>INDIAN BANKING: The New Guideline: Introducing the Base rate (FIRST GLOBAL)

RBI’s micro-management moves and their likely impact on bank margins

Shift in credit pricing from Benchmark Prime Lending Rate (BPL R) to Base Rate as minimum lending rate for banks…

Teaser home loan rates come to an end…Margins of banks, particularly PSBs, to come under strain

The Reserve Bank of India (RBI) has decided to take a more activist (or micro-management) role in management of banks including the pricing of credit facilities and the calculation of interest on deposits. A series of moves it has undertaken to this end will have significant implications for the banking sector, from margins to relative competitive positioning of banks. The RBI recently released a draft circular that provided new guidelines for increasing transparency in credit pricing, wherein the Benchmark Prime Lending Rate (BPLR) will be replaced with the Base Rate from April 1, 2010 or FY11. This marks a significant development for the Indian banking industry, as it will change the way banks calculate their lending rates and sub-PLR lending will now come to an end. Presently, there exists a wide disconnect between the BPLR and actual rates For instance, the actual lending rate for Public Sector Banks (PSBs) in September 2009 stood at 4.25- 18%, as against a BPLR of 11-13.5% for the same period. The same pattern existed for Private sector banks and Foreign sector banks as well. Thus, the BPLR failed to represent the actual lending rates, as well as respond to the changes in monetary instruments (a decline of 275-425 bps in the policy rates was followed by a lower than proportionate decline in the BPLR of public, private and foreign sector banks. PSBs reduced their BPLR by 150-275 bps, which was higher than that of its counterparts, partly due to the moral pressure exerted by the Central Bank). Once banks calculate their base rate according to the method recommended by the Working Committee on BPLR (Chairman: Shri Deepak Mohanty) (as shown in the illustration attached in the Annexure), the rate will work out to around 8-9% for a majority of the banks. This could make the base rate more responsive and ensure transparency in credit pricing.

To our mind, banks that have a higher proportion of CASA deposits, lower costs as a percentage of assets, and are technologically upgraded, are likely to have a lower base rate, thus enabling them to price their loan products more competitively. Big banks that enjoy economies of scale could increase their business at the cost of some inefficient and small banks. On the home loans front, teaser home loan rates are likely to be withdrawn by the end of FY10, though the margins of banks, particularly PSBs, will come under strain. Moreover, the regulatory requirement for providing interest on savings deposits on a daily balance basis will come into effect from FY11, which will lead to an increase the interest expenses of banks. That said, the RBI has actually gone for micro management of the banking industry and full implications of its move will be clear only after the finer details of the circular is released. Also, it remains to be seen what mechanisms the market
throws up to counteract the RBI’s push to banks to move towards a what is essentially a ‘cost-plus’ model. We do not rule out unintended consequences coming into play here.

The New Guideline: Introducing the Base rate

■ Intended Purpose: To increase transparency in credit pricing and address the shortcomings of the BPLR system

■ The Guidelines: The base rate is proposed to be calculated by including the cost of deposits, cost of maintaining the statutory liquidity ratio and cash reserve ratio, cost of running the bank, and profit margin. This will be the minimum lending rate for banks. Hence, the actual rate will depend upon the base rate plus borrower specific charges, which will include product specific operating costs, credit-risk premium, and tenure premium. Moreover, the guidelines direct banks to disclose their base rate on a quarterly basis and ensure that the interest rates charged to the customers are non-discriminatory in nature.

■ Expected Outcome: The RBI expects an increase in credit flow to small borrowers at reasonable rates at the current stipulation of BPLR, as the ceiling rate for loans up to Rs.0.2 mn has been withdrawn. Also, the base rate of banks will now decline to the single digit (as shown in an illustration by the working committee group using data for FY09, the base rate works out to 8.55%).We have attached the Illustration of the base rate calculation in the Annexure.

