Why is Equity worth more than KCB?

Monday August 16 2010

Faida, a stockbrokerage firm, recently issued a report in which it hopes that the market premium that Equity enjoys will be eroded as its profitability grows to match the market’s expectations. If this does not happen, the report does not state that investors will be holding overpriced shares. Photo/FILE

Faida, a stockbrokerage firm, recently issued a report in which it hopes that the market premium that Equity enjoys will be eroded as its profitability grows to match the market’s expectations. If this does not happen, the report does not state that investors will be holding overpriced shares. Photo/FILE 

By EMMANUEL WERE

KCB and Equity Bank were valued in the same league at the beginning of 2010.

KCB’s market capitalisation, the value of all of a firm’s listed shares, was put at Ksh47.5 billion ($594 million) on the Nairobi Stock Exchange and Equity Bank was worth Ksh56 billion ($703 million).

But eight months on, the two banks have had widely differing fortunes.

Equity’s valuation has grown to Ksh89.8 billion ($1.1 billion) as its share price has rallied to new highs while KCB’s value has shrunk to Ksh41.8 billion ($500 million).

KCB’s share price is clearly underperforming and in the language of the stock market, it is selling at a steep discount compared with its peers, in particular Equity Bank.

This, in theory, underlines the pessimism in the market about the ability of KCB’s management to outperform its peers in delivering profits.

The market is hugely confident that Equity will beat its peers.

Since 2004, KCB has asked shareholders thrice to put in more money in the bank to boost its capital base and this has enabled the management to come out of its bad debt troubles of the 1990s and grow its balance sheet fivefold.

At the beginning of the year, it had used up most of the capital it raised in 2008 and was running out of headroom to grow as it expanded to the East African region.

Last week, it raised Ksh12.4 billion ($155 million), through a rights issue where it sought Ksh15 billion ($187 million). With this new capital, KCB could easily double its balance sheet and future profits.

The current situation, however, begs the question: Why would the market value KCB, the region’s biggest bank with assets of Ksh240 billion ($3 billion), at nearly half the value of Equity, which is just half its size?

Is Equity’s management that good at making money? Some in KCB’s top management ranks believe the market is being too harsh on KCB and does not appreciate its growth potential.

Though most analysts are optimistic about Equity, they are divided over KCB’s share price outlook, though they largely believe in its prospects and regional growth strategy.

They say that, in coming months, the issue is a question of timing: Whether you are buying these shares as a long-term investment or for short-term speculation.

Faida, a stockbrokerage firm, recently issued a report in which it hopes that the market premium that Equity enjoys will be eroded as its profitability grows to match the market’s expectations.

If this does not happen, the report does not state that investors will be holding overpriced shares.

Faida is also upbeat on KCB, though the report observes that KCB has excess layers of management and could do more to use technology to cut costs.

Analysts at Sterling Investment, Kestrel Capital, and Renaissance Capital are however worried about KCB’s short-term prospects because of the huge stock of shares it has released into the market.

This could depress trading and dilute earnings per share.

The expected dilution does not substantively affect the total value of the free cashflows or total value of the company, it is merely an accounting effect.

However, a key issue that rarely comes to the surface is the extent to which stockbrokers, who in the industry are known to be on the “sell-side” because they earn commissions on transactions, share the same wavelength with portfolio investment managers, who are said to be on the “buy-side” on the prospects of KCB and Equity.

Stockbrokers tend to encourage investment strategies that favour active trading of shares, and portfolio managers take a long-term view of the market and produce superior returns by making a calculated bet of buying into a share when it is undervalued.

The advice of the sell-side won the day in the current rights issue, which was undersubscribed by small investors who gave up their rights.

Analysts expect that in the coming months, foreign portfolio investors will come swooping down on KCB shares, especially as Kenya’s political risk rating and economic outlook improve.

Kenyan banks mainly make money by raising cheap deposits from small savers and then lending back to them at exorbitant rates and investing the rest of the money in government securities, which are considered secure and with low default risks.

These banks are increasingly charging fees for many activities, ranging from printing an extra bank statement, walking into the branch for human-assisted services, and using cash machines.

The banks are increasingly being accused of profiteering and holding back economic growth by charging higher interest rates than are warranted.

Analyst say that Equity Bank has been shrewd at raising its deposits cheaply while pushing the growth of interest earning assets on its balance sheet.

“We are optimistic of the growth potential Equity Bank holds in banking the informal sector and increasing appeal to middle-class customers who are largely net savers and hence a good source of deposits,” wrote the Kestrel Capital analysts in their end of June 2010 update report on the bank.

Equity Bank has thus enjoyed the benefits of a high interest margin, the difference in what it pays on deposit and what it earns in interest from loans.

The bank has an average interest margin of 12 per cent for 2010.

The interest margin rose in the second quarter of 2010, to 14 per cent, thanks to increased liquidity as the Central Bank of Kenya eased monetary policy to encourage banks to lend.

More money in circulation meant that banks could get deposits cheaply but on the other hand lower the lending rates piecemeal.

Equity Bank’s half-year interest income jumped 45 per cent to Ksh7.3 billion ($91.25 million) compared with the period ended June 2008, when it stood at Ksh5 billion ($62.5 million).

While KCB is also enjoying growing interest income, as net interest margin rose to 10.62, its cost of funds remains high.

Analysts highlight the fact that term deposits — deposits made by customers for a fixed number of days that are generally more expensive compared with regular savers — account for 20 per cent of the bank’s total deposits.

This will serve to increase the costs of funds for KCB.

It is not only the cost of funds that is increasing, but also the bank’s operating costs, measured by cost-to-income ratio, which at 67 per cent remain higher than Equity Bank’s.

KCB’s high costs have been associated with high staff numbers and running an extensive branch network.

Equity too has been a victim of rising branch costs lately.

Although KCB’s net profit per branch is high, at Ksh30 million ($375,000) for the full year ended December 2009, the ease with which Equity Bank is opening up alternative delivery channels is boosting its transactional income.

The M-Kesho account, a revolutionary tie-in with Safaricom, is estimated to increase the bank’s transactional income.

But even as KCB lags behind Equity in some metrics, it is one step ahead when it comes to mortgage lending, a possible growth avenue in the East African region.

Part of the Ksh12.4 billion ($155 million) from the rights issue is expected to go into the mortgage business.

Equity bank has faltered, thus far, in its attempts to acquire a controlling stake in Housing Finance, which would see it gain a foothold in the mortgage market.

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