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Updated on June 16, 2001

The KSE Overview: Now a Post- Budget Rally?

The market has simply been rocking back and forth, amidst alternate bouts of buying and selling that continues to keep the KSE - 100 Index tightly range bound. Two weeks ago the Index closed at 1382. Previous Friday (June 8) it closed at 1367, down 1.08%. Last Friday (June 15), the Index closed at 1390, up 1.68%. More interesting, on Friday the Index oscillated between -3 to +3 points throughout the day. Then, 15 minutes before closing bull, it jumped up 8 points to close at 1390. Why?

Having exhausted all other (fundamental as well technical) rationale, we can only think of two possibilities for the last minute rise in the KSE-100 Index. Either the first shower of the monsoon season after a long dry spell perked up market players' spirit OR, as some observers suggest, smart money simply wants to keep the Index above a key technical level. The movement of the Index has now brought it to a critical juncture where, going forward, if the 40DMA crosses upwards of the 40WMA, a medium term upward trend would become established.

Intermediate Term (4 - 6 weeks) Outlook

We can clearly see the gradual buildup of a positive trend line albeit the Index having hugged the lower end closely. 1390 then becomes an important inflection point. In the immediate term the key levels to keep in mind are the 1376 support level and 1415 - 1422 resistance band. Whether the breakout of the Index is UP or DOWN is likely to depend critically on the Index breaking its key resistance or breaching its support.

Next Weeks' Outlook

Average daily volumes declined massively last week to 67.8mn shares from the previous week's volume of 132.9mn shares indicating the shallowness of the current up tick in the Index. Further, weak holders' position building is clearly apparent by the sharp rise in average badla rate to 20% from the 16-17% perverting rates in the last few weeks. Clearly people are expecting some goodies in the budget from sectoral perspective and hence building up positions to make a quick profit.

Tactical Portfolio Strategy

In our view, serious investors need to beware of the risks in such dynamics. Even institutional portfolio managers who have become almost "day - traders", need to keep in view the IMMEDIATE DOWN SIDE RISK that can potentially extend to 1370's levels before the market moves to an intermediate term bullish pattern.

In our view buy side positions should be taken with tight stop losses and partial profit taking needs to be executed if the current move extends to 1405 - 1410, with a view of moving back in at 1380-90 levels.

The price performance matrix (of selected stocks) indicates that previous week's losers have turned into last week's winners. As we had stated in our technical outlook last week, World Call Payphones was ripe for a fall and the fall it took, slipping by 13.75% last week. On the other hand, our buy side recommendations Hubco and Fauji fared reasonably well and held their own.

PSO's sees the light of day

Last week's star turned out to be PSO, mainly after the news of petroleum price increases and rose to PkR144.90, up 2.44% for the week. While this was to be expected, in our view, the maximum upside in the intermediate term is possibly not more than 8 - 10% . On fundamentals, we continue to remain NEUTRAL on PSO as even if the stock moves up, it is unlikely to significantly out perform the market in 3Q01. On technicals, the key immediate resistance and support levels are PkR146.80 and PkR142. However, if the overall market weakens, risk could extend as low as PkR138.

Banking All the Way for Tax Cuts

The one sector, which might see dynamic activity next week, is commercial banking. With rumors of tax cuts getting stronger, we have already seen Askari and MCB rally by over 6% and 4.5% respectively last week. If a tax - cut arrives, other banking stocks could follow suit and these two might extend their gains further. We feel that Prime Bank may also be a surprise mover given its extremely attractive valuations based on our FY01 earnings growth forecast of over 50%.

Finally, Lets Not Forget PTCL

PTCL has remained out of the limelight for quite some time but has quietly been making a solid base for a potentially sustainable upwards moves in the intermediate term. Fundamentally, PTCL remains a BUY in the intermediate term, in view of its rerating potential related to privatization news flow and the fact that it is trading at an attractive discount to regional fixed line telcos on several valuation metrics. We believe that in the INTERMEDIATE TERM the domestic investors should accumulate PTLC during market weaknesses.

Sector outlook

Commercial Banking: Viva la Tax Cut!

