Kenyan Banks_Could Equity Be a Victim of Its Own Success

8/8/2019 Kenyan Banks_Could Equity Be a Victim of Its Own Success

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KENYAN BANKS

Could Equity Bank become a victim

of its success?Equity Bank Group (the Bank, or Equity bank) has carved itselfa niche as a premier micro-finance institution in Kenya. In thisreport, we provide key information on industry structure. Theprimary areas of debates on the banks prospects are:

Growth opportunities: The bank has 8.3% market shareon loans and a 6.5% market share on deposits, making it atop 5 bank (CY09). Taking into consideration that thesystem is heavily fragmented, with 44 registeredcommercial banks, further market share acquisition could

come at a higher cost (lower lending rates on the assets

side and higher deposit rates on the liability side). Weexpect Equity banks growth rates to progressively convergewith the industry but it should continue to benefit fromrising penetration and the resultant volume increase.

Regional expansion: We believe the regional expansion isimportant for the bank. Capital generation is vital for the

expansion programme. We think the bank is well placed andhas access to other funding sources. The bank is yet toexploit its non-dilutive capital. We like the Ugandan and

Southern Sudan markets, but we expect solid competition inTanzania where the major banks are key players in micro-finance.

ROE: We note that the banks asset yield and margin aremoving towards industry averages although we expect the

new markets to support them in FY11 and FY12. The margindeclined in CY09 to 27% (vs. 25% for industry) from 32%in FY07 (vs. 26.5% for industry). The asset yield at 15.5%(vs. 10.2% for industry) is still higher but lower than 16.8%

in FY06. The strong deposit franchise allows furtherleverage. We anticipate a sustainable ROE of ~25%, beingan ROA of ~3% and leverage ratio of around ~8.5X.

M&A play: Equity bank is a strong franchise but we do notthink it could be an M&A play, notwithstanding the

expansion of South African and Nigerian banks into EastAfrica (EA). Most of the banks seem to prefer green fields oracquiring relatively smaller and at times weaker orstruggling entities to established ones;

Key man risk: Mr Mwangi has been at the helm of themanagement team for some time now. The team has beenhighly successful in executing the banks strategy. There issome key-man risk, but we do not believe it is critical.

Valuation: We move to the sidelines for now : Despitefavourable structural positioning, the share price seems tohave factored in most of our good news. Our PER-basedFY11 target price is Kes28.6. We recommend a HOLD.

Peter Mushangwe

Lawrence Madzwara+27 11 551 3675

[email protected]

December 7, 2010 African Markets: Equity

HOLD


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Page 1 of 22

Contents page

1. Industry Overview : Key features 2

2. Equity Bank, Follow Up, FY11 Kes28.6, HOLD 12

2.1 Key debates: Could it become a victim of its success? 12

2.2 Valuation: A revisit to our model 17


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Page 2 of 22

1. Industry overview

Penetration rising, growth opportunities remainencouraging: The key attraction, as is the case with most African

markets, is the under-penetration. The ratio of bankingassets/GDP has increased from 40% in CY00 to 54% in 1H10.Having said that, the banking assets have outgrown nominal GDP

growth when indexed to CY99. (see Fig 1). Banking assets havegrown by a CAGR of 17% between CY00 and CY09 while nominalGDP has expanded by 11% over the same period. Nonetheless, thelow banking assets/GDP ratio is the primary long-term investment

theme supporting exposure to the Kenyan banking sector. Systemloans and deposits growth rates have been strong since CY05 (seeFig 2). Banking sector loans and advances increased toKes828.9bn in 3Q10 and we expect loans and advances to breach

Kes1trn mark by 1H11. Deposits rose to Kes1,270.6bn by end of3Q10. The primary factors, i.e. population growth, penetration andper capita income, are supportive of strong banking assets growth.

The number of accounts in the system increased to 8.45mn inCY09, about 20% of the population. By end of 3Q10, the system

had 11.142mn accounts, an enormous growth rate of 32% from8.45mn at the end of FY09. The system branch network hasincreased to 996, with 353 of them located in Nairobi. (see Fig 3).

By end of 3Q10, the system branch network was 1,030. The ATMnetwork increased to 1,717 from 1,325 in CY08. The rising numberof branches and ATMs indicates rising penetration. We shouldhighlight that mobile banking has also been highly successful in

Kenya, aiding penetration. In our view, mortgage loan growth should support credit expansion

going forward. Loans to real estate were only Kes37.7bn for FY09,

which was low at 0.9% and 5.6% of GDP and private sector totalcredit respectively (see Fig 4). Growth in real estate related loanswas strong this year, jumping to Kes64.7bn in 1H10 and broke theKes100bn mark to Kes100.4bn by end of 3Q10. Private household

credit has increased from Kes59.5bn in CY00 to Kes115.2bn in1H10. This is still low as a percentage of GDP and provides roomfor upside. We expect loans and advances growth rates to remain

in the double digit zone, probably not the upper-20s but mid-20sto upper-teens.

The positive macro-outlook is also constructive and we expectopportunities in the banking space to remain attractive. The IMFexpects Kenyas GDP to grow by 4.1% this year from 2.4% in

CY09. The average growth rate for the next 5 years is 6.3%. TheCentral Bank of Kenya (CBK) has maintained a largelyaccommodative monetary policy although one would not besurprised to see some tightening now. However, we remain

concerned by political risks and high levels of corruption.


