Interest rates may display upward bias over the next two quarters

The interest rates have been rising over the past two years and may continue to be firm for the next 2 quarters, giving rise to ‘mark to market’ losses on the investment portfolio. Rising interest rates would moderate credit growth as the price elasticity of the demand plays out. NIM would be under pressure, due to the lock in at lower yields in existing investment portfolio and fixed rate loans. We also reckon that the industrial capex appears to be in the late cycle which, together with firm interest rates, could lead to higher delinquencies and keep loan loss provisioning high, going forward. As money supply growth continues to remain high at 21% as of 8th June 2007 above the RBI’s target range of 17.0-17.5% and Forex market posing significant challenge, monetary tightening measures could continue. Hence, we expect the business environment to be challenging for the Indian banks.

The massive equity infusion would get fully leveraged only by FY12

The bank has just concluded a follow on domestic public issue of equity & ADR to raise USD 5 billion. As a result, net worth of the bank has gone up by about 80%. This addition to equity in the environment of a credit slowdown, would ensure a suppressed ROE till the time the equity gets adequately leveraged. We reckon that the next full leverage point for the capital, with bank’s tier I Capital to Risk–weighted Assets Ratio (CRAR) dipping below 7%, would not arrive before FY2012. Hence, the maximum ROE of 15.3% is likely to be achieved by the bank only during FY12 and the bank may again tap the capital market during that fiscal, given its past track record of tapping capital markets aggressively. But until then, ROE, which is just 13.2% at present, is likely to remain low and depress the valuations.

Outlook and valuation

We expect the credit growth to slow down marginally to 30% and 27% over the next two fiscals but NIM is expected to expand by 41 bps during the current fiscal to 2.97%. We have projected rising delinquencies of 1.75% for FY08 and 2.1% for FY09 & FY10. The feebased income would grow by 34% to 40% during the next 5 years. With these assumptions, we expect the bank to achieve a net profit CAGR of 27.5% and maximum ROE of 15.3% during FY12. With ROE of 15.3%, cost of equity at 12.75% and terminal growth rate at 8.5%, we ascertain fair book value at 1.6x, using Gordon’s growth model. Hence, we value the stock at Rs 662 on a stand-alone basis at 1.6x of FY08, 75% ABV of Rs.413. We value the contribution by subsidiaries at Rs.238 per share. The SOTP valuation of the stock is thus estimated at Rs 900 per share. Since the target price indicates a downside of 4% from the current market price of Rs 935, we rate the stock as ‘Underperformer’.