Monday, June 18, 2012

>PSU Banks: Valuation Mirage (CLSA)

Many PSU banks are trading close to their core book and may not de-rate further; but as core book remains flat/ declines over FY12-14, returns may be negative. PSU banks’ asset quality experience will be far worse than private banks due to 1) higher leverage that will amplify impact of NPLs, 2) higher exposure to risky sectors, 3) higher exposure to riskier project within risky sectors and 4) weaker collateral. These factors compound, hence divergence in asset quality experience could be big. 10% NPL in power loans can impact PSU banks book by ~12% while for private banks impact would be ~2%. Union, PNB and tier II PSU banks will be worst impacted. Higher NPLs, rising costs and lack of capital may lead small PSU banks into losses and force a merger with larger ones.

Attractive valuations or value trap?
Most PSU banks are trading close to core book and look ‘attractively valued’. However, we see limited upside as we expect that core book values for most of these banks would not grow over next two years.

Though they may not ‘de-rate’ further, absolute upside may not be much.
Higher NPLs will be a drag on book values–100bps higher gross NPL impacts the book values by 10%-20% for PSU banks vs. 6%-9% for private (fig 11). 4 compounding factors would lead to a wide divergence

#1: PSU banks are much more levered- average asset / equity ratio for PSU banks is 17x (some are +20x) vs. 10x for private banks. So the impact of 10% higher of NPL for PSU banks will be much more than for private banks.
#2: Higher exposure to risky sectors like Power (3%-11% v/s 1%-5%), SMEs, aviation, textiles etc. (see fig 3-7).
#3: Higher exposure to riskier projects / corporates within high risk sectors - for ex: PSU banks seemingly have higher exposure to UMPPs, projects where coal
linkages are not adequate or where proportion of merchant power is high.
#4: Weaker collateral- Private banks have better collateral for their exposures to troubled corporate / projects - for ex: Kingfisher Airline (see fig 9).

Cumulatively, these factors could lead to a big divergence in impact on profits / net worth; For ex: If 10% of power loans go bad, then impact for PSUs could be ~12% of book while for private banks it would be ~2% only.

Forced mergers of smaller PSU bank to protect depositor interest?
Some small PSU banks carry a risk of getting to a state where they may have to be merged with large PSU bank to protect depositors' interest.

Higher NPL will hurt core net-worth leading to higher capital requirements which most banks would be unable to meet given that the government would need to contribute 50% of the fresh capital.

Factor this - Central Bank of India is a US$1.1bn market cap bank and its Cahairman recently mentioned that the bank would need US$2.5bn of equity in next 5 years. We believe this is highly unlikely and hence the bank may be forced to cut down dividend pay-out and even lower growth targets.

The bigger issue is that most of these banks have relatively 'fixed' increase in their cost structures due to unionised labour, peak branch efficiency etc. 

We believe the inflection / tipping point is 14% growth - a growth lower than 14% in top line could lead to a vicious cycle of ROA contraction as the cost growth would remain at 14% or thereabouts.

Some PSU banks that are highly leveraged would be forced to bring down growth to <14% and may see ROA contracting from 1% now to 30-40bps in 5 years - leading to a forced merger of these banks with a larger PSU banks.

SBI is the only PSU bank we have a BUY on given it's a) stable and strong deposit franchise, b) early recognition of NPLs.

To read report in detail: PSU BANKS