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Bank of Punjab (BOP): Initiating coverage with a 'Sell'

• Investment thesis: We initiate coverage on Bank of Punjab (BOP), Pakistan’s tenth largest Commercial Bank, with a ‘Sell’ call and target price of Rs8.7. We attribute this to 1) high loss ratio of 16%, 2) below average provisions coverage of 63%, 3) requirement to book further provisions, and 4) below average CAR of 12% & likelihood of Tier I & Tier II capital raise. Resultantly, earnings growth will remain contained amid higher provisions & expected capital raise. We expect earnings to grow at a 3-year (2018-20) earnings CAGR  of 7% vs. our banking sample earnings CAGR of 14%.
• High loss ratio remain key risk: BOP, owned by government of Punjab (GoPb), remains affected from one of the highest loss ratios of 16% amongst peer banks. Severe loan losses suffered during 2008 crisis and public sector lending have infected the loan book of the bank. Loan losses of BOP climbed to 51% in 2008 which has gradually come down to 16% as of Sep 2017. However, further improvement beyond 2018 would remain a challenge as interest rates are expected to pickup.    
• Coverage ratio well below Peer Banks average: Coverage ratio of the bank stands at 63% which is well below the Peer Bank’s average of 86%. Due to  lower than the required coverage, bank is required to book additional provisioning expense going forward. 
• Pending provisioning: State Bank of Pakistan (SBP) provided BOP relaxation to book provisioning in a staggered manner. In 2017, BOP was required to book up to 25% of the un-booked Rs16.5bn and the remaining provisions are to be booked in 2018. In 2018, we expect BOP to book net provisioning of Rs9bn (net of recoveries) which will dent bank’s profitability.  
• Capital adequacy ratio (CAR) remain well below average: CAR of the bank stood at 12.3% in 2016 which is well below CAR of 15% of Peer Banks and slightly above the requirement of 11.3% set by SBP for 2017 (11.9% for 2018). This is primarily due to huge prior year losses. The bank issued 70% right shares worth of Rs13bn during 2017 to support CAR of the bank. In order to improve the capital base of the bank, BOP is anticipated to issue Tier I & Tier II capital which could affect BOP’s earnings going ahead. We have assumed Rs5bn of Tier II capital to be issued in 2018 and 2019.   
• Valuation discount has narrowed: BOP is currently trading at a 2019 PE of 6.0x and PBV of 0.7x. The stock trades at a 30% discount to the market PE as compared to its 10-year historical average discount of over 50% to the market PE. Similarly, Peer Banks are trading at a 2019 PE of 7.7x and PBV of 0.9x with ROE of 12%. BOP has historically traded at a 46% discount to Peer Bank’s PE and 22% discount to Peer Bank’s PBV.  
• Risk: Key risks for BOP includes 1) increase in loss ratio, 2) delay in interest rate hike, 3) higher than expected deterioration in CAR ratio, & 4) government intervention.