December 7, 2010 African Markets: Equity

HOLD KENYAN BANKS

Could Equity Bank become a victim
of its success?
Equity Bank Group (‘the Bank’, or Equity bank’) has carved itself
a niche as a premier micro-finance institution in Kenya. In this
report, we provide key information on industry structure. The
primary areas of debates on the bank’s prospects are:
ƒ Growth opportunities: The bank has 8.3% market share
on loans and a 6.5% market share on deposits, making it a
top 5 bank (CY09). Taking into consideration that the
system is heavily fragmented, with 44 registered
commercial 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). We
expect Equity bank’s growth rates to progressively converge
with the industry but it should continue to benefit from
rising penetration and the resultant volume increase.
ƒ Regional expansion: We believe the regional expansion is
important for the bank. Capital generation is vital for the
expansion programme. We think the bank is well placed and
has access to other funding sources. The bank is yet to
exploit its non-dilutive capital. We like the Ugandan and
Southern Sudan markets, but we expect solid competition in
Tanzania where the major banks are key players in micro-
finance.
ƒ ROE: We note that the bank’s asset yield and margin are
moving towards industry averages although we expect the
new markets to support them in FY11 and FY12. The margin
declined 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 further
leverage. We anticipate a sustainable ROE of ~25%, being
an ROA of ~3% and leverage ratio of around ~8.5X.
ƒ M&A play: Equity bank is a strong franchise but we do not
think it could be an M&A play, notwithstanding the
expansion of South African and Nigerian banks into East
Africa (EA). Most of the banks seem to prefer green fields or
acquiring relatively smaller and at times weaker or
struggling entities to established ones;
ƒ Key man risk: Mr Mwangi has been at the helm of the
Peter Mushangwe management team for some time now. The team has been
Lawrence Madzwara highly successful in executing the bank’s strategy. There is
+27 11 551 3675 some key-man risk, but we do not believe it is critical.
peterm@legae.co.za ƒ Valuation: We move to the sidelines for now: Despite
favourable structural positioning, the share price seems to
have factored in most of our good news. Our PER-based
FY11 target price is Kes28.6. We recommend a HOLD.
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

Page 1 of 22
1. Industry overview

ƒ Penetration rising, growth opportunities remain

encouraging: The key attraction, as is the case with most African
markets, is the under-penetration. The ratio of banking
assets/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 have
grown by a CAGR of 17% between CY00 and CY09 while nominal
GDP has expanded by 11% over the same period. Nonetheless, the
low banking assets/GDP ratio is the primary long-term investment
theme supporting exposure to the Kenyan banking sector. System
loans and deposits growth rates have been strong since CY05 (see
Fig 2). Banking sector loans and advances increased to
Kes828.9bn in 3Q10 and we expect loans and advances to breach
Kes1trn mark by 1H11. Deposits rose to Kes1,270.6bn by end of
3Q10. The primary factors, i.e. population growth, penetration and
per capita income, are supportive of strong banking assets growth.
ƒ The number of accounts in the system increased to 8.45mn in
CY09, about 20% of the population. By end of 3Q10, the system
had 11.142mn accounts, an enormous growth rate of 32% from
8.45mn at the end of FY09. The system branch network has
increased to 996, with 353 of them located in Nairobi. (see Fig 3).
By end of 3Q10, the system branch network was 1,030. The ATM
network increased to 1,717 from 1,325 in CY08. The rising number
of branches and ATMs indicates rising penetration. We should
highlight that mobile banking has also been highly successful in
Kenya, aiding penetration.
ƒ 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 total
credit respectively (see Fig 4). Growth in real estate related loans
was strong this year, jumping to Kes64.7bn in 1H10 and broke the
Kes100bn mark to Kes100.4bn by end of 3Q10. Private household
credit has increased from Kes59.5bn in CY00 to Kes115.2bn in
1H10. This is still low as a percentage of GDP and provides room
for upside. We expect loans and advances growth rates to remain
in the double digit zone, probably not the upper-20s but mid-20s
to upper-teens.
ƒ The positive macro-outlook is also constructive and we expect
opportunities in the banking space to remain attractive. The IMF
expects Kenya’s 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%. The
Central Bank of Kenya (CBK) has maintained a largely
accommodative monetary policy although one would not be
surprised to see some tightening now. However, we remain
concerned by political risks and high levels of corruption.

