Karachi, May 30, 2012 (PPI-OT): Banks have shed 5.9% since recent peak, underperforming the KSE-100 index by 2.2% in the process, primarily on concerns of higher taxation.
According to AKD Securities, these stem from potential 1) increase in income tax rate to 40% or 2) increase in tax rate on T-bill income to 50% from 35% at present. AKD Securities estimates that an increase in corporate tax rate would shave 6%-7% across AKD Securities’ forecast earnings horizon, which appears to have been priced in already, While AKD Securities attachs lower probability to higher tax T-bills (systemic risk), this scenario would likely entail a 10%+ reduction in earnings estimates for the majority of AKD Securities’ coverage banks (surprisingly, NBP appears relatively insulated but this may not last). If tax on T-bill income is indeed raised, bearish sentiment in Banks is likely to continue (Islamic banks may be relative winners). However, if status quo remains, AKD Securities believes Banks will lead a 2HCY12 Index rally where AKD Securities’ Dec’12 Index target is 16,000 points. AKD Securities retains a selective preference for the larger banks, especially UBL and BAFL.
Banks in the limelight: Traditionally, calls for higher taxation on Banks have already always added to pre-Budget noise. This time around however, robust profitability (AKD Banks Universe profits up 21% YoY in 1QCY12) amidst continued private sector crowding-out adds more conviction to tax concerns. An increase in income tax rate to 40% shaves 6%-7% across AKD Securities’ forecast earnings horizon while a 50% tax rate on T-bill income would likely entail a 10% reduction in earnings estimates. Regarding the latter, AKD Securities assumes that investment in T-bills over and above SLR requirement will come in for higher taxation. That said, AKD Securities continues to attach low probability to higher tax rate on T-bills, with high GoP borrowing requirements acting as a mitigating factor.
Available options: If T-bill tax rate is enhanced, AKD Securities believes banks will likely try to dilute the impact at the margin; through routing of T-bills through asset management subsidiaries, more aggressive use of excess CRR and higher rate bids on T-bills. Nevertheless, AKD Securities rules out a drastic shift away from T-bills due to 1) liquidity considerations, 2) subdued private sector demand going by low corporate sector capacity utilizations and 3) nascent asset quality concerns. In such a scenario, more expose banks (e.g. MCB) may potentially explore options abroad, either through organic growth or M and A.
A 2HCY12 rally? Higher T-bill tax rate will likely extend bearish sentiments in Banks post budget. Nevertheless, AKD Securities continues to see long-term value in Banks where AKD Securities point to 1) sustainable 7%+ spreads (May/Jun numbers may take a temporary blip on higher floor on savings deposits), 2) declining credit costs and 3) continued strong balance sheet growth. Should status quo remain on the taxation front, Banks are likely poised for a sustained bull run. AKD Securities retains a selective preference for UBL (diversification through foreign operations) and BAFL (2nd largest Islamic balance sheet in Pakistan).