Macquarie Research: SELL Canara Bank, Union Bank and IDBI

India PSU banks
The party is over
Risk/reward highly unfavourable; BOB, PNB now Neutral
We believe that after the recent significant outperformance of the Indian public
sector banks, the risk/reward has become highly unfavourable, and we foresee
near-term pressures in the form of weak loan growth, lower margins and issues
regarding opex and asset quality, resulting in earnings downgrades by the street.
Our earnings estimates are 10–15% below consensus. We downgrade PNB and
BOB to Neutral based on valuations. We reiterate our non-consensus bearish
call on the sector.
Do not look at history, look beyond
During the past five years, PSU banks have been re-rated due to their stronger
growth profile, superior technological platform and improving ROA. However, the
market seems to ignore several important aspects. Loan growth in this cycle is
expected to be far lower (20–22% vs 30% in the earlier cycle), fee income
momentum is structurally likely to be lower, and opex and credit charges are
likely to remain high in the early part of the cycle, due to waning productivity
benefits and the regulatory requirement of 70% NPL coverage, respectively.
Moreover, with capital requirements likely to become more stringent, we think
leverage structurally is likely to be lower, thereby resulting in lower ROEs.
Near term: Loan growth and margins could disappoint
We think loan growth could disappoint, mainly due to increasing financial
disintermediation, exacerbated by the new base rate regime and structural
challenges to recovery in several segments. Margins could disappoint in the next
two quarters, due to sharp increases in deposit and wholesale funding rates
without commensurate increase in PLR or base rates. Weak loan growth would
further result in deposits being parked in low-yielding government securities (Gsecs),
which would result in negative carry.
Opex burden: Additional headwind on earnings
After several years of productivity benefits, the pace of increases in such
benefits is likely to slow, due to a net increase in the employee base. Pensions
that have not been accounted for could erode PSU banks’ net worth by 10%.
Assumptions used to arrive at pension obligations are very conservative. Our
revised assumptions result in an additional 5% impact on net worth.
Asset quality: Near-term pains exist
Our interactions with credit rating agencies reveal that, in the near term, overall
system NPLs could increase 50%-plus in FY11 vs our estimate of 30% for our
coverage universe. Slippages could be mainly from restructured assets, SME
segments and sectors such as textiles, leather, chemicals, steel intermediaries
and commercial real estate.
Valuation multiples: No room for comfort
PSU banks are trading one standard deviation above historical averages, with
many trading at historically high multiples. Even after we assume the multiples at
the peak of 2007 bull market, when fundamentals were far better than they are
today, upside to current market price is limited, in our view. The discount of PSU
banks to private banks at 40% is now the lowest ever. Our key Underperforms
are banks with weak deposit franchises, such as Canara Bank, Union Bank and
IDBI. For investors who want exposure to PSU banks, we recommend adding
BOB and PNB on corrections.