The spike in Indian Bank?s NPLs (non-performing loans) during the Q1FY11 was the key disappointment of the results; even though operating earnings were largely in line. During the quarter, Indian Bank?s NPL formation spiked to Rs 8.3 bn, almost 1.5x of the FY10 levels.

Indian Bank, clarified that the ?headline numbers? for restructured loans are still at Rs 52.4 bn against expectations that the restructured loan share declined sharply to Rs 14 bn (from Rs 34 bn in Mar 2010). As per the clarification Indian Bank got from the RBI, a restructured loan cannot be ?upgraded? even if it pays its revised principal and interest on time. It has to be classified as ?restructured? through the life of the asset. This implies that the ?restructured loans? would remain pegged at a substantially high number even while these loans may continue to be serviced. Many of the ?restructured loans?, in our opinion, are being serviced but remain classified as restructured owing to the definitional issues relating to them.

Hence, in our view, the focus would have to be on the relapse rate or the % of restructured loans that have become NPLs. The rest of the loans that are being serviced should have lower probability of being a NPL (if they pay interest and principal) even if they remain classified as ?restructured?.

Relapse rate may peak at <13-15%: For Indian Bank, Rs 4.1 bn (8%) of the restructured loans have become NPLs. But the encouraging part is that almost 65% of the restructured loans (Rs 34 bn) have finished a 12-month period and are paying interest and principal. Earlier, these would have been deducted from the ?restructured loans?, but now they are being shown as restructured as per the new clarification. But, as discussed above, the probability of these loans becoming NPLs is very low.

Only Rs 14 bn of the total restructured loans that are yet to finish a 12-month period. Hence, the total relapse rate from the restructured loan, in our estimate, may peak at <13-14%, even assuming an additional Rs 3 bn (20%) of the Rs 14 bn were to become NPLs.

The NPL spike, in part, has been due to moving to an online system generated NPL recognition method. As per the bank, the percentage of such loans could be as high as +40-50% of the NPL accretion. As per Indian Bank, there were many ?technical issues? in the NPL classification, resulting in a ballooning of the NPLs. Hence, it remains equally confident that NPL recoveries may be as high as Rs 6 bn (on analyst call) in the ensuing quarters.

Operationally, largely in-line: Indian Bank?s reported earnings of Rs 3.7 bn, 22% below estimates, driven by higher NPL provisions. But at the operating level, earnings were only <2% below estimates. This was partly driven by Rs 230 m of AS-15 and gratuity of Rs 82 m. Topline growth of 26% was only <3% below estimates driven by 31% loan growth and margins sustaining QoQ (quarter- on-quarter) at 3.7% and up 15 bps YoY (year-on-year). CASA also improved YoY and QoQ to 33% (up +280 bps YoY). Other income, ex treasury grew 20% YoY.

FY11/12 Outlook: We are cutting earnings by 8% for FY11 to factor in higher credit costs on the back of our revised NPL forecasts. Additionally, we are also penciling in Rs 1.5 bn of pension-related costs. Operationally, we are expecting margins to be better than estimated as CASA levels have been sustained. We are also raising loan growth estimates to 24% and expect a topline growth of 18%.