>INDIAN BANKS' VALUATIONS (DEUTSCHE BANK)

How blue is my sky

■ Advising caution - we could be pushing the limits in valuation
An in-depth study of valuations of Indian financials from the fundamental, cyclical and regional standpoint, as well as multiple sensitivity analyses re-inforce our belief that the sector could be stretched. This in turn implies that positive performance now becomes almost wholly dependent on continued strength of market liquidity. While news flow may not be incrementally negative, material risks remain. We retain our relative preference for private banks.

■ Historical and regional context: valuation cushion seems to be thinning
Indian banks have outperformed regional peers recently and even the valuation expansion has been higher. Private banks are trading at a lower-than-average premium to Bankex, whereas PSU banks’ discount to Bankex has narrowed. Nearly all banks are trading at higher than historical average valuations. Almost all banks are trading at or above the “recovered” valuation in 2004 when the sector last rode out of a downturn. We have also applied Chinese new business multiples
to Indian insurers, even though the former are more profitable.

■ Need aggressive assumptions to justify higher TPs or even current prices
We demonstrate that present stock prices do factor in elevated levels of expectations, except HDFC Bank and PNB. TPs increase by 0-23% under bullish assumptions, not good enough to offer a cushion. A rollover to FY11 as the base leads to positive upside only in three out of 13 cases. Meaningful positive upsides are obtained only when we apply historically highest-ever valuations or highestever premium to Bankex, and to a lesser extent the “recovered” valuation of 2004. Overall cushion appears to be high for HDFC Bank and low for SBI.

■ Key valuation drivers do not support peak-cycle valuations
Outlook for benchmark interest rates – generally a powerful short-term driver of bank valuations – is no longer benign due to large government borrowings and rising inflationary expectations. RoEs face several challenges, particularly for rapidly growing banks. We also demonstrate the interesting strong correlation between earnings volatility and valuations, but also do not see reasons for the volatility to go down in the near future. Structural drivers such as new products, consolidation and legal changes are also unlikely to be forthcoming.

■ Valuations and risks
We value lending businesses on the Gordon Growth model, insurance on appraisal value, asset management on % of AUM and other non-banking businesses on P/E. The key risks to our pessimistic stand are strong flows, particularly in the context of the progressively reduced foreign investor positions in Indian financials relative to benchmarks, and a significant drop in cost of funds improving margins sharply.

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