Banking Sector - No earnings recovery in sight for PSUs; Still prefer Private Banks - Systematix

We remain positive on the Indian Banking sector over the next 12-15 months and expect the Bank Nifty to deliver 10%+ returns over the same period. However, between private banks and their PSU counterparts, we expect PSU banks to underperform their private sector peers and Bank Nifty on weak core operating performance.

PSU banks core operating performance to remain weak over the next two years: For PSU banks under our coverage, ROEs are estimated to drop by 110-400 bps over the next two years - SBI's ROE would decline by 400 bps to 11.6% in FY15E, BOI's ROE by 170 bps to 11.9% in FY15E, and PNB's ROE by 110 bps to 14.9% in FY15E. PSU banks are expected to face several headwinds over the next two years viz: 1) margin deterioration in a declining interest rate scenario, 2) opex cost to remain elevated on account of additional wage revisions and pension & gratuity provisions, 3) modest recovery in gross NPLs, but credit cost to remain elevated, and 4) Moderate credit growth given the asset quality headwinds. We expect economic recovery would be slow and gradual - recovery would be more of "U" shaped rather than "V"shaped. Hence, given the lack of corporate credit demand, credit growth is likely to witness marginal uptick in FY14E and FY15E. Banks witnessing asset quality pressures would prefer to grow at subdued rates than the industry averages. Unwinding of asset quality stress on balance sheet (~10-15% of assets are under stress) is likely to take longer than expected. Despite our estimates being optimistic on the growth and windfall trading gains, we expect core operating performance of PSU banks to remain weak dragging down the overall profitability of the banks.

Visibility of core operating performance of private banks is strong: Private banks having strong balance sheet (facing less asset quality headwinds and having high coverage ratios) would emerge as winners over the next 4-5 years and gain considerable market share too. ROAs of private banks under our coverage would improve by 4-16 bps over the next two years while ROEs are likely to remain stable or contract marginally (contraction will be largely due to capital issuance). Assets would continue to grow at premium rates to industry averages given less asset quality pain, which is likely to remain one of the strongest earnings drivers for private sector banks over the next 4-5 years. In a declining interest rate scenario, bulk depositors (Axis Bank) and fixed priced lenders (Indusind Bank) would witness stable to improving margin profile. For other private banks under our coverage, margin contraction would be marginal. Further, private banks are not expected to witness significant asset quality headwinds too. Operating performance would be strong to absorb higher incremental delinquencies.

Valuations: ROE/ROA multiples of PSU banks under our coverage would drop by 110-400 bps/3-30 bps over the next two years. At the same time, ROA of private banks under our coverage would improve by 4-15 bps and ROE would contract marginally due to capital issuance. Current valuations don't capture the divergent return profile of PSU and private banks. For PSU banks, estimated ROEs (FY15E) would be 380-650 bps lower than historical 7-year averages. For example, for SBI, given the steep deterioration in the return profile of the bank, FY15E P/ABV multiple will be down by only 9%. Hence, we recommend a SELL and Sector Underperformer rating on SBI with 12-15 month TP of Rs. 1,787. BOI's ROE/ROA would be lower by 640bps/30bps for FY15E than historical averages, while the bank is currently trading at mean multiples. We downgrade our rating on the bank from BUY (earlier) to SELL with 12-15 month TP of Rs. 275 (vs earlier TP of Rs. 375). In case of PNB, given more steeper correction in prices than return profile, we recommend a HOLD and Sector Underperformer rating with 12-15 month TP of Rs. 821. Given private banks' attractive valuations, better return profile and healthier B/S, we are more positively biased for them. Our top picks in the sector are Yes Bank, Karur Vysya Bank, HDFC Bank, Axis Bank, Indusind Bank, ICICI Bank (in this order).

Source : Equity Bulls

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