Union Bank of India -Cheap can remain cheap : Macquarie Research

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Union Bank of India
Cheap can remain cheap
Event
 Downgrade to Underperform: We expect Union Bank’s ROE to witness
severe pressure and fall from the 18-20% seen in FY08-11 to 12-13% by
FY14E given slower growth and asset quality issues. Downgrade to
Underperform with a revised TP of Rs185.

Impact
 Asset quality to overhang the performance: Once known for superior asset
quality, Union Bank has steadily disappointed, with net NPA rising close to 2%
in 3Q12. This has led to a continued de-rating of the stock over the past 1.5
years. Restructured assets in 3Q12 grew by a steep 3x sequentially to
Rs86bn (stood at 5.5% of loan book). We expect the slippage ratio to remain
close to 2% compared to the 1.5% seen in FY07-10. With poor reported
provision coverage of 45%, we expect credit costs to pile up over FY12-14E.
 Business growth slowing down: In 3Q12, domestic advances grew YoY by
15% and domestic deposits increased by just 10%, indicating a sharp
slowdown. These growth rates are particularly poor compared to industry
averages. We expect credit growth to come off over FY11-14E and record a
16% CAGR against +25% seen in FY09-11.
 Franchise remains weak, fee traction disappointing: Union Bank has
invested heavily in technology, re-branding and infrastructure/systems in
order to lift the CASA ratio above 33-35% and fee income growth. However,
the bank has failed to show any sustained meaningful improvement in CASA
(remains at 30-31%) and non-interest income.
 Management change in April 2012. The current CMD, Mr. Nair, is expected
to superannuate/retire in April 2012. Management changes at PSU banks
tend to cause significant uncertainty, due to past experience. This makes us
additionally cautious on the stock.
Earnings and target price revision
 We cut our earnings by 21% for FY13E and by 31% for FY14E, mainly due to
higher credit costs, lower growth and equity dilution. We cut our TP by 18% to
Rs185 mainly due to a lower ROE and lower projected earnings growth.
Price catalyst
 12-month price target: Rs185.00 based on a Gordon Growth methodology.
 Catalyst: Pressure on asset quality – increase in NPLs and restructured
assets.
Action and recommendation
 Downgrade to Underperform: Lower loan growth, asset quality issues and a
weakening franchise, along with a management change, are likely to
overhang stock performance in the medium term. We downgrade Union Bank
to Underperform with a revised TP of Rs185.


Valuations and TP
We value UNBK on a two stage Gordon growth model using
P/BV = RoE * {(p(1+g) * (1- (1+g)n/(1+r)n)) + (pn(1+g)n(1+gn))/((r-gn)(1+r)n)} where g=growth rate
for the first n (high-growth period) years, p=payout ratio in the first n years, gn=perpetual growth rate,
pn=perpetual payout ratio.
Fig 1 UNBK – sum-of-parts methodology
Cost of equity 13.0%
RoE 12.5%
g (initial growth) 10%
n(initial growth period) 5
Steady growth 4%
Theoretical P/BV – using two stage Gordon growth model 0.97x
FY13E adjusted book value (INR) – Adjusted for Net NPLs 228
Assumed restructuring hit at 20% to gross book value 40
Book value used in calculation of fair value 189
Target Price (Rounded off) 185
Source: Macquarie Research, March 2012