Bank AL Habib (BAHL) PAKISTAN INSIGHT BUY. Pakistan s rising mid-size bank. Branch network: From 70 to 320 in 10 years

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1 PAKISTAN INSIGHT July 03, 2014 Topline Securities (Private) Limited 306, Continental Trade Centre, 3rd Floor Block-8, Clifton, Karachi, Pakistan Tel: Fax: Pakistan s rising mid-size bank We initiate coverage on with a Buy. Expanding its network aggressively BAHL is a top tier mid-size bank in Pakistan that provides one of the best ROEs of more than 22% with excellent asset quality. The stock is trading at PE of 8.3x and PE of 6.9x with PBV of 1.7x for and 1.5x for. It offers 25% upside from current levels inclusive of dividend yield. Branch network: From 70 to 320 in 10 years BAHL has increased its branch network from 70 in 2003 to 320 in 2013, a CAGR of 16.4% compared to commercial banking sector branch expansion CAGR of 4.1%. Rising branch network not only results in higher operating efficiencies and easy access to its customers but also provides cheaper source of deposit mobilization. Thanks to its rising network and brand image, BAHL overall operations are perceived to be at par with large banks. In last 5 years, BAHL s deposits have risen at CAGR of 22% (10-year CAGR 24%). This above average deposit and branch growth makes BAHL 7th largest bank in Pakistan versus 10th a decade ago. Going forward, due to rising branch network, we expect deposits to grow at 3-year ( ) CAGR of 17% to reach Rs615bn by Coverage ratio: One of the highest Following a cautious strategy BAHL has more than provided for bad loans. At present, bank s coverage ratio stands at 164% which is one of the highest in the industry. This also shows that the bank has recorded provisions more than its actual NPLs (Nonperforming Loans). Though these provisions can be utilized against any new NPLs, there are also some chances of provision reversal. From 2014 onwards, we expect provision expense of Rs bn each in next 3 years. Better asset quality will help credit growth BAHL is ideally set to reap benefit of economic recovery led credit growth in Pakistan. Low ADR (Advances to Deposits) of 43% coupled with favorable gross infection ratio of 2.1% and net infection ratio of -1.4% will help BAHL to expand its loan book. During , we estimate advances growth of 14% CAGR compared to last 3-year ( ) CAGR of 1. KATS Code Bloomberg Code Reuters Code Market Price Market Cap BAHL BAHL PA BKEQ.KA Rs45.06 Rs50.1bn /US$507.4mn Free float Market Cap Rs30.1bn /US$304.4mn 1-Yr Avg. Daily Volume (mn) Yr High/ Low BUY Rs45/28 Estimated free float 6 Share outstanding (mn) 1, Index weight 0.71% BAHL: Key Numbers EPS Earnings Growth 2-5% 17% 2 19% PE at Rs Div. Yield 6% 4% 6% 7% 8% ROE 25% 21% 22% 23% 23% PBV Source: Topline Research The Research Department of Topline Securities has prepared this report for information purpose. The information on which this report is based from sources, which Topline Research believes to be reliable, but we do not guarantee that it is accurate or complete. In particular, the report takes no account of the investment objectives, financial situation and particular needs of investors who should seek further professional advice or rely upon their own judgment and acumen before making any investment. This report should also not be considered as a reflection on the concerned company s management and its performances or ability, or appreciation or criticism, as to the affairs or operations of such company or institution. Warning: This report may not be reproduced, distributed or published by any person for any purpose whatsoever. Action will be taken for unauthorized reproduction, distribution or publication. Report completed on July 02, 2014 Prices as of July 02, 2014 Zeeshan Afzal zeeshan.afzal@topline.com.pk Tel: Topline Research is also available on Bloomberg, Thomson Reuters & Capital IQ

2 Table of Contents Valuation: Target price Rs Branch network: From 70 to 320 in 10 years Coverage ratio: One of the highest Deposits to grow at 17% CAGR, CASA will rise Better asset quality will help credit growth Rising bond investments to support NIMs Cost to income ratio will decline Non-Interest Income growing Risks BAHL: A brief history P a g e