Page 2 of 22
Fig 1: The banking assets/GDP ratio is still low despite banking assets outstripping nominal
GDP growth since CY99

2500 65% 4.0

GDP,bn Nominal GDP
Banking assets,bn 3.5
60% Banking assets,bn
2000 Banking assets/GDP; %
3.0
55%
2.5
1500
50%
2.0
45%
1000 1.5

40% 1.0
500
35% 0.5

0 30% 0.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

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

1,600  30% 1,200  50%

Assets,bn Deposits,bn
45%
1,400  Growth,RHS 25% 1,000  Growth,RHS
40%
1,200 
35%
20% 800 
1,000  30%

800  15% 600  25%

20%
600 
10% 400 
15%
400 
10%
5% 200 
200  5%

‐ 0% ‐ 0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: CBK, Legae Securities

Page 3 of 22
Fig 3: System accounts reached 20% of the population in CY09

9 8.45 1100
System accounts,mn Branchnetwork
996
8 1000

7 6.45 887
900
6
800
740
5
4.12 700
4
3.33 575
600
3
500
2
400
1

0 300

2006 2007 2008 2009 2006 2007 2008 2009

Source: CBK, Legae Securities

Fig 4: We expect real estate loans penetration to increase

40 80% 2.5% Real estate loans/GDP

Real estate loans,Kesbn
70%
35 Growth
2.0%
60%
30
50%
25 1.5%
40%

20 30%
1.0%
20%
15
10%
10 0.5%
0%
5
‐10%
0.0%
0 ‐20%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: CBK, Legae Securities

Page 4 of 22
 ƒ Profitability; still high: Industry profitability growth has been
strong reaching Kes47.6bn in CY09, a CAGR of 26.4% from
Kes24.7bn in CY04. However, growth has been declining since
peaking in CY05 to grow by 12%, 15pp below the 27% simple
average growth rate since CY04. (see Fig 5). The worrying issue is
the declining non-interest income/total operating income ratio as
bank fees reduced. However, this could be a segment that banks
can exploit through product development and innovations that
encourage transactional activities. Competition would remain high
given the fragmentation.
ƒ Depending on funding profiles, the low interest rate environment
this year is beneficial to interest spread and Net Interest Margins
(NIM) as the lending rate is sticky. Banks that have higher
dependence on interbank funding should benefit more from lower
short-term wholesale funding costs.
ƒ The industry pre-tax ROE is still high, notwithstanding deterioration
from the CY06 and CY08 level. Pre-tax ROE declined to 25% from
28.3% in CY06 although ROA increased to 2.6% from 2.4% over
the same period. The interest spread improved from 7.5% in CY04
to 9.5% in CY09. (see Fig 6). As penetration rises, competition will
put pressure on interest rate spread. We, however, continue to see
favourable credit conditions in the country (and region) especially
for micro-banks, which should be supportive of the industry
profitability. Against our selected countries, Kenya’s ROA and ROE
are relatively high. (see Fig 7).

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

50.0  47.6  45%

Pre‐tax profit,bn NIR/Total income
45.0  42.6  44.0%
40%
Growth rate,RHS
40.0  43.0%
35%
35.1 
35.0  42.0%
30%
30.0  41.0%
26.4  25%
25.0  40.0%
18.9  20%
20.0  39.0%
14.7  15%
15.0  38.0%
10% 37.0%
10.0 

5.0  5% 36.0%

‐ 0% 35.0%
2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009

Source: CBK, Legae Securities

Page 5 of 22
Fig 6: ROE is >20% despite a decline in FY09; interest spreads steady and higher at >9%

14.0%
30.0% 2.9%
ROE
28.0% 12.0%
ROA 2.7% 2.7%
26.0% 2.6% 2.6%
2.5% 10.0%
24.0% 9.7% 9.5%
9.2%
2.4% 2.4% 8.8%
22.0% 8.4%
2.3% 8.0%
2.1% 7.5%
20.0%
Yield on assets
28.3% 28.0% 26.6% 25.0% 2.1% 6.0%
18.0% 22.5% 23.9% Cost of deposits
Spread
16.0% 1.9% 4.0%
14.0%
1.7% 2.0%
12.0%

10.0% 1.5% 0.0%

2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009

Source: CBK, Legae Securities

Fig 7: System ROA and ROE remain comparatively high against a select countries
4.0% 40%
ROA ROE