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Page 3 of 22

Fig 1: The banking assets/ GDP ratio is still low despite banking assets outstripping nominal

GDP growth since CY99

30%

35%

40%

45%

50%

55%

60%

65%

0

500

1000

1500

2000

2500

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

GDP,bn

Bankingassets,bn

Bankingassets/GDP;%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1 99 9 2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9

NominalGDP

Bankingassets,bn

Source: CBK, Legae Securities

Fig 2: System assets growth has lagged system deposits growth with CAGR of 15% and 17%

respectively from CY00 to CY09

0%

5%

10%

15%

20%

25%

30%

200

400

600

800

1,000

1,200

1,400

1,600

2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 0 05 2 0 06 2 00 7 2 00 8 2 00 9

Assets,bn

Growth,RHS

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

200

400

600

800

1,000

1,200

2 0 00 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9

Deposits,bn

Growth,RHS



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Page 4 of 22

Fig 3: System accounts reached 20% of the population in CY09

3.33

4.12

6.45

8.45

0

1

2

3

4

5

6

7

8

9

2006 2007 2008 2009

Systemaccounts,mn

575

740

887

996

300

400

500

600

700

800

900

1000

1100

2006 2007 2008 2009

Branchnetwork


Fig 4: We expect real estate loans penetration to increase

20%

10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

0

5

10

15

20

25

30

35

40

1 99 9 2 0 00 2 00 1 2 00 2 2 0 03 2 00 4 2 00 5 2 00 6 2 0 07 2 00 8 2 0 09

Realestate loans,Kesbn

Growth

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

1 99 9 2 0 00 2 0 01 2 00 2 2 00 3 2 0 04 2 0 05 2 0 06 2 00 7 2 0 08 2 0 09

Realestateloans/GDP



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Profitability; still high: Industry profitability growth has beenstrong reaching Kes47.6bn in CY09, a CAGR of 26.4% from

Kes24.7bn in CY04. However, growth has been declining sincepeaking in CY05 to grow by 12%, 15pp below the 27% simpleaverage growth rate since CY04. (see Fig 5). The worrying issue isthe declining non-interest income/total operating income ratio asbank fees reduced. However, this could be a segment that banks

can exploit through product development and innovations thatencourage transactional activities. Competition would remain highgiven the fragmentation.

Depending on funding profiles, the low interest rate environmentthis year is beneficial to interest spread and Net Interest Margins

(NIM) as the lending rate is sticky. Banks that have higherdependence on interbank funding should benefit more from lowershort-term wholesale funding costs.

The industry pre-tax ROE is still high, notwithstanding deteriorationfrom the CY06 and CY08 level. Pre-tax ROE declined to 25% from28.3% in CY06 although ROA increased to 2.6% from 2.4% overthe same period. The interest spread improved from 7.5% in CY04

to 9.5% in CY09. (see Fig 6). As penetration rises, competition willput pressure on interest rate spread. We, however, continue to seefavourable credit conditions in the country (and region) especially

for micro-banks, which should be supportive of the industryprofitability. Against our selected countries, Kenyas ROA and ROEare relatively high. (see Fig 7).

Fig 5: Industry profitability growth has declined; Non-interest revenue growth is muted

35.0%

36.0%

37.0%

38.0%

39.0%

40.0%

41.0%

42.0%

43.0%

44.0%

2004 2005 2006 2007 2008 2009

NIR/Totalincome

14.7

18.9

26.4

35.1

42.6

47.6

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

50.0

2004 2005 2006 2007 2008 2009

Pre

tax

profit,bnGrowthrate,RHS



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Page 6 of 22

Fig 6: ROE is >20% despite a decline in FY09 ; interest spreads steady and higher at >9%

2.1%

2.4 % 2.4%

2.7%

2.6% 2 .6%

22.5% 23.9%28.3% 28.0% 26.6% 25.0%

1.5%

1.7%

1.9%

2.1%

2.3%

2.5%

2.7%

2.9%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

22.0%

24.0%

26.0%

28.0%

30.0%

2004 2005 2006 2007 2008 2009

ROE

ROA

7.5%

8.4%8.8%

9.2%9.7% 9.5%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

2004 2005 2006 2007 2008 2009

Yieldonassets

Costofdeposits

Spread


Fig 7: System ROA and ROE remain comparatively high against a select countries

4.0%

3.0%

2.0%

1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

Ukraine

UnitedKingdom

UnitedStates

Japan

Canada

Australia

Russia

India

Rwanda

SouthAfrica

China

Poland

Malaysia

Brazil

Chile

Mexico

Morocco

CzechRepublic

Nigeria

Argentina

Turkey

Indonesia

Ghana

Kenya

Mozambique

Uganda

ROA

30%

20%

10%

0%

10%

20%

30%

40%

Ukraine

UnitedKingdom

UnitedStates

Japan

Russia

Rwanda

Canada

Nigeria

Australia

Poland

India

Malaysia

Brazil

Mexico

Morocco

Ghana

SouthAfrica

Chile

Turkey

Argentina

Uganda

CzechRepublic

Kenya

Indonesia

Mozambique

ROE

Source: IMF, Legae Securities


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Page 7 of 22

Credit risks; coverage ratio deteriorates, we remainconcerned with asset quality: The credit risk profile of the

system has significantly improved as indicated by theprovisions/loans and advances and NPLs/loans and advancesratios. Sector-wise, the systems greatest exposure is the personalloans which constituted about 28% of the systems loan book as atthe end of 3Q10. (see Fig 8).

The stock of system NPLs increased in FY08 by Kes6.5bn after asteep decline in CY07. NPLs continue to increase in CY09 (byKes1.6bn). (see Fig 8). By end of 3Q10, the systems stock of NPLshad increased to Kes61.2bn. To an extent, we are concerned bythe falling coverage ratio (see Fig 10). 1) The growth of NPLs lag

the growth of system loans and advances 2) the NPL coverageratio has declined to only 53% from 59% in CY04. This impairsquality of earnings. Further downward movement in the coverageratio is unlikely this year, so the stock of provisions could increase

should NPLs remain elevated. We believe this year NPLs willremain high as NPL cycle generally lag economic cycle. (theeconomy grew by 1.3% and 2.4% for CY08 and CY09 respectively

a steep decline from 6.9% in CY07). There is NPL overhang risk,in our view.

