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Sector valuations looks reasonable, however we believe headwinds are not yet factoredin.
High interest rate and liquidity issue, which seems to be a structural problem, are
likely to result in a slowdown in credit off take, compression in margins and pressure on
asset quality.
Consensus expectation on margin compression stands at 15-20 bps. However, we expect
impact on margins to be more severe at 30-50 bps, especially for private players whose
funding cost would rise steeply.
‘CASA is King’, but demand deposits have a tendency to fall when liquidity situation is
tight. We expect demand deposits to fall by at least 2% until Q2FY12. Every 1% fall will
have an impact of 8bps on margins. Private and Foreign banks are most vulnerable.
Lower Incremental CDR and decrease in investment spread would result in a sharp fall in
margins. Banks, whose loan books have grown due to a low base rate will see margin
deterioration in the next few quarters. Corporation bank and SBI are most vulnerable.
Rising interest rates and high inflation would lead to higher delinquencies. Slippages
would remain elevated especially from mortgage, SME portfolio and a shift towards CBS
based NPA calculation in Q4FY11.
Expected decrease in CDR, likely pressure on CASA deposit, lower treasury income and
higher NPA provisions will result in subdued profitability growth for the sector in FY12.
We prefer franchise with better deposit growth (trailing CDR of <80%), lower bulk
dependence, better saving balance and higher coverage ratio.
On broader terms, our investment pecking order would be Public Sector Banks (PSBs),
Private Sector Banks, PSU NBFCs and Other NBFCs. Within PSBs, we prefer Indian Bank,
Bank of Baroda, Punjab National Bank and Allahabad Bank.
Investment summary BFSI: Headwinds Persist; Play Safe Over the past year, the Bankex has outperformed the broader markets by almost 16%. However, as indicated in our report, Banking Sector: Negative headwinds expected (September 2010), Bankex fell by about 12% and underperformed Sensex since the release of the report, especially stocks like SBI and Corporation bank where we had recommended sell ratings. Although valuations now look reasonable, the big question arises “is it the right time to go for bottom fishing”. We believe that headwinds are not yet over considering consensus estimate, which assumes 15-20bps decrease in margins, liquidity issue getting resolved by Apr‟11 and peaking of asset quality. We expect high interest rate and liquidity issues, which seems to be a structural problem, to result in a) slower economic growth b) slowdown in credit off take, c) compression in margins and d) pressure on asset quality. Our key arguments are as follow
Liquidity shortage is a structural problem and we expect it to remain longer in the system at more than 1% of Net demand and time liability (NDTL), which would ensure high short-term rates. We expect treasury yield curve to remain flat. However, bond yield curve is expected to further slope downwards.
Currently banks are witnessing strong demand for credit and disbursements of old sanctions. However, if interest rates continue to remain at elevated levels, it could hamper credit growth. Most bankers have already indicated that further rate hike by RBI cannot be passed on to borrowers. Therefore, any further rise in rates would have be absorbed by banks, impacting their NIMs.
Consensus expectation on margin compression is 15-20 bps. However, we expect margin compression to be more severe, especially for private players whose funding cost would rise more steeply.
Currently the theme is “CASA is King”. However, our analysis indicates that demand deposits have a tendency to drop when the liquidity situation is tight. For Private and Foreign banks, demand deposits constitute a relatively larger pie of CASA (19% and 29% of deposit respectively), and hence impact on profitability will be more severe due to shifting. Deposit share is likely to fall by more than 2% until Q2FY12. As per our calculation, every 1% fall in share of demand deposit will have an impact of about 8bps on margins.
The share of saving deposit is likely to decline due to rise in interest differential compared to term deposits. We expect a 1% fall in savings account deposits to impact margins by about 4bps.
Rising funding cost would mean compression of investment spread. If yields move up, increase in spread would be compensated by higher investment MTMs.
Strategy of maintaining a low base rate in order to attract working capital loan demand from corporate clients will boost loan book. However, we believe that while such a strategy would improve the balance sheet in the short term, in the long term it would lead to margin deterioration. Corporation bank and SBI are most vulnerable to this phenomenon.
We expect sector loan growth to moderate to 16% in FY12 leading to a fall in trailing credit to deposit ratio (CDR) from the current 103% to 95% in FY11 and 60% in FY12E. CBoI, IDBI, United bank and Corporation bank are expected to be impacted the most by this phenomena.
Wholesale rates have moved up significantly by about 440 bps YoY to 10.13% and outstanding borrowing has increased from INR1.9tn to INR3.8tn YoY, which forms about 7.5% of total deposits. Wholesale spread fell gradually from about +150 bps in Mar‟09 to almost NIL in Mar‟10 and has further dropped to about (150) bps currently.
Asset quality: Rising interest rate and higher inflation would lead to higher delinquencies. We believe that asset quality has not peaked yet and slippages would be elevated especially from mortgage and SME portfolio, which would be further fueled by a shift towards CBS based NPA calculation in Q4FY11.
Hence, a key change in the environment is the change in interest rate outlook. We continue to view further hardening of interest rates in coming quarters and believe that the market is not pricing in the downside risk of rising rates.
Earnings to slow down considerably We believe that large number of negative factors at the same time would influence profitability significantly. Sharp rise in interest rates, an expected decrease in CDR, likely pressure on CASA deposit, lower treasury income and higher NPA provisions may lead to subdued profitability growth for the sector in FY12E. Hence, we have re-assessed our earnings outlook for the covered stocks and are cutting FY12E NII growth estimate to 12% and earnings growth estimate to 17%. Banks most impacted banks by this would be SBI, Corporation bank and Dena Bank whereas those least impacted would be BOB, Indian Bank and PNB. Best Play - PNB, BOB, INBK, ALBK; Least Preferred - SBIN, BOI, CRPBK We prefer franchise with better deposit growth (trailing CDR of <80% in Q3FY11), lower bulk dependence, better saving balance, and higher coverage ratio. On broader terms, our pecking order would be Public Sector Banks (PSBs), Private Sector Banks, PSU NBFCs and Other NBFCs. Within PSBs, we prefer Indian Bank, Bank of Baroda, Punjab National Bank, and Allahabad Bank
We maintain „BUY‟ rating on Punjab National Bank, Bank of Baroda, Allahabad Bank, Indian Bank & Dena Bank with upsides of 10-30%. Low Net NPAs and better coverage will help keep slippages in check. Further, margin impact on these banks is expected to be lower. Our top picks continue to be Indian Bank and Punjab National Bank.
