December 19, 2014

Banking Sector Sector Update

Banking sector has seen strong outperformance in the recent months….. After a prolonged period of significant underperformance, the Banking sector stocks have seen sharp outperformance over the past 8-9 months. Since, April 2014 till date, the S&P BSE BANKEX has generated returns to the tune of 43.7% vis a vis the S&P BSE Sensex returns of 24.2% in the same period.

Source: Capitaline

…on the back of revival in sentiments in the markets and hopes of improving macro situation The revival in the banking stocks can be largely attributed to the recent developments that have taken place both on the macro and on the political front. Prior to the general elections, the economy was on a lower growth trajectory with the banking sector facing the bigger brunt of the slow policy actions and environmental issues which impacted both infrastructure and corporate capex spending. Also ban on mining in various states, issues of gas availability and rising state electricity boards’ indebtedness led to rising incidences of NPA for the banking sector, especially the PSU banking sector. However, post the general elections with a single party getting an absolute majority in the Lok Sabha, there have been significant revival in investor sentiments (as reflected by the sharp rise in the equity markets). Along with that, we have also seen gradual uptick in the big macro indicators which suggest that the worst may be over for the economy. The GDP data for FY15 so far has been better than the previous year and is on a rising trajectory. The key reasons for the growth in the GDP data for the previous two quarters has been improving services and government spending. Also, while the Capex recovery isn’t yet being seen, as reflected by the volatility in the Gross fixed capital formation, anecdotal evidence suggests to rising optimism amongst corporate to take up large projects.

Source: mospi.nic,in Also the IIP data for the past six quarters has gradually inched up and seems to have bottomed out from a medium term perspective. (Except the latest one in October, this was dragged down sharply due to big decline in the production of telecom equipment, which could have been a consequence of

HDFC Bank Investment Advisory Group

December 19, 2014

closure of Nokia’s Chennai Factory. Also the higher number of holidays in October could have led to the dip. Therefore November data is crucial) The IIP data also has been gradually inching up

Source: mospi.nic,in Also a look at the passenger vehicle sales data, which is a gauge of the consumer sentiments suggests to a revival in demand, This means that the consumer sentiments too are starting to see a pickup, which can lead to steady demand trajectory in the near to medium term.

Source: Bloomberg ….Also, falling inflationary pressure has also added to the optimism on decline in the interest rates and have helped the banks to lower deposit rates. Another positive factor for the banking sector has been the steady decline in the inflation rates, which has meant that the real rate of return of the savers have started to become positive. This has put the banking system at an advantage and some banks have started to gradually bring down their deposit rates which could also be the precursor to reducing the lending rates in the near to medium term, while keeping the interest spreads intact. Banks like State Bank of India, Punjab National Bank, Bank of Baroda and some Pvt. Sector banks have cut their deposit rates on select maturities. CPI and WPI growth has fallen sharply over last few months

Source: Bloomberg

December 19, 2014

CPI inflation in November 2014 declined to ~4.4% YoY against ~5.5% YoY in October 2014. While food inflation tumbled nearly 200 bps, core inflation fell by ~40 bps. Also, the WPI inflation for the month of November 2014 declined to 0% YoY from 1.7% YoY in October 2014. The decline in the inflation has been in line with the recent trend of decline in prices of food items, industrial commodities and crude oil. We expect that the sharp decline in the prices of crude oil would continue to keep the inflation trajectory lower over the next four to six months (assuming the crude oil prices stabilize in the lower range recently witnessed).

Source: Bloomberg, BBG stands for Bloomberg Lower inflation is likely to allow the RBI to cut Policy rates in the near future The sharp decline in the commodity prices and the fall in the crude prices apart from stable food prices have been the reasons for the inflationary pressures to abate in India. Also, the impact of the crude oil price decline would take time to fully reflect in the economy, which means that the inflationary trend could continue to be on the lower side even going forward. Also, the current CPI inflation has come well below the RBI threshold level of 6%, below which the RBI has stated that it feels comfortable to reduce policy rates. While the RBI in its latest policy statement has not cut the policy rates, it has given ample indications that it would be looking at a sustained cut in the interest rates beginning early next year (calendar year) if the macro scenario continues to be positive and inflation/inflationary expectations remains well anchored. This would mean that the overall borrowing costs of the banks would sustainably trend lower in the medium to longer term.

