Re-rating to continue in top PSU banks

Despite recent run up and mixed performance in the March 2014 quarter, these stocks could gain further as economic growth and private capex revives

Stocks of public sector banks have made new 52-week highs this month cheering their improved show in the March 2014 quarter and also pricing in a potential pick-up in economic growth after the election of a strong government at the centre. Though a few have also disappointed, notwithstanding this run up, most analysts believe there are more legs to this rally given that a) most of these scrips are still trading closer to their historical average one-year price/book ratio and b) Foreign holding in these banks has not moved much from the lows of March 2009.

“Given a pro-growth and stable government, we are convinced that PSU banks provide a compelling investment opportunity. This hope is backed by the tangible prospects of a cyclical improvement in macros. Also, FII ownership in select PSU banks continues to remain at historic lows, providing further upside”, says Darpin Shah, Banking analyst at HDFC Securities.

Reasonably valued, under-owned by FIIs

While State Bank of India (SBI) trades at 1.6 times FY15 estimated book value (higher than its one-year average forward of 1.4 times), Bank of Baroda (BoB; 1.2 times) are trading below their historical average of 1.3 times. Post the positive surprise on asset quality in March 2014 quarter results, most analysts have raised their target price on SBI. Brokerages such as CLSA, Credit Suisse, Bank of America Merrill Lynch, Goldman Sachs and Citigroup have raised their target price on SBI valuing it between Rs 2,400 to Rs 3,200. Macquarie though holds a contra view and believes that SBI's asset quality is not out of the woods yet. It has a target price of Rs 1,800 versus Monday’s closing price of Rs 2,700.

Punjab National Bank (PNB; one time FY15 estimated book value) and the remaining four banks, too, trade at low valuations of 0.7-0.8 times FY15 estimated book. The risk-reward equation for the stocks of PNB and IDBI Bank, however, is not as favourable. For instance, IDBI Bank has been falling short on Street’s expectations given muted loan growth (single digits in last few quarters). Likewise, BoI, Canara Bank and Union Bank are under-capitalised and could witness high equity dilution by FY18 as they raise funds to comply with Basel III norms.

Meanwhile, FII holding in SBI and BoB has gone up marginally from 8.3% and 13.5% in March 2009 quarters to 9.7% and 15.6% in March 2014 quarter, respectively. That in PNB has moved up from 14.9% to 17.2%. In case of other four banks, FII holding has reduced by 96 (IDBI to 2.9%) to 418 (BoI to 10.2%) basis points in the same period.

Economic boost

Experts now believe immediate reforms are likely in stalled projects and in power sector. Public sector banks stand to gain most from these reforms due to their high exposure to infrastructure, power sectors. Improved cash flows in the hands of corporate India along-with kick starting of projects could lead to better asset quality and credit growth for these banks, believe analysts.

However, these positives will come in with a lag effect.

“We believe Indian banks, especially high-beta PSU banks, could be at the cusp of re-rating given improving macro and post-election reforms. PSU banks may see NPAs fall by 3% in FY16. We therefore upgrade SBI and BoB to Buy from Neutral, and PNB to Neutral from Sell”, says Tabassum Inamdar of Goldman Sachs.

March quarter performance

For the March 2014 quarter, SBI, BoB and Canara Bank outperformed the Street’s expectations while PNB, BoI and IDBI Bank disappointed. Union Bank posted in-line results. While IDBI Bank and Union Bank reported subdued year-on-year loan growth of 0.7% and 10.1% respectively; that of other banks was robust between 13-28%. Agriculture and Retail segments were key drivers of domestic loan growth. Net interest margins of the public sector banks remained largely stable due to lower cost of funds.

Barring BoB, all other banks witnessed fall in net profit (see table) in the quarter due to higher provision for bad loans. However, the profit beat was driven by stringent cost savings, strong fee-income growth and better asset quality for SBI, BoB and Canara Bank. PNB, BoI, Union Bank and IDBI Bank however disappointed on the asset quality front. Among these top banks, PNB’s gross non-performing assets (NPA) ratio is the highest at 5.3% of its advances. BoB has been maintaining its asset quality even in the toughest times and is amongst the top PSU banks on this front. SBI, too, is addressing this issue as a top priority and is now reaping the benefits of its measures. Sale of bad debts to Asset Reconstruction Companies (ARC) also benefitted most banks.

Net slippage ratio (represents the addition of NPAs in a given period) improved sequentially for SBI (down 150 basis points to 2.5%), BoB (down 50 basis points to 1.3%), Canara Bank (down 30 basis points to 3.5%) and Union Bank (down 20 basis points to 2.3%).  This metric worsened by huge 240-250 basis points for remaining banks to 3.1% for PNB, 4.2% for IDBI Bank and BoI to 4.9% in the March 2014 quarter.  

Going forward though, managements of SBI, PNB and BoB have indicated that asset quality seems to have bottomed out and could improve. Asset quality woes, however, are likely to continue in the near term for BoI, Canara, Union Bank and IDBI Bank given their sizeable restructuring pipelines.