Corporation Bank is expected to be impacted the most due to increase in slippages and an expected decline in margin. We expect valuations of State Bank of India and Bank of India to be significantly impacted due to low coverage ratio and high NPA provisioning/PPP ratio.
Investment Summary
Although the sector valuation looks reasonable, but we believe headwinds are not yet factored-in. High interest rate and liquidity issue, which seems to be a structural problem, is likely to result in slowdown in credit off take, compression in margins and pressure on asset quality
Large number of negative at the same time would influence profitability significantly. Expected decrease in CDR, likely pressure on CASA deposit, lower treasury income and higher NPA provisions may result in subdued profitability growth for the sector in FY12
On broader term, our pecking order would be Public Sector Banks (PSBs), Private Sector Banks, PSU NBFCs and Other NBFCs. Within PSBs, we prefer Indian Bank, Bank of Baroda, Punjab National Bank and Allahabad Sector underperformance likely to continue
Banks Have Corrected Sharply Over the past year, the Bankex has outperformed the broader markets by almost 16%. However, as indicated in our report, „Banking Sector: Negative headwinds expected (September 2010)‟, Bankex fell by about 9% and underperformed Sensex especially stocks like SBI and Corporation bank. The key reason for the fall in last few months has been sharp rise in asset quality risk and interest rate risk. High commodity inflation, rising oil price and high CAD has led to significant monetary tightening leading to sharp rise in interest rates and tighter liquidity situation.
Not a right time for bottom fishing
Although valuation now looks reasonable, the big question arises “is it the right time to go for bottom fishing”. We
believe that headwinds is not yet done considering consensus estimate, which assumes only 15-20bps decrease
in margins, liquidity issue getting resolved in Apr‟11 and peaking of asset quality. We expect high interest rate
and liquidity issue, which seems to be a structural problem, to result in a) slower economic growth b) slowdown in
credit offtake, c) compression in margins and d) pressure on asset quality.
Margins to fall significantly
We expect margins to compress sharper than industry expectations. Full impact of this would be visible in
Q2FY12. Decrease in margins is likely to be owing to decrease in CASA share, fall in credit to deposit ratio,
negative wholesale spread and compression of investment spread. Private Banks are likely to impacted more
severely due to higher bulk borrowing and vulnerability of CASA due to high share of demand deposits.
Is CASA really a King? Currently the theme is “CASA is King”. However, we would raise questions on sustainability of the CASA share. Low cost deposits are likely to be under pressure as the interest rate gap between current account (0% interest) & saving deposit (3.5% interest) vs. term deposit has risen very steeply (1 year FD rate at +8%). Our analysis indicates that demand deposits have a tendency to fall sharply in a scenario when liquidity situation gets tight and wholesale rates rises drastically. Since, for private banks, demand deposit constitutes relatively larger pie of CASA, we believe impact on their profitability can be more severe due to shifting. Current account balance is more vulnerable to liquidity situation We believe that demand deposit has direct relation with interest rate, liquidity and economic activity; hence, it declines when the cycle turns. We expect current account share to decrease drastically due to slowdown in capex cycle, rising working capital requirement owing to commodity inflation, drying up of liquidity and most importantly, rise in wholesale rates As per the seasonality analysis of RBI, it is observed that the share of demand deposit rises during December to March period and falls from May onwards. This is also visible in our analysis of deposit seasonality over last 4 years. However, from 31st Dec 10 to 11th Mar 11, demand deposit share has declined by 130bps.
Mystery of low base rate Some banks are focusing on strategy of maintaining low base rate in order to attract working capital loan demand from corporate clients to boost their loan book. However, we believe that this strategy would improve balance sheet in short-run but would be margin deteriorating in longer term. Corporation bank and SBI have maintained their base rate at 7.75% and 7.5% respectively in 2QFY11, which boosted their corporate loan book growth. However, due to rising deposit rates and pressure on margins, these banks would have to shortly raise their base rate, which would result in fall in base rate differential with other banks. This would result in slower advance growth and lower NIMs. Corporation bank‟s loan book grew by 7.7% QoQ in 2QFY11 as against industry growth of less than 1% during that period. Similarly, SBI reported a growth of 4.4% during the same period.
For SBI, currently the base rate is at 8.25%, which is about 125bps lower than median and BPLR is at 13% (75 bps discount to median). SBI is the only bank to continue with teaser loans. Also, it has aggressively raised deposit rates in-order to garner a higher deposits share. Hence, even though the bank would be able to maintain its loan growth due to low base rate, we may see ALM mismatches as well as margin pressures in coming quarters.
For Corporation bank, although BPLR rate is in line with industry, over the last few quarters base rate has quoted lower than industry. This clearly indicates that the management‟s strategy to garner corporate loans in-order to boost balance sheet size. We believe that this could be negative in terms of margins. Due to higher repayment of these loans in next few quarters owing to compression in base rate differential, we may see sharp margin compression and even de-growth in loans.
Loan growth to moderate to 16% and trailing C DR to fall to 60%
Loan growth currently at 23% YoY, Likely to moderate to 16% in FY12
We expect sector loan growth to moderate to 16% in FY12 resulting in fall in trailing CDR to 60%. Currently strong infrastructure and corporate lending is driving loan growth; however we are forecasting growth slowdown in FY12 compared to expected 23% growth in FY11 due to sharp rise in interest rate levels
Deposit growth to pick up in FY12
Aggregate deposits of SCBs increased by 17% YoY compared to 19.8% in the corresponding period of FY10. On YTD basis, deposit of SCBs grew by 12%. Slower deposit growth was owing to negative real interest rates, which de-motivated depositors to put money into time deposits. Additionally, excess liquidity in the system at beginning of the year de-motivated banks from aggressively mobilizing deposits. As most banks aggressively raised deposit rates, we expect growth in deposit mobilization to accelerate from the current 17% YoY to 20% in FY12.