3 Valuation: Target price Rs54 We initiate coverage on with Buy call and 12-month target price of Rs54 per share. BAHL is Pakistan s 7th largest bank with rising branch network. The bank is providing one of the best ROEs (Return on Equity) of more than 22% (listed banks average ROE 15%) with excellent asset quality. The scrip is trading at PE of 8.3x and PE of 6.9x with PBV of 1.7x for and 1.5x for. During high growth period of , BAHL traded at average PBV of 2.7x. Thus, the stock offers 25% upside from current levels inclusive of dividend yield. BAHL DY (Dividend Yield) is at 6-7% ( ) which is also attractive when compared to average listed banks DY of 5%. PBV at discount to banks with similar ROE Despite premium asset quality and high deposit & profit growth, the stock is trading at discount on PBV when compared to large banks with similar ROE. At present, MCB and UBL have ROE above 2 while their PBV is 2.8x and 1.9x, respectively. We believe BAHL discount is due to lower NIMs (3.8%) versus that of MCB (6.2%) and UBL (5.4%). That said, we expect this discount to reduce going forward considering bank s high ROE, good asset quality and branch expansion. With expected economic recovery-led credit growth, rising investments in high-yield PIBs and limited risks of NPL resurgence, we expect annual earnings growth to remain intact at 19% in next 3 years despite expected monetary easing. Following are the key numbers of BAHL: BAHL: Key Numbers Topline Banking Universe: PE & PBV PE PBV BAFL BAHL HBL MCB NBP UBL Source: Topline Research Topline Banking Universe: ROE & DY ROE DY BAFL 16% 17% 8% 1 BAHL 22% 23% 6% 7% HBL 18% 19% 5% 5% MCB 21% 23% 5% 6% NBP 9% % UBL 2 22% 7% 8% Source: Topline Research Markup interest Income (Rs mn) 36,503 41,468 37,256 40,861 45,604 52,116 Net Interest Income (Rs mn) 14,002 15,362 14,261 16,765 19,554 22,723 Non-Interest Income (Rs mn) 2,721 2,967 3,908 4,479 5,119 5,850 PAT (Rs mn) 4,533 5,446 5,155 6,018 7,249 8,658 Equity (Rs mn) 19,739 23,814 25,282 29,484 34,181 39,740 Deposits (Rs mn) 302, , , , , ,217 Investments (Rs mn) 222, , , , , ,803 Advances (Rs mn) 114, , , , , ,448 BAHL Key Ratios EPS (Rs per share) Earnings Growth 26% 2-5% 17% 2 19% Cost of Deposits 6.9% 6.1% % 4.4% 4.2% Net Interest Margins (NIMs) 4.6% 4.1% 3.5% 3.8% 3.7% 3.7% Gross Infection Ratio 2.7% 2.4% 2.1% 2.1% 2.1% 2.1% Coverage Ratio 160.2% % 154.9% 147.5% 141.2% CASA 58.1% 70.2% ROA 1.3% 1.3% 1.1% 1.2% 1.2% 1.3% ROE 25.3% % 23.4% 3 P a g e

4 2009A 2009A 2004A 2005A 2006A 2007A 2008A 2009A Branch network: From 70 to 320 in 10 years In the last 10 years, deposits of BAHL have increased at impressive 24% CAGR, which is significantly higher than 15% CAGR for commercial banks. Though bank s active deposit mobilization strategies and better return helped, BAHL s aggressive penetration played a vital role. With the presence in 117 cities, the bank has increased its branch network from 70 branches in 2003 to 320 branches in This turns out to a branch expansion CAGR of 16.4%. During the same period, overall branches of commercial banking sector grew from 6,916 in 2003 to 10,361 in 2013, 4.1% CAGR. This above average deposit and branch growth makes BAHL 7th largest bank in Pakistan vs. 10th a decade ago. BAHL also operates with 96 sub-branches while all its branches are 10 online. On the global front, BAHL has 3 offshore branches in Bahrain, EPZ and Malaysia while it has 3 representative offices in China, UAE and Turkey. Rising branch network not only results into higher operating levels and easy access to its customers but also provides cheaper source of deposit mobilization. Branch environment and overall operations of the bank are perceived at par with the large banks. Now that the bank has achieved decent balance sheet size, we expect more global expansion in addition to the local market. Islamic and branchless banking are also growing at fast pace in Pakistan. Currently, the bank has 17 Islamic branches and offers internet and phone banking facilities. At present, Islamic deposits contribute only 2% of bank s total deposits compared to Islamic banking contribution of 1 in overall banking sector. Growing tendency toward these segments will also help the bank to increase its penetration in the country. Best asset quality and coverage ratio The main distinction of BAHL from the industry is its asset quality. Not only the bank remained very selective in its lending, it has more than provided its bad loans. In 2013, bank s NPL s stood at 2.1% of advances (Commercial banks average 12.6%) which is lowest amongst listed banks. Bank s quality of advances is also evident from the fact that BAHL s gross infection peaked to 2.7% in 2010 (Post-2008 economic crisis) when overall commercial banks ratio stood at 14.5%. The bank has provided 96% of its NPLs while its general provisions against consumer advances stand at Rs40mn (1.5% of secured & 5% of unsecured consumer portfolio). Moreover, BAHL has provided additional Rs2.5bn (Rs2.3/share) as general provisions. So, the total Coverage Ratio stands at 164%, highest in listed banks. Though these provisions can be utilized against any new NPLs, there are also some chances of provision reversal. We expect provision expense of Rs bn each in next 3 years. Coverage Ratio: BAHL vs. Industry Gross Infection: BAHL vs. Industry BAHL: Branch network (number) BAHL: Deposit Growth & Market Share Deposit growth (LHS) 4 Market Share (RHS) 6% 3 4% 2 1 2% BAHL Banking Industry 15% BAHL Banking Industry % 4 P a g e

