Sector update: Indian Financials - Oct 2011 by IDFC Sec

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A series of interest rate hikes, global economic weakness and worries on domestic growth have soured the pitch for financials. A difficult operating environment is bound to manifest in muted credit growth, lower NIMs and worsening asset quality - leading to a sharp de-rating of bank stocks (down 9% vis-à-vis Sensex in two months). To ascertain what stocks are pricing in, we have conducted a sensitivity analysis based on Gordon Growth Model assuming a stable cost of capital at current levels. Our analysis reveals that the market is building in steep profitability erosion (up to 70bp decline in RoA) due to a rise in gross NPAs (to 5-8%) and further margin decline of 25-30bp. However, we believe the margin contraction is largely behind (~15bp decline in FY12E). Also, we see banking system NPAs+restructured assets peaking at 7.8% in FY13 vis-à-vis 5.8% now (refer our asset quality report dated 2 August 2011). With bulk of the stress likely to be restructured, associated credit costs would be minimal. While global uncertainties remain an overhang, any whiff of easing interest rates would trigger a rebound in financials, led by large cap sector bell-weathers. However, we believe higher beta stocks with maximum skepticism on profitability and highest discount to long-term valuations will outperform over 12-18 months.

Headwinds do exist but concerns seem overdone…: Given a sluggish domestic economy as also global uncertainties, we expect the RBI to pause after another 25bp hike in policy rates (if any). Peaking of the rate cycle and seasonal pick-up in credit would bode well for NIMs. For FY12, we see a ~15bp decline with a milder dent for private banks (~7bp) than PSU peers (~20bp). Also, we see banking system NPAs + restructured assets peaking at 7.8% in FY13 vs. 5.8% now.

…and valuations discounting exaggerated negatives: Financials have corrected sharply on concerns of higher interest rates (lower credit growth and NIMs) and slower economic growth (asset quality deterioration). Using the Gordon Growth Model, we evaluate what stock prices are building in. Our analysis reveals that the market expects steep profitability erosion for banks, primarily led by a spike in credit costs. The market implicitly estimates a 2-3x rise in banks’ NPA ratios and 20-70bp rise in credit costs over the next two years.

High-beta stocks should outperform as the cycle turns: With stocks trading at a discount to historical averages, the risk-reward is favorable. Though near term overhang of a global crisis remains, we see a sharp rebound in banking stocks in next 12 months as interest rates peak. We recommend shifting to higher beta stocks to play the upturn. Our preferred picks are Union Bank (23% discount in valuations and 45bp disbelief on RoA), Canara Bank (27% and 90bp), PNB (16% and 65bp), OBC (25% and 54bp), Axis Bank (23% and 34bp), Yes Bank (27% and 28bp) and ING Vysya Bank (14% and 37bp).

Comparative valuations
Companies	Recommendation	Price	Mkt cap	TP	Earnings CAGR	EPS*	P/E*	P/Adj BV*	RoE*	RoA*
		(Rs)	(Rs bn)	(Rs)	FY11-13E (%)	(Rs)	(x)	(x)	(%)	(%)
Union Bank	Outperformer	230	120	415	26.5	51.2	4.5	1.0	22.2	1.0
Canara Bank	Outperformer	459	203	650	18.4	102.7	4.5	1.0	22.8	1.2
PNB	Outperformer	973	308	1350	20.4	166.3	5.8	1.3	23.6	1.3
OBC	Outperformer	301	88	470	22.0	59.9	5.0	0.8	14.8	1.0
Axis Bank	Outperformer	1,103	453	1700	25.0	103.4	10.7	2.0	20.5	1.6
ING Vysya Bank	Outperformer	313	46	480	33.0	35.5	8.8	1.2	13.4	1.0
Yes Bank	Outperformer	283	98	440	33.0	28.3	10.0	2.1	23.3	1.4
Source: IDFC Securities Research, * For FY12E