3.0%
30%

2.0%
20%

1.0%

10%

0.0%
South Africa

Mexico

Nigeria
China

Indonesia
India

Kenya
Argentina

Ghana
Morocco
United Kingdom

Rwanda

Turkey

Uganda
Ukraine

Japan

Australia

Malaysia
Poland
Canada

Russia

Brazil
Chile

Czech Republic
United States

Mozambique

0%
South Africa
Mexico
Nigeria

India

Indonesia
Ghana

Argentina

Kenya
Morocco
United Kingdom

Rwanda

Turkey
Australia

Malaysia

Uganda
Ukraine

Japan
Russia

Canada

Brazil
Poland

Chile

Czech Republic

Mozambique
United States

‐1.0%

‐10%
‐2.0%

‐20%
‐3.0%

‐4.0% ‐30%

Source: IMF, Legae Securities

Page 6 of 22
 ƒ Credit risks; coverage ratio deteriorates, we remain
concerned with asset quality: The credit risk profile of the
system has significantly improved as indicated by the
provisions/loans and advances and NPLs/loans and advances
ratios. Sector-wise, the system’s greatest exposure is the personal
loans which constituted about 28% of the system’s loan book as at
the end of 3Q10. (see Fig 8).
ƒ The stock of system NPLs increased in FY08 by Kes6.5bn after a
steep decline in CY07. NPLs continue to increase in CY09 (by
Kes1.6bn). (see Fig 8). By end of 3Q10, the system’s stock of NPLs
had increased to Kes61.2bn. To an extent, we are concerned by
the falling coverage ratio (see Fig 10). 1) The growth of NPLs lag
the growth of system loans and advances 2) the NPL coverage
ratio has declined to only 53% from 59% in CY04. This impairs
quality of earnings. Further downward movement in the coverage
ratio is unlikely this year, so the stock of provisions could increase
should NPLs remain elevated. We believe this year NPLs will
remain high as NPL cycle generally lag economic cycle. (the
economy 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
300
Credit risk expsoure, Kes bn 1.3%
248.4 2.3% Credit  exposureby sector,%
250 2.7%
3.3%
5.1% Mining &Quarrying
200
162.9 28.3%
Tourism
150 5.2%
122.3 Construction
100.4 Energy 
100
68.9 7.9% Agriculture
44.6 45.4
50 29.1 Financial services
19.8 23.6
11.2
Transport & Comm.
0
11.5% Real Estate
Financial services
Agriculture

Personal
Energy 

Trade
Construction
Mining &Quarrying

Tourism

Manufacturing
Transport & Comm.

Real Estate

Manufacturing
18.6%
Trade
Personal
14.0%

Source: CBK, Legae Securities

Page 7 of 22
Fig 9:Industry NPLs remain above the Kes40bn mark but incremental NPLs declined in FY09

50 70
Provisions,bn NPLs,bn
60 Incremental NPLs,bn
40 Incremental provisions,bn
50
30
40

20 30

10 20

10
0
0
‐10
‐10

‐20 ‐20

‐30 ‐30

2005 2006 2007 2008 2009 2005 2006 2007 2008 2009

Source: CBK, Legae Securities

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

70%
25% NPL coverage
Total provisions/Loans
65%
NPL/Loans 65% 63%
20%

60% 59%
57%
15%
55% 54% 53%

10%
50%

5% 45%

0% 40%

2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009

Source: CBK, Legae Securities

Page 8 of 22
 ƒ Liquidity risks; high levels of liquid assets: The system carries
sufficient liquidity in our view. The LDR was 72% by end of CY09.
The liquidity ratio which was 37% in CY08 improved to 40% in
CY09. (see Fig 11). By end of 3Q10 the liquidity ratio stood at
46.7%. The stock of liquid assets has grown by 13.6% versus a
growth of 14.7% for banking assets. The high level of liquid assets
has 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 has
declined to 1.1% by end of 1H10 from 6% in January 2009. The
low interbank rate indicates the high liquidity level in the system.
ƒ The mix of demand deposits and time and savings deposits has
also changed over time. As at the end of 1H10, 32% of system
deposits were demand type, while savings and time deposits
constituted 72%. Demand deposits have, however, grown faster
than savings and time deposits (see Fig 12). Demand deposits
generally do not attract interest. Data released by the CBK shows
that the cost of savings deposits has declined to 1.75% in 1H10
from 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%

74%
LDR 48% Liquidity ratio
73%
72% 46% 46%
72%
44%
70% 70%
42% 42% 42% 42%
68%
40% 40%
66%
66% 38%
66%
37%
65%
36%
64%
34%
62%
32%

60% 30%
2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009

Source: CBK, Legae Securities

Page 9 of 22
Fig 12: Demand deposits growing faster than time and savings accounts, liquid asset high

40% 600,000 
8
Demand
35% Liquid assets Growth,LHS
7 Time and Savings 500,000 
30%
6 25%
400,000 
5 20%

15% 300,000 
4
10%
3 200,000 
5%
2
0%
100,000 
1 ‐5%

0 ‐10% ‐

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

1H10
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1H10

Source: CBK, Legae Securities

ƒ Capital risks; highly capitalised and low leverage: The system

holds high levels of capital, with a core capital/RWA and total
capital/RWA ratios of 18% and 21% respectively, against statutory
requirements of 8% and 12% in that order. The system leverage is
low, at just 5.9X in CY09. (see Fig 13). By end of 3Q10, total
capital/RWA and core capital/RWA ratios stood at 20.6% and
18.6% 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 still
comparatively high which to an extent indicates the high level of
system profitability.

