Valuations of Indian banks within palatable range; quality remains key driver: Jefferies’ Prakhar Sharma

Indian banks are entering a phase of cautious optimism with valuations seen as reasonable and quality continuing to remain the key differentiator, according to Prakhar Sharma, Financial Services Analyst at Jefferies India.

Speaking to CNBC-TV18, Sharma noted that both credit and deposits are growing at around 10%, which is broadly in line with the Reserve Bank of India’s target. “We should always keep in mind that inflation being at a very, very low level probably has a drag of maybe about 150 to 200 basis points vis-à-vis a normal level. So, what used to be 4–5% inflation, which feeds into credit growth, is probably running at 2%, and therefore, the like-to-like number, I think we are running at somewhere close to 12%,” he said.

He added that the sentiment in the sector is upbeat, helped by policy measures. “Bank CEOs are seeing potential benefits of the recent cut in GST. The government had also come down with a decent cut in income tax rates, which boosted middle-class income by about 5–7%, and the RBI has given rate cuts and liquidity improvements. So, the expectation among most of the people and management we have interacted with is optimism that we should see decent demand starting next week,” Sharma said.

On valuations, Sharma pointed out that Indian banks are trading at reasonable levels compared to global peers. “Good, high-quality stocks that deliver high teens RoEs are trading between 15–16 times earnings. In many ways, Indian stocks are not significantly cheap—but in some cases they are even at a discount to large global banks,” he said, while stressing that Jefferies’ preference remains with quality names.

Sharma played down concerns around asset quality, particularly in the SME segment. He said the stress seen recently is not widespread and may be temporary. “From our top-down perspective, the retail unsecured part may have issues only for about a quarter at best. Many have already started to see it fading out. A couple of banks in the previous calls said that either things have stabilised or have started to improve. So, I’m not really concerned about asset quality,” he said.

Below is the verbatim transcript of the interview.

Q: Let's see the big picture on the banks. We've all been waiting for banking growth to come back in a big way. It hasn't so far. I think the system-wide loan growth has barely been close to about 10% for the last couple of quarters. Are you seeing a pickup? What would the number look like? And what is the broad call on the Indian financial space? Do you like it? Which segments of it do you like?

Sharma: I think the bank credit as well as deposits have aligned at about 10%, which is where the RBI also wanted to go. We should always keep in mind that inflation being at a very, very low level probably has a drag of maybe about 150 to 200 basis points vis-à-vis a normal level. So, what used to be 4–5% inflation, which feeds into credit growth, is probably running at 2%, and therefore, the like-to-like number, I think we are running at somewhere close to 12%. As the inflation base normalises, we'll probably get there.

I think the mood is one of optimism. Bank CEOs are seeing potential benefits of the recent cut in GST. The government had also come down with a decent cut in income tax rates, which boosted middle-class income by about 5–7%, and the RBI has given rate cuts and liquidity improvements. So, the expectation among most of the people and management we have interacted with is optimism that we should see decent demand starting next week, when we get into a new GST regime. We keep our fingers crossed for that.

Q: Prakhar, if we are seeing a pickup happening next week, could that continue by the end of this fiscal as well? What is your take? Do you prefer private banks versus public sector banks? In terms of valuations where do things stand right now?

Sharma: We are restricted from making specific comments. At a very broad level, in the Indian banking sector, we think that valuations are actually within a very palatable range. Good, high-quality stocks that deliver high teens RoEs are trading between 15–16 times earnings. In many ways, Indian stocks are not significantly cheap—in some cases, even at a discount to large global banks.

Globally, we’ve seen banks rally and their valuations have also re-rated. In that context, Indian banks do not appear particularly expensive. Our preference has always been to own quality, and we think that quality drives growth in deposits, which allows growth in credit. Most investors come to India for growth and quality; quality still remains. Growth depends on the expectation of benefits from all the changes that have been done by the RBI, the government, and the banks themselves. The second half should be a period where we see those benefits come through. I'll just avoid making specific comments on banks.

Q: In the previous quarter, most banks that reported results—barring a few large ones—had two issues. There was some asset quality pressure; slippages had increased, and they had also spoken about credit costs remaining at elevated levels. There is commentary suggesting that credit costs will continue to remain elevated, particularly because of stress seen in specific segments like the SME market. Do you believe that this will continue to weigh on earnings going forward, even if their bottom line continues to recover? Asset quality stress would be a concern even if valuations are palatable.

Sharma: In my view, the stress we are seeing in the SME segment is not widespread. Most large banks as well as NBFCs have not seen any significant stress coming through. That is one line of thought the large banks have reiterated at our conference. Even within NBFCs, slow economic growth and something around tariffs might have led to some asset quality pressures.

As we all know, Q1 is a seasonally weak period. There were unseasonal rains, which might have accentuated the cash flow impact on the SME sector. But I don’t think this is a widespread issue. Some companies may face issues depending on their clients. Even in the retail unsecured segment, we are at the fag end of the cycle. The RBI came in timely to warn most banks and NBFCs of potential stress.

From our top-down perspective, the retail unsecured part may have issues only for about a quarter at best. Many have already started to see it fading out. A couple of banks in the previous calls said that either things have stabilised or have started to improve. So, I’m not really concerned about asset quality. Wherever stress came last year is already fading. SME stress, in my view, is not widespread issue at all.

Q: Do you look at the exchanges space? There is a regulatory overhang. How do you expect it to play out?

Sharma: The SEBI and the exchanges are planning to take a consultative approach. SEBI chairman has been very clear. There were indications that the expiry period will be extended from weekly to either fortnightly or monthly. Let’s wait for the guidelines to come. It is an issue relevant for exchanges. Thankfully, we have well-run and profitable exchanges, so whatever approach they take will not disrupt the market. It will likely be a phased implementation.

Q: Another big update with respect to GST has been the insurance space. While talking about the exempt status coming in for insurance premiums, the input tax credit being unavailable continues to be a worry. How do you look at insurance players right now? Do you think there will be an increase in premiums to pass on the increase in costs? What’s the overall take on the stocks?

Sharma: Generally speaking, the GST issue relates to the loss of input tax credit, especially for cost items like commissions and other expenses where paying GST is not permissible to be taken as credit. The industry, as well as IRDAI, are in discussions. The industry is being careful. They see this as an opportunity to deepen penetration in the sector. At the same time, they are consulting with the government to see if a middle path can be struck.

If it doesn’t come through, there may be some impact. Insurance companies will try to manage this with better product mix and distribution commission changes. Consultations are ongoing. It is important for the government to recognise that this is an important product. The exempt category puts it on the right side of government policy making as well.

Q: A decade ago, when insurance companies went public, the narrative was that insurance is under-penetrated in the country. That narrative still exists today. Despite all the reforms and GST changes, does the under-penetration factor remain the main reason someone should invest in these companies? Without asking for a specific recommendation, where does your preference lie within this space—life insurance, general, or health insurance?

Sharma: In the Indian context, life insurance companies have run their business very well. They have not seen risks from the assets they hold for policyholders, have managed interest rate cycles well, and have maintained decent profitability. The sector doesn’t trade at obscenely expensive valuations. It is very well-run sector.

There have been some regulatory changes that caused near-term issues in growth, but those are settling. We should have a few good years of consistent growth in life insurance. General insurance has fewer direct listings but is also a fairly good sector from an RoE perspective. There are drags on profitability due to pricing and competitive intensity, but the sector has continued to deepen penetration. So, it is a very well-run sector. Despite some economic and sector-specific issues they have done fairly well.