The issues related to the NPA/ Stressed assets continue to haunt the banks, specially the PSU banks While the macro scenario for the sector seems to be looking up, the latest quarterly results for the large PSU banks suggests that the NPA issues are continuing to haunt the sector. While most of the issues have been due to the slowdown in the economy (and hence related to the Infrastructure sector), the balance sheet of some of the corporate have meaningfully deteriorated for them to regularly service their loans, Also, the cost overruns and the delay in commissioning could have made some projects unviable in the medium term. Gross NPA (%) Q1FY14 Q2FY14 Q3FY14 Q4FY14 Q1FY15 Q2FY15 Bank of Baroda 2.99 3.15 3.32 2.94 3.11 3.32 Bank of India 3.04 2.93 2.81 3.15 3.28 3.54 Punjab National Bank 4.84 5.14 4.96 5.25 5.48 5.65 State Bank of India 5.56 5.64 5.73 4.95 4.90 4.89 Union Bank 3.50 3.64 3.85 4.08 4.27 4.69 Source: Companies, Media Reports, BSE India Net NPA (%) Q1FY14 Q2FY14 Q3FY14 Q4FY14 Q1FY15 Q2FY15 Bank of Baroda 1.69 1.86 1.88 1.52 1.58 1.74 Bank of India 2.10 1.85 1.75 2.00 2.14 2.32 Punjab National Bank 2.98 3.07 2.80 2.85 3.02 3.26 State Bank of India 2.83 2.91 3.24 2.57 2.66 2.73 Union Bank 1.96 2.15 2.26 2.33 2.46 2.71 Source: Companies, Media Reports, BSE India

December 19, 2014

Restructured loans (%) Q1FY14 Q2FY14 Q3FY14 Q4FY14 Q1FY15 Q2FY15 Bank of Baroda 5.4 5.3 5.1 4.8 6.0 5.8 Bank of India 5.3 5.3 4.7 3.7 2.8 3.0 Punjab National Bank 10.5 11.1 9.6 10.2 9.8 10.2 State Bank of India 4.2 4.8 4.9 3.6 3.5 3.6 Union Bank 6.5 4.9 4.8 5.3 5.0 5.2 Source: Companies, Media Reports, BSE India However, the recent steps taken by the RBI to allow banks to refinance existing projects which have been delayed would help the PSU banks in a big way in the near to medium term.

The RBI has recently allowed the banks to have flexible refinancing and repayment option (5/25 scheme) for long term infrastructure projects (as defined under the Harmonized Master List of Infrastructure of RBI and in the core industries sector included in the Index of Eight Core Industries, base: 2004-05, published by the Ministry of Commerce and Industry, Government of India) and has extended this scheme even to the existing ones for loans where the total exposure of lenders is more than Rs 5 bn. A 5/25 structure allows banks to lend to a project for 25 years, with an option of rewriting/resetting the terms of the loan or transferring it to another bank or financial institution after five years.

Restructuring of existing project loans would be allowed once during the life time of the project, after the date of commencement of commercial operations (DCCO), based on the reassessment of the project cash flows, without this being treated as ‘restructuring’ on fulfillment of certain conditions.

The revised guidelines also allow banks to fix a fresh loan amortization schedule in accordance with the 5/25 structure to existing loans without this being treated as restructuring. This provision can be implemented only in case that the loan is a standard asset at that time and the Net Present Value of the loan remains the same before and after the revision in the amortization schedule.

We think that with the new norms, the pace of fresh restructuring is likely to come off for the currently standard loans and fresh NPA accretion for the restructured loans. Several large companies which are facing balance sheet stress and could be a case for fresh restructuring could see some respite, while the credit costs for the banks is likely to reduce in the medium term. Lower credit growth for the Banking system is also a concern.

Another concern for the Banking sector has been the lack of credit growth due to slow GDP growth. Also, with the Crude prices coming down, there is an expectation of decline in the lending activity to the Oil Marketing companies, who have been among the big borrowers. "From an oil company's perspective, the fall in crude oil price has done us a world of good. We used to be very big borrowers. If you look at the last year and the current year, our borrowings are down by Rs 25,000 crore. Till last year we were hovering at about Rs 85,000 crore of borrowings and today we have around Rs 60,000 crore in borrowings. Our interest cost has also come down from Rs 1,700-1,800 crore to Rs 1,100 crore," said Ashok Balasubramanian, chairman and managing director, Indian Oil Corporation (IOC). Hindustan Petroleum Corporation Limited said it has seen its borrowings come down from Rs 38,000 crore in November last year to Rs 22,000 crore this year. (Source: Business Standard) Also, the stress in many of the large borrowing sectors (like Infrastructure, Mining) have meant that the bank could have also become bit unwilling to lend to such segments and would prefer to consolidate their balance sheet. While, the NPA accretion may have slowed, lower credit growth would mean that the PSU Banks’ profitability could be under pressure in the near term. This may lead to valuation correction in some PSU banks in the near term.

