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Sector Outlook – A tale of two halves
We believe FY2012 is likely to be a tale of two halves where the first half is likely to see weak
loan growth as well as margins. The weak loan growth should be more due to large amount of
telecom lending done in1HFY11, which is unlikely to be repeated in 1HFY12E. However as
the year progresses we expect loan growth to recover mainly as capex funding picks up.
Overall FY2012 is likely to see slightly better loan growth than FY2011 in our view. Again the
sharp deposit rate hikes done recently without a commensurate increase in lending rates is
likely to affect NIMs in 1HFY12 as deposits re-price with a lag. As a result the first half would
have weaker margins and then banks are likely to see some recovery in second half. Opex
issues due to pensions would also affect earnings growth prospects for PSU banks. However
the biggest relief could be in the form of sharply declining credit costs as asset quality is likely
to show significant improvements. We would recommend investors to remain UW the sector
as we believe the near term pains are not fully captured in price.
Near term margin pressures likely: Since June’10, commercial paper (CP) rates, which are
a proxy for wholesale funding rates, are up 300bp, Banks have hiked retail deposit rates by
200bps since June 2010. Banks’ base rates – the new system by which all new loans are
sanctioned with respect to base rate as the reference rate – have changed by 50bps at
best. PLR (substantial portion of loans are still linked to PLR – the old lending rate system)
has been increased by around 75bp. So clearly we see that lending rate increases have
not kept pace with retail deposit rates as well as wholesale funding rate increases. We
expect margins to be under pressure in the near term.
Opex burden could severely dent profits in case of PSU banks: We believe consensus has
yet to adequately capture the impact of the second option of pension being given to the
employees of state-owned banks. In the early 1990s, bank employees were given an
option to select between Provident Fund (PF) and pension. The pension option has always
been a more lucrative option than PF. In the recently concluded wage negotiation,
employees who had opted for PF for the first time will again be given an option to switch to
pension. The impact of gratuity and pensions for most banks is greater than 10% of networth
and banks are likely to amortise the pension impact over a period of 5 years. As a
result FY2012 is likely to see a huge jump in pension provisions (consequently operating
expenses) as many PSU banks are yet to provide for the second option of pension.
Asset quality - lower slippages should lead to lower credit costs: We expect 20bp
decline in credit costs in FY12 over FY11 and that could offset partially the impact due to
lower margins and higher opex. Credit costs of both private and PSU banks should decline
as the incremental delinquencies should ease toward second half of 2011. The decline in
the case of PSU banks could be sharp, in our view, as much of the restructured loans
would have already turned into NPLs by FY2011E. Corporate asset quality is likely to be
far better in 2012 than 2011 and that should result in lower credit costs for PSU banks.
Sector Top Picks
Key reasons for PSU banks to underperform
We expect PSU banks to de-rate after the recent involvement of some of them in the
housing-loan scam. Though the financial impact is negligible, investor confidence in PSU
banks’ ability to assess credit risk and underwriting practices could take a hit thereby
affecting valuations.
NIM pressures in the near term due to asymmetric rate increases. We believe margins
have peaked at 2QFY11 levels.
Negative surprises on opex due to pensions
Earnings downgrades by the street.
Key picks – Outperforms
ICICI Bank (ICICIBC IN, Outperform, CMP Rs1026, TP Rs1400)
• Loan growth expected to smartly recover to 18-20% levels
• Possible upside to margins coming from international business
• Positive surprises on asset quality and consequently credit costs resulting in earnings
upgrades
• A good defensive stock to hold as even if the cycle were to reverse, ICICI Bank by virtue
of having done little business over the past 2 years is relatively in a safe position
Key picks – Outperforms
HDFC Bank (HDFCB IN, Outperform, CMP Rs2144, TP Rs2570)
• Best deposit franchise in the country and best play in a rising interest rate environment
• Stellar asset quality
• Strong loan growth and earnings growth visibility over the next three years
Key picks – Outperforms
HDFC Ltd (HDFC IN, Outperform, CMP Rs675, TP Rs775)
• Biggest beneficiary of withdrawal of teaser home loan schemes. Competition was an
overhang on the stock and with relatively lesser competition at the margin due to possible
removal of teaser home loan products, the stock could re-rate further
• Stellar asset quality. Excellent credit appraisal standards
• Stable loan spreads. Has managed to pass on the funding costs increase to its customers
by hiking lending rates.
Key picks - Underperforms
SBI (SBIN IN, Underperform, CMP Rs2579, TP Rs2300)
• Continued pressure on asset quality. Doesn’t have enough buffer on NPL coverage and
hence incremental slippages are likely to hurt its bottom line further due to the need to
provide higher and reach 70% NPL coverage ratio
• Higher opex due to pensions and other retrial benefits. SBI has one of the highest costs to
average assets ratio amongst PSU banks. Any actuarial revaluation hurts SBI the most as
all employees get pension in SBI
• Near term pressure on margins. Deposit rates have been hiked significantly. However
lending rate increases have been modest
Key picks - Underperforms
Canara Bank (CNBK IN, UW, CMP Rs578, TP Rs525)
Union Bank (UNBK IN, UW, CMP Rs324, TP Rs315)
• Weak liabilities franchise (poor CASA ratio) to hurt margins especially in a tight liquidity
scenario
• Asset quality pressures: Slippage ratio expected to remain high
• Equity dilution could be a near-term hangover. Union Bank is likely to be capitalised by the
government whereas Canara Bank has already announced its intention to raise equity
capital.
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