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Banking on valuations

Arun Rajendran | November 17, 2003

Economies across the globe are looking up. And economists are predicting that interest rates may be on their way up.

Central banks in England and Australia have already hiked rates and if the growth numbers continue to be good in the US this quarter, even the Federal Reserve could up rates.

The scenario is not very different back home. The mid-term review of the monetary and credit policy 2003-04 sprang up a few surprises.

Contrary to expectations, RBI governor Y V Reddy did not cut the bank rate and the cash reserve ratio which have been maintained at 6 per cent and 4.5 per cent respectively. Not all the surprises were unpleasant.

Reddy revised the growth estimates to 6.5-7 per cent from 6 per cent in April, even hinting that the growth may be larger than estimated. He also expressed confidence about the lower inflation rate of 4-4.5 per cent.

What do these developments mean for banks? Till date, the main beneficiaries of rate cuts have been banks which have been thriving because of increasing spreads and higher treasury income under a low interest rate regime.

Is the rise in interest rates a threat or an opportunity? The Smart Investor spoke to a number of industry experts to analyse the impact of this cyclical upturn on the performance of banks and their stock prices.

The consensus that has emerged is that banking stocks are looking fighting fit and the increase in stock prices has not resulted in their valuations looking bloated.

Stocks may not sky-rocket from here on, but the relative valuation of the banking sector looks cheap compared to the rest of the market. That's one reason, analysts say, bank stocks are not as risky, even at current levels.

Still cheap?

Bank

EPS (trailing
12 months)

Forward
EPS
(04)

Current
price
(Rs)

P/E
ratio

Forward
P/E

Andhra Bank

12.66

12.50

44.95

3.55

3.60

Bank of Baroda

32.49

38.00

187.55

5.77

4.94

Bank of India

18.64

21.00

61.60

3.30

2.93

Canara Bank

28.80

31.00

132.05

4.59

4.26

Corporation Bank

34.34

37.00

220.65

6.43

5.96

HDFC Bank

15.52

18.50

307.80

19.83

16.64

ICICI Bank

22.98

22.50

240.15

10.45

10.67

Oriental Bank

28.35

33.00

244.55

8.63

7.41

Punjab National Bank

39.75

40.00

196.80

4.95

4.92

State Bank of India

65.11

72.00

477.15

7.33

6.63

 

Despite the fact that bank stocks did not take too well to the fact that interest rates were left unchanged in the credit policy -- all bank stocks ended lower on November 3 while Sensex gained 156 points -- analysts say that interest rates are not a big concern yet.

Most analysts opine that rates will remain soft and, thus will not hurt banks. They also say that although NPAs may show a rise with the new 90-day sticky assets rule, they would remain a technicality and would not have a major bearing on the overall efficiency of the sector.

However, there is one difference this time. The banking story is not a song sung in chorus by all analysts anymore. There are some analysts who would play on the side of caution after the meteoric rise.

Says Abhishek Agarwal, research analyst at Quantum Securities, "The last two quarters have been good for most banks with growth in the core business and rationalisation in the cost of deposits. But I really do not see a lot of appreciation from these levels."

Aashish Agarwal, research analyst at Edelweiss Capital, feels that the banking rally has been largely event-driven in the past, but going forward, it would now rest on the fundamentals to drive up scrips.

Agarwal feels that the movement in the sector won't be broad-based as in the past and it would ultimately boil down to specific stocks according to the changes in their key ratios.

"In that sense, banking stocks will resemble other stocks, with movement being more stock-based than the broad sectoral movement that we have been accustomed to so far," adds Agarwal.

Over the last three quarters banking stocks have done exceedingly well on the bourses, partly propelled by good financial results.

Consequently, FIIs have also been mopping up stocks of public sector undertakings during the September quarter.

As per the shareholding patterns available for 31 PSUs, including banks, FIIs purchased 57.82 million fresh PSU stocks during the quarter.

Notably, FIIs increased their holding by around 2-3 per cent in banking stocks like Andhra Bank, Bank of Baroda, Bank of India, IDBI and Oriental Bank of Commerce.

In State Bank of India, the FII holding remained unchanged during the quarter, but that is just because the permissible 20 per cent limit has been reached. Analysts say that institutional buying interest in banks would continue.

Positivity galore
Many analysts feel that there has been no significant change on banking stocks from the credit policy and say that the sector should continue to do well.

"Banking stocks look very good for the medium to long term, riding on a number of factors," says Rajesh Jain, head of research at Pranav Securities.

Although Jain was expecting a rate cut from the credit policy he is still confident that the sector is on a firm footing, especially since the RBI has kept the door open for a rate cut.

