Despite some positives in recent months, a turnaround in the economy is unlikely before FY18
We remain cautious on Indian banks after a muted Q4 for the private banks. The weak economy continues to reflect in corporate asset quality and we do not see an imminent turnaround. Though some positives are coming through, they do not point to a definitive turnaround before FY18, which is too far out. We retain our preference for low NPL (non-performing loans) banks such as HDFCB and IIB; we see value in Axis and ICICI and continue to avoid PSUs.
Sector strategy: Our top picks remain HDFC Bank and IndusInd —strong EPS compounders, which support elevated valuations. On Axis and ICICI, we see value but expect volatility over the next two to three quarters—we would accumulate slowly or pair with PSU banks. We remain negative on the PSU banks as our macro view indicates continued asset quality stresses.
Q4FY16 trends: Q4FY16 earnings were weak with the better banks reporting. (i) Headline numbers were disappointing with four misses and three in line, (ii) Revenue growth remained weak, despite market-share gains from PSU banks—weak fees being the main culprit. (iii) Asset quality was largely in line, with ICICI/Axis’s stress disclosures the main talking point.
Reforms—LT positives: There has been positive progress on reforms in the last few months. It started with the RBI AQR (asset quality review) which sets the stage for greater transparency and quicker NPL resolution. The government has pitched in with the Bank Boards Bureau to professionalise PSUs and the new bankruptcy code. All these measures strengthen the institutional framework, but are also long-term measures—we think the impact on this cycle will be limited. We think that the turn in the asset quality cycle (the key catalyst for the sector) is almost completely dependent upon accelerating growth.
Challenging macro: There have been some immediate positives over the last few months—domestic steel prices have turned around, there’s less stress in the power sector, corporate deleveraging is progressing. However, the recovery is slow and protracted—we do not see a meaningful improvement in the economy before FY18. There is no joy from interest rates either—we think any material down-step in rates is likely in FY18 after the RBI has fully transitioned to a liquidity-neutral environment.
Our top picks remain HDFC Bank and IndusInd—strong EPS compounders which support elevated valuations. On Axis and ICICI, we see value but see “sine-wave” volatility over the next 2-3 quarters—we would accumulate slowly or pair with PSU banks. We remain negative on the PSU banks as our macro view indicates continued asset quality stresses.
We like the low NPL banks for three reasons: Earnings visibility and momentum: The key advantage of these banks is their dependence on a robust economy and strong system growth is minimal. Their diversified revenue streams and secular market share gains “protect” the growth rates. Strong deposit franchises ensure stable margins and, thus, EPS growth remains robust and stable.
Visibility of earnings is a significant factor for these banks. Low NPLs translate into fewer lumpy earnings shocks, especially because these banks have diversified loan exposures with low concentration risk. India’s staccato NPL provisioning drives significant earnings opacity, which these banks elude.
Valuations are elevated, but these are supported by strong earnings growth—the key driver of stock performance has been EPS/BPS compounding rather than valuation changes. As long as growth and quality are maintained, we see little risk to valuations.
Stock preferences: HDFC Bank and IndusInd remain our top picks. We do not see these as defensive stocks—these are high quality growth stocks with robust and visible earnings profiles. We see absolute returns, not just downside protection. For Kotak, our Neutral rating is largely because the 25x F17 EPS looks too high—we see some time correction before the stock starts to perform. We continue to like the bank from a 2-3 year perspective, and see it as one of the best quality banks in our universe.
Bank Boards Bureau
We think the Bank Boards Bureau (BBB) is a positive step towards reforming PSU banks. It facilitates progress towards making the banks linearly accountable to their boards and should also improve board oversight in due course. The impact will be, however, long-term as the process is likely to take some time to complete,
in our view. The three areas we see as the key positives are: Efficient capital allocation: Capital allocation is now likely to be determined by the BBB rather than the FinMin. This should facilitate a system where capital is earned by better performance rather than pure shortage, and create an incentive structure for the PSU banks to focus on performance. The only caveat is that the immediate needs of some of the weaker banks would have to be met, as in FY16.
Commercialising decision-making:The other contribution of the BBB is likely that the PSU banks can now focus more on profitability and commerciality a little more. The BBB could create incentive structures that reward profitability, and this would be a positive. The process, again, could take 2-3 years as the businesses realign.
Aggressive resolution: One immediate area of impact could be a framework to resolve NPLs. PSU banks suffer from their employees not being empowered enough to sign off on the write-offs necessary to resolve existing NPAs. A caveat, however, is that this framework may be possible only after a holdco is created, which would need legislative approval.
Strong legislation: The bill is comprehensive and leaves little ambiguity on how resolutions should be reached. It covers most aspects and unifies all creditors on a single platform, which should serve to streamline the process, in our view.
Time-bound schedules: The tight timelines address the biggest weakness in the system—delayed processes. It also leaves little room for banks to postpone problems due to fears of recognition. The tight schedules should also avoid issues where the company bleeds due to lack of attention once the business turns stressed. Timebound resolution is especially important in a high-inflation, high-interest rate economy.
Not an immediate panacea: The Bankruptcy Bill will take time to implement, in our view. The infrastructure will have to be built carefully, and the ecosystem could take 1-2 years to resolve. Also, we think the judiciary has to be engaged in the process so that resolutions do not get delayed by litigation.