The Papua New Guinean bank sector is, I imagine, well outside the realm of normal investments for many Australian investors. Yet it is extremely profitable, and Papua New Guinea's 4th and smallest bank, Kina Securities Ltd (ASX: KSL) is dual-listed on both the Port Moresby stock exchange, and our own ASX. It boasts a staunch 16% return on equity, 8% Net Interest Margins, and pays a 9% dividend.
These figures compare very favourably with Australia's biggest bank, Commonwealth Bank of Australia (ASX: CBA), which also has a return on equity of ~16%, albeit with NIMs of 2% and a 5% dividend. So why am I not jumping to buy Kina today?
Profitability concerns
Over the past couple of years, Kina's Net Interest Margins have steadily declined from 10% to 8%, due entirely to domestic competition. ANZ, Westpac, BSP, and Kina Securities are the 4 biggest banks and between them, they have the market locked up.
Without suggesting any impropriety, I believe that the PNG market is a 'soft' monopoly. There is no low-cost competition of the likes of ING Direct that we see here in Australia, and minimal incentive for the incumbents to provide better value to customers.
Furthermore, all funding for Kina's loans is achieved through domestic deposits. This means that its high net interest margin is achieved entirely through a) low rates on deposits and b) high rates of interest on loans. Yet net interest margins are narrowing even in a fairly benign competitive environment, suggesting that current levels of profitability (which would justify today's share price) are not sustainable.
On top of this, Kina's profits for 2016 actually came in ~20% below the 'pro-forma' (including the estimated full-year result from the bank acquisition) profit that management reported in 2015.
Market share
Kina has just a 4% share of the Papua New Guinean banking market. If it could achieve even a 6% share, it would probably be a pretty good deal for shareholders. Yet with declining net interest margins it looks as though Kina will have to sacrifice profitability to grow its market share. Management states that Kina competes on service, not price, but steadily declining Net Interest Margins suggest otherwise.
One possible lesson from the history of the Australian market is that second-tier banks (outside the 'Big 4' + Macquarie) have lost market share over the past 10 years, not gained it. The New Guinean market is different, but the 'one-stop shop' status of Australia's biggest banks has been bad news for their competitors.
Non-performing loans
Kina's non-performing loans (loans in arrears) have been steadily rising over the past 2 years, and now stand at 5% of total loans written. Surprisingly this has not been matched by an increase in impaired loans ('bad loans'), but it is a point of concern. Ideally, investors should be looking to get non-performing loan levels of 2% or below (Commbank: 2.2%).
Currency risks
More so than with other investments, Kina securities is also a bet on the Papua New Guinean economy. The Kina is not a completely free-floating currency, and has been partly pegged against the US Dollar in the past. Papua New Guinea also has a balance-of-payments problem, and the government appears to rely on selling bonds to fund its budget. Around 15% of Kina's income comes from the yield on government bonds, making the company implicitly a bet on the country's finances, which are commodity and agriculture-driven.
Executive remuneration
Management have not yet set new guidelines for their remuneration report, as the previous one expired in 2015. The previous threshold to earn short-term incentives was very low (the company simply had to deliver a profit in 2015 and deliver monthly reports on time) and a new short and long-term incentive plan have not yet been released to the market. Shareholders should use the new incentive benchmarks to see what the company's own internal expectations for 'outstanding performance' are, and use these to inform their own expectations for the company.
This is not a stab at management (who indeed are not even required to provide a remuneration report), simply a reflection that shareholders don't yet know what the executives are being paid to achieve.
Foolish Takeaway
I like Kina a lot, and indeed would love to own shares in this company. However, with some of the concerns I've identified above, I am not certain that it is great value despite its high dividend and low price. I will be waiting for either a lower price or more information to make a more informed investment decision.