Fig 8: Personal and household loans remain the highest credit exposure as at 3Q10

11.219.8 23.6

29.144.6 45.4

68.9

100.4

122.3

162.9

248.4

0

50

100

150

200

250

300

Mining&Quarrying

Tourism

Construction

Energy

Agriculture

Financialservices

Transport&Comm.

RealEstate

Manufacturing

Trade

Personal

Creditriskexpsoure,Kesbn 1.3%2.3%

2.7%3.3%

5.1%

5.2%

7.9%

11.5%

14.0%

18.6%

28.3%

Credit exposurebysector,%

Mining&Quarrying

Tourism

Construction

Energy

Agriculture

Financialservices

Transport&Comm.

RealEstate

Manufacturing

Trade

Personal



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Page 8 of 22

Fig 9:Industry NP Ls remain above the Kes40bn mark but incremental NPLs declined in FY 09

30

20

10

0

10

20

30

40

50

2005 2006 2007 2008 2009

Provisions,bn

Incremental provisions,bn

30

20

10

0

10

20

30

40

50

60

70

2005 2006 2007 2008 2009

NPLs,bn

IncrementalNPLs,bn


Fig 10: Credit risks have improved materially, but coverage ratios have w orsened.

0%

5%

10%

15%

20%

25%

2004 2005 2006 2007 2008 2009

Totalprovisions/Loans

NPL/Loans

59%

63%

65%

57%

54% 53%

40%

45%

50%

55%

60%

65%

70%

2004 2005 2006 2007 2008 2009

NPL coverage



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Page 9 of 22

Liquidity risks; high levels of liquid assets: The system carriessufficient liquidity in our view. The LDR was 72% by end of CY09.

The liquidity ratio which was 37% in CY08 improved to 40% inCY09. (see Fig 11). By end of 3Q10 the liquidity ratio stood at46.7%. The stock of liquid assets has grown by 13.6% versus agrowth of 14.7% for banking assets. The high level of liquid assetshas a negative impact to profitability especially at this point of low

interest rates. The 90-day Treasury Bill rate has declined to 2.9%at 1H10 from 8.5% at the start of CY09. The interbank rate hasdeclined to 1.1% by end of 1H10 from 6% in January 2009. Thelow interbank rate indicates the high liquidity level in the system.

The mix of demand deposits and time and savings deposits hasalso changed over time. As at the end of 1H10, 32% of systemdeposits were demand type, while savings and time depositsconstituted 72%. Demand deposits have, however, grown fasterthan savings and time deposits (see Fig 12). Demand deposits

generally do not attract interest. Data released by the CBK showsthat the cost of savings deposits has declined to 1.75% in 1H10from 4.5% in CY00 while time deposits of a tenor of less than 3

months are more expensive at 5.1% as at 1H10.

Fig 11: Industry liquidity is high; LDR declined to 70% ; Liquidity ratio increased to 40%

66%

65%

66%

70%

73%

72%

60%

62%

64%

66%

68%

70%

72%

74%

2004 2005 2006 2007 2008 2009

LDR

42% 42% 42%

46%

37%

40%

30%

32%

34%

36%

38%

40%

42%

44%

46%

48%

2004 2005 2006 2007 2008 2009

Liquidityratio



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Page 10 of 22

Fig 12: Demand deposits grow ing faster than time and savings accounts, liquid asset high

0

1

2

3

4

5

6

7

8

1 9 99 2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 0 07 2 00 8 2 00 9 1 H 10

DemandTimeandSavings

100,000

200,000

300,000

400,000

500,000

600,000

10%

5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

1H10

Liquida ss ets Growth,L H S


Capital risks; highly capital ised and low leverage: The systemholds high levels of capital, with a core capital/RWA and totalcapital/RWA ratios of 18% and 21% respectively, against statutory

requirements of 8% and 12% in that order. The system leverage islow, at just 5.9X in CY09. (see Fig 13). By end of 3Q10, totalcapital/RWA and core capital/RWA ratios stood at 20.6% and18.6% respectively. As we show in Fig 14, the system is one of the

best capitalised. In spite of the high capital level, the ROE is stillcomparatively high which to an extent indicates the high level ofsystem profitability.

Fig 13: The industry is well capitalised; Low leverage provides room for grow th

17% 17%17%

19%20%

21.0%

16% 16% 16%

18% 18% 18%

0%

5%

10%

15%

20%

25%

2004 2005 2006 2007 2008 2009

Corecapital/RWA

Totalcapital/RWA

CoreMin.

Totalmin.8.5

7.8

8.7

7.8

6.2

5.9

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

2004 2005 2006 2007 2008 2009

Leverage



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Page 11 of 22

Fig 14: One of the best capitalised systems (Jun e 2009).

5%

7%

9%

11%

13%

15%

17%

19%

21%

23%

China

Australia

Morocco

Poland

India

Unit

edKingdom

SouthAfrica

Cze

chRepublic

U

nitedStates

Chile

Canada

Malaysia

M

ozambique

Nigeria

Egypt

Ukraine

Mexico

Indonesia

Ghana

Brazil

Argentina

Kenya

Turkey

Russia

Uganda

Rwanda

Capital/RWAs

30%

20%

10%

0%

10%

20%

30%

40%

Ukraine

UnitedKingdom

UnitedStates

Japan

Russia

Rwanda

Canada

Nigeria

Australia

Poland

India

Malaysia

Brazil

Mexico

Morocco

Ghana

SouthAfrica

Chile

Turkey

Argentina

Uganda

CzechRepublic

Kenya

Indonesia

Mozambique

ROE

Source: IMF, Legae Securities


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Page 12 of 22

2. Equity Bank, Follow up, HOLD

2.1 Key Debates

We are changing our recommendation from a BUY to a HOLD (FY11Target price is Kes28.6). We see constrained upside potential in the

next 12 months. Our potential total return of 13% does not provide areal rate of return that could make the risk/return profile attractive. Atthe same time, we believe in the Equity bank story and if the expansionis managed the same way the local strategy was handled, there is

significant potential. The regional play is an important valuation anchor,in our view.

