[T.S.R:17993] Banks-The Asset Quality Conundrum (MS Raises Questions On Indian Banks With A Negative Bias)

Indian banks may appear attractive on long-term

growth outlook and nominally cheap multiples, but

reported earnings are likely flattered by relaxed NPL

recognition norms. In a difficult macro climate, the

growing disconnect between reported and

underlying earnings might prompt multiples to

decline, as we've seen with China's bank stocks.

SOE valuations below historical averages.

Stocks are

trading at 7.0x EPS, and 1.0x book. On reported earnings,

this would appear a buying opportunity. But, we believe

reported earnings are not necessarily accurate reflections

of profitability; on term loans (infrastructure), revenues

are being booked now, but costs will come later in the

form of provisions, as NPLs increase.

Balance sheets are weaker than in 2008.

Impaired

loan ratio is closer to 6% (vs. 2008's 3.5%), as banks still

have restructured loans from 2008. While consumer

loans and real estate caused concern in 2008, today's

problems can arise from infrastructure, real estate, MFIs

and other corporate loans. While problems on these

loans are rising, banks, with support from restructurings,

are unlikely to take provisions over the next 1-2 years.

We focus on underlying profits.

Given weak asset

classification norms, provisioning is unlikely to shoot up,

despite evident problems. We adjust reported profits for

coverage, lower ROEs on infrastructure loans (by

increasing provisions), and right-size capital. Canara,

PNB, and IDBI are worst affected, while HDFC Bank,

IndusInd, and KMB have underlying profits > reported.

To be constructive, we need to see material decline

in rates. Our view is that rates have peaked but will

stay at elevated levels for 6-9 months.

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