May 26, 2006|
Banks: After an eventful FY06...
Better economic growth, relatively lower interest rates, capacity expansion by corporates, retail credit penetration and technological upgradation are factors that have facilitated the banking sector's 'dream run' so far. In the initial years of this decade, with the spiraling bond prices, banks could afford 'lazy banking'. Later on (2004 onwards), the highest credit growth in two decades, net interest margins and asset quality comparable to global standards and extended reach, more than made up for the treasury losses.
- Exponential growth: A consistent year on year growth in incremental credit disbursals of more than 30% persuaded banks to lighten their treasury portfolios and concentrate on the higher yielding advance book.
- Not just retail...The growth was not just in the retail segment (especially mortgage loans) but also in the corporate book (primarily SMEs). The corporates who initially borrowed only for working capital purposes, gradually sourced capital for capex also, as overseas borrowing became expensive.
- Margins at the zenith: Higher demand for credit coupled with low cost of deposits enabled banks to extract a very attractive spread (interest income less interest expended). The average NIMs of above 3% in FY06 are almost comparable to that of the banking sector in the developed countries.
- Marked improvement in quality: The asset quality of Indian banks has shown a remarkable improvement over the last 5 years, wherein average gross NPA levels have shrunk from the highs of 11% in FY02 to 3% in FY06. Also, banks that enjoyed high treasury gains, utilized the same to write off the stressed assets from their books. Of late, the secondary market for stressed assets has further facilitated banks to offload the bad assets.
Nevertheless, we reckon, that the route forward is not as rosy for the players in this sector.
Going forward, we perceive certain encumbrances that may handicap the ability of the players in this sector to enhance their profitability.
- High base effect: With the larger banks in the sector now having attained a sizeable asset book, the growth hereon with be at a lower clip due to the high base effect. While we are not trying to negate the possibility of future credit growth being robust, the YoY growth in percentage terms (as against absolute terms) is expected to be lower. Also, the fact that interest rates charged across asset classes have seen an upward revision over the last couple of months, may discourage potential borrowers.
- Margin pressures inevitable: With interest rates headed northwards (impact of rising global interest rates weighing heavily), banks have been compelled to raise funds at higher interest rates to meet the incremental credit demand. However, the time lag for passing on the rate hike to the customers is typically 6 to 9 months. This has started squeezing the net interest margins for players across the sector and we see the margin pressure continuing, going forward.
Investors should look for...
- Attractive valuations: The valuation parameter typically used for banks is price to adjusted book value. Unlike other sectors, a bank's asset is cash and the ability to grow the topline (interest income) is therefore, largely dependent on the capital base (net worth in a broader sense). Therefore, rather than price to earnings ratio, the price to adjusted book value (book value less net NPA per share) is more relevant while valuing a banking stock.
Besides this, investors could also look at some of the unconventional parameters such as net interest income per share and net NPA per share. While the former is to banking what sales per share is to manufacturing, net NPA per share could be considered as erosion from the book value per share. Similarly, the price to pre-provisioning profit (PPP) per share multiple would be similar to the price to EBIDTA valuation used for manufacturing companies.
* Considering prices as on 25th May 2006
** For OBC the pre-provisioning profits are net of the extraordinary write-offs.
- Dividend yield: Investors must also look out for a regular dividend history and an attractive dividend yield that can provide them with a regular income stream at times when capital appreciation is not commensurate with expectations.
Not undermining the banking sector's ability to capitalise on the superior growth prospects of the Indian economy, what we would like to point out to investors, is the fact that the historic growth levels seen so far are not sustainable. Also, the future growth prospects will be subjective and dependent on a bank's scalability, operating efficiency and competitive edge, more so once the sector opens to foreign players in 2009. Investors, must therefore, take their decisions based on critical evaluation of the parameters as mentioned above.
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