December 19, 2014

Source: Bloomberg

Longer term for the sector looks bullish:

We believe that India is standing at the cusp of a long term uptrend in the economic growth, led by a very stable government at the Centre, which has its focus very clearly on improving the economic scenario of the country. The government has taken a lot of initiatives which would gradually start to show the impact over the next four-six quarters (as per our discussion with the various corporate). Initiatives like the Clean Ganga, Smart cities, Make In India and Swachh Bharat and focus on improving the governance delivery would help India kick start the investment cycle over the next few quarters. Also the fall in the crude oil has come as a huge blessing for the country as it would help to improve both the Fiscal health and the Current Account deficit of the country. Also falling inflation would mean that the interest rates in the economy could trend lower for both consumption and investments to gradually pickup, without meaningfully disturbing the savings rate. Most of the global multilateral agencies have raised India’s economic growth projections for the next year, while downgrading global growth, reflecting the relatively stronger position that India has at this point in time compared to a lot of its peers. Hence, we clearly believe that the future holds a lot of promise for the Indian economy. Banking, as a sector is clearly a play on the economic growth of the country and especially the PSU banks which have relatively lower focus on the retail segment. Hence, we believe that the worst seems to be over for the Banking Sector (PSU Banks) and if the economic growth pans out as expected, we think that over the next three-five years this sector could outperform the broader indices. Hence, we believe that any short term decline in the sector due to weak earnings performance could be an opportunity to add exposure in line with the risk profile of the investor. However, the caveat in this case is the above scenario not panning out over the next few quarters which could lead to significant underperformance by the sector. We currently have a Hold on State Bank of India and a BUY on Union Bank and Bank of India in our Model Portfolio.

Companies CMP PE Multiple

FY14 FY15E FY16E TP State Bank of India (Standalone) 304.3 20.9 15.0 11.5 302 Bank of India 287.2 6.2 7.2 6.0 449 Union Bank of India 220.9 8.0 5.7 4.8 372

December 19, 2014

Daily closing price for last three years

December 19, 2014

Disclaimer: This communication is being sent by the Investment Advisory Group of HDFC Bank Ltd., registered under SEBI (Investment Advisors) Regulations, 2013 This note has been prepared exclusively for the benefit and internal use of the recipient and does not carry any right of reproduction or disclosure. Neither this note nor any of its contents maybe used for any other purpose without the prior written consent of HDFC Bank Ltd, Investment Advisory Group. In preparing this note, we have relied upon and assumed, without any independent verification, accuracy and completeness of all information available in public domain or from sources considered reliable. This note contains certain assumptions and views, which HDFC Bank Ltd, Investment Advisory Group considers reasonable at this point in time, and which are subject to change. Computations adopted in this note are indicative and are based on current market prices and general market sentiment. No representation or warranty is given by HDFC Bank Ltd, Investment Advisory Group as to the achievement or reasonableness or completeness of any idea and/or assumptions. This note does not purport to contain all the information that the recipient may require. Recipients should not construe any of the contents herein as advice relating to business, financial, legal, taxation, or other matters and they are advised to consult their own business, financial, legal, taxation and other experts / advisors concerning the company regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this note and should understand that statements regarding future prospects may not be realized. It may be noted that investments in equity and equity-related securities involve a degree of risk and investors should not invest any funds unless they can afford to take the risk of losing their investment. Investors are advised to undertake necessary due diligence before making an investment decision. For making an investment decision, investors must rely on their own examination of the Company including the risks involved. Investors should note that income from investment in such securities, if any, may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Neither HDFC Bank nor any of its employees shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information contained in this material. This note does not constitute an offer for sale, or an invitation to subscribe for, or purchase equity shares or other assets or securities of the company and the information contained herein shall not form the basis of any contract. It is also not meant to be or to constitute any offer for any transaction. HDFC Bank and its affiliates, officers, directors, key managerial persons and employees, including persons involved in the preparation or issuance of this material may from time to time, have long or short positions in, and buy or sell the securities thereof, of company (ies) mentioned herein. HDFC Bank may at any time solicit or provide commercial banking, credit, advisory or other services to the issuer of any security referred to herein. Accordingly, information may be available to HDFC Bank, which is not reflected in this material, and HDFC Bank may have acted upon or used the information prior to, or immediately following its publication. Disclosures: Research analyst or his/her relatives or HDFC Bank or its associates may have financial interest in the subject company in ordinary course of business. Research analyst or his/her relatives does not have actual/ beneficial ownership of 1% or more securities of the subject company at the end of the month immediately preceding the date of publication of research report: HDFC Bank or its associates may have actual/beneficial ownership of 1% or more securities of the subject company at the end of the month immediately preceding the date of publication of research report. Subject company may have been client of HDFC Bank or its associates during twelve months preceding the date of publication of the research report. HDFC Bank or its associates may have received compensation from the subject company in the past twelve months. HDFC Bank or its associates may have managed or co-managed public offering of securities for the subject company in the past twelve months. HDFC Bank or its associates may have received compensation for investment banking or merchant banking or brokerage services from the subject company in the past twelve months. HDFC Bank or its associates may have received compensation for products or services other than investment banking or merchant banking or brokerage services from the subject company in the past twelve months. HDFC Bank or its associates has not received compensation or other benefits from the subject company or third party in connection with the research report. Research analyst has not served as an officer, director or employee of the subject company. Neither research analyst nor HDFC Bank has been engaged in market making activity for the subject company. Three year price history of the daily closing price of the securities covered in this note is available at www.nseindia.com and www.bseindia.com.