The Hindu Business Line : Union Bank of India: Buy

Strong thrust on SME and farm credit as also prudent asset management are likely to improve Union Bank's profitability, while progress in fee income remains a challenge.

30 per cent decline in Q1 earnings
Share of low-cost deposits improves
Expects 21 per cent business growth in FY-07
Bond book largely insulated
Trading at P/BV of 1.3 times; RONW of 22 per cent

MR M. V. NAIR (RIGHT), CMD, and Mr R. S. Reddy, Executive Director

Union Bank of India is among the few public sector outfits to record consistent business growth over the last few years. The last two quarters, however, proved disappointing. We expect the picture to change over the next year or so. Strong business outlook, sharper focus on managing bad loans, greater thrust on small and medium enterprises (SME), farm lending and attractive valuations lend credibility to the Union Bank stock.

Fresh exposure can be contemplated at its current price of about Rs 115. We, however, recommend that investors buy the stock in small lots and moderate their return expectations on the back of near-term volatility in the market. Any price weakness in the stock linked to the broad market can be used to step up exposure. Higher provisioning and tax outgo resulted in Union Bank reporting a subdued performance for the June quarter. This affected the bank's earnings, which dipped 30 per cent on a year-on-year (Y-o-Y) basis.

Provisions for tax, non-performing assets (NPAs) and investments rose 150 per cent, 129 per cent and 187 per cent respectively; total provisions thus more than doubled.

However, the momentum in the business growth has been strong. Growth in advances was 34 per cent and deposit accretion 21 per cent compared to the industry averages of 31 per cent and 20 per cent respectively.

Focus on low-cost deposits

Banking on business growth.

A key improvement has been in low-cost deposits, which have grown 27 per cent and now constitute about 34 per cent of the total deposits against 30 per cent a year ago. If the bank manages to mop up this base, the margins could improve. Yields on advances improved by about 15 basis points.

The benefit of this was, however, more than offset by the declining yields on investment and the rising cost of deposits. Hence, the net interest margin (NIM) fell to 2.9 per cent from 3 per cent in the corresponding previous quarter. On the net interest income (NII) front, Union Bank fared well. Brisk credit growth helped the bank's NII rise 19 per cent against 15 per cent for most of its peers in the public sector.

Union Bank intends notching up a total business of Rs 1.6 lakh crore for the financial year ending March 2007, up from Rs 1.32 lakh crore now.

It expects to generate additional business from such key areas as agriculture and SMEs. SME and agriculture loans make for 12.5 per cent and 16 per cent respectively of its total loan portfolio now. Union Bank intends this share to 20 per cent each by 2010.

Over the last couple of years banks have expanded in a big way their retail assets — housing loans being the largest contributor.

With higher risk weightage on housing and real-estate loans, banks are likely to tighten their exposure to these sectors. They are increasingly looking at farm credit, which is likely to be the next frontier.

With an assured minimum return of 9 per cent and a risk cover in most cases, farm loans are turning out to be attractive. Union Bank, with close to 40 per cent of its branches in the rural areas, is well-placed to reap the benefits.

Union Bank has also charted out an expansion plan abroad. It plans to open branches and offices in Hong Kong, Dubai and Shanghai. If it succeeds in getting the regulatory clearances, the bank may corner a share in the global business.

Insulated bond book

Union Bank now has 95 per cent of government securities under HTM (held-to-maturity) category. This makes its bond book less vulnerable to the risk of rising interest rate.

Asset quality

With a combination of measures ranging from strict credit monitoring to faster recoveries, Union Bank has brought down the level of non-performing assets to 1.2 per cent of net advances from 2.4 per cent a year ago.

The bank, which has a gross NPA level of Rs 2,098 crore, plans to bring it down to Rs 1,500 crore by the end of this fiscal. It had a cash recovery of Rs 365 crore in FY-06 and has set the same amount as the target for September 2006. The bank's efforts to reduce the slippage also appear to have paid off.

Last year, the bank had a slippage of Rs 752 crore and plans to restrict it to Rs 335 crore this year. In the first quarter, with total advances of Rs 55,802 crore, the bank's slippage was Rs 78 crore and recovery Rs 193 crore.

Having got the board's nod, the bank is considering selling NPAs in the secondary market in the near future. If Union Bank manages to dispose off its bad loans on fairly reasonable terms, it can clean up its loan book and boost its profitability.

Attractively valued

The Union Bank stock trades at a price-to-book ratio of 1.3 times its trailing 12-month earnings. It has one of the higher debt-equity ratios in the industry. This exaggerates its return on net worth which, at about 22 per cent, puts it in the top league.

Assuming an earnings growth of 10-12 per cent over the next year or two, the return on net worth works out to 20 per cent. This is superior compared to most of its peers, strengthening its case for investment.

Key concerns

Union Bank's capital adequacy ratio is 11.3 per cent. Taking into account the credit growth and the Basel-II requirements, the bank is likely to raise fresh capital.

With the Government holding at about 55 per cent, there is still room for raising equity. If the bank adopts this route, there is the likelihood of some contraction in its RONW (return on net worth).

Although the possibility of equity expansion cannot be ruled out, we believe the bank is likely to explore the option of issuing debt capital to shore up its CAR (capital adequacy ratio). While this may put pressure on its return on assets, the decline is likely to be offset by an expansion in RONW.

The bank's progress in enhancing its fee income has been rather slow.

The proportion of the fee income to the total has been stable at 10 per cent over the last one year, while it is 15-18 per cent for many of its peers in the public sector.

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