We discuss the key issues that investors should examine when gettingexposure to the stock. Our assumption is that investors will take a long

term view on the stock and we try to answer key questions that webelieve are important to the medium to long-term investment case forEquity bank.

a) Will Equity continue to outperform the industry by widemargins?

We indicate that Equity bank is already one of the big banks(number 4) in a market that is exceedingly fragmented. Equitybank enjoys 8.3% of the industry loan book in a market where

the top 10 banks have a combined market share of 62%. (TheSouth African system has top 5 banks enjoying a combinedmarket share of >90%). On customer deposits, the bankcommands a market share of 6.54%. The bank has managed toincrease its market share on both loans and advances and

deposits from 1.7% and 1.8% respectively in CY05 to 8.3% and6.3% in CY09. Equity bank is now a top 5 bank as indicated bythose metrics. (see Fig 15). Comparing the asset and depositsgrowth rates of Equity bank against the industry, we note that

Equity bank has materially outperformed the industry since 2001.(see Fig 16). In terms of profitability, Equity banks earningsgrowth rates outperformed system by a colossal margin,especially given that Equity bank is now a top 5 bank and thus

has a higher weight to industry metrics. However, Equity bankspre-tax ROE has lagged the industry since CY07. (see Fig 17).Commercial banking, to an extent can become generic and we

doubt that Equity banks competitors are going to allow it tocontinue to claim market share. We think organic growth in thelocal market is going to be difficult and earnings growth willmoderate despite our expectations of a recovery this year when

compared to FY09. Nonetheless, Equity bank, as one of the bigbanks will continue to benefit from rising industry penetration.


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Page 13 of 22

Fig 15: Equity bank is now a top 5 bank, has increased market share materially in a K enya

1.7%

4.4%

8.3%

1.8%

4.4%

6.5%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

2005 2007 2009

Equitybank'smarketshare

Loans

Deposits

0%

2%

4%

6%

8%

10%

12%

14%

16%

NBK

Citibank

Comm.

BoA

Diamond

Trust

CFCStanbic

Stanchart

Equity

CoopBank

Barlcays

KCB

Marketshares

of

the

top

10

Advances

Deposits


Fig 16: Equity bank outpace industry growth in assets and deposits grow th

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

2001 2002 2003 2004 2005 2006 2007 2008 2009

Assetgrowth IndustryEquitybank

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09

Depositgrowth IndustryEquitybank



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Page 14 of 22

Fig 17: Equity bank outpace system earnings growth but lag on pre-tax ROE

29%

39%33%

21%

12%

129%

120%116%

111%

5%

0%

20%

40%

60%

80%

100%

120%

140%

2005 2006 2007 2008 2009

EarningsgrowthratesSystem

Equitybank

24%

28%28% 27%

25%

31%

50%

16%

26%23%

0%

10%

20%

30%

40%

50%

60%

2005 2006 2007 2008 2009

ReturnonEquity SystemEquitybank

Source: CBK, Company reports, Legae Securities

b) Will the foreign strategy work out?Equity bank is pursuing an expansion strategy into regionalforeign markets. Footprints have already been established inSouthern Sudan and Uganda. Management indicates that theywill work towards establishing presence in all major east Africaneconomies, which in our view includes Tanzania and Rwanda.

This regional pure play could be a strategic strength. As the EAmarkets and economies integrate, the bank would haveopportunities to gain market share, particularly in the SME trade

finance space. The acquisition in Uganda could be a drag this FY

due to legacy issues but we believe it will be value accretive fromFY11 onwards. Southern Sudan is already a tailwind to the banksearnings. Given the low level of financial markets development,

we agree that this market is going to be key to Equity bank.Major risks in Sothern Sudan would be political and regulatory innature. Tanzania should be the market that will test the ingenuity

of Equity banks management to the limit given the strongpositions that CRDB and NMB command in the micro-financesegment. CRBD and NMB are two biggest banks by assets,

deposits and loans in Tanzania, and both play a significant role inMFI space.

Equity banks capital generation to fund expansion is critical aswell. Currently, with a pre-tax profit/NPL cover ratio of > 1X,capital generation is possible. The pre-tax profit/provision level

has declined to 5.1X from 8.3X in CY06 but is still relatively highand allows for capital generation. The pre-tax profit growth ishigh, at an average of >50% between FY06 and FY09, despite a

low growth rate of only 5% in FY09. Dividend payout of


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Page 15 of 22

Expansion can also be funded from non-dilutive capital which isnot yet fully utilised on the banks capital structure. Tier 1 capital

types such as preference shares are yet to be utilised while thecapital structure is also currently devoid of Tier 2 capital typessuch as subordinated bond. The downside would be that non-dilutive capital could result in higher cost of funding for the bank,

and consequently negatively affect NIM but we believe the new /target markets would provide attractive asset yields andmargins in the medium term.

c) Is the ROE going to improve and exceed the CoE by aw ider margin?

The other area for debate is the ROE development. The Banks

ROE has been volatile despite a strong growth in earnings,

primarily due to capitalisation exercises taken in 2007. Webelieve the banks ROE has been overshadowed by the high

earnings growth rate and investors have not paid attention to itas it was rightfully distorted. The key question now is whetherthe ROE will revert to the upper-20s/lower-30s? We believe therecovery in ROE will be robust as capital in regional markets

begins to sweat. Leverage could be increased as loan books inUganda and Southern Sudan expand should growth in Kenyamigrate towards industry levels. With our deposit growth ratesof 50% for FY10 and 15% for FY11 and FY12, we probably have

not modelled for material penetration in the new markets.

