Our internal analysis also suggests that Ebitda (earnings before interest, taxes, depreciation and amortisation) margins of corporates have bottomed out and that falling commodity prices coupled with a benign rate cycle should result in a reduction in SME sector NPL formation.
Also, in the overall pall of gloom, the market has failed to recognise structural changes like lower reliance on bulk deposits, less funding of short-term unsecured corporate advances and movement towards system-based recognition of NPLs. Indian banks over the past three years have also reduced their concentration risksa fact that has been largely unnoticed.
We upgrade State Bank of India (SBI) to Outperform from Neutral and Punjab National Bank (PNB) to Neutral from Underperform, as these are the two banks that are most leveraged to the SME/mid-corporate NPL cycle. We rate 'Outperform' on Axis Bank now that it has come off the restricted list.
So what has changed and why the upgrade
Two main aspects led to the upgrade. Our view on the asset quality cyclewhich we believe is close to the bottom. Further, loan growth and margins have also bottomed out.
Liquidity and interest rate scenario: Interest rates are set to come down with inflation moderating (we expect a 100 bps points cut in benchmark rates which may translate into a 50 bps cut in lending and deposit rates). The liquidity situation also has improved and is set to further improve, driven by RBI OMOs (open market operations) as well as government spending. Short-term rates are already down 250 bps from the peak.
Bottoming out of growth: Needless to say, there is a strong correlation between economic growth and the NPL cycle, and with GDP growth expected to bottom out in FY13e and recover 100 bps, we expect cyclical-related stress to come down. A recent stress analysis by Fitch revealed that more than 50% of the stress is contributed by cyclical sectors. Sectors like SMEs are very leveraged to the interest rate cycle and demand revival and hence they would be the biggest beneficiaries.
Channel checksfeedback from rating agencies, Sidbi, etc: Our channel checks with rating agencies confirmed that the credit ratio, which is the ratio of upgrades to downgrades, has bottomed out. The number is still expected to be below one, ie downgrades will outpace upgrades but the ratio has bottomed out and improvement could happen albeit at a slow pace. Our meetings with industry bodies also revealed that the stress continues but they have not seen any signs of further deterioration. All of them also unanimously said that sentiment has improved but they have not translated that into any action.
India Inc margins have bottomed out: Our internal analysis (and also an analysis by Crisil ) reveals that Ebitda margins have bottomed out. With corrections in commodity prices plus an expected reduction in interest rates, we expect Ebitda margins to improve. Some of the companies are highly leveraged to a reduction in interest rates and hence lending rate cuts could improve debt-servicing ability.
Reforms and SEB debt restructuring: We believe that actions such as amending banking laws, increasing FDI in several sectors and other measures that have been taken or proposed would play on sentiment and eventually kick-start the investment cycle, albeit at a slow pace. Having said that, we believe even the SEB debt restructuring, if implemented in the way it is proposed, is a step in the right direction.
Both loan growth and margins have bottomed out: Both loan growth and margins have bottomed out. With interest rates set to decline and some recovery in the economy expected for FY14e, we think loan growth and margins are unlikely to go down further. Even with practically no new investments, credit growth has been managed at around 16% so far. The deposit rate cuts coupled with the fall in wholesale cost of funds should flow into margins with a lag. We expect NIM impacts coming from interest reversals to be lower this year.
Why not an outright Outperform
There are four main risks which prevent us from taking a very bullish stance.
Populist budget: The budget for FY14 to be presented in 2013 February-March could be a populist one, as it is the last budget before the central government holds elections in 2014. Room for fiscal profligacy is low, as fiscal compulsions this time around are far different from the situation seen five years ago, as it was the pre-GFC (global financial crisis) era.
Capital raising: Basel-III capital requirements are large and though, in our view, the government is in a position to meet the demands, a lot would depend on support of equity markets as well as economic recovery.
Regulatory risks: The regulators are in the process of tightening provisioning standards, which could be good in the longer term with respect to soundness of the financial system. However, in the near term, there could be some weakness in stock prices.
Opex issues for PSU banks: Opex (operating expenditure) is a big black box in PSU banks. Though we have factored an increase in wage costs, it is usually very difficult to estimate pension liabilities, as it involves complex actuarial calculations and some of the assumptions used by PSU banks to derive them are aggressive. Going by past experiences, opex has tended to surprise negatively however conservative one has been, and hence we would not like to overlook this risk.
Earnings downgrades bottoming out
Earnings downgrades have moderated over the past three-six months. Though upgrades would take some time, as it would be contingent on overall demand revival in the economy, we clearly believe downside to earnings estimates from loan growth, margin, or credit costs (the three very important drivers of P&L) is limited.
Our picks, valuation and recommendation change
We believe that the banks that are more leveraged to the recovery in the SME and midcorporate Yes Bank, Axis Bank and SBI are our top three picks for 2013. Over the longer term well-run private sector banks with good earnings growth and franchises should be core holdings. HDFC Bank and ICICI Bank are our preferred picks in this category.