[T.S.R:16023] Sell PSU Banks-Macquarie

Macquarie Banks: The party is over Risk/reward highly unfavourable; BOB, PNB now Neutral We believe that after the recent significant outperformance of the Indian public sector banks, the risk/reward has become highly unfavourable, and we foresee near-term pressures in the form of weak loan growth, lower margins and issues regarding opex and asset quality, resulting in earnings downgrades by the street. Our earnings estimates are 10–15% below consensus. We downgrade PNB and BOB to Neutral based on valuations. We reiterate our non-consensus bearish call on the sector. Do not look at history, look beyond During the past five years, PSU banks have been re-rated due to their stronger growth profile, superior technological platform and improving ROA. However, the market seems to ignore several important aspects. Loan growth in this cycle is expected to be far lower (20–22% vs 30% in the earlier cycle), fee income momentum is structurally likely to be lower, and opex and credit charges are likely to remain high in the early part of the cycle, due to waning productivity benefits and the regulatory requirement of 70% NPL coverage, respectively. Moreover, with capital requirements likely to become more stringent, we think leverage structurally is likely to be lower, thereby resulting in lower ROEs. Near term: Loan growth and margins could disappoint We think loan growth could disappoint, mainly due to increasing financial disintermediation, exacerbated by the new base rate regime and structural challenges to recovery in several segments. Margins could disappoint in the next two quarters, due to sharp increases in deposit and wholesale funding rates without commensurate increase in PLR or base rates. Weak loan growth would further result in deposits being parked in low-yielding government securities (Gsecs), which would result in negative carry. Opex burden: Additional headwind on earnings After several years of productivity benefits, the pace of increases in such benefits is likely to slow, due to a net increase in the employee base. Pensions that have not been accounted for could erode PSU banks' net worth by 10%. Assumptions used to arrive at pension obligations are very conservative. Our revised assumptions result in an additional 5% impact on net worth. Asset quality: Near-term pains exist Our interactions with credit rating agencies reveal that, in the near term, overall system NPLs could increase 50%-plus in FY11 vs our estimate of 30% for our coverage universe. Slippages could be mainly from restructured assets, SME segments and sectors such as textiles, leather, chemicals, steel intermediaries and commercial real estate. Valuation multiples: No room for comfort PSU banks are trading one standard deviation above historical averages, with many trading at historically high multiples. Even after we assume the multiples at the peak of 2007 bull market, when fundamentals were far better than they are today, upside to current market price is limited, in our view. The discount of PSU banks to private banks at 40% is now the lowest ever. Our key Underperforms are banks with weak deposit franchises, such as Canara Bank, Union Bank and IDBI. For investors who want exposure to PSU banks, we recommend adding BOB and PNB on corrections. Safe Harbor Statement: Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.   Nothing in this article is, or should be construed as, investment advice.

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