Asset quality not peaked yet
Expect slippages to remain high in next few quarters
We believe that NPA cycle is likely to see further slump in next few quarter before it peaks out. Consistent rise in
rates with rising risk spread and rising global commodity prices would result in higher slippages especially from
M/SME corporate, which may be visible in FY12. We believe that mortgage and SME portfolio would be under
maximum stress. Although we do not see any systematic risk on balance sheet, we believe it would dampen
ROEs of banks in short-run thus impacting valuation multiples.
Recognition of NPA to be sudden due to CBS based NPA recognition
As indicated in our report, Banking Sector: Negative headwinds expected, dated 9 Sept 2010, we expect most
banks to start shifting to purely system-based NPA recognition by 4QFY11, which may result in sharp increase in
recognized gross NPAs. Largely, spurt in NPAs is expected to be higher in smaller ticket loans as larger accounts
undergo stringent auditing by internal committee and auditors as well as from RBI. Further, slippage may arise
due to lack of proper data in the system.
We prefer banks with high coverage ratio
As the increase in NPAs may be sudden, provisioning requirement in next couple of quarters may be very high
especially for banks with low coverage ratio. ROEs will take a significant hit, since 70% need to be provided
immediately even for substandard assets for the banks with low coverage. Other banks that hold decent
coverage ratio will have a liberty to allow net NPA to rise and provide in next few quarters. Hence, it will protect
sudden hit on profitability.
High provision/PPP to drag profitability
We expect NPA provisioning as percentage of PPP to remain high. However, due to lower net interest income growth and lower treasury gains, impact is expected to be more severe on profitability. Worst impacted banks are expected to be Corporation Bank, Dena Bank, SBI, BOI and Canara Bank. We expect least impact on profitability of PNB, BoB, UNBK, Indian bank and Allahabad bank. Fee income may not be savior/ higher investment MTM We believe fee income growth to be slower especially for private banks, due to lower processing fees, investment banking fees and distribution income. We believe G-sec yield to remain elevated and curve to remain flat, which would trigger investment MTM and lower treasury income.
Earnings to slow down considerably We believe large number of negative factors at the same time would influence profitability significantly. Sharp rise in interest rates, expected decrease in CDR, likely pressure on CASA deposit, lower treasury income and higher NPA provisions may result in subdued profitability growth for the sector in FY12. Hence, we have re-assessed our earnings outlook for the covered stocks and we are cutting FY12 NII growth estimate to 12% and earnings growth estimate to 18%. We expect profits to grow at 9-17% for our covered stocks. The most impacted banks would be SBI, Corporation bank and Dena Bank whereas least impacted bank would be BOB, Indian Bank and PNB.
Best Play - PNB, BOB, INBK, ALBK; Lagards - SBIN, BOI, CRPBK We prefer franchise with better deposit growth (trailing CDR of <80% in Q3FY11), lower bulk dependence, better saving balance, and higher coverage ratio. On broader term, our pecking order would be Public Sector Banks (PSBs), Private Sector Banks, PSU NBFC and Other NBFC. Within PSBs, we prefer Indian Bank, Bank of Baroda, Punjab National Bank, and Allahabad Bank
We maintain „BUY‟ rating on Punjab National Bank, Bank of Baroda, Allahabad Bank, Indian Bank & Dena Bank with an upside of about 15-35%. We do not expect much impact of higher slippages on profitability due to low net NPA and better coverage. Also margin impact on these banks are expected to be lower. Our top pick continues to be INBK and PNB
Worst impact of increase in slippages is expected to be on Corporation bank due to expectation of increase in slippage and decrease in margins. We expect State Bank of India and Bank of India valuation to be significantly impacted due to low coverage ratio and high NPA provisions/PPP ratio.
Recommedations Bank of Baroda: Consistent performer with premium business quality Rating: BUY TP: INR1,025 Upside: 11% Bank of Baroda trades at 1.7x FY12E ABV (8.7x FY12E earnings); we expect it to re-rate to 1.9x FY12E ABV, which yields a target price of INR1,025 (FY12E earnings of 9x), implying potential upside of 11%. We believe that the bank will continue to trade at a premium to peers given its ability to consistently deliver strong earnings growth, its international presence, a superior business model and high ROE. A stronger global economy and cross border trade finance may lead to sharp increase in its fee-based income. Key risk to our call is a downturn in the global economies in which the bank operates, which would affect its business and asset quality significantly. Punjab National Bank: Superior fundamentals in most parameters Rating: BUY TP: INR1,350 Upside: 18% The stock trades at a premium valuation of 1.5x FY12E ABV and 7.4x earnings; we believe it will continue to be at a premium to other larger banks given PNB‟s relatively superior fundamentals in most parameters. We expect the stock to trade at 1.8x FY12E ABV considering that the bank is well capitalised with high ROE, cost efficiency, and a low AFS portfolio. Hence, we reiterate our Buy rating on the stock with an decreased price target of INR1,350 (9x FY12E EPS). Indian Bank: Leverage step up likely to boost margins and ROE Rating: BUY TP: INR290 Upside: 31% Indian Bank is a south-based, mid-size public sector bank with business size of INR1.75tn and a network of +1,800 branches. The stock trades at 1.0x FY12E ABV and 4.6x earnings; we believe it would re-rate to 1.3x ABV on the back of strong core performance and superior sustainable ROA of 1.5%. Expected improvement of leverage from 12.5x to industry levels of c18x which would result in superior business growth and sharp improvement in ROE. Our Buy recommendation is supported by the following: 1) Strong focus on the corporate segment, which comprises 64% of advances (including SMEs that account for 13%); 2) Robust ROE of more than 20%, supported by high ROA of 1.5%; 3) Low opex ratio of 38%; 4) Well-capitalised with high Tier-I (+10%); 5) Robust margins and high dividend yields of 4%. Allahabad Bank: On a strong footing to leverage economic growth Rating: BUY TP: INR270 Upside: 24% Allahabad bank trades at an attractive valuation of 1.1x FY12E ABV and 5.9x FY12E EPS, which is at a significant discount to larger players. We expect the stock to re-rate on the back of the bank‟s continuous strong outperformance vis-a-vis the industry. Our Buy recommendation is underpinned by the following: 1) Strong business growth with good quality book; 2) Well-captialised with headroom for increase in tier I and tier II capital; 3) High coverage ratio; 4) High dividend yield & attractive valuation and 5) Strong ROEs. We believe that due to improving growth visibility and sustainable ROE of c19%, the stock can trade at ABV of 1.35x FY12E. Consequently, we recommend „Buy‟ on Allahabad Bank with a decreased target price of INR270, at which the stock would trade at 6.7x FY12E EPS.
