The recent stock correction in PSU banks (-27% YTD–year-to-date) has made valuations attractive and their risk-reward profiles appear extremely favourable. Stocks are now trading at 0.4x-1x FY16e P/B (price-to-book value) for a likely near-term RoE (return on equity) of 10-14%. Although NPL (non-performing loan) challenges may continue in the near term, valuations are closer to distress and more than factor the NPL effect.
We are turning more positive on PSU banks given their distress valuations, which now factor low (8-12%) RoEs and extremely high credit costs (120-200 basis points) perpetually. We prefer larger names such as SBI, PNB, Bank of Baroda. We upgrade BOI to Buy (from Hold) and Canara Bank to Hold (from Sell) following large underperformance.
Current stock prices factor in extreme pessimism: Our analysis suggests perpetually lower long-term RoEs of 8-12% vs. current levels of 10-14%, with credit costs perpetually around 120-200bps, while our assumptions are in the 90-150bps range for FY16/17. We believe market expectations for these credit costs assume an extreme distress situation.
Despite our fairly conservative assumptions and our CoE (cost of equity) assumptions of 14-15%, which are much higher than for private banks, we find meaningful upsides (30-50%) for our PSU bank universe. Further, we believe most of the stress is largely recognised (either restructured or NPL) and that stress should start moderating from FY16 onwards following a weak Q4FY15.
Government focusing on improving governance in banks: We like that the government is working to improve governance standards at PSU banks. It is increasing due diligence for their top management, opening them to management from the private sector, and looking to set up a bank board bureau, all of which gives us some confidence that the government seems to be addressing the key problem, though it could be argued that the process is taking more than appropriate time.
Stricter moves by the government/RBI—especially on the proposal to enact a bankruptcy law–can go a long way towards resolving some stressed assets quickly. Even RBI has made norms stricter by not allowing restructuring from FY16 onwards, making asset sales tougher on SR (security receipts) basis, and introducing the SMA 1/SMA 2 (special mention accounts) categories.
Credit costs and slippages should trend lower from FY16: We are in the sixth year in the downturn. Banks have already recognised 9-14% of the loans as NPL and another 4-8% as restructured over last five years. Accordingly, they have taken P&L (profit& loss account) charges of 6-9% of loans over the last five years. Although these higher credit costs may continue in the very near term, an improving macro could even lead to sharply higher recoveries and much lower credit costs, although we do not factor that currently.
Long-term argument favours private banks: Over the longer term, we continue to favour the private banks, as they have better growth and profitability. Private banks have made significant investments in distribution and technology and should steadily gain market share from PSU banks. However, on an absolute basis, we believe that the current attractive valuations should see upsides for PSU banks.
Valuation and risks: We value the lending businesses on two-stage residual income model. Upside risk is lower NPL formation; downside risk is a weaker macro environment.
Upgrading Bank of India to Buy: We upgrade Bank of India to Buy from Hold, mainly as a result of attractive valuations (0.4x FY16e book) and an improving macro, which could result in improved recoveries. We reduce FY16e/FY17e earnings by 10% and our target price to R250 from R275. We expect margins to improve, slippages to decline, and treasury gains to increase for Bank of India. Earnings CAGR (compound annual growth rate) will still be fairly strong at 27% CAGR over the next two years.
Upgrading Canara Bank to Hold: We upgrade Canara Bank to Hold from Sell, as we believe its valuation of 0.6x FY16e book remains comforting and the downside remains limited from current levels. We reduce FY16e/FY17e earnings by 10-12% and our target price to R390 from R410. Its large treasury book should provide gains as bond yields come off.
Risk-reward is now favourable: Although we still prefer private banks over the long run, we now believe there is enough value in a few of the smaller PSU banks to make a positive investment case. A slight improvement in the economy and some bold measures by the government could lead to a sharp increase in valuations. With valuations at 0.4-1.1x FY16e BV (book value), even moving closer to book could result in big gains for the smaller banks. For SBI, we believe it is a long term 14-15% RoE business and could trade at 1.3x book (its capital needs are low).