Valuations, EPS growth are concerns for investors comforted by long-term investments

By: | Updated: April 3, 2017 4:04 AM

Economic Activity saw small improvement in February led by foreign trade and consumer indicators — especially Autos. Activity Index growth 3m m.a. improved to 0.8% vs 0.3% in Jan.

Economic Activity, consumer indicators, Activity Index growth, Electricity, Oil, 2W, Coal offtake, Oil consumption, FII Economic Activity saw small improvement in February led by foreign trade and consumer indicators — especially Autos. Activity Index growth 3m m.a. improved to 0.8% vs 0.3% in Jan. (Source: IE)

Most investors saw valuations & weak earnings growth for the sector as an immediate headwind. But there was comfort with the longer-term investment thesis driven by government initiatives — with the recent UP election win adding to the longevity of the government at the Centre. Power sector NPLs and ‘bad bank’ were discussed along with an update on demonetisation. SBIN is our key buy recommendation within banks.

Earnings growth vs. Valuation doesn’t gel well: Most investors while acknowledging the better long term fundamentals were somewhat concerned with the lack of earnings growth and premium valuation of the sector, in line with our assessment. While the liquidity inflow to DIIs could remain high in the near term, we don’t see the current environment as a good opportunity for adding to the stocks. A look at the change in consensus EPS forecast for next year on both one-month and three-month basis reflects EPS downgrades across stocks except the power financiers.

Power sector overhang needs a faster asset quality resolution: Investors were concerned about the lack of asset quality resolution which could stall the medium term loan growth for the banks. With 12.4% in aggregate NPL with restructured assets, along with another 1.5-2% in other stress asset buckets (5/25, SDR, S4A etc.), such concerns do seem legitimate. Power sector issues did come up for intense discussion. We highlighted our concerns of significantly weak power sector demand, falling Plant Loan Factor (PLF) and weak merchant pricing which would impact interest service capability of the existing/operating power plants. Within this context, the ~20 GW of additional thermal power capacity (coal & gas based) coming online in private sector and 40-50 GW in public sector could increase the headwinds.

‘Bad bank’ a necessity now? We think so. But expect large capital issuance: On the contrary, we highlighted that should the government manage to structure a ‘bad bank’ or asset management company for the stressed assets, which will most likely include the distressed power sector assets, balance-sheet clean-up of banks will get a major boost. We believe with the RBI, bureaucrats in Department of Finance Services, and the NITI Aayog all talking the same language, the government could be panicking given the stressed portfolios and hence a ‘bad bank’ structure could be a reality sooner than later.

Falling loan growth doesn’t augur well with NIMs: In our opinion, both SBIN and ICICIBC publicly suggesting that they don’t expect to see any hurry in increasing lending rates is the clearest indication that loan growth is weak. Further, a weak loan-to-deposit ratio is also bad for NIMs.

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However, a lower savings rate could lift near term earnings: On the other hand, with falling L/D ratios, weak loan growth and compressing spreads, banks are looking at the possibility of lowering the savings interest rate. Most banks currently offer 4%, while some of the Private sector banks offer a much higher rate. A 50 bp cut in savings rate would result in ~8% improvement in the sector’s core pre-provision operating profit.

Demonetisation — is the event risk behind us now? Give it a quarter more: Demonetisation as a topic figured much less in our conversations. We believe lenders could see an increase in NPLs in the small ticket retail/SME segment. This will be largely driven by the earlier postponement of asset classification wherein RBI had provided a 90 day window during the demonetisation phase. In our opinion, this is still a grey area, and should the March & June 2017 quarter not reflect in any heightened increase in NPLs, we have to concede that the Indian economy and borrowers managed to work their way through the black-swan event relatively unscathed.

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