HBL: A Case of the Market Not Pricing In Earnings

 

HBL announced its CY23Q2 financial results a couple of days ago on the 26th of July. The market responded by dumping its shares after the announcement of results. At one point, HBL shares traded 5% down for the day. It ended the day trading 0.59% down. What happened?

Well, for some irrational reason, the market was expecting a significant dividend from HBL. Perhaps the expectations had been built up after UBL’s results – announced a week earlier – beat market expectations. However, HBL’s payout ratio had been 29% for CY22. It had been 17% for CY23Q1. Its payout ratio for Q2 came in at 23%, which is normal. So, to expect a large dividend would be foolish. And boy was it foolish.

A day later on the 27th of July, HBL shares finished the day trading at Rs 90.77 – up 7.4% for the day. Now, why exactly had this happened? Well, because HBL’s financial result was still spectacular. HBL’s earnings per share (EPS) came in at Rs 8.86 – just below Q1’s Rs 9. HBL’s earnings were 52% higher than what it had earned in each quarter of CY22 on average.

Now, obviously none of this is limited to just HBL. The banking sector, on the whole, has enjoyed a period of incredible earnings. This comes on the back of SBP hiking the interest rate to an all-time high of 22% – which is expected to go up further by 100 basis points on 31st July. As a result, banking spreads are at a record high 9.73%.

Banks borrow from depositors at an average cost of 11-12% and lend it to the government at 22%. In the process, they earn an incredible risk-free return. On top of this, SBP injects cash into the banking sector through open-market operations allowing banks to borrow funds from SBP at 20-21% and lend it out to the government at 22%. Another risk-free, easy spread.

Now that the banking story is out of the way, why did HBL’s share price witness that seesaw? Well, the market suddenly realized that HBL’s earnings were too good for the price at which its share was currently trading. In other words, its price to earnings ratio (PE) was too low. Where other banks are trading at a PE of 3 and beyond, HBL was trading at a PE of 2.57 when its Q2 results were announced. The market hadn’t priced in HBL’s earnings.

Why is this important? Because earnings – whether retained or paid through dividends – are cash that has or will be returned to the shareholders. Usually, we would say that free cash flow is the metric to look at when determining how much cash would be returned to shareholders. However, in the case of banks it is impossible to know their free cash flow. This is simply because a bank’s business model relies on cash itself. So, earnings are the way to go for a bank.

HBL is currently trading at a trailing PE of 2.76. In comparison, UBL and MCB are trading at a trailing PE of 3.92 and 3.53 respectively. UBL and MCB are the most comparable banks to HBL based on risk, growth, deposit/asset base and legacy/brand.

So, the comparison of them to HBL makes the most sense. This is also crucial because the driving or defining variable in PE ratio calculation is growth and secondarily, risk and dividend yield. This is why many investors choose to use PEG ratio instead of PE for fundamental analysis. Calculations for the trailing PE can be found here.

The key thing to note is that HBL offers a lower dividend payout ratio than its peers. Secondly, HBL possesses some idiosyncratic risk with regards to some legal cases. Consequently, it makes complete sense that HBL would trade at a discount to other banks like UBL or MCB. However, its current share price implies a discount which is way too steep.

The average of UBL and MCB’s trailing PE is 3.72. And since HBL is trading at a PE of 2.76, that implies a 26% discount. This is way out of order. Especially since HBL had been trading at a PE ratio of 3 plus for most months of the current year. In fact, it was trading at a PE ratio of more than 3.1 after its CY22 and CY23Q1 financial results. At the same time, it was trading at a discount of about 15% to other banks like UBL and MCB.

So, if we assume a 15% discount to UBL and MCB’s PE and assume that HBL should trade at this PE, then HBL’s share price comes out at Rs 104.4. That imputes a 14.8% return if one were to buy HBL shares at its closing price on Thursday.

It’s clear that HBL is undervalued, but is it guaranteed that the market would realize this? Well, the market has already begun realizing it since the share traded 7.4% up on Thursday. In addition, the banking sector is witnessing an incredible rally with many banking stocks up by 30-50% since the announcement of IMF SLA. Hence, there is a high chance that the market would not leave this unnoticed.

The trigger might not be definitively strong but it is strong enough to make a quickfire 15% return likely.