The primary issue for Equity bank is to be able to maintain itsasset yield and margin higher than the industry. In FY06, Equity

banks asset yields outpaced the industry by 6.5pp (16.8% vs.industrys 10.3%) but this has declined to 5.3pp in FY09. Margins

were lower than the industry in FY06 before outpacing theindustry by 6pp in FY07 and FY08. This outperformance hasnarrowed to 2pp in FY09. To a great extent, the trend seems toindicate that Equity banks asset yield and margin are converging

with the industry averages. However, we do not expect thisconvergence in our forecast period (3 years) as positive benefitsfrom new markets, particularly Sothern Sudan and Ugandashould support asset yields and margins. Efficiency benefits and

lower credit losses (as the economic conditions improve; GDPexpected to recover to 5.8% for FY11) would also be supportiveof margins. Leverage should support ROE and we believe that the

bank boasts a strong deposit franchise that could provide it withthe required funding and liquidity. We expect the bank to close

FY10 with a stock of approximately Kes20bn in governmentsecurities. This could be redeployed to higher earning assets (i.e.change in asset mix) especially as the bank has minimal reliance

on the interbank market funding. The need for liquid assets isprimarily to meet regulatory and asset/liability managementobjectives. In our opinion a sustainable ROE of ~25% is


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achievable being a ROA of ~3% and a leverage ratio of ~8.5X.(see Fig 18).

Fig 18: We expect ROE to increase on leverage

ROEbreakdown 2006 2007 2008 2009 2010F 2011F 2012F

Assetyield:Revenue/Total Assets 16.8% 11.0% 16.0% 15.5% 14.5% 13.6% 14.3%

Margin:NetIncome/Revenue 22.3% 32.5% 31.0% 27.0% 29.1% 31.9% 30.8%

ROA 3.8% 3.6% 5.0% 4.2% 4.2% 4.3% 4.4%

Leverage 9.1 3.6 4.0 4.4 6.3 6.7 7.1

ROE 34.2% 12.7% 20.0% 18.5% 26.3% 29.3% 31.5%

Source: Company reports, Legae Securities

d) Would Equity bank become a potential M&A play?There has been a lot of coverage on international banksexposure to African markets, especially Sub-Sahara. Barclaysand Standard Chartered already carry significant exposure.

Nigerian and South African banks that are expanding into otherAfrican markets could be possible buyers, but we just do not seeit happening. 1) Equity bank plays in the MFI space, where creditrisks (and capital requirement), and liquidity/funding risks are

higher and there is need to forge closer relationships with clients2) Equity bank is still mainly Kenyan despite its recent expansioninto foreign markets. In fact opportunities exist for the bank toplay in the M&A as it expands into the region. In our view, Equity

bank is not likely to be an M&A play. (i.e. as a target).

e) How much key-man risk risk in priced in?Equity bank has been familiarly linked with its founder, Mr JamesMwangi who is the current managing director and has been

leading the management team for some time. The superiormicro-banking execution capability of the Mwangi-led teammakes the key-man risk more visible. In our view, Mr Mwangiand his team have played a central role in building the bank and

its brand. We, however, do not expect the key-man risk to pulldown valuations. The assumption is that the CBK and the board(which is dominated by non-executive directors) will ensure that

there is a succession plan and a smooth transition should it berequired. Of course, the other side of key-man risk, which isoften ignored, is the decision by key-man to remain with the firmwhen one should move on.


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2.2 Valuation: A revisit to our model

We revise the major assumptions of our model after incorporating3Q10 results. The salient assumptions are:

We grow deposits by 50% for FY10 before reducing itdrastically to 15% for FY11 and FY12. Industry deposit growthrate in CY09 was 14%;

We reduce the LDR and maintained it at 85%; We reduce yields on advances and loans from 15% in FY09 to

12.8% for FY11 taking into account declining interest rates andcompetition development in the system;

We increased the interest cost to deposits from 1% in FY09 to1.3% for FY10 and 1.2% for FY11 and FY12;

We reduce the fee and commission income as a percentage ofloans and advances to 2.5% for FY10 and FY11 from 3.3% forFY09.

We hike the loan loss provision/advances ratio to 2.5% from1.6% in FY09 and reduce it to 2% for FY11 and 1.5% for FY12.

The average rate between FY06 and FY09 is 1.3%.

The results of our changes to our assumptions can be summarised bythe CAMEL ratios shown on Fig 19. The CAMEL ratios are strong; with

the NIM at 11.2% in FY12 (from 12.5% in FY09). The ROE increases to31.5% by FY12 as we expect leverage to increase, and a slight uplift onROA from new markets.

Fig 19: CAMEL analysis

2006 2007 2008 2009 2010F 2011F 2012F

C:Equity/Loans 20.1% 68.3% 44.2% 36.1% 25.4% 23.6% 21.8%

C:Leverageratio 9.1 3.6 4.0 4.4 6.3 6.7 7.1

A:Provisions/Loans 1.2% 0.1% 2.3% 1.6% 2.5% 2.0% 1.5%

A:Provisions/NPL 23.4% 2.6% 40.3% 21.4% 31.3% 26.7% 20.8%

M:Cost/Income 67.3% 59.4% 60.4% 66.7% 62.0% 59.4% 60.7%

M:NIR/Totalrevenue 55.3% 52.6% 47.5% 41.5% 38.0% 41.0% 41.8%

E:NIM 10.2% 6.5% 12.0% 12.5% 11.2% 10.6% 11.2%

E:ROE 34.2% 12.7% 20.0% 18.5% 26.3% 29.3% 31.5%

L:Liquidassets/Totalassets 20.6% 35.2% 13.4% 13.3% 19.3% 17.2% 13.0%

L:Loan/Deposit 66.9% 69.2% 87.8% 90.7% 85.0% 85.0% 85.0%


Current valuation looks expensive at first glance: Valuationfor Equity bank seems expensive at first glance, given the trailing

PER of 22X. If one considers some of the concerns we highlightedon our key debates section, one could be fairly bearish on theshare but we find some solace in its regional expansion strategy.The outlook for regional expansion and the consequent effect to


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the ROE means that valuation, even on a PER basis could beattractive on a 3-years horizon. In fact regional expansion is the

key valuation anchor while convergence of yields in Kenya is themain risk, particularly if it takes place faster than we expect.