To read the full report: INDIAN BANKING

>RELIANCE CAPITAL LIMITED (MERRILL LYNCH)

■ KG D9 prospective gas resources may be cut; Underperform
Hardy Oil is a partner of Reliance Industries (RIL) in KG D9, KG D3 and GS-01 blocks. Hardy Oil’s 2009 preliminary results report published on March 4 included updates on the exploration of these blocks, in which it has 10% interest. 3 exploration wells each are scheduled to be drilled in KG D9 and D3 by 3Q 2011.
1-2 wells are also planned in KG D3 by February 2011 to appraise the 2 gas discoveries made in 2008. Hardy Oil also intends to publish an evaluation report on all its assets by end of 1H 2010. In this report risked prospective resources in KG D9 may be cut from the earlier estimate of 10.8tcf due to the first dry well in the block. This may mean downside to RIL’s E&P valuation. We are still valuing 10.8tcf of risked prospective resources in KG D9 at US$5.2bn. We retain an Underperform on RIL.

■ KG D9: first well dry but 3 more wells by 3Q 2011
In May 2009, independent expert GCA had estimated risked prospective gas resources of 10.8tcf (unrisked 54.8tcf). However, the first well drilled in KG D9 was dry. Therefore, in the evaluation report expected by end of 1H 2010, prospective resource estimates may be cut. Next exploration well in KG D9 is likely in 3Q 2010. It will be followed by one well each in 1Q 2011 and 3Q 2011.

■ KG D3: 3 gas discoveries already made; more upside
Three exploration wells have been drilled in KG D3 with gas discoveries being made in all the wells. 1-2 appraisal wells are planned in KG D3 by February 2010, to appraise the 2 gas discoveries made in 2008. There are several other leads and prospects in KG D3 with GCA estimating gross risked prospective resources at 2.5tcf. Three more exploration wells are planned in KG D3 in Q2-Q4 2010 to appraise some of these prospects and complete committed drilling of 6 wells.

To read the full report: RIL

>India Shipping: Global Growth Recovery to Drive Demand; OW GESCO

Investment conclusion: We assume coverage of the India Shipping industry with an In-Line view. We expect
demand to remain strong in both tanker and bulker segments, given our expectation of 4% global GDP
growth in C2010 vs. 1.1% contraction in C2009. Bulker demand will be led by continued growth in Asia, while
recovery in OECD nations and increased demand from Asian countries will propel oil demand, in our view.
Delivery of new fleet is a concern, but we believe the impact will be moderated by delays and scrapping of old
vessels. This gives us comfort that freight rates and asset prices will strengthen from current levels.

Demand recovery should propel asset prices higher. Baltic indices have risen 60-100% from the lows of C09,
but are below historical averages. In our view, as global growth gains ground led by recovery in OECD countries, charter rates will rise (gains here have been modest). Such improved profitability and better earnings visibility are likely to drive asset prices higher.

New supply remains a concern, however. Current order book scheduled to be delivered in C2010 is 15% and 27% of the existing fleet (tonnage) in the tanker and bulker segments, respectively. We believe that effective growth in global capacity will be modest due to delays and scrapping. This should support utilization, resulting in recovery in spot / charter rates in C2010.

We assume coverage of GE Shipping (GESCO) with an OW rating and upside of 18% to our price target of Rs345. Apart from recovery in profitability and asset prices, GESCO should benefit from scaling up of its offshore business, demand for which is likely to improve as global exploration activity picks up. We rate Shipping Corporation of India (SCI) EW, given near-term stock performance and modest upside of 6% from our price target of Rs162.

Key risks: Slower recovery than expected and an influx of new capacity.

To read the full report: INDIA SHIPPING

>CAIRN INDIA LIMITED (KOTAK SECURITIES)

■ Downgraded to SELL. We would advise investors to book profits in Cairn India stock
noting potential muted stock performance led by (1) likely weakness in crude prices, (2) negative development on cess issue and (3) concerns on execution and production ramp-up from its key Rajasthan block. We have downgraded the stock to SELL, noting the stock offers potential downside of 15% to our revised 12-month DCF-based target price of Rs230. Key upside risk stems from higher-than-expected crude prices.

■ Likely near-term weakness in crude price will result in muted performance
We expect muted stock performance for Cairn in the near term led by (1) likely weakness in crude prices and (2) potential negative development on the cess issue. We expect crude prices to remain weak over the next quarter led by (1) seasonally weak global demand in 2QCY10, (2) high inventory levels (59 days of forward cover), (3) potential slippage in OPEC compliance (down to 58% in January 2010) and (4) simultaneous start of several delayed NGL projects in CY2010E (see our report titled ‘Crude price outlook: Expect short-term weakness’ released on March 3, 2010). We note that the Cairn stock has very high correlation with crude price (see Exhibit 1).

