10 Indian Banking Stocks to Watch

NEW YORK (Karvy Global) -- HDFC Bank (HDB) and ICICI Bank (IBN) are among the Indian bank stocks that have the potential to appreciate despite a recent selloff.

Over the past two weeks, Indian bank stocks plummeted on concerns about the European debt crisis and India's housing loan scandal, in which authorities arrested bank executives in connection with alleged bribery and fraudulent loans.

Adding to the selling were worries about margin pressure because of a rise in deposit rates and slower growth. The declines caused India's BSE banking index to fall 7% in the first two weeks of December.

To be sure, Indian banks will face pressures in an environment of rising interest rates. But the impact will vary depending on the bank. Banks that have a higher percentage of low-cost deposits, such as State Bank of India (SBIN:Mumbai), Punjab National Bank (PNB:Mumbai) and HDFC Bank, will fare better.

So will IDBI Bank (IDBI:Mumbai) and ICICI Bank ( IBN), which have hiked lending rates, thereby limiting the negative impact on their margins. We expect margin pressures to become visible over the next two quarters.

In the current fiscal year, Indian banks have managed credit growth of around 10%, which is lower than the Reserve Bank of India's target of 20% for 2010-2011. Nonetheless, we expect robust domestic growth, higher capital expenditures and working capital demand across industries to accelerate credit growth during the next two quarters.

Concerns about the banking sector's exposure to sectors like telecom and real estate surfaced recently. However, the overall exposure to these sectors is around 4% to 5%, and these loans are backed by adequate collateral.

The government is proposing to infuse $2.25 billion into nine banks to shore up their capital bases and fund future growth. The bank that is expected to see the biggest increase in its book value from this infusion is Bank of Baroda (BANKBAROD:Mumbai), followed by Union Bank of India (UNIONBANK:Mumbai).

We have identified large-cap Indian banking stocks that could appreciate. The banks listed here have the advantage of a strong deposit base, better asset liability management, and strong asset quality. They are ranked in ascending order of average upside expected by analysts.

HDFC Bank provides retail and wholesale banking, as well as treasury operations.

The bank has increased the proportion of its corporate banking as well as the share of nonsecured retail banking. In addition, high capitalization and prudent lending practices have offset the impact of bad loans. Analysts estimate that for fiscal 2011, the bank's bad loans will constitute 1.3% to 1.4% of total loans.

HDFC Bank had earnings growth of around 30% over the last three years, and its balance sheet grew about 30% over the past five years. However, asset growth could narrow to about 25% on a higher base over the next couple of years. Improved return ratios could sustain net profit growth at 28%-30%, according to analysts. The stock is trading at 3.7 times 2011-2012 estimated book value.

ICICI Bank operates in a broad range of banking and financial segments.

The bank's margins have improved by 10 basis points to 2.6% sequentially in the September quarter due to enhancement of low-cost deposits. Further, we expect the bank to improve its ratio of current accounts and savings accounts to total deposits (CASA ratio) to about 42% in the next couple of years, in part through the expansion of its branch network to 2,500 outlets. Analysts expect ICICI to maintain margins of 2.5%-2.6% for the 2011 fiscal year.

During the present quarter, the bank's loan book expanded 5% sequentially with growth coming from domestic corporate and agricultural loans. Management expects its loan book to grow at 20% for the full year. Positively, net nonperforming loans narrowed by 15 basis points to 1.6%, and provision coverage improved to 69% for the quarter.

Overall, the bank's net profit grew 20% year-on-year in the September quarter, while analysts expect earnings to grow at 20% to 25% during 2010 and 2012. ICICI is trading at 2.1 times 2012 estimated book value.

Bank of India (BANKINDIA:Mumbai) is an India-based bank with operations in treasury, wholesale and retail banking.

Bank of India reported a 91% year-on-year jump in net profit, led by better productivity and lower nonperforming asset provisions.

Business volume grew at 22% year over year, due to improving credit growth and deposits. Net interest margins increased by 24 basis points year over year to 2.81%. The CASA ratio rose by 136 basis points year over year to 33.5%, one of the lowest among large state-controlled banks. Modest credit growth and a lower CASA share are likely to pressure the bank's net interest margin.

Gross nonperforming loans rose 1.6%. Nonperforming asset coverage including technical write-offs stood at 70%, meeting the Reserve Bank of India's requirement. However, slippages have increased from 1.4% of loans to 1.9%.

The shift in focus from aggressive growth to profitability could drive return on equity, led by improved margins and normalized credit costs. The stock is trading at 1.5 times its 2011 estimated earnings and 1.1 times 2012 adjusted book value.

State Bank of India is India's largest bank.

During the September quarter, net advances increased by 19% year over year, underpinned by strong growth in retail and midcorporate loans. Deposits grew 10.7%, benefiting from a robust 27.7% growth in low-cost deposits during the same period.

SBI reported a 113-basis-point improvement in its net interest margin to 3.43% compared with the same period last year, due to growth in low-cost deposits, a substantial decline in bulk deposits, and higher yield on advances. On the asset quality front, the bank faced large slippages, with the nonperforming asset provision coverage ratio, including technical write-offs, increasing to 62.8% from 60.7%.

Due to the strong low-cost deposit base and high fee income, SBI's return ratios have improved over the past few years. Factoring in the bank's fundamentals and robust operating performance over the past several quarters, analysts have improved their ratings on the stock. The stock is trading at 2.1 times estimated fiscal 2012 adjusted book value.

