>INDIAN BANKS (CLSA)

Coming of age

Private banks will emerge stronger

Despite the growth and asset-quality issues facing global financials, Indian banks are likely to sustain their structural growth trajectory, driven by an under-penetrated financial-services sector, a conducive economic environment and a supportive regulatory regime. We estimate a 17% credit Cagr over FY09-14 and believe the current credit cycle is fairly manageable.

Over the next five years, bond-market development will lead to commoditisation of credit and margins will mainly be a function of retail liability franchise. As the distribution network and technological infrastructure become basic requirements - which are insufficient to drive profit on their own - softer skills such as service standards and product innovation will be critical to enhance the franchise. Fee growth is likely to be healthy as a pickup in corporate activity further boosts retail-fee momentum. We expect industry consolidation to continue, but big-scale M&A activity is unlikely. Meanwhile, Tier II public-sector-undertaking (PSU) banks will lose market share at a faster pace. However, regulatory relaxation will help improve the industry’s overall profitability.

Private banks are better positioned to leverage the changing industry landscape, as their superior servicing skills and innovation will drive market share gains in retail liabilities, allowing wider margins. Their ability to generate higher fee revenue means a wider ROE differential between them and the public banks. Our customer survey of 100 small/medium enterprises and 300 individuals highlights evolving customer preferences, suggesting that private banks’ market-share gains are structural. Although a few PSU banks have bridged the technological infrastructure gap to some extent, our on-the ground study suggests that they are significantly lacking on the more important soft skills.

Private banks will continue to grow earnings ahead of their PSU counterparts over the next five years, even as the diversity in profitability increases. We expect the ROE differential between the two segments to expand to 500- 600bps, leading to further widening of valuation multiples. On a three- to five-year investment horizon, we prefer private banks, especially ICICI Bank and Axis Bank, which still offer rerating potential on the back of their improving liability franchise. Be selective on PSU banks, where management continuity remains the key risk. We prefer only Tier I PSU banks for long-term investment. Some non-banking finance companies (NBFCs) like Housing Development Finance Corp (HDFC), Infrastructure Development Finance Corp (IDFC) and Reliance Capital can deliver returns over the longer term as they have built strong liability franchise and domain expertise.

Investment ideas
Our analysis of long-term returns indicates that private banks offer the best positioning to play the continuing story of the Indian banking sector. Their low market share, coupled with their ability to gain more, promises sustained healthy growth trajectory over the next five years. In our view:

■ Private banks could rerate, barring a couple of banks that trade over 4x, even from current levels, as they sustain their healthy earnings growth trajectory and report improvement in ROE.

■ Returns on public-sector banks will vary significantly as the valuation range expands, unlike in the past when most PSU bans have traded in a narrow band. We believe select PSU banks could re-rate marginally from current levels as they maintain stable earnings growth with high ROEs.

■ Short-term variations in the overall-return scenario are possible, especially given the triggers in the form of movement of bond yields (especially for banks like Oriental Bank of Commerce and Corporation Bank, which have a higher proportion of holding in non-held to maturity (HTM) category and are vulnerable to mark-to-market hits), NPL issues (corporate blowout might lead to short-term underperformance for the lead bankers) and other near-term factors. However, in our view, longterm sustainable stock returns are likely to revert to about 20% for private banks and to mid to high teens for well-run PSU banks.

■ Excluding a structural slowdown scenario for the Indian economy, ICICI Bank offers the best risk-reward from a three- to five-year perspective owing to its presence across the financial-services space. ICICI Bank has recently reorganised its operating structure, aiming to improve
profitability, a move that may address the long-due investor concern of frequent equity dilution, stemming from sub-par profitability metrics. Trading at a discount to most of its peers, ICICI may see a structural rerating, if it is able to demonstrate an improvement in its operating metrics to match up with its peers. Over time, we expect ICICI to expand its footprint further into rural banking, micro credit, and even explore overseas M&A. A sharp economic slowdown can expose ICICI to faster changes in its business environment than it can manage, leading to structural pain points like NPL.

To see full report: INDIAN BANKS