Dena Bank: Focus on industrially progressed states Rating: Buy TP: INR115 Upside: 14% Dena Bank has a strong network base with focus on regions progressing well industrially and relatively higher CASA deposits. We believe infusion of further capital by GoI will lead to comfortable capitalisation levels, which will help the bank to continue with its growth momentum. The stock trades at a valuation of 0.9x FY12E ABV and 4.9x FY12E EPS. With improving business conditions, higher ROE, de-risked investment book and cost efficiency, we expect the stock to trade at FY12E ABV of 1.1x and 5.6x EPS. Due to steep underperformance and reasonalble valuation, we upgrade the bank to Buy from Hold with a decreased target price of INR115. State Bank of India: Leadership position but rich valuation and concerns ahead Rating: Hold TP: INR2,560 Downside: 6% State Bank of India trades at 1.9x FY12E consolidated ABV and 10.9x EPS. We value the bank at 1.8x FY12E ABV, which is at premium to other PSBs given its leadership position, superior technology, and well diversified business. Key positives are: well-capitalised with a leadership position, strong network base, high fee income share, good liability franchise, improving operating efficiency, and decent dividend yield of 1.5% and the value of its subsidiaries is increasing. Key negatives are high AFS book and lower provision coverage ratio. Although after a steep fall in stock price on recent news flow, we remain cautious on the stock due to downside risk of margins and slippages concerns. We maintian our Hold recommendation on the stock with lower target price of INR2,560, which implies 10x FY12E earnings. Corporation Bank: Margin pressure likely; Slippages may rise further Rating: Hold TP: INR535 Downside: 5% The stock currently trades at a valuation of 1.1x FY12E ABV and 5.6x FY12E EPS, which is in line with other similar size banks. However, we value the bank at a discount at a multiple of 1.1x FY12E ABV as we expect further headwinds for the stock. Thus, we reiterate hold rating on the stock with an decreased target price of INR535, at which the stock would trade at 5x FY12E EPS. We expect near-term weakness in the stock based on the following:
a) Recent sharp increase in deposit rate will result in sharp increase in deposit cost, impacting margins.
b) We expect incremental credit to deposit ratio in FY12 would be 63% vs. 108% in Q3FY11. Hence, incremental spreads are likely to fall due to low CDR and higher marginal cost of borrowing.
c) The bank holds a CASA share of 25%, which is much lower relative to peers. Hence, the current increase in short-term rate is likely to impact margins significantly.
d) Slippages are expected to rise in coming quarters given the bank‟s high exposure to sensitive sectors such as gems and jewelry, textiles, and commercial real estate (excluding corporate rentals and mortgage). Moreover, Corporation Bank has the lowest provision/asset ratio in our coverage; so, negative surpises may impact profitability significantly.
Union Bank of India: Fairly valued Rating: Hold TP: INR340 Upside: 1% We expect Union Bank‟s NII to achieve a CAGR of 15% during FY11-13 due to margin compression and lower incremental CDR. However, due to high base of NPA provisions in FY10, net profit growth expected to be strong at 27% CAGR over FY11-13. The stock trades at 1.5x FY12E ABV and 6.5x FY12E EPS. We value the bank at 1.55x FY12E ABV (in line with other PSBs of similar size), given its strong ROE of c19%. We maintian our Hold recommendation on the stock with a target price at INR340 (6.4x FY12E earnings). Canara Bank: Fairly valued but Laggard in technology Rating: Hold TP: INR660 Upside: 8% Canara Bank trades at reasonable valuation at 1.4x FY12E ABV given well capitalization of the bank, high fee income share, good liability franchise, improving operating efficiency, rising value of subsidiaries and decent dividend yield. However, we value the bank at 1.6x FY12E ABV which is at discount to other larger players due to the bank‟s high infrastructure exposure (22% of book), high proportion of AFS book and as it is a laggard in technology. Hence, we reiterate HOLD on the stock with a target price of INR660. At our target price, the stock would trade at 6.7x FY12E earnings. Bank of India: Recoveries likely to be strong; but already rich valuation Rating: Hold TP: INR440 Downside:4% The stock trades at a premium valuation of 1.8x FY12E ABV and 9.0x FY12E EPS, which seems fair given the strong expected NPA recoveries. Continuous high slippages in the next few quarters is a key risk for the bank, as it would dampen its profitability significantly. We believe that strong rebound in earnings in FY11-13 and improvement in ROE have already been priced in. We expect the stock to trade at 1.8x FY12E, which yields a price target of INR440. Hence, maintain our Hold recommendation on the stock. Key Risk
We believe that rising treasury yields may result in significantly lower treasury gains or MTM losses. We believe that stable-to-increasing yields may result in a sharp MTM impact during 4QFY11 as yields have already moved above the bank‟s threshold limit
Although we assume high slippages for FY12, if actual slippages are higher than expected, the bank may be required to make higher provisioning, which will impact profitability.
