>INDIA BANKS (CITI)

1Q10 Results Review: Great Headlines, but Look Beyond Them

■ The headlines look great, but the fine print doesn’t — 1Q10, at first glance, looks great. Profits are up 56% yoy (highest in four years, 22% ahead of estimates), most stocks (not all) have gone up post results, and in terms of the outlook it appears to be business as usual. We do not believe all is that well. There are qualitative strains, the outlook remains a little uncertain, and operating pressures have risen. While some of these pressures might have peaked, the recovery might be a little slower and less certain than the market is likely extrapolating.

■ P&L: Fundamentally tough — The sector's profit surge is a trading gains/writeback phenomenon. Excluding these, pre-provisioning profits were down 5% yoy and –16% qoq, the lowest in four years. More importantly, they reflect strains in profit parameters: a) Margins: down a further 20bps (50bps from 3Q09 peak); b) Fees: growth down to +9% (–10% for private banks, third consecutive qtr of decline); and c) Costs: continued high growth, though predominantly for Government banks. The worst is probably over – margins should start firming up – but banks need a strong 2H10 for a quick bounce back in margins.

■ Balance sheet: Difficult, though under control — The overall balance sheet for the sector probably did better than expected: a) Modest and continued asset quality deterioration, but no alarm bells; b) Increased loan restructurings – actually a doubling to 4% of loans – but largely along guided lines (PNB was the big exception); and c) Loan growth – relatively flat over the quarter, but still up 16% yoy. Managements are relatively measured on asset quality – expect some pain, but generally manageable – and hoping for a 2H10 economic bounce-back, which would provide the growth, asset improvement and P&L support to reverse recent pressures.

■ Government banks taking the more aggressive approach — The Government banks are now growing faster, lending more aggressively and trading more actively than their private peers. This shows in their relative B/S and P&L trends, but more importantly leverages them even more to the economic outlook. We believe that a real 2H10 recovery would not favor the private banks (on a relative basis), recovery with stable rates would favor Government banks stocks, while a recovery with rising interest rates would tend to be more stock specific.

■ We believe relatively full valuations are discounting a recovery and would be a little cautious here — Bank stocks seem to be already discounting a recovery in 2H10, which we believe is a little early and would be a little more cautious (though still overweight) here. Preferred picks are SBI, HDFC Bank, Yes Bank and Corporation Bank.

To see full report: INDIA BANKS