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India Financial Services
The Asset Quality
Conundrum – Part II
Indian banks may appear attractive on long-term
growth outlook and nominally cheap multiples, but
reported earnings are likely flattered by relaxed NPL
recognition norms. In a difficult macro climate, the
growing disconnect between reported and
underlying earnings might prompt multiples to
decline, as we’ve seen with China’s bank stocks.
SOE valuations below historical averages. Stocks are
trading at 7.0x EPS, and 1.0x book. On reported earnings,
this would appear a buying opportunity. But, we believe
reported earnings are not necessarily accurate reflections
of profitability; on term loans (infrastructure), revenues
are being booked now, but costs will come later in the
form of provisions, as NPLs increase.
Balance sheets are weaker than in 2008. Impaired
loan ratio is closer to 6% (vs. 2008’s 3.5%), as banks still
have restructured loans from 2008. While consumer
loans and real estate caused concern in 2008, today’s
problems can arise from infrastructure, real estate, MFIs
and other corporate loans. While problems on these
loans are rising, banks, with support from restructurings,
are unlikely to take provisions over the next 1-2 years.
We focus on underlying profits. Given weak asset
classification norms, provisioning is unlikely to shoot up,
despite evident problems. We adjust reported profits for
coverage, lower ROEs on infrastructure loans (by
increasing provisions), and right-size capital. Canara,
PNB, and IDBI are worst affected, while HDFC Bank,
IndusInd, and KMB have underlying profits > reported.
Rating changes – ICBK to EW (from OW). We like its
strong balance sheet profitability, but growth outlook is
weakening, thereby reducing our conviction. We
upgrade IndusInd to OW and Kotak to EW.
To be constructive, we need to see material decline
in rates. Our view is that rates have peaked but will
stay at elevated levels for 6-9 months.
Maintain Cautious View on Indian Banks
The Indian banking industry presents a dilemma. After the
correction, over the last few months, multiples are looking
attractive – making investors wonder whether they should be
buying Indian banks. On the other hand, concerns are rising on
the transparency of book value and quality of earnings, which
would suggest avoiding Indian banks until macro headwinds
abate.
In our view, there is a growing disconnect between the
reporting earnings (accounting profit) and underlying earnings
(economic profit). This is especially true for banks with large
infrastructure loan books. In this note, we try to create a
framework to assess the difference.
We are also rebasing our target prices to reflect underlying
profits. This, coupled with earnings estimate changes and
stock price moves, prompts us to change a few ratings –
downgrade ICICI Bank to EW (from OW); upgrade IndusInd to
OW (from EW), and upgrade Kotak to EW (from UW). We
maintain our cautious view on Indian banks, with UWs on SBI,
PNB, BoB, BoI, Canara Bank, and IDBI
Why are we looking at underlying profits?
In the previous cycle, F2004-F2008, the primary driver of loan
growth for Indian banks had been consumer loans. Asset
quality on consumer loans is binary – either these loans are
performing or they become NPLs, and banks provide for them
quickly, which is what happened in F2009-F2010.
However, over the last three years, corporate loans have been
the primary driver, and, within that, term loans have seen
strong growth. On corporate loans, especially in India, the
issue of loan restructuring creates a big grey area. Given that
the level of provisions required on restructuring is just 2%,
there is no incentive for banks not to push NPLs into the future
by restructuring loans. Hence, while there are obvious
instances of problem loans among Indian corporates (and this
is likely to intensify, given the macro climate), we are unlikely to
see any meaningful pickup in provisioning on these loans in
F12-F13. This is likely to create a disconnect between reported
and underlying earnings.
If current macro conditions persist, we expect the market to
focus on the underlying robustness of book. An example would
be China banks, where earnings expectations have continued
to be revised up over the last 12-18 months, but multiples have
continued to shrink, given market wariness about underlying
credit quality issues. Hence, the market is saying that it is not
comfortable with reported earnings, as underlying asset quality
(in the market’s expectation) is weaker than reported. We
would not be surprised if the same thing happens in India,
especially if there is a surge in restructuring.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India Financial Services
The Asset Quality
Conundrum – Part II
Indian banks may appear attractive on long-term
growth outlook and nominally cheap multiples, but
reported earnings are likely flattered by relaxed NPL
recognition norms. In a difficult macro climate, the
growing disconnect between reported and
underlying earnings might prompt multiples to
decline, as we’ve seen with China’s bank stocks.