The rumor mill is now in full grind about the possibility of a cut in commercial banks' tax rate. Figures floating around in the market range from 6% cut from the present 58% (i.e. to 53%) to 10% cut. As we have been highlighting over the last few weeks in our reports, we believe that there is a high potential for a tax rate - although we believe that the range is likely to be between 4-5%.

Further, we believe that once the government moves towards reducing commercial banks' tax rate in the forthcoming FY01 -02 budget, it will follow this up by another round of tax cuts to 50% next year. This is the important point we want to highlight. For value investors having or building up a long-term portfolio, it is important to view the banks' profit growth potential over a multi-year period in order to assess appropriate value.

Likely winners from any cut in the tax-rate of commercial banks include Al-Habib, Metro, and Askari. MCB should also benefit, depending on its loss write-off tax shield, while Prime could be the surprise, coming in to take the lead in earnings growth league in FY01.

Valuation wise, even without a tax cut, based on our forecast earnings, Prime is poised for a rerating and Askari may also hold good upside potentially. A merger between Faysal and Al-Faysal would be net-net be shareholder value adding, although any share-exchange formula would need to be studied.

On the whole, if the tax cuts materialize, we would recommend an OVER WEIGHT on the commercial banking sector.

We have conducted a scenario analysis of the impact of approximately 5- 10% cut in the tax rate from the present statutory rate of 58%. The exercise was done for seven private sector commercial banks as under:

•Askari. •Al-Habib. •Faysal. •MCB. •Metro. •Prime. •Soneri.

In the scenario analysis reductions in tax rates will be found varying due to either historical trends or specific tax situation in FY00 (for example in the case MCB and Prime).

FY00 Performance

The sample banks mentioned above, increased their NPAT by 63% as a group in FY00 including MCB after a meager growth of 3% in FY99. Out of the total profit of this group in FY00 of PkR1.9 billion, MCB's share was 40%. Excluding MCB, the nse was 98%. To give a sense of proportion, this sample of seven banks constitutes 91% market capitalization of the total listed commercial bank's capitalization of PkR13.8 billion and 40% of the Investment Companies and Banking Sector's capitalization .

Total Income (Fund's based and Non Fund's based) of this sample group rose by 15.6% to PkR14.5 billion including MCB in FY00 and 27.7% to PkR5.5 billion excluding MCB.

The almost 100% rise in NPAT in FY00 for the sample excluding MCB is due both to the top line growth as well as the fact that total provisions fell by 15% and the effective tax rate came out at 57% versus well over 60% in FY99. Including MCB, the picture is somewhat different. Due to MCB's large total provisioning of PkR1.086 billion, the Sample's provisioning rose by 210% while the effective tax rate fell to 53% due to MCB's effective tax rate of 44% in FY00.

The sample group of commercial banks grew total assets by 9.3% in FY00 to PkR300.9billion. Out of this MCB constituted 54.4%. Excluding MCB, the total assets rose by 17.6%. Total deposits including MCB increased by 10.1 % to PkR237.1 billion, with MCB constituting 57.3%. Without MCB the total deposits rose by 19.0%. Shareholders equity including MCB showed 15.7% rise to PkR14.3 billion, with MCB constituting 31.4% of the total. Excluding MCB, the shareholders equity increased by 16.3% to PkR9.8 billion.

Return on Assets below Regional Average

Thus the ROA and ROE for the sample as a whole were 0.63% and 13.3% in FY00 respectively versus 0.42% and 9.4% in FY99. Excluding MCB, the ROA and ROE were 0.85% and 11.9% in FY00 versus 0.50% and 6.9% in FY99. (FY99 figures are impacted by the PkR248 million loss shown by Faysal Bank).

The above data clearly show the significant improvement in the private commercial banking sector's performance in FY00. However, if a regional comparison is done, we believe that the ROA and, to some extent, ROE would come out at the lower range of regional rankings. The sector's ROA needs to reach at least 1.0% before one can say that the domestic banking sector is adding real value.

Looking at 2000 year-end figures, .we find the basic equity to asset ratio of the commercial banks at 4.7% being still low for comfort. In our opinion, this average needs to rise much higher. Of course, the culprit here is MCB. Its basic equity to asset ratio at 2.7% is simply too low. Recent news of a large TFC issue should help it to raise its Tier 11 capital and thus improve risk-adjusted ratio but, in our view, minority investors would like to see the shareholders equity to rise by a substantial amount to provide long-term comfort. In our opinion, if Pakistan's country risk reduces in CY02, MCB should seriously consider a US$50 million GDR issue in second half of 2002. Excluding MCB, the basic capital to equity ratio for the sample group comes out at 7.1 %.