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

Core capital/RWA 9.0
25% Total capital/RWA Leverage
8.7
Core Min. 8.5 8.5
Total min. 21.0%
20%
19% 8.0
20% 7.8 7.8
17%
17% 17% 7.5
18% 18% 18%
15% 16% 16% 16% 7.0

6.5
6.2
10% 6.0 5.9
5.5

5% 5.0

4.5

0% 4.0
2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009

Source: CBK, Legae Securities

Page 10 of 22
 11%
13%
15%
17%
19%
21%
23%

5%
7%
9%
China
Australia
Morocco
Poland
India
United Kingdom
Capital/RWAs

South Africa
Czech Republic
United States
Chile
Canada
Malaysia
Mozambique
Nigeria
Egypt
Ukraine
Mexico
Indonesia

Source: IMF, Legae Securities

Ghana
Brazil
Argentina
Kenya
Turkey
Russia
Uganda
Rwanda
‐30%
‐20%
‐10%
10%
20%
30%
40%

0%

Ukraine
United Kingdom
ROE

United States
Fig 14: One of the best capitalised systems (June 2009).

Japan
Russia
Rwanda
Canada
Nigeria
Australia
Poland
India
Malaysia
Brazil
Mexico
Morocco
Ghana
South Africa
Chile
Turkey
Argentina
Uganda
Czech Republic
Kenya
Indonesia

Page 11 of 22
Mozambique
2. Equity Bank, Follow up, HOLD

2.1 Key Debates

We are changing our recommendation from a BUY to a HOLD (FY11

Target price is Kes28.6). We see constrained upside potential in the
next 12 months. Our potential total return of 13% does not provide a
real rate of return that could make the risk/return profile attractive. At
the same time, we believe in the Equity bank story and if the expansion
is 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 getting
exposure 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 we
believe are important to the medium to long-term investment case for
Equity bank.

a) Will Equity continue to outperform the industry by wide

margins?
We indicate that Equity bank is already one of the big banks
(number 4) in a market that is exceedingly fragmented. Equity
bank enjoys 8.3% of the industry loan book in a market where
the top 10 banks have a combined market share of 62%. (The
South African system has top 5 banks enjoying a combined
market share of >90%). On customer deposits, the bank
commands a market share of 6.54%. The bank has managed to
increase its market share on both loans and advances and
deposits from 1.7% and 1.8% respectively in CY05 to 8.3% and
6.3% in CY09. Equity bank is now a top 5 bank as indicated by
those metrics. (see Fig 15). Comparing the asset and deposits
growth 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 bank’s earnings
growth 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 bank’s
pre-tax ROE has lagged the industry since CY07. (see Fig 17).
Commercial banking, to an extent can become generic and we
doubt that Equity bank’s competitors are going to allow it to
continue to claim market share. We think organic growth in the
local market is going to be difficult and earnings growth will
moderate despite our expectations of a recovery this year when
compared to FY09. Nonetheless, Equity bank, as one of the big
banks will continue to benefit from rising industry penetration.

Page 12 of 22
Fig 15: Equity bank is now a top 5 bank, has increased market share materially in a Kenya

9.0% 16% Market shares of the top 10

Equity bank's market share 8.3%
8.0% 14%

7.0% 6.5% 12%

Advances
Loans
6.0% 10% Deposits
Deposits
5.0% 8%
4.4% 4.4%
4.0% 6%

3.0% 4%

2.0% 1.7% 1.8% 2%

1.0% 0%

KCB
Citibank

Stanchart

Equity 
NBK

Comm. 

Barlcays
CFC Stanbic
Diamond 

Co‐op Bank
BoA

Trust
0.0%
2005 2007 2009

Source: CBK, Legae Securities

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

180% Industry
Asset growth 100% Deposit growth Industry
Equity bank Equity bank
160%
90%

140% 80%

120% 70%

60%
100%
50%
80%
40%
60%
30%
40%
20%
20% 10%

0% 0%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: CBK, Legae Securities

Page 13 of 22
Fig 17: Equity bank outpace system earnings growth but lag on pre-tax ROE

Earnings growth rates 60% Return on Equity

System System
140%
129% Equity bank Equity bank
120% 50% 50%
120% 116%
111%

100% 40%

80% 31% 28%

30% 28% 27%
25%
60% 26%
20% 24%
23%
39%
40% 33% 16%
29%
21% 10%
20% 12%
5%
0%
0%
2005 2006 2007 2008 2009
2005 2006 2007 2008 2009

Source: CBK, Company reports, Legae Securities

b) Will the foreign strategy work out?

Equity bank is pursuing an expansion strategy into regional
foreign markets. Footprints have already been established in
Southern Sudan and Uganda. Management indicates that they
will work towards establishing presence in all major east African
economies, which in our view includes Tanzania and Rwanda.
This regional pure play could be a strategic strength. As the EA
markets and economies integrate, the bank would have
opportunities 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 from
FY11 onwards. Southern Sudan is already a tailwind to the bank’s
earnings. 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 in
nature. Tanzania should be the market that will test the ingenuity
of Equity bank’s management to the limit given the strong
positions that CRDB and NMB command in the micro-finance
segment. CRBD and NMB are two biggest banks by assets,
deposits and loans in Tanzania, and both play a significant role in
MFI space.
Equity bank’s capital generation to fund expansion is critical as
well. 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 high
and allows for capital generation. The pre-tax profit growth is
high, at an average of >50% between FY06 and FY09, despite a
low growth rate of only 5% in FY09. Dividend payout of <40%
should result in capital generation through retained earnings.

