% in FY16 to 65% in FY17 – resulting in nominal loan growth of -0.4%) – and 55% by FY20) and potentially raise more capital (to plug the capital hole we estimate it may need to raise Tier 1 capital of NGN50bn vs its current market cap of NGN116bn).
Based on our assumptions, we estimate the bank’s CAR to drop by 100bp yoy to 16.1% in FY16, edging up to 16.8% in FY17 (on the back of the potential capital issuance) and 19.7% by FY21.
As indicated above, given the continued economic malaise in Nigeria, we think there is roughly an equal chance of our base and bear case scenarios becoming a reality. We therefore attach a 48% probability to our bear case scenario, in effect we continue to imply a potentially dilutive capital issuance for shareholders. The latter will be further complicated by the dysfunctional FX market and subsequent low foreign investor confidence towards NGN denominated assets and local investors’ general preference for government securities.
Short-term profitability trajectory remains as uncertain as ever
Based on the above scenarios, our FY17 ROE estimate ranges from as high as 14.1% to as low -4.2%. On a probability weighted basis, we estimate the bank’s ROE will continue to remain below our COE until FY20, partly justifying its current valuation; we estimate an average probability weighted ROE of 11.7% between FY17 and FY21, which implies a justified P/BVPS of 0.3x (using a terminal growth rate of 8% and cost of equity of 20%).
We tweak our usual dividend discount valuation methodology slightly in view of the asset quality uncertainty. We calculate an intrinsic value for each scenario as per the methodology below. We then calculate our target price using the probability of each scenario to calculate a weighted average intrinsic value, to which we add the final dividend for FY16.
Intrinsic value calculation methodology
To calculate our fair value estimate for each scenario we apply a two-stage dividend discount model:
Stage 1 - between FY17 and FY21 we estimate the present value of dividends using the profitability drivers discussed above.
Stage 2 – we determine the terminal value as the perpetual growth rate in the bank’s book value based on its average ROE between FY17 and FY21 and a terminal growth rate assumption of 8.0%.
We assume a cost of equity (CoE) of 20.0%*, using a risk-free rate of 11.0%, an equity risk premium of 9% and a beta of 1.0x. As our valuation is Nigerian nairabased, we have applied an 8% terminal growth rate.
*Our equity risk premium for FBNH is higher than our normal 5% due to the significant uncertainties facing the bank including, as described above, potential capital issuance, aggressive de-risking of the balance sheet and successful restructuring of large governmentrelated oil and gas exposures.
The table below summarises our valuation estimates for each scenario.
The key risks to our earnings and valuation estimates are:
Asset quality: as discussed above, the biggest source of uncertainty for Nigerian banks’ profitability is the quality of their balance sheet. We have mitigated this risk by calculating probability-weighted profitability and earnings estimates. Nonetheless, a higher or lower than expected deterioration in asset quality is a big source of uncertainty (especially in the upstream oil and gas sector).
FX policy: in this report, we have implicitly assumed the Naira devalues by 27.5% and the liberalisation of the exchange rate eases the liquidity of FX flows in the system, enabling banks to cover their LC positions and roll over their FXdenominated borrowings. A higher than expected devaluation and/or continued constraint in FX liquidity could, in our opinion, result in a liquidity crisis in Nigeria.
Capital uncertainty: as highlighted above, the bank’s capital position remains precarious and requires the bank to continue de-risking its balance sheet. Inability to de-risk the balance sheet (as obligors may find it difficult to pay down their loans) and/or higher than expected asset quality losses may require the bank to raise significantly higher than expected capital, which would be highly dilutive for shareholders.