Analysts cautious on top 3 private banks

Slowing profit growth and high valuations turned analysts sceptical on near-term stock performance

Weakening growth in loans or credit, continued stress on asset quality and cuts in lending rates have impacted profitability at banks, both in the private and public sector.

Public sector banks' (PSBs') problems are more structural and will resolve only when they become self-sustained, especially the mid and smaller ones. Large private banks seem to be faltering on a key strength, their hitherto healthy pre-provisioning operating profits. Growth in this metric has been coming down over the past two quarters for most of the large ones (see table).

While the drop in the latest December quarter could be attributed partly to demonetisation and to slower economic growth, this weakness started in the June 2016 quarter, even earlier in some cases. Not a good sign for investors. Higher pre-provisioning operating profit provides a cushion to earnings, even amid stress on asset quality, as the bank can use part of these for higher provisions for bad loans. This was a key reason why most brokerages were positive on large private banks in India.

Higher profits had also pushed up the return on equity (RoE) ratios, a key parameter that markets look at to arrive at stock valuations, to the high teens for most large private banks. With slowing profit growth, this metric is likely to come under pressure.

"Core pre-provisioning operating profit performance clearly remains a worry, with ICICI Bank /Axis Bank reporting 11-14 per cent contraction and PSBs reporting flat pre-provisioning operating profit but on a very low base (December quarter). With slow corporate growth, risk aversion and 60-70 basis point of MCLR (marginal cost of funds-based lending rate) cut by banks, we expect pressure on pre-provisioning operating profit to remain high in the near term," say analysts at foreign brokerage Nomura.

With no turnaround in sight in the trend, it implies lower normalised RoEs and, hence, lower stock valuation multiples for corporate banks than the previous cycle, the analysts add.

Core pre-provisioning operating profit excludes non-operational streams such as treasury income and, thus, reflects how the business is performing. Including treasury income would add volatility to the profits and, hence, analysts say, it is better to look at the number excluding non-operation income.

In this backdrop, it is not surprising that more and more brokerages are turning cautious on large private banks. Credit Suisse recently trimmed its exposure to Indian banks in favour of their Indonesian counterparts. "India banks (both private and public sector) look expensive on the price/asset versus return on asset (RoA) chart," say analysts at the brokerage in a recent report.

Nilanjan Karfa, analyst at Jefferies India, has downgraded the stock of the three largest private banks -- HDFC Bank, ICICI and Axis -- from 'Buy' to 'Hold' this month. "The bank index is reaching the 2008 (peak) valuation levels and the gap with the broader market is wider. Both ICICI and Axis are taking in significant provisions. With the added risk of weak power sector fundamentals, NPLs (non-performing loans) can only increase, which could depress the book value further. In the case of HDFC Bank, post a significant run-up driven by technical factors, valuations are near-full, limiting the out-performance," he says.

At current levels, the large private banks trade at two to six times their FY18 estimated book value. This would have seemed justifiable if it had not been for the weakening fundamentals. Investors should tread cautiously and wait for better valuations to consider quality private bank stocks.