Page 14 of 22
 Expansion can also be funded from non-dilutive capital which is
not yet fully utilised on the bank’s capital structure. Tier 1 capital
types such as preference shares are yet to be utilised while the
capital structure is also currently devoid of Tier 2 capital types
such 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 and
margins in the medium term.

c) Is the ROE going to improve and exceed the CoE by a

wider margin?
The other area for debate is the ROE development. The Bank’s
ROE has been volatile despite a strong growth in earnings,
primarily due to capitalisation exercises taken in 2007. We
believe the bank’s ROE has been overshadowed by the high
earnings growth rate and investors have not paid attention to it
as it was rightfully distorted. The key question now is whether
the ROE will revert to the upper-20s/lower-30s? We believe the
recovery in ROE will be robust as capital in regional markets
begins to sweat. Leverage could be increased as loan books in
Uganda and Southern Sudan expand should growth in Kenya
migrate towards industry levels. With our deposit growth rates
of 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 its
asset yield and margin higher than the industry. In FY06, Equity
bank’s asset yields outpaced the industry by 6.5pp (16.8% vs.
industry’s 10.3%) but this has declined to 5.3pp in FY09. Margins
were lower than the industry in FY06 before outpacing the
industry by 6pp in FY07 and FY08. This outperformance has
narrowed to 2pp in FY09. To a great extent, the trend seems to
indicate that Equity bank’s asset yield and margin are converging
with the industry averages. However, we do not expect this
convergence in our forecast period (3 years) as positive benefits
from new markets, particularly Sothern Sudan and Uganda
should support asset yields and margins. Efficiency benefits and
lower credit losses (as the economic conditions improve; GDP
expected to recover to 5.8% for FY11) would also be supportive
of margins. Leverage should support ROE and we believe that the
bank boasts a strong deposit franchise that could provide it with
the required funding and liquidity. We expect the bank to close
FY10 with a stock of approximately Kes20bn in government
securities. 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 is
primarily to meet regulatory and asset/liability management
objectives. In our opinion a sustainable ROE of ~25% is

Page 15 of 22
 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

ROE breakdown 2006 2007 2008 2009 2010F 2011F 2012F

Asset yield: Revenue/Total Assets 16.8% 11.0% 16.0% 15.5% 14.5% 13.6% 14.3%
Margin: Net Income/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 banks’
exposure to African markets, especially Sub-Sahara. Barclays
and Standard Chartered already carry significant exposure.
Nigerian and South African banks that are expanding into other
African markets could be possible buyers, but we just do not see
it happening. 1) Equity bank plays in the MFI space, where credit
risks (and capital requirement), and liquidity/funding risks are
higher and there is need to forge closer relationships with clients
2) Equity bank is still mainly Kenyan despite its recent expansion
into foreign markets. In fact opportunities exist for the bank to
play 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 James
Mwangi who is the current managing director and has been
leading the management team for some time. The superior
micro-banking execution capability of the Mwangi-led team
makes the key-man risk more visible. In our view, Mr Mwangi
and his team have played a central role in building the bank and
its brand. We, however, do not expect the ‘key-man risk’ to pull
down 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 be
required. Of course, the other side of key-man risk, which is
often ignored, is the decision by key-man to remain with the firm
when one should move on.

Page 16 of 22
2.2 Valuation: A revisit to our model

ƒ We revise the major assumptions of our model after incorporating

3Q10 results. The salient assumptions are:

ƒ We grow deposits by 50% for FY10 before reducing it

drastically to 15% for FY11 and FY12. Industry deposit growth
rate in CY09 was 14%;
ƒ We reduce the LDR and maintained it at 85%;
ƒ We reduce yields on advances and loans from 15% in FY09 to
12.8% for FY11 taking into account declining interest rates and
competition development in the system;
ƒ We increased the interest cost to deposits from 1% in FY09 to
1.3% for FY10 and 1.2% for FY11 and FY12;
ƒ We reduce the fee and commission income as a percentage of
loans and advances to 2.5% for FY10 and FY11 from 3.3% for
FY09.
ƒ We hike the loan loss provision/advances ratio to 2.5% from
1.6% 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 by

the 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 to
31.5% by FY12 as we expect leverage to increase, and a slight uplift on
ROA 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: Leverage ratio 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/Total revenue 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: Liquid assets/Total assets 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%