5 2009A FY07 FY08 FY09 FY10 FY11 FY12 FY13 10MFY A 2009A Deposits to grow at 17% CAGR, CASA will rise In last 5 years, BAHL s deposits have risen at CAGR of 22% (10-year CAGR 24%). 10 years back, BAHL ranked 10th in terms of deposit size. At present, as on Mar 31, 2014, bank s deposits stand at Rs397bn (US$4.0bn) making it the 7th largest bank in Pakistan with 5% market share. Going forward, due to rising branch network, we expect deposits of the bank to grow at 3-year ( ) CAGR of 17% to reach Rs615bn by Rising focus on low cost and more stable CASA (Current Account Saving Account) deposits along with falling interest rates have also helped the bank to reduce its deposit costs. In 2013, banks CASA deposits stood at 75% of total deposits which has significantly increased from 58% in 2009 while Cost of Deposits (CoD) stood at 5% in 2013 much lower than 6.8% in Though BAHL s deposit cost has reduced, it is still higher than other larger banks. We expect that bank with extensive branch network will continue its strategy to shed costly fixed deposits and keep focusing on CASA deposits with higher focus on CA (Current Account) deposits which are immune from SBP requirement of minimum profit payment on PLS (Profit and Loss Sharing) Savings Accounts. We estimate BAHL s CASA deposits to reach 78% of total deposits by 2016 while we expect deposit cost to reach 4.3%. Better asset quality will help credit growth Owing to economic slowdown and rising NPLs, BAHL remained very cautious while lending in the last few years. As a result, bank s ADR declined from 57% in 2009 to 45% in Decline in advances is in line with the industry trend but bank s NPLs did not grow as much as the banking industry mainly due to bank s quality advances portfolio. At present, most of the advances are concentrated towards the corporate sector while consumer lending stands at 1% (approx. Rs2bn) of total advances. Now with expected economic recovery, advances of the banking sector have started to pick up. During first 10 months (Jul-Apr) of FY14, local banks advances portfolio has increased by 5.7% to Rs4.1tn. However, contrary to previous years, this time growth is fueled by private sector credit demand. In 10MFY14, private sector credit grew at 1, up by Rs305bn, to record Rs3.3tn versus avg. growth of 4% in last 5 years (FY09-13). BAHL: Net Advances and ADR Rs bn Advances (LHS) ADR (RHS) Industry Private Sector Credit Growth 2 15% 1 5% -5% BAHL: Deposit Cost vs Discount Rate 15% Deposit Cost Policy Rate 1 5% Source: Company Accounts, SBP, Topline Research BAHL: Total Deposits and CASA Ratio 750 Deposits Rs bn (LHS) 10 CASA (RHS) 75% % - BAHL Advances in different segments Textile Food Commerce Agriculture Consumer Others Source: SBP, Topline Research 5 P a g e