He also expects the economic revival to result in increased credit offtake, boosted by the picking up of commercial and industrial demand.

A lot of PSU banks have also undergone restructuring in the form of computerisation and modernisation along with a rationalisation in HR costs in the form of VRS.

Jain expects, within a couple of years, increased capital-based restructuring from a spate of mergers and acquisitions among PSU banks which would add to the positivity in the sector.

However, apart from these, analysts agree that valuations are a huge factor why the sector still retains its allure.

In fact, a host of banking stocks were trading at P/Es of 1.5-2.5x just six months ago. That along with the sprucing up of their balance sheets certainly seemed to work better than any magic potion to lure investors to the sector.

What lies in store for banking Inc

PROS

Volumes are expected to grow significantly through new branches and ATMs

Impending consolidation via mergers and acquisitions

NPA levels to continue to go down as a percentage of advances

CONS

Global interest rates are on an uptrend and domestic rates could bottom out.

Income from treasury gains to see a dip

Dearth of new products in the segment, giving rise to unhealthy competition

Reaffirms Milind Mucchala, banking analyst at Dalal and Broacha Stockbroking, "Although the interest in banking stocks was mainly valuation-driven at first, investors also began to look at other positives like increasing treasury income and a large reduction in NPAs. The reduction in NPAs has been significant in the banking industry and the average net NPAs in the industry have come down to 2.5-3 per cent from the earlier levels of 6-7 per cent. In fact, some banks like Oriental Bank of Commerce has a zero per cent NPA level."

However, he says that net NPAs were lower because of provisioning by banks. At the gross levels, NPAs have not seen much change in the last year and they are hovering between 10-11 per cent.

Mucchala feels that the recovery of NPAs have just started and they will continue to go down as a percentage of advances.

Abhishek Agarwal feels that historically, FIIs have not really looked at the pre-reform banking sector in India as far as investing is concerned.

But as FIIs increased their allocation in Asia, PSU banks, with their huge reach and improved fundamentals and the way they do business, looked like a natural choice.

The positivity has reflected in the earnings of the banks. Analysts say that the banking sector, on the whole, reported handsome numbers in the last three quarters, fortified by handsome treasury income.

However, analysts say while sustainability of treasury income is suspect, the fact that the proceeds from treasury income have spruced up of balance sheets in terms of higher provisioning augurs well.

The worries
The interest rates environment has been benign in the last few years, thanks to the slew of rate cuts. However, with many analysts saying that interest rates are near the bottom, the moot question is whether rates are headed for a turnaround.

"Interest rates are directly linked to inflation and if inflation is lower then it would automatically point to lower interest rates," says Rajesh Mokashi, executive director of credit rating agency CARE.

"On the face of the stable economic environment and the global liquidity conditions, interest rates are clearly headed downwards," he adds.

However, the recent move by the Bank of England and Australian central bank to hike rates has left global economists debating on the direction of interest rates in the coming quarters.

Notwithstanding this, Mokashi feels that banks' balance sheets would ultimately reflect the state of the economy and looking at the upward revision in GDP growth and the increasing efficiency in the corporate sector, banks are headed for good times ahead. He also feels that almost all banks would show a reduction in their NPAs.

Financial snapshot

Bank

NP FY03
(Rs cr)

NP FY02
(Rs cr)

%
change

Sept qtr.
(Rs Cr)
NP 03

%
NP 02

Net
change

Current
NPA
 03 %

Net
 NPA %

Andhra Bank

402.99

202.27

99.23

136.98

68.40

100.26

1.79

1.07

Bank of Baroda

772.78

545.93

41.55

259.56

137.22

89.16

3.72

3.37

Bank of India

851.00

508.83

67.25

226.76

194.43

16.63

5.59

5.36

Canara Bank

1018.89

741.40

37.43

325.35

278.68

16.75

3.59

3.28

Corporation Bank

415.99

308.10

35.02

144.93

118.70

22.10

1.65

1.44

HDFC Bank

387.60

297.04

30.49

117.14

89.69

30.61

0.40

0.30

ICICI Bank

1206.18

258.30

366.97

401.40

285.30

40.69

5.21

4.80

Oriental Bank

456.95

320.55

42.55

162.72

113.15

43.81

1.40

Nil

Punjab National Bank

842.20

562.39

49.75

299.76

210.26

42.57

3.86

2.47

State Bank of India

3105.00

2431.62

27.69

988.74

817.20

20.99

4.50

2.56

 

Should one worry about banks profitability getting impacted in the event of a rise in rates because treasury income has been the mainstay of most banks' profits over the last few quarters?