Justified PE and PBV ratios inapplicable: We would havepreferred to use a Justified PE and PBV ratio to estimate our FY11price target, but because the growth estimates are higher than our

estimate of the CoE, the ratios would be meaningless. We havetherefore use 1) the earnings capitalisation method to estimateFY11 price target. We use the industry average PER. We apply adiscount of 5% to indicate execution risks in the new markets; and

2) the Discounted Future Earnings method to estimate a fairvalue, which we use for reasonability check of our PER-basedvaluation. We use a CoE of 17.5%.

Earnings capitalisation method shows upside of 13% whilethe DFE method indicates full valuation, HOLD: The FY11

price target using our earnings capitalisation method is Kes28.6which provides a potential total return of 13%. (see Fig 20).However, the DFE indicates a lower potential total return of 0.7%,

with a capital loss of -2.3%. We believe our discount rate isconservative, so to a great extent one could argue there is not

easy upside in the stock. (see Fig 21). Our FY11 target priceshows an implied PBVR of 4.3X which we consider realistic for a

bank that we expect to return >25% and has strong growthprospects. In our view, a total return of 13% does not provide anattractive risk/return profile (execution risks in foreign markets

and convergence/competition in local market). We admit that our3-year forecasts show quite strong growth expectations, andstrong CAMEL ratios, but we doubt if this is not yet priced in. We

therefore recommend investors to HOLD.

Fig 20: Earnings Capitalisation model

Industry average PER 15.6

Discount for regional execut ion risks -5%

Adjusted capitalization rate 14.8

FY11 Earnings Kes,mn 7,079

Capitalized Earnings Kes,mn 104,782

Shares in Issue mn 3,660

Per share value (FY11 P Kes 28.6

Current price Kes 26

Upside potential 10%

Dividend yield 3%

Total potential return 13%

Source: NSE, Legae Securities


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Fig 21: Discounted Future Earnings Valuation Mo del

2008 2009 2010F 2011F 2012F TerminalValueEarnings 3,910.26

4,233.99

5,957.93

7,078.87 8,072.05

TerminalValue n/a n/a n/a n/a n/a 103,983.2

TotalEarnings 3,910.26 4,233.99 5,957.93 7,078.87 8,072.05 103,983.23

PresentValuefactor 0.97 0.85 0.72 0.72

PresentValueofEarnings 5,807.72 6,024.57 5,846.66 75,316.06

Value 92,995.01

Persharevalue 25.41

ForwardPER 13.14

Currentprice 26.00

CapitalGain 2.3%

DividendYield 3.0%

Totalreturn 0.7%

Numberofshares 3660

CostofEquity 17.5%



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Financial Statements

Fig 22: Income statement model

InterestIncome 2006 2007 2008 2009 2010F 2011F 2012F Growthrates 2007 2008 2 009 2 010 2 011 2 012

Loansandadvances 1,435.7 2,512.4 6,175.5 9,483.9 11,353.8 13,569.0 16,487.6 Loansandadvances 75% 146% 54% 20% 20% 22%

GovernmentSecurities 103.1 545.5 1,540.6 1,275.1 3,377.1 2,208.3 1,715.1 GovernmentSecuritie s 429% 182% 1 7% 1 65 % 35% 22%

Placementswithbanks 95.7 196.7 262.9 33.2 89.0 51.2 75.9 Placementswithbanks 105% 3 4% 8 7% 1 68 % 43% 48%

Other Other 0% 0% 0% 0% 0% 0%

Interestincome 1,634.5 3,254.6 7,979.0 10,792.2 14,820.0 15,828.4 18,278.6 Interestincome 99% 145% 35% 37% 7% 15%

InterestExpense Interestexpense

Customerdeposits 118.1 244.6 552.3 815.2 1,309.6 1,445.7 1,662.6 Customer deposits 107% 126% 48% 61% 10% 15%

Placementsfrombanks 6.0 2.6 22.8 4.4 5.5 11.8 6.2 Placementsfrombanks 5 6% 7 68 % 81% 24% 116% 47%

Otherinterestexpense 2.6 247.3 787.1 802.5 784.2 1,270.2 1,359.9 Otherinterestexpense 9394% 218% 2% 2% 62% 7%

Totalinterestexpense 126.6 494.5 1,362.2 1,622.1 2,099.3 2,727.8 3,028.8 Total interestexpense 290% 175% 19% 29% 30% 11%

NetInterestIncome 1,507.8 2,760.1 6,616.8 9,170.1 12,720.7 13,100.7 15,249.8 NetInterestIncome 83% 140% 39% 39% 3% 16%

Fees&Commission onloans 366.1 883.3 1,869.2 2,106.8 2,226.2 2,560.2 3,267.7 Fees&Commission onloans 141% 112% 13% 6% 15% 28%

Otherfees&c om mi ss io n 1, 430. 2 1,948.9 3,281.1 3,928.4 4,452.5 5,120.4 6,358.8 Otherfees&commission 36% 68% 20% 13% 15% 24%

Foreign exchangetrading 23.3 147.4 754.4 222.2 655.8 888.1 767.1 Foreignexchangetradi ng 533% 4 12% 71% 195% 35% 14%

Dividendincome 17.2 6.0 8.7 16.6 Dividendincome 0% 0% 0% 0% 0% 92%

Othernoninterestincome 44.0 83.0 83.9 231.6 445.2 512.0 522.8 Othernoninterestincome 89% 1% 176% 92% 15% 2%

Totalnoninterest i ncome 1,863.6 3,062.5 5,988.6 6,506.1 7,785.8 9,089.3 10,933.0 Totalnoninterest income 64% 96% 9% 20% 17% 20%

