>BANKS-RETAIL (MERRILL LYNCH)

1QFY10: Bumper profits; but margins hit trough

■ 1QFY10 earnings driven by trading profits; top line was weak
1QFY10 earnings were quite a mixed bag. Reported earnings growth was very strong ranging from 20-50% for most of the banks (and even +100%); beating our estimates by 10-40%. But earnings quality was somewhat weak, as most of the growth came from a jump in trading profits (30-60% of PBT) as banks benefited from high equity gains and trading G-secs during the quarter. In contrast, top-line (net interest income) growth was modest at 10% was a function of a) Margin collapse, especially for govt. banks; and b) Moderation in loan growth.

■ Margins collapsed as incremental LDR fell to 14%; Fees was the silver lining
The margin collapse can be traced to 3Q of FY09 (when banks’ refused to lend) and continued through Jun’09. Govt. banks are more impacted, as they got much higher deposit inflows during 3QFY09, esp. SBI, while loan growth moderated, saddling them with excess liquidity. The impact of this became very visible in this quarter, as incremental LDR fell to an 8-year low of
14%. Most govt. banks saw 40-60bps qoq margin compression. The 20-40% rise in fees (govt. bk) from technology benefits that helped offset higher opex was the key positive. In contrast, private banks contained costs while fees slipped.

■ Future outlook: Margins have bottomed out; LDR set to rise
Margins are set to expand sequentially, owing to a) Rising LDR that would allow banks to re-deploy their lower-yielding G-secs towards loans; and b) Re-pricing of their high-cost deposits from Oct’09 onward. The LDR will rise owing to a likely pick-up in
credit, driven by greater infra lending; a likely pick-up in housing (by year-end) and, most importantly, due to the cyclicality of the economy (60-70% of all loans are disbursed in 2H of any fiscal). Hence, core earnings should begin to improve; though reported earnings may continue to seesaw (weak 3Q on high base effect; followed by a very strong 4Q).

■ Buy ICICI Bk, SBI, HDFC Bk
Post results, SBI appears amongst the better positioned to see large margin expansion, having raised low-cost funds and likely to grow loans at 20%. ICICI Bk, while disappointing on the top line, delivered ahead of expectations on its B/S profile and is also well positioned for future growth (missing piece) and challenges. HDFC Bk may end the year with highest growth
despite a weaker top line. Amongst govt. banks, PNB and BOI appear to offer the best risk/return.

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