Source: Company reports, Legae Securities

ƒ Current valuation looks expensive at first glance: Valuation

for Equity bank seems expensive at first glance, given the trailing
PER of 22X. If one considers some of the concerns we highlighted
on our key debates section, one could be fairly bearish on the
share but we find some solace in its regional expansion strategy.
The outlook for regional expansion and the consequent effect to

Page 17 of 22
 the ROE means that valuation, even on a PER basis could be
attractive on a 3-years horizon. In fact regional expansion is the
key valuation anchor while convergence of yields in Kenya is the
main risk, particularly if it takes place faster than we expect.
ƒ Justified PE and PBV ratios inapplicable: We would have
preferred to use a Justified PE and PBV ratio to estimate our FY11
price target, but because the growth estimates are higher than our
estimate of the CoE, the ratios would be meaningless. We have
therefore use 1) the earnings capitalisation method to estimate
FY11 price target. We use the industry average PER. We apply a
discount of 5% to indicate execution risks in the new markets; and
2) the Discounted Future Earnings method to estimate a ‘fair
value’, which we use for reasonability check of our PER-based
valuation. We use a CoE of 17.5%.
ƒ Earnings capitalisation method shows upside of 13% while
the DFE method indicates full valuation, HOLD: The FY11
price target using our earnings capitalisation method is Kes28.6
which 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 is
conservative, so to a great extent one could argue there is not
“easy upside” in the stock. (see Fig 21). Our FY11 target price
shows an implied PBVR of 4.3X which we consider realistic for a
bank that we expect to return >25% and has strong growth
prospects. In our view, a total return of 13% does not provide an
attractive risk/return profile (execution risks in foreign markets
and convergence/competition in local market). We admit that our
3-year forecasts show quite strong growth expectations, and
strong 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 execution 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 PTKes 28.6
Current price Kes 26
Upside potential 10%
Dividend yield 3%
Total potential return 13%

Source: NSE, Legae Securities

Page 18 of 22
Fig 21: Discounted Future Earnings Valuation Model

2008 2009 2010F 2011F 2012F Terminal Value

Earnings       3,910.26         4,233.99       5,957.93  7,078.87  8,072.05
Terminal Value n/a n/a n/a n/a n/a             103,983.2
Total Earnings       3,910.26         4,233.99       5,957.93  7,078.87  8,072.05           103,983.23
Present Value factor 0.97 0.85 0.72 0.72
Present Value of Earnings       5,807.72  6,024.57  5,846.66             75,316.06
Value    92,995.01
Per share value             25.41
Forward PER             13.14
Current price             26.00
Capital Gain ‐2.3%
Dividend Yield 3.0%
Total return 0.7%
Number of shares 3660
Cost of Equity 17.5%

Source: Company reports, Legae Securities

Page 19 of 22
 Financial Statements
Fig 22: Income statement model
Interest Income 2006 2007 2008 2009 2010F 2011F 2012F Growth rates 2007 2008 2009 2010 2011 2012
Loans and advances       1,435.7       2,512.4         6,175.5           9,483.9       11,353.8       13,569.0           16,487.6 Loans and advances 75% 146% 54% 20% 20% 22%
Government Securities           103.1           545.5         1,540.6           1,275.1         3,377.1         2,208.3             1,715.1 Government Securities 429% 182% ‐17% 165% ‐35% ‐22%
Placements with banks             95.7           196.7             262.9                 33.2               89.0               51.2                   75.9 Placements with banks 105% 34% ‐87% 168% ‐43% 48%
Other                ‐               ‐                 ‐                   ‐                 ‐                 ‐                     ‐ Other  0% 0% 0% 0% 0% 0%
Interest income       1,634.5       3,254.6         7,979.0         10,792.2       14,820.0       15,828.4           18,278.6 Interest income 99% 145% 35% 37% 7% 15%

Interest Expense Interest expense
Customer deposits           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%
Placements from banks               6.0               2.6               22.8                   4.4                  5.5               11.8                      6.2 Placements from banks ‐56% 768% ‐81% 24% 116% ‐47%
Other interest expense               2.6           247.3             787.1               802.5             784.2         1,270.2             1,359.9 Other interest expense 9394% 218% 2% ‐2% 62% 7%
Total interest expense           126.6           494.5         1,362.2           1,622.1         2,099.3         2,727.8             3,028.8 Total interest expense 290% 175% 19% 29% 30% 11%
Net Interest Income       1,507.8       2,760.1         6,616.8           9,170.1       12,720.7       13,100.7           15,249.8 Net Interest Income 83% 140% 39% 39% 3% 16%

