Low valuations offer opportunity to capitalise on the potential turnaround.

In the 2012 stock market rally, Punjab National Bank (PNB) underperformed with returns of 13 per cent. The bank witnessed steep slippages in the vulnerable agriculture and small and medium enterprise (SME) segments.

Weak asset quality, high levels of restructured assets and elevated provisioning constrained earnings growth.

However, the bank is consolidating its SME and agriculture loan book to reduce further deterioration in asset quality.

With interest rates expected to moderate, the SME segment, in particular, is expected to witness improvement in asset quality. Also, amidst a tight fiscal situation, the forthcoming budget for 2013-14 may not feature big freebies in the form of cheaper crop loans.

The recent December quarter results of the bank hint at the first signs of a turnaround. While asset quality remains a risk for PNB, the bank’s low valuation of 1.1 times adjusted book value for 2013-14 (versus a historic average of 1.4) provides a case for buying the stock.

Where it slipped

PNB has one of the highest exposures to the infrastructure and power sectors among its peers. The growth in loan book last fiscal was led by growth in stressed sectors.

Infrastructure lending grew around 29 per cent in the year ended March 2012, power 43 per cent, and agriculture 29.5 per cent. Of the total restructured assets during 2011-12, over half came from the infrastructure space.

Asset quality deterioration loomed with gross non-performing assets (GNPA) in absolute terms almost doubling over the year. The other key concern has been the significant decline in low cost CASA (current account savings account) ratio from 38 per cent in 2010-11 to 35 per cent in 2011-12.

A larger share of bulk deposits increased the cost of deposits from 4.9 per cent to 6.2 per cent and led to contraction in the net interest margins (NIMs) by 40 bps in 2011-12 to 3.5 per cent.

The first half of 2012-13 saw weakness continue with provisioning costs at 1.3 per cent and NIMs at 3.5 per cent.

First signs of recovery

But the recent December quarter results have been better than expected, and the stock has rallied somewhat. The highlight was higher recoveries and upgrades (around Rs 3,000 crore). While slippages continued to remain high, (4 per cent of loans), gross and net NPAs declined marginally (0.2 per cent and 3.8 per cent).

Also, profit growth at 13.5 per cent year-on-year was better than expected, primarily on account of lower provisioning. Following the conscious strategy of shedding high-cost deposits, the bank’s share of bulk deposits in total deposits has come down to 15 per cent as against 24 per cent a year ago. While loan book growth moderated to 13 per cent (with subdued growth in large corporate and MSME segment), retail loans witnessed healthy growth of 16.5 per cent.

The risk/reward trade-off

PNB is well-positioned to benefit from a recovery in the macro environment. It still has the structural advantage of a higher CASA ratio (36.9 per cent as of December 2012), better NIMs and return ratios in comparison to its PSU peers.

While consolidation of its agriculture and SME portfolios is on, PNB’s focus on retail loans may aid loan growth of 16 per cent in 2013-14. Reduced bulk deposits may help maintain the NIMs at 3.3 per cent, despite lower yield on advances and cut in base rates (PNB cut base rate by 25 bps recently). Asset quality concerns, however, continue to be an overhang on the stock

The restructured assets still remain high at 10 per cent of loan book. This is a key risk if the RBI’s recent draft guidelines on restructuring are implemented.

Hence, investors should be aware of the high return-high risk nature of the stock.

The sensitivity analysis assessing different asset quality scenarios (see Table), indicates the downside risk on the stock.

Valuations

On a base case, we assume credit/deposit growth at 16/15 per cent for 2013-14. The available for sale (AFS) portion of investments (at 28 per cent) is expected to result in treasury gains in a declining yield scenario. Overall, we assume an annual earnings growth of 19 per cent from 2013-15 and the pace of recovery to be gradual with provisioning cost at 1.1 per cent for 2013-14.

We have valued the stock on adjusted book value (ABV) taking into account 100 per cent of net NPA. We value the stock at 1.25 times 2013-14 ABV with a target price of Rs 1039.

(This article was published on February 9, 2013)
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