PSU bank valuations have corrected, PBV multiples (1.3x one year forward) and discount to private banks (~50%) are now in line with the five-year mean. Though more attractive, current multiples are well above the trough (0.6x PBV Mar ?09, previous macro down cycle). Structural business improvements should limit downsides but upsides are linked to uptrends in macro (currently an overhang). Meanwhile, we retain our bias for private banks (Axis top pick). Within PSU banks, we remain selective ? preferred picks: State Bank of India (strong deposit franchise, likely NIM improvement) and Oriental Bank of Commerce (low valuations); avoid mid-cap PSU banks (Union). Our India strategist Aditya Narain remains overweight on banks.

We are closer to getting more positive on PSU banks, but would still wait for initial signs of macro upturn (big upsides correlate with low inflation, easy liquidity, high loan growth); moderation in cyclical pain (margins likely lower in Q1 FY12); and reduction in NPA formation (top-down overhang, partly priced in, but could worsen if macro deteriorates).

PSU banks have come a long way since 2006, having increased market share (up 7 percentage points for covered banks), improved loan pricing/mix (higher loan spreads), reduced cyclical dependence on bonds (higher LDRs); and gained operating efficiencies (cost/assets down 50bps, leveraging technology). Some gains are structural, fundamentally stabilising return profiles (lower bond gains). Loss of funding franchise is the key negative in our view, increasing sensitivity to liquidity and NIM volatility. Overall, we believe the structural improvements provide PSU banks a higher valuation floor, but up/down swings in growth and profitability, will remain leveraged to the cyclical.

We expect Indian banks to see healthy loan growth and reasonable pricing/profitability. But there will be challenges like more competition with likely new bank licences, higher core capital requirements that could moderate leverage, ROEs and challenging funding mix, and low CASA and high LDRs are set to accentuate cyclical gains/pains.

Valuations for Indian banks have corrected recently, especially for PSU banks (down 10% vs +1% for the Sensex over the last three months). PBV multiples for PSU banks are now in line with five-year historical averages (FY06-FY11) ?1.3x one-year forward PBV. The discount to private sector banks has also widened recently to 50% and is now in line with its five-year mean.

While valuations have become more reasonable, they are still not cheap in a historical context and are certainly well above their trough in the previous macro down cycle (they traded at 0.6x PBV in March 2009). The discount to the private sector banks has also been higher at times (peaking at 61% in March 2007). While we believe downsides from current levels should be limited, there is a possibility of further pain, especially if the overall macro and asset quality environment deteriorates from here.

Public sector banks have relatively higher leverage to interest rates, dependence on liquidity and a top-down overhang on asset quality. These can increase earnings volatility significantly, especially if the inflation, liquidity and interest rates remain high for long periods of time.

Higher macro leverage on operating fundamentals also reflects on stock performance and valuations of public sector banks. Historically, the most upsides for PSU bank stocks have come during periods of easy liquidity, high loan growth and improving asset quality performance.

We believe the current environment is still uncertain and visibility of near-term improvements in macro remains clouded.

Moreover, there is also likely to be a near-term (Q1 FY12) moderation in operating fundamentals for most banks ? loan growth is likely to grind downwards; NIMs should come off 10-20 basis points in Q1 FY12; and the asset quality environment remains uncertain with incremental slippages being at elevated levels for most PSU banks (mostly from agriculture and restructured accounts).

Overall, while valuations are now more reasonable, we would wait to see initial signs of a turn in the macro (likely to be seen in easing liquidity or lower inflation) and moderation in near-term operating pain, before turning more positive on PSU bank stocks. Meanwhile, we retain our preference for private banks with large deposit franchises. We remain selective with public sector banks and prefer SBI (reasonable valuations) and OBC in this space.

We are also revising our earnings estimates and target prices for public sector banks, incorporating recent results, moderation in net interest margins and loan growth, as well as recent capital infusions from the government.

PSU bank stocks have significantly outperformed the broader Indian market over FY06-FY11, with Corporation Bank and OBC being the only exceptions. The best performances have come from the larger banks ? Bank of Baroda has been the stand-out performer, followed by Union, SBI and PNB, in that order.fe

Key factors for the outperformance have been improvement in return profile and growth in book values. Dividends don?t seem to have been a significant differentiator/driver of stock performance. Notably, stocks have outperformed despite a de-rating in valuation multiples during this period, with BoB and SBI being the only exceptions.

Citi