6 Jan-09 Sep-09 Jun-10 Mar-11 Nov-11 Aug-12 May-13 Jan-14 We believe overall improvement in credit appetite and easing Govt. bank borrowing requirements is likely to help overall banking sector to earn higher yield by lending to the private sector. BAHL, in such a scenario, would be in a better position considering its low ADR and high asset quality. At present, bank s gross infection ratio stands at 2.1% while its net infection ratio is - 1.4%. This negative ratio shows that BAHL has recorded provisions against NPLs higher than the actual NPLs as depicted by 164% coverage ratio. Now, BAHL has also started focusing towards on consumer lending as witnessed from its recent car financing media campaigns. During , we estimate advances growth of 14% CAGR. Rising bond investments to support NIMs BAHL s risk averse attitude is also evident from its investment portfolio which is 95% invested (Rs226bn) in Govt. securities as of Dec 31, However, the trend is tilting towards high-yield PIBs as Govt. is re-profiling its debt position from short term to long term. In first 5 months (Jan-May) of 2014, Pakistan banks and local investors have invested a record Rs1.7tn in Govt. bond auction (PIB auction). On Dec 2013, BAHL had invested Rs30.1bn in PIBs (7.3% of earning assets) which has increased to Rs71.6bn (16.3% of earning assets) as on Mar 31, We estimate BAHL s PIB position to reach around Rs80bn by Dec 2014 which will result in 20bps improvement in NIMs in Substitution of T-bill with PIBs will help BAHL along with other banks to yield abnormally high spread between 6-month T-bill and 3-year PIB of 209bps compared to average 57bps in NIMs (Net Interest Margins) of BAHL are likely to increase to 3.8% in 2014 from 3.5% in 2013 on the back of higher PIB accumulation, rising CA deposit portion in deposits and likely credit growth. NIMs are likely to stabilize at 3.7% in next 3 years, we believe. Cost to income ratio will decline Though bank s rising operating levels and new branches have resulted into high deposit growth and earnings in last 10 years, bank s administrative costs have also increased. In 2013, bank incurred administrative cost of Rs10bn which has increased at 25% CAGR in last 10 years. The growth rate is much higher than large banks. As a result, bank s cost to income ratio increased from 4 in 2003 to 56% in Though the cost ratio is higher than larger banks average of 45%, it is in line with growing mid-size banks. For coming years, we expect admin cost to remain high as BAHL is in the growth phase and is opening new branches. In next 3-years ( ), we expect bank s administrative cost to increase by 13% CAGR. However, due to higher growth in income, bank s cost to income ratio will slightly decline to 51% by month T-bill vs. 3-yr PIB yields % 16 6-month T-bill 3-yr PIB Source: Business Recorder, Topline Research NIMs: BAHL vs. Industry 8% BAHL Banking Industry 6% 4% 2% Cost to Income: BAHL vs. Industry 6 BAHL Banking Industry P a g e

7 2009A Non-Interest Income growing In last 3 years ( ), BAHL s Non-Interest Income has increased at 22% CAGR to Rs3.9bn in Similarly, the contribution of Non-Interest Income to total income stood at 22% in 2013 which was at 16% in The growth is mainly attributable to 17% CAGR of fee income while gain on sale of securities and forex income grew at 121% and 26%, respectively. We believe rising branch network and branchless banking services have caused the fee income growth in addition to overall increase operations level. On the other side, gain on sale of securities increased as the bank has recently built an equity portfolio of Rs2.5bn. We expect, Non-Interest Income to grow by 14% CAGR in next 3-years ( ) to Rs5.8bn in Growth rate is expected to remain lower than the recent past, as we expect normalized capital gains on investment portfolio. Risks Sharper fall in discount rate can depress earnings We have assumed gradual monetary easing and expect policy discount rate may drop to 9.5% and 9% by 2014 and 2015, respectively. Risk to our valuations come from any change in economic outlook and SBP monetary policy. Our workings suggest for every 100bps change in discount rate, BAHL profits inversely move by 15-18% much higher than large banks change of around 1. Economic slowdown or energy crisis can hurt local banking Overall improvement in economic activity, rising business confidence and recent GSP Plus status are all likely to bode well for local banks. It will also result into better demand for fresh credit. Banks will benefit from this situation in terms of higher margins, falling NPLs/provision and provisions reversals. However, security and energy crisis demands cautious oversight. In case of deteriorating situation, not only investment plans by locals and foreigners will get hurt but also derail recent economic recovery. SBP minimum deposits return requirements In a gradual phase, SBP has tightened profit payment requirement for commercial bank on PLS saving accounts. At present, banks are obligated to pay policy rate (of 1) minus 300bps on average monthly balance of PLS saving accounts. This has limited the magnitude of any gain/loss on policy rate increase/decrease. Though there are fewer chances, SBP can reduce the spread between PLS saving return and policy rate. Our workings suggest that profits of BAHL will decline by 15% if SBP increase return requirement by 100bps. BAHL: Non-Interest Income Rs bn Non-Interest Income (LHS) Percent of Total Income (RHS) 25% 2 15% 1 5% 7 P a g e

