Bank stocks have been underperforming over the last 12 months with negative news flows, starting with deposit rate increase in October 2010, increase in non-performing assets or NPAs, both from the previous cycle (restructured book) and current book (high rates), sooner-than-exp-ected news on restructuring from the power book, regulatory pressure, including savings account de-regulation and lately slowdown fears. The near-term macro outlook continues to remain challenging but we believe financials stocks are pricing in a large part of the negative news flow. Though growth and asset quality is unlikely to turn around in the next one or two quarters, markets are ignoring some positives that are playing out at the margins.
Moderating economic growth and sticky rates would continue to impact loan growth and asset quality trend would remain volatile over the next two quarters for the banking sector. Some more pain is expected from small and medium enterprises (SMEs) and agriculture portfolios.
However, net interest margins have bounced back and peaking rate cycle would be a positive. Also, FY12 has seen a strong beginning for the much needed power sector reforms, which over the next two years will help address significant asset quality concerns.
Asset quality of SMEs remains weak, while that of large companies continue to be robust. Government-owned banks exposure to stress sectors, excluding infrastructure, is 18-22% against 12-15% for private banks. Government-owned banks’ discom exposure (3-5%) would need to be restructured but strong policy moves and steep tariff increases would help bridge the gap and secure incremental funding from banks and financial institutions.
Fuel remains a risk for independent power producers and our detailed analysis indicates that 16% of incremental projects could face significant challenges.
Valuations at 25-30% discount to historical average do indicate asset quality risks being priced in. The impact on book value—factoring in write-offs of 10% in power fund and non-fund based exposure, 5% in other infrastructure exposures and 2-4% inch-up in gross non-performing assets in other stress sectors—is 9-13% for ICICI Bank Ltd and Axis Bank Ltd and 14-20% for government-owned banks. Valuations adjusted for the write-offs still remain 15-20% lower than historic valuations for ICICI Bank and Axis Bank and on a par with historic valuations for government-owned banks.
We prefer ICICI Bank and Axis Bank. We do not see any cracks in the near-term retail asset quality. However, valuation premium for defensives is already at 2009 levels and we expect no further outperformance on sharp market declines reflected in our accumulate rating on HDFC Bank Ltd and HDFC Ltd. Government-owned banks’ valuations look interesting, but we expect near-term asset quality volatility to continue.
Among government owned banks, State Bank of India (SBI) is our preferred pick as near-term negative surprises are largely priced in but market is ignoring SBI’s low risk power exposure and operating profit resilience due to high margins. We have an accumulate on Punjab National Bank, Bank of Baroda and reduce on Bank of India.
Edited excerpts from a report by Prabhudar Lilladher Ltd. Send your comments at firstname.lastname@example.org
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