Weaker than expected core performance or lower fee income, would impact ROEs
India Equity Research Reports, IPO and Stock News
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Sector valuations looks reasonable, however we believe headwinds are not yet factoredin.
High interest rate and liquidity issue, which seems to be a structural problem, are
likely to result in a slowdown in credit off take, compression in margins and pressure on
asset quality.
Consensus expectation on margin compression stands at 15-20 bps. However, we expect
impact on margins to be more severe at 30-50 bps, especially for private players whose
funding cost would rise steeply.
‘CASA is King’, but demand deposits have a tendency to fall when liquidity situation is
tight. We expect demand deposits to fall by at least 2% until Q2FY12. Every 1% fall will
have an impact of 8bps on margins. Private and Foreign banks are most vulnerable.
Lower Incremental CDR and decrease in investment spread would result in a sharp fall in
margins. Banks, whose loan books have grown due to a low base rate will see margin
deterioration in the next few quarters. Corporation bank and SBI are most vulnerable.
Rising interest rates and high inflation would lead to higher delinquencies. Slippages
would remain elevated especially from mortgage, SME portfolio and a shift towards CBS
based NPA calculation in Q4FY11.
Expected decrease in CDR, likely pressure on CASA deposit, lower treasury income and
higher NPA provisions will result in subdued profitability growth for the sector in FY12.
We prefer franchise with better deposit growth (trailing CDR of <80%), lower bulk
dependence, better saving balance and higher coverage ratio.
On broader terms, our investment pecking order would be Public Sector Banks (PSBs),
Private Sector Banks, PSU NBFCs and Other NBFCs. Within PSBs, we prefer Indian Bank,
Bank of Baroda, Punjab National Bank and Allahabad Bank.
Investment summary BFSI: Headwinds Persist; Play Safe Over the past year, the Bankex has outperformed the broader markets by almost 16%. However, as indicated in our report, Banking Sector: Negative headwinds expected (September 2010), Bankex fell by about 12% and underperformed Sensex since the release of the report, especially stocks like SBI and Corporation bank where we had recommended sell ratings. Although valuations now look reasonable, the big question arises “is it the right time to go for bottom fishing”. We believe that headwinds are not yet over considering consensus estimate, which assumes 15-20bps decrease in margins, liquidity issue getting resolved by Apr‟11 and peaking of asset quality. We expect high interest rate and liquidity issues, which seems to be a structural problem, to result in a) slower economic growth b) slowdown in credit off take, c) compression in margins and d) pressure on asset quality. Our key arguments are as follow
Liquidity shortage is a structural problem and we expect it to remain longer in the system at more than 1% of Net demand and time liability (NDTL), which would ensure high short-term rates. We expect treasury yield curve to remain flat. However, bond yield curve is expected to further slope downwards.
Currently banks are witnessing strong demand for credit and disbursements of old sanctions. However, if interest rates continue to remain at elevated levels, it could hamper credit growth. Most bankers have already indicated that further rate hike by RBI cannot be passed on to borrowers. Therefore, any further rise in rates would have be absorbed by banks, impacting their NIMs.
Consensus expectation on margin compression is 15-20 bps. However, we expect margin compression to be more severe, especially for private players whose funding cost would rise more steeply.
Currently the theme is “CASA is King”. However, our analysis indicates that demand deposits have a tendency to drop when the liquidity situation is tight. For Private and Foreign banks, demand deposits constitute a relatively larger pie of CASA (19% and 29% of deposit respectively), and hence impact on profitability will be more severe due to shifting. Deposit share is likely to fall by more than 2% until Q2FY12. As per our calculation, every 1% fall in share of demand deposit will have an impact of about 8bps on margins.
The share of saving deposit is likely to decline due to rise in interest differential compared to term deposits. We expect a 1% fall in savings account deposits to impact margins by about 4bps.
Rising funding cost would mean compression of investment spread. If yields move up, increase in spread would be compensated by higher investment MTMs.
Strategy of maintaining a low base rate in order to attract working capital loan demand from corporate clients will boost loan book. However, we believe that while such a strategy would improve the balance sheet in the short term, in the long term it would lead to margin deterioration. Corporation bank and SBI are most vulnerable to this phenomenon.
We expect sector loan growth to moderate to 16% in FY12 leading to a fall in trailing credit to deposit ratio (CDR) from the current 103% to 95% in FY11 and 60% in FY12E. CBoI, IDBI, United bank and Corporation bank are expected to be impacted the most by this phenomena.
Wholesale rates have moved up significantly by about 440 bps YoY to 10.13% and outstanding borrowing has increased from INR1.9tn to INR3.8tn YoY, which forms about 7.5% of total deposits. Wholesale spread fell gradually from about +150 bps in Mar‟09 to almost NIL in Mar‟10 and has further dropped to about (150) bps currently.
Asset quality: Rising interest rate and higher inflation would lead to higher delinquencies. We believe that asset quality has not peaked yet and slippages would be elevated especially from mortgage and SME portfolio, which would be further fueled by a shift towards CBS based NPA calculation in Q4FY11.
Hence, a key change in the environment is the change in interest rate outlook. We continue to view further hardening of interest rates in coming quarters and believe that the market is not pricing in the downside risk of rising rates.
Earnings to slow down considerably We believe that large number of negative factors at the same time would influence profitability significantly. Sharp rise in interest rates, an expected decrease in CDR, likely pressure on CASA deposit, lower treasury income and higher NPA provisions may lead to subdued profitability growth for the sector in FY12E. Hence, we have re-assessed our earnings outlook for the covered stocks and are cutting FY12E NII growth estimate to 12% and earnings growth estimate to 17%. Banks most impacted banks by this would be SBI, Corporation bank and Dena Bank whereas those least impacted would be BOB, Indian Bank and PNB. Best Play - PNB, BOB, INBK, ALBK; Least Preferred - SBIN, BOI, CRPBK We prefer franchise with better deposit growth (trailing CDR of <80% in Q3FY11), lower bulk dependence, better saving balance, and higher coverage ratio. On broader terms, our pecking order would be Public Sector Banks (PSBs), Private Sector Banks, PSU NBFCs and Other NBFCs. Within PSBs, we prefer Indian Bank, Bank of Baroda, Punjab National Bank, and Allahabad Bank
We maintain „BUY‟ rating on Punjab National Bank, Bank of Baroda, Allahabad Bank, Indian Bank & Dena Bank with upsides of 10-30%. Low Net NPAs and better coverage will help keep slippages in check. Further, margin impact on these banks is expected to be lower. Our top picks continue to be Indian Bank and Punjab National Bank.