Punjab National Bank is the second-largest public-sector bank in India.

In the latest quarter, the bank reported strong net interest income, attributable to higher credit growth and improved margins. The bank reported net profit growth of 16% year over year, in line with analysts' expectations. However, net interest income growth was a positive surprise, coming in at 49% year over year due to a 28% increase in the bank's loan book and a 56-basis-point expansion in net interest margins.

Noninterest income fell 7% year over year and 18% sequentially, due to lower treasury income. Operating expenses increased on growing staff expenses, leading to a higher cost-to-income ratio of 43%. Staff expenses were up 53% year over year on higher provisioning for pension and gratuity liability.

PNB is expected to deliver one of the highest return ratios among its peers, with an average return on asset of 1.5% and return on equity of 25% over the next two years. Given PNB's core operating strength, the bank would be able to deliver superior performance going forward. The stock is trading at 1.9 times 2012 estimated adjusted book value and 8 times 2012 estimated earnings.

Union Bank of India is a public-sector bank with diversified operations.

Despite slower credit growth of about 4% during the first half of 2011, UBI's management is confident of achieving 25% credit growth in the current fiscal year, driven by lending for infrastructure, small and medium-sized businesses and retail.

Analysts estimate the bank's earnings could average 18% over fiscal 2011 and 2012. Slippages could taper towards the end of fiscal 2011, while margins would expand. Analysts expect an improvement of about 100 basis points in the CASA ratio and a further expansion in the credit-deposit ratio, as they expect the bank to maintain its net interest margin at about 3% for the next two years.

Concerns relating to the microfinance and telecommunications sectors and the recent housing finance scandal have led to sharp corrections in bank stocks including Union Bank. However, after the correction, the stock is trading at 1.3 times estimated 2012 book value and looks attractive.

Bank of Baroda gets around 25% of its business volumes from overseas operations.

The bank's strong origination capabilities are reflected in incremental delinquencies at 1.05% in the first half of 2011 -- the lowest level in the industry. Incremental delinquencies are expected to be 1.25% during the second half of the year, thereby building a margin of safety into analysts' forecasts.

The management expects its loan book to expand 200-300 basis points, ahead of the sector average. RBI's guided 20% growth in credit will enable Bank of Baroda to grow its loan book by 22% to 23% during fiscal 2011.

The Indian government already has a 53% stake in Bank of Baroda, but the cabinet-approved plan to infuse equity into nine banks is expected to raise that stake to 58%. The equity infusion would immediately support the bank's Tier 1 capital, but it should also enable the bank to raise additional capital from nongovernment investors at a later stage.

The stock is trading at 1.6 times 2012 adjusted book value -- a premium to other banks -- because of its higher earnings quality and consistent profitability.

Axis Bank's (AXISBANK:Mumbai) credit growth slowed during the first half of 2011, to 6%, as corporate capex is expected to pick up over the next few months, which could scale up loan growth by 25% for the full year, with the midcorporate segment contributing the most growth.

Although margin moderation is expected for Axis Bank as leverage increases and CASA ratios stabilize, margins could be under pressure over the next couple of quarters. The management lowered guidance on net interest margins for fiscal 2011, highlighting the risk to margins, especially from higher wholesale rates. Asset quality is expected to remain stable with large corporate and retail assets holding up well. However, there may be slippages in assets related to small and medium-sized businesses.

In view of strong growth, better franchise value, and diversified fee income business, we expect Axis Bank to trade at a valuation premium, compared to its peers. The stock is trading 2.5 times estimated 2012 book value.

Yes Bank (YESBANK:Mumbai) started out as a new-age bank but evolved into a commercial bank with offerings in corporate and institutional banking, financial markets, investment banking, corporate finance, branch banking, business and transaction banking, and wealth management services.

Yes Bank's advances have grown at more than 60% on average during the last five years. The bank's management expects to sustain the momentum with advances growing at 35% between 2011 and 2015.

The bank's net interest margin (NIM) is expected to decline due to interest rate hikes, although not substantially because of the strong repricing power on the asset side and favorable asset liability duration. Considering the high dependence on bulk deposits, analysts have factored in a 20-basis-point decline in NIM for fiscal 2012.

With gross nonperforming assets of 0.22% and net nonperforming assets of 0.06%, Yes Bank's asset quality remains among the best in the industry. The bank's restructured assets are merely 0.23% of its loans, much lower than those of its peers. Although asset quality risks have emerged from the microfinance, telecom, and real estate sectors, analysts do not foresee any significant deterioration in the bank's asset quality.

The bank's strong earnings growth, consistent return ratios and stable asset quality are positives. The stock is trading at 2.7 times estimated 2012 book value.

IDBI Bank is one the largest private sector banks, dominating the infrastructure lending space.

The September quarter financial indicators signal a turnaround. The bank is embarking on building new franchisees and cleaning its books of nonperforming assets.

The government's capital infusion will fuel higher credit growth, decline cost of funds, thereby aiding net interest margin expansion. Other key positives are the relatively low cost-to-income ratio and higher contribution from fee income.

IDBI is one of the largest loan syndicators in the financing space, which enables it to earn a steady fee income that supports loan book growth. Going forward, the expected follow-on public offer by 2012 will support future growth.

For 2012, analysts expect the bank's net interest margin to improve by 2%, its return on assets to improve by 1% and its return on equity to improve by 17%. The stock is trading at 1.1 times estimated fiscal 2012 adjusted book value.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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