Not bankable yet

SPECIAL REPORT

Though the downside in banking stocks seems limited, margins pressures may hamper a dramatic turnaround.

Barring price movements last week, markets have not been kind to banking stocks. Public sector banks have seen a higher erosion in their prices as compared to their counterparts in the private sector. Going forward, the downside for stocks seems to be limited.

"The upside for stocks would be led by improvement in core earnings in line with the credit growth," says Sejal Doshi, CEO, FINQUEST.

"At this juncture, the best strategy is to accumulate stocks in small quantities," adds Ajit Dange, analyst, UTI Securities. The growth in earnings will depend on the ability of banks to generate higher margins.

BSE Bankex has outperformed the Sensex over the last one week with a 7.54 per cent gain vis-a-vis 5.89 per cent by the latter as the market had already priced in the increase of a 25 bps in repo and reverse repo rates.

Analysts suggest that investors must wait for one more quarter till there is clarity on margins and share prices stabilise. The overall performance of major banks, which have declared their Q1 FY07 results so far has been in line with analysts' expectations.

Private banks shine
As usual, private sector banks such as ICICI Bank, HDFC Bank and UTI Bank have fared better than public sector majors due to a substantial leap in fee-based income and bulging retail credit portfolio.

Business has grown at a scorching pace with both deposit and advances growing at over 50 per cent (albeit with the help of a hike in rates) leading to stable net interest margins (NIMs).

In addition to this, fee-based income has shown a robust increase leading to faster growth in operating and net profit. The only exception is ICICI Bank, the largest in the private sector, which has witnessed unimpressive growth in operating and net profit, due to lower treasury income.

Mark to market losses and provisioning requirements for private sector banks is not a concern as they don't have excess SLR investments and even if they do, it is in shorter tenure securities, which are less vulnerable to short-term interest rate hikes.

However maintaining credit growth, (especially in the retail segment) in a rising interest rate scenario will be the key issue.

Though there is less choice, looking at P/Adj BVs for FY07E and FY08E , ICICI Bank (1.4x and 1.3x),UTI Bank (2.0x and 1.7x) and Yes Bank (3.4x and 2.9x) are analysts' favourite picks.

Public Sector Banks lag
PSBs have reported a strong business growth with deposits and advances growing in the range of 19-25 and 20-30 per cent respectively.

However, lower growth in investment income and other income in combination with higher operating expenses and provisioning requirements for investment portfolio (taxes for some ) have taken a toll on their net profit growth. Bank of India, Indian Overseas Bank, Andhra Bank and J&K Bank have fared better among their peers on almost all parameters.

India's largest bank, State Bank of India (even after excluding the one time payment of Rs 712 crore on account of interest on IT refund in the corresponding quarter in the previous year) has performed worse than analysts' expectations.

The bank's operating and net profit has grown only 3.99 per cent and 20.31 per cent to Rs 2,836 crore and Rs 799 crore respectively.

Analysts expect the net profit of PSBs to remain subdued for at least one more quarter. This is because even though roughly 60-70 per cent of their investments is in HTM (hold to maturity) category, public sector banks will still have to provide for higher amortisation and mark to market losses in the event of further hardening of yields.

Analysts are positive on Indian Overseas Bank, Union Bank of India and Bank of India, given their reasonable valuation and decent upside potential. They are in a better position with reference to mark to market losses as over 75 per cent of their investments are in HTM category. All of these banks trade at P/Adj BV of about 1.5x and 0.9x for FY07E and FY08E respectively.

Margins, margins
Going ahead, though banks will be able to post better net interest margins (NIMs), their performance in terms of net profit growth is unclear.

According to a senior banking official, "NIMs will remain stable as both interest expenses and income will be adjusted and yield on investments are unlikely to go down. The recent rate hikes by RBI is unlikely to trigger a hike in deposits and advances rates immediately as many banks have recently increased their rates. Also banks are flush with liquidity, which can also be gauged from the daily turnover of reverse repos," he adds.

Doshi of FINQUEST and Rajesh Malhani, analyst, Prabhudas Lilladher agree that going forward margins are expected to be better as the benefits of the hike in the PLRs undertaken by the banks will start showing results in subsequent quarters.

However, Dange has a different opinion. He thinks lower yield on investments will impact margins despite the rise in yield on advances. Even TS Narayanasami, chairman and managing director, Indian Overseas Bank agrees, but for a different reason.

"NIMs are already under pressure and may continue to be so as deposit mobilisation will be a bigger challenge for the banks and the sustainability of the robust credit growth is questionable."