INDIAN FINANCIALS: Fuelled to fly; top picks SBI, ICICI Bank, PNB, IndusInd Bank, Yes Bank :: Motilal Oswal

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INDIAN FINANCIALS: Fuelled to fly; top picks SBI, ICICI Bank, PNB, IndusInd Bank, Yes Bank

Loan growth of ~20%, operating leverage and fall in credit cost will drive banking sector's profitability over FY12 and FY13. Margins, even with some moderation from their peaks in 3QFY11, would be above/near the average level of FY04-09. Higher recoveries could provide positive surprise to earning estimates (write-offs were aggressive over FY09 and FY10 to keep reported GNPAs lower). We expect banks to report 20%+ earnings growth on an aggregate basis and return ratios to be healthy with RoA of 1.1%+ and RoE of ~18%. Valuations at P/E of 8x and P/BV of 1.3x for PSU banks and P/E of 16x and P/BV of 2.3x for private banks are at the five-year average multiples, despite strong core operating performance expected. Our top bets are SBI, ICICI Bank and PNB. In the mid-cap space we like Indusind Bank and Yes Bank.

Margins robust; to remain above/near FY04-09 average levels

-     Downward deposit re-pricing, fall in excess liquidity on the balance sheet, better pricing power (led by a liquidity crunch and a higher CD ratio) and stronger CASA growth led to a sharp improvement in margins in 9MFY11. Overall, FY11 blended margins are expected to be ~50bp higher YoY, driving core operating profits.

-     Given the tight liquidity and rising rates scenario, margins are unlikely to fall in a hurry, and gradual moderations have been factored in estimates. As FY11 is amongst the best year of margins for Indian banks, we expect margins to moderate 10-20bp (bank specific), but to remain above/near the average margins of FY04-09.

-     Banks that reported higher slippages over the past two years are likely to have lower margin compression because of expected improvement in asset quality.

-     Our sensitivity analysis suggests that for every 5bp change in margins, profits will be impacted by ~3%. With a 1% fall in CASA ratio and a 1% fall in CD ratio, margins are likely to compress by 5bp and 7bp, respectively.

Asset quality improvement; lower credit cost to drive earnings growth

-     Banks added higher stressed assets over FY09-11 due to fall out of the financial crisis and moderation in economic growth.  However, incremental trends on asset quality are positive. Over the last two quarters, the slippage ratio has been coming down and we expect the trend to continue in 4QFY11 and FY12. In our view, large corporate and retail delinquencies and slippages from restructured loans have peaked.

-     Private banks are well placed in terms of asset quality as retail delinquencies have peaked and due to conservative restructuring policy adopted in the past.

-     Banks like SBI, PNB and Union Bank, which posted higher slippages, can surprise positively with a fall in slippages, higher upgradation and recoveries.

-     Lower slippages, higher upgradations and recoveries should reduce credit costs and drive earnings growth. Risk to our call is slowdown in industrial growth led by possible shocks on crude oil prices and delay in project implementation. Technical slippages on account of CBS implementation can also lead to negative surprise for PSU banks.

-     Our assumptions for slippages and credit costs are conservative. While FY11 earnings upgrades were led by higher margins, FY12 upgrades will be led by lower credit costs due to falling slippages, higher upgradations and recoveries.

Operating leverage - a key driver for RoA improvement

-     PSU banks' operating cost growth will peak in FY11 as full pension provisions for retired employees and wage revision will be provided for. On a higher base, we expect opex growth to be limited to 15%, providing banks with strong operating leverage.

-     Private banks’ operating expenses will rise with wage and rental inflation, and large scale branch expansion. However, due to strong core operating income, we expect C/I ratio to remain stable.

Valuations at five-year average multiples; inflation remains a key risk

-     Banks' core operating performance is likely to be strong led by improving asset quality and operating leverage. We believe valuations are attractive with stocks trading at five-year average multiples.

-     Correction in valuations from their peaks largely discount some of the macro headwinds such as tight liquidity, a sharp increase in interest rates, high inflation and mixed key economic indicators like IIP.

-     Net market borrowing of Rs3.6t for FY12 (including T Bills of Rs150b) is below the market estimates of Rs3.8t+. Lower-than-expected fiscal deficit is positive for domestic liquidity and will allay fears of crowding out for private players.

-     Food inflation, which is showing a decelerating trend, gives confidence of moderation in inflation. However, turmoil in the MENA region and its resultant impact on oil prices and inflation is a key risk.

-     Some of the key regulatory headwinds, such as savings bank deregulation and change in the status of certain loans granted by banks to NBFCs as priority sector loans (PSL) etc, are specific risks.