Macquarie Cap Securities expects things to be much uglier for banking sector in FY18

He has a sell on all PSU banks, as well on Axis Bank from the private sector. However, he recommends a buy on Yes Bank because he expects the bank to restrict its credit costs at 50-70 basis points in FY18.

Below is the verbatim transcript of the interview.

Latha: You have always had a healthy sceptisim about these issues, but is there an argument that in the course of the merger, the big bank has taken a huge hit and things will get better in FY18?

A: It is not likely to be the case that they are going to report another 0 percent return in equity (RoE) next year on a consolidated levels, so, obviously things will be better from what it was in FY17. However, the real problem is that the watchlist itself has been revised upwards, so, it is pretty surprising that the management did not take into account telecom as well as some of these power sector assets where PPAs has not been signed which had to be taken as a part of the watchlist in FY16 itself. So, what is the sanctity if the new watchlist?

So, it is again similar at the same levels as FY16 as far as the watchlist is concerned, and if you were to take 70 percent slippage from the watchlist, then you are going to see another FY18 with high amount of slippages and management very explicitly said in the analyst meet that they will have to take more than 50 percent write-off in some of these cases and they have only provided 40 percent on these large cases. So, provisioning levels are also going to remain very elevated which means RoEs are going to be in low single digits heading into FY18.

Surabhi: The stocks have gone through the roof, so, is this only the beginning of a correction, or do you think the market will kind of take it in its stride because these are back dated numbers?

A: The problem is the market is expecting some quick fix resolutions to happen and people will realise that it is not going to happen overnight.

Just to give you an example, even if say a quarter later if banks refer the cases to the Bankruptcy Code, it can take up to 270 days to resolve and then banks go ahead and try to revive the asset. So, you are probably talking about FY18, which is going to be another year where you will have actually to be honest, very high levels of credit cost eating into the profitability of all these public sector banks.

So, when the market sees that there is not going to be any visible improvement in the next couple of quarters, you will definitely see the stocks taking a beating and you have already seen that happening over the course of last one week with these PSU bank results be it Allahabad Bank, look at Bank of India today, Canara Bank, Union Bank, Punjab National Bank (PNB), all of them obviously have already taken a correction and there is more to come to be honest.

Latha: On State Bank of India (SBI) itself, I know it is extremely difficult to forecast provisioning or NPLs especially when resolution is what we are expecting, but still what would your RoE guess be for the consolidated giant in FY18?

A: My focus for FY18 is 5 percent and for FY19 is about 7-8 percent odd. So, what we are telling is that for the next couple of years, the bank at best will have a late single digit, higher single-digit RoE but it is not likely to be in double digits at all for the next couple of years.

Latha: Is there another factor that the market is overlooking? The hope trade is in the hope of resolution, but in the first year of resolution, there may actually be higher credit cost because banks may actually take haircuts?

A: That is true, that is what we are telling, that is what the management, SBI chairperson very clearly said that the resolutions can happen and it will happen only when we decide to take higher haircuts and that is what she very clearly indicated in the analyst meet that the 40 percent provisioning that they have got, on the top 50 NPL accounts, it is 50 percent of the overall portfolio is not adequate and there will be larger write-offs coming in that.

Latha: What is your next best public sector bank, or least worst?

A: The next best would be Bank of Baroda (BoB) because from an overall capital standpoint, BoB is as good as State Bank of India (SBI). So at least the extent of dilution in BoB compared to the other public sector banks, would be relatively lower. Of course they have also done a pretty good job of about beefing up the NPL coverage ratio. So, in case there are any further large haircuts to be done, the quantum is going to be lower in BoB compared to the others.

Surabhi: On the flip side, what are your top sells, stocks that you would advise people to completely clean out from their portfolio right now?

A: Sell all the public sector banks, as simple as that.

Latha: What is your sense, since your brokerage also looks at other sectors as well, power, infrastructure, gas-based plants, and telecom, what is your sense of stress, how much more -- cases like Videocon, which came out in Dena Bank, how many more such hidden traps are there in terms of a quantum that corporate facing banks have to recognise?

A: One sector where pain is yet to be fully recognised is power because so far most of the assets have been put under restructured assets category and the amount of NPLs in the power sector also would not be more than 4-5 percent of the overall power sector portfolio of banks.

Our infrastructure analyst has also been pretty pessimistic in general about the private sector power projects because of the fact of both demand as well as supply being now an issue. So, power sector, there are increasing worries. You can clearly see SBI had put a larger amount of power sector assets under the watchlist category and the PPA is not being signed.

So, power is one area where we would really be worried about heading into FY18.

Latha: And this would also impact Axis Bank and ICICI Bank? They also have exposures to similar companies. So, what is your call on those two stocks?

A: If you look at both, Axis as well as ICICI, they have put a lot of power sector assets under their watch list and now, of course, SBI has also done this particular quarter. The only advantage that at least ICICI has relative to others is that the capital position is relatively sound. So, their ability to absorb the hits is better, plus of course, they have a 55 percent stake in ICICI Prudential where the market valuations are pretty high. So, they can always sell the stake and provide for the bad assets. So, to that extent, from a risk reward angle, we are favourably placed towards ICICI compared to the others. We have a sell on Axis also at this point in time.

Surabhi: Yes Bank at Rs 1,400. This whole issue of divergence, etc. do you think it is in the price? Is it a sell? Is it a hold for you?

A: It is a buy for us. It is already there in the price very clearly. One has to understand that their business model has always revolved around recovering some of these assets pretty well. And even in this divergence, they very clearly said that though the divergence was Rs 4,000 crore, they could manage to recover Rs 3,000 crore in a single year, recover or sell through the asset reconstruction companies (ARC) and the balance Rs 1,000 crore which is the Jaypee Cement asset is likely to be recovered over the course of next couple of quarters.

So, the business model relies heavily on the aspect of trying to recover some of these loans and they remain extremely confident about maintaining their 50-70 basis points credit costs. And that is what they delivered last year.

So, assuming they deliver the same credit cost next year, you are possibly talking about very high levels of earnings growth as well as return on equities (ROE). So, I am pretty confident about their ability to recover some of these bad loans.

Surabhi: This prompt corrective action (PCA) that is starting, the correction plan which RBI has already started for IDBI Bank and UCO Bank, we just had some flashes from IDBI official saying that we will sell some assets, things will get better, etc. how much weightage are you giving and as more and more banks fall under this PCA, what will that mean for earnings?

A: It is going to be, when you are in a contraction mode and you are not able to grow your topline because of a lot of corrective action taken by RBI, though that is the right step, you actually go through a very prolonged period of pain. So, on the contrary, things will look even uglier purely from a financial standpoint over the course of the next 12 months. But that is the right thing to do because obviously, if these guys land up growing much faster, then it is going to be a pretty big systemic issue.

So, at least in the next 12 months, things will look even uglier considering that you will not have topline momentum and of course you are in the process of kitchen sinking or cleaning up your balance sheets.