Indian Financials: Peak rates, low valuations :: Motilal Oswal

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 Valuations of Indian banks are below long-period average.
 India's rate hike cycle is at its peak. This is a key positive to (1) ease asset quality concerns, and
(2) help sustain loan growth.
 Indian banks can manage asset quality given (1) well-diversified loan mix, (2) healthy core
operating performance to absorb credit cost, and (3) focus on upgradations and recoveries.
 Profitability vectors such as operating leverage and stable credit costs will drive earnings
CAGR of ~18% over FY11-13 and sustain healthy return ratios.
 Top large-cap picks: SBIN, AXSB, ICICIBC and PNB. Top mid-cap picks: YES and OBC.
A. Stock valuations below long period average
 After a correction in YTD CY11, Indian financials' valuations are below mean levels of the past five
years. While moderation in economic growth will lead to some macro concern, vectors of profitability
such as margins, operating leverage and stable credit costs will drive earnings growth to 18%.
 As market sees evidence of the end of the rate cycle, the stage will be set for a return of performance for
Indian financials. Favorable valuations provide significant return possibilities. Top large-cap picks:
SBIN, AXSB, ICICIBC and PNB; top mid-cap picks: YES and OBC.
B. Peak of the rate cycle
 Expected fall in inflation and moderating economic growth will compel the RBI to end its series of
interest rate hikes soon. Our economist expects inflation to start moderating from December 2011 and to
end at 7.3% by the end of March 2012. Recent global headwinds are leading to a significant correction in
commodities and can ease inflation further.
 RBI has raised rates aggressively by 350bp over the past 24 months to rein-in inflation. Banks responded
with lending rate hikes of ~250bp and deposit rate increases of 275-325bp, demonstrating complete
monetary transmission. We expect another 25bp hike and a pause thereafter.
 Stable/falling interest rates and expected improvement in liquidity augurs well for financials, especially on
asset quality and loan growth.


C. Asset quality issues to be limited; Loan book well diversified; Some segments to see
stress
 Indian banks have a well diversified loan mix and high coverage ratios compared with earlier cycles.
GDP growth (7.5%+) will limit asset quality issues, in our view. Besides, over the past few quarters
slippages have been rising, but upgrades are also picking up, leading to largely stable net slippages.
 Some export-driven sectors like textiles, gems and jewelry and sectors affected by domestic bottlenecks
such as infrastructure and power, will witness stress. The power sector, which is affected by fuel linkages
and falling SEB demand, may see some restructuring.
 We expect stress to rise but adequate provisions will be made as banks deliver strong revenue growth.
Credit cost remains high due to one-off provisioning on 70% PCR and continued higher slippages. As a
result, it is unlikely to impact earnings growth meaningfully.
D. Core operating performance to remain healthy, driven by strong operating leverage
and stable credit cost
 Strong operating leverage, revenue growth of 18-20% and stable credit costs will keep core profitability
strong despite margin moderation.
 On an aggregate basis, we expect profit growth of ~18% and return ratios with RoA of ~1% and RoE of
~17% for our coverage universe.
D.1 Margins moderated sharply; We expect stabilization from 3QFY12
 Banks' NIM declined 20-50bp from their peak of 3QFY11 due to (a) increase in savings deposit rates,
(b) lag impact of term deposit re-pricing, and (c) higher NPA formation.
 Term deposits cost have increased 100-175bp across banks over the past five quarters. And with a large
part of the increase in cost of term deposits behind us, margins are expected to stabilize from 3QFY12.
In FY12, on a higher base, margins will moderate 20-40bp (bank specific) but will remain near the
average prevailing in FY04-09.
D.2 Operating leverage a cushion for earnings growth
 We expect strong operating leverage for PSU banks as they have provided fully for their retired employees'
pension. PSU banks' overall opex is likely to grow less than 15%.
 Private banks' operating expenses will rise with wage and rental inflation and large-scale branch expansion.