State Bank of India
Rating: Underweight
The SBI management is doing well at trying to improve ROE (return on equity). But at 1.4x book, the market is pricing in a very strong economy and 15-16% sustainable RoE. This is unlikely to be achieved as leverage declines (higher capital) and RoA (return on assets) normalises. Move to UW (underweight). We expect sustainable RoE to average 13%, driven by two factors:
(i) Leverage: This has averaged 18x over last 10 years with relatively lower capital needs. But, with new capital norms, SBI needs to raise $10 bn of equity over five years. This would cap leverage at a max of 14-15x. Normalising historical RoE for 15x leverage would cause a decline of 3ppt (percentage point) to 12.7%.
(ii) RoA: Historically it has needed big bond gains and very low provisioning to get RoA >1%. Neither is likely over the next two-three years. We assume average RoA of 0.8% over the next two years. Big growth pickup is not likely either: At the consolidated level, market share in loans is down to 22% from 26% ten years back. The loan growth slowdown has been acute at subsidiaries– driven by lack of capital.With capital hard to come by, the subsidiaries will struggle to grow.
We would own private banks: As we move to the second stage of the rally, investors will pay for banks which show a capacity to grow (similar to the 2004 cycle). This implies private banks should outperform given an expectation of continued market share gain.
SBI is trading at 1.4x book– can it expand from here? We believe it’s unlikely. A look at what current multiples imply in terms of long-term profitability. We commend the management team for trying to improve profitability by working on costs and keeping the spreads high. This will help raise ROE from current low levels. But, in the new regulatory environment of higher capital need, we expect the stock to trail the industry returns as investors start focusing on profitability and revenue growth capacity.
Long-term growth outlook is weak: Over the last few years, SBI has been losing share in system loans at an aggressive pace. At the parent level, the market share has fallen – but at a slow pace. But, at the level of subsidiaries, market share loss has been exceptionally fast. As of Q2FY15 loan growth at almost all SBI subsidiaries was less than 10% –and it was sub-5% at three of the largest ones.
This continuous deceleration in loan growth has been driven by weak balance sheets, especially with low capital ratios. Even at the parent level, loan growth has been weak – given the need to preserve capital. Since the bank’s valuations are pricing in a reasonable pickup in growth momentum, we believe it will be tough, in the absence of a big dose of capital injection by the government.
We expect this cycle to be similar to the 2004-2008 cycle: Initially, it was about taking tail risk out from the system–reflected in 2004 performance, where state-owned banks outperformed private banks. However, after that it was about banks that could grow— and those banks (private) outperformed the others (state-owned) materially. SBI is not pricing in a tail risk anymore—in fact, it is pricing in growth. Thus, we expect underperformance.
Looking at RoE decomposition–rules of the game on leverage have changed: The average RoE that SBI has reported over the last 10 years has been 15% on a consolidated and parent basis. This was fairly strong compared with private banks. For instance, the best in class, HDFC Bank, averaged 18-19% over this time period and ICICI Bank has been lower. However, over the next two years, while we expect other banks to show a material pickup over the last 10 years’ average, we project that SBI and other state-owned banks will lag cost of capital.
*The stock has been downgraded
By Morgan Stanley