PSU banks still sitting on unreported NPLs: Morgan Stanley

Anil Agarwal, Head – Research banks, Asia ex-Japan at Morgan Stanley believes that the public sector banks are still sitting on unreported non-performing loans (NPLs). Speaking to CNBC-TV18, Agarwal says that the asset quality issues will take more time to run its course especially with a slowing nominal gross domestic product (GDP) growth. He expects more bad loans and restructured loans over the next 18-20 months. In the near term — three to six months — there will be more volatility in NPLs, he adds. However, he says private lenders could give meaningful returns over the next 12 months. Agarwal prefers private banks over public sector banks. Though the PSU banks valuation is cheap, they are sitting on unreported NPLs. Even the big PSU banks will see rise in NPLs, but at a slowing rate, he says. Banks will have difficulty in growing loan books and will need promised capital infusement from the government as soon as possible. Agarwal says there are very few banks across Asia where investors are comfortable with balance sheets. He says wholesale funding cost is likely to reduce at a more gradual rate than base rate. Agarwal is cautious on non-banking finance companies (NBFCs) and says 2016 will challenging for them as well.Below is the verbatim transcript of Anil Agarwal’s interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18.Latha: Let me start with the Axis Bank numbers, they revealed a lot in terms of the quality of the book exposed to the indebted companies. Now do you get a sense that there is some stability in the book, what is the view on Axis?A: Unfortunately I can’t discuss individual bank numbers. I can talk about overall sector but talking about individual bank balance sheets, etc I can’t.Latha: Just wanted to ask you how worried would you be about banks that are exposed to infrastructure sectors or to the economy, I mean there are one set of banks like HDFC Bank and IndusInd Bank which haven’t got any infrastructure, economy exposure and then there are the private sector banks which have this exposure. Where would your preference lie in terms of choice within the private sector space? A: I think asset quality cycle will take some more time to fully run its course. Banks have reported a significant amount of non-performing loans (NPLs) over the last few years and the problem is that if I look at economic growth from a nominal growth perspective, that has continued to slowdown. Nominal gross domestic product (GDP) growth has continued to slowdown and at the same time interest rates have been relatively sticky. So, if I am a corporate, I am struggling to repay because my revenue growth is weak and interest rates are not coming down. I think you will continue to see more and more bad loans, restructured loans or 5:25, etc over the next 12-18 months. So, in that backdrop, banks with weak balance sheets, we would avoid. So, state owned banks, our view is that those stocks look cheap on the face of it but if you adjust for the capital that they need, they are actually not cheap and the return on equities (RoEs) will be very low. We like the private sector banks. Private retail players are clearly the best but then that reflects in the multiple also because they don’t have an asset quality issue and the revenue growth there is very strong. I think the private corporate lenders are relatively well off because the good thing about them is that they make a significant amount profitability, PE provision profitability so they can take a lot of NPL hit and still report RoEs which are in mid to high teens. So, those stocks also looking relatively attractive. However, for the next three to six months, there can still be volatility around NPL and NPL news flow.Sonia: Because of the volatility around the NPL news flow do you expect the private corporate lenders to be under further pressure say for the next three to six months?A: We like those stocks because it is tough to take a call on three to six months because while there is volatility on news flow, a lot is reflected in multiples. Some of these stocks are trading at less than 10 times earnings now. So, if I am an investor who can hold these stocks for 12 months, my view is that you will end up with banks which will give you EPS growth depending on the bank we are talking about between 15 percent and 20 percent or higher and reasonably higher RoEs. So, from a 12 month perspective, even the private corporate lenders I think should give very meaningful returns. I think the returns should be fairly significant. The risk here is that the economy just fails to take off. So, nominal GDP growth is a measure that I look at and that has continued to slowdown. The view we have taken is that that will start picking up at some point of time over the next few months. So, if I take over a 12 month period, I think private corporate lender should be okay. Three to six months, very tough, it depends on the volatility in the market, volatility in NPL news flow, etc.Latha: You are not attracted to the public sector lenders at all? A: