We issue a BUY recommendation on Equity Bank Limited (Equity Bank) with a 1 year fair value price of KES 41.29, 21.4% upside from the current price. With GDP growth expected to rise over the next coming years (Kenya government forecast of 5.6%, World Bank forecast of 5.8% in FY13E), we believe that the banking sector will be a major beneficiary. Equity Bank, with 7.8m customers and the 2nd largest loan book in East Africa, is well positioned to take advantage of the expected growth. We forecast that faster loan book growth (3 year CAGR of 27.5%) will drive growth in net interest income, while increased transactional income from the 7.8m customers will drive non-interest income. Agency banking should reduce the cost to income ratio (to 48.0% in FY13E) and help keep cost of funds low by attracting low cost deposits. For FY13E, we estimate an EPS of KES 3.80 (+16.4% y/y) with lending in the next 3 quarters expected to make up for the slow growth in 1Q13.
Positives
• Improving macroeconomic conditions across the region will drive loan book growth over the next 3 years (3 year CAGR of 27.5%) compensating for Net Interest Margin (NIM) compression
• Cost of funds is expected to decline from 3.9% in FY12A to 2.4% in FY13E, 2.6% in FY14F and 2.2% in FY15F
• Increased long-term borrowed funds from DFIs (from 6.1% of average assets in FY10A to 12.1% in FY12A) will lead to less volatile cost of funds
• Increased SME lending will lead to an improvement of Net Interest Income and asset quality
• Growth in non-interest income will be driven by increased customer numbers, transactions per customer, remittances and additional fees from loan book growth
• The regional subsidiaries will continue to be significant sources of non-interest income while increasingly contributing to net interest income as they grow their loan books
• Agency banking in Kenya, Tanzania and Rwanda will bring down cost-to-income ratio, reduce operational leverage and grow low cost deposits (at a 3 year CAGR of 24.7%)
• Branch expansion will be focused on SMEs and supporting agency banking
• The bank’s continuous focus on innovation is key in maintaining and extending its competitive advantages
Negatives
• The yield on interest earning assets is expected to decline from 16.9% in FY12A to 14.3% in FY13E, 14.1% in FY14F and 11.6% in FY15F which will consequently lead to a decline in Net interest margins (NIMs) from 13.0% in FY12A to 11.8% in FY13E, 11.5% in FY14F and 9.4% in FY15F)
• Potential 10% excise duty on financial transactions may lead to compression in non-interest income margins
• Additional provisioning is required (+95.2% y/y) to keep up with the rise in non-performing loans
• With strong loan book growth expected (3 year CAGR of 27.5%) and more stringent prudential guidelines, Equity Bank may need to raise capital in 2014
• High turnover of senior management is a concern
Source: Kestrel Capital, 12th June, 2013