In terms of ranking on the basis of basic capital to equity ratio, Prime Bank comes out on top in FY00 with 10.3%, followed by Faysal at 9.7%. In the case of Prime, the recent 30% bonus issue has further strengthened the capital base, allowing significant room to grow assets and earnings going forward.

Faysal too, should recover its earnings growth momentum in the future. If the rumored merger of Faysal and Al Faysal Investment Bank actually comes about, Faysal's previous losses tax-shield ought to allow significant earnings boost on an after tax basis. The new management team at Faysal has certainly done a good job of cleaning up the credit portfolio over the last two years.

In our assessment it is likely that from an earnings growth perspective, Prime Bank may take a lead in FY01 after having substantially cleared up its credit portfolio from historic non-performing assets. It has contained well non-interest operating costs and the recent rise in interest rates should positively impact spread going forward. MCB, of course would continue to grow earnings driven by rising efficiency, strong spreads and non-funded income as well as tax benefits related to write-offs of historical non-performing assets already accounted for. Metro and Al-Habib, in our opinion, are also likely to show 19% and 18% earnings growth this year driven by both growth in earnings assets as well as spread benefit from higher interest rates. Askari and Soneri are likely to show continued stable NPAT growth in the 14-15% region while Faysal, finally turning around from historic pitfalls, is forecast to raise earnings by 14%, in our opinion.

Tax Rate Sensitivity Analysis

Now what would happen to expected earnings if the much anticipated tax rate cuts come through in the budget.

The earnings boost possible in FY01 for the commercial banking sector by a tax rate cut is clearly demonstrated by the analysis — although investors may differ on the quantum depending on their assumption about the degree of accuracy of our BASE CASE forecasts and expectations of the actual tax rate cut.

As far as potential gains are concerned, at current prices, we believe Prime Bank is poised for a potential rerating. Whether one looks at historic PER multiples or prospective PER multiples based on our forecasts, Prime is trading at a significant discount (51%) to the sample group's FY01 PER 5.4x, and 39% discount to historic average PER of 6.4x. With the expected 51 % earnings growth, these are attractive valuations, in our opinion, particularly given its high basic capital to asset ratio.

In value terms, Askari is the next one. At our forecast FY01 PER of 4.00x, Askari is currently trading at a discount of 26% to the sample's average FY01 PER. Although, we are not looking at earnings momentum pick up in FY01 in our BASE CASE scenario, in the event of a tax-cut, under Scenario - I, Askari's EPS growth this year could rise to 23%.

MCB remains in a class of its own. Its FY01 perspective PER, based on our earnings forecasts of 6.6x, comes out at a premium of 22% to the sample group's average PER for FY01. But MCB can easily command this premium, if not even higher, in our opinion because its real peer group is the BIG-4 public sector banks and in relative terms, it is miles ahead of them on most performance benchmarks. We have always maintained the inherently high earnings generating capacity of MCB and with continued cleaning up of its credit portfolio, refocusing back to its strength in medium sized business lending, and growing presence in consumer-credit driven by alliances and technologically advanced delivery platforms, MCB, in our opinion, should continue growing earnings in excess of 20% over the next 3 years.

Metro, Soneri and Al-Habib are classic niche players — all displaying a "steady-as-she-goes" business philosophy. This is apparent in their steady earnings growth pattern. In valuation terms, Metro is currently trading at a discount of 13% to the sample group's FY01 PER, while Soneri is almost at par and Al-Habib is at a 16% premium as per our forecast earnings. With their strategic focus on specific ethnic group markets, short-term self-liquidating working capital and trade financing, these are, in our opinion the lower risk investment candidates in the domestic banking sector. With new capitalization requirement put in by the central bank, we also expect these banks to continue paying out healthy bonuses in FY01, FY02 and FY03. The quantum of bonus issues could infact rise if tax cuts materialize, boosting these banks' bottom lines.






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.Source: KSE, MSCI, KASB







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