SOE valuations below historical averages. Stocks are
trading at 7.0x EPS, and 1.0x book. On reported earnings,
this would appear a buying opportunity. But, we believe
reported earnings are not necessarily accurate reflections
of profitability; on term loans (infrastructure), revenues
are being booked now, but costs will come later in the
form of provisions, as NPLs increase.
Balance sheets are weaker than in 2008. Impaired
loan ratio is closer to 6% (vs. 2008’s 3.5%), as banks still
have restructured loans from 2008. While consumer
loans and real estate caused concern in 2008, today’s
problems can arise from infrastructure, real estate, MFIs
and other corporate loans. While problems on these
loans are rising, banks, with support from restructurings,
are unlikely to take provisions over the next 1-2 years.
We focus on underlying profits. Given weak asset
classification norms, provisioning is unlikely to shoot up,
despite evident problems. We adjust reported profits for
coverage, lower ROEs on infrastructure loans (by
increasing provisions), and right-size capital. Canara,
PNB, and IDBI are worst affected, while HDFC Bank,
IndusInd, and KMB have underlying profits > reported.
Rating changes – ICBK to EW (from OW). We like its
strong balance sheet profitability, but growth outlook is
weakening, thereby reducing our conviction. We
upgrade IndusInd to OW and Kotak to EW.
To be constructive, we need to see material decline
in rates. Our view is that rates have peaked but will
stay at elevated levels for 6-9 months.
Maintain Cautious View on Indian Banks
The Indian banking industry presents a dilemma. After the
correction, over the last few months, multiples are looking
attractive – making investors wonder whether they should be
buying Indian banks. On the other hand, concerns are rising on
the transparency of book value and quality of earnings, which
would suggest avoiding Indian banks until macro headwinds
abate.
In our view, there is a growing disconnect between the
reporting earnings (accounting profit) and underlying earnings
(economic profit). This is especially true for banks with large
infrastructure loan books. In this note, we try to create a
framework to assess the difference.
We are also rebasing our target prices to reflect underlying
profits. This, coupled with earnings estimate changes and
stock price moves, prompts us to change a few ratings –
downgrade ICICI Bank to EW (from OW); upgrade IndusInd to
OW (from EW), and upgrade Kotak to EW (from UW). We
maintain our cautious view on Indian banks, with UWs on SBI,
PNB, BoB, BoI, Canara Bank, and IDBI
Why are we looking at underlying profits?
In the previous cycle, F2004-F2008, the primary driver of loan
growth for Indian banks had been consumer loans. Asset
quality on consumer loans is binary – either these loans are
performing or they become NPLs, and banks provide for them
quickly, which is what happened in F2009-F2010.
However, over the last three years, corporate loans have been
the primary driver, and, within that, term loans have seen
strong growth. On corporate loans, especially in India, the
issue of loan restructuring creates a big grey area. Given that
the level of provisions required on restructuring is just 2%,
there is no incentive for banks not to push NPLs into the future
by restructuring loans. Hence, while there are obvious
instances of problem loans among Indian corporates (and this
is likely to intensify, given the macro climate), we are unlikely to
see any meaningful pickup in provisioning on these loans in
F12-F13. This is likely to create a disconnect between reported
and underlying earnings.
If current macro conditions persist, we expect the market to
focus on the underlying robustness of book. An example would
be China banks, where earnings expectations have continued
to be revised up over the last 12-18 months, but multiples have
continued to shrink, given market wariness about underlying
credit quality issues. Hence, the market is saying that it is not
comfortable with reported earnings, as underlying asset quality
(in the market’s expectation) is weaker than reported. We
would not be surprised if the same thing happens in India,
especially if there is a surge in restructuring.
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