Indian Banks – Corporate Health Check How intense is the credit cycle and what is factored in ? Prabhudas Liladhar

Our detailed corporate health check for ~3500 listed companies indicates that the
credit cycle is getting deeper with breadth of mid and small cap companies facing
stress increasing at a brisk pace along with an elongated down cycle, leading to
higher ultimate delinquencies. But the good part is asset for large caps (excl. Infra,
~60% of debt) have held up relatively better and more importantly, stress sectors
have already seen large scale recognition, either as NPA or restructured asset. We
do not see a significant rebound in the credit cycle near term and hence, prefer
ICICI/Axis, where corporate underwriting has been robust and our sensitivity
analysis indicates 15% upside even considering ~15-20% write-offs. PSU banks’ adj.
valuation is undemanding indicated in our rating upgrades in some PSU names
after 4Q12 but the BUY case for PSU banks is more contingent upon a fast recovery
and more importantly front ended monetary easing.

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 Corporate health check – Analysing pain points: We ran a detailed Interest
coverage (IC) analysis of all listed companies to understand breadth/depth of
the credit cycle. The bad news: (1) IC, for mid corporate and SMEs, has come to
levels below 08-09 levels with increasing intensity - 25% of mid and SME
companies with IC of <1x. (2) The bigger worry is that IC for mid and small caps
have remained low for 3-4 quarters now and elongated stress time leads to
ultimate delinquency. The good news: (1) Some pockets in large caps are seeing
some incremental stress but overall IC levels remain comfortable and this
reduces asset quality risks as they constitute ~60% of the total Rs15trn of
industrial credit we analysed.
 What levels of stress is recognized/discounted? Though the credit cycle is
building up, segmental data provided by SBI/PNB indicate that 10-25% of total
exposure in some stress sectors has already been recognized (either NPA or
restructured), though intensity continues to increase. Engineering/construction
still remains vulnerable as stress recognition remains lower than stress indicated
by our IC analysis.
 Factoring risks not captured through our IC analysis: Infra risks/delays are still
to hit P&L and hence, our IC analysis does not capture Infra/power risks. Our
bottom-up analysis indicates that ~20GW of thermal plants face fuel/off take
issues (~20% of capacities commissioned in 09-15E). Though we expect large
restructuring in private power space, strong promoter financials in some cases,
extension of loan tenure and most importantly systemically acceptable level of
cost of power produced (Rs3.1-3.2/unit) even assuming 25% imported coal
blending, will significantly limit ultimate delinquencies.
 Stress testing- ICICI/Axis remain top Buys : Our stress test indicates that
valuations for ICICI/Axis is ~15% lower than their LT averages after considering
~15-17% hit to book values. The hit on PSU banks book is larger at ~30% of book
given NPA shortfalls and higher restructuring, but that seems to be fcatored to
some extent in valuations. The credit cycle is getting elongated and challenging
and easing modetary stance now will bring some relief to asset quality.