Fees & Commission on loans           366.1           883.3         1,869.2           2,106.8         2,226.2         2,560.2             3,267.7 Fees & Commission on loans 141% 112% 13% 6% 15% 28%
Other fees & commission       1,430.2       1,948.9         3,281.1           3,928.4         4,452.5         5,120.4             6,358.8 Other fees & commission 36% 68% 20% 13% 15% 24%
Foreign exchange trading             23.3           147.4             754.4               222.2             655.8             888.1                 767.1 Foreign exchange trading 533% 412% ‐71% 195% 35% ‐14%
Dividend income               ‐               ‐                 ‐                 17.2                  6.0                  8.7                   16.6 Dividend income 0% 0% 0% 0% 0% 92%
Other non‐interest income             44.0             83.0               83.9               231.6             445.2             512.0                 522.8 Other non‐interest income 89% 1% 176% 92% 15% 2%
Total non‐interest income       1,863.6       3,062.5         5,988.6           6,506.1         7,785.8         9,089.3           10,933.0 Total non‐interest income 64% 96% 9% 20% 17% 20%
Operating Income       3,371.4       5,822.6       12,605.4         15,676.2       20,506.5       22,190.0           26,182.9 Operating Income 73% 116% 24% 31% 8% 18%

Loan loss provision       (133.13)           25.34     (1,019.63)       (1,035.33)     (2,226.24)     (2,048.14)         (1,766.52) Loan loss provision ‐119% ‐4124% 2% 115% ‐8% ‐14%
Staff costs       (942.96)   (1,453.47)     (2,937.86)       (4,295.32)     (5,126.62)     (5,270.13)         (6,218.43) Staff costs 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) Rental charges 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%
Other operating expenses       (794.61)   (1,409.51)     (2,518.46)       (3,262.84)     (3,339.37)     (3,584.25)         (4,867.05) Other operating expenses 77% 79% 30% 15% 20% 36%
Total operating expenses   (2,268.55)   (3,458.78)     (7,617.19)     (10,456.35)   (12,714.77)   (13,172.76)       (15,886.26) Total operating expenses 52% 120% 37% 22% 4% 21%
Profit before exceptional items     1,102.88     2,363.82       4,988.18         5,219.82       7,791.72       9,017.26         10,296.60 Profit before exceptional items 114% 111% 5% 49% 16% 14%
Exceptional items               ‐           14.70             34.08               58.31                 ‐                 ‐ 0 Exceptional items 0% 132% 71% ‐100% 0% 0%
Profit before tax     1,102.88     2,378.52       5,022.26         5,278.13       7,791.72       9,017.26         10,296.60 Profit before tax 116% 111% 5% 48% 16% 14%
Taxation: current tax       (333.99)       (454.28)     (1,062.60)       (1,116.70)     (1,833.79)     (1,938.39)         (2,224.55) Taxation: current tax 36% 134% 5% 64% 6% 15%
                     Deferred tax         (15.51)         (33.96)           (49.40)               72.56                 ‐                 ‐ 0                      Deferred tax 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 Growth rates 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%
Balances due from CBK              923     2,138.35       2,468.49         3,739.75       5,342.99       6,144.43           7,066.10 Balances due from CBK 132% 15% 51% 50% 0% 15%
Government Securities           1,651  13,542.94       4,329.66         5,016.51     20,036.20     15,361.09         11,776.83 Government Securities 720% ‐68% 16% 120% 0% ‐23%
Foreign treasury bills               ‐               ‐             88.77            308.76           153.18           220.19               316.52 Foreign treasury bills 0% 0% 248% ‐60% 0% 44%
Placements with local banks           1,786     4,105.15       5,160.78         3,378.99       2,671.49       3,072.22           3,533.05 Placements with local banks 130% 26% ‐35% ‐50% 0% 15%
Placements with foreign banks              459     2,786.25       1,162.11         1,516.38       1,781.00       2,048.14           2,656.32 Placements with foreign banks 507% ‐58% 30% 0% 0% 30%
Securities for dealing               ‐               ‐       8,145.45         6,827.15       6,501.37       9,345.72         13,434.47 Securities for dealing 0% 0% 0% 200% 0% 44%
Tax recoverable               ‐               ‐             13.31               74.52             32.88             47.27                 67.95 Tax recoverable 0% 0% 0% ‐50% 0% 44%
Loans and 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%
Investment securities               ‐               ‐                 ‐               32.31             11.35             16.31                 23.45 Investment securities 0% 0% 0% 75% 0% 44%
Balances due from Group cos               ‐               ‐                 ‐                 9.61               3.37               4.85                   6.97 Balances due from Group cos 0% 0% 0% 600% 0% 44%
Investment in associates               ‐        441.83       1,155.56         1,213.87       1,458.95       2,097.24           2,419.06 Investment in associates 0% 162% 5% 0% 0% 15%
Investment in subsidiaries               ‐               ‐             51.00                   ‐             25.69             36.93                 53.09 Investment in subsidiaries 0% 0% 0% 0% 0% 44%
Investment in JV               ‐               ‐                 ‐                   ‐                 ‐                 ‐                     ‐ Investment in JV 0% 0% 0% 0% 0% 0%
Investment in properties                 11           11.27             11.27                 8.49             43.10             35.56                 35.93 Investment in properties 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%
Pre‐paid lease                   4             4.15               4.10               30.89             25.63             27.09                 33.35 Pre‐paid lease 0% ‐1% 653% 0% 0% 23%
Intangible assets              161        224.34       1,465.43         1,762.93       1,558.37       1,792.13           2,355.37 Intangible assets 39% 553% 20% 0% 0% 31%
Deferred tax               ‐               ‐                 ‐                 5.54               1.94               2.80                   4.02 Deferred tax 0% 0% 0% 0% 0% 44%
Retirement benefit asset               ‐               ‐                 ‐                   ‐                 ‐                 ‐                     ‐ Retirement benefit asset 0% 0% 0% 0% 0% 0%
Other assets           1,089     2,420.66       2,110.73         2,706.62       4,452.49       6,434.26           5,985.48 Other assets 122% ‐13% 28% 50% 25% ‐7%
Total assets        20,024        53,129           78,837    100,811.75        141,714        163,063            182,812 Total assets 165% 48% 28% 41% 15% 12%