■ Stock discounting US$93/bbl in perpetuity; large downside risk to our target price of Rs230
We have downgraded Cairn India to SELL from REDUCE noting that the stock is trading significantly above our revised 12-month target price of Rs230 (potential downside of 15% from the current stock price). We highlight that the current stock price is discounting US$93/bbl in perpetuity based on (1) recoverable reserves (about 1.1 bn bbls) from its key Rajasthan block and (2) exchange rate of Rs46/US$ in the long term (from CY2013E). We highlight that the current stock price is ascribing US$1.7 bn as the option value of new discoveries/upgrade of reserves.

■ Revised earnings and valuation for cess payment, budget-related changes
We have revised our 12-month DCF–based target price to Rs230 (from Rs265 previously) to reflect (1) payment of cess at Rs2,575/ton by Cairn, (2) lower discount of US$5/bbl (versus US$6/bbl previously) on account of change in import duty on crude to 5.15% from nil previously in the Union Budget 2011; we may be too lenient on the discount at 6% of long-term Dated Brent price and (3) higher MAT rate of 19.9% versus 17% previously. We have revised our FY2010-12E EPS to Rs5.4, Rs17.8 and Rs35.3 from Rs6, Rs20.9 and Rs42.7 to reflect the above-mentioned changes. Key upside risks to our valuation and earnings stem from (1) higher-than-expected crude price, (2) higher-than-disclosed reserves and (3) favorable outcome of the cess issue; key downside risks stem from (1) lower-than-expected crude price and (2) slower-than-expected ramp-up in
production from Rajasthan block.

To read the full report: CAIRN INDIA

>JSW STEEL: Capitalising on growth (EDELWEISS)

■ Steel players to maintain/improve margins despite cost push
We expect raw material costs for the non-integrated steel producers to rise by ~USD 100/tonne in FY11. In the previous recovery cycle between CY02 and CY07, global steel prices generally rose more than the raw material cost push each year. We believe that global recovery and steel demand would be strong enough to: (1) either pass on the raw material cost push; or (2) in regions where demand is even more robust (like India), to see improvement in per tonne margins.

■ India end-user steel demand in strong uptrend
We expect India steel demand to grow 12% in FY11 and to remain in the 9-10% range thereafter. All end-use sectors such as infrastructure/construction, auto, consumer durables, engineering and packaging are expected to be in the growth mode. In the recent budget, GoI has earmarked 47% of the plan outlay, i.e. INR
1,736 bn, towards infrastructure spending. Both auto and consumer durables are already in strong uptrend with volumes up 40% Y-o-Y currently.

■ JSW Steel: To capitalise on India’s growth potential
With India’s second largest capacity of 7.8 mtpa and likely addition of ~3 mtpa next year, JSW Steel (JSW) is well-positioned to benefit from the country’s growth potential. JSW’s market share has increased from ~5% in Q4CY08 to 10% currently and is expected to further rise to 12% in FY12. Its conversion costs are amongst the lowest in the world. Internal benefits, going forward, would include improving product mix due to 3.5 mtpa HSM expansion, higher proportion of captive coke and iron ore beneficiation (savings of USD 10-12/tonne). We see JSW’s EBITDA margin rising from USD 165/tonne in Q3FY10 to its pre-crisis level i.e. ~USD 200/tonne in FY12.

■ Outlook and valuations: Poised for growth; upgrade to ‘BUY’
We have raised our FY11 and FY12 EPS upwards by 13.5% and 23%, respectively, taking into account steel price hikes, expected product mix enhancement and visible cost benefits. We see high probability of commencement of captive iron ore mine, but have not considered benefits of the same in our earnings. We estimate our fair value for JSW at INR 1,487 per share based on FY12E EV/EBITDA of 6.0x. Considering the upsides in the stock, we upgrade our recommendation to ‘BUY/Sector Outperformer’ from ‘HOLD/Sector Underperformer’.

To read the full report: JSW STEEL