Corporation Bank is expected to be impacted the most due to increase in slippages and an expected decline in margin. We expect valuations of State Bank of India and Bank of India to be significantly impacted due to low coverage ratio and high NPA provisioning/PPP ratio.
Investment Summary
Although the sector valuation looks reasonable, but we believe headwinds are not yet factored-in. High interest rate and liquidity issue, which seems to be a structural problem, is likely to result in slowdown in credit off take, compression in margins and pressure on asset quality
Large number of negative at the same time would influence profitability significantly. Expected decrease in CDR, likely pressure on CASA deposit, lower treasury income and higher NPA provisions may result in subdued profitability growth for the sector in FY12
On broader term, our pecking order would be Public Sector Banks (PSBs), Private Sector Banks, PSU NBFCs and Other NBFCs. Within PSBs, we prefer Indian Bank, Bank of Baroda, Punjab National Bank and Allahabad Sector underperformance likely to continue
Banks Have Corrected Sharply Over the past year, the Bankex has outperformed the broader markets by almost 16%. However, as indicated in our report, „Banking Sector: Negative headwinds expected (September 2010)‟, Bankex fell by about 9% and underperformed Sensex especially stocks like SBI and Corporation bank. The key reason for the fall in last few months has been sharp rise in asset quality risk and interest rate risk. High commodity inflation, rising oil price and high CAD has led to significant monetary tightening leading to sharp rise in interest rates and tighter liquidity situation.
Not a right time for bottom fishing
Although valuation now looks reasonable, the big question arises “is it the right time to go for bottom fishing”. We
believe that headwinds is not yet done considering consensus estimate, which assumes only 15-20bps decrease
in margins, liquidity issue getting resolved in Apr‟11 and peaking of asset quality. We expect high interest rate
and liquidity issue, which seems to be a structural problem, to result in a) slower economic growth b) slowdown in
credit offtake, c) compression in margins and d) pressure on asset quality.
Margins to fall significantly
We expect margins to compress sharper than industry expectations. Full impact of this would be visible in
Q2FY12. Decrease in margins is likely to be owing to decrease in CASA share, fall in credit to deposit ratio,
negative wholesale spread and compression of investment spread. Private Banks are likely to impacted more
severely due to higher bulk borrowing and vulnerability of CASA due to high share of demand deposits.
Is CASA really a King? Currently the theme is “CASA is King”. However, we would raise questions on sustainability of the CASA share. Low cost deposits are likely to be under pressure as the interest rate gap between current account (0% interest) & saving deposit (3.5% interest) vs. term deposit has risen very steeply (1 year FD rate at +8%). Our analysis indicates that demand deposits have a tendency to fall sharply in a scenario when liquidity situation gets tight and wholesale rates rises drastically. Since, for private banks, demand deposit constitutes relatively larger pie of CASA, we believe impact on their profitability can be more severe due to shifting. Current account balance is more vulnerable to liquidity situation We believe that demand deposit has direct relation with interest rate, liquidity and economic activity; hence, it declines when the cycle turns. We expect current account share to decrease drastically due to slowdown in capex cycle, rising working capital requirement owing to commodity inflation, drying up of liquidity and most importantly, rise in wholesale rates As per the seasonality analysis of RBI, it is observed that the share of demand deposit rises during December to March period and falls from May onwards. This is also visible in our analysis of deposit seasonality over last 4 years. However, from 31st Dec 10 to 11th Mar 11, demand deposit share has declined by 130bps.
Mystery of low base rate Some banks are focusing on strategy of maintaining low base rate in order to attract working capital loan demand from corporate clients to boost their loan book. However, we believe that this strategy would improve balance sheet in short-run but would be margin deteriorating in longer term. Corporation bank and SBI have maintained their base rate at 7.75% and 7.5% respectively in 2QFY11, which boosted their corporate loan book growth. However, due to rising deposit rates and pressure on margins, these banks would have to shortly raise their base rate, which would result in fall in base rate differential with other banks. This would result in slower advance growth and lower NIMs. Corporation bank‟s loan book grew by 7.7% QoQ in 2QFY11 as against industry growth of less than 1% during that period. Similarly, SBI reported a growth of 4.4% during the same period.
For SBI, currently the base rate is at 8.25%, which is about 125bps lower than median and BPLR is at 13% (75 bps discount to median). SBI is the only bank to continue with teaser loans. Also, it has aggressively raised deposit rates in-order to garner a higher deposits share. Hence, even though the bank would be able to maintain its loan growth due to low base rate, we may see ALM mismatches as well as margin pressures in coming quarters.
For Corporation bank, although BPLR rate is in line with industry, over the last few quarters base rate has quoted lower than industry. This clearly indicates that the management‟s strategy to garner corporate loans in-order to boost balance sheet size. We believe that this could be negative in terms of margins. Due to higher repayment of these loans in next few quarters owing to compression in base rate differential, we may see sharp margin compression and even de-growth in loans.
Loan growth to moderate to 16% and trailing C DR to fall to 60%
Loan growth currently at 23% YoY, Likely to moderate to 16% in FY12
We expect sector loan growth to moderate to 16% in FY12 resulting in fall in trailing CDR to 60%. Currently strong infrastructure and corporate lending is driving loan growth; however we are forecasting growth slowdown in FY12 compared to expected 23% growth in FY11 due to sharp rise in interest rate levels
Deposit growth to pick up in FY12
Aggregate deposits of SCBs increased by 17% YoY compared to 19.8% in the corresponding period of FY10. On YTD basis, deposit of SCBs grew by 12%. Slower deposit growth was owing to negative real interest rates, which de-motivated depositors to put money into time deposits. Additionally, excess liquidity in the system at beginning of the year de-motivated banks from aggressively mobilizing deposits. As most banks aggressively raised deposit rates, we expect growth in deposit mobilization to accelerate from the current 17% YoY to 20% in FY12.