Public sector banks, we had done a report recently where we said let us do a stress testing of book because obviously these stocks on the face of it look very cheap, 0.2-0.3 times book in some of the stocks that we cover. However, the problem is that the banks are sitting on a lot of NPLs that they have not reported. You can look at the corporate list and you know that there are a lot of NPLs that have not been reported as yet. The coverage ratios and the bad loans that they have reported is very low. So, if I write size for bad loan formations, so, if I say that okay bad loans will go up by 8 percentage points from here and you take up the coverage levels to a level which we see in anywhere else is Asia, say 50-60 percent at least, the share count in some of the smaller banks, some of the state owned banks will have to go up by 3-4 times from where we are right now. So, the minority shareholder in these banks, I just don’t see how you would make any return unless the call is that economy is going to shoot up dramatically which given the global context is tough. So, state owned banks, we generally are underweight almost across the sector.Latha: That would be true of what you said, the smaller PSU banks, but what about the bigger ones like a Bank of Baroda (BoB) and an State Bank of India (SBI). Without naming the banks, for the better of the PSU banks you still expect that bad loans would be 8-10 percentage points higher than reported and there as well you expect a huge share issue and equity dilution? A: The bigger ones, will they also see a meaningful increase in bad loan ratios? Our view is yes. Do they need to increase the coverage ratio meaningfully? I think yes. The good thing about the bigger banks versus smaller banks is that again the PE provision profitability is higher than the smaller banks so they also need dilution. However, our view is that larger state owned banks dilution is probably going to be about 60-70 percent over the next three years; with the other banks the dilution is much higher. So, if I look at the share count in other banks, as I said, the share count will go up by between two and four times. This is for our coverage stocks and we cover reasonably large state owned banks; for smaller ones probably it can potentially be worse or better. For the larger banks the dilution would be less but still you will see share counts which are going up quite meaningfully. The problem is that till they get capital, and reasonable amount of capital, they can’t grow the loan book because RoEs of these banks is like 7-10 percent. So, they can’t really grow loan book at all or they can grow loan book only by a very small amount. So, it is not that the size of bad loan book is stagnant, if you don’t grow the loan book and whatever growth you are seeing is essentially rollover of interest rates, I think the size of bad loan book will keep increasing. So, my view is that the capital needs to be given as quickly as possible so that you get out of a vicious cycle. Sonia: I just had one question on some of these retail lenders like HDFC Bank, Kotak Mahindra Bank and IndusInd Bank. That is a bit of a crowded trade now but how much of a valuation premium do you think these banks can enjoy versus the corporate lenders? A: That is a question that people keep asking and tough to say what should be the right PE multiple. The thing is what is happening there is that, if you look at banks across Asia, not just India, there are very few banks right now where investors are comfortable with the balance sheets. So, if they are comfortable with balance sheets in a particular bank and they can see earnings growing between 20 and 30 percent, they can keep paying a higher multiple. The way we look at these stocks is that we are not saying that the multiples will expand from current levels, we are essentially saying, assuming multiples remain where we are just because of the fact that EPS will grow again between 20 and 30 percent, the returns can be reasonably meaningful. So, we are not making a case for multiple re-rating here but just the EPS compounding should be fairly good. Latha: Any of the non-bank lenders you like?A: Non-bank lenders also generally I think this year is going to be challenging because what was happening last year was that wholesale funding cost was coming down at a relatively fast pace, at the same time because of the base rate mechanism, their base rates are not coming down quickly enough. So the gap between base rate and wholesale funding cost was expanding. So, the result of which, if you are a wholesale funding institution, you are seeing margin expansion. This year our view is that wholesale funding cost, they may come down but they will come down at a more gradual pace compared to base rates. So, you will start seeing net interest margins (NIMs) compression for most of these NBFCs especially the housing finance companies. Outside of housing finance companies, you still have NPL issue. So, we don’t really like any of the NBFCs baring one. We generally have a cautious to equal weight view on NBFC sector as a whole.