8 BAHL: A brief history In terms of deposits and branch network, BAHL is Pakistan s 7th largest bank operating in Pakistan. Dawood Habib Group, the sponsor of Bank AL Habib Limited, has a long track record in banking sector which dates back to the 1920s. It was among the founder members of Habib Bank Limited in 1930 which is today the largest bank of Pakistan. Today, the Group is engaged in financial services, ranging from banking across the world to asset management and equity brokerage, manufacturing and trading of refined sugar, ethanol, carbon dioxide, textiles and auto motives. Under the privatization policy of Government of Pakistan, Dawood Habib Group was granted permission to set up a commercial bank. Bank AL Habib was incorporated as a Public Limited Company in October 1991 and started banking operations in At present, BAHL s total share outstanding is 1,111mn out of which sponsors hold estimated 4 shareholding in the bank. As per KSE, 6 of the bank capital is categorized as free float. In a span of 20 years, BAHL's assets have grown to more than Rs397bn, with a network of 422 branches and sub-branches, offshore branches in Kingdom of Bahrain and Malaysia, and representative offices in Dubai, Istanbul and Beijing. In last 10 years, deposits of BAHL have increased by 24% while profit growth remained at 18%. At present, bank s Capital Adequacy stands at 14.6% which is much higher than statutory requirement of minimum 1 while PACRA has rated AA+ long term credit rating and A1+ short term credit rating. Habib Group Companies Banking: Bank AL Habib Limited, Pakistan Habib Overseas Bank Limited, South Africa Habib African Bank Limited, Tanzania Insurance: Habib Insurance Company Limited, Pakistan Greenshield Insurance, UAE Private Equity & Asset Management: AL Habib Capital Markets Limited, Pakistan Habib Asset Management, Pakistan i5 Capital, Canada Manufacturing: Habib Sugar Mills Limited, Pakistan HSM Textiles, Pakistan Habib Motorcycles, Pakistan Oil Field Services: Inclusive Energy Limited, Canada Community: Masumeen Hospital, Pakistan Husaini Blood Bank, Pakistan Habib Public School, Pakistan Habib Girl s School, Pakistan Source: Habib Group website 8 P a g e

9 CONTACT US Mr. Mohammed Sohail CEO Dir: +92 (21) Research Team: Mr. Zeeshan Afzal Senior Research Analyst +92 (21) Mr. Vahaj Ahmed Senior Research Analyst +92 (21) Mr. Tahir Saeed Research Analyst +92 (21) Mr. Nabeel Khursheed Research Analyst +92 (21) Mr. Uzair Ahmed Research Officer +92 (21) Mr. Fahad Qasim Database Manager +92 (21) Equity Sales Team: Mr. Imran Ali Head of Equity Sales Dir: +92 (21) Mr. M. Rizwan Manager Equity Sales Dir: +92 (21) Ms. Samar Iqbal Manager Equity Sales Dir: +92 (21) Corporate Office: 306, Continental Trade Center, 3rd Floor Block 8, Main Clifton, Karachi, Pakistan Phone Fax Analyst Certification I, Zeeshan Afzal, for the views expressed in this report certify that all the views about the subject matter are accurate depiction of my personal views and no part of my compensation or any other benefits, was/will be, directly or indirectly, related to the specific recommendation expressed in this report. Furthermore, I do not hold any beneficial holding in the scrip. This report has been prepared for information purposes by the Research Department of Topline Securities. The information on which this report is based is obtained from sources which Topline Research believes to be reliable but we do not guarantee that it is accurate or complete. In particular, the report takes no account of the investment objectives, financial situation and particular needs of investors who should seek further professional advice or rely upon their own judgment and acumen before making any investment. This report should also not be considered as a reflection on the concerned company s management and its performances or ability, or appreciation or criticism, as to the affairs or operations of such company or institution. Warning: This report may not be reproduced, distributed or published by any person for any purpose whatsoever. Action will be taken for unauthorized reproduction, distribution or publication. 9 P a g e