Asset quality not peaked yet
Expect slippages to remain high in next few quarters
We believe that NPA cycle is likely to see further slump in next few quarter before it peaks out. Consistent rise in
rates with rising risk spread and rising global commodity prices would result in higher slippages especially from
M/SME corporate, which may be visible in FY12. We believe that mortgage and SME portfolio would be under
maximum stress. Although we do not see any systematic risk on balance sheet, we believe it would dampen
ROEs of banks in short-run thus impacting valuation multiples.
Recognition of NPA to be sudden due to CBS based NPA recognition
As indicated in our report, Banking Sector: Negative headwinds expected, dated 9 Sept 2010, we expect most
banks to start shifting to purely system-based NPA recognition by 4QFY11, which may result in sharp increase in
recognized gross NPAs. Largely, spurt in NPAs is expected to be higher in smaller ticket loans as larger accounts
undergo stringent auditing by internal committee and auditors as well as from RBI. Further, slippage may arise
due to lack of proper data in the system.
We prefer banks with high coverage ratio
As the increase in NPAs may be sudden, provisioning requirement in next couple of quarters may be very high
especially for banks with low coverage ratio. ROEs will take a significant hit, since 70% need to be provided
immediately even for substandard assets for the banks with low coverage. Other banks that hold decent
coverage ratio will have a liberty to allow net NPA to rise and provide in next few quarters. Hence, it will protect
sudden hit on profitability.
High provision/PPP to drag profitability
We expect NPA provisioning as percentage of PPP to remain high. However, due to lower net interest income growth and lower treasury gains, impact is expected to be more severe on profitability. Worst impacted banks are expected to be Corporation Bank, Dena Bank, SBI, BOI and Canara Bank. We expect least impact on profitability of PNB, BoB, UNBK, Indian bank and Allahabad bank. Fee income may not be savior/ higher investment MTM We believe fee income growth to be slower especially for private banks, due to lower processing fees, investment banking fees and distribution income. We believe G-sec yield to remain elevated and curve to remain flat, which would trigger investment MTM and lower treasury income.
Earnings to slow down considerably We believe large number of negative factors at the same time would influence profitability significantly. Sharp rise in interest rates, expected decrease in CDR, likely pressure on CASA deposit, lower treasury income and higher NPA provisions may result in subdued profitability growth for the sector in FY12. Hence, we have re-assessed our earnings outlook for the covered stocks and we are cutting FY12 NII growth estimate to 12% and earnings growth estimate to 18%. We expect profits to grow at 9-17% for our covered stocks. The most impacted banks would be SBI, Corporation bank and Dena Bank whereas least impacted bank would be BOB, Indian Bank and PNB.
Best Play - PNB, BOB, INBK, ALBK; Lagards - SBIN, BOI, CRPBK We prefer franchise with better deposit growth (trailing CDR of <80% in Q3FY11), lower bulk dependence, better saving balance, and higher coverage ratio. On broader term, our pecking order would be Public Sector Banks (PSBs), Private Sector Banks, PSU NBFC and Other NBFC. Within PSBs, we prefer Indian Bank, Bank of Baroda, Punjab National Bank, and Allahabad Bank
We maintain „BUY‟ rating on Punjab National Bank, Bank of Baroda, Allahabad Bank, Indian Bank & Dena Bank with an upside of about 15-35%. We do not expect much impact of higher slippages on profitability due to low net NPA and better coverage. Also margin impact on these banks are expected to be lower. Our top pick continues to be INBK and PNB
Worst impact of increase in slippages is expected to be on Corporation bank due to expectation of increase in slippage and decrease in margins. We expect State Bank of India and Bank of India valuation to be significantly impacted due to low coverage ratio and high NPA provisions/PPP ratio.
Recommedations Bank of Baroda: Consistent performer with premium business quality Rating: BUY TP: INR1,025 Upside: 11% Bank of Baroda trades at 1.7x FY12E ABV (8.7x FY12E earnings); we expect it to re-rate to 1.9x FY12E ABV, which yields a target price of INR1,025 (FY12E earnings of 9x), implying potential upside of 11%. We believe that the bank will continue to trade at a premium to peers given its ability to consistently deliver strong earnings growth, its international presence, a superior business model and high ROE. A stronger global economy and cross border trade finance may lead to sharp increase in its fee-based income. Key risk to our call is a downturn in the global economies in which the bank operates, which would affect its business and asset quality significantly. Punjab National Bank: Superior fundamentals in most parameters Rating: BUY TP: INR1,350 Upside: 18% The stock trades at a premium valuation of 1.5x FY12E ABV and 7.4x earnings; we believe it will continue to be at a premium to other larger banks given PNB‟s relatively superior fundamentals in most parameters. We expect the stock to trade at 1.8x FY12E ABV considering that the bank is well capitalised with high ROE, cost efficiency, and a low AFS portfolio. Hence, we reiterate our Buy rating on the stock with an decreased price target of INR1,350 (9x FY12E EPS). Indian Bank: Leverage step up likely to boost margins and ROE Rating: BUY TP: INR290 Upside: 31% Indian Bank is a south-based, mid-size public sector bank with business size of INR1.75tn and a network of +1,800 branches. The stock trades at 1.0x FY12E ABV and 4.6x earnings; we believe it would re-rate to 1.3x ABV on the back of strong core performance and superior sustainable ROA of 1.5%. Expected improvement of leverage from 12.5x to industry levels of c18x which would result in superior business growth and sharp improvement in ROE. Our Buy recommendation is supported by the following: 1) Strong focus on the corporate segment, which comprises 64% of advances (including SMEs that account for 13%); 2) Robust ROE of more than 20%, supported by high ROA of 1.5%; 3) Low opex ratio of 38%; 4) Well-capitalised with high Tier-I (+10%); 5) Robust margins and high dividend yields of 4%. Allahabad Bank: On a strong footing to leverage economic growth Rating: BUY TP: INR270 Upside: 24% Allahabad bank trades at an attractive valuation of 1.1x FY12E ABV and 5.9x FY12E EPS, which is at a significant discount to larger players. We expect the stock to re-rate on the back of the bank‟s continuous strong outperformance vis-a-vis the industry. Our Buy recommendation is underpinned by the following: 1) Strong business growth with good quality book; 2) Well-captialised with headroom for increase in tier I and tier II capital; 3) High coverage ratio; 4) High dividend yield & attractive valuation and 5) Strong ROEs. We believe that due to improving growth visibility and sustainable ROE of c19%, the stock can trade at ABV of 1.35x FY12E. Consequently, we recommend „Buy‟ on Allahabad Bank with a decreased target price of INR270, at which the stock would trade at 6.7x FY12E EPS.
