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Financial Q4FY18 preview - All eyes on slippage; NBFCs to report a robust quarter

Key sector highlights for the quarter: 1) 4Q18 earnings will be weak for corporate banks with a sharp increase in slippages driven by the new debt code. While most of the slippage will be from the pool of bad debts already disclosed by banks, credit cost will rise and provisioning cover will likely fall. As for the state owned banks, even strong banks like BoB and SBI may see their net NPL levels getting close to the mark which triggers PCA by the central bank. But we believe RBI will take a more pragmatic view of PCA for 4Q given that it will be extraordinary in terms of slippages. 2) Loan growth at 10.7% yoy and 2.8% qoq is higher than in 3Q driven by the base effect of demonetization. Retail loan growth continues to outpace corporate loan growth with retail loans growing 17.2% yoy and 4.9% qoq and corporate loans growing 0.4% yoy and 0.2% qoq. There are no visible signs of loan growth accelerating in any meaningful way in FY19E. 3) Incremental deposit growth is slowing down and banks have started hiking rates for a few segments. YoY deposit growth looks low at 3% partly because of a high base from demonetization. 4) After rising sharply, bond yields fell in the last week with the government announcing lower than expected borrowing in 1HFY19E. In addition, RBI’s dispensation that banks can amortize mark-to market losses of 3Q and 4Q will be a much needed relief for banks. In addition to being able to amortize MTM provisions of 4Q, banks will also be able to write back half the MTM provisions they made for 3Q.

Slippage led by power, OP Jindal, Garden, Aircel: Slippages will be high driven by RBI’s new debt code and also RBI’s hard stance on divergence. We believe following the PNB scam, RBI has taken an even tougher stance on divergence. We understand that RBI had recently called the heads of audit committee of banks to discuss how divergence should be minimized. Based on RBI’s new debt code of Feb 12, existing SDRs will slip as most SDR accounts will likely be 90 days past due. There will be some borderline cases like Essar Power Gujarat where SDR was invoked in December and may complete 90 days in 1Q. We have assumed that all SDRs will slip. A large proportion of S4As will also slip because of stricter definitions of implementation such as lack perfection of security.  While existing 5:25 and outstanding restructured loans should not be impacted by the new debt code, banks and auditors may now not want to risk divergence and will use this opportunity to downgrade all weak accounts in these segments also. Power loans will be a key contributor to slippage. In addition, many OP Jindal group companies – JSL, Jindal Steel Hissar and Garden Silk (SDR) will also slip from the existing stress pool. Besides, there will be three large accounts outside the stress pool that will slip – Gitanjali group, Nirav Modi group and Aircel. We expect slippage of 2 to 12% of lagged loans for state banks and 9 to 25% for private corporate banks. We have assumed that all border line cases slip given RBI’s tough stand on divergence but auditors can take a different view and defer some slippage to 1Q.

PNB allowed spreading scam related loss over 4 quarters: Bloomberg has reported that PNB has got approval to spread Nirav Modi related losses over 4 quarters. If only those LoUs that mature in FY18 are accounted for and provisioning is spread over 4 quarters, PNB’s loss will be Rs21bn, CET1 will stay at above 8% while net NPLs will be above 9%. If the entire provisioning is taken upfront, the bank will report a loss of Rs132bn and CET1 will fall to 6.5%. In both cases, PNB becomes a PCA candidate for high net NPLs.

Stock specific – earnings expectations: IIB, HDBK, YES, KMB are expected to report healthy earnings growth among banks. We expect state banks to post a combined loss of Rs82.2bn versus loss of Rs56.7bn in 3 Q18 and loss of Rs39.6bn in 4Q17. Each bank will post a loss. We expect ICICI and AXIS to report weak earnings. NBFCs will likely report a strong 4Q with strong loan and earnings growth. MMFS, SHTF and HDFC will post strong earnings and offer good risk reward. LICHF which has consistently disappointed on earnings will also show a sequential recovery in 4Q driven by the seasonal 4Q pick up and lower credit cost which was inflated in the last few quarters due to worsening of the developer loan portfolio.

Recommendations: We prefer retail banks and NBFCs over corporate banks. We believe on most parameters including loan growth, capitalization, future NIMs, asset quality and RoE state banks continue to rate poorly. IIB and HDFC Bank remain our top picks. We believe there is no rush to buy private corporate banks despite a sharp correction in their valuations. The only two corporate bank stocks where we have an Outperformer rating are ICBK and BoB. We believe these will also underperform in the short term.

RBI will get stricter going ahead: We believe RBI is getting stricter about divergence and re-appointments of existing CeOs. Re-appointment will be a key monitorable for banks where CeO terms are ending soon.