The move is expected to impact PSU banks more while the effect on the larger new private banks is expected to be muted, since they hold a much lower stock of government securities.

Overall, analysts say that since most banks have utilized their treasury gains to make provisions for NPAs, provisioning requirements will be lower going forward. Besides, a buoyant economy and recovery in sectors like steel and textiles should also help banks sustain profits.

"The effect of a 1-2 per cent increase in interest rates would not be immediately visible on banks and that would be offset by raising the interest rates on advances and debt instruments," feels Thakker.

There are, however, other fear factors like the uncontrolled growth in the housing sector. "NPAs from the housing sector would be the bane of the banking sector," says Jain.

"The growth has been too fast and a lot of unethical practices like inflating the property cost to avail of higher loans combined with other measure to get ahead of the neck to neck competition in the segment are extremely unhealthy for the segment," adds Jain.

Another area that analysts are wary about is the credit card segment where the competitive scenario gives rise to unhealthy practices.

Reaffirms Mokashi, "Going forward, competition among small players would be intense, more so with banks going for retail customers in a big way. So, banks should take extra precautions to ensure that quality of assets are not compromised."

Analysts have a negative view of the 90-day sticky assets rule for financial institutions in the credit policy, which is expected to have an adverse impact on weak banks.

The rule stipulates assets of FIs to be treated as non-performing if the interest and/or the principal installment remains overdue for a period of more than 90 days as against the previous stipulation of 180 days.

This would increase the NPA levels in these banks, but analysts dismiss it as a technicality. Another negative that analysts see is the large number of interlinkages between banks and financial organisations.

Many banks have holdings in financial instruments of other organisations. If the financial organisation is in trouble, it would have a contagion effect on the bank.

PSU or private?
The pertinent question to ask now is which category of banks should one focus on? Till date, banks stocks, particularly the PSU ones, have gained popularity because they offered excellent dividends yields. Some banks offered yields better than their deposit rates!

For instance, Andhra Bank and Vijaya Bank offered dividend yields of 15.6 per cent and 14.11 per cent respectively while those of Oriental Bank of Commerce, Bank of Punjab and Bank of Baroda hovered around the 8-9 per cent mark in March 2002.

But the re-rating that has happened in the past few months has made many of these banks pale on the dividend yield front compared to the scene a couple of years back.

Even though some banks like Andhra Bank, Bank of Rajasthan, Indian Overseas Bank, IndusInd Bank and Syndicate Bank still offer dividend yields between 5-6 per cent, analysts point out that further rise in banks stocks will be driven by growth expectations.

However, banking will be a sector which will offer both value stocks based on good dividend yields as well as fast growth stocks.

Analysts expect PSU stocks to lead the bandwagon as far as buying interest goes. This is because of the significant reach that they have combined with the increasing operational efficiencies and cost reductions - which would ultimately result in healthier balance sheets.

Analysts also see a lot of consolidation in the banking environment over the next few years.

"The banking sector will see some kind of shakeout in the next few years with a spate of mergers and acquisitions resulting in widening the scope and quality for small banks," adds Mokashi.

SBI is still the favourite and analysts feel that the consolidation would reflect well on the bank as a lot of its subsidiaries are quoting at P/Es of 1.5-2x.

Another stock which has seen its share price spurt to Rs 230 from the Rs 40 levels is Oriental Bank of Commerce and Mucchala says that there is still room for upside.

Other analyst favourites include Jammu & Kashmir Bank, Corporation Bank, Bank of Baroda and Canara Bank. Vijaya Bank and Andhra Bank also find themselves in the list, given their low P/Es.

But then, some analysts are bullish on private sector, too. Jain says the primary reason for that is because India is 'underbanked'.

"The next one to two years should see private players looking at aggressive volume growth by setting up branches and ATMs. However, one field where they would have a problem is product diversity as the competitiveness in the same is high among the private players.

In the future, banks which do not restrict themselves to have a retail focus should do well. ICICI Bank and HDFC Bank look good in that regard.

Between ICICI Bank and HDFC Bank, analysts go for the latter as they feel that ICICI's merger with ICICI Bank has robbed the bank of its sheen unlike HDFC Bank which still commands a higher discounting. UTI Bank is another private player which is expected to do well with its strong balance sheet finding favour with analysts.

To sum up, analysts say that these are small blips in the big picture and the banking sector is looking to lead the economic recovery.

An analyst puts it very aptly: "Banking is the lifeblood of any economy. So how can there be an economic recovery without a corresponding effect on the banking sector?"


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