OperatingIncome 3,371.4 5,822.6 12,605.4 15,676.2 20,506.5 22,190.0 26,182.9 OperatingIncome 73% 116% 24% 31% 8% 18%

Loanlossprovision (133.13) 25.34 (1,019.63) (1,035.33) (2,226.24) (2,048.14) (1,766.52) Loanlossprovision 119% 4124% 2% 115% 8% 14%

Staffcosts (942.96) (1,453.47) (2,937.86) (4,295.32) (5,126.62) (5,270.13) (6,218.43) Staffcosts 54% 102% 46% 35% 20% 18%

Directors'costs (15.70) (16.09) (16.66) (43.42) (59.01) (54.00) (70.53) Directors' costs 3% 4% 161% 20% 0% 31%

Rental charges (102.28) (181.87) (375.43) (645.39) (809.57) (924.17) (1,110.90) Rentalcharges 78% 106% 72% 20% 10% 20%

Depreciation (242.55)

(357.51)

(649.38)

(1,035.73)

(998.91)

(1,118.10)

(1,614.39)

Depreciation 47% 82% 59% 20% 15% 44%Amortization charges (37.32) (65.67) (99.78) (138.32) (155.04) (173.96) (238.43) Amortization charges 76% 52% 39% 0% 0% 37%

Otheroperatinge xp en se s ( 79 4. 61) (1,409.51) (2,518.46) (3,262.84) (3,339.37) (3,584.25) (4,867.05) Otheroperatingexpenses 77% 79% 30% 15% 20% 36%

Totaloperatinge x pe n se s ( 2, 26 8. 55 ) (3,458.78) (7,617.19) (10,456.35) (12,714.77) (13,172.76) (15,886.26) Total operatingexpenses 52% 120% 37% 22% 4% 21%

Profitbeforeexceptionali t em s 1 ,1 02 .8 8 2,363.82 4,988.18 5,219.82 7,791.72 9,017.26 10,296.60 Profitbeforeexceptionalitems 114% 111% 5% 49% 16% 14%

Exceptionalitems 14.70 34.08 58.31 0 Exceptionalitems 0% 132% 71% 100% 0% 0%

Profitbeforetax 1,102.88 2,378.52 5,022.26 5,278.13 7,791.72 9,017.26 10,296.60 Profitbeforetax 116% 111% 5% 48% 16% 14%

Taxation: currenttax (333.99) (454.28) (1,062.60) (1,116.70) (1,833.79) (1,938.39) (2,224.55) Taxation:currenttax 36% 134% 5% 64% 6% 15%

Deferredtax (15.51) (33.96) (49.40) 72.56 0 Deferredtax 119% 45% 0% 0% 0% 0%

Profit/(Loss) 753.38 1,890.28 3,910.26 4,233.99 5,957.93 7,078.87 8,072.05 Profit/(Loss) 151% 107% 8% 41% 19% 14%

EPS 0.28 0.69 1.07 1.16 1.63 1.93 2.21 EPS 148% 55% 8% 41% 19% 14%

Dividends 0.2 0.2 0.3 0.40 0.65 0.77 0.88 Dividends 0% 50% 33% 63% 19% 14%

Fig 23: Balance Sheet model

Assets 2006 2007 2008 2009 2010F 2011F 2012F Growthrates 2007 2008 2009 2010 2011 2012

Cash 1,545 3,015.01 3,652.14 4,359.23 1,885.63 6,288.98 4,653.35 Cash 95% 21% 19% 90% 30% 26%

BalancesduefromCBK 923 2,138.35 2,468.49 3,739.75 5,342.99 6,144.43 7,066.10 BalancesduefromCBK 132% 15% 51% 50% 0% 15%

GovernmentSecurities 1,651 13,542.94 4,329.66 5,016.51 20,036.20 15,361.09 11,776.83 GovernmentSecuri ti es 720% 68% 16% 120% 0% 23%

Foreigntreasurybills 88.77 308.76 153.18 220.19 316.52 Foreigntreasurybills 0% 0% 248% 60% 0% 44%

Placementswithlocalbanks 1,786 4,105.15 5,160.78 3,378.99 2,671.49 3,072.22 3,533.05 Placementswithlocalbanks 130% 26% 35% 50% 0% 15%

Placementswithforeignbanks 459 2,786.25 1,162.11 1,516.38 1,781.00 2,048.14 2,656.32 Placementswithforeignb an ks 5 07% 58% 30% 0% 0% 30%

Securitiesfordealing 8,145.45 6,827.15 6,501.37 9,345.72 13,434.47 Securitiesfordealing 0% 0% 0% 200% 0% 44%

Taxrecoverable 13.31 74.52 32.88 47.27 67.95 Taxrecoverable 0% 0% 0% 50% 0% 44%

Loansand

advances 10,930

21,836.44 44,193.75

63,378.23

89,049.78

102,407.24 117,768.33

Loans

and

advances 100% 102% 43% 20% 20% 15%

Investmentsecurities 32.31 11.35 16.31 23.45 Investmentsecurities 0% 0% 0% 75% 0% 44%

BalancesduefromGroupcos 9.61 3.37 4.85 6.97 BalancesduefromGroupcos 0% 0% 0% 600% 0% 44%

Investmentinassociates 441.83 1,155.56 1,213.87 1,458.95 2,097.24 2,419.06 Investmentinassociates 0% 162% 5% 0% 0% 15%

Investmentinsubsidiaries 51.00 25.69 36.93 53.09 Investmentinsubsidiaries 0% 0% 0% 0% 0% 44%

InvestmentinJV InvestmentinJV 0% 0% 0% 0% 0% 0%

Investmentinproperties 11 11.27 11.27 8.49 43.10 35.56 35.93 Investmentinproperties 0% 0% 25% 0% 0% 1%

Property&Equipment 1,465 2,602.88 4,824.26 6,441.97 6,678.73 7,680.54 10,622.85 Property&Equipment 78% 85% 34% 0% 0% 38%

