Union Bank of India:Strong play on improvement in asset quality : Motilal oswal,

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Strong play on improvement in asset quality
Fall in credit cost and operating leverage to drive RoA; earnings CAGR of 30%
Union Bank of India (UNBK) is one of the few state-owned banks making extensive
investments in building strong IT infrastructure, manpower training, and brand and branch
makeovers. We believe this would enable the bank to grow faster than the industry.
Under the leadership of Mr Nair, UNBK has reported loan CAGR of 22% v/s ~20% for the
industry over FY06-11. Significant improvement in RoA is expected with a fall in credit
cost and operating leverage. Capital will not be a constraint for growth as the Government
of India has already infused Rs6.8b in FY11. We maintain Buy with a target price of Rs425
(1.4x FY13E BV).
Margins to remain at 3%+; positive surprise likely: Over FY10-11, UNBK has
reported significant volatility in margins, led by build-up of excess liquidity in the
balance sheet. Margins improved sharply to 3.44% in 3QFY11 after hitting the bottom
in 1QFY10 at 2.3%. We have modeled in blended margin improvement of ~60bp in
FY11 to 3.2% and a decline of ~15bp in FY12 (on a higher base). Our margin
assumptions are conservative considering (a) strong accretion in CASA deposits, (b)
expected improvement in CD ratio (72% as on 3QFY11), (c) benefit of capital infusion,
and (d) expected improvement in asset quality.
Asset quality improvement will lead to lower credit cost and improve RoA:
Over FY10-11, UNBK has reported significant stress on asset quality, led by slippages
from restructured loans, agri waiver related loans and slippages from SME and retail
segment. Slippage ratio for 9MFY11 stood at 2.8% v/s 1.9% in FY10 and average of
1.8% over FY04-09. In our view, slippage ratio is near to peak, with slippages from
restructured loans at ~18%, and strong economic growth outlook. Coupled with fall in
slippages, higher upgradations and recoveries will lead to lower credit cost in FY12.
To keep headline GNPA numbers low, UNBK aggressively wrote off NPAs over FY10-
11; higher than expected recoveries from the same will result in earnings surprises.
Operating leverage to play out; cost to core income ratio to decline: In FY11,
UNBK is likely to report 40%+ opex growth, led by 60%+ growth in employee expenses.
UNBK has reported pension deficit liability of Rs24b, translating into per employee
liability of ~Rs1.6m, significantly higher than Rs0.9m-1m for peers. Thus, downward
revision remains a possibility. On a higher base, opex growth is expected to be less
than 5%, lower than core income growth of 15%+. We expect cost to core income
ratio to come down sharply from 47% in FY11 to ~40% in FY12 and ~38% in FY13.
Opex to average assets will also decline from 1.7% in FY11 to 1.3% in FY12 and
1.2% in FY13, driving RoA improvement.
Fee income can provide positive surprises: Under the leadership of Mr Nair, UNBK's
fee income has improved sharply, with a CAGR of 25% over FY06-10. However, in
9MFY11, fee income growth has moderated (in line with the industry) to less than 5%,
led by lower processing charges. UNBK's fee income (excluding forex) to average
assets is one of the lowest at ~50bp v/s an average of 65bp for peers, indicating
significant scope for improvement. While we model in fee income growth of 15% over
FY12-13 on a lower base, positive surprise is likely.


3QFY11 highlights
Union Bank of India
Key positives
 NII grew 48% YoY and 5% QoQ, led by 67bp YoY
and 9bp QoQ improvement in NIM to 3.44%. Adjusted
for one-offs in 2QFY11, NIM improved 23bp QoQ.
 CASA ratio improved ~60bp QoQ to 33.3%. CASA
grew 27% YoY and 7% QoQ, led by strong growth
in savings deposits (33% YoY and 10.4% QoQ).
Key negatives
 Addition to GNPA was higher than expected at
Rs7.7b (annualized slippage ratio of 2.6%). High
write-offs (Rs4.5b v/s Rs1.5b in 2QFY11) and
recoveries (Rs2.6b v/s Rs1.9b in 2QFY11) resulted
in stable GNPA QoQ on reported basis.
 Core fee income growth remained muted QoQ and
grew 7% YoY.
Other highlights
 The bank has maintained its earlier guidance of
Rs24b towards second pension option (to be
amortized over five years) and of Rs2.5b towards
gratuity (to be fully provided in FY11). During the
quarter, it provided Rs1.2b (Rs3.6b till 9MFY11)
towards second pension option and Rs635m
towards gratuity (Rs1.9b provided till 9MFY11).
 Outstanding restructured loans stood at Rs52.5b
(3.9% of the loan book, facility-wise), of which ~18%
has slipped in to NPA.