Liabilities
Balances due to CBK               ‐               ‐                 ‐                   ‐                 ‐                 ‐                     ‐ Balances due to CBK 0% 0% 0% 0% 0% 0%
Customer deposits  16,336.73  31,535.52     50,334.53      69,842.96  104,764.44  120,479.11      138,550.98 Customer deposits 93% 60% 39% 20% 20% 15%
Placements due to local banks               ‐               ‐                 ‐                   ‐                 ‐                 ‐                     ‐ Placements due to local banks 0% 0% 100% 0% 0% 0%
Placements due to foreign banks               ‐           53.32               0.90                   ‐             54.81             78.80                 41.38 Placements due to foreign banks 0% ‐98% ‐100% 0% 0% ‐47%
Other money market deposits               ‐               ‐                 ‐                   ‐                 ‐                 ‐                     ‐ Other money market deposits 0% 0% 100% 0% 0% 0%
Borrowed funds        485.45     4,521.39       6,463.14         6,486.12     11,132.53     14,865.88         15,273.51 Borrowed funds 831% 43% 0% ‐10% ‐15% 3%
Balances due to group cos               ‐               ‐                 ‐                   ‐                 ‐                 ‐                     ‐ Balances due to group cos 0% 0% 100% 0% 0% 0%
Tax payable        147.03        209.04           513.73               20.23           778.50           774.68               831.76 Tax payable 42% 146% ‐96% 100% 0% 7%
Dividends payable               ‐               ‐                 ‐                 1.05               0.37               0.53                   0.76 Dividends payable 0% 0% 100% 0% 0% 44%
Deferred tax liability           10.92           44.88             94.14                   ‐           115.41           140.33               141.22 Deferred tax liability 311% 110% ‐100% 2% 0% 1%
Retirement benefit liability               ‐               ‐                 ‐                   ‐                 ‐                 ‐                     ‐ Retirement benefit liability 0% 0% 100% 0% 0% 0%
Other liabilities        843.36     1,848.44       1,892.57         1,552.51       2,226.24       2,560.18           2,355.37 Other liabilities 119% 2% ‐18% 43% 15% ‐8%
Total liabilities        17,823        38,213           59,299      77,902.88        119,072        138,900            157,195 Total liabilities 114% 55% 31% 53% 0% 13%

Shareholders' Funds
Paid up capital        452.82     1,811.05       1,851.39         1,851.39       1,851.39       1,851.39           1,851.39 Paid up capital 300% 2% 0% 0% 0% 0%
Share premium/discount        480.36  10,543.04     12,161.02      12,161.02     12,161.02     12,161.02         12,161.02 Share premium/discount 2095% 15% 0% 0% 0% 0%
Revaluation reserve             1.20           12.13         (349.32)           (142.19)                 ‐                 ‐                     ‐ Revaluation reserve 907% ‐2981% ‐59% ‐100% 0% 0%
Retained Earnings     1,085.48     1,754.07       4,455.47         7,108.07       3,574.76       4,247.32           4,843.23 Retained Earnings 62% 154% 60% ‐50% 19% 14%
Statutory reserves               ‐        252.91           308.42            449.48       2,671.49       3,072.22           3,533.05 Statutory reserves 0% 22% 46% 494% 15% 15%
Proposed dividends        181.13        543.39       1,110.83         1,481.11       2,383.17       2,831.55           3,228.82 Proposed dividends 200% 104% 33% 61% 19% 14%
Total shareholders' funds     2,200.99  14,916.58     19,537.80      22,908.87     22,641.83     24,163.49         25,617.51 Total shareholders' funds 578% 31% 17% ‐1% 7% 6%
Total Liabilities and Equity        20,024        53,129           78,837    100,811.75        141,714        163,063            182,812 Total Liabilities and Equity 165% 48% 28% 41% 15% 12%

Source: Company reports, Legae Securities

Page 20 of 22
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