We upgrade our rating to Buy with a revised TP of Rs 600 (21% upside potential) as we believe that: (i) major NPL recognition is largely over, and coverage at ~60% is comfortable — a higher number would be preferable. There is a strong likelihood of near-term stress from the power sector, but this is known and expected, (ii) valuations have corrected 40% from the peak while they have expanded for the sector in general; the stock has seen a major underperformance of >30% vs. Bankex in the past 12 months, (iii) the business model has now become more retail-oriented, which should support higher valuations, (iv) growth & earnings should revive from FY19 (we expect 16% loan growth and 38% PAT growth in FY19), and (v) the market seems to be currently ignoring its subs’ value, which is worth about Rs 51/share (10% of market cap).
Overall, at 1.7x FY19e core book for a 16-17% medium term RoE, and with the NPL cycle in its final stages, we find risk-reward very favourable; Buy A long NPL cycle is seemingly peaking now; FY19 will be the year of change: Over the last six quarters, Axis has been aggressive in recognising NPLs and we believe that, barring power sector stress, most large ticket NPLs have now been recognised. Of the total reported stress (10% of loans), 62% is now recognised as NPLs vs. 58% in FY17 and 18% in FY16. In the power sector, which is 69% of the watch list now, we expect more recognitions and this may result in higher slippages in the near term, post which we expect slippages to sharply trend lower. With some of the recent NCLT cases likely to come up for resolution in early FY19, the incremental provisioning requirement could decline sharply. We expect credit costs to decline from 334 bps in FY17 to 215/135 bps in FY18/19. Consequently, RoAs and RoEs should bounce back to 1.1/12.5% in FY19 and 1.3/14.5% in FY20.
Business model getting better: higher share of retail is de-risking balance sheet—Axis Bank has also transitioned towards becoming a retail bank on both the asset and liability sides. Its CASA ratio has now reached 51%+ (among the highest) vs. 45% two years ago. Similarly, the share of retail assets (SME + retail) is now 58%. The retail business is growing >20%, and as concerns on its corporate book gradually decline, we expect valuations to improve.
Valuation and risks: We now value Axis on an SOTP basis with a revised target price of `600 (21% upside potential). We value the core bank on a two-stage residual income model. Assumptions: income CAGR 16%, a dividend payout of 14%, CoE 13.19% (DBe), terminal growth rate = 5%. We value the AMC business as a percentage of AUM and the rest on P/E. Key risks: higher-than-expected slippages on account of a further weakening in economic conditions.