Slippages to decline

Updated: Sep 1 2014, 07:39am hrs
We believe that State Bank of India is among Indias top beneficiaries of an emerging macro recovery, where indicators are turning positive. We upgrade SBI to a Buy with a TP (target price) of R3,000 (valuing it at 1.3x FY16e P/BVprice-to-book value), premised on the following: (i) a macro recovery will drive materially positive swings in slippages, credit costs and NPLs (non-performing loans), which investors have been worried about; (ii) cost issues are being addressedwe expect a 400 bps positive swing in cost/income ratio; and (iii) SBI has done well to hold on to its liabilities and margins in the down cycle, which should benefit it in an improving cycle. We expect an earnings CAGR (compound annual growth rate) of 28% over the next three years, with a medium-term RoE (return on equity) of 15%.

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Asset qualityimproving economy could create big swings: On the back of an improving macro outlook, we expect both slippages and restructuring to decline in FY15 (despite the weak trends in Q1FY15). A strong recovery/upgradation cycle from FY16 should drive a sharp NPL decline, resulting in lower credit costs. Average credit cost for SBI in the recovery cycle of FY06-09 was about 30-70 bps, but it has been running at 130 bps over the last two years. Normalised credit costs should result in a sharp earnings uptick over FY14-17e. A decline in slippages should also help the banks margins.

Rising comfort on asset quality; credit costs could decline sharply: We believe that SBI is among the top beneficiaries of an improving macro economy, where we are seeing a perceptible turnaround. An improving macro, stable to declining interest rates and a government working consciously to resolve critical issues in sectors like power, roads and other infrastructure should translate into a sharp improvement in all asset quality parameters: slippages will decline, recoveries will pick up and, as a result, credit costs will decline.

Big increase in slippages likely to be followed by a recovery cycle : Slippages have increased very sharply over the last three years, owing to (i) large agriculture slippages, accentuated by the late impact of the loan waiver of 2009; (ii) SME slippages due to a weak economy and late payment cycle by the larger corporate; and (iii) mid-market NPLs, again impacted by a weak economy, project delays and late payment cycles.

We see most adversities easing now: (i) the economy is looking up, which should result in payment cycles reducing; (ii) corporates are resorting to asset sales, driving comfort on asset quality improvement; and (iii) the loan waiver is now behind us and the monsoon has also picked up.

Restructured loans have already started to come off; pipeline is limited: In what we believe is a positive testimony to the banks ability to manage stress, restructured loans have remained constant at 3.5% of loans over the past few quarters, despite macroeconomic challenges. However, new restructured loans have started coming off from their peak, which is positive. Restructuring in Q1FY15 was down 28% y-o-y

and down 53% q-o-q. The pipeline for restructuring also remains limited.

Holding on to margins, despite higher NPLs: Despite huge NPLs, SBI has focused on its liability franchiseCASA and retail depositsand this has allowed it to sustain its margins at 3.5% (domestic margins). While we expect some pressure as interest rates decline, a fall in slippages should result in reduced negative carry and be positive for SBI.

Addressing concerns on costs; we like its focus: One of our key concerns about SBI has been its high cost/income ratio, which was skewed by its aggressive branch and manpower additions and owing to catch up for pension provisions. SBI has taken a few measures to address this: (i) it has slowed down its branch additions; (ii) retirements are now likely to outnumber new joiners; (iii) it has very tight control over non-salary costs; and (iv) retiral costs are now fully provided. We expect cost growth to be much slower than historical trends and this could result in improving cost ratios.

Worsening asset quality is the key risk: We are raising our FY14e/FY15e net profit estimates by 1-4% and TP by 9% to R3,000. The key downside risk is a further deterioration in asset quality.

Deutsche Bank