Financial sector results preview for Q3FY12: MOST

3QFY12 was a challenging quarter for Financials, led by increasing macroeconomic uncertainty, policy paralysis, worsening business sentiment and moderating growth. In the domestic economy, while inflation has started moderating, slowdown in growth has become more pronounced. We expect operating profits for the Banks under our coverage to remain healthy, led by superior margins however, increasing stress in the system could throw negative surprises on asset quality and profitability. Banks that reported higher net stress (on GNPA) in 2QFY12 might report a sharp dip, led by (a) recoveries in soft accounts, which slipped into the NPA category due to system-driven NPA recognition and (b) sharp decline in slippages. NPV losses (in some cases) and 2% provision for incremental restructured accounts would keep provisioning expenses elevated despite fall in NPA provisions. Overall, we expect 14% NII growth, 13% operating profit growth and 9% PAT growth for our coverage universe in 3QFY12.

Business growth moderating, CD ratio stable QoQ: For the fortnight ended 16 December 2011, loans and deposits grew ~17% and ~18% YoY respectively. Though loan growth remained healthy on a YoY basis, on a QTD basis, loans grew 4.2%. CD ratio improved to 75.2% as against 74% at the end of 2QFY12. For YTD FY12, loan growth was 8.3% and deposit growth was 9%. Incrementally, credit demand is being driven by sectors like Infrastructure, Metals, Petroleum and Coal Products, and NBFCs. Our interactions with bankers suggest that elevated interest rates coupled with uncertain macroeconomic environment is leading to slowdown in fresh capex, but demand for working capital remains healthy.

Margins likely to remain stable sequentially: In 2QFY12, Banks had reported strong margin performance (despite higher slippages in case of State-Owned Banks) - up 10- 30bp QoQ on average, led by (a) loan re-pricing, and (b) cooling bulk deposit rates. However, as Banks refraining from increasing lending and deposit rates in 3QFY12, we expect margins to stabilize. For Banks that reported higher slippages in 2QFY12, lower reversal of interest income may lead to margin expansion.

Net slippages to improve QoQ for State-Owned Banks: We expect slippages to decline sequentially on a higher base for most Banks (as they have already transited their entire portfolio to system-based NPA recognition in 2QFY12). However, increasing stress in the economy may keep slippages at an elevated level. Our interactions with bankers indicate that their focus has shifted to recoveries, which has started yielding results. The key parameter to monitor will be net slippages. Private Sector Banks are relatively better placed, as retail delinquencies have been declining and a conservative restructuring policy adopted in the past reduces the risk of higher slippages from the restructured portfolio.

Restructuring likely to increase in 2HFY12; provisions to remain elevated: With large corporate clients under stress, we expect restructuring to increase in 2HFY12. Given the increasing stress in Textiles, Sugar, Iron and Steel, etc, restructuring in the mid corporate segment is also likely to increase. In our view, in most cases, Banks will not take higher NPV losses. Further, Banks will have to make 2% provisions on restructured loans in accordance with RBI guidelines. While NPA provisions are likely to decline, higher restructuring will keep overall provisioning elevated.

G-Sec yield movement highly volatile; higher MTM losses unlikely: During the quarter to date (as on 27 December 2011), 10-year G-Sec yields increased marginally to 8.5% as against 8.4% in the previous quarter. As of 27 December 2011, one-year G-sec yield increased to 8.4% (10bp QoQ). With high volatility in yields during the quarter, Banks may book higher treasury gains.

Estimate aggregate operating profit growth at 13% YoY, PAT growth at 9%: We believe Private Sector Banks would deliver better performance compared with their State- Owned counterparts. For the Private Sector Banks under our coverage, we expect aggregate NII growth of ~16% YoY (led by healthy loan growth and stable margins), operating profit growth of ~15% YoY (due to lower trading gains and slowdown in fees) and PAT growth of ~20% (due to lower credit costs). State-Owned Banks are likely to report NII growth of ~13% YoY and ~5% QoQ (driven by healthy loan growth and stable margins), and ~4% YoY increase in PAT (led by lower trading profits and higher provisions).

Asset quality trends will drive valuations: Persistent higher interest rates and continued macroeconomic uncertainty are leading to increased asset quality fears and sharp fall in valuations. In the current scenario, asset quality performance will be a key driver of valuations for Financials. Post correction in YTD CY11, Financials sector valuations are 15-30% below 5-year averages and offer good risk-reward from a long-term perspective. Top picks: ICICIBC, AXSB, SBIN, PNB and LICHF.

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