Prepaidlease 4 4.15 4.10 30.89 25.63 27.09 33.35 Prepaidlease 0% 1% 653% 0% 0% 23%

Intangibleassets 161 224.34 1,465.43 1,762.93 1,558.37 1,792.13 2,355.37 Intangibleassets 39% 553% 20% 0% 0% 31%

Deferredtax 5.54 1.94 2.80 4.02 Deferredtax 0% 0% 0% 0% 0% 44%

Retirementbenefitasset Retirementbenefitasset 0% 0% 0% 0% 0% 0%

Otherassets 1,089 2,420.66 2,110.73 2,706.62 4,452.49 6,434.26 5,985.48 Otherassets 122% 13% 28% 50% 25% 7%

Totalassets 20,024 53,129 78,837 100,811.75 141,714 163,063 182,812 Totalassets 165% 4 8% 2 8% 4 1% 1 5% 12%Liabilities

BalancesduetoCBK BalancesduetoCBK 0% 0% 0% 0% 0% 0%

Customerd ep os it s 16, 336. 73 31 ,535. 52 5 0, 334. 53 69,842.96 104,764.44 120,479.11 138,550.98 Customerdeposits 93% 60% 39% 20% 20% 15%

Placementsduetolocalbanks Placementsduetolocalbanks 0% 0% 100% 0% 0% 0%

Placementsduetoforeignbanks 53.32 0.90 54.81 78.80 41.38 Placementsduetoforeignbanks 0% 98% 100% 0% 0% 47%

Othermoneymarketdeposits Othermoneymarketdeposits 0% 0% 100% 0% 0% 0%

Borrowedfunds 485.45 4,521.39 6,463.14 6,486.12 11,132.53 14,865.88 15,273.51 Borrowedfunds 831% 43% 0% 10% 15% 3%

Balancesduetogroupcos Balancesduetogroupcos 0% 0% 100% 0% 0% 0%

Taxpayable 147.03 209.04 513.73 20.23 778.50 774.68 831.76 Taxpayable 42% 146% 96% 100% 0% 7%

Dividendspayable 1.05 0.37 0.53 0.76 Dividendspayable 0% 0% 100% 0% 0% 44%

Deferredtaxliability 10.92 44.88 94.14 115.41 140.33 141.22 Deferredtaxliability 311% 110% 100% 2% 0% 1%

Retirementbenefitliability Retirementbenefitliability 0% 0% 100% 0% 0% 0%

Otherliabilities 843.36 1,848.44 1,892.57 1,552.51 2,226.24 2,560.18 2,355.37 Otherliabilities 119% 2% 18% 43% 15% 8%

Totalliabilities 17,823 38,213 59,299 77,902.88 119,072 138,900 157,195 Totalliabilities 114% 55% 31% 53% 0% 13%Shareholders'FundsPaidupcapital 452.82 1,811.05 1,851.39 1,851.39 1,851.39 1,851.39 1,851.39 Paidupcapital 300% 2% 0% 0% 0% 0%

Sharepre mi um/ di scount 4 80 .3 6 10,543.04 12,161.02 12,161.02 12,161.02 12,161.02 12,161.02 Sharepremium/discount 2095% 15% 0% 0% 0% 0%

Revaluationreserve 1.20 12.13 (349.32) (142.19) Revaluationreserve 907% 2981% 59% 100% 0% 0%

RetainedEarnings 1,085.48 1,754.07 4,455.47 7,108.07 3,574.76 4,247.32 4,843.23 RetainedEarnings 62% 154% 60% 50% 19% 14%

Statutoryreserves 252.91 308.42 449.48 2,671.49 3,072.22 3,533.05 Statutoryreserves 0% 22% 46% 494% 15% 15%

Proposeddividends 181.13 543.39 1,110.83 1,481.11 2,383.17 2,831.55 3,228.82 Proposeddividends 200% 104% 33% 61% 19% 14%

Totalshareholders'f un ds 2, 200. 99 14,916.58 19,537.80 22,908.87 22,641.83 24,163.49 25,617.51 Totalshareholders'funds 578% 31% 17% 1% 7% 6%TotalLiabilitiesandEq ui ty 20,024 53,129 78,837 100,811.75 141,714 163,063 182,812 TotalLiabilities andEquity 165% 48% 28% 41% 15% 12%



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Legae Securities (P ty) Ltd

Member of the JSE Securities Exchange

1st Floor, Building B, Riviera Road Office Park, 6-10 Riviera

Road, Houghton, Johannesburg, South Africa

P.O Box 10564, Johannesburg, 2000, South Africa

Tel +27 11 551 3601, Fax +27 11 551 3635

Web: www.legae.co.za, email: [email protected]

Analyst Certification and Disclaimer

I/we the author (s) hereby certify that the views as expressed in this

document are an accurate of my/our personal views on the stock or sector

as covered and reported on by myself/each of us herein. I/we furthermore

certify that no part of my/our compensation was, is or will be related,

directly or indirectly, to the specific recommendations or views as expressed

in this document

This report has been issued by Legae Securities (Pty) Limited. It may not bereproduced or further distributed or published, in whole or in part, for any

purposes. Legae Securities (Pty) Ltd has based this document on information

obtained from sources it believes to be reliable but which it has not

independently verified; Legae Securities (Pty) Limited makes no guarantee,

representation or warranty and accepts no responsibility or liability as to its

accuracy or completeness. Expressions of opinion herein are those of the

author only and are subject to change without notice. This document is not

and should not be construed as an offer or the solicitation of an offer to

purchase or subscribe or sell any investment.

Important Disclosure

This disclosure outlines current conflicts that may unknowingly affect the

objectivity of the analyst(s) with respect to the stock(s) under analysis inthis report. The analyst(s) do not own any shares in the company under

analysis.

Disclaimer & Disclosure

Kenyan Banks_Could Equity Be a Victim of Its Own Success

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