>KARNATAKA BANK (JM FINANCIAL)

Satisfactory Performance

■ 4Q’09 PAT up 37% yoy: 4Q’09 PAT of Rs 831 mn is up 37% yoy and is 26% above our estimates. This is primarily on account of significantly higher treasury income of Rs 950 mn booked during the quarter and lower than expected provisions.

■ Significant moderation in advances growth: Loan book witnessed growth of 9% for FY09.This was primarily on account of 1) management turning cautious in an uncertain environment 2) bank’s focus on containing delinquencies. We favour KBL’s strategy to moderate growth in an uncertain environment and believe this move should benefit the bank in controlling delinquencies going forward. For FY10E management has guided for strong growth of 27% which looks unlikely to us. We expect loan book to grow by ~17% over the next two years.

■ Margin surprised negatively: Margins decline of ~40 bps in FY09 was a negative surprise (2.22% in FY09 vs ~2.6% last year). However, this was primarily due to the fact that the bank was unable to meet direct agricultural sector lending target and consequently had to invest ~Rs 10 bn in RDIF deposits (earns interest of ~4%) which impacted margins adversely. Further, decline in loan deposit ratio by 5.4% yoy to ~58% also impacted margins negatively. CASA continues to remain weak at 21% and the management intends to improve it by ~300 bps in FY10. We forecast margins to improve by 20bps over the next two years driven by 1) repricing of deposits at lower rates 2) improvement in CASA mix to ~23% by FY11E 3) Improvement in loan deposit ratio by 150 bps.

■ Improvement in asset quality but restructured assets at ~4.2% of advances: Asset quality improved sequentially for KBL with gross and net NPL declining 2% and 31% respectively on an absolute basis. Coverage ratio improved from 63% in 3Q’09 to ~74% during 4Q’09. However, the bank has restructured accounts amounting to Rs 4.8 bn in FY09 and there are further pending applications of Rs 0.1 bn, totaling to ~4.2% of advances. Most of these loans are standard currently. Delinquencies remained stable in FY09 at 1.5%.Going ahead, we believe that delinquencies could increase to ~190 bps over the next 2 years which would lead to LLP of 76 bps in FY11E vs. 41 bps in FY09.

■ Revision in estimates: We cut our FY10E and FY11E earnings estimates by 9% and 13% respectively driven by slower loan growth and lower than expected margins. We now forecast profits to decline by 3% in FY10E. We expect the bank to report ROE of ~15% over the next 2 years. We have assumed dilution of 13% at price of Rs 125 per share in FY10E.

■ Solid franchise at attractive valuation: KBL is one of the cheapest private sector banks in India, trading at P/BV of 0.85x FY11E. Given the expected return ratios and valuable franchise, we believe KBL is an attractive value pick. Based on a normalised ROE of 16.1% (earlier 17%), we value the stock at 1.06x book (earlier 1.4x), implying May’10 target price of Rs.170 (earlier Rs 190).

■Risks to recommendation: Higher than expected delinquencies is the key downside risk to our recommendation.

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