Smaller banks could be better bets

City Union and Karur Vysya among preferred picks; valuation gap with larger peers seen narrowing

Valuations of HDFC Bank and IndusInd Bank are inching northwards whereas pressures on assets persist for most other private and public sector banks. In these conditions, smaller banks like Karur Vysya Bank and City Union Bank, with over half their business in South India, emerge as investment alternatives in the banking space.

Smaller banks had solved asset problems and were among the first to shift focus to retail (individual) lending. Karur's retail business grew 19 per cent in September-December over a year. With a well-spread retail portfolio of home loans (35-40 per cent of total credit), vehicle and home loans (30 per cent of business), SBI Capital expects Karur's loan business to grow 14.3 per cent in FY17.

City Union Bank draws its strength from loans to micro, small, and medium enterprises, which grew 27 per cent in September-December over a year. Loans to traders (18 per cent of total loans), grew 14 per cent in September-December over a year. City Union Bank cut its corporate loans to seven per cent of total credit in September-December versus 11 per cent a year ago. It did this to check non-performing assets (NPAs). HDFC Securities expects City Union Bank's loans to grow 16 per cent in FY15-18. IndiaNivesh expects the bank's earnings to grow 19 per cent a year during FY16-18.  

These two banks posted net interest income (NII) growth of 15 and 20 per cent, respectively, in September-December, over a year, indicating that the retail strategy is paying off. Net profits rose 34 and 10 per cent in September-December over a year, respectively, for Karur and City Union Bank with net interest margins a little upwards of 3.5 per cent for both.

The Street is comfortable with Karur's gross NPA (GNPA) ratio of 1.91 per cent. City Union Bank's GNPA ratio in September-December was 2.37 per cent. Analysts at Motilal Oswal Securities say City Union Bank is better than government-owned banks and other small private banks such as South Indian Bank and Dhanlaxmi Bank (gross NPA ratios of 2.75 and 9.69 per cent, respectively).

With fundamentals intact, Siddharth Purohit of Angel Broking says Karur and City Union Bank may see significant re-rating. Both trade at a reasonable one-two times the price-to-book value.