The Nigerian banking sector has witnessed dramatic changes that have put a brake on the RoE uptrends we saw in 2012. Whilst re-visiting the investment case for the Nigerian banks, we narrow our analysis to the tier 1 banks, and it appears to us that Guaranty Trust Bank and Zenith Bank are head-and-shoulders above the competition.
When we consider that the Nigerian banks have been faced with multiple regulatory constraints on earnings since 2012, this implies to us that moving into a deteriorating macro environment, with ultimately negative implications for asset quality, it would be even harder to create value in a higher cost of equity environment as risk-free rates adjust upwards. On the back of this, we believe it is important to focus on banks that currently create value despite the headwinds and identify banks whose earnings have proven resilient or have unique buffers to withstand these challenges.
Analysing returns delivered by the tier 1 banks since the 2009 financial crisis and comparing this with a standardised cost of equity estimate, we conclude that in the years prior to the banking crisis, the legacy tier 1 banks (i.e. excluding Access) all delivered positive excess returns. Since the 2009 banking crisis however, only GTBank has managed to deliver more value than was eroded during the crisis on a cumulative basis. Furthermore, with the legacy tier 1 banks struggling to sustain peak returns achieved in 2012, we think Zenith stands out as GTBank’s key competitor because of the resilience of its earnings and its response to the changing environment. UBA has struggled to create cumulative excess returns since the 2009 banking crisis, owing to unimpressive returns between 2009 and 2011 (when it recorded a loss). That said, if we stretch our analysis back to 2004, we find that UBA is the only other tier 1 bank, in addition to GTBank, that has cumulatively delivered excess returns over this period. FBNH created decent excess returns in the years we look at prior to the 2009 banking crisis, but has struggled to replicate this in any year since 2008. Access has created the least value, which we attribute to its past life as a tier 2 bank. That said, since the bank joined the league of tier 1 banks in 2012, after its acquisition of Intercontinental Bank, its returns profile has evolved, albeit with occasional volatility.
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One of the most significant earnings-constraining regulations, in our view, is the cash reserve ratio (CRR), which is at its highest ever level on a blended basis. We do not expect the CRR to remain at these high levels forever, but the timing of any easing and how it will be phased in, remain highly uncertain. On our estimates, RoE for the tier 1 banks would improve by 130-650 bpts on average given a 10-50% CRR release scenario (i.e. RoE improving from 20% in 9M14 to a range of 21-26%), assuming current T-bill yields of 12% as the base-case opportunity cost. This tells us that the tier 1 banks are inherently profitable, but their earnings capacity is being limited by the CBN’s strive for macro stability. We maintain our view that any significant near-term improvement in sector returns is likely to be driven by a loosening of monetary policy, particularly in terms of the CRR. We think investors are currently working on the assumption that this high CRR level is the new normal, and have more significant near-term concerns on the underlying asset quality picture at the banks. We believe that once the CBN has more flexibility to make exchange rate adjustments post elections, and the treasury single account (TSA) is successfully implemented, an easing in the CRR could be on the cards, potentially triggering an upward bias in share prices.
In an environment where returns of GTBank and Zenith stand out, it is not surprising that management teams at either bank considers the other to be the key competitor, albeit for different reasons. GTBank sees an aggressiveness in Zenith’s moves, and the efficiency of GTBank’s operations stands out to Zenith. On balance, we think the size of balance sheets and profits, as well as consistency in strategic focus, also play a part. More importantly, however, we think the operational and returns challenges faced by other key tier 1 banks since the banking crisis has simply left these two banks tracking each other.
For many investors, the key concern when looking at Nigerian banks today surrounds asset quality and the conclusion of our analysis of these two banks is that both have significant earnings buffers to withstand an asset quality shock. For Zenith to record a loss in 2015, its cost of risk (CoR) must exceed 7.5%. Its 10-yr peak is 5.2% and management is guiding to 0.7-1% in 2015. For GTBank to record a loss in 2015, its CoR must exceed 9%. Its 10-yr peak is 7% and management is guiding to max 1% CoR in 2015. Clearly, guidance from both management teams does not suggest a disaster scenario in 2015 but we continue to see investors question the guidance given the macro concerns. That said, we note that even at 10-yr peak CoR levels, these banks will still be profitable in 2015, on our estimates.
When looking at GTBank and Zenith, a recurrent question is: why is GTBank more efficient than Zenith? Our findings suggest that GTBank is more efficient at revenue generation (more revenue per unit of assets) and is also a slightly more cost-efficient operator (lower costs per unit of assets), a combination that magnifies the cost-to-income ratio differential. Our analysis suggests that for Zenith to close this efficiency gap with GTBank, it needs to improve the earning capacity of its balance sheet by proportionately growing its earning asset base and improving the gross yield of its balance sheet. On the cost side, we think there is still room for improvement, but believe this is work in progress, as the trend in recent years has been encouraging. Some of the changes required to drive through these improvements could be structural and dependent on the regulatory environment, but underlying any successes, in our view, will be exceptional execution by the bank’s management team.
Overall, we believe Nigerian banks’ earnings could face potentially significant pressures over the next 12-24 months, implying further downward pressure on share prices as macro concerns and structural adjustments to correct these issues feed through to the banks’ earnings. We are most concerned about asset quality implications for the banks, but after our recent discussions with the management teams of all the tier 1 banks, we maintain a relative preference for Zenith and GTBank moving into this likely rough patch. Amongst the tier 2 banks, Stanbic is our top pick because of the diversity of its business model, which shields its earnings during this period of heightened uncertainty. Specifically, we note that it has an even higher earnings buffer than GTBank and Zenith to withstand an asset quality shock in 2015. On our estimates, its CoR will have to exceed 13% for it to record a loss, which compares against management’s 1.5% expectation for the year, and 10-yr peak CoR of 5%.
Adesoji Solanke