Dena Bank: Focus on industrially progressed states Rating: Buy TP: INR115 Upside: 14% Dena Bank has a strong network base with focus on regions progressing well industrially and relatively higher CASA deposits. We believe infusion of further capital by GoI will lead to comfortable capitalisation levels, which will help the bank to continue with its growth momentum. The stock trades at a valuation of 0.9x FY12E ABV and 4.9x FY12E EPS. With improving business conditions, higher ROE, de-risked investment book and cost efficiency, we expect the stock to trade at FY12E ABV of 1.1x and 5.6x EPS. Due to steep underperformance and reasonalble valuation, we upgrade the bank to Buy from Hold with a decreased target price of INR115. State Bank of India: Leadership position but rich valuation and concerns ahead Rating: Hold TP: INR2,560 Downside: 6% State Bank of India trades at 1.9x FY12E consolidated ABV and 10.9x EPS. We value the bank at 1.8x FY12E ABV, which is at premium to other PSBs given its leadership position, superior technology, and well diversified business. Key positives are: well-capitalised with a leadership position, strong network base, high fee income share, good liability franchise, improving operating efficiency, and decent dividend yield of 1.5% and the value of its subsidiaries is increasing. Key negatives are high AFS book and lower provision coverage ratio. Although after a steep fall in stock price on recent news flow, we remain cautious on the stock due to downside risk of margins and slippages concerns. We maintian our Hold recommendation on the stock with lower target price of INR2,560, which implies 10x FY12E earnings. Corporation Bank: Margin pressure likely; Slippages may rise further Rating: Hold TP: INR535 Downside: 5% The stock currently trades at a valuation of 1.1x FY12E ABV and 5.6x FY12E EPS, which is in line with other similar size banks. However, we value the bank at a discount at a multiple of 1.1x FY12E ABV as we expect further headwinds for the stock. Thus, we reiterate hold rating on the stock with an decreased target price of INR535, at which the stock would trade at 5x FY12E EPS. We expect near-term weakness in the stock based on the following:
a) Recent sharp increase in deposit rate will result in sharp increase in deposit cost, impacting margins.
b) We expect incremental credit to deposit ratio in FY12 would be 63% vs. 108% in Q3FY11. Hence, incremental spreads are likely to fall due to low CDR and higher marginal cost of borrowing.
c) The bank holds a CASA share of 25%, which is much lower relative to peers. Hence, the current increase in short-term rate is likely to impact margins significantly.
d) Slippages are expected to rise in coming quarters given the bank‟s high exposure to sensitive sectors such as gems and jewelry, textiles, and commercial real estate (excluding corporate rentals and mortgage). Moreover, Corporation Bank has the lowest provision/asset ratio in our coverage; so, negative surpises may impact profitability significantly.
Union Bank of India: Fairly valued Rating: Hold TP: INR340 Upside: 1% We expect Union Bank‟s NII to achieve a CAGR of 15% during FY11-13 due to margin compression and lower incremental CDR. However, due to high base of NPA provisions in FY10, net profit growth expected to be strong at 27% CAGR over FY11-13. The stock trades at 1.5x FY12E ABV and 6.5x FY12E EPS. We value the bank at 1.55x FY12E ABV (in line with other PSBs of similar size), given its strong ROE of c19%. We maintian our Hold recommendation on the stock with a target price at INR340 (6.4x FY12E earnings). Canara Bank: Fairly valued but Laggard in technology Rating: Hold TP: INR660 Upside: 8% Canara Bank trades at reasonable valuation at 1.4x FY12E ABV given well capitalization of the bank, high fee income share, good liability franchise, improving operating efficiency, rising value of subsidiaries and decent dividend yield. However, we value the bank at 1.6x FY12E ABV which is at discount to other larger players due to the bank‟s high infrastructure exposure (22% of book), high proportion of AFS book and as it is a laggard in technology. Hence, we reiterate HOLD on the stock with a target price of INR660. At our target price, the stock would trade at 6.7x FY12E earnings. Bank of India: Recoveries likely to be strong; but already rich valuation Rating: Hold TP: INR440 Downside:4% The stock trades at a premium valuation of 1.8x FY12E ABV and 9.0x FY12E EPS, which seems fair given the strong expected NPA recoveries. Continuous high slippages in the next few quarters is a key risk for the bank, as it would dampen its profitability significantly. We believe that strong rebound in earnings in FY11-13 and improvement in ROE have already been priced in. We expect the stock to trade at 1.8x FY12E, which yields a price target of INR440. Hence, maintain our Hold recommendation on the stock. Key Risk
We believe that rising treasury yields may result in significantly lower treasury gains or MTM losses. We believe that stable-to-increasing yields may result in a sharp MTM impact during 4QFY11 as yields have already moved above the bank‟s threshold limit
Although we assume high slippages for FY12, if actual slippages are higher than expected, the bank may be required to make higher provisioning, which will impact profitability.
Weaker